What Is Trading Authority?
Trading authority refers to the legal authorization granted by a client (the principal) to a financial professional, such as an investment advisor or broker, to execute trades in a brokerage account on the client's behalf. This power is a fundamental aspect of investment management and establishes an agency agreement where the financial professional acts as the client's agent. The scope of this authority can vary significantly, from broad discretion over all investment decisions to highly specific instructions for individual trades. Implicit in any grant of trading authority is the financial professional's fiduciary duty or other applicable standard of care to act in the client's best interest.
History and Origin
The concept of granting trading authority to an agent has roots in the broader theory of agency, which has existed in law and commerce for centuries. In finance, this relationship became more formalized with the growth of modern securities markets and the rise of professional money managers. The separation of ownership and control, a core idea in agency theory, describes how shareholders (principals) delegate decision-making power to managers or financial agents (agents) to oversee their investments11, 12. This delegation naturally gives rise to the need for clear delineation of authority. Early financial markets saw more direct client involvement, but as investment strategies grew more complex and global, the practicality of delegating trading decisions to informed professionals became evident. Regulatory frameworks, such as those established by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), evolved to govern these relationships, emphasizing investor protection and clear standards of conduct.
Key Takeaways
- Trading authority is the formal permission for a financial professional to execute trades on a client's behalf.
- It is a core element of the client-advisor relationship in investment management.
- The scope of trading authority can range from full discretion to limited, trade-by-trade instructions.
- Proper documentation and adherence to regulatory standards (e.g., FINRA Rule 3260) are crucial for both parties.10
- Unauthorized trading occurs when trades are executed without the appropriate grant of authority, leading to potential legal and disciplinary actions.9
Interpreting Trading Authority
Understanding trading authority hinges on distinguishing between its two primary forms: discretionary account and non-discretionary account.
In a discretionary account, the client grants the financial professional the power to make investment decisions, including what securities to buy or sell, the quantity, and the timing of the trades, without needing the client's explicit approval for each transaction. This type of authority typically requires a written agreement signed by the client and accepted by the firm's principal.
Conversely, in a non-discretionary account, the financial professional must obtain the client's specific authorization for every single trade before it is executed. While the professional may offer recommendations, the ultimate decision-making power for each transaction rests solely with the client. Most retail brokerage accounts operate on a non-discretionary basis.8
Hypothetical Example
Consider Sarah, a busy doctor, who wants her investment portfolio professionally managed. She decides to work with an investment advisor, David. After discussing her financial goals, risk tolerance, and investment horizon, Sarah signs a discretionary trading authority agreement with David's firm. This agreement explicitly states that David has the power to buy and sell securities within her account to achieve her agreed-upon portfolio management objectives, without needing to call Sarah for approval on every trade.
A month later, David identifies an opportunity to rebalance Sarah's portfolio by selling some overperforming tech stocks and buying shares in an underperforming healthcare mutual fund to maintain her desired asset allocation. Because he has discretionary authority, David can execute these trades immediately. Had Sarah's account been non-discretionary, David would have had to contact Sarah, explain his rationale, and obtain her explicit approval before placing the orders.
Practical Applications
Trading authority is a cornerstone in various aspects of the financial industry:
- Brokerage and Advisory Services: Broker-dealers and registered investment advisors both operate under specific rules regarding trading authority. Investment advisors are generally fiduciaries, meaning they must act in their clients' best interest, and often manage accounts on a discretionary basis. Broker-dealers, while primarily executing trades, must adhere to suitability standards for recommendations unless a discretionary agreement is in place. The Securities and Exchange Commission (SEC) provides guidance on the differing regulatory standards and obligations of these entities.7
- Regulatory Compliance: Regulatory bodies like the Securities and Exchange Commission (SEC) and FINRA (Financial Industry Regulatory Authority) have stringent rules governing trading authority to protect investors. FINRA Rule 3260, for instance, outlines requirements for written authorization and supervisory oversight of discretionary accounts to prevent abuses such as excessive trading or unauthorized transactions.6 This includes rules that prohibit brokers from exercising discretion without prior written authorization from the customer and the firm's approval.5
- Estate Planning and Trusts: Trading authority can be granted through a power of attorney, allowing an agent to manage investments if the principal becomes incapacitated or wishes to delegate management during their lifetime.
Limitations and Criticisms
While trading authority offers convenience and professional management, it comes with inherent risks and criticisms:
- Potential for Abuse: The primary concern is the potential for financial professionals to abuse their authority. This can manifest as unauthorized trading, where a broker makes trades without the client's explicit permission in a non-discretionary account, or excessive trading (churning) in discretionary accounts, where transactions are made primarily to generate commissions rather than benefit the client.4 Regulators like FINRA actively monitor and penalize such misconduct, but investors must exercise due diligence.3
- Conflicts of Interest: Even with a fiduciary duty, conflicts can arise. For example, an advisor managing a discretionary account might be incentivized by certain commission structures or proprietary products.
- Misalignment of Goals: If the client's evolving risk tolerance or investment objectives are not regularly communicated and updated with the advisor, the advisor's actions, even if authorized, might cease to align with the client's best interests. This underscores the importance of ongoing communication and the advisor's obligation to ensure the suitability of investments.
Trading Authority vs. Discretionary Trading
While often used interchangeably in casual conversation, "trading authority" is a broader concept that encompasses the specific type of "discretionary trading."
| Feature | Trading Authority | Discretionary Trading |
|---|---|---|
| Scope | General permission granted to manage trades, whether on a trade-by-trade basis (non-discretionary) or with full autonomy. | A specific type of trading authority where the client grants the financial professional full power to make investment decisions without prior approval for each trade. |
| Client Approval | May require client approval for each trade (non-discretionary accounts) or not (discretionary accounts). | Does not require client approval for each trade, only initial written authorization and ongoing review. |
| Mechanism | Established through various agreements (e.g., account agreements, power of attorney). | Established specifically through a written discretionary account agreement. |
The key distinction is that discretionary trading is a form of trading authority, representing the highest level of delegated decision-making power a client can grant for executing trades. All discretionary trading involves trading authority, but not all trading authority is discretionary.
FAQs
1. What is the main difference between a discretionary and non-discretionary account?
In a discretionary account, your financial professional can make trades without asking for your permission each time, based on an initial written authorization. In a non-discretionary account, they must get your approval for every single trade.2
2. How can I grant trading authority to someone else?
You can grant trading authority by opening a discretionary account with a financial firm and signing the necessary written agreements. For broader financial matters, including investments, you might also use a power of attorney that specifically outlines investment management powers.
3. What should I look for in an investment advisor if I'm considering giving them discretionary authority?
When considering a financial professional for discretionary authority, look for someone with a strong professional reputation, clear communication practices, and a demonstrated commitment to their fiduciary duty. It's also important to ensure their investment philosophy aligns with your goals, such as your approach to asset allocation and risk.
4. Can I revoke trading authority?
Yes, clients generally have the right to revoke trading authority. For discretionary accounts, this typically involves providing written notice to the financial firm. It's advisable to review your account agreement for the specific procedures.
5. What are the risks of granting discretionary trading authority?
The main risks include the potential for unauthorized trading (if the advisor exceeds the agreed-upon scope), excessive trading (churning), or simply poor investment decisions that do not align with your best interests or stated objectives. Regular communication and review of account statements are crucial to mitigate these risks.1