1. Chapter 7 Brokers

2. What brokers do Brokers arrange trades for their clients 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

3. Types of markets Order flow markets (NYSE and NASDAQ) Brokers match clients’ buy and sell orders Block markets Brokers search for traders who will take clients’ order Offering markets (IPO and SEO) Brokers sell securities on behalf of issuers Mergers and acquisition Brokers find one or both parties

4. 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

5. Structure of a brokerage firm Front office operations All activities that involve client contact Back office operations All activities that support the front office operations Proprietary operations Cash and risk management activities and any speculative trading that the firm conducts for its own accounts

6. Front office operations Sales and trading department Sales brokers interact with clients Floor brokers arrange trades at exchanges Corporate finance department Investment banking operations Research department (Use supplements) Analysts provide services to various departments Customer service department Help their clients manage their accounts

7. 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

8. 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

9. Broker profitability Revenues 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

10. 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)

11. Principal-agent problem Performance measurement (Chapter 22) Public disclosure (SEC Rules 11Ac1-5 and 11Ac 1-6) Best execution – NBBOs and others Dual trading problem Internalized orders (Chapter 25) Front running (Chapter 11) Order preferencing (Chapter 25) Payment for order flow

12. More on dual trading problem Dual traders trade both as dealers and as brokers (known as broker-dealers) They fill client orders themselves for internalized orders 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 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

13. Dishonest brokers Front running Inappropriate order exposure Fraudulent trade assignment Prearranged trading and kickback schemes Unauthorized trading and churning Securities theft