Investors typically leave their securities in storage with the broker for
safekeeping. If the securities are left with the broker, they are insured against loss by
the Securities Investor Protection Corporation (SIPC), an agency of the federal government.
This guarantee is not against loss in value, only against loss of the securities
themselves.
Brokers also provide margin credit. Margin credit refers to loans advanced by
the brokerage house to help investors buy securities. For example, if you are certain
that Intel Corporation stock is going to rise rapidly when its latest computer chip
is introduced, you could increase the amount of stock you can buy by borrowing from
the brokerage house. If you had $5,000 and borrowed an additional $5,000, you could
buy $10,000 worth of stock. Then, if the price goes up as you predict, you could
earn nearly twice as much as without the loan. The Federal Reserve sets the percentage
of the stock purchase price that brokerage houses can lend. Interest rates
on margin loans are usually 1 or 2 percentage points above the prime interest rate
(the rate charged large, creditworthy corporate borrowers).
As noted in Chapter 19, the forces of competition have led brokerage firms to
offer services and engage in activities traditionally conducted by commercial banks.
In 1977, Merrill Lynch developed the cash management account (CMA), which provides
a package of financial services that includes credit cards, immediate loans,
check-writing privileges, automatic investment of proceeds from the sale of securities
in a money market mutual fund, and unified record keeping. CMAs were adopted
by other brokerage firms and spread rapidly. Many of these accounts allow checkwriting
privileges and offer ATM and debit cards. In these ways, they compete directly
with banks.
The advantage of brokerage-based cash management accounts is that they make
it easier to buy and sell securities. The stockbroker can take funds out of the account
when an investor buys a security and put the money into the account when the
investor sells securities.
Full-Service vs. Discount Brokers Prior to May 1, 1975, virtually all brokerage
houses charged the same commissions on trades. Brokerage houses distinguished
themselves primarily on the basis of their research and customer relations. In May
1975, Congress determined that fixed commissions were anticompetitive and passed
the Securities Acts Amendment of 1975, which abolished fixed commissions. Now
brokerage houses may charge whatever fees they choose. This has resulted in two
distinct types of brokerage firms: full-service and discount.
Full-service brokers provide research and investment advice to their customers.
Full-service brokers will often mail weekly and monthly market reports and recommendations
to their customers in an effort to encourage them to invest in certain
securities. For example, when the investment banking department of the brokerageChapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms 555
house has an initial public offering available, brokers will contact customers they feel
may be interested and offer to send a prospectus. Full-service brokers attempt to
establish long-term relationships with their customers and to help them assemble
portfolios that are consistent with their financial needs and risk preferences. Of
course, this extra attention is costly and must be paid for by requiring higher fees
for initiating trades. Bank of America Merrill Lynch is the biggest of the fullservice
brokers with about 15,000 financial advisors and $2.2 trillion in client assets.
Discount brokers simply execute trades on request. If you want to buy a particular
security, you call the discount broker and place your request. No advice or
research is typically provided. Because the cost of operating a discount brokerage
firm is significantly less than the cost of operating a full-service firm, lower transaction
costs are charged. These fees may be a fraction of the fees charged by a fullservice
broker. Charles Schwab Corp. is the best-known discount broker. Many
discount brokerage firms are owned by large commercial banks, which have historically
been prohibited from offering full-service brokerage services.
Regardless of which type of brokerage firm you choose, it will be a member of
the major exchanges and have computer links to the NASDAQ (National Association
of Security Dealers Automated Quotation System). Suppose that you place an order
for 10,000 shares of IBM with your local Merrill Lynch office. Your broker will send
an electronic message to the Merrill Lynch traders who work on the floor of the
New York Stock Exchange (NYSE) to buy 10,000 shares of IBM in your name. On
the floor of the NYSE, there are circular work areas where specialists in each security
that is traded on the exchange stand. Each specialist is responsible for several
stocks. The Merrill Lynch floor trader will know where the IBM specialist is and will
approach that person to fill your buy order. Confirmation of the purchase will then
be communicated back to your local broker, who will inform you that the trade has
been completed (see the Mini-Case box). Smaller orders will be handled by a computer
system that matches buy and sell orders
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