Broker and Dealer: Agency Versus Principal

A broker acts for somebody else and never holds what is traded: it arranges the trade and is paid a charge for arranging it. A dealer acts for itself and does hold what is traded: it sells out of its own holding or buys into it, so the far party is the dealer, and what it earns sits inside the price rather than beside it.

Two words get used as though they were job titles, and they are not. Both words are a statement about where a thing sits one second after a trade. Everything else said about the difference, the charges, the conflicts, the reason one of them is cheaper on paper, follows from that one placement and cannot be understood before it.

One question runs underneath every arrangement a reader will meet, and it is worth holding on to. Immediately after the trade, whose holding changed? Answering that gives the label, without anybody having to say what they call themselves. Get it wrong and every comparison made afterwards is between two things that have not been identified.

What does acting for somebody else commit a party to?

The stranger of the two only looks strange against the plainer one, so start with the plainer one. A party acting for a client is carrying out that client's instruction. The client says buy, the party goes and buys, and it is the client's trade from the beginning of it to the end of it. The party never holds the thing, not for a second and not in any technical sense, and the client's money is the client's money throughout.

The everyday version is somebody who queues at a ticket window on another person's behalf. The money and the request are handed over, they stand in the line, and they hand back the ticket and the change. The ticket was never theirs. If the price of that ticket triples an hour later, they are not richer. They were never holding one. The queueing is what they were paid for, and the queueing costs what it costs whatever happens to tickets afterwards.

Because the arranging party never held anything, its income cannot move when the price moves, and that is what makes it possible for it to be indifferent between a price going up and a price going down. This is not a moral claim about anybody's character. The indifference is an arithmetic observation about what is on somebody's books, and it is the only reason the word agent means anything at all. Take the position away and the indifference goes with it.

A second thing matters three sections down. The charge is fixed when the order is carried out. A share of the order valueThe rupee size of one order, being how much of the thing was traded multiplied by the price it traded at. Order value is a base that a charge can be struck on, not a charge itself. is still a share of a number that stopped moving the moment the trade happened. Nothing that occurs afterwards reaches back into it.

What does dealing for yourself commit a party to?

Now the one that turns the picture inside out, and it does turn it inside out rather than merely adding to it. A dealer is not standing in the middle of anything. The dealer has stepped out of the middle and become the far party, and once that placement is seen, half the confusion around this subject drains away.

The party the client was talking to is the other side of the trade, and there is no third party in the room at all. On a purchase, the thing comes out of a holding that party already had. On a sale, it goes into a holding that party will now carry. Nobody was matched with the client. Nobody needed to be.

The everyday version is a shop with rice on its shelves. The shopkeeper bought that rice before the customer walked in, using their own money, and they will carry whatever is not bought until somebody else buys it. The shopkeeper is not finding the customer a farmer. The shopkeeper is the far end of the transaction, and somebody willing to hold the rice in the gap between buying it and selling it is what makes the arrangement work at all.

Hold on to what that gap actually costs. The shopkeeper's money is tied up in rice rather than sitting in a bank. The rice can go out of condition. The price of rice can fall between the buying and the selling, and the shopkeeper eats that fall because the sack is theirs. None of this is true of the person who queues at the ticket window, and all of it is true of a party dealing on its own account in securities.

Broker vs Dealer: whose holding changed?

The whole distinction is one question asked twice rather than a list of differences. A list invites the memorising of seven bullet points. One question, asked of two drawings of the same trade, gives something that can be applied to an arrangement nobody has labelled.

Take one purchase worth Rs 1,00,000/-. In the agency case the thing travels from a selling client to a buying client, and the party that arranged it went into the trade holding nothing of it and came out holding nothing of it. In the principal case the thing travels out of the dealer's own holding into the buying client's, and the dealer came out of the trade one positionThe amount of a thing a party is carrying at a given moment, and what that amount is worth. A holding, as opposed to the order that created it. lighter than it went in.

Asking whose holding changed gives the answer without needing anybody's label, and the test therefore survives every arrangement. The two clients' holdings move under either arrangement, so they settle nothing. The arranging party's own holding moves under exactly one of them, so it settles everything.

Where does a price move after the trade actually land?

A price move after the trade lands somewhere, and the guess is worth making before the answer arrives.

Take the same Rs 1,00,000/- position and let the price move 10.00 per cent of the position value in either direction. At minus 10.00 per cent the position is worth Rs 90,000/-. At plus 10.00 per cent it is worth Rs 1,10,000/-. Either way the party carrying the position is Rs 10,000/- better or worse off, and the period over which this happens is between the trade and whenever that party closes the position. How long that takes is not fixed by anything in the arrangement.

Now put the three parties against those two numbers. The client bought the same thing at the same price under both arrangements, so the client's outcome is the same under both: Rs 10,000/- one way or Rs 10,000/- the other. The dealer sold out of its own holding and will have to buy back, so the dealer moves in the opposite direction to the client by exactly the same amount. The broker held nothing at any point, and has its Rs 100.00/- and nothing else at every possible price.

The client's outcome is identical under both arrangements and the intermediary's is not, and that single asymmetry is the whole of what agency and principal mean. Readers reliably expect the asymmetry the wrong way round, and expect the arrangement to change something for the client while leaving the intermediary a bystander in both. The asymmetry runs the other way about, for a reason that states in one line: only one of the two intermediaries is carrying anything, and a price can only act on what somebody is carrying.

The trade worked twice, as static text

The whole worked instance stands as a table, whatever the control underneath it is set to. Every figure in it is a chosen setting rather than a reported one.

