Trading on Behalf of Clients: How It Works and Key Considerations

Handling trades for clients is a fundamental role in financial markets, carried out by brokers, investment managers, and financial advisors. These professionals execute buy and sell orders on behalf of individuals or institutions, aiming for the best possible outcomes based on client objectives and market conditions.

This process involves different execution methods, regulatory requirements, and compensation structures that affect both traders and their clients. Understanding these factors is essential for anyone involved in or considering professional trading services.

Agency vs. Principal Transactions

Financial professionals execute trades under two primary models: agency and principal transactions, each affecting execution, risk exposure, and potential conflicts of interest.

In an agency transaction, the broker acts as an intermediary, executing trades without taking ownership of the securities. The broker seeks the best available price and charges a commission for facilitating the trade. For example, if an investor wants to buy 500 shares of Apple stock, the broker finds a seller and completes the transaction at the best available market price. The broker never holds the shares but connects buyers and sellers, aligning their interests with the client’s.

In a principal transaction, the broker-dealer trades directly with the client using its own inventory. Instead of acting as an intermediary, the firm sells securities from its holdings or buys them for its own account. This is common in bond markets, where dealers maintain inventories of fixed-income securities and offer them to clients at a markup. If a client wants to purchase a corporate bond, the dealer may sell it from its inventory at a price that includes a spread—the difference between what the dealer paid for the bond and the price at which it sells to the client. This spread represents the dealer’s profit but can create a conflict of interest.

Regulatory oversight ensures transparency. In the United States, agency trades are governed by SEC Rule 15c3-5 and FINRA Rule 5310, which mandate that brokers seek the most favorable terms for their clients. Principal transactions are subject to additional disclosure requirements under SEC Rule 206(3)-2, requiring investment advisers to obtain client consent before executing such trades.

Discretionary vs. Non-Discretionary Accounts

Investment professionals manage client portfolios through discretionary or non-discretionary accounts, each offering different levels of control and responsibility.

In a discretionary account, the investment manager has the authority to make trades without obtaining prior approval from the client. This allows for quicker execution, which can be beneficial in volatile markets. Portfolio managers follow an agreed-upon strategy based on the client’s risk tolerance, investment objectives, and financial situation. For example, a high-net-worth individual may grant discretionary authority to a wealth manager, allowing them to adjust asset allocations or rebalance holdings without requiring constant client input. Financial advisors managing these accounts must adhere to fiduciary standards, acting in the client’s best interest.

Non-discretionary accounts require client approval for each trade. The advisor provides recommendations, but the final decision rests with the client. This offers greater control to the investor but can lead to slower execution if the client is unavailable. If a financial advisor identifies a strong buying opportunity, they must first communicate the recommendation to the client, who then decides whether to proceed. This structure is common among investors who prefer active involvement in managing their portfolios.

Discretionary accounts are subject to stricter oversight due to the autonomy granted to the investment manager. In the U.S., the SEC and FINRA impose compliance obligations, including suitability assessments and periodic reviews. Registered investment advisers (RIAs) managing discretionary accounts must comply with the Investment Advisers Act of 1940, ensuring that investment decisions align with the client’s best interests. Non-discretionary accounts, while still regulated, place more responsibility on the client.

Common Execution Channels

Trades are executed through different venues, each affecting pricing, liquidity, and transaction speed. The primary channels are exchanges, electronic communication networks (ECNs), and over-the-counter (OTC) markets.

Exchanges

Stock exchanges are centralized marketplaces where securities are bought and sold under standardized rules. Major exchanges, such as the New York Stock Exchange (NYSE) and Nasdaq, provide transparency, liquidity, and price discovery. When a client places an order through a broker, the trade is executed at the best available price based on supply and demand.

Exchanges operate under strict regulatory oversight to ensure fair trading practices. The Securities Exchange Act of 1934 requires exchanges to maintain orderly markets and prevent manipulation. Listing requirements, such as minimum market capitalization and financial reporting standards, help maintain the quality of securities traded.

A key advantage of exchange trading is price transparency since bid and ask prices are publicly available. However, trading on an exchange may involve higher costs due to exchange fees and brokerage commissions. The NYSE, for example, charges transaction fees based on trade volume, which can impact execution costs for large institutional investors.

ECNs

Electronic communication networks (ECNs) are automated trading systems that match buy and sell orders directly, bypassing traditional market makers. Platforms such as Instinet and BATS allow investors to trade securities outside of standard exchange hours.

One advantage of ECNs is lower trading costs. Since they eliminate intermediaries, they often offer tighter spreads compared to traditional exchanges. An investor looking to buy shares may find a better price on an ECN than on the NYSE, where market makers add a markup. ECNs also support anonymity, useful for institutional investors executing large trades without revealing their intentions.

Despite these benefits, ECNs have limitations. They typically require users to pay access fees, and liquidity can be lower for less actively traded securities.

Over-the-Counter

The over-the-counter (OTC) market facilitates trading in securities not listed on formal exchanges. This decentralized market is commonly used for bonds, derivatives, and smaller company stocks. Transactions occur directly between buyers and sellers, often through broker-dealers who negotiate prices.

A major advantage of OTC trading is flexibility. Unlike exchanges, which have standardized contracts and trading hours, OTC markets allow for customized agreements and extended trading periods. This is particularly beneficial for complex financial instruments like interest rate swaps or credit default swaps.

However, OTC markets carry higher counterparty risk, as transactions are not subject to the same level of regulatory oversight as exchange-traded securities. During the 2008 financial crisis, the lack of transparency in OTC derivatives contributed to market instability, prompting regulatory reforms such as the Dodd-Frank Act, which introduced clearing and reporting requirements for certain OTC trades.

Regulatory Considerations

Handling client trades requires adherence to regulations designed to maintain market integrity, prevent fraud, and protect investors. Regulators impose oversight to ensure fair and transparent practices, preventing misconduct such as front-running, where a broker executes personal trades ahead of client orders to benefit from price movements. Violations can lead to penalties, including fines and license revocations.

Trade reporting obligations ensure transactions are properly documented and disclosed. The SEC’s Regulation NMS (National Market System) mandates fair access to market data and order execution, preventing firms from prioritizing proprietary trades over client orders. Additionally, under the Consolidated Audit Trail (CAT) system, brokerage firms must submit trade details to regulators for market surveillance.

Fee and Commission Arrangements

Compensation structures for executing trades vary depending on the financial institution, account type, and services provided.

Commission-based models charge clients a fee per trade, either as a flat rate or a percentage of the transaction value. Traditional brokerage firms often follow this structure. While this model aligns the broker’s earnings with trading activity, it can incentivize excessive trading, known as churning, where brokers execute unnecessary trades to generate commissions. Regulators, including FINRA under Rule 2111, monitor such practices.

Fee-based arrangements charge clients a percentage of assets under management (AUM) rather than per trade. RIAs commonly use this model, with fees typically ranging from 0.25% to 2% annually. Some firms offer hybrid models, combining commissions and AUM fees.

Record-Keeping and Reporting

Brokers must provide clients with trade confirmations detailing execution price, order type, and applicable fees. SEC Rule 10b-10 mandates that these confirmations disclose whether the broker acted as an agent or principal. Periodic account statements summarize holdings, recent trades, and overall portfolio performance.

Regulatory reporting requirements extend beyond client disclosures. Financial firms must submit transaction records to oversight bodies such as the SEC’s EDGAR system or FINRA’s TRACE for fixed-income securities.