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Chapter 7
Brokers
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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
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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
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Why brokers?
Brokers can solve clearing and settlement
problems at low costs
Brokers can access exchanges and dealersthat 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
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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
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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
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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
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Proprietary operations
All trading activities that the firm conducts
for its house account
For pure brokers, these include cashmanagement and the borrowing and
lending of securities
Include principal trading as a dealer,speculator, or arbitrager
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Broker profitability
Revenues
Commissions (deregulated in1975):Table 7-2
Soft commissions
Payment for order flow
Interest
Underwriting fees (7%) Mergers and acquisition fees
Costslabor costs and interest payments
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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 asexpenses)
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Principal-agent problem
Performance measurement (Chapter 22) Public disclosure (SEC Rules 11Ac1-5 and
11Ac 1-6) Best executionNBBOs and others
Dual trading problem
Internalized orders (Chapter 25) Front running (Chapter 11)
Order preferencing (Chapter 25) Payment for order flow
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More on dual trading problem
Dual traders trade both as dealers and as brokers(known as broker-dealers)
They fill client ordersthemselves for internalized
orders For client buy (sell) orders, they want sell (buy) at high
(low) pricesConflict 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 tobenefit from the market impact of the others trades
Front running
Some markets prohibit all dual trading
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Dishonest brokers
Front running
Inappropriate order exposure
Fraudulent trade assignment Prearranged trading and kickback
schemes
Unauthorized trading and churning Securities theft
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