Now I want to talk about exchanges, notably stock exchanges and brokers, dealers, and clearinghouses. So let's just go to some really basics, a broker. I've written down BOAC. The definition of a broker is someone who acts on behalf of others, that's the O, as an agent for which they earn a commission. So a stock broker, what he or she does is brings people together so that if someone who wants to buy a stock, he finds someone who wants to sell that. Puts the two together, charges a commission for finding the other side. That's a broker. A dealer is different. A dealer, Always acts for himself or the H is a problem, or herself. They both start with H. [LAUGH] A dealer always acts for herself. In other words, as a principal in the transaction for which she makes a markup. So that's a fundamental difference. So if you're buying from a dealer, the dealer owns some of the shares that you're buying. And the dealer sells it to you at a price. There's no commission but the price is higher because your buying. If you want to sell to the dealer, the dealer will buy from you and they'll buy from you at a lower price. The difference between the two prices is called the bid-ask spread. A broker-dealer is a, it could be an individual or a company. It's typically a company that potentially involves both brokers and dealers. So a dealer posts prices, bid and asked, and stands ready to buy. They may be required by the exchange to execute a small number, at least a small amount at the posted price. But if you want to buy a million shares, the dealer is not expected to stay with the posted bid announced. They're analagous to an antique dealer. If you go to a antique store, the dealer has bought the antiques and there won't be any sales commission, they'll just sell you the product. Bid-ask spreads on antique dealers are much wider than stockbrokers. Why is that? Well, I think it's because they have more cost of dealing. Antiques are unique items, hard to sell. They have to put them on a showroom floor. They have to answer questions. So they have to make more money per transaction percentage wise. So they typically have very wide bid-ask spreads. But in a dealer market, where the dealers are competing with each other and they're all posting their bids and ask. Then it gets competed down to a very narrow margin. And so the cost of trading, the bid-ask spread is like a cost of trading even though it's not booked as that. An inter-dealer broker is a broker that facilitates exchange between dealers, that happens. So a broker-dealer is usually a firm doing business. A person can never be both a broker and a dealer on the same transaction. You have to choose one or the other. You can't both make a commission and then markup on the same trade. Now here's an interesting question. When you buy or sell a house, you will probably deal with a real estate broker, also called real estate agent and also, well, there's a trademark realtor. The realtor is a trademark of the National Association of Realtors in the United States, but these are all brokers. What about dealers? If stocks are traded both by brokers and dealers, why not real estate? So when you sell your house, I shouldn't say that there are no dealers. But you don't hear about them very much. When you sell your house, do you find that a dealer comes to you and buys it and hopes then to market it and sell it? I've been asking people why we have so few dealers. One answer has something to do with taxes, that the dealers would have to pay ordinary income on capital gains. So it just doesn't work out as well. But we do have Immobilienmakler in Germany, so as far as I know, the dealer market is alive and well in Germany. And I still haven't completely figured out, but it's still a minority, I think, of sales that go to [LAUGH] Immobilienmakler. So what is good and bad broker behavior? One problem, here's some example of bad behavior. Churning, all right, now a broker charges a commission, remember. So every time they make a sale, they charge a commission. So brokers, with the advent of the telephone, have developed a habit of calling people up regularly and saying I have this hot new investment prospect. [LAUGH] And encourage you to sell what you've just bought last week. Maybe not that quickly and buy something else. And then you get another phone call in another week. And the broker is such a friendly guy. [LAUGH] You can call him up any, call me anytime. He's bubbling with ideas. But every idea involves a trade. So he doesn't care about you. He's only trying to make commissions for himself or herself. [LAUGH] So the SEC decided that this is a crime. That you can get barred from securities trading for the rest of your life, as happened to Robert Magnan in 1999. He had clients with an annual turnover rate of 11. That means they were trading about once a month, their whole portfolio. And the transactions across were so heavy that they would have to earn 50% on their investments in order to pay the transactions cost. So anyone who has any serious knowledge of finance knows that you can't be trading all the time, especially with a broker that's charging high. He wasn't a discount broker. [LAUGH] So he wasn't charging low commissions. So churning is bad. [SOUND] >> So let's recap what churning means. Say you have given your broker discretionary authority over your trading account. If your broker is unethical, he or she may engage in churning by executing excessive trades simply to generate commissions for him or herself. Although this is not always easy to detect. Churning is an illegal and unethical practice that violates SEC rules and securities laws. One way to avoid this risk is to always maintain full control over your own trading account. [SOUND] >> It's one of those tricks that anyone in the industry knows it when they see it. That's why it's enough. Magnan could have had argued, I'm sure he did. All these were good trades. I have so many good ideas. It just turned out badly [LAUGH] in history. [LAUGH] But they should have really, I was sincere, I wanted them to make money. But well, maybe he was sincere, I don't know. But probably everyone in the business knows that that kind of broker behavior is bad.
