US Equity Market Structure (4): The Players – Broker-Dealers and Investors

This is the fourth post of a series on US Equity Market Structure (a total of 6).

I didn't write any of these posts; while I was learning the fundamentals about investment, I came across this series on Interactive Brokers' IBKRCampus. If you are interested you can go to their site here.

（Disclosure: I'm using Interactive Brokers for my personal investing, but I'm not paid by them to write about it.)

This series is mostly platform-agnostic, meaning that you don't have to be on Interactive Brokers to find this series useful. Enjoy.

Welcome back to our introduction to U.S. equity market structure. Now that we've discussed the rules of the game, the playing field, and the "ball" (the stocks), let's dive into how trading really happens by focusing on the key players: broker-dealers and investors.

Investors

Investors are the ultimate stakeholders in the market—the ones the SEC is designed to protect. Investors provide the capital that companies use to grow and fuel the economy. They can be individual investors, like people buying stocks or contributing to a 401(k), or institutional investors, like asset managers handling pension funds or mutual funds on behalf of individuals.

If you invest in a company or have a retirement account, you're considered an investor. Approximately half of Americans are invested in the stock market in some form. Investors play a key role by researching companies, making decisions on whether to buy or sell, and holding stocks whose value fluctuates with market performance.

While investors are central to the market, they often can’t execute trades directly. When you place a trade on your brokerage account, you're not submitting that order directly to the exchange. Instead, you rely on a registered broker-dealer to execute the trade on your behalf.

Broker-Dealers

In many ways, broker-dealers are the actual "players" on the field. These firms are licensed to buy and sell securities, playing both the role of agent (when trading on behalf of clients) and principal (when trading for their own account). Broker-dealers provide the crucial bridge between investors and the stock exchanges.

• Broker (or agency broker) refers to firms or individuals that execute trades for clients.
• Dealer (or principal trader) refers to those who trade on their own account.
• Prime brokerage is a term for brokers that offer additional services like securities lending, leveraged trade executions, and cash management, which large investors often require.
• Proprietary traders trade mostly for their own accounts, and they tend to have more flexibility because they don’t handle client orders. High-frequency traders (HFTs) are often proprietary traders.
• Retail broker-dealers serve individual investors, helping them buy and sell stocks.

Responsibilities of Brokers

Brokers have certain responsibilities to their clients, particularly regarding "best execution" and "order routing."

1. Best Execution
   Brokers are legally required to seek the best execution for their clients' orders. This means they must strive to achieve the best price reasonably available at the time of the trade. At a minimum, this means they can't execute an order at a price worse than what's being displayed in the market elsewhere. However, brokers are also encouraged to seek "price improvement," aiming for a price better than the current market quote if possible.
2. Order Routing
   When you place a trade, brokers must decide where to send your order for execution. This is called order routing. If you don't specify where to route your trade, brokers have discretion over the decision. According to Rule 606 of Regulation NMS, brokers must report where they send orders that don't have specific instructions. You can find these reports online by searching for a broker's "606 report."

Brokers balance different priorities depending on whether they represent themselves or their clients. The strategies and tactics they use will vary based on the instructions or goals of their clients.

In the next lesson, we'll explore the strategies and tactics that broker-dealers use when trading in the U.S. equity market.