Economics of Broker-Dealer Banks

 

From  Matching Collateral Supply and Financing Demands in Dealer Banks

Broker-dealers are firms that participate in markets by buying and selling securities on behalf of themselves and their clients. They must register with the Securities and Exchange Commission (SEC), and are often a subsidiary of a larger bank holding company. Any securities purchased by the firm for its account can be sold to clients or other firms, or can become part of the firm’s own holdings. Our definition of dealer banks includes activities performed by broker-dealers, but also includes OTC derivative dealing activities, which are often conducted in the affiliated depository institution subsidiary of the parent holding company (rather than the broker-dealer subsidiary).

From Matching Collateral Supply and Financing Demands in Dealer Banks

 

Dealer banks are active in the intermediation of many markets, either in their role as dealers or in their role as prime brokers where they provide financing to investors. Dealer banks are financial intermediaries that make markets for many securi- ties and derivatives by matching buyers and sellers, holding inventories, and buying and selling for their own account when buyers and sellers approach the dealer at different times, for different quantities, or are clustered on one side of the market. Many banks with securities dealer businesses also act in the primary market for securities as investment banks, underwrit- ing issues to sell later to investors. Services typically provided by dealers include buying and selling the same security simul- taneously, extending credit and lending securities in con- nection with transactions in securities, and offering account services associated with both cash and securities.

 

From Matching Collateral Supply and Financing Demands in Dealer Banks

Many dealers carry out their activities in a broker-dealer subsidiary of a bank holding company. For most derivatives trades, dealers are one of the two counterparties, with many dealers recording their derivative exposures at their affiliated bank, the depository institution subsidiary of the parent com- pany. Prime brokers are the financing arm of the broker-dealer, offering advisory, clearing, custody, and secured financing services to their clients, which are often large active investors, especially hedge funds. Prime brokers can conduct a variety of transactions for their customers, including derivatives trading, cash management, margin lending, and other types of financ- ing transactions.

From  Broker-Dealer Finance and Financial Stability

Broker-dealers were at the epicenter of the financial crisis. Their reliance on collateralized borrowing in the form of repurchase agreements was assumed to insulate them from runs, perhaps because many viewed collateralized lending as providing little default risk. This proved wrong. Many of their creditors did not want to take possession of the collateral backing the repurchase agreements in the event of default of a broker-dealer. As a result, there were widespread runs on broker-dealers, particularly those experiencing acute financial problems.  This was not, however, just a problem for broker-dealers. Because of broker-dealers’ crucial role as market-makers, liquidity in markets was severely impaired.

Importantly, these broker-dealers fund their holdings in uninsured short-term credit markets, which makes them inherently more subject to runs than institutions that finance their holdings with longer-term or insured borrowing. As the crisis showed, when investors lose confidence in broker-dealers, short-term funding “runs” from them, and as a consequence the broker-dealers lose their ability to effectively serve as middlemen in markets, which in turn can impair the ability of investors to buy or sell a wide variety of stocks and bonds.

 

Perhaps the defining event of the 2008 financial crisis was the failure of Lehman Brothers, one of the largest broker-dealers in the United States. However, the collapse of Lehman was not an isolated failure of a single broker-dealer – but rather one of a string of crises for multiple broker-dealers. Bear Stearns had failed earlier that year, Merrill Lynch experienced significant funding difficulties and was eventually acquired, and Goldman Sachs and Morgan Stanley opted to become bank holding companies. Foreign broker-dealers did not fare much better: several large foreign broker-dealers operating in the United States experienced very substantial losses that required a significant rebuilding of capital.

While there have been significant reductions in some broker-dealers’ holdings of highly risky assets, and some improvements in capital and liquidity positions (and collateral quality), their reliance on a wholesale funding model that is subject to runs remains surprisingly unchanged.

 

 

Key Sources of Research:

Failure mechanics of Dealer Banks

 

 

Matching Collateral Supply and Financing Demands in Dealer Banks

 

Adam Kirk, James McAndrews, Parinitha Sastry, and Phillip Weed

2014

https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412kirk.pdf

 

How does failure spread across broker-dealers and dealer banks?

Jefferson Duarte and Adam Kolasinski

November 26, 2014

 

http://coller.tau.ac.il/sites/nihul_en.tau.ac.il/files/media_server/Recanati/management/conferences/finance/2014/How_Does_Failure_Spread_Across_Jefferson_Duarte.pdf

 

Repo Runs

Antoine Martin, David Skeie, and Ernst-Ludwig von Thadden

May 2010

https://www.econstor.eu/bitstream/10419/60827/1/635888602.pdf

 

Financial intermediaries, Financial Stability and Monetary policy

Tobias Adrian and Hyun Song Shin

2008

https://www.kansascityfed.org/media/files/publicat/sympos/2008/shin031209.pdf

 

Financial Intermediaries and Monetary Economics

Tobias Adrian Hyun Song Shin

2009

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr398.pdf

 

The Changing Nature of Financial Intermediation and the Financial Crisis of 2007-09

Tobias Adrian and Hyun Song Shin

April 2010

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr439.pdf

 

Dealer Financial Conditions and Lender-of-Last-Resort Facilities

Viral V. Acharya, Michael J. Fleming, Warren B. Hrung, Asani Sarkar,

September 2015

 

http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/Dealer%20Financial%20Conditions%20Sep_7_2015_with_tables_appendix.pdf

 

The Federal Reserve’s Primary Dealer Credit Facility

Tobias Adrian, Christopher R. Burke, and James J. McAndrews

 

https://www.newyorkfed.org/medialibrary/media/research/current_issues/ci15-4.pdf

 

 

The Federal Reserve’s Commercial Paper Funding Facility

 

Tobias Adrian, Karin Kimbrough, and Dina Marchioni

https://www.newyorkfed.org/medialibrary/media/research/epr/11v17n1/1105adri.pdf

 

Repo and Securities Lending

Tobias Adrian

Brian Begalle Adam Copeland Antoine Martin

February 2013

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr529.pdf

 

Mapping and Sizing the U.S. Repo Market

Adam Copeland, Isaac Davis,Eric LeSueur, and Antoine Martin

http://libertystreeteconomics.newyorkfed.org/2012/06/mapping-and-sizing-the-us-repo-market.html#.V2NIrFehmoo

 

Key Mechanics of the U.S. Tri-Party Repo Market

Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin

 

https://www.newyorkfed.org/medialibrary/media/research/epr/12v18n3/1210cope.pdf

 

The Tri-Party Repo Market before the 2010 Reforms

Adam Copeland Antoine Martin Michael Walker

2010

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr477.pdf

 

The Evolution of a Financial Crisis: Panic in the Asset-Backed Commercial Paper Market

 

Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez

2009

http://www.federalreserve.gov/pubs/feds/2009/200936/200936pap.pdf

 

Matching Prime Brokers and Hedge Funds

Egemen Eren

2015

http://web.stanford.edu/~eren/eren_jmp.pdf

 

Haircuts and Repo Chains

Tri Vi Dang

Gary Gorton

Bengt Holmström

http://www.columbia.edu/~td2332/Paper_Repo.pdf

 

Reference Guide to U.S. Repo and Securities Lending Markets

Viktoria Baklanova, Adam Copeland, and Rebecca McCaughrin

December 2015

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr740.pdf

 

Systemic risk in the repo market.

 

Alexander Shkolnik

 

http://helper.ipam.ucla.edu/publications/fmws1/fmws1_12590.pdf

 

 

 

 

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Author: Mayank Chaturvedi

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