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FINANCIAL SERVICES AND FINANCIAL INSTITUTIONS

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FINANCIAL SERVICES AND FINANCIAL INSTITUTIONS

    FINANCIAL SERVICES AND FINANCIAL INSTITUTIONS:

    VALUE CREATION IN THEORY AND PRACTICE

    J. Kimball Dietrich

    CHAPTER 9

     Securities Trading, Dealing, and Origination

Introduction

     Securities investment and trading are among the most publicized and exciting activities we

    observe in the financial services industry. In line with our earlier discussion of the financial system,

    securities are only a means of transferring savings to investors.

    ? How do securities differ in this role from the extensions of credit we discussed in the previous

    two chapters?

    ? What are the sources of value from those financial firms that trade securities on financial

    markets to providers and users of funds?

    ? Why are traders in securities willing to pay to transact sooner rather than later and what

    specialized firms have emerged to service this demand for immediacy?

    ? What skills and resources are required in order to bring securities to the market?

Answers to these and related questions are essential to understanding the dynamics governing the

    transition in this financial industry segment from traditional forms to new and

    emerging delivery and production systems.

     This chapter reviews the basic economics of the value added by securities trading, market

    making, and securities origination. The emphasis is on economic analysis of these basic financial

    services to isolate sources of value in the value chain we have used in previous chapters. Securities

    markets grow in importance as economies grow in extent and sophistication in terms of technology and

    institutional complexity. Securities markets represent a development beyond raising funds in the form

    of credit as discussed in the previous chapter. Securities markets can be expected to grow ever more

    important around the world in the future.

9.1 Overview of Securities Markets and Instruments

     This chapter explores value production in those financial services traditionally associated with

    brokers and investment bankers. In order to set the stage for the dynamic changes taking place in this

    sector of the financial services industry, the position of traditional and non-traditional firms in the

    securities markets and the economic role of securities markets are reviewed in the following sections.

     The purpose here is to provide perspective on the creation of value in the major services provided by

    firms active in securities markets.

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Firms Active in Securities Markets

     The traditional concept of a securities firm is represented by a brokerage firm, like Merrill Lynch, or an investment banking firm, like Salomon Brothers. These and other firms involved in securities markets perform the established functions of buying and selling securities (brokerage) and advising clients on how to originate new securities (investment banker) to raise money. Traditional firms can be providers of the full range of securities markets services or can be more specialized. "Full line" firms like Merrill Lynch offer retail brokerage services and corporate securities advice, while narrowly focussed firms like Jeffries Securities concentrate on trading for institutional clients.

     In recent years, non-financial firms tried providing securities market services: Sears Roebuck, the retail giant and owner of Allstate Insurance, acquired the full-line broker Dean Witter, and then spun it off in 1993. General Electric, maker of refrigerators and jet engines, bought the investment banking concern Kidder-Peabody, and sold it to PaineWebber in 1995. A development of even broader potential significance has been the entrance of non-securities related financial service firms, such as commercial banks and thrift institutions, into securities businesses through expansion of their authorized powers. Other financial service firms have entered securities business through acquisitions, for example Travelers Insurance (then known as Primerica) bought Smith-Barney and Prudential Insurance acquired Bache.

     There are four key factors influencing the future of the industry: (1) possible synergies realized by non-securities financial service firms from offering securities markets services; (2) synergies gained by non-financial firms from offering securities markets services; (3) technological change; and (4) structural changes in the flow of savings into investment.

     Non-securities financial firms, principally commercial banks, have a number of synergistic connections to securities market services. Banks are portfolio lenders to non-financial firms and are involved in open-market, short-term financing in the form of letters of credit backing commercial paper. As discussed in Chapter 8, banks increasingly arrange credit for their customers. Banks already trade and make markets in a variety of money market and government securities, a natural basis for expansion into the corporate securities markets. Bank branch networks also offer ready marketing outlets for both retail and small corporate securities market services. It seems a natural extension of bank functions to arrange funding in the form of public securities issues. Finally, banks in Germany and Japan already have these authorities.

     Non-banks like large manufacturing corporations have already entered the financial services industry through their finance company subsidiaries. They offer the securities business one important advantage: a lower cost of funds. Their enormous size, equity capital, and top credit ratings mean that they can commit large amounts of capital to securities business. Their reputations can be of enormous value in competition for securities market services. Furthermore, non-banks are not hampered by the regulations limiting traditional securities and deposit-taking financial institutions.

