Why Do Institutional Investors Use Reputable Brokers?

Alex Frino

Macquarie University

David R. Gallagher

UNSW Business School; Centre for International Finance and Regulation (CIFR); Capital Markets CRC Limited; Macquarie Graduate School of Management

George Li

Macquarie Graduate School of Management

Vito Mollica

Macquarie Graduate School of Management; Capital Markets CRC Limited (CMCRC)


Using a long term sample, our study examines why institutional traders may prefer reputable full-service brokers. In particular, we examine two possible determinants in this choice: execution ability and information. We find that, while top-tier brokers achieve better trading costs for their clients, this is not the primary reason why institutional investors route their orders to them. Rather, the choice is driven by information value. We argue that the superior research offered by top-tier brokers distinguishes broker channel.

Why Do Institutional Investors Use Reputable Brokers? – Introduction

Institutional investors have competitive access to brokers who execute orders on their behalf. In a typical scenario, institutional investors determine their buy and/or sell orders for a list of securities prior to the market open, and submit those orders for execution to brokers. Routing those orders via a discount broker, or a full service broker is an important decision as the execution ability of the broker impacts the investment returns institutional investors earn on behalf their investors. The important choice and motivations behind the use of discount and full service brokers remains a contentious issue in the academic literature. Using a unique dataset of Australian fund managers that spans over 18 years (1992 to mid-2010), this study investigates some of the factors that determine an institutional investor’s choice between brokers.

Australia is an interesting setting to examine institutional investors’ choice between brokers. It is a market where trading and stock broking activities are highly concentrated. There are three areas of concentration in Australian markets. First, during our sample period, trading occurs exclusively on the ASX. This is in contrast to North American markets which are much more fragmented. In some of these market fragments, brokers hold the dual role of an exchange and that of a traditional broker, blurring the lines of exchange fees and brokerage commissions. Second, there are far fewer brokers to choose from in Australia, creating a high level of concentration in broker activity. Qualitatively, there are also fewer variations in the types of services that they offer. Finally, traders in Australia typically focus on the largest and most liquid stock, despite having over 2,000 stocks to choose from. For example, the top 10 stocks on the S&P/ASX200 index accounts for over 50% of the market capitalization and similarly a disproportionate share of its trading value.

Most capital markets have seen a large growth in discount brokerage services over the last 20 years. In Australia, several players such as Commonwealth Securities (Commsec) and E-Trade, have attracted significant market share from traditional brokers. These discount brokers offer lower commissions, but also provide fewer services to institutional investors. By choosing to use discount brokers, investors may forgo superior execution and/or research services typically offered by a traditional full service broker.1 To a lesser extent, the same argument applies to less reputable full-service brokers in comparison to more reputable ones. This leads us to two natural and plausible reasons behind the choice between various brokers: execution ability and information.

Brokers offer varying degrees of execution service to their clients. On the one side, discount brokers offer no execution services other than access to markets through a trading platform. Full service brokers conversely devote significant resources to research and the implementation of trading strategies aimed at minimizing the price impact of orders for their clients or maximizing investment returns.

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Institutional Investors