Broker Duties, Conflicts, and the Trust Problem (Chapter 7, Part 2)
Most brokers are honest. But the relationship between broker and client has a built-in conflict that can’t be fully eliminated. The second half of Chapter 7 in “Trading and Exchanges” covers this conflict, the ways dishonest brokers exploit it, and the systems markets have built to keep everyone (mostly) honest.
Previous: Brokers in Financial Markets
The Principal-Agent Problem
This is the central issue. Whenever someone works for someone else, there’s a potential conflict of interest. Your broker is supposed to do what you want, but they might do what’s best for themselves instead. They might be lazy, cut corners, or in the worst case, actively work against your interests.
This isn’t unique to trading. It’s the core problem of management everywhere. But it’s especially tricky in brokerage because clients usually can’t easily measure the quality of service they receive.
Think about it. How do you know whether your broker got you the best possible price? Maybe they did, maybe they didn’t. How do you know they didn’t sit on your order? You can’t see everything happening on the floor or in the electronic systems. This measurement problem is what makes the principal-agent problem so persistent in brokerage.
Clients use the standard toolkit to manage this problem: rewards (sending more orders to good brokers) and penalties (pulling business from bad ones, or suing). Rating agencies and consultants help by evaluating execution quality. Regulators require brokers to publish order-handling and execution data. But none of these fully solve the problem.
Best Execution: A Slippery Concept
When brokers accept your order, they take on an agency responsibility to get you best execution. But what does “best” actually mean? Harris identifies three progressively sophisticated definitions.
Unsophisticated version: “Get me the best price possible” for a market order, or “trade as quickly as possible” for a limit order. This sets an absolute standard.
Intermediate version: “Get me the execution I’m paying you to provide.” This acknowledges that you get what you pay for. Pay more in commissions, expect better execution on average.
Sophisticated version: “Get me the execution I expect, given what I pay you and the limitations of my ability to audit your performance.” This recognizes that you can’t buy quality you can’t measure. If brokers know you can’t tell the difference between good and mediocre execution, competition will drive all brokers toward mediocre execution. Any broker who spends extra resources on unmeasurable quality will be undercut by those who don’t.
That last point is important. It means that improving execution measurement tools actually improves execution quality across the entire market.
The Dual Trading Problem
Many brokers are also dealers. They trade for their own account and for clients’ accounts. These dual traders (or broker-dealers) face an unavoidable conflict.
When a broker-dealer internalizes your buy order (fills it from their own inventory), they want a high price and you want a low price. These objectives are directly opposed. What’s best for you is never what’s best for them on any given trade.
Even when they’re not internalizing, there’s conflict. If both the broker and the client want to buy, the broker wants to buy first to get the best price and profit from the client’s subsequent market impact.
Many markets regulate dual traders heavily. U.S. futures regulations prohibit them from filling agency orders for their own accounts. At the same price, they must fill client orders before their own. Some markets ban dual trading entirely, requiring traders to be exclusively agents or exclusively proprietary traders.
Order Preferencing
Order preferencing is when brokers routinely send orders to specific dealers based on their relationship, not based on who’s offering the best price at that moment.
Dealers pay brokers for this order flow. In U.S. stock markets, dealers used to pay about 1 cent per share for each market order sent their way. These payments dropped after the 1997 order exposure rules and decimalization narrowed spreads.
This looks a lot like a kickback. A broker routes your order to a dealer who pays them, rather than to the dealer offering the best price. But brokers and dealers involved in these arrangements argue that the preferencing dealers commit to minimum service levels, and that for small orders, individual price negotiation is prohibitively expensive. The small commissions on small orders simply don’t justify the attention every client desires.
Large institutional traders are less concerned about this because they personally negotiate their trades or insist their brokers negotiate aggressively. Regulators generally assume big traders can protect themselves.
Front Running
Front running is when a broker lets one order trade ahead of another improperly. The front-running order profits from the price impact of the order behind it.
Harris tells a remarkable story from the 1960s. A floor trader named “Jack” befriended a telephone clerk at a major brokerage. The clerk would signal large incoming orders by how he carried the order ticket when bringing it to the floor broker. Jack would immediately buy or sell ahead of the large order. They front-ran more than 50 orders this way and profited on every single one.
Front running was eventually detected through FBI sting operations in the 1990s. Today it’s much harder because audit trails have improved and buy-side traders use electronic systems to monitor execution quality. When execution quality drops precipitously, investigations are triggered.
