A) The Role of Stockbrokers as Intermediaries
When talking about capital markets, special references is made to stocks and stockbrokers because the history of these markets, and securities markets in general, is closely associated with the evolution of stock markets.295 Evidently, stock markets have been in existence for a long time. In the seventeenth century, shares in public companies became very attractive and were sold by Dutch, French and English companies to people in their countries.296 Stockbrokers were deemed important because they worked as intermediaries ‘who arrange on behalf of private investors the sale and purchase of shares’.297 In England, company shares were sold and traded at the Royal Exchange and in coffeehouses by agents of investors, and this activity is considered the first expression of specialized jobbers and brokers.298
In well-functioning stock markets, it has long been considered that a broker or brokerage firm should exercise care and demonstrate a reasonable level of skill in accordance with reasonable practice in the brokerage business.299 It is for this reason, it is claimed, that stock exchanges were established; to restrict entrance to stock exchanges to brokers in order to ensure the conduct of its members and to limit
295 K.G. Davis, ‘Joint-Stock Investment in the Later Seventeenth Century’ (1952) 4 Econ. Hist. Rev.
293, 287; Skand Chaturvedi, Financial Management: Entailing Planning for the Future, (Global India Publ. 2009) 11
296 Davis, Ibid
297 Ralph Tench and Liz Yeomans, Exploring Public Relations (2nd ed., FT Prentice Hall 2009) 467
298 Edward Morgan and William Thomas, Stock Exchange: Its History and Function (Elek Books Limited 1969) 14 -17
299 R.S. Bhatia, Encyclopaedia of Investment Management (Anmol Publications 2000) 74; Massimo Cirasino and others, Payments and Securities Settlement Systems in Latin America (World Bank 2006) 240
fraudulent practices.300 Accordingly, it could be argued that the conduct of brokers can affect the health of stock markets.
In the twenty-first century brokers are just as important for the functioning of capital markets as they always were in acting as intermediaries between sellers and buyers. The role of brokers has been extended from the execution of their customers’
orders to performing other services for them such as clearing, custody and settlement services.301 It should be noted that investment and merchant banks also work as intermediaries to arrange the sale and purchase of stocks and other securities, but they work mainly with institutional investors and financial institutions.302
While the important role of brokers could be highlighted in theory, in practice it is evident that stockbrokers have various roles depending on the structure of the markets in which they work. Three broad forms of the structure for secondary securities markets have been identified: brokers-markets, dealers-markets and auction-markets. In each form, brokers play different roles in facilitating the functioning of these markets.
The first form of structure of secondary capital markets is the auction markets, of which there are two kinds: call auctions where brokers meet at a specific time such as in gold markets; or continuous auctions which offer trading throughout the day such as with shares on the New York Stock Exchange (NYSE). The distinctive feature of an auction market is that orders are centralized, and thus the highest bidder
300 William Antwerp, The Stock Exchange From Within (1st published in 1913, Arno Press, 1975) 20
301 Given their central role, it is claimed that brokers ‘handle and control the life blood of the Capitalism system’ in Daniel Montano, The Twenty-First Century Stockbroker: A New Wave (Montano1993) 19. For more details as to the role of brokers in modern markets see Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners (OUP 2003) ch 7
302 Larry Harris, Ibid
and the lowest offer are exposed to each other.303 In this type of secondary market the broker serves as a recorder or an auctioneer of the interests of buyers and sellers.304
Secondly, a secondary securities market could tend to take the form of a brokered market if there was a lack of sufficient participants to deal with each other at the same time.305 In a brokered market buyers and sellers employ a broker to search for the other side of the deal in exchange for a commission.306 Certain derivatives markets that are OTC or off-exchange are brokered markets. Here, the behaviour of brokers is more important compared to these in auction markets, because they maintain a high degree of influence and are aware of the trading and prices of securities executed where there is no public transparency.
Finally, dealer markets exist where there are rapid shifts in the movement of prices. This makes it profitable to remain in the market to serve as a counterparty while brokers are still searching for sellers or buyers.307 A dealer or a jobber, thus, buys for herself when people are selling and sells when people are buying. Dealer markets can exist in either brokered markets or auction markets. The United States government bonds and equities are examples of auction markets, whereas bonds traded off-exchange are examples of dealers markets existing in brokered markets.
Moreover, it is possible for a certain market to exhibit the characteristics of two types. The NYSE market, for example, shifts to being a dealers market when
303 Other examples include auctions for new government debt, such as British gilt and U.S. Treasury Bills. For more details see Roy Bailey, The Economics of Financial Markets (CUP 2005) 38
304 Ibid
305 Laura Beny, ‘US Secondary Stock Markets: A Survey of Current Regulatory and Structural Issues and a Reform Proposal to Enhance Competition’ (2002) 2002 Colum. Bus. L. Rev. 399
306 Ibid
307 Ibid
there is insufficient public demand or offers. In this case, brokers are part auctioneers and part dealers.308
However, looking at brokerage from a business services perspective rather than as part of the market structure appears to raise different legal issues. Essentially, it has been argued that as a result of globalization and de-regulation, investment banking including brokerage, has merged with other banking activities and is being provided with other financial services by the same institution.
