The agency model, in the context of order execution, refers to a business model where a broker or intermediary acts solely as an agent on behalf of their clients, rather than trading as a principal or market maker.
The primary role of the broker under this model is to facilitate trades between buyers and sellers by matching orders and providing access to liquidity from various sources, such as exchanges, electronic communication networks (ECNs), or other market participants.
In the agency model, brokers do not take on any risk or hold any positions in the securities or assets being traded. Their main responsibility is to provide efficient and transparent execution services to their clients.
Brokers typically earn revenue through commissions or fees charged on each transaction, which are based on the volume or size of the trade.
The agency model offers several advantages:
- Transparency: Since the broker only acts as an intermediary and does not trade as a principal, there is less potential for conflicts of interest between the broker and the client. Clients can be confident that the broker’s primary objective is to secure the best possible execution for their trades.
- Best execution: Brokers following the agency model are obligated to seek the best possible execution for their clients’ orders. They must consider factors such as price, speed, size, and the likelihood of execution when routing orders to different liquidity providers or trading venues.
- No proprietary trading: Unlike market makers or principal traders, brokers operating under the agency model do not engage in proprietary trading. This means that they do not take positions in the market for their own account, which can help mitigate potential conflicts of interest.
However, there are also some potential downsides to the agency model:
- Higher fees: Since brokers do not profit from trading spreads or holding positions, they typically rely on commissions or fees to generate revenue. As a result, the cost of trading under the agency model may be higher compared to other models where brokers generate revenue through trading spreads.
- Limited access to liquidity: Some brokers operating under the agency model may not have access to the same level of liquidity as market makers or principal traders, which could impact the speed and efficiency of trade execution.
Overall, the agency model aims to provide transparent and unbiased trade execution services to clients by eliminating potential conflicts of interest between brokers and their clients.
This model is particularly popular among institutional investors and high-frequency traders who prioritize best execution and transparent pricing.