NEW YORK, NY - OCTOBER 26: A trader works on the floor of the New York Stock Exchange on October 26, 2012 in New York City. Following the release of a stronger-than-expected report on U.S. economic growth, stocks rose in morning trading. According to government data, the Gross Domestic Product (GDP), the broadest measure of economic activity, rose at a 2% annual rate in the third quarter. (Photo by Spencer Platt/Getty Images)
Interdealer broking firms are there to add an element of mystery to the process of buying and selling securities. Thanks to them, buyers and sellers don’t know exactly who they’re dealing with.
This can be advantageous. Imagine, for example, that you’re a large bank – Bank A, and have purchased three thousand bonds issued by company X to sell on behalf of a client. Another bank, Bank B, has a client who wants to buy those bonds for $1.5 each. However, traders at Bank B know from experience that Bank A likes to sell its bonds on as quickly as possible. With this in mind, they offer $1.45 each - $0.05 less than if Bank A had been an anonymous seller, and X loses out $75.
Interdealer brokers insert themselves into the middle of this kind of transaction between banks. They match buyers and sellers (in this case Bank A and Bank B) without revealing the identity of either party. Instead of Bank A selling its bonds to Bank B directly, it will now sell them to an interdealer broker, who will sell them again on its behalf. Neither bank will be any the wiser, and Bank A will get a better price. The interdealer broker makes its money by taking a small percentage of each trade as commission. This can be very lucrative. Large firms like ICAP have annual revenues well in excess of $1bn.
The brokers then often spend the evenings the entertaining traders to ensure they continue to win their business
Known (appropriately) as ‘broking’, this matching service is interdealer broking firms’ bread and butter business. Each firm employs hundreds of so-called ‘voice brokers’ who spend their days working the phones and talking to traders in banks who are buying and selling securities. The brokers then often spend the evenings the entertaining traders to ensure they continue to win their business in future.
As financial markets evolve and increasing amounts of trading takes place electronically, interdealer brokerage firms are also turning to electronic systems to broke deals between buyers and sellers. These electronic ‘platforms’ allow traders to make (‘execute’) trades directly. Human beings are still needed to persuade traders to use the electronic systems, however, and to make sure that the service they’re receiving is satisfactory.
Beyond voice broking and electronic broking, interdealer brokers also offer services like, ‘post-trade risk reduction.’ This helps the parties buying and selling financial securities (e.g stocks and bonds and complex derivatives) to make sure that nothing goes wrong after the trade has taken place. For example, the seller wants to ensure it gets paid and the buyer wants to ensure that the security it’s purchased is transferred into its ownership. This kind of post trade risk reduction service is especially important when so-called 'over the counter' (OTC) derivative products are bought and sold. These kinds of transactions are more complicated, and more risky as a result.