     Technology offers vastly cheaper ways of communicating all the types of information required by providers of securities market services. Information on prices and communication with market participants are all available at costs below levels observed even a short time ago. Processing information, applying complex analytical tools, and plugging into related financial service functions, such as clearing networks and information providers, mean smaller firms and new entrants can quickly enter securities markets. These firms can compete on a relatively even footing with established firms for securities business.

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     Finally, the institutional changes in the flow of funds dramatically alter the markets within which securities markets service firms operate. Globalization integrates world capital markets. American securities firms are active around the world but must compete in the United States with securities firms from Europe and Japan, as well as Singapore and Hong Kong. Political and demographic trends foster emergence of locally important securities markets, like California and the Southeast in the United States, and China, the former Soviet Union, and Latin America abroad. Investment opportunities in these markets attract investors funds from around the world. The continuing accumulation of savings in institutional investors such as pension funds and money management firms means that the market for trading securities and target markets for new securities issues is more sophisticated than the past.

     To appreciate developments in securities related financial services, industry observers must understand the role of securities markets and the economic functions performed by financial service firms active in them. After a review of the basic attractiveness of tradable financial instruments and the economic determinants of the demand for each of these services, the underlying economics of the business is examined to identify sources of value in the securities business.

Demand and Supply for Securities

     Securities are standardized financial claims that can be readily transferred between parties and therefore traded on securities markets. Typical individuals acquire or dispose of securities in the retail markets for securities services. Large firms and investors operate in the market for institutional securities market services. There are many reasons why individual and institutional investors prefer securities to portfolio investments.

     Securities have desirable attributes relative to portfolio investments. They are liquid, meaning they can be exchanged for cash easily because there are markets where the securities are traded (not always at a prices pleasing sellers). Securities markets produce technical information (as defined in Chapter 6) including prices for the same or similar investments, unlike portfolio investments which are often difficult to price. Trading volume reflects the depth of the market for securities and investors' ability to convert investments into cash at predictable transaction prices. Publicly traded securities of large corporations in many countries are accompanied by a wealth of information in the form of disclosures. The investment community provides ongoing analysis of securities when they are issued or as they subsequently trade. Finally, securities market services are offered by established firms and institutions with reputations. Rules and regulations govern securities issuance and trading which can be a source of confidence or basis for litigation for investors investing in securities.

     Issuing securities in order to raise funds has advantages for users of funds. Issuers may prefer to raise funds through issuance of securities rather than credit or direct placements described in the previous chapter because the liquidity of securities means that costs of funds are cheaper. Technical information reflected in the prices of similar or identical securities provided by securities markets clearly establishes the costs of funds for issuers. Prices and returns associated with alternative or substitute investments traded in securities markets provide issuing firms feedback on opportunity costs of making investments or returning funds to investors.

     Some of the principal-agent problems between investors and users of funds discussed in the previous chapter may be less severe if firms are willing to disclose information required of firms with publicly traded issues. Firms issuing publicly traded securities can take advantage of competition in

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securities markets to reduce issue costs relative to costs implicit in negotiated deals with portfolio

    investors. In the case of some large firms, like Exxon, open market auctions of securities issues may

    eliminate the need for financial intermediaries and their fees altogether. These considerations also lead

    firms to prefer securities issues to private deals.

    Demand for Securities Trading Services

     Buyers and sellers of securities, trading either new issues or seasoned issues, are motivated by

    two basic reasons. The first reason trade securities for cash or cash for securities is because of normal

    variation in consumption or business needs for cash. Traders making portfolio adjustments requiring

    offsetting changes in cash and securities in response to factors unrelated to events in the securities

    markets are called liquidity traders. An individual selling stock to finance a child's education or an

    insurance company buying bonds to finance future payment of claims are both liquidity traders

    motivated by their specific portfolio considerations.

     A second type of trader knows something that the rest of the participants in the market do not

    know. This information may be that a lawsuit has been filed or that a takeover attempt is imminent.

    Traders placing buy or sell orders based on private knowledge are called information traders.

    Information traders expect to profit because they buy securities at prices which are low relative to their

    true values or sell them at prices which are high relative to what they will sell for when the information

    the trader possesses becomes available to the market.

Function of Securities Firms and Security Types

     A broker finds a buyer for a seller. Because most traders are not continuously buying and selling securities, they turn to professional brokerage firms to complete their trades. Often, a buyer or

    seller wants to trade sooner than would be required by waiting for a counterpart seller or buyer to show

    up in the market. Financial institutions which facilitate quick trades by buying or selling securities on

    their own accounts are called market makers or dealers in securities. When offering new securities to

    investors, firms raising funds require guidance as how to design and price newly issued securities in

    order to make them attractive to investors. This guidance is one of the functions performed by

    financial service firms assisting borrowing entities with securities origination.

