Brokers: Their Role in Financial Markets (Chapter 7, Part 1)
Brokers are the middlemen of trading. You might think of them as a necessary evil, but Larry Harris makes a compelling case in Chapter 7 of “Trading and Exchanges” that they provide services most traders simply cannot replicate on their own. Understanding what brokers do, and what they might do to you, is essential whether you’re a retail trader or managing billions.
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What Brokers Actually Do
A broker is an agent who arranges trades for clients. Unlike dealers who trade with you using their own inventory, brokers trade your orders for you. You pay them commissions for this service.
Brokers operate in four types of markets. In order flow markets, they take your orders and match them with orders and quotes from other traders. In block markets, they take large orders and hunt for counterparties. In offering markets, they distribute new securities to buyers. And in merger and acquisition markets, they help companies buy other companies. The largest investment banks operate in all four. Most brokerage firms specialize in just one or two.
Why Traders Need Brokers
There are five core reasons traders use brokers instead of doing everything themselves.
Clearing and Settlement
This is the most important reason, and probably the least appreciated. When you trade, there’s a gap between when the trade is arranged and when it actually settles. During that gap, there’s a risk that the other party might not acknowledge the trade, refuse to settle, or go broke. You’d have to check the credit of every single person you trade with.
Harris illustrates how brokers solve this with a scaling argument. In a market with 1 million traders and no brokers, there are nearly 1 trillion potential credit relationships. Add 100 brokers, each serving 10,000 clients, and the total number of credit relationships drops to about 2 million. That’s 500,000 times fewer. Brokers dramatically simplify the trust problem.
Brokers solve clearing problems by taking responsibility for their clients’ trades. If a client fails to acknowledge a trade, the broker resolves it. They solve settlement problems by either guaranteeing their clients’ trades or by staking their business reputation on their clients’ ability to settle. To do this safely, they must carefully screen who they take on as clients.
Access to Exchanges
Exchanges generally only let members trade. Everyone else needs a member broker. This is partly about clearing and settlement (exchanges need approved credit relationships) and partly about floor trading skills. Exchange floors are complex environments requiring knowledge of trading rules, jargon, and hand signals. Markets don’t let unskilled traders on the floor because they’d slow things down, confuse people, and generate mistakes.
Access to Dealers
Retail traders rarely trade directly with dealers because establishing credit, clearance, and settlement relationships is expensive for small, infrequent trades. Brokers have these relationships already. They also know which dealers are offering the best prices.
Institutional clients often do trade directly with dealers. Their large, frequent trades make the relationship costs worthwhile. They employ buy-side traders who negotiate directly and typically pay on a net price basis instead of commissions.
Expert Trading Skills
Block brokers are expert negotiators who know who wants to trade, who might want to trade if presented with the right opportunity, and at what prices various clients will be interested. This knowledge is incredibly valuable for arranging large trades.
The circularity of block brokerage is fascinating. If you don’t know your clients well, you can’t serve them well. If you can’t serve them well, they won’t talk to you. If they won’t talk to you, you can’t learn about them. This network externality means established brokers get stronger while new brokers struggle to break in.
New brokers typically break the cycle by offering investment research to attract initial relationships. They also spend heavily on entertainment: fancy dinners, Super Bowl tickets, NBA finals. The real purpose isn’t the entertainment itself. It’s learning about clients’ trading interests and generating goodwill.
Brokers also need to be great at order exposure management. Large traders don’t want the whole market to know their full order size. Other traders would either step aside until the order moves prices, or trade ahead of it to profit from the expected impact. Good brokers reveal only small portions of large orders, and only to traders they expect will genuinely want to fill them. They protect clients from front-runners.
Harris notes that successful brokers must be like good poker players. Floor traders scrutinize every mannerism of the brokers around them, looking for tells that reveal information about the orders they hold.
Representing Limit Orders
Many traders give limit orders and stop orders to their brokers so someone monitors the market on their behalf. This matters more for retail clients who can’t watch the market all day than for institutional traders whose full-time job is paying attention to markets.
Inside a Brokerage Firm
Brokerage firms split into three parts: front office, back office, and proprietary operations.
The front office handles everything client-facing. Sales brokers interact with clients. Floor brokers arrange trades at exchanges. Financial analysts produce research. Customer service agents manage accounts.
The back office supports everything else: maintaining accounts, clearing and settling trades, running information systems, managing credit, and ensuring compliance with regulations. In 1968, U.S. equity volumes grew so fast that brokerage firms couldn’t keep up with their paperwork. Exchanges actually closed on Wednesdays for several months to let back offices catch up. The crisis was solved by automation.
Proprietary operations include cash management, securities lending and borrowing, risk management, and any speculative trading the firm does for its own account.
How Brokers Make Money
Commissions are the obvious revenue source, but they’re not the only one. And understanding the other revenue streams explains a lot about broker behavior.
Commissions vary widely. Deep discount brokers offer the cheapest rates with minimal service. Full service brokers charge more but offer advice, research, and personal attention. U.S. institutional stockbrokers typically charge 5-6 cents per share, but the range is 1 to 12 cents.
Soft dollars are a fascinating wrinkle. Before commission deregulation in 1975, fixed rates were much higher than costs justified. Brokers competed for business by giving away free services: research, computing systems, trips to conferences at expensive resorts. This evolved into a formal accounting system where clients earned soft dollars from commissions and spent them on services.
Soft dollars persisted even after deregulation because of how investment funds account for expenses. When a fund pays for research with hard dollars, it shows up as a reported expense. When it pays through inflated commissions (soft dollars), the cost gets buried in lower reported returns, which is harder for investors to detect in volatile markets. The SEC has tried to close this loophole, but a Congressional safe harbor from 1975 protects it.
Interest on cash balances can be surprisingly lucrative. If a broker can invest money at 7% and pays no interest to clients, that’s $70 per year for every $1,000 on deposit. Retail futures brokers especially benefit from this. A typical client with $20,000 in free cash generates $1,000/year for the broker, equivalent to 50 round-turn commissions.
Short interest rebate is another major revenue source. When a client sells short, the broker keeps the cash proceeds as collateral and earns interest on them. For a $100,000 short position at 5% interest, that’s $5,000 per year. Almost all retail brokers refuse to share this interest with clients.
Payments for order flow are payments dealers make to brokers to get their clients’ orders. These dropped significantly after decimalization narrowed spreads, but they remain a meaningful revenue source.
The Bottom Line
Brokers provide services that most traders can’t replicate: credit intermediation, market access, expert trading skills, and order representation. The best brokers work hard to learn about their clients, maintain poker faces on the floor, and carefully manage order exposure. The economics of brokerage strongly favor large, established firms with extensive networks and automated back offices.
But brokers are also agents, and agents don’t always act in their principals’ best interest. That’s where the problems start, and that’s what we’ll cover next.
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 first half of Chapter 7 on brokers.