For the sake of simplicity, especially from the point of view of the retail investor, it is often appropriate to refer to an investment dealer as a broker. When we deal with a securities firm as an individual, we are asking that firm to broker a transaction on our behalf. However, we should know that the firm has plenty of other business that does not involve retail trades. In fact, the firm's underwriting and principal trading may form the largest portion of its ongoing business. Here we look at what these activities are and how they function in the process of issuing securities.
The Primary Market
Perhaps the most lucrative aspect of the securities business is the selling of new securities issues to large institutional and retail investors. The sale of new issues in this manner constitutes what is known as the primary market. Originally, only securities firms were involved in this business activity, which is called underwriting or financing, and it did not involve the retail broker whatsoever. However, most integrated firms now have both underwriting departments and brokering departments. (For more insight, see What's the difference between institutional and non-institutional investors?)
In its function as an underwriter, a firm owns the new security issue as part of its inventory, thereby taking on a certain amount of risk. The rewards for taking this risk, however, are often huge: the underwriting firm receives a profit from the difference between the buying and selling prices, so naturally, this firm will aim to sell as many units of the issue as possible at the highest price possible. By contrast, the new issuer generally does not assume the same risk, since payment is guaranteed by the underwriter regardless of the price at which the issue eventually sells in the market, or even whether it sells at all.
Given the risks involved, the securities issuer and its investment dealer work together very closely to determine the original price for the issue, its timing and other marketability factors that will help attract investors. In general, the underwriting firm is concerned that the price of the securities might deteriorate while they are in inventory, which would erode profits or even turn potential profits into losses. To deal with the large risks involved, a consortium of like-minded investment firms will form to mitigate some of the individual risk and ensure a speedy distribution of securities among all of the firms' clients, instead of those of only one firm.
In negotiating the terms of the primary securities issue, the underwriting firm uses all of its expertise of trading in the secondary market (which we define in detail below). The firm gains a sense of the nature of the market to which the new issue of securities will be released - the security's current attractiveness to investors and the market valuation of close competitors. One of the reasons why investment firms became involved in both aspects of the market around the mid-20th century is that they possessed expertise in the secondary market, which aids in primary market sales.
Once a new security is transacted between its issuer and an underwriter, that security is considered issued and outstanding and, as such, it begins to trade on the secondary market. Investment firms participate on the secondary market in one of two ways: as principals, holding securities for sale in their own inventory, and as agents, acting on behalf of a buyer or seller but not owning the security at any point during the transaction.
In principal trading, the investment firm hopes to profit from buying securities in the open market, holding them in its own inventory for a certain period of time, and selling them later for a higher price. As mentioned earlier, it is advantageous for investment firms to engage in principal trading because they're well acquainted with current market conditions and, therefore, they have the expertise to devise suitable benchmarks for pricing primary market issues or the yields on new bond issues.
Another advantage an investment firm gains from principal trading activities is liquidity. Because it can accomplish the buy or the sell side of any transaction with its own inventory, the investment firm need not wait for simultaneous matching of buy and sell orders from outside investors in order to complete a transaction. This advantage of principal trading greatly adds to the liquidity of the market and ensures that there will typically be a buyer for almost every security, even if retail investors are generally not active in trading that security. (To learn more about this process, check out The Nitty-Gritty Of Executing A Trade.)
Broker or Agency Transactions
In terms of investment banking, the role of the securities broker is the one with which retail investors are most familiar. In their function as brokers, firms simply act as an agent or intermediary in a transaction on the secondary market, never actually owning the securities themselves. The broker can represent buyers and sellers, who in fact are the principals, or owners of the securities. In exchange for facilitating or executing a trade, brokers charge their clients a commission.
Intermingling of Principal and Agency Functions
When the distinction between securities firms working solely in the primary market and those working solely in the secondary market disappeared, the functions of principal and agency roles became intermingled. There are several examples of principal activities that resemble agency roles and vice versa.
In certain circumstances, underwriting firms will not wish to take ownership of a new issue and will instead issue it on a 'best efforts' basis. The dealer will sell as much of the issue to its clients as it can at the best possible price, but may return any unsold portion to the issuing company. Clearly, a best efforts placement is suitable when a full placement may not be possible due to poor market conditions or to the speculative nature of the issuing company.
Another variation on principal and agency roles occurs when a company issues new securities to the secondary market, supplementing its lot of issued and outstanding shares that began trading on the secondary market when the original issue was completed. In some instances, such a secondary issue may be referred to as a private placement and the issuer has a sufficiently solid reputation so that the dealer takes very little risk in distributing the quality issue to a few large institutions.
In the case of non-equity securities, secondary trading is generally conducted with the securities firm as principal. However, agency trades occasionally take place. For example, in a new money market issue, the dealer may sell the securities as an agent or take them into inventory as principal for later resale.
Finally, when an investment firm trades stocks out of its own inventory, acting as principal, the stock exchange appoints the firm as a registered trader or market maker. This gives the firm the responsibility of maintaining positions in a particular listed stock to enhance market liquidity for that stock. In such situations, there is no central marketplace for the firm's principal activities: the transactions are conducted on the over-the-counter market comprised of computer systems linking dealers and large institutions.
Investment firms were not always the large, multifaceted business entities that we know today. In times past, individual securities firms conducted business in only one area, but in the early 20th century investment dealers began acting as principals on new securities issues and as agents for the trading of securities on the secondary market. Now the roles of principal and agent have intermingled, as investment firms are involved in both the primary and secondary markets.
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