     Brokers and dealers of securities buy and sell a wide range of financial instruments to

    flexibility for investors or issuers in their portfolio or balance sheet composition. The variety of

    securities makes it possible to fine-tune investments or fund raising to particular investor or borrower

    needs. Most of us are familiar with securities in the form of common stocks and various types of bonds.

     Stocks and bonds represent ownership or debt claims against the earnings and underlying income

    producing assets of firms. These traditional securities are a significant part of trading volume in

    today's markets.

     Stocks and bonds are important but relatively simple securities. To achieve an optimal

    combination of risks and returns against a variety of future economic scenarios, issuers and investors

    often look for more innovative securities designs. If these securities achieve a better risk and return

    combination in terms of investors' and issuers' preferences than existing securities, they will be more

    marketable. Classic examples are convertible bonds, preferred stock, and warrants. Newer examples

    are collateralized mortgage obligations and index options.

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     There is an unlimited number of possible risks investors or borrowers may be concerned about.

     For example, a financial instrument which pays higher returns with higher inflation would offer protection against inflation risks. A security which pays off more if automobile demand drops might be useful to some particular investors. Conceptually there are an infinite number of possible future outcomes which could be of concern to individual investors and borrowers.

     Creating financial instruments which pay future cash flows under economic conditions offfering new protection to market participants is a move toward completing the market. A complete

    securities market offers securities which pay returns under every conceivable circumstance, for example which pays $1 if Mongolia attacks India next year and zero otherwise.

     It is not possible to define much less trade the infinite number of securities which would be necessary to complete financial markets. Practically speaking, financial markets will never be complete. With inventive and aggressive people active in the securities industry, however, there are always opportunities for inventing and trading new securities for which sufficient demand exists because customers desire security payoffs under circumstances important enough to worry about.

     Recent developments in futures and options markets, allowing the hedging behavior discussed in Chapter 19, are described as developments making markets more complete. A 1990 example of successful innovative security which made the market more complete is a Nikkei put option, which pays off for investors if the Japanese stock market falls, whereas issuers keep the sale price and pay nothing if the Nikkei index rises. Innovating new securities can create value for issuers and investors as well as financial service firms.

     Securities can be classified by type of issuer: foreign or domestic corporations, governments, or issues based on consumer borrowing. They can be classified by the nature of the claim on borrowers.

     Debt provides investors a fixed claim on the income and assets of issuers. Equity represent a residual claim against income and assets firms after other claims are met. Securities can be convertible into other securities, callable or redeemable for cash, and so forth. Securities can pay in any currency or in amounts indexed to commodities. The list of features is endless and growing with innovations in securities markets. Table 9-1 provides an overview of the basic types of securities which are of major significance in financial markets.

     The market for securities issues is large. Table 9-2 provides figures giving the total size of the securities markets in the United States. The Panel A of the table provides the size of the entire stock of securities listed on exchanges issues by class. Some markets, like the market for common stocks, is subdivided by where these issues are traded, such as on the New York Stock Exchange (NYSE) or the so-called Over the Counter Market (OTC). Panel B provides data on trading volume on the exchanges and Panel C provides amounts of new issues of securities for recent years. The tables demonstrate both large growth, as in new issues in Panel C, and substantial variation, as in trading volume in Panel B, in securities markets activities.

9.2 Value in Trading Securities: Economies of Market Structure

     Identifying willing buyers for sellers and vice versa is an information problem. Solving this problem is as old as civilized man. Early solutions to the problem of finding partners in trade are market day in the country or annual horse auctions. Markets are a means to reduce the costs of identifying people who want to buy and sell given commodities at different prices.

     The microeconomics of securities market organization and price-setting rules has become a

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major focus of study in financial economics, the economics of market micro-structure. This line of

    analysis examines the role market organization, for example auctions or continuous trading, plays in influencing a market's efficiency in absorbing and disseminating new information.

     Costs of physically delivering items bought and sold, which are pieces of paper or computer files, is very low in securities markets. Trades can be fast and information can change rapidly. The effect of information flow on prices and trading volume and the market's ability to handle variations in the volume of trading under different market organization and structures is an important issue. This is apparent from the Stock Market Crash of October, 1987, when different securities market organizations in Chicago, New York, and around the world reacted very differently to the dramatic stresses of that period.

