After Madoff and Stanford: researching brokers and brokerage firms.

The recent frauds of Bernard Madoff, and most recently, the suspected dubious activities of Sir Allen Stanford and his firm made me think about understanding how "brokerage" firms work. This led me to the complexities and difficulties of researching them. From most of the press reports that are coming out about this type of investment firm and these frauds, the one consistent theme is that only the most rudimentary amounts of investigation and due diligence as to their suitability for their business had been done by some apparently very, very trusting investors, their agents, and also by the various regulatory authorities. In my January 2009 article "The Process of Business Research", I indicated some areas that I felt would be prudent to investigate for any business, using the Madoff Ponzi scheme as an example. In this article, I look specifically at the professional brokerage firm and the published sources available for further research.

Even before news of these frauds, there were questions about "brokerage" as an activity in financial services. The U.S. investment banks that had conspicuously failed in September 2008 during the second phase of the credit crisis were all operating, and most importantly, regulated as brokers by two authorities, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, Inc. (FINRA). In the long article "Lack of confidence raises doubts on broker-dealers" by Renee Schultes in Financial News on September 22, 2008 (1), there was considerable disquiet in both the City of London and on Wall Street about brokers and their role in investment banking, especially in relation to the "profits" that were made in trading and dealing in the collateralized instruments that were at the root of the credit crisis. Schultes discusses three models of brokerage: the incumbents (such firms as Goldman Sachs and Morgan Stanley), the universals (banks like Citicorp and Barclays that have brokerage divisions), and the boutiques (firms such as Madoff's that may also be considered hedge funds or even private equity partnerships). This is a complicated breakdown, but it gives us an idea of the fragmented nature of this part of the financial services sector. It also shows how difficult these firms can be to pin down and therefore research successfully. Schultes' article also makes the point that the whole financial brokerage industry is based on confidence and certainly is not sustainable when most of the traders who work in these firms are quite prepared to take profits, but are not prepared for the consequences if the trades turn bad.

Definition

When I went in search of what the term "broker" actually meant, there was no real indication of the divisions described in the Schultes article. The picture was still not simple to describe or understand. To me the term is most often associated with stocks and shares and hence the term "stockbroker," meaning a middleman or "intermediary" who buys, sells, or deals in securities for a client as an agent. A broker can be an individual or firm and can also do all buying or selling for its account, with not a client in sight. This is known as principal trading, which was much practiced by the now defunct investment banks. There are many other types of "broker" in common parlance in financial services, e.g., commodity broker and insurance broker. And, let us not forget the mortgage brokers that got into so much trouble with sub-prime lending.

There are also very specific definitions: for example, a "prime broker" (2) who conducts the settlement activity for a range of financial firms, especially hedge funds. The word "broker" can also be used much more widely to mean anyone who trades in anything for a living, making money on the turn, or difference between buying and selling goods or services. The SEC definitions at the part of their website describing brokers take this much broader approach in defining brokerage activity. The descriptions made by the SEC are in 10 different categories and can be found in Section A ("Who is a Broker") at www.sec.gov/divisions/marketreg/bdguide.htm.

I learned very quickly from this research into definitions that the actual term for the type of activity being conducted by both the investment banks and by Madoff and Stanford was actually described in the U.S. as being a "broker-dealer." It seems that under U.S. law, a broker-dealer is any person, other than a hank, who is engaged in the business of buying or selling securities for themselves on their own account. The principal trading for clients is known as "agency trading." This anomaly of not technically being able to act as a "broker-dealer" as well as a "bank" is a hangover from the days of Glass Steagall regulation and the separation of commercial from investment banking activity in the 1930s. More details about this issue are explained in the next section of this article.

A definition from the Bank of America Investor Relations website gives a much more technical, but very detailed description of the full range of activities done and the types of operations where they are found: