Have you ever wondered what happens when you buy or sell a
stock through a stockbroker? Trading is as simple as clicking a mouse, but it
is actually quite a complicated matter behind the scenes. When entering an
equity order on your computer or through your broker, you are, on some
occasions, trading with another person through an exchange, but on other
occasions you are only making a trade with your broker. These are the two main
types of trades that investors will encounter: principal and agent transactions.
Let's look at this in more detail.
Principal Trading
Principal trading occurs when a brokerage buys securities in
the secondary market, holds these securities for a period of time and then
sells them. The purpose behind principal trading is for firms (also referred to
as dealers) to create profits for their own portfolios through price
appreciations. So when an investor buys and sells stock through a brokerage
firm that acts as the principal to a trade, the firm will use its own inventory
on hand to fill the order for the client. With this method brokerage firms earn
extra income (over and above the commissions charged) by making money from the
bid-ask spread of a particular stock.
For instance, if you were looking to buy 100 shares of ABC
at $10, the principal firm would first check its own inventory to see whether
or not the shares are available to sell to you. If they are available, the firm
would sell the shares to you and then report the transaction to the necessary
exchange. This reporting may be, for ensuring regulations and safeguarding
clients, the most important action of a principal trade. The Securities and
Exchange Commission and exchanges require that the brokerage firms complete the
trades at prices comparable to those of the market.
Agency Trading
An agency transaction is the other popular method for
executing a client's orders. More complicated than regular principal
transactions, these deals involve the search for and transfer of securities
between clients of different brokerages. The increasing number of participants
in the securities market and the need for extremely accurate bookkeeping,
clearing, settlement and reconciliation make ensuring the smooth flow of the
securities markets quite a task.
Agency transactions are comprised of two distinct parts.
First, your brokerage needs to bring your request to the appropriate market in
order to find a party wishing to assume the opposite position. So, if you wish
to buy at a certain price, the broker needs to find someone wishing to sell at
the same price and vice versa. Once both parties are found, the exchange
records the transaction on its ticker tape, and an exchange of money and
securities between the parties occurs on settlement.
The second portion of the agency transaction occurs after
the trade is completed and has been properly documented on the exchange. This
portion is commonly referred to as clearing. While all brokers maintain
individual books recording the entire amount of buy and sell orders transacted
by clients, the actual act of clearing these transactions is handled by a
larger institution.
The basic act of clearing involves matching buys and sells.
Once the transactions are executed on the exchange, details of the trades are
sent to a subsidiary, and are subsequently recorded and matched for accuracy.
After all the trades sent by member firms
are matched for buys and sells,
notifies all member firms of their associated obligations, and arranges
the transfer of appropriate funds and securities. Thus, rather than having
individual brokers dealing with one another after every trade on a securities
exchange, it acts as middleman collecting all transactions and streamlining the
transfer of stocks and cash. This reduces the amount of time required for
delivery and receipt of obligations and provides flexibility for brokerages in
choosing dealing partners. This entire clearing process usually takes three
days to complete.
It is important to note that not only facilitates but also
guarantees delivery. If one party fails to deliver the securities or cash to
the other, it will step in and fulfill the obligations of the failing party.
Brokers are required to inform you as to whether a filled
trade was an agency or principal transaction; you are usually notified in your
trade confirmation sent in the mail (or electronically). Although you cannot
specify to your broker how you want the trade to be filled, as a client you
have the right to know how your transaction was completed.
The Bottom Line
Although this information might not make you any more money
in the market, it is important for investors to understand the process of
filling orders. These two ways of transacting orders not only help reduce the
risk for investors, but also give brokerage clients a relatively liquid and
efficient way of placing and executing trades.
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