Roles

In general, there are three participants (roles) you’ll need to be aware of that operate in the secondary market:

• Traders
• Broker-dealers
• Market makers

Traders

Traders are natural persons (human beings) or entities (businesses or organizations) that buy and sell securities on behalf of their clients. However, traders rarely speak with or maintain relationships with clients. For example, many mutual funds employ several or dozens of traders to fulfill the strategy of the fund manager. The fund manager may create and adjust the fund’s strategy, but traders execute the strategy by buying and selling securities for the fund. Traders that work for large portfolios (like mutual funds) generally do not maintain relationships with their clients (those who invest in the portfolios).

Broker-dealers

Broker-dealers are financial firms in the business of performing securities transactions on behalf of others (broker/agency) or for their own account (dealer/principal). In plain English, broker-dealers help their customers trade securities and make a profit doing so. 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:

• Fidelity Investments
• Charles Schwab
• Wells Fargo
• Edward Jones
• TD Ameritrade

While traders and broker-dealers sound similar, broker-dealers tend to maintain relationships with their clients, while traders do not. If you currently have an account at a broker-dealer, you’re probably offered various services like retirement planning, portfolio analysis, and cash management. Relationship management is an important part of a broker-dealer’s business model due to competition and ease of moving assets (it’s very quick and easy to move assets from broker-dealer to broker-dealer). On the other hand, traders simply trade for their clients usually because it’s their sole job as a part of a large portfolio.

Market makers

Market makers are financial organizations that buy from and sell securities solely on a principal basis (with inventory) to traders, broker-dealers, and other public customers. These organizations maintain ongoing bid & ask spreads (see below), which are prices they’re willing to trade securities at. Market makers serve a very important function in the financial markets as they provide much-needed liquidity for the securities they trade.

The last paragraph is full of financial lingo, so let’s discuss the topic in plain terms. Assume you have a large inventory of apples (for whatever reason). If you put an apple stand in front of your house with a sign that said:

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 apples, which makes you an apple market maker. The $1 apple quote is your bid (the price you’re willing to buy apples at) and the $2 apple quote is your ask (the price you’re willing to sell apples at). Your presence in the neighborhood makes it very easy to buy and sell apples, which is 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 make a profit doing so. They maintain bid and ask prices (discussed in more detail below) which enable profits while adding liquidity to the market. If you place a trade with a broker-dealer*, the firm is most likely to send your trade to a market maker, who then fulfills the trade request. With most publicly traded stocks (especially those that are listed on exchanges), there are dozens of market makers trading the security. Traders and broker-dealers seek out market makers with the best possible price to maximize returns 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.