Whenever we buy or sell an asset, a broker becomes an integral part of the transaction. A broker is a trade facilitator or an agent. His job is to match two potential counterparties. A pure broker does not carry an inventory of the product in which his client seeks to transact. Thus a broker carries out what are termed ‘agency trades’. There exists another entity called a dealer. He carries an inventory of the asset in which the potential client is interested. If the client wants to buy, the dealer will sell at his ask price, and if the client wants to sell, the dealer will buy at his bid price. Thus a dealer takes over the trading problem of potential clients.
Brokers, dealers work closely
Brokers and dealers work closely in many cases. Some entities work as agents in certain transactions and as dealers in others. They are termed as dual traders. In other markets, brokers source and channel trades to a dealer of their choice. In return, he compensates them. This is termed as ‘payment for order flow’. If we want to buy or sell securities on an exchange such as the BSE or the NSE, we need to route the order through a broker. Entities like ICICI Direct are also brokers. They give us seamless connectivity between our system and the exchange. When we want to buy an insurance policy or invest in a mutual fund, we typically use an agent. Most banks act as agents in the mutual fund industry. Insurance policies can be procured with the intervention of an individual or with the help of an entity such as a commercial bank. Certain markets are dominated by brokers, for instance, the real estate market. Brokers help find and match potential counterparties.
Compatibility in price
There should be compatibility in terms of price as well as quantity. For instance, if a trader wants to buy 100 shares while a potential seller wants to sell 500, there is a quantity mismatch. From a price standpoint, if a trader wishes to pay no more than `100 for a share at a time when no potential seller is prepared to sell for less than `125, there is a mismatch from a price perspective. One of the crucial roles paid by a broker is a reduction in the time required to find and match counterparties. If two unknown parties were to attempt to locate each other without third party assistance, the time required would invariably be more. And in the world of finance, time is money. There are various categories of brokers. Full service brokers provide extensive advice and guidance to clients. Their fees are also higher. On the other hand, discount brokers do not provide any advice but charge much lower fees. There also exists a category of brokers known as deep discount brokers, who do not provide advice but insist on transactions or large magnitude, as a result of which they are able to charge even lower brokerage fees as compared to a discount broker. In many countries till a decade ago, brokers were required to charge a minimum fee. Thus institutional clients were cross-subsidising retail clients. Entities such as discount and deep discount brokers are a consequence of a deregulated brokerage industry.
Sunil K Parameswaran
The author is visiting faculty at various business schools including IIMs