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An Introduction to Trading in the Financial Markets
Market Basics
By R. "Tee" Williams
Academic Press
Copyright © 2011 Elsevier Inc.
All right reserved. ISBN: 978-0-08-095117-1
Chapter One
The Buy Side
We begin our discussion of participants in the markets by exploring the buy side. These are firms and individuals that use the services of intermediaries (the sell side) to raise capital and to trade instruments both for investment and to profit from trading. Figure 1.1 shows buy-side entities.
NONFINANCIAL COMPANIES
Nonfinancial companies have two primary roles within the trading markets (see Figure 1.1.1). First, nonfinancial companies, together with many financial companies, are customers of the investment banking activities that comprise the primary market described in Parts 3 and 4. In addition, some nonfinancial companies are active participants in trading either by actively purchasing commodities (Part 2) in the cash market, hedging their financial transactions with derivatives (also Part 2), or in some cases actively managing their excess cash by investing in securities and other instruments.
Business Models
Nonfinancial companies do not typically profit directly from the financial markets (see Figure 1.1.1.1). Some nonfinancial companies do invest cash balances and trade in commodities markets to fulfill needs for raw materials, but such companies are just traders and investors in the context of the markets. Nonfinancial companies are major contributors to the revenues of the sell side when they buy investment banking and securitized financing services. (See Book 2, An Introduction to Trading in the Financial Markets: Trading, Markets, Instruments, and Processes, for an explanation of securitization.)
RETAIL INVESTORS
Individuals investing for their own accounts are small players by themselves in the overall markets. Collectively, however, Retail investors represent a significant portion of the total invested funds. Although the investments of individuals are significant in most markets, they typically represent a smaller portion of aggregate assets than institutional investors (see Figure 1.1.2). Individual investors perform most of the tasks described in the trading process (see the discussion around Figure OV.1 in the "Overview"), although they typically do not have a say in where their orders are routed.
Business Models
Retail investors profit from income paid by traded instruments and from appreciation in the market value of their instruments (see Figure 1.1.2.1). Individuals provide revenues to the institutional buy side through the fees they pay, both directly and indirectly, for investment management services. They pay commissions and spreads to the sell side for direct securities purchases and sales and fees for assets held for their benefit by sell-side firms. They are indirectly responsible for institutional commissions and spreads for the funds managed on their own behalf.
INSTITUTIONAL INVESTORS
Firms that have as their business purpose the management of money for others are collectively referred to as investment managers, institutional investors, or money managers. These generic terms refer to a wide array of entities operating under differing financial regulations. The financial regulations generally circumscribe the activities of entities within each regulatory category, define the way the regulated firms must conduct their business, demand a level of professional conduct, and require explicit reporting on activities. Most regulation is intended to protect the interests of the customers of these institutional investors. Typical regulatory distinctions for investment managers include the categories shown in Figure 1.1.3.
Investment Counselors
Investment counselors typically manage investments for individuals as separate accounts owned by the individual (see Figure 1.1.3.1). Each account in turn may be invested either in part or completely in pooled investments, but the counselor has a direct relationship with the investor.
Providing individualized services to retail customers involves significant administrative burdens for the investment counsel firm. As a result, these services have typically been reserved for very wealthy individuals. However, broker/dealers have created products known as wrap accounts in which a broker/dealer offers individualized investing to the broker/dealer's customers. An investment firm actually manages the investment activities, and the broker/dealer handles the direct customer relationship. This makes individualized investment services possible for less wealthy retail customers.
Packaged-Investments Managers
Mutual funds and unit trusts permit an investor with limited funds the opportunity to purchase a share in a pool of investments that contains the combined funds of a large group of smaller investors. These investment pools offer the benefit of a professional manager and portfolio diversification that would otherwise be unavailable to an investor with modest funds.
Unlike an investment counselor, a mutual fund or unit trust manager does not have a direct or personal relationship with the individual investor. Instead, the investor purchases shares or units of the investment pool, and must rely on the stated purpose of the investment's funds or units defined in marketing materials to assess the suitability of the investments for his or her purposes (see Figure 1.1.3.2).
Trustees
Some investment organizations such as trustees assume special responsibilities beyond managing invested funds for a profit (see Figure 1.1.3.3). One typical case occurs when funds are placed in a trust for an individual, and the manager is given responsibility not only to invest the funds, but also to control how and when money from the fund is paid to the individual and how it can be used. This is referred to as a personal trust. A second case involves a situation in which the money left by an individual at the time of his or her death is managed while the funds are being paid out as instructed by the individual's will, or managed over longer periods of time for specific purposes established by the will.
A fund managed on behalf of a person who is deceased is called an estate. A third type of trust is created when money is donated with specific instructions concerning how the donated funds are to be managed for an organization or special purpose. There can be a wide variety of trusts or estates with differing characteristics.
The authority for managing funds in these manners may require a trustee, who is an individual or organization granted the authority to manage trusts and estates by regulators. Banks and lawyers often have trust powers. Trust accounts may have the standing of an "individual" under the law. Therefore, trustees are able to bring lawsuits on behalf of the trust, and trust accounts may have special tax obligations that the trustee must file and pay.
In addition to other special trust powers, trust and estate managers have special responsibilities known as fiduciary obligations. A fiduciary is required by law to act with respect to the funds in his or her care as a "prudent man would manage his own money." This is known as the prudent man rule.
Eleemosynary funds refer to money set aside to be invested to benefit charitable purposes and educational institutions. Eleemosynary funds may require unique management skills and responsibilities as well. Managers of these funds are treated as fiduciaries, and some are trustees.
