What Is Agency Trading and How Does It Work?

Investors rely on different methods to buy and sell securities, and one common approach is agency trading. This method involves a broker acting on behalf of a client rather than trading for their own account. It differs from proprietary trading, where firms trade with their own capital to generate profits.

Understanding how agency trading works helps investors evaluate execution costs, market transparency, and the role brokers play in facilitating trades.

Main Mechanics

When an investor places an order through an agency broker, the broker seeks the best available price by routing the order to an exchange, an alternative trading system (ATS), or another liquidity venue. The broker does not take ownership of the security but facilitates the transaction between the client and the counterparty.

To improve execution, brokers use smart order routing (SOR) technology, which scans multiple venues to find the most favorable price. This is especially useful in fragmented markets where liquidity is spread across different exchanges and dark pools. An order for Apple stock, for example, might be routed to the New York Stock Exchange (NYSE), Nasdaq, or an ATS, depending on where the best price and execution speed can be achieved.

Market conditions also affect execution quality. During high volatility, bid-ask spreads widen, making trades more expensive. Brokers may use algorithms to break large orders into smaller ones to minimize market impact. This is common in institutional trading, where large asset managers must execute sizable trades without significantly affecting stock prices.

Role of Intermediaries

Brokers connect investors to financial markets, ensuring efficient order execution while complying with regulations. They access various trading venues, maintain relationships with liquidity providers, and use technology to optimize trade execution.

Beyond execution, brokers provide market insights and research that help clients refine strategies. Institutional investors, such as pension funds and mutual funds, often rely on brokers for proprietary research, trading analytics, and historical market data to guide decisions on large trades.

Risk management is another key function of agency brokers. While they do not take on direct market risk, they must comply with client mandates, regulatory frameworks, and risk controls. This includes monitoring trading activity for potential market abuse, such as front-running or manipulation, and ensuring adherence to best execution policies. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) enforce strict guidelines to maintain market integrity.

Commission Structures

Brokers in agency trading earn revenue through commissions, which vary based on the pricing model, trade size, and security type. Understanding these structures helps investors assess trading costs and choose brokers that align with their strategies.

Per-Share

A per-share commission model charges a fixed fee for each share traded. This structure is common among active traders and institutional investors handling high volumes. For example, a broker might charge $0.005 per share, meaning a trade involving 10,000 shares would result in a $50 commission.

This model benefits traders executing small orders since they only pay for the shares they trade. However, for large trades, per-share pricing can become expensive unless volume discounts apply. Some brokers offer tiered pricing, where the per-share rate decreases as trading volume increases.

Investors should also consider liquidity. In highly liquid stocks, commission costs may be minimal, but for less liquid securities with wider bid-ask spreads, total execution costs—including commissions and market impact—can be higher.

Value-Based

A value-based commission structure charges a percentage of the total trade value rather than a fixed amount per share. This model is common in markets where share prices vary significantly, such as international equities or fixed-income securities. For instance, a broker might charge 0.1% of the trade’s total value, meaning a $100,000 transaction would incur a $100 commission.

This approach aligns costs with trade size, making it more predictable for investors dealing in high-priced securities. It is particularly useful for those trading low-volume, high-value stocks, as they avoid excessive per-share fees. However, frequent traders dealing in lower-priced stocks may find this model more expensive than per-share pricing.

Value-based commissions are also prevalent in bond markets, where trades are typically executed in large denominations. Since bond prices fluctuate based on interest rates and credit risk, a percentage-based fee ensures that commission costs scale with investment size.

Flat-Fee

A flat-fee commission model charges a fixed amount per trade, regardless of the number of shares or total transaction value. This structure is popular among retail investors and discount brokerage platforms, as it provides cost certainty and simplifies fee calculations. For example, a broker might charge $10 per trade, whether the order involves 100 shares or 10,000 shares.

This model benefits investors trading in large volumes, as they pay the same commission regardless of trade size. However, for small trades, a flat fee can be disproportionately expensive. A $10 commission on a $100 trade represents a 10% cost, significantly reducing potential returns.

Some brokers offer subscription-based pricing, where investors pay a monthly or annual fee for unlimited trades. This can be cost-effective for active traders who execute multiple transactions per day. Investors should evaluate their trading frequency and average order size to determine whether a flat-fee structure suits their approach.

Regulatory Landscape

Regulatory oversight in agency trading promotes market fairness, transparency, and investor protection. In the United States, the SEC enforces rules requiring brokers to act in their clients’ best interests. FINRA monitors broker-dealer activities and imposes penalties for violations such as misleading order handling or inadequate disclosures.

A key regulatory requirement is best execution, which obligates brokers to seek the most favorable terms for their clients based on price, speed, and likelihood of execution. SEC Rule 606 of Regulation NMS mandates that brokers disclose their order routing practices, ensuring transparency in whether they prioritize execution quality over financial incentives from market makers or trading venues. Firms that fail to comply with best execution requirements risk enforcement actions, as seen in cases where brokers have been fined for routing orders based on payment for order flow rather than securing optimal prices for clients.

Brokers must also adhere to recordkeeping and reporting obligations under SEC Rule 17a-4, which requires firms to maintain detailed transaction records for at least six years. These records enable regulators to audit trading activity and detect potential misconduct, such as wash trading or undisclosed conflicts of interest.

Settlement and Clearing

After a trade is executed, it must go through settlement and clearing to ensure securities are delivered to the buyer and funds are transferred to the seller. Clearinghouses and depositories manage this process to mitigate counterparty risk and prevent failed trades. In equity markets, the Depository Trust & Clearing Corporation (DTCC) plays a central role in clearing trades, while fixed-income securities often settle through platforms like the Fixed Income Clearing Corporation (FICC).

Settlement cycles vary by asset class and jurisdiction. In the U.S., most equity trades follow a T+1 settlement cycle, meaning the transaction is finalized one business day after execution. This shift from the previous T+2 standard, implemented in May 2024, reduces counterparty risk and improves market efficiency. Shortening the settlement period minimizes the time during which a trade could fail due to price fluctuations or liquidity issues. However, it also requires market participants to have robust operational processes to ensure timely delivery of securities and funds.

Clearinghouses act as intermediaries between buyers and sellers, guaranteeing trade completion even if one party defaults. They achieve this by requiring margin deposits and maintaining default funds to cover potential losses. For institutional investors, central clearing reduces systemic risk, particularly in derivatives markets where exposures can be substantial. Retail investors typically rely on their brokers to handle clearing and settlement, with little direct involvement in the process. As technology advances, blockchain-based settlement solutions are being explored to further streamline post-trade operations and reduce reliance on traditional clearing mechanisms.