Level 1 CFA® Exam:
A word intermediary reflects the essence of tasks performed by financial intermediaries. They are institutions which act as a link between two other entities. One entity has a surplus of capital and the other lacks it. Thanks to intermediaries, funds are transferred from one entity to another so that both can achieve their financial goals.
We can have very different financial intermediaries:
- investment banks,
- depository institutions,
- insurance companies,
- clearinghouses, depositories, custodians.
Brokers are intermediaries that purchase and sell instruments, which is how they fill orders for their clients. Remember for the exam that brokers do not enter into any transactions with their clients. Their task is to link their client’s order with the order of another entity that will want to take the other side in the transaction. We say that brokers act on someone else’s account.
Depository institutions are also financial intermediaries as they facilitate the transfer of funds. This is possible, for example, by taking deposits and transferring funds from depositors to other entities in the form of loans. In exchange for the loans, depository institutions receive interest and pay returns to depositors. Examples of depository institutions include: commercial banks and savings and loan banks.
Insurance companies conclude insurance contracts with their clients. In exchange for a regular premium, they provide risk transfer through an obligation to pay the sum insured in case of an event specified in the contract. This event can be for example fire, theft, or a natural disaster. Sometimes, an insurance company doesn’t want to bear the risk arising from an insurance contract and decides to buy a reinsurance policy so the risk is transferred to the reinsurer.
Insurance companies act as financial intermediaries as they connect buyers of insurance contracts, that is their clients, with reinsurers, investors or creditors.
Arbitrageurs is a group of market participants that make a profit by buying an instrument in one market at a price which is lower than the sale price of the same instrument in another market. Because of what they do, they are financial intermediaries as they buy an instrument in one market and sell in another. This is how they connect buyers from one market with sellers from another. What distinguishes arbitrageurs from dealers is the fact that they connect two entities from two different markets.
Clearinghouses, Depositories, and Custodians
Since financial intermediation also includes settlement and custodial services, entities carrying out such activities may be referred to as financial intermediaries.
Clearinghouses are an example of settlement services. A clearinghouse settles transactions and plays an important role in the whole financial system because without it, it would not be safe to carry out transactions. If there was no clearinghouse, different entities in the market would mistrust each other. Every market transaction involves counterparty risk. Thanks to clearinghouses and services they provide, this type of risk is limited. Also, owing to clearinghouses, the number of potential entities that may act as the opposite side of the transaction goes up, which increases liquidity in the market.
The second group of entities, namely entities providing custodial services, includes depositories and custodians. Thanks to their work, the risk of loss of securities is minimized because they hold their clients’ securities and take care of them. Nowadays, in many cases securities take an electronic form, thanks to which their destruction is impossible.
- Financial intermediaries are entities transferring capital from entities with surplus capital to ones that lack it.
- There are many different types of financial intermediaries in the market, e.g. brokers, dealers, exchanges, investment banks, depository institutions, insurance companies, arbitrageurs, clearinghouses, depositories, or custodians.
- All those entities help liquidity in the market increase.
- Brokers are intermediaries that fill orders for their clients by purchase and sell of financial instruments.
- Unlike brokers who connect entities wishing to take opposing positions, dealers fill orders by trading with their clients.
- Investment banks mainly provide consultancy services, help their clients with issuing shares and bonds and advise on mergers and acquisitions.
- In exchange for a regular premium, insurance companies provide risk transfer through an obligation to pay the sum insured in case of an event specified in the contract.