Brokerage Commissions and Institutional Trading Patterns

Why do brokers charge per share commissions to institutional traders? What determines the commission charge? The choice of per share commissions as a payment method is puzzling, as commissions are not the most natural way to charge for order execution because costs are not proportional to the trade size and commissions are supposed to deter trading. We contend that commissions, rather than representing a per share price of execution, constitute a convenient way of charging fixed fees for brokers’ services. We develop a simple theoretical model of how brokers choose to allocate services to their clients. We claim that client payments are structured in the form of commissions for convenience and regulatory reasons; however, it is the total payments that determine a client’s level of service from their brokers. Clients adjust the order flow routed to a particular broker and the per-share commissions to maintain the required payment for their desired level of service. Using a large data set of institutional trades, we investigate the distribution of institutional commissions analyze commissions by client and broker attributes. We find results that are consistent with our view of the commission contract. Preliminary version. We would like to thank Abel Noser for providing the data. We also thank Chester Spatt, Ekkehart Boehmer and the participants in the 2001 New York Stock Exchange conference for their helpful comments. We apologize for the errors remaining in this draft.