Industry Overview and Structure
This domain tests how the investment industry is organized: who supplies capital, who intermediates it, how firms split into buy-side and sell-side roles, and what duties and controls keep the system working. Questions typically ask you to place a participant in the correct part of the value chain or identify a conflict of interest.
The players
- Households, companies, governments, and foreign investors are the ultimate savers and borrowers.
- Buy-side firms manage or own money: asset managers, pension funds, insurance companies, endowments, sovereign wealth funds, and private wealth firms. They issue orders to buy or sell.
- Sell-side firms help clients trade and raise capital: investment banks, broker-dealers, and market makers. They provide research, underwriting, and execution.
- Infrastructure and support includes exchanges, clearing houses, central securities depositories, custodians, fund administrators, transfer agents, index providers, and credit rating agencies.
- Regulators and standard setters set conduct, disclosure, and prudential rules; professional bodies set ethical and professional standards.
How firms are organized
Front office performs sales, trading, research, and portfolio management. Middle office covers risk, compliance, and performance measurement. Back office handles settlement, custody, accounting, and record keeping. Asset managers earn fees, often as a percentage of assets under management; performance fees align pay with results but can encourage excessive risk-taking. A custodian safekeeps assets and processes settlements but does not make investment decisions. A broker executes orders as agent; a dealer trades as principal and earns the bid-ask spread.
Worked example
A pension fund decides to buy a corporate bond. The pension fund is buy-side. It may use an asset manager, also buy-side, to select the bond. A broker-dealer on the sell-side quotes a price and executes. A clearing house novates and guarantees the trade, a depository settles it, and the custodian holds the bond for the pension fund. The pension fund bears investment risk; the broker bears counterparty risk only until clearing.
Traps
- Calling an investment bank buy-side because it manages a balance sheet; its client-facing underwriting and trading are sell-side.
- Confusing custody with asset management.
- Mixing front-office and back-office tasks.
- Assuming a broker and dealer are the same: agents versus principals.