Chapter 7
Brokers
What brokers do
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Brokers arrange trades for their clients
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Search for traders who are willing to trade
Represent their clients at exchanges
Arrange dealers to fill clients’ orders
Introduce their clients to electronic trading
systems
Match clients’ buy and sell orders
Types of markets
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Order flow markets (NYSE and NASDAQ)
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Block markets
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Brokers search for traders who will take clients’
order
Offering markets (IPO and SEO)
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Brokers match clients’ buy and sell orders
Brokers sell securities on behalf of issuers
Mergers and acquisition
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Brokers find one or both parties
Why brokers?
Brokers can solve clearing and settlement
problems at low costs
 Brokers can access exchanges and dealers
that their clients cannot access
 Brokers know who are willing to trade
 Brokers are better negotiators
 Brokers can represent clients’ orders when
they cannot represent them themselves
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Structure of a brokerage firm
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Front office operations
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Back office operations
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All activities that involve client contact
All activities that support the front office
operations
Proprietary operations
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Cash and risk management activities and any
speculative trading that the firm conducts for its
own accounts
Front office operations
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Sales and trading department
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Sales brokers interact with clients
• Floor brokers arrange trades at exchanges
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Corporate finance department
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Research department (Use supplements)
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Investment banking operations
Analysts provide services to various
departments
Customer service department
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Help their clients manage their accounts
Back office operations
Maintaining accounts
 Clearing and settling trades
 Providing the information systems that the
firm uses to transmit market data, quotes,
orders, etc
 Ensuring that the firm extends credit only to
good credit risks
 Ensuring compliance with regulations
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Proprietary operations
All trading activities that the firm conducts
for its house account
 For pure brokers, these include cash
management and the borrowing and
lending of securities
 Include principal trading as a dealer,
speculator, or arbitrager
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Broker profitability
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Revenues
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Commissions (deregulated in1975):Table 7-2
Soft commissions
Payment for order flow
Interest
Underwriting fees (7%)
Mergers and acquisition fees
Costs – labor costs and interest payments
Soft Commissions
To obtain order flow under fixed
commissions before deregulation (May
1975)
 To reduce expense ratios by minimizing
hard dollar expenses after deregulation
(because commissions are not treated as
expenses)
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Principal-agent problem
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Performance measurement (Chapter 22)
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Public disclosure (SEC Rules 11Ac1-5 and
11Ac 1-6)
Best execution – NBBOs and others
 Dual trading problem
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Internalized orders (Chapter 25)
• Front running (Chapter 11)
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Order preferencing (Chapter 25)
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Payment for order flow
More on dual trading problem
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Dual traders trade both as dealers and as brokers
(known as broker-dealers)
They fill client orders themselves for internalized
orders
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For client buy (sell) orders, they want sell (buy) at high
(low) prices – Conflict of interest!!
They compete with clients when they want to
trade on the same side of the market
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They want to trade first to get better price and also to
benefit from the market impact of the others’ trades
Front running
Some markets prohibit all dual trading
Dishonest brokers
Front running
 Inappropriate order exposure
 Fraudulent trade assignment
 Prearranged trading and kickback
schemes
 Unauthorized trading and churning
 Securities theft
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