15 Types of Financial Market Participants ExplainedIn this post, I’ll be going over the 15 types of financial market participants as listed above.
You want to keep your friend close, and your enemies closer. As an investor or a trader, jumping into the market without knowing what these entities are doing is like jumping into a battlefield with just a stick in your hand.
So understanding the roles of each of these entities can help you significantly later as you mature as an investor, especially if you’re a beginner.
Investment Banks
- Investment banks buy, sell, and issue stocks and bonds, lead mergers and acquisitions, conducts market research, and provide asset management services.
- They act as a bridge between people who want to invest their capital, and people who need investments.
- Investment banks can be more specifically divided into two types: bulge brackets and boutiques.
- Bulge brackets are general investment banks like Goldman Sachs, JP Morgan, Morgan Stanley, and Deutsche Bank.
- Boutiques are more specialized investment banks such as Lazard, Evercore, and Guggenheim.
Structure of an Investment Bank
- A general investment bank can be divided into three offices: the front, middle, and back office.
- The front office consists of four divisions: the investment banking division, sales and trading, asset management division, and research division.
- The front office refers to the divisions that directly interact with clients, and are in full charge of generating profits for the company.
- The image of investment bankers portrayed in movies generally all refer to the front office. These are the people who make six figure monthly salaries.
- The middle office is in charge of supporting the front office.
- They are responsible for risk management or capital management.
- The back office is in charge of the operations of the investment bank as a company, so it includes IT, HR, and other administrative teams.
Front Office Divisions Explained
1) Investment Banking Division (IBD)
- The investment banking division is in charge of everything that happens in the primary market.
- The primary market is where securities are created, and the secondary market is where those securities are traded.
- Normally when retail investors invest, it all happens in the secondary market.
- In the primary market, investment banks offer a variety of services including the issuance of stocks and bonds, leading an IPO, or leading an M&A.
- Teams are normally divided by sectors, but they can also be divided into specific teams depending on the deal they’re doing.
- Their day to day work involves company valuation, industry analysis, analyzing a company’s financials, preparing for presentations, and financial modelling. (When I say financial modelling, I mean that they use excel. They don’t really use extremely sophisticated statistical models in this division.)
2) Sales and Trading
- When you think of Ivy League alumni who work in finance, it usually refers to people in the investment banking division, or in sales and trading.
- But recently, this division has been dying, and is on a downtrend.
- Trading can be divided into two types: prop trading or proprietary trading, and flow trading.
- Prop trading refers to the type of trading that we know, where traders buy low, and sell high.
- Flow trading refers to order flows, where if a client makes an order the trading desk fills that order on the client’s behalf.
- In that process, they leave a small profit margin and take a certain amount of fees.
- In the past, both types of trading were extremely active.
- But with the global financial crisis in 2008, prop trading within investment banks got banned, according to the Volcker rule.
- As a result, most major banks spun off their prop trading desks, and the people who used to be prop traders in investment banks left to create their own hedge fund.
- What’s left now is flow trading, but since flow trading refers to simply filling orders on the customer’s behalf, this process has recently been automated to a huge extent, especially with the emergence of high frequency trading
- Along with this, their profit margins and commission started to decline, and the sales and trading industry as a whole is shrinking over time.
- As such, the teams left in this division are teams such as high frequency trading teams, quant teams, and OTC market traders. (OTC refers to over-the-counter, which is where customized products are bought and sold, as opposed to standardized products that we see in secondary markets.)
3) Research
- The research division is in charge of market research.
- They make analyst reports that we’re familiar with.
- But this is another division that’s dying.
- Research conducted by these institutions were actually provided to their clients as a token of gratitude for using their services, and paying commission.
- But, with brokers like WeBull and Robinhood offering zero commission, their business model deteriorated.
- Especially in Europe, laws have been set to distinguish payments for commissions and payments for research material, and people don’t really want to pay money for services like these.
- Lastly, with the development of data science, the way research is conducted has completely changed.
