Types of Financial Intermediaries

Financial intermediaries help entities achieve their goals by providing products and services that help connect buyers and sellers. The key financial intermediaries are defined below.

Brokers: Agents who fill orders for their clients, helping reduce their client’s transaction costs by efficiently matching them with someone else willing to take the other side of their trades.

Block Brokers: Provide brokerage service to large traders. Large orders typically cause the market to move against the trader: large buy orders trade at a premium, and large sell orders trade at a discount. Block brokers serve to manage large orders so that their clients lose the least amount of money due to adverse movements in the market.

Investment Banks: Primarily help corporate clients in issuing a wide range of securities, including common stock, preferred stock, notes, and bonds. In addition, they assist their clients with potential takeover targets.

Exchanges: Provide places where traders can meet to arrange their trades. Over time, exchanges have progressed to usually arranging the trades for their traders based on orders coming in from brokers and dealers. In addition, exchanges usually regulate the issuers and members to promote an efficient marketplace and derive their authority from their national or regional governments.

Alternative Trading Systems/Electronic Communications Networks/ Multilateral Trading Facilities:  Alternative Trading Systems (ATS), Electronic Communications Networks (ECNs), and Multilateral Trading Facilities (MTFs) are trading venues similar to exchanges. However, they don’t have regulatory authority over their subscribers, except for their trading system’s conduct. Some ATS are called dark pools because they don’t display orders to other market participants.

Dealers: Fill their clients’ orders by trading with them. Unlike brokers, dealers directly buy from or sell to their clients, hoping to find another client to take the opposite side of the trade.

Broker-dealers: Describes an entity that is both a broker and a dealer. Broker-dealers have an inherent conflict of interest in that a broker aims to acquire the best price for their clients, but a dealer maximizes their profit by buying from their clients at low prices and selling to their clients at high prices.

Securitizers: Banks and investment companies can create new financial products by purchasing and repackaging various securities or assets. Mortgage-backed securities are among the most common securitizations and allow investors to purchase a diversified portfolio of mortgages. For many mortgage-backed securities and other securitizations, the financial intermediary splits the securities into different classes, or tranches, which have different rights to the cash flows from the asset pool. This helps the intermediary tailor securitizations to the risk/return profile of different investors. In addition to the diversification benefits, securitization also greatly improves liquidity in the mortgage market that can pass through to homeowners in the form of lower interest rates. Securitizations are often set up in special-purpose vehicles/entities to better protect investors if the intermediary goes into bankruptcy.

Depository Institutions: Depository institutions, such as commercial banks, savings and loan banks, and credit unions, gather funds from depositors and investors to lend to borrowers. Depositors receive transaction services and interest on their deposits, while the banks access funds without seeking capital from investors. Additionally, other financial intermediaries, like acceptance corporations, discount corporations, payday advance corporations, and factors, offer secured loans to borrowers by selling commercial paper, bonds, and shares to investors.

Depository banks and financial corporations can be viewed as securitized asset pools supported by a diverse portfolio of loans. Depositors hold the safest part (most protected against losses), while the institutions’ shareholders hold the riskier portion (least protected).

Insurance Companies: Help people and companies hedge their risks by underwriting contracts that pay out in the event of losses from a wide variety of causes. Insurance companies basically transfer the risk from the buyers of the insurance contracts to the insurance company’s creditors and shareholders. Common problems with insurance contracts include fraud, moral hazard (losses are more likely when people know they’re insured), and adverse selection (those who buy insurance may be more prone to losses).

Arbitrageurs: Aim to profit through buying an asset in one market and selling an identical or similar asset in another market at a higher price. Thus, arbitrageurs provide liquidity to buyers and sellers across different markets. In efficient markets, opportunities for pure arbitrage – or profiting from the purchase or sale of an identical asset in different markets – are rare because market participants can easily acquire the best prices. Instead, arbitrageurs often take part in replication: purchasing and selling risk in different forms using securities and contracts.

Clearinghouses: Arrange the final settlement of trades by guaranteeing contract performance in futures markets and acting only as escrow agents in other markets. To protect against losses, clearinghouses require members to have adequate capital and post margins. In addition, clearinghouse members trade on behalf of brokers and dealers that are non-members and similarly ensure that the non-members have enough capital to back their trades.

Question

If a corporation wants to protect against potential losses from fire damage to a newly constructed factory, it would most likely make use of what financial intermediaries?

1. Arbitrageurs.
2. Investment banks.
3. Insurance companies.

Solution

The correct answer is C.

Insurance companies are the appropriate financial intermediaries for protecting against potential losses from fire damage. They provide risk management services by offering policies that transfer the financial risk of events like fires to the insurer in exchange for a premium.

A is incorrect. Arbitrageurs are market participants who take advantage of price differences in different markets to make risk-free profits. They do not provide services related to insuring against physical risks such as fire damage.

B is incorrect. Investment banks focus on underwriting, issuing securities, mergers and acquisitions, and other capital market activities. They do not provide insurance services related to property protection or fire damage.