In the secondary market, you’ll usually see three main participants (roles):
Traders are individuals (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. In practice, traders typically don’t speak with clients or manage client relationships.
For example, many mutual funds employ several (sometimes dozens of) traders to carry out the fund manager’s strategy. The fund manager designs and adjusts the strategy, and the traders execute it by buying and selling securities for the fund. Traders who work for large portfolios (like mutual funds) generally don’t have relationships with the end investors in those portfolios.
Broker-dealers are financial firms that execute securities transactions either:
In plain terms, broker-dealers help customers trade securities and earn profits for providing that service. They can operate in one of two capacities: agency or principal (discussed in the previous chapter).
Here’s a list of the 5 largest broker-dealers in 2020:
Although traders and broker-dealers can sound similar, there’s an important difference: broker-dealers typically maintain client relationships, while traders usually don’t.
If you have an account at a broker-dealer, you’re often offered services such as retirement planning, portfolio analysis, and cash management. Relationship management matters because competition is high and moving assets from one broker-dealer to another is relatively quick and easy. Traders, by contrast, are usually focused on one core job: executing trades as part of managing a large portfolio.
Market makers are financial organizations that buy and sell securities on a principal basis (from their own inventory) with traders, broker-dealers, and other public customers. They continuously quote bid and ask prices (see below), meaning prices at which they’re willing to buy and sell. Market makers play a key role in financial markets because they provide liquidity in the securities they trade.
That definition includes a lot of market terminology, so it helps to translate it into a simple example.
Assume you have a large inventory of apples. If you set up an apple stand in front of your house with a sign that says:
I will buy or sell apples with anyone who is willing to do so. You can sell an apple to me for $1, or you can buy an apple from me for $2.
You’re willing to trade apples with anyone who wants to buy or sell, which makes you an apple market maker.
Because you’re always available to buy or sell, it becomes easier for others to trade apples. That’s another way of saying apple liquidity is high. If there are multiple apple market makers in your city, liquidity would be even higher.
Now replace apples with securities. Market makers buy and sell securities with the public and earn profits by maintaining bid and ask prices (discussed in more detail below). Those quotes both support liquidity and create an opportunity for profit.
If you place a trade with a broker-dealer*, the firm will often route your order to a market maker, who then fills the trade. For many publicly traded stocks (especially those listed on exchanges), there may be dozens of market makers trading the same security. Traders and broker-dealers look for market makers offering the best available prices to improve results for their clients.
*When investors place trades with broker-dealers, most trades are fulfilled on an agency basis. In this scenario, the broker-dealer connects the investor with a market maker and charges a commission. Broker-dealers have the structure and capacity to act as principals, usually in one of two ways. First, they can act as market makers and trade with the public on a principal basis. Second, they act as dealers while taking part in underwriting syndicates.
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