Stock brokers vs underwriters: what’s the difference?

Underwriting vs Leading Roles: An Overview

When people think of a brokerage firm, they may think of a financial services company that provides retail investors with access to markets with the ability to buy and sell securities on their behalf. Brokers provide additional trade-related features including research tools, news, analytics, and price quotes.

However, most brokerage firms also have many other trading roles that don’t always involve retail. The firm’s core underwriting and trading divisions may indeed make up the bulk of its ongoing business.

Here we look at what these other two activities are and how they work in the securities issuance process.

Key points to remember

  • Brokerage firms are well known for facilitating transactions on behalf of clients, in what is known as their agency role.
  • However, a broker’s primary profit centers may actually lie elsewhere.
  • Underwriting can be a lucrative business, helping a company register and issue securities to trade in the primary and then the secondary market.
  • Brokerage firms may also have trading desks that buy and sell securities with company money, using sophisticated strategies in a variety of markets.

Subscription: the primary market

Often the most lucrative aspect of the brokerage business is the sale of new issues of securities by companies seeking to raise capital. The sale of new issues constitutes what is called the primary market.

Originally, only securities firms were involved in primary market activity, which involves the underwriting or funding processes, and for a long time this did not involve any retail brokers. Things have changed and today most integrated brokerages now have strong underwriting and brokerage departments.

In its underwriting function, a brokerage firm handles the initial issuance and distribution of securities – in the form of common or preferred stock, or corporate bonds – of a company or other issuing body. The subscriber charges a fee for this service and can also take advantage of an initial public offering (IPO). Perhaps the most important role of a stock underwriter is through the IPO process, where stocks that exist in the primary market are made available to the public on stock exchanges, that is, say the secondary market.

To negotiate the terms of the primary issue of securities, the underwriting company uses all of its expertise in secondary market trading. The firm gains an idea of ​​the nature of the market in which the new issue of securities will be issued (i.e. the current attractiveness of the security to investors and the market valuation of nearby competitors). One of the reasons that investment firms became involved in both aspects of the market around the middle of the 20th century is that they had expertise in the secondary market, which facilitates sales in the primary market.

Risk vs Reward

Underwriting therefore involves understanding the risks of newly issued securities and then determining the most efficient way to market and sell them to investors. The company issuing new securities and its brokerage firm work together to determine the initial price of the issue, its timing and other marketability factors that will help attract investors.

Typically, the underwriting department is most concerned that the price of securities will deteriorate while they are still in the broker’s inventory, which would erode profits or even turn potential profits into losses. To address the large risks involved, a consortium of like-minded investment firms will form to mitigate some of the individual risks and ensure rapid distribution of securities among all of the firms’ clients, instead of those of just one. company.

Main role: Brokerage and negotiation

Once a new security is issued and sold, that security is considered marketable and it begins to trade in the secondary market. Investment firms participate in the secondary market in one of two ways: as principals, holding securities for sale in their own stock, or as agents, acting on behalf of a buyer or a seller but not holding title at any time during the transaction and earning a commission for this service.

In primary trading, the investment firm hopes to profit from buying securities in the open market using the firm’s money, holding them in its own inventory for a period of time, and reselling them for more. later at a higher price. As mentioned earlier, it is beneficial for investment firms to engage in primary trading as they are familiar with current trends and market conditions and hence they have the expertise to design appropriate benchmarks for the pricing of primary market issues or the yields of new bonds. problems. Additionally, brokerage house trading desks are often equipped with state-of-the-art automated trading platforms and other technological advantages that are not readily available to most retail traders.

Market creation

Another source of income that an investment firm derives from its main trading activities is to provide liquidity. Since the broker has a large inventory of securities, the broker does not need to wait for the simultaneous matching of buy and sell orders from his clients to complete a transaction. Instead, they may engage in market making (MM) activities.

This advantage of principal trading adds significantly to market liquidity and ensures that there will generally be a buyer for almost any security, even if retail investors are generally not active in trading that security.

Interweaving of director and agency functions

Sometimes the distinction between brokerage firms working only in the primary market and those working only in the secondary market becomes blurred, where principal and agency functions intertwine. There are several examples of primary activities resembling agency roles and vice versa. Therefore, certain measures must be taken to remain in compliance with various regulations.

Under certain circumstances, underwriting companies will not be able to support a new issue and will instead issue it where possible. The dealer will sell as much of the issue to its customers as possible at the best possible price, then return any unsold portion to the issuing company. A best-efforts placement is appropriate when a full placement may not be possible due to poor market conditions or the speculative nature of the issuing company – or if the subscriber is prevented from directly holding the securities of the issuer due to a conflict of interest elsewhere in the solidify.

Another variation between principal and agency roles occurs when a company issues new securities directly into the secondary market, supplementing the existing pool of issued and outstanding shares that began trading after the end of the market. initial issue. In some cases, such a secondary issuance may be classified as a private placement offered only to pre-qualified investors and institutions rather than on the open market. If the issuer has a strong enough reputation, the dealer takes very little risk by distributing the quality issue to a few large institutions. In other situations, there is no central marketplace for the core business activities; transactions are conducted on the over-the-counter (OTC) market, now comprised of computer systems directly linking dealers and major institutions.

Is an underwriter the same as a broker?

Underwriting is the process of evaluating, pricing and marketing a new issue of securities. This involves assessing the potential risks and benefits of the business and the problem itself. Today, many large brokerage firms have an underwriting division that helps companies raise capital in this way by selling stocks or bonds. So, although underwriting is a different role than agency brokerage, they can both be services provided by the same parent company.

What is the difference between brokerage and underwriting?

Brokerage involves executing market transactions on behalf of clients or buying and selling securities. Underwriting consists of putting new securities on the market.

Which career pays more money: brokerage or underwriting?

According to salary aggregator, the average compensation for a broker in 2022 in the United States was $74,100. In comparison, subscribers earned $69,925.

What are the other types of subscription?

Underwriting is used in the insurance industry to assess risk and assign the appropriate premium amount to insurance policies. Underwriting also takes place when people apply for loans, such as mortgages. Here, the lender will determine if the borrower is creditworthy and what interest rates should be awarded based on that risk.

The essential

Brokerage firms weren’t always the large, multi-faceted business entities we know today. In the past, individual securities firms only operated in one area, but in the early 20th century, stock brokers began to act as principals on new issues of securities and as as agents for the trading of securities on the secondary market. Today, the roles of principal and agent have become mixed, with investment firms being involved in both primary and secondary markets.

Dolores W. Simon