Agency trading
Agency trading is any type of trade that the broker or participant executes for their clients in exchange for a brokerage fee.
This type of trade may come in the form of a direct order from the client or on the agency’s own volition if and only if the client gave the broker approval to do so.
How agency trading works
To better understand how agency trading works, consider the way discount and full-service brokers work.
Discount or non-advisory brokers simply execute agency trades when their client sends them an order. On the other hand, full-service or advisory brokers may execute certain trades that benefit their client’s portfolio if the client gave them prior approval, which is the case for managed funds that own a shares portfolio.
In both cases, the broker executes and/or initiates transactions for the benefit of their clients.
Proprietary trading
Proprietary trading – also known as prop trading – refers to when an agency or broker executes trades for the benefit of its own institution.
The broker uses only the company’s own money and alters, diversifies or improves its portfolio to hedge risks or increase profits. By extension, this means the firm does not and should not use any of its clients’ money in these transactions.
How does proprietary trading work?
Proprietary trading only affects the firm’s own portfolio. The broker or proprietary trader focuses only on finding better investment opportunities and executes profit-making strategies for the benefit of its own firm, not for its clients.
These traders don’t have to think about protecting the money and the portfolio of any of the institution’s clients, so they don’t have to focus on providing liquidity for their clients’ assets in case of a stressed market environment.
Unlike agency trading, proprietary traders are hired by firms to manage its own portfolio – hence, these traders don’t charge brokerage fees or receive profit.
Agency trading v proprietary trading
To better illustrate, consider the situation where the market experiences high volatility. A trading firm sees this volatility as a temporary circumstance that would clear up and create profit-making opportunities after a quarter. However, their strategy would differ depending on what type of trade they make.
Agency traders and risk
If the investor client is too shaken by the sudden drop in the value of their portfolio and wants to sell off the volatile assets, the agency trader can execute their orders. In the case of an advisory broker, they can explain their position and make appropriate recommendations. But advisory brokers are bound by their client’s decision and should execute orders according to it.
In the case of managed funds that allow clients to exit anytime, clients can simply sell their shares if they don’t like the direction the fund manager is taking. Because of this option, the fund manager must balance risk, opportunities and liquidity to keep the fund going.
Proprietary traders and risk
Proprietary traders, on the other hand, can retain their position or take advantage of high-risk conditions if they believe that it is temporary and would most likely result in profit.