Front running hurts the traders whose orders get jumped. They fill at worse prices because the front-runner takes liquidity that would have gone to them. It also hurts the brokers who represent the front-run orders, because alert clients will notice the poor execution and direct future orders elsewhere.
Inappropriate Order Exposure
A broker exposes your large buy order to their friend, who then buys ahead of you. Or they show your full order size to a dealer, who raises their offer price to avoid giving you a good deal. Inappropriate order exposure happens when brokers show orders to other traders for the other traders’ benefit, not for the client’s.
Fraudulent Trade Assignment
When a broker fills orders on the same side for multiple clients, each client should get the price their specific order filled at. A dishonest broker might give the best prices to their friends and stick other clients with the worst prices.
This gets especially problematic when brokers also act as dealers. Without safeguards, they might keep the best fills for their own account.
Prearranged Trading and Kickbacks
Prearranged trading happens when a broker fills your order with a predetermined counterparty without exposing it to others who might offer better prices. In floor-based futures markets, traders must shout out bids and offers so everyone gets a chance. Prearranging trades around this requirement is illegal.
In a kickback scheme, a broker sends your order to a dealer who fills it at a deliberately bad price. The dealer then kicks back some of the excess profit to the broker. You get ripped off, and the broker and dealer split the spoils.
Payments for order flow look similar but generally aren’t kickbacks, because the preferencing dealers commit to specific execution quality standards.
Churning
Churning is when brokers recommend excessive trading to generate commissions rather than to benefit clients. The classic strategy is “churn ’em and burn ’em.” Firms that do this devote more resources to acquiring new clients than retaining existing ones, because they exhaust clients’ money and patience.
These firms target unsophisticated people: lonely individuals eager for trusting relationships, gamblers looking for action, and envious people trying to keep up with successful peers. As P.T. Barnum allegedly said: “A sucker is born every minute.”
To prevent churning, compliance officers at brokerage firms monitor account turnover. If trading seems excessive relative to the client’s profile, they investigate. Regulators require brokers to “know their customers” and ensure trading is suitable.
Securities Theft
In extreme cases, brokers simply steal. Sunpoint Securities, a Texas-based broker-dealer, systematically stole $25 million from a client money market account between 1997 and 1999. They transferred client funds to the firm’s accounts to meet capital requirements and for personal use. When it collapsed, the SIPC paid $31 million to restore assets to nearly 10,000 investors.
Institutional traders protect themselves by using depositories or custodians to hold their assets. The broker never touches the securities. They just arrange trades and send reports to both the client and the depository. This makes theft impossible because the broker never holds anything.
The SIPC (Securities Investor Protection Corporation) provides additional protection. If a brokerage fails, the SIPC distributes securities registered in clients’ names, then distributes remaining assets pro rata, and covers any remaining claims up to $500,000 per client ($100,000 for cash).
What Keeps Brokers Honest
Several forces work together:
Reputation. Firms with good reputations attract business. That reputation has real monetary value. Managers at established firms work hard to prevent rogue brokers from destroying it. New, unknown firms have less reputation to protect, which is why most penny stock fraud happens at small, new brokerages.
Audit trails. Good audit trails record everything that happens to every order, with detailed timestamps and market conditions. They discourage dishonest behavior because brokers know their actions can be reconstructed and examined.
Transparency. Brokers are more honest in transparent markets where clients and regulators can see what’s happening. Opaque markets invite abuse.
Regulation. Government agencies, exchanges, clearing houses, and industry associations all regulate broker behavior. They ensure adequate capital reserves, proper managerial controls, and functioning accounting systems.
Competition. Clients can always take their business elsewhere. This implicit threat is the most common penalty for poor service.
Harris makes a subtle but important point about deterrence systems: they work best when they prevent bad behavior entirely. But the better they work, the less necessary they seem. People underestimate the value of systems that deter problems they never see. The cost of regulation is concrete and visible. The fraud it prevents is invisible. That creates a constant political pressure to weaken the very systems that keep markets honest.
The Bottom Line
The broker-client relationship is fundamentally built on trust, but trust alone isn’t enough. Markets have built an elaborate infrastructure of regulation, audit trails, transparency requirements, and investor protection to address the principal-agent problem. Most brokers are honest because they’re good people, because honesty is good for business, and because the systems in place make dishonesty risky and expensive.
But as a trader, you should still know your broker, understand their incentives, and pay attention to your account statements. The systems are good. They’re not perfect.
This post is part of a series on Larry Harris’s “Trading and Exchanges: Market Microstructure for Practitioners” (Oxford University Press, 2003). This covers the second half of Chapter 7 on broker duties and conflicts.