     Brokers take buy and sell orders to the market and execute them for their customers. In organizing trading activity, brokers need to produce value for their clients and themselves. Brokers' participation in markets is costly. It takes time to plan, organize and conduct a market. Physical facilities or electronic counterparts must be arranged. A convenient location is essential to attract other traders: high-rent space in large cities may be necessary. Traders need offices and places to keep records. Communications links must reflect advanced technology.

     The fixed and variable costs of participating in markets can be large. Identifiable markets emerge when interest in exchanging claims on financial assets or contracts reaches a point where the investments necessary to develop the infrastructure and train people are justified by the expected future trading income of market participants.

     Markets in the United States and around the world take surprisingly wide and varied forms. A few different market structures can be distinguished: there are two dimensions to describing market structure. The first is the physical/institutional organization of the market, determining whether trading occurs in one place and is exclusive or is open to all who wish to trade. The second dimension concerns the rules by which the prices at which trades occurs are established. In discussing these different dimensions of market organization, keep in mind that hybrids and combinations are possible.

     Economic forces may produce an evolution from one form to another.

     The physical and institutional aspect of markets concerns whether trading locations or systems are exclusive or open. One structure is for trading to take place in a single location where access is limited to members, called an organized exchange or market. The most famous example is the New

    York Stock Exchange NYSE). A second market structure is that traders are connected by communication links like telephones and wire systems, often augmented with computer screens or other display devices and that the system is open to all. These markets are called

    over-the-counter-markets, since anyone can buy or sell securities who is authorized and is willing to

    plug into the information network.

     When trading is exclusive only those paying dues can trade. For example, trading on the New York Stock Exchange is limited to members called seat holders. Members own the exchange and buy

    their seats. These seats have value because of the trading privilege on the exclusive floor. Recent seat prices are shown in Table 9-3.

     Over the counter markets can be open to all traders who have telephones, like the United States Treasury securities or foreign exchange markets. Access to over the counter markets can be somewhat restricted, as in the case of the National Association of Securities Dealers Automatic Quotation (NASDAQ) system, which is open only to members subscribing to communication systems.

     The second dimension of securities markets concern rules covering trading activity. The most

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    1. Brokers and other market

    participants trading in markets with frequent activity agree on rules in order to prevent chaotic trading and disagreements. Rules are intended to assure that buyers and sellers obtain the best prices possible and that disputes about transactions are minimized. The economic need for rules will become clear important rules govern how prices for traded securities are establishedfrom our discussion below.

     Trading rules establishing prices can be described in terms of a two-dimensional tables as in Figure 9-1. Members of organized markets agree on rules covering members. Rules in

    over-the-counter markets can be conventions, regulations, or laws. Table 9-1 arrays different basic methods of arriving at transaction prices and indicates examples of financial markets that use one or the other of the rules. The two attributes of trading rules described in the array concern the frequency of trading and nature of the traders.

     A call auction securities market is a market where orders given to brokers, called public orders

    since brokers represent investors buying or selling securities, are collected at one time. An auction is held on a scheduled basis. Many markets started out as call auction markets, as did the NYSE and the Paris Bourse, meeting to conduct auctions at fixed intervals. The first trade prices of the day on most organized exchanges are set by a call auction procedure which clears the buy and sell orders accumulated since the market closed.

     When buy and sell orders are constantly being filled with representatives of buyers and sellers negotiating and trading all the time, the market is described as a continuous auction. Following the

    opening on the NYSE and other exchanges, trading is continuous as brokers arrive with buy and sell orders. On the NYSE, the specialist in given securities is charged by exchange rules with assuring an orderly price setting process for the security throughout the day.

     The second dimension of pricing setting rules concerns the way trades are conducted, specifically, how traders get their price information and close transactions. In an auction market, traders or their broker representatives find out what prices are being offered and conclude transactions with any other traders or brokers currently in the market. In dealer markets, brokers or traders contact securities market participants who specialize or who are designated to quote prices for immediate purchase or sale of the securities. Some markets, such as the NYSE, allow both types of trades.

     The price setting rules on organized exchanges like the NYSE are intended increase the likelihood that buyers and sellers receive the best prices available. One way to concentrate information on prices for securities to traders is to limit trading to one market where all orders must be filled. Exchange rules often require that members trade only on one exchange and when that exchange is open. These rules prevent deals at favorable prices from occurring after hours or on other exchanges to the detriment of other traders on the exchange.

