The Conflict of Interest: Brokers (Chapter 7, Part 2)
Is Your Broker on Your Side?
In the second half of Chapter 7, Larry Harris gets into the messy reality of the Principal-Agent Problem. You are the principal (the boss), and the broker is the agent. In a perfect world, they do exactly what you want. In the real world, they have their own bills to pay.
The Problem of “Best Execution”
Every broker promises “best execution,” but what does that actually mean?
- To a retail trader, it means “get me the best price right now.”
- To a pro, it means “get me the execution I’m paying you for, given the effort I expect you to put in.”
The kicker is that you can’t manage what you can’t measure. If you can’t audit your broker’s performance, they have very little incentive to work hard for you. This is why high-end firms pay consultants thousands of dollars just to check if their brokers are actually getting them good deals.
Dual Trading: The Ultimate Conflict
Some brokers are also dealers (Broker-Dealers). They trade for you, but they also trade for themselves.
- The Conflict: If you want to buy 10,000 shares, and they also want to buy 10,000 shares, who goes first?
- Front-Running: If they see your massive buy order coming in, they might buy for their own account first, knowing your order will push the price up. This is illegal, but it’s a constant temptation.
The Dark Side: Dishonest Practices
Harris warns us about the various ways a “rogue” broker can clean you out:
- Churning (“Churn ’em and Burn ’em”): Recommending trades just to generate commissions. If your broker is calling you every day with a “hot tip” that requires a new trade, be careful.
- Inappropriate Exposure: Showing your order to their friends so the friends can trade against you.
- Fraudulent Assignment: If they have two clients buying at different prices, they give the lower (better) price to their favorite client and the higher price to you.
Why You Don’t Legally “Own” Your Stocks
Most people hold their stocks in “Street Name.” Technically, the broker or a central depository (like Cede & Co. in the US) is the owner of record. You are just the “beneficial owner.”
- Why? It makes trading way faster. You don’t have to mail physical certificates around.
- The Catch: It allows brokers to lend your shares to short sellers without you even knowing it. They keep the interest earned on that loan, while you just see the shares sitting in your account.
Summary: Trust but Verify
Most brokers are honest because a good reputation is worth more than a one-time scam. But the system is built on “checks and balances”:
- Audit Trails: Every order is recorded.
- SIPC: In the US, if your broker goes bust, you’re insured up to $500k.
- Compliance: Every firm has a department whose only job is to make sure the brokers aren’t breaking the law.
Next time, we’re moving into Part II: The Benefits of Trade. We’ll look at why people actually trade in the first place. Hint: It’s not always to make a profit!
Next Post: Why People Trade