Trading and Exchanges Chapter 3: The Trading Industry - Who Does What (Part 1)
Chapter 3 is a guided tour of the entire trading industry. Harris warns upfront it’s packed with jargon. He also says you can skip it if you already know this stuff. But if you’re new to how markets work, this chapter is the map you need before going deeper.
Splitting it into two parts because there’s a lot here. Part 1 covers the players, the facilitators, and the instruments they trade.
Buy Side vs Sell Side (Not What You Think)
First thing Harris clarifies: “buy side” and “sell side” have nothing to do with buying or selling stocks. Both sides buy and sell stuff all day long. The distinction is about who buys services.
The buy side is everyone who uses the market to solve some problem. Pension funds invest for retirees. Mutual funds build portfolios. Individuals save for retirement. These are all buy-side players. They are customers of the market.
The buy side has layers. A state pension fund has beneficiaries (retirees), an investment sponsor (the fund itself), an investment adviser (the portfolio manager), and a buy-side trader who executes orders. Four layers between the retiree’s money and the actual trade. Each layer creates opportunities for things to go wrong.
The sell side is dealers and brokers who provide services to the buy side. They exist because the buy side pays them. No buy-side demand, no sell side. Simple economics.
Dealers vs Brokers
Dealers trade with you directly. Nobody wants to sell you those 30,000 shares right now? A dealer will sell them from their own inventory. They profit by buying low and selling high. The spread is their margin.
Brokers never trade with you. They find someone else who wants the other side of your trade and charge a commission. Classic middlemen.
Many firms do both, hence broker-dealer. Fun fact from Harris: big broker-dealers are called “wirehouses” because firms that adopted the telegraph in the 1800s could collect orders from distant cities and grew massively. Speed has always been money in this business.
Exchanges
Exchanges are where traders meet to arrange trades. Historically a physical floor. Now mostly electronic.
Not all exchanges work the same way. Some just provide a forum for free negotiation. Others have order-driven systems that match buyers and sellers automatically using rules. These rule-based exchanges are basically brokerages, which means exchanges and brokers are often competitors.
Harris mentions ECNs (Electronic Communications Networks) which were a big deal in 2003. Island ECN, Instinet, Archipelago. Many eventually became exchanges or got absorbed. Technology was already shaking up the old model of member-owned exchanges with floor traders.
Important detail: lots of trading happens away from exchanges. The corporate bond market is almost entirely over-the-counter (OTC). No exchange involved.
The Plumbing: Clearing and Settlement
The stuff nobody talks about until something breaks.
After a trade, both sides submit records to a clearing agent (like the NSCC). It checks that records match. If they don’t, it’s called a “DK” in securities markets, short for “Don’t Know.” One side literally saying “I don’t know what you’re talking about.” With electronic systems this is mostly a non-issue.
Settlement agents handle the actual exchange of cash and securities. They use net settlement, adding up all buys and sells for each client and only settling the net amount. This massively reduces transactions.
Clearinghouses in futures and options markets go further. They guarantee both sides perform by becoming the buyer to every seller and seller to every buyer. If someone defaults, the clearinghouse covers it and taxes its members. Basically mutual insurance. They require margin deposits and monitor everyone constantly.
Harris tells a great story called the Brazilian straddle. A technically bankrupt trader has nothing to lose by making huge bets. If it works, they survive. If not, they grab a one-way ticket to Brazil and let the clearing member deal with the mess. This is exactly why clearing firms monitor positions so aggressively.
Trading Instruments
Harris puts everything into buckets.
Real assets: physical things like commodities, real estate, metals, pollution credits. Most liquid markets are in fungible stuff (gold, oil, wheat) where one unit equals another.
Financial assets: represent ownership of real assets. Stocks, bonds, currencies. They trade in primary markets when first created (IPOs) and secondary markets afterward. Underwriters help issuers sell new securities.
Derivative contracts: get value from something else. Forwards, futures, options, swaps. Key property: derivatives are in zero net supply. Every long has a short. No wealth created or destroyed, just redistributed.
Insurance and gambling contracts: both depend on future events. Insurance is for hedgers with real exposure. Gambling is for people with no financial stake. Many use derivatives as gambling instruments. Harris is not judging, just observing.
Hybrid instruments: convertible bonds (part bond, part stock option), equity warrants. Finance loves combining things into new things.
One Stat to Remember
Despite media attention, stocks represent only about 20% of US capital wealth. Most wealth is in real estate and bonds. And the 250 most active NYSE stocks accounted for 62% of total trading volume. Most of the action is concentrated in a small number of names. Most listed stocks rarely trade.
That’s Part 1. In Part 2 we look at where these markets are geographically, how exchanges around the world operate, and how regulators keep an eye on everything.
Previous: Chapter 2: Trading Stories