Benefits and Costs of Market Concentration

     Traders in securities may benefit from the concentration of trading in securities to one trading and information center. Price information is available to all brokers in the market. Organized markets or exchanges display the latest prices on traded securities prominently for all market participants to see.

     Concentration of buy and sell orders of members of organized exchanges may mean that buyers and

     1 For an excellent discussion, see Stoll (1990). For a more complete discussion, see Cohen et al (1986), Chapter

    2.

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    sellers obtain the best prices available anywhere. The greater the flow of transactions in a given market, the less likely are better buy or sell prices. Concentration of trading is said to produce economies of scale Some exchanges like the NYSE have achieved a near monopoly in the trading of listed securities.

     Restrictions against member brokers trading off the floor are essential in maintaining an exchange's market power. These rules benefit members since they can charge commissions which are higher than costs since buyers and sellers believe the best prices will be found on the most active exchange, reducing their total costs of trading including securities prices and commissions. High commissions relative to transactions costs for brokers on exchanges achieving monopolies on trading allow abuses in terms of exorbitant commissions.

     In contrast to organized exchanges, over the counter markets are typically dealer markets. Diffuse information networks of individuals and firms buying and selling particular financial assets are funneled through a smaller number of dealers. The largest market of this type is the United States Treasury securities market, where investors and brokers contact dealers who are linked by telephone and computer networks. Information on prices offered by dealers and technical market information is communicated by a variety of specialized communication and reporting systems. Some of these communication systems are provided by third-party suppliers, like Money Market Services or Reuters, as described in Chapter 12. Other communication systems are owned by dealers, like the National Association of Securities Dealers Automatic Quotation (NASDAQ) system discussed above.

     The flow of trading activities on some organized exchanges has been shifting off the floor of the exchange. The costs of transacting on monopoly exchanges or on exchanges where trading activity is cluttered with small orders was higher for some well informed and active traders than finding alternatives trading partners off the exchange. Large institutional traders sometime trade large blocks of securities "upstairs" at the NYSE, where trades are arranged by member brokers specializing in large block transactions at heavily discounted commissions. This trading activity is called the second market. By exchange rules, second market trades and prices are included in the market information

    flow coming from NYSE reported immediately on the transaction tape.

     Additional competition with the exchanges has come from some firms setting up alternative markets, like Jeffries Securities, which handle large and even some smaller trades totally outside the exchange in the growing third market. Since exchange rules prohibit members from trading off the

    trading floor, Jeffries and third market brokerage firms do not have seats on exchanges. Increasingly, institutions and other large traders avoid trading on exchanges and deal directly with each other, in the so-called fourth market. Fourth market transactors do not pay commissions and thus bear only the

    costs of finding counterparts to trade with.

     To summarize, brokers find buyers for sellers through their membership and participation in organized exchanges or their access to the communication linkages typical of over-the-counter markets. Concentration of trading in one location with rules on price setting is one solution for minimizing the costs of finding counterparties to trades. Modern technology and competition increasingly favor more dispersed communication networks typical of over-the-counter dealer markets.

     The communication advantage in bringing buyers and sellers together in a single place is being replaced by modern technology and alternative price-setting mechanisms.

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Pricing and Term Setting in Brokerage

     Brokers price their services to cover costs and earn a reasonable risk-adjusted return on their investment. Costs of trading consist of the operating costs and the costs of locating buyers or sellers in the market. At this point we wish to discuss the value production possible through pricing and term setting of brokerage services.

     Brokers typically price their services on a per transaction basis. Price setting for brokers in the United States on the NYSE was immeasurably easier and more profitable for member brokers prior to May 1, 1975. Until that date, commission rates on stock transactions were fixed by exchange rules. On May 1, 1975, or "Mayday" as the industry refers to the date, the Securities and Exchange Commission prohibited such price fixing by members.

     The U.S. Congress and the Securities and Exchange Commission have required that all transactions of NYSE listed securities on all exchanges, like the Midwest and Pacific Stock Exchanges, be reported on a Consolidated Transaction Tape so that information on all trade prices are available from one source. The objective is to provide regional market traders information on prices in New York and elsewhere around the country to develop a "National Market System (NMS)." A true NMS would erode the informational advantage the NYSE has due to its larger volume and concentration of information and permit competition from brokers on regional exchanges.

