Intermediaries are vital for a well-functioning financial system and allow their clients to solve the problems they face more efficiently than they could by themselves.
We find several types:
- Brokers, Exchanges, and Alternative trading systems
- Dealers and Securitizers
- Depository Institutions
- Insurance Companies
- Arbitrageurs, and
- Clearinghouses and Custodians
Let’s take a closer look at Dealers and Securitizers.
What Is a Dealer?
Unlike brokers, these financial intermediaries can buy and sell securities on their behalf.
Dealers act as a principal for their own account and can fill clients’ orders by trading from their own inventory. They can buy a security directly from the market or borrow it in order to complete the trade. This feature provides liquidity to the market because clients know that their orders will be promptly executed. Keep in mind that dealers profit from the difference between the buying and the selling price of an asset, also referred to as “spread”.
In practice, dealers might also act as brokers, which we call broker-dealers.
Broker-dealers have an inherent conflict of interest. As brokers, they seek the best prices for their clients, but as dealers, their goal is to profit through prices or spreads. That’s why traders typically place limits on how their orders are filled when they transact with broker-dealers.
What Are Securitizers?
These entities are usually banks and investment companies that pool various financial assets into one group. The process is called securitization; it involves converting the assets into a marketable security, which is then sold to investors.
Imagine that a bank provides mortgage loans to hundreds of homeowners. Each loan represents an asset on the bank’s balance sheet, right?
If the bank combines the loans into a pool and sells shares of that pool to investors as securities, it implements securitization. In this context, the bank is an intermediary that connects investors who want to buy mortgages with homeowners who want to borrow money. By buying into the security, investors effectively take the position of the lender. This allows the bank to remove the associated assets from its balance sheets.
How do the involved parties make money? Investors earn a rate of return based on the associated interest and principal payments made by the homeowners, whereas the bank receives an administration fee for servicing the portfolio, plus the price of the mortgage-backed security (or MBS).
Along the way, securitizers often create several classes of securities, called tranches.
The latter give certain rights to the cash flows from the asset pool. Those who receive their returns first are more likely to be paid and thus require lower yields for their investment. Alternatively, buyers that are compensated last are least likely to benefit in case of default, and therefore expect higher yields for their investment. Practitioners often call the most junior tranche “toxic waste” because it is very risky. After all, the higher the risk, the higher the return…
Securitization ― Benefits and Drawbacks
First and foremost, the process creates liquidity by letting retail investors purchase shares in instruments that would normally be unavailable to them.
Moreover, it builds up a diversified portfolio of assets with a more predictable cash flow structure compared to that of individual assets.
What about the shortcomings?
Even though the securities are backed up by tangible assets, there is no guarantee that they will maintain their value should a debtor cease payment.
In addition, different tranches can carry different risk levels. So, investors must fully understand the debt underlying the product they buy.
Another risk for the investor is that the borrower may pay off the debt early. When interest rates fall, they may refinance the debt. And so, early repayment will reduce the returns the investor receives.
Dealers are market makers that profit from the bid-ask spread. They trade for their own account and create market liquidity. By contrast, a securitizer is a financial institution that converts its receivables into a marketable security, further sold to investors.
You may now want to find out more about the third financial intermediary ― Depository Institutions.