Such business practice of brokerage business has in the last thirty years shifted its business model. Previously, for years if not centuries, charging commission for each transaction was the most common, if not the only practice enabling profit to be made from providing brokerage services. Currently, it is argued that the business model adopted by most, but not all, financial institutions has shifted to charging fees based on the volume of assets under management.309
Such a change in business model has resulted in two major developments in practice. Firstly, from an investor’s perspective, the investor is better off increasing the volume of trading;310 since the more trade which is executed, the less costly the charges become. Secondly, brokers have become more aggressive in marketing other services in order to generate additional income.311 In doing so, brokers and brokerage institutions may encourage their customers to amend their investment strategies or adopt a strategy that would bring more benefit to the brokers, but at the same time
308 Ibid; Spencer (n 140) 80
309 Ingo Walter, ‘Conflicts of Interest and Market Discipline Among Financial Service Firms’ (2004) 22 European Management Journal 361. Note that the commission-base model still exists especially in retail markets.
310 See Claudio Salini, ‘Recent Evolution in Securities Market Price Formation Mechanisms’ (IOSCO Conference, Amman, 2004) <http://www.iosco.org/library/annual_conferences/pdf/ac18-14.pdf>
accessed 29 June 2011
311 Ingo Walter (n 309)
exposing the customers to additional risks, such as in stock lending and margin financing.
Despite the significance and importance of the topic, there has been little empirical research into how such a change in business model may increase the exposure of stockbrokers to regulatory risks. A similarly neglected more fundamental question is whether or not the legal solutions which have evolved throughout history are still appropriate in dealing with brokerage service given the change in business model.
For example, a broker may be encouraged by a firm’s compensation arrangements to sell in-house products as opposed to other products that would better suit the client’s needs,312 or a broker may inadequately assess the customer’s attitude towards risks.313 It is one thing to say that brokers are selling services and products aggressively, but it is quite a different thing to state that brokers provide inappropriate advice to their customers. The difference between them is critical from an economic point of view; an intermediary with no direct selling or buying interests will use her experience and skills to filter out bad items and provide the investor with the best available products in the market,314 thus guiding demand to the most efficient and most needed financial products.315
312 Ibid
313 In a recent survey about stockbrokers in retail markets in Australia, it has been found that stockbrokers overestimate their customers’ attitude to risk when brokers are giving advice, see Marilyn Clark-Murphy and Geoffrey Soutar, ‘Do Retail Stockbrokers Understand Clients' Investment Preferences?’ (2008) 13 J.F.S.M. 135
314 Spencer (n 140); John Coffee, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70 Va.L.Rev. 717, 753; William Whitford, ‘The Function of Disclosure Regulation in Consumer Transactions’ (1973) Wis.L.Rev. 400; Isaac Alfon, ‘An Additional Perspective for Retail Financial Products and their Regulation’ (2004) a paper presented in the FSA conference
<http://www.fsa.gov.uk/pubs/consumer-research/rfp_paper.pdf > accessed 29 June 2011
315 Sally McKechnie, ‘Consumer Buying Behaviour in Financial Services: An Overview’ (1992) 10 International Journal of Bank Marketing 5
In short, brokers in general, and stockbrokers in particular, play an important role in the functioning of secondary securities markets. This role will be determined to a great extent by the structure of the market itself. It is also clear that the globalisation and deregulation of financial markets and services as well as the change in the business model of brokerage businesses are likely to have created an incentive for brokers to mis-sell financial services and products to their customers, which may negatively affect the efficiency of the distributional process in financial markets in general and securities markets in particular. The discussion so far draws attention to the importance of evaluating common legal resolutions in relation to the brokerage business, and to question the need for revising some of these legal assumptions.
B) IOSCO’s Principles Concerning the Conduct of Intermediaries
The increased globalization of securities markets and markets for capital renders the role of international organisations more critical for their effective and efficient function.316 These organisations are important as a forum in which professionals exchange experience and transfer knowledge about how to attract and deal with international funds and finance.
The international organisations that deal with financial markets issues can be classified into three groups depending on their functions. Firstly, there are organisations which promote broad policy agendas relevant to capital markets, such as the liberalisation of financial markets. Examples are the WTO, International Monetary Fund, Organisation for Economic Co-operation and Development (OECD) and the World Bank. Secondly, some private international organisations enjoy the
316 Dominik Egli, ‘How Global Are Global Financial Markets? The Impact of Country Risk’ (2000) a paper presented in International Financial Markets and The Implications for Monetary and Financial Stability, BIS Conference Papers No. 8, <http://www.bis.org/publ/confer08.htm> accessed 29 June 2011