- It has become more technical, using machine learning techniques of pattern recognition, and it’s becoming more common on the buy side.
Mutual Funds, Hedge Funds, Proprietary Trading Firms
- In the case of mutual funds, the capital of the fund comes from people, or the general public.
- The capital for hedge funds come from accredited investors who qualify the capital requirement.
- Normally, these investors need to invest a minimum of $500,000 to $1 million.
- In the case of prop trading firms, they trade with their own money. Hence the term ‘proprietary’.
- In terms of their investments, mutual funds are mostly limited to investments in stocks and bonds.
- Hedge funds and prop trading firms don’t have any limitations or regulations in terms of the asset they want to invest in.
- Even in terms of the trading/investment strategies that are used, mutual funds strategies are quite limited and regulated heavily, as opposed to hedge funds or prop trading firms that have no restrictions in their strategies.
- The logic behind restricting strategies that mutual funds use is that mutual funds manage capital of the general public, and thus have to be more careful with how they manage their funds.
- The regulations that the government poses on mutual funds are essentially ways to protect the general public from potential losses that might incur.
- As such, even when it comes to revealing information, mutual funds need to be transparent about everything.
- In the case of hedge funds, the government acknowledges that accredited investors with $3-4 million to invest are probably aware of the potential risks, and thus is relatively less limited in having to reveal their information.
- Lastly, in the case of prop trading firms, because they’re trading with their own money, they have no obligation to reveal any of their information.
- This is why prop trading firms use exclusive trading techniques and strategies that cannot be exposed to the general public.
- Mutual funds take a 1-2% management fee, and don’t take any other incentive fees.
- Thus, they focus on gathering as many people as possible in order to capitalize on a huge management fee.
- They are also legally allowed to advertise and do sales.
- Hedge funds take 1-2% as management fees, and 15-20% in incentives. This is also known as the Two and Twenty.
- Hedge funds are also limited from advertising.
- Lastly, prop trading companies take all of the profits they generate, and thus do not need any advertising at all.
- Examples of mutual funds include Vanguard, Fidelity, and State Street.
- Famous hedge fund examples include Bridgewater Associates, Renaissance Technologies, and Elliott.
- Lastly, prop trading companies are companies like D. E. Shaw, Hudson River Trading, and DRW.
Private Equity
- Private equities are very similar to hedge funds in terms of their nature, the way they receive management fees and incentives.
- But as opposed to hedge funds that normally invest and trade in the secondary market, private equities directly invest in a company. Hence the name ‘private’ equity.
- A prime example is a leveraged buyout fund. This is when private equities acquire a huge stake within a company, increase its profitability, and sell their stake for a higher price.
- In movies, these people are portrayed as bloodless and merciless people who lay off tens of thousands of workers to cut costs of a company.
- Similarly, there are venture Capital funds that invest in early startups, and Growth Equity Funds that invest in startups at later stages.
Exchange Traded Funds (ETFs), Index Funds
- Before I explain index funds, it’s important that you understand exchange traded funds, or ETFs.
- An ETF is essentially a basket of securities that trades on an exchange like a stock.
- In mutual funds, when they have a fund that tracks an underlying index, it’s called an index fund.
- Similarly, an ETF that tracks an underlying index is an Index ETF.
- An Index ETF is essentially the same thing, but a security listed on an exchange, into smaller bits, so that individuals can buy and sell the ETF like a stock.
- For instance, for an individual to invest in all 500 companies on the S&P 500 index is extremely difficult.
- What institutions do is, they buy the shares of all 500 companies on the client’s behalf, creating a basket with all companies.
- From there, they sell the ownership of the basket to clients, which is the ETF.
- Because these companies actually own the underlying asset, they are not exposed to the risk of bankruptcy.
- This is a passive fund, in which a fund manager does not really intervene actively.
- Thus, the fund manager of an Index ETF just needs to mechanically buy and sell shares according to the index, so that the ETF can perform in correlation to the index.
- Ever since the global financial crisis in 2008, quantitative easing has pushed market indices to move upwards over time, making passive Index ETFs a very attractive option for investment.
