Why do we need stock brokers?

Financial Analysts Journal

Volumn 52, Issue 2, 1996, Pages 21-30

  Brown, David P ^a  

^a INDIANA UNIVERSITY   (United States)

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EID: 0009358344     PISSN: 0015198X     EISSN: None     Source Type: Journal    
DOI: 10.2469/faj.v52.n2.1977     Document Type: Article

References (15)

1. See SEC Release no. 34-35038, File no. S7-34-94, entitled "Transfer Agents Operating Direct Registration System."
2. Note that directly registered shares are not held at a depository in the name of the retail owner of the shares. It is conceivable that, in the not-too-distant future, individuals (as well as institutions) will be allowed to open accounts in their own names at depository institutions that hold bookentry shares.
3. See James V. Jordan and George Emir Morgan, "Default Risk in Futures Markets: The Customer-Broker Relationship," The Journal of Finance, vol. 45, no. 3 (July 1990):909-33, for a discussion of a defaulting dealer in the futures market. See "Malaysian Exchange Says 12 Defaulters in Union Paper," Dow Jones International News, Dow Jones News Retrieval Service (July 13,1993) for an incident of default in the Malaysian stock market.
4. See James V. Jordan and George Emir Morgan, "Default Risk in Futures Markets: The Customer-Broker Relationship," The Journal of Finance, vol. 45, no. 3 (July 1990):909-33, for a discussion of a defaulting dealer in the futures market. See "Malaysian Exchange Says 12 Defaulters in Union Paper," Dow Jones International News, Dow Jones News Retrieval Service (July 13,1993) for an incident of default in the Malaysian stock market.
5. Customers of brokerage firms face risk from default in at least two ways. First, trade agreements are at risk of not being settled or at least being delayed in settlement when the broker defaults. A shorter settlement time reduces but does not eliminate this risk. Second, ownership records of bookentry shares may be lost or may be tied up in bankruptcy proceedings. The stockholder may lose the right to sell those shares immediately, so that liquidity is at risk. Direct registration eliminates this risk entirely because share ownership is not registered in the broker's street name but in the issuer's name.
6. We argue that transfer times of directly registered shares are likely to be shortened if this proposal is instituted. Therefore, the greatest impediment to the use of direct registration by retail investors will vanish.
7. One possible form that payments for share lending might take is a premium on dividends. For example, the borrowing firm might promise an individual lending a $100 stock an additional $0.50 on each quarterly dividend the firm pays, which would amount to (approximately) an additional income of 2 percent a year.
8. Here, we use the label direct registration in a sense that is different from its formal definition under SEC Release no. 34-35038. Institutions currently may establish accounts at depository institutions in their own names and not in an issuer's name.
9. The NYSE reports an average execution time of 22 seconds on its SuperDot System. See "Among NYSE's Growing Challenges: Fighting Regulatory Barriers, Payment for Order Flow," Global Investment Technology (July 12,1993) by Investment Media.
10. The form an electronic exchange should take is an important question. It has been argued that the efficiency of an open limit-order book dominates that of other exchange mechanisms; see L.R. Glosten, "Is the Electronic Open Limit-Order Book Inevitable," The Journal of Finance, vol. 49, no. 4 (September 1994):1127-61.
11. In the Indiana University working paper "Organization of Competitive Financial Exchanges," V. Bhasin and D.P. Brown provide a formal analysis of this intuition. Limited membership and finite ticks between prices jointly create valuable exchange seats. Traders recognize the possibility of default by exchange members and choose to trade at an exchange that guarantees settlement despite the fact that trade is less expensive in a market without similar guarantees.
12. See, for example, J.B. De Long, A. Shleifer, L.H. Summers, and R.J. Waldmann, "Noise Trader Risk in Financial Markets," Journal of Political Economy, vol. 98, no. 4 (August 1990):703-38.
13. Short selling occurs for a variety of reasons, which include speculation on future price declines, hedging of options or other derivative positions, and capital gains tax avoidance. To the extent that firms are successful in limiting short selling, they also reduce the efficiency of the market in their shares.
14. The SEC proposal is not clear on the issue of transparency. One can imagine a system of direct registration such that transfer agents appointed by the issuer hold the names of the beneficial owners and use these names for the distribution of dividend payments and corporate correspondence. In this case, the issuer may know the number of and/or the distribution of securities across security owners but does not know the names and identities of owners. An alternative system would allow the issuer complete transparency: The identities of all directly registered shareholders are known.
15. The helpful comments of Michael Simkowitz are very much appreciated.