KEY PLAYERS IN FINANCIAL MARKETS

THE ROLE OF CLEARING HOUSES

WHAT IS CLEARING

• Clearing is the procedure by which financial trades settle - that is, the correct and timely transfer of funds to the seller and securities to the buyer.

• Often with clearing, a specialized organization acts as intermediary and assumes the role of tacit buyer and seller in a transaction, to reconcile orders between transacting parties.

• Clearing is necessary for the matching of all buy and sell orders in the market.

• Clearing provides smoother and more efficient markets as parties can make transfers to the clearing house rather than to each individual party with whom they transact.

BASICS OF CLEARING

• Clearing is the process of reconciling purchases and sales of various options, futures, or securities, as well as the direct transfer of funds from one financial institution to another.

• The process validates the availability of the appropriate funds, records the transfer, and in the case of securities ensures the delivery of the security to the buyer.

• Non-cleared trades can result in settlement risk, and if trades do not clear accounting errors will arise where real money can be lost.

WHAT ARE CLEARING HOUSES

• A clearing house acts as an intermediary between a buyer and seller and seeks to ensure that the process from trade inception to settlement is smooth.

• Its main role is to make certain that the buyer and seller honor their contract obligations.

• For example, a clearing house ensures that a stock buyer delivers the money and that the seller provides the stock he is selling.

• The Clearing House can do this by acting as the counter-party to the trade. Essentially, they seller sells the asset to the clearing house who then transfers the asset to the buyer. The money for the trade moves in the opposite direction.

WHAT ROLE DO CLEARING HOUSES PLAY IN FINANCIAL MARKETS

Investor ASelling Apple

Stock

ClearingHouse

Investor BBuying

Apple Stock

Investor A sendshis stock to Investor B

Investor B sendsmoney to Investor A

The clearing houseexecutes the actualtransaction

Stock Exchange

Stock exchange matchesEquity Buyers and Sellers

EXAMPLE OF A CLEARING ISSUE

• A buyer and a seller submit trades to transact a trade on AAPL stock. The exchange matches the two but there is an error in the data creating an out trade.

• An out trade is a trade that cannot be placed because it was received by an exchange with conflicting information.

• The associated clearing house cannot settle the trade because the data submitted by parties on both sides of the transaction is inconsistent or contradictory.

SERVICES PROVIDED BY CLEARING HOUSES

• Responsibilities include settling trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery of the bought/sold instrument, and reporting trading data.

The trade executionoccurs on the exchange

The Clearing Houseensures the two parties deliver ontheir agreement

HOW DO CLEARING HOUSES MAKE MONEY

• Clearing Houses make money primarily by selling and leasing memberships, and charging transaction fees. Specifically, …

Selling memberships - Clearing firms make big money by selling memberships to professional individual traders and corporations. The higher the membership price, the more rights and privileges the member enjoys. At the time of publication, the selling price for a Chicago Mercantile Exchange, or CME, membership was $400,000.

Leasing memberships - Leased memberships appeal to individuals and corporations that want to reduce their trading costs without purchasing an expensive membership. At the time of publication, a CME clearing firm-leased membership cost $1,900 per month, or $22,800 per year.

HOW DO CLEARING HOUSES MAKE MONEY

• Other ways that Clearing Houses make money are …

• Charging Members Transaction Fees - Clearing firms charge their members a transaction fee every time they make a trade. Transaction fees are usually no more than pennies or fractions of a penny that are added to the trading costs. The trading volume determines how much income the clearing firm makes in transaction fees for that day.

• For example, the Chicago Board of Trade charges individual members a transaction fee of 9 cents for every agricultural commodity futures contract traded. If 250,000 corn contracts are traded, CBOT makes $22,500, which is 250,000 contracts multiplied by 9 cents, in transaction fees for that day.

HOW DO CLEARING HOUSES MAKE MONEY

• Other ways that Clearing Houses make money are …

• Charging Brokerage Firms Clearing Fees - A clearing fee is charged every time an entity such as an individual or corporation makes a trade. The trader’s brokerage firm is responsible for assessing and collecting the clearing fees.

• For example, Interactive Brokers charges a clearing fee of $ 0.00020 for each stock share traded. The clearing fee for trading 100 shares is 2 cents (100 multiplied by $0.00020). The brokerage firm lists the amount of the clearing fee separately on the trader’s brokerage statement. The clearing fee is imposed no matter which brokerage firm the trader uses.