The charge of Rs 100.00/- is 0.10 per cent of order value on Rs 1,00,000/-, carried over as a control setting from what a broker does, where the same order also carried a flat charge of Rs 20.00/- as the other shape. Neither of those is anybody's price. The two figures are two shapes of charge, one struck on order value and one flat, set side by side so the shapes can be told apart.

How is each of them paid, and which payment is visible?

Both parties are paid. The difference is not whether, it is where, and where turns out to decide what can be compared.

A broker is paid a charge that sits beside the price. On an order of Rs 1,00,000/- with the charge struck at 0.10 per cent of order value, the client pays Rs 1,00,000/- for the thing and Rs 100.00/- for the arranging, and Rs 1,00,100/- leaves the account. Both numbers appear on the confirmationThe document a client is sent after a trade, setting out what was bought or sold, how much of it, at what price, and what was added to or taken off that price., on separate lines, with the second one usually called brokerageThe ordinary name for the charge a broker makes on an order. Brokerage names the charge, not the business, and it is one line on a document rather than everything the client paid.. Both numbers can be read, totalled and compared against another confirmation.

A dealer is paid the difference between the price it acquired the thing at and the price it passes the thing on at. The difference is not added to the price. The difference is a property of the price, in the same way that a shopkeeper's margin is a property of what the rice costs on the shelf rather than a line printed under it. A payment inside a price has no line, no label and no total anywhere on any document the client receives.

People do something predictable with a payment that has no line. Clients compare the charges column on two documents, see Rs 100.00/- on one and nothing on the other, and conclude that the second arrangement charged less. The visible payment is not the larger one merely because it is visible, and the invisible one is not free merely because nobody wrote it down. A column can only compare what has been put into it.

What follows from being both the arranger and the far party?

A confirmation cannot be read by somebody who cannot say the next sentence out loud. When the party arranging a client's trade is also the party on the far side of it, the price it offers is its own income. Not related to its income, not a factor in its income. The quoted price is the income. The income is the gap between what that party acquired at and what it passes on at, and one end of that gap is the number being quoted.

The overlap is arithmetic rather than an accusation, and refusing to say it does not make it untrue. The overlap is also completely ordinary. A shop is obviously a shop, so nobody is shocked that the shopkeeper selling rice quotes a price that is their own income. The securities version is harder: the same party can do both jobs, sometimes on the same day, and the document the client receives does not always shout about which one it just did.

So there is one question worth asking of any trade, and it is short. Was the party dealt with arranging this for the client, or were they the other side of it? Everything else here is a consequence of the answer. Telling a client which of the two just happened, and when, is a matter of disclosureTelling a client something before or after a trade that they would have no way of working out for themselves. The authority named in the reference table below sets what has to be told, and when., and the Securities and Exchange Board of India (SEBI) sets it at sebi.gov.in.

Why would anyone want a dealer at all?

A dealer's conflict is only a complaint until there is a reason anybody would want a dealer at all.

A party acting only for clients can match a client with somebody who is there, and cannot match a client with somebody who is not. If nobody wants to sell the thing the client wants at this moment, an agency arrangement has exactly one thing to offer, and that thing is waiting. Waiting is not a defect. Waiting is the arrangement itself.

A party willing to be the far side will complete the trade now, out of a holding it already has, and then carry whatever it is left with until somebody else turns up. The client is buying the ability to have the thing now rather than the thing itself, and the dealer's income is the price of that immediacy. The everyday version, again, is the shop. Nobody thinks the shopkeeper is cheating them by charging more than the wholesale market. The shopkeeper is being paid for having the rice on the shelf on a Tuesday evening when the wholesale market is shut.

Immediacy is the half of the subject that gets left out, and leaving it out produces a reader who thinks one arrangement is honest and the other is a trick. Both are arrangements. One is paid for arranging and one is paid for standing at the end of the queue with stock, and both of those are real work with real money behind them.

Remove each of them: what fails in each case?

The same test used throughout, applied twice, and the two answers are different in kind rather than in degree. A difference in kind is worth more than any definition.

Remove the broker and the order has no route to the venue at all. A trading venue deals with the short list of parties admitted to its rules, and a person is not on that list. Nothing arrives late. Nothing arrives.

Remove the party willing to be the far side and the route is completely fine. The order goes out, arrives, sits there, and waits for somebody who may or may not turn up in the next minute or the next hour. Nothing has broken. There is simply nobody at the other end right now.

One of these parties stands in the middle and the other is willing to be the end, and confusing those two roles is what makes this whole subject hard. A party in the middle is about access. A party at the end is about availability. Access and availability are not two grades of the same service. A charges column compares only what each party put into it, so no amount of comparing charges will tell the two apart.

Who sets the conditions on all of this?

Four things a reader will reasonably want a number for, each of them set by an authority rather than stated here. The conditions a party meets before it may act for a client at all, and the conditions on which it may deal on its own account. Then the disclosure owed to a client when the party arranging the trade is also the party on the far side of it. The net worthWhat a party has left over once everything it owes is taken off everything it has. How the figure is arrived at is settled separately; here it is only a condition somebody has to meet. a party carrying its own positions keeps behind them. And the position limits and exposure limitA ceiling on how much a member may have riding on the market at one time. Where the ceiling sits is set by the authority named in this section. conditions a member has to work inside. A fifth condition sits alongside those four, the segregationKeeping a client's money and a client's securities apart from the party's own, so that the two can never be treated as one pool. The authority named in this section sets what segregation requires. of a client's money and securities from the party's own.

The second of those four matters more to this subject than anywhere else, and it is the one that stays blank. Every one of them is set by SEBI at sebi.gov.in and every one of them moves. A value printed today would not be merely out of date the day it changed, it would be a wrong answer.