Pension Fund Managers
Pensions and other types of retirement funds often have special tax treatment or implications for the individuals who benefit from the pensions. Retirement funds also require that managers of the funds act as fiduciaries on behalf of the individuals covered by the plan. In particular, pension managers must take special care to ensure that the funds under their control are managed in a reasonable manner without excessive risks, and that all aspects of management are conducted in a professional manner. Pensions were among the first funds for which managers were charged with best execution requirements, which demand that all trades for the fund be effected with the lowest possible net transaction costs (see Figure 1.1.3.4).
Insurance Companies
There are two primary types of insurance in most markets. Life insurance provides a component of protection against death and, in the case of whole-life insurance, also provides investment returns as well. Whole-life insurance is one of the first forms of private investment in most markets, and the premiums paid are invested on behalf of the insured (see Figure 1.1.3.5). Premiums for whole-life insurance have two components. The first component pays the cost of the insurance against the death of the insured. The second component is an investment that belongs to the policy owner. Term-life insurance provides protection against death only and does not include an investment asset.
The second type of insurance is known as property and casualty insurance. "Property and casualty" is a collective term for insurance against specific types of risk such as property loss through fire, flood, or theft as well as medical costs and business losses. Premiums for property and casualty insurance are paid to the insurance company, which has the obligation to protect against the insured type of loss but is free to invest the premiums as it sees fit. However, insurance investments are often constrained by regulations.
For the purposes of this set of books, insurance is of interest primarily because it generates huge quantities of investable funds. We leave the description of the risk mitigation part of the insurance business to others.
Hedge Funds
Finally, the most aggressively managed fund groups are collectively known as hedge funds (see Figure 1.1.3.6). Hedge funds originally got their name from investing in a variety of different strategies in order to "insure" or hedge portfolios. These hedging strategies often included aggressive techniques. Regulators do not believe risky strategies are appropriate for less sophisticated investors who may not understand the risks involved or investors who are not able to absorb a significant loss. Therefore, hedge funds are not permitted to seek investors who are not able to demonstrate a level of sophistication and a relatively high net worth. (Actual requirements differ from country to country and over time.) Also, hedge funds are often regulated as partnerships, and the total number of investors may be limited.
Buy-Side Business Models
Generally buy-side firms charge fees for managing funds that are a percentage of the funds being managed (see Figure 1.1.3.7). These fees vary but are usually only a few percentage points of the funds-under-management except for hedge funds that often charge substantial fees for presumed better returns. The advantage of a fee based on a percentage of funds-under-management is that there is an implicit incentive for the manager to make money for the client because the fees rise as the value of the fund increases. For some kinds of funds and in some regulatory environments, fees may be regulated or capped. In most markets, competitive forces limit fees.
An important factor in the economics of fund management is that any costs directly attributable to the management of the fund are charged against the fund. This means that the customers pay direct costs while the investment manager pays indirect costs from the manager's revenues. Regulators may define the distinction between direct and indirect costs, but a working definition is that a direct cost is any cost necessary to provide the investment service.
As an example, the commission paid for a trade is a direct cost, whereas rent on the building where an investment manager works is an indirect cost. Because direct costs are paid by the fund, there is a strong incentive for the manager to convert as many costs as possible to direct costs. We explore this topic in more detail in Book 2, where we discuss soft dollars or soft commissions.
Chapter Two
The Sell Side
Next, we look at the organizations that provide intermediary services, that is, the sell side. Sell-side firms provide both capital-raising and trading services to the buy side (see Figure 1.2).
BROKERS, DEALERS, AND BROKER/DEALERS
The sell side is composed of firms performing the functions of brokers and dealers. These functions are described in detail in Part 4, but briefly a broker (or agent) operates on behalf of investors or other brokers. Dealers act for their own benefit buying and selling as principals. Firms that act as both brokers and dealers are referred to as "broker/ dealers." Broker/dealers are also commonly referred to as "brokerage firms" or "investment banks" although we use the term "investment bank" more narrowly.
Broker/dealers perform a variety of tasks, but they have two major roles. The first role is to help companies and governments raise money to fund their operations by issuing new securities. The second role is to help customers buy and sell securities that are already issued. We describe the many tasks of broker/dealers in Part 4 on functions.
It is important to understand what we mean by the terms "broker," "dealer," and "broker/dealers." Categories of sell-side firms are grouped by these three categories in Figure 1.2.0 and are also differentiated by whether they service retail or institutional customers.
BROKERS OR AGENTS
A broker is an individual or organization that is permitted to buy or sell securities or other instruments on behalf of others. Another term for a broker is "agent." An agent or broker is paid a commission for the transaction by the individual or organization for which the service is performed. A broker is expected to look out for the best interest of his or her customer, and the broker should not profit from knowledge of a customer's intentions at the customer's expense. This is shown in Figure 1.2.1.
Several types of firms specialize in doing agency-only business. These firms often promote their business by emphasizing that in trading they are always acting in the best interest of their customers. Also, the amount of capital required for trading as an agent is substantially less than is required for a dealer.
Retail
A number of firms specialize in offering agent-only services to retail customers. The retail brokers we place in this category tend to have branch offices in shopping malls, on high streets, and in other public places. Retail sales agents operate from these branches dealing with customers in person or by phone. Figure 1.2.1.1 includes two different types of firms that in most cases provide only agency services for retail customers.
INTRODUCING FIRMS
Some retail brokers do not perform their own processing for customers, securities, or both. They use the services of a correspondent broker/dealer described later. Firms that perform only the selling function of the brokerage process are known as introducing firms because they "introduce" their customers to the markets (see Figure 1.2.1.1.1).
(Continues...)
Excerpted from An Introduction to Trading in the Financial Markets by R. "Tee" Williams Copyright © 2011 by Elsevier Inc. . Excerpted by permission of Academic Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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