     Today, commissions on stock transactions in the United States and some other countries are competitive, described by observers as "negotiated". Commission rates on different stock trades are all over the map. There are different rates for retail customers and institutional traders. There are different commission rates for odd lots, small transactions, and for round lots or blocks (multiples of

    100 shares or $5,000 face value of bonds). Commissions on large blocks of stocks (hundreds of blocks)

    are arrived at differently, usually by negotiation or bidding.

     Different commission rates charged on different transactions are due in part to costs of executing different trades. Odd-lot trades involve more effort and paper work per share than large blocks. The costs of finding buyers or sellers for small or large amounts of stock are different given different markets for these transactions. Odd-lot buyers and sellers are primarily small retail investors.

     Odd-lot brokers must break blocks in order to fill demand, requiring additional activity. Large block traders may be matched in so-called "upstairs" trades with very low per share costs.

     The two key aspects affecting brokerage commission rates is the level of competition and other services associated with the trading activity. Since Mayday, most trading activity in the United States has been priced competitively in active and open markets. Pure brokerage charges seem to be closely tied to the costs of providing the trading services. The analysis of brokerage fees is confounded by the fact that most commissions include compensation for other financial services.

     Most of the services offered by brokers in addition to finding buyers for sellers are economically different financial services: (1) information services in the form of securities research and/or advising; (2) market making services which we discuss in the following section; and (3) safekeeping and clearing services, which we discuss in the next chapter. The point here is that pricing in the brokerage business is bundled with prices for other services.

     Many brokerage firms, like Merrill Lynch and Smith Barney, have research departments which make "buy," "sell," and "hold" recommendations on securities they follow. This stock and bond research constitutes information and advisory services discussed in Chapter 12. Brokerage firms offering trading services and advice are called full-line brokers. Michael Brennan and Tarun Chordia

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    (1993) analyze economics of bundling the sale of advice with trading services and priced jointly in the form of higher brokerage commissions. Their analysis demonstrates that careful pricing of full-line brokerage services can produce value for the broker and trader using the advice.

     Brennan and Chordia examine the total expected revenues from providing advice under three pricing schemes: (1) fixed charges before advice is rendered so that revenue is fixed, as charged by advisors for newsletters; (2) brokerage commissions charged as a percent of the value of trades (purchases or sales), so that revenue is related to the buy, sell, or hold advice provided; and (3) management fees for information provided indirectly through management of mutual funds. These last two forms of providing information are discussed in Chapter 12 dealing with information and asset management services.

     Brennan and Chordia find that when investors have different risk preferences, expected revenues from providing information and trading services with transaction-based fees like trading commissions produce maximum expected revenue for the broker-advisor firm when the

    broker/advisors' information is relatively precise. Expected revenue is higher than with fixed fees for information or management fees for fund managers.

     Traders' expected utilities are maximized even though higher expected brokerage commission raises the cost of securities traded. The seller of advice shares the risk of variations in trading activity with the trader. When research suggests not trading securities, as when "hold" advice is rendered, low commission volume results. Strong buy or sell advice generates more commission revenue but improves traders' welfare. In contrast, indirect compensation for information, like management fees for mutual funds, produce maximum expected revenue for investment advice when information is imprecise.

     The implication of Brennan and Chordia's analysis is that value can be produced for securities traders by providing them with information and charging them for the information through brokerage commissions. This pricing means traders share the brokerage revenue/cost risk stemming from implications of the information. The value is that risk averse traders will pay more for information when they act on it after they receive the advice. The analysis does not address the dissipation of information's value when it is made public and the reliability of information providers' over time. The analysis does demonstrate that value can be produced by careful pricing of brokerage service when combining advisory service.

     Brokers also routinely make money by making markets in securities, where market making is discussed in the next section. Full-line brokers like Merrill Lynch often buy and sell securities directly from traders, profiting from their market-making activities as well as charging commissions. Exchange rules require disclosure of the fact that the broker participated in a trade as a principal. Some discount brokers, like Charles Schwab, also profit from market making activities of affiliated 2firms, like Schwab's Mayer and Schweitzer subsidiary, without revealing that trades are made from . Brokerage commissions may be priced below cost or competitive rates and be

    their own portfoliovalue producing if market-making profits are high enough.

     The main example of providing "unbundled" trading services in the retail market for brokerage

    services is from the so-called "discount" brokers. In the retail market, Fidelity Brokers and Charles Schwab are the best known, although there are many other discount brokers. Pure discount brokers

    simply take orders and execute them with no frills. A call to a discount broker will confirm that their

     2 Craig Torres, "How Street Turns Your Stock Trades to Gold," Wall Street Journal, February 16, 1993. p. C1.

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