SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 24)

Brokers and Dealers: The Secondary Market

by

Charles Lamson

Brokers and dealers make up brokerage firms, which are security firms that also facilitate the smooth and orderly functions of secondary financial markets. Brokers arrange trades between buyers and sellers---that is, they arrange for a buyer to purchase securities from a seller. The broker charges a brokerage fee, or commission, for arranging the trade. Dealers are market makers who, in addition to arranging trades between buyers and sellers, stand ready to be a principal in a transaction and may maintain an inventory of securities. Dealers stand ready to purchase and hold previously issued securities sold by investors. The dealer carries an inventory of securities and then sells them to other investors. Since the dealer holds a stock of securities, there is the risk that the price of the securities will fall and the brokerage firm will experience a capital loss.

Types of Orders

Three types of orders may be placed with brokerage firms: market orders, limit orders, and short sells. Market orders direct the broker or dealer to purchase or sell the securities at the present market price. Limit orders instruct the broker or dealer either to purchase the securities at the market price if it is above a certain minimum. Securities are bought at one price (the bid price) and sold at a higher price (the asked price).

A short sell instructs the broker or dealer to borrow shares of stocks and sell them today with the guarantee that the borrowed stocks will be replaced by a particular date in the future. The investor engages in a short sell if he or she believes that the stock's price is going to fall in the future and that the borrowed shares will be paid back with shares purchased in the future at the lower price. If the volume of short sells is very high, this is an indication that investors believe the stock's price is going to fall. If the price does not fall, the buyer of the short sell must purchase the shares at a higher price and thus loses money. If many buyers of short sells are in this position, the market price is pushed even higher.

Margin Loans

Full-service brokerage firms not only arrange for the trading of securities, but they also give investment advice to potential investors. They also make loans called margin loans, to investors to help them purchase securities. In this case, investors do not have to put up funds equal to the full value of the purchase. Rather they can purchase stocks on the margin by borrowing. The margin requirement is the percentage of a stock purchase that can be borrowed as opposed to being paid in readily available funds. Many individual brokerage firms set higher margin requirements and vary those requirements, depending on the stocks being traded and the trading behavior of individual customers.

Brokerage Fees

Until 1975, all brokerage firms charged investors virtually the same brokerage fees for executing trades of financial securities. Brokerage firms distinguished themselves among investors by engaging in nonprice competition. Some attempted to offer better and more attentive advice established through market research. Others had geographical advantages, name recognition, or other attributes that led to better customer relationships. All of this began to change when Congress passed the Securities Acts Amendment of 1975 that eliminated fixed commissions. Instead of engaging only in nonprice competition, brokerage firms could compete by offering lower fees.

In addition to regulation by the SEC, the securities industry is also self-regulated by the National Association of Securities Dealers (NASD) and various securities exchanges, such as the New York and American Stock Exchanges. Brokerage firms that are registered with the SEC must also purchase insurance for their customers from the Securities Industry Protection Corporation (SIPC). SIPC is a nonprofit membership corporation that U.S. registered brokers and dealers are required by law to join. Congress established SIPC in 1970. The purpose of SIPC is to protect investors securities from liquidation by the brokerage firm. Each investor is insured for $500,000. Note that this does not protect investors from losses because of falls in securities prices. Rather, it protects the investor from losses resulting in the bankruptcy or insolvency of the brokerage firm.

Recap

Brokerage firms are important financial institutions because they facilitate the smooth functioning of securities markets. Brokers arrange the trading of financial securities markets. Brokers arrange the trading of financial securities among corporations and investors in exchange for a brokerage. Dealers not only arrange trades, but also buy and sell financial securities for their own portfolios, in order to make a market. Market orders direct the broker or dealer to purchase or sell the securities at the present market price if it is above a certain minimum. A short sell instructs the broker or dealer to borrow shares of stocks, and sell them today with the guarantee that the borrowed stocks will be replaced by a date in the future. The investor engages in a short sell if he or she believes that the stock's price is going to fall in the future and that the borrowed shares will be paid back with shares bought at a lower price.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003,  MAUREEN BURTON & RAY LOMBRA, PGS.  354-355*

END