THE ROLE OF BROKERS

WHAT IS A BROKER

• A broker is an individual or firm that charges a fee or commission for executing buy and sell orders submitted by an investor.

• A broker also refers to the role of a firm when it acts as an agent for a customer and charges the customer a commission for its services.

• This whole process was revolutionized by the paradigm shift caused by the internet. Online (discount) brokers greatly reduced transaction fees and increased participation of retail investors in the stock market.

• Large investors don’t need brokers.

WHAT ROLE DO BROKERSPLAY IN FINANCIAL MARKETS

Investor ASelling Apple

Stock

Investor BBuying

Apple Stock

Stock Exchange

Broker Broker

Brokers take the orders from the buyer and seller and submitted it to the exchange. They also maintain custody of their client’s financial assets (usually cash or securities).

ClearingHouse

MORE SERVICES PROVIDED BY BROKERS

• Brokers may provide investors with research, investment plans and market intelligence.

• Brokers may also cross-sell other financial products and services their brokerage firm offers, such as access to a private client offering that provides tailored solutions to high net worth clients.

• In the past, only the wealthy could afford a broker and access the stock market.

• Online broking triggered an explosion of discount brokers, which allow investors to trade at a lower cost, but without personalized advice.

DISCOUNT VS. FULL-SERVICE BROKERS

• Discount brokers can execute many types of trades on behalf of a client, for which they charge a reduced commission in the range of $0 to $15 per trade.

• Their low fee structure is based on volume and lower costs.

• They don’t offer investment advice and brokers usually receive a salary rather than commission.

• Most discount brokers offer an online trading platform which attracts a growing number of self-directed investors.

DISCOUNT VS. FULL-SERVICE BROKERS

• Full-service brokers offer a variety of services, including market research, investment advice, and retirement planning, on top of a full range of investment products.

• For that, investors can expect to pay higher commissions for their trades.

• Brokers receive compensation from the brokerage firm based on their trading volume as well as for the sale of investment products.

• An increasing number of brokers offer fee-based investment products, such as managed investment accounts.

BROKER REGULATION

• Brokers register with the Financial Industry Regulatory Authority (FINRA), the broker-dealers’ self-regulatory body.

• In serving their clients, brokers are held to a standard of conduct based on the “suitability rule,” which requires there be reasonable grounds for recommending a specific product or investment.

• The second part of the rule, commonly referred to as “know your customer,” or KYC, addresses the steps a broker must use to identify their client and their savings goals, which helps them establish the reasonable grounds of the recommendation.

• The broker must make a reasonable effort to obtain information on the customer's financial status, tax status, investment objectives and other information used in making a recommendation.

REGISTERED INVESTMENT ADVISERS

• This standard of conduct differs significantly from the standard applied to financial advisors registered with the Securities and Exchange Commission (SEC) as Registered Investment Advisers (RIAs).

• Under the Investment Advisers Act of 1940, RIAs are held to a strict fiduciary standard to always act in the best interest of the client, while providing full disclosure of their fees.

• RIAs are brokers or financial advisors that deal with high net worth individuals. RIAs cater to more sophisticated investors while brokers focus on retail investors.

LARGEST US BROKERS

• These four top U.S. regulated brokers provide investors and traders access to financial markets. Brokerage rates as of May 2019.

• TD Ameritrade: TD Ameritrade Holding Corporation (AMTD) provides trading in stocks, options, exchange-traded funds (ETFs), mutual funds, futures contracts and fixed income investments. The Omaha, Nebraska-based broker services 11 million accounts that total more than $1 trillion in assets.

• Charles Schwab: The Charles Schwab Corporation (SCHW) facilitates trading in most financial markets along with margin lending and cash management services. The broker operates more than 330 brick-and-mortar locations in 46 states and has $3.36 trillion in total client assets.

LARGEST US BROKERS

• These remaining four top U.S. regulated.

• E*TRADE: Founded in 1982, E*TRADE Financial Corporation (ETFC) provides trading in a wide variety of securities, holding over three million brokerage accounts, with $285 billion in client assets. The broker offers its customers an assortment of educational resources relating to investing.

• Interactive Brokers: Interactive Brokers Group, Inc. (IBKR), with over $150 billion in client equity. The broker connects to any electronic exchange globally, which enables trading in equities, options and futures. Customers receive access to a wealth of tools for tracking and analyzing the financial markets.