Sovereign Wealth Funds, Pension Funds, Endowment Funds
- A sovereign wealth fund is a state-owned investment fund that invests in financial assets, and is run by the state.
- A pension fund is a fund that is set up by contributions from employers, unions, or other organizations to provide retirement benefits to its employees or members.
- Pension funds are one of the largest players in the market by size.
- They invest in stocks and bonds, but also increasingly stated exposing themselves to other asset classes.
- There are also endowment funds, which is a fund that invests with the money that was gifted to them.
- These funds are often run by universities, nonprofit organizations, and sometimes even churches.
- The funds operated by Harvard and Yale are known as Super Endowment Funds due to their fund size and impressive returns.
- A general portfolio that consists of 60% stocks and 40% bonds would give an annual return of 5.4%.
- Super Endowment Funds have managed to reach an annual return rate of 11.5% over the past 20 years.
- These funds have great network value, easy access to premium information, and expertise in alternative asset class investments.
- This means that they don’t invest in just stocks and bonds, but also real estate, private equities, emerging equities, global bonds, and natural resources.
Brokers, Dealers, Exchanges
- Brokers play the role of middlemen who connect buyers and sellers within a market, and profit from commissions.
- Exchanges play the same role within the cryptocurrency market.
- Dealers play the role of market makers for customized financial products that are traded in the OTC markets.
- Essentially, they take the opposite position of the person trying to trade.
- Dealers mostly do business with institutional investors, because individual investors normally don’t trade customized financial products.
- As a rule of thumb, when someone says dealers, think of investment bankers who trade interest rate swaps, bonds, or CBS over the counter.
Insurance Companies
- Moving onto insurance companies; they receive premiums from their clients, and while their role is to pay their clients back in case of an accident, during day to day operations, they also participate in the financial markets with the capital they have.
- However, compared to the size of their fund, they play a relatively less significant role in the market.
Federal Reserve Board
- The Federal Reserve Board, or Fed, consists of 12 regional federal banks.
- They control the national monetary policy, supervise and regulate banks, and maintain financial stability.
- There’s a colloquial term that ‘the Fed prints money’, but this is not to be taken literally.
- One of the ways in which they control money supply is by buying or selling bonds in the open market, also called the open market operations.
- One of the reasons that all asset markets have been so bullish ever since the market drop in March is because the Fed has increased money supply at an unprecedented rate, thereby inflating asset prices.
Limited Liability Companies
- Limited liability companies are also players within the financial markets.
- They initiate share buybacks, give out dividends to shareholders, and insider transactions take place as well, which is actually highly illegal.
- Insider transaction refers to an insider of the company trading the company’s shares based on information asymmetry.
- For instance, if an executive at Pfizer bought the company’s shares before the vaccine announcement, knowing that the vaccine was ready, that would be considered insider trading, and he’d do jail time for it.
Securities and Exchange Commission (SEC)
- The Securities and Exchange Commission is in charge of imposing federal securities laws and regulating the stock and options exchange.
- In the example suggested previously of an executive from Pfizer, the SEC would be the entity to investigate the case.
Retail Investors, Accredited Investors
- Retail investors refer to the general public that take part in the financial market.
- These are the people who work 9-5 jobs, and invest in stocks over the long run, or sometimes they’re full time traders and investors.
- Accredited investors are similar to retail investors in that they are an individual, but they’re different from other retail investors in the sense that they’re acknowledged by the SEC.
- Essentially, the government understands that an accredited investor has more knowledge and capital, and is capable of bearing more risk compared to the average retail investor.
- Thus, they get more opportunities to participate in the financial market that normal retail investors don’t.
- For instance, they can buy private companies that aren’t listed on the secondary markets, and they can invest their capital in hedge funds.
- To become an accredited investor in the US, your net worth must exceed $1 million, not including primary residence, or your annual income must exceed $200,000 for the past 2 years, or $300,000 in annual income with your spouse for the past 2 years.
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