What it means
When you place an order to buy or sell a security, the firm handling it can act in one of two ways. As an agent it goes into the market and finds a counterparty for you, charging a fee for the service, or as a principal it sells you the security from its own inventory and makes its money on the difference between what it paid and what you pay.
An agency broker only ever does the first. The appeal is alignment.
A principal firm has an economic interest in the price the client gets, because a worse price for the client is a better outcome for the firm's trading book, whereas an agency broker's revenue does not change with the execution price. That is why large institutional investors, particularly pension funds and their consultants, often insist on agency-only relationships for sensitive orders.
The main service an agency broker provides is careful execution of large orders. A fund wanting to sell two million shares of a mid-cap company cannot simply place the order, because doing so would move the price against it, so the broker works the order over hours or days across multiple venues to minimise market impact.
Skill in that process is worth far more than a small difference in commission rate. Costs are measured in two parts.
The explicit part is the commission, quoted either in cents per share or in basis points of the value traded, and the implicit part is slippage, the gap between the price when the order arrived and the average price actually achieved. Institutional trading desks track both, because a cheap commission paired with poor execution is a false economy.
Regulation reinforces the model in most major markets through best execution obligations, which require a broker to take reasonable steps to obtain the best available result for the client. Agency brokers argue their structure makes compliance straightforward, since they have no competing book to serve.
In practice
Real-world examples.
Example
A public sector pension fund mandates that all equity trading be routed through agency-only brokers. Its trustees accept slightly higher headline commissions in exchange for knowing no counterparty on the other side of their orders is also being paid to sell them research or inventory.
Example
A small-cap fund manager needs to build a position equal to fifteen days of average volume. The agency broker breaks the order into small pieces across several weeks and multiple venues, and the manager measures success against the volume-weighted average price rather than the commission invoice.
Example
A listed company running a share buyback appoints an agency broker to execute the programme within strict daily volume and price limits. Because the broker has no proprietary position, the company's advisers are satisfied that no conflict arises between the buyback and the broker's own trading.
Formula
Calculation
Commission = Shares traded x Commission rate per share
Commission in basis points = Commission / Notional value x 10,000
Worked example: a fund manager instructs an agency broker to buy 250,000 shares of a company trading at $40.
Notional value: 250,000 x $40 = $10,000,000.
Commission at 3 cents per share: 250,000 x $0.03 = $7,500.
Expressed in basis points: $7,500 / $10,000,000 = 0.075%, which is 7.5 basis points.
Now measure the implicit cost. The price when the order arrived was $40.00, and the average price actually achieved across the day was $40.06, so slippage is $0.06 per share.
Slippage cost: 250,000 x $0.06 = $15,000, which is $15,000 / $10,000,000 = 0.15%, or 15 basis points.
Total trading cost: $7,500 + $15,000 = $22,500, or 22.5 basis points. Slippage is twice the commission, which is why an execution-focused broker charging 4 cents can easily be cheaper overall than one charging 2 cents.Case study
Seen in the real world.
Thistlewood Asset Management is an invented equity house used purely as an illustrative example. Trading around $4,000,000,000 of equities a year, it came under pressure from clients to cut costs, and the obvious target was the 9 basis points it was paying in commission, worth $3,600,000 annually.
The firm ran a tender and moved the bulk of its flow to a cheaper agency broker at 6 basis points, cutting commission to $2,400,000 and booking a $1,200,000 saving that looked excellent in the next client report. What the report did not show was execution quality, which was not measured with any rigour at the time.
A year later an independent transaction cost analysis found that average slippage had risen from 12 basis points to 16 basis points, or from $4,800,000 to $6,400,000. The extra $1,600,000 of implicit cost had more than swallowed the $1,200,000 commission saving, leaving the fictional firm roughly $400,000 a year worse off and prompting it to select brokers on total cost rather than on the commission line alone.
Watch out
Common mistakes.
- Choosing a broker purely on the commission rate, ignoring slippage, which is usually the larger and less visible part of the total cost.
- Assuming an agency broker guarantees a better price, when what it guarantees is only the absence of a conflicting proprietary position.
- Confusing an agency broker with a discount retail platform, since the two serve completely different clients and the agency model is primarily institutional.
Questions
People also ask.
What is the difference between an agency broker and a market maker?
A market maker quotes prices and trades from its own inventory as principal, while an agency broker never takes a position and is paid a commission instead.
Is agency execution always more expensive?
Not on a total-cost basis, because although the commission is explicit, a principal trade's cost is embedded in a wider spread that the client rarely sees.
How is broker performance actually assessed?
Through transaction cost analysis, which compares achieved prices against benchmarks such as arrival price or volume-weighted average price across many orders.
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