Financial Intermediaries in the US Stock Market
The US Stock market is the largest in the world accounting for under 50% of the market capitalization of all listed companies around the globe. With millions of shares traded every day and thousands of active investors, the US stock market is a volatile place.
Back in 1929, when the US markets crashed (The Great Depression), investors lost confidence in the markets. As the government analyzed the crash and tried to identify the problems, it discovered that the markets needed transparency and regulation. Hence, the US Securities and Exchange Commission (SEC) was created. The primary objective of the SEC was to protect investors, ensure that the markets function in a fair and orderly manner, and facilitate the formation of capital.
To meet these objectives, the SEC assumed a pivotal role in controlling and regulating all participants in the stock markets. In the US, there are the following intermediaries:
- Broker-Dealers
- Clearing Agencies
- Credit Rating Agencies
- Investment Banks
- ECNs/ATSs
- Securities Exchanges
- Transfer Agents
- Self-Regulatory Organizations
Let’s take a detailed view of each intermediary.
Broker-Dealer
In the US, a broker-dealer or B-D is a financial entity that can trade securities for itself or on behalf of its clients. When it buys or sells securities in its name, it becomes a dealer. On the other hand, when it executes orders on behalf of its clients, it functions like a stockbroker. In the US markets, the B-D fulfils many critical functions including:
- Facilitating market trades for investors
- Offering investment advice (optional)
- Ensuring liquidity via market activities
- Researching the stock markets and publishing the results
- Raising capital for companies, etc.
There are two types of broker-dealers in the US:
- Wirehouse – This is a B-D that usually recommends proprietary products to its clients. Even if the B-D offers third-party products, preference is given to its own products. A classic example of a wirehouse is a bank functioning as a B-D.
- Independent B–D – An independent broker-dealer, on the other hand, can recommend any investment product based on the investor’s needs.
Companies | Type | Bidding Dates | |
| Regular | Closes 18 Nov | ||
| SME | Closes 18 Nov | ||
| Regular | Opens 19 Nov | ||
| SME | Opens 21 Nov | ||
| Regular | - |
Clearing Agencies
A clearing agency is an entity that facilitates the settlement of a trade in the stock market. According to Section 3(a)23(A) of the US Securities Exchange Act, 1934, a clearing agency is:
“Any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for the comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities. Such term also means any person, such as a securities depository, who
- acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry without physical delivery of securities certificates, or
- otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates”
When a stock is bought or sold, the market needs to ensure that the buyer receives the stock and the seller receives the money within a stipulated time. This is where clearing agencies step in. There are two types of clearing agencies in the US:
1. Clearing Corporations
Clearing corporations Clearing Houses or Clearing Firms are organizations that handle the confirmation, settlement, and delivery of transactions in the stock market. Their primary responsibility is to ensure the efficiency of each transaction.
They ensure this by becoming a buyer for every seller and a seller for every buyer and assuming an offsetting position in every transaction. So, when a trade takes place in the market, the clearing corporation becomes the middle-man and facilitates purchase at one end and sale at the other. Additionally, clearing corporations regulate the delivery of securities and report data relating to trading activities.
2. Depository
The Depository Trust Company (DTC) is the largest securities depository in the world. It provides safekeeping of securities via electronic record-keeping. It also assists in transferring ownership and maintains updated ownership records of all companies registered with it. The DTC operates through a network of participants like banks and broker-dealers.
Credit Rating Agencies
A credit rating agency analyzes the financial strength of a company or entity and assesses its potential to repay the interest and principal on its debts. The rating provided by the agency is an indicator of how confident it is about the borrower honouring its debt obligations as per the terms of the debt. In the US, the credit rating industry has three major players:
- Moody’s Investor Services
- Standard and Poor’s (S&P)
- Fitch Group
Together, these agencies control around 95% of the global credit rating business. They help create a sense of comfort for investors by providing an unbiased and independent evaluation of the creditworthiness of a security.
Investment Banks
Investment banks play a crucial role in handling the Initial Public Offering (IPO) of stock when a company decides to go public for the first time. When a company decides to launch an IPO, it approaches an investment bank to function as an underwriter of the IPO. The bank researches and analyzes the company’s financials and manages the issuance of shares after considering the percentage of ownership that the company wants to relinquish. The company pays the investment bank a fee for its services and an assurance of a minimum price per share.
ECNs/ATSs
Electronic Communications Networks or ECNs are electronic trading systems that are designed to automatically match buy/sell orders at specific prices. Individual investors cannot place an order with an ECN directly. They need to have an account with a broker-dealer to route their orders to an ECN. However, apart from broker-dealers, institutional investors and market makers can place their orders directly with this automatic system. Usually, orders placed in the ECN are limit orders.
An Alternative Trading System or ATS is a trading system that meets all the requirements of stock exchange but is not required to register as one if it operates under the exemption provided vide Exchange Act Rule 3a1-1(a). ATSs are regulated as broker-dealers as opposed to stock exchanges. They offer an alternative option for accessing liquidity and can be used to trade shares away from the normal market.
Securities Exchanges
Securities exchanges are marketplaces where investors buy and sell securities. When a company launches shares, it chooses the exchange(s) on which it wants them listed. Investors can buy or sell stocks only from the exchanges where they are listed. In the US, there are many securities exchanges that are registered with the SEC:
- The New York Stock Exchange (NYSE)
- American Stock Exchange (AMEX)
- National Association of Securities Dealers Automated Quotation System (Nasdaq)
- BATS Global Markets (The BZX Exchange and the BYX Exchange), etc.
Every stock exchange has a primary market where the IPOs are launched and a secondary market where shares listed after the IPO are traded.
Transfer Agents
Transfer agents are responsible for recording changes of ownership of a security, maintaining records, distributing dividends, etc. They are the liaison between the company and the security holders. Hence, they play an important role in ensuring efficient trades in secondary markets. The SEC regulates the transfer agents and ensures that they facilitate prompt and efficient settlement of security transactions while keeping them secure.
Self-Regulatory Organizations
A Self-regulatory organization or SRO is a non-governmental entity that regulates various market entities on its own. Despite being private organizations, the government has reasonable regulatory control over them. SROs primarily function as watchdogs for the markets and guard against fraudulent activities or unprofessional practices. Securities Exchanges and Clearing Houses are classic examples of SROs.
Two important SROs that you must know about are:
- Financial Industry Regulatory Authority (FINRA) – It is the largest SRO in the capital market industry and is the primary regulator for broker-dealers.
- Municipal Securities Rulemaking Board (MSRB) – It makes rules and regulations to manage the dealers of municipal securities.
Summing Up
The core structure of the US stock markets is similar to the Indian stock markets. While some terms and regulations might differ, the role of Financial Intermediaries in the US Stock Market is to ensure that the capital markets remain investor-friendly and safe to help the generation of capital. Being the largest stock market in the world, the US needs stringent laws and regular monitoring to keep miscreants and errors away. With this network of intermediaries and a tight regulatory framework, the US markets are dependable to a great extent.
Happy Investing!