Gold News

Principals and agents

How internet markets (should) work.

BullionVault's founder Paul Tustain has been a user of financial markets for 25 years. He he describes some of their subtleties, and explains features which might not seem important but which have a big impact for all users of all markets.

What are 'principals' and 'agents' and why are they important?

In most modern financial trading environments - especially on-line - you are trading directly with the opposing principal to your trade. Your opposing principal is whomever is selling when you are buying, and buying when you are selling.

An opposing principal's interest conflicts with yours, because what is best for them - i.e. to sell you something for the highest possible price - is clearly not best for you.

This conflict of interest was well understood for 200 years up to the 1980s, and many traditional financial exchanges around the world - including major exchanges like 'The London Stock Exchange" - were structured to eliminate the conflict by forcing market access to come through member agents.

In markets structured with member agents each agent was a professional who knew the marketplace intimately, but did not own inventory and was barred from buying from or selling to customers. This meant that an agent had no conflict in overpricing what was bought on the customer's behalf, and could be relied upon to act within the market in the customer's best interest.

The problem with this old structure was that agents were remunerated by commission, which they supposedly earned by assiduously checking the marketplace for the best available price, negotiating hard with principals in the market, and by otherwise generally taking care of the customer.

But as investment buying power concentrated in fewer and fewer large financial corporations they grew to resent paying commissions to agents when they themselves were well capable of locating and acting with opposing principals on their own behalf.

These big exchange users, the 'mutuals' and their global equivalents, demanded the right to trade direct with the market principals.

So the agent structure was widely discarded and the principal conflict re-appeared. It was thought that if the conflict was allowed back in, but strict rules were made telling firms how not to abuse it, then they wouldn't; and meanwhile the big market users would be happy too.

The main rules implemented to defuse the direct principal trading conflict were:

  • When a firm dealt as principal it should declare so, which would flag the conflict to the customer. Unfortunately the subtlety of the principal/agency dilemma was not understood by many customers, who have tended to assume that as long as the second rule was obeyed they were being fairly treated.
  • The second rule was that when a firm dealt as principal with its customer it must at least match the best price available elsewhere on the market. This was widely called the 'duty of best execution'.

But the rules approach is widely thought to have failed smaller investors, and here's why.

A problem with almost all financial exchanges is that there is a delay from trade to settlement, which imposes a risk that one side or another can default - which means fail to pay for, or deliver, what has been traded. So if you deal on an exchange you need to be confident settlement will occur smoothly - in other words that your opposing principal is credit-worthy.

Because of this an exchange based on competing prices only works well where the identity of the opposing principal is irrelevant in credit-risk terms. Otherwise buyers and sellers only deal with people they trust, and the exchange degenerates into an over-the-counter system where offering the best price doesn't necessarily win business.

So on modern exchanges the delay in settlement - and the credit risk of default - ends up being managed by a central clearing mechanism, which guarantees the performance of every trade regardless of counterparty. This makes price the only remaining material fact in selecting who you're going to deal with.

Yet no central clearer is prepared to extend that guarantee against default unless it has some measure of control over who is receiving it, so clearers at the centre of exchanges require an exclusive membership which is monitored for creditworthiness. Then the advertising of competing prices on the exchange is reserved exclusively to those members.

And this is where the system starts to go wrong. When exchange member firms are granted exclusivity on posting prices each is soon best served by making an effort to specialise in a narrow range of instruments. As they develop this specialised liquidity they deliberately don't post their own trading prices publicly, and they allow publicly posted market spreads to widen as liquidity drops across all the less specialised competition. But to their own customers they trade inside the illiquid, posted and wide prices - apparently serving their customers well and enhancing their own reputation in their chosen specialisation.

The end result is that many orders do not make it to the public order board, and no-one knows what the best exchange price is. A wide spread soon accumulates to specialists at very little risk, and the cost is borne by buyers and sellers, not through commissions but through the difference between wide buying and selling prices. The duty of 'best execution' is now unverifiable, and almost meaningless.

BullionVault offers an overdue solution to the dilemma. Unlike the legal rights to a stock or a bond recorded in a central clearer's records, the ownership of physical gold can be exchanged instantaneously for cash - just as if it were bought in a street market.

So BullionVault settles gold trades immediately at the instant of trade. This eliminates the credit exposure involved in settlement delays. By demanding that the cash and bullion resources are on hand for all participants at the instant of trade the exclusive monitored membership problem disappears, and then the technology of the order board can be made available to anyone and all can benefit from fair and open price competition.

On BullionVault gold is bought and sold in a public exchange through transmitting orders directly to the market, and absolutely anyone can do this on their own account. The result is that when you trade it can be said with true confidence - and proven - that there were no better available prices. BullionVault cannot hide customers' prices, suppress competition, and take an inflated turn. It is forced to compete openly with all holders of gold in the system.

This is the underlying reason why dealing spreads available to the retail customer are much narrower in BullionVault gold, and why they will stay that way.

Paul Tustain is the founder and chairman of BullionVault.

See the full archive of Paul Tustain articles.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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Market Fundamentals