Four of the Worst Brokerage Practices

by James & Miel on June 16, 2009 · 0 comments

Hi All,

While I’m certainly not an expert observer of economic events, one thing thats changed since last years meltdown is the prestige of big financial institutions. This is important, because the popularity of financial firms has allowed them to engage in business practices that ignore the well being of their customers.

Now, I don’t know much about wall street generally, but we do know a little bit about buying stocks, so to illustrate here are four kinds of bad practices that stock brokers do to pad their bottom lines at the expense of customers. I’m posting this both to show whats gone on over the past 20years and to make you, dear reader, aware of what happens you when you decide to buy stocks. You should assume that ALL companies engaged in the sale of stocks are involved in this to some degree.

1) Spread Capture: The spread is defined as the difference between the bid and asked prices. So, if a stock is trading between $10.50 and $11.00 – the 50 cent difference between the prices is called the spread. Spread capture is when the broker will get the stock for $10.50 and turn around and sell it to you for $11.00. Typically retail customers get the wrong end of the spread.

2) Unloading In House Shares: Many brokers are also dealers. This means they have inventories of stocks in their institutional accounts. If the dealer has stock in a company they think is going to decline in value, they will sell you their shares rather than buying them on the open market. Naturally, markups and commissions apply.

3) Stock Loans: Many brokerage account agreements allow your broker under certain circumstances to take a loan and use your securities as their collateral. The brokerage gets all the profit from these deals, you get nothing.

4) Payment For Order Flow: If the stock you are buying trades on the Nasdaq, your broker may get paid for routing your order through the Nasdaq. Specifically in a broker/dealer market the exchange has set up with its members acting as market makers in particular stocks. The problem is that payment for order flow creates an incentive for brokers to route your orders to exchanges that provide the best value for them, NOT for you.

As I mentioned earlier, these practices exist in ALL firms, even discount brokerage houses which are otherwise geared towards small investors like Schwab or Scottrade.

However, on a more optimistic note, there has been some recent discussion of appropriate regulation to address ongoing problems in the financial sector. Hopefully this will include increased transparency and a critical review of some of the worst business practices that have gone on over the past 20 years. It is essential, though, that you understand what is going on when it is your money and your wealth that is being used behind the scenes.

Best,

James

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