Trading and Exchanges Chapter 7: Broker Conflicts and Trust Issues (Part 2)
In Part 1 we covered what brokers do, different broker types, and how they make money. Now we get to the uncomfortable part: what happens when your broker does not have your best interests in mind.
The Principal-Agent Problem
Fancy economics term for a simple idea. You hire someone to work for you, but they have their own agenda. Your broker is supposed to get you the best deal. But maybe they are lazy. Maybe they cut corners. Maybe they actively work against you.
Harris says most brokers are honest. But the structure creates temptation. How do you know if your broker got you the best price? You usually cannot. That is the core problem.
Clients manage this with carrots and sticks. More orders for good brokers. Lawsuits for cheats. But all of this requires measuring performance. And measuring broker performance is really hard.
Best Execution: What Does It Even Mean?
When a broker takes your order, they owe you “best execution.” Sounds great. Except nobody agrees on what that actually means.
For retail traders it means “get me the best price right now.” Sophisticated traders see it differently: you get what you pay for, so best execution means “give me quality that matches my commission.”
The most sophisticated clients go further. They know you cannot buy something you cannot measure. If your broker thinks you have no way to check their work, why would they try hard? For them, best execution means “give me execution I can realistically audit.” Honest definition. A bit depressing too.
Dual Trading and Order Preferencing
A dual trader is both a broker and a dealer. They trade for clients and for themselves. When they fill your buy order from their own inventory, they want a high price. You want a low price. Harris calls these objectives irreconcilable.
Then there is order preferencing. Your broker routes your order to a specific dealer not because that dealer offers the best price, but because that dealer pays for the order flow. In U.S. stocks, dealers paid about 1 cent per share for each routed market order. Looks a lot like a kickback. Harris leaves the question open but makes sure you see the conflict.
Front Running: The Classic Scam
Front running is when a broker jumps ahead of your order to profit from its market impact. You place a huge buy order. Broker knows it will push the price up. So he buys first, executes your order second, and pockets the difference. You get a worse fill.
Harris tells a great story. In the 1960s, a guy named Jack traded silver futures. He bribed a telephone clerk to signal when big orders were coming by how the clerk carried the order slip. They front-ran over 50 orders, profiting on every one. When Harris told Jack this was illegal, Jack shrugged: “everyone was doing it.”
The FBI ran sting operations in the 1990s and caught several floor traders. Better audit trails made it harder since. But the incentive never disappeared.
Other Dirty Tricks
Harris catalogs a whole menu of broker fraud:
Inappropriate order exposure is when your broker shows your order to his buddy, not to get you a fill, but to let the buddy trade ahead of you or adjust his prices against you.
Fraudulent trade assignment is when a broker fills two orders and gives the better price to his favorite client. Your good fill gets swapped out.
Prearranged trading means your broker sets up a trade at a bad price with a friendly dealer instead of shopping around. Sometimes the dealer kicks back part of the profit.
Churning is when your broker pushes you to trade way more than necessary, just to generate commissions. The industry calls this “churn ’em and burn ’em.” These firms burn through clients fast and constantly cold-call new ones. Favorite targets: lonely people, gamblers, and folks envious of their successful peers.
Securities theft is the extreme case. Sunpoint Securities in Texas had executives who stole $25 million from client money market accounts before collapsing in 1999.
How to Protect Yourself
Harris gives practical advice. Use brokers at large, well-established firms. They have reputations worth protecting. New, unknown firms have less to lose.
Check your broker’s record before handing them your money. In the U.S., FINRA (formerly NASD) maintains databases with complaints, arbitrations, and disciplinary actions. Use them.
Read your trade confirmations. If statements stop coming, investigate immediately. Some fraudsters change your mailing address first so you do not notice unauthorized trades.
Keep securities in a depository. When brokers never hold your actual assets, they cannot steal them. The Depository Trust Co. exists specifically for this. And if things go wrong, SIPC covers up to $500,000 per account, but you have to file claims within 30 to 60 days of the bankruptcy.
The Bottom Line
Most brokers are honest. The system works because of regulation, audit trails, reputation effects, and the threat of lawsuits. But it works precisely because these deterrents exist. Remove them, and things get ugly fast.
Harris ends with a clever observation: the best security systems are the ones you never have to use. They work by deterring bad behavior. People see the cost of regulation but not the fraud it prevents. Keep that in mind next time someone argues we have too many rules in financial markets.
Previous: Chapter 7: Brokers (Part 1)