Last Updated on 3 November, 2022 by Samuelsson
Whether it is called bucket shops or bucketing in the western world or Dabba trading in India, certain questionable and unethical trading practices have been going on in various stock markets over the years. These practices are perpetrated by some brokerage firms to rip off unsuspecting naïve traders. While the practices have been criminalized in different climes, they are still going on.
In this post, we will discuss what bucket shop is and its origin. We will also define bucketing and give some examples before suggesting ways traders can identify and avoid bucket shop brokers.
What is a bucket shop?
A bucket shop is a term used to describe a brokerage firm that engages in questionable and unethical business practices. In the past, bucket shops were used to describe brokerages that allowed their customers to use too much leverage to gamble on stock prices.
This is how a U.S. Supreme Court ruling in 1906 defined a bucket shop: “it’s an establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in.”
In essence, bucket shops are businesses (brokerage firms) that allow gambling based on the prices of stocks or commodities, as they usually deal in securities, grain, or cotton. Here’s how they operated: instead of executing a customer’s orders, they would secretly hold out (bucket) the orders, with the hope of buying or selling the stock or commodity at a more favorable price later on.
For example, if a customer placed a buy order and the bucket shop operator was expecting a market decline, he would hold the order so that when the price of the stock declines and the customer wants to sell, he would return the lower price of the stock to the customer and pocket the difference. This way, the bucket shop operator gambled against the customer on market trends.
From the mid-1800s to the early 1900s, bucket shops were found in many large American cities; however, after the practice was ruled illegal, it largely disappeared by the 1920s. The common requirement that brokers should send specific confirmation slips to all customers after executing their trade orders is aimed at eliminating the bucket shop practice.
In recent times, bucket shops are used to describe firms that practice bucketing, which is generally profiting from a client’s trades without their knowledge.
The origin and history of bucket shops
As we stated earlier, bucket shops are now used for brokerage firms that have some form of conflicts of interest when dealing with their customers, but historically, bucket shops were stock and commodity gambling houses, where customers were encouraged to take on substantial leverage to speculate on the future prices of those securities.
The name “bucket shop” may have originated from the practices of small-time U.S. wheat dealers who were dealing on odd lots known as “bucketsful.” When customers occasionally profited on their trades, the bucket shops would advertise the gains to recruit new customers. But eventually, the customers would lose everything and more, and just like any other gambling activity, the bucket shops benefited from their customer’s losses.
Another possible explanation for the origin of that name, bucket shop, might have to do with the technique used by these firms to manipulate tickets: after collecting their trades throughout the day, bucket shops would sometimes throw the trade tickets into a bucket and then mix the tickets together. They would then share winning and losing trades to certain clients based on their assessment of which clients would likely make the most profit for the firm.
With the spread of new communications technologies, such as the telegraph, in the late 1800s, which made it possible to speculate on stock prices in a timely manner, bucket shops became common in U.S. cities and London. They made it possible for people to gamble on stock prices in the same way that they might otherwise bet on racehorses.
However, this particular practice has been prohibited by current regulatory standards. But there are still many dishonest brokers out there today. So, the term is now used more precisely to refer to those dishonest brokerage firms that unethically profit from their clients’ transactions. It specifically refers to firms that engage in bucketing — the practice of misleading clients about the actual price at which a requested transaction was executed and using this deception to profit from their trades.
What is bucketing?
Sometimes known as bucketeering, bucketing is an unscrupulous and unethical practice engaged by some brokers, which involves misleading their clients about the execution of their trade orders. Most times, it refers to a situation whereby the broker delays the execution of trade orders while claiming to have executed the orders at a certain price, so as to profit from the price difference.
That is, the broker claims that a requested trade has taken place without actually executing that order and then attempts to execute the order at a more favorable price than the one recorded for the client. So, the difference between these two prices is then kept by the broker as profit, without the client knowing about it.
In essence, bucketing is not just an unethical business practice but actually stealing: the broker effectively steals from the client. And this can occur with both buy and sell orders. The broker lies to the client about the terms on which a trade was executed, so as to profit from the difference between the actual and reported execution prices. A brokerage firm that engages in this dishonest practice, or similar practices, is often referred to as a bucket shop, while the individual who engages in the practice is referred to as a bucketeer.
There are other meanings of bucketing. For example, bucketing can also refer to a retirement strategy where retirees divide up their assets into different “buckets” and use them when needed. We will say more about that later on in this post.
Normally, brokers take clients’ orders and execute them accordingly. Limit orders are executed at the price specified by the client, while market orders are executed at the best price in the market at that moment. Since limit orders specify the prices for execution, bucket shop brokers engage their dishonest activities on market orders.
The point is that there is a conflict of interest: the broker places its interest ahead of that of the client, while also misleading the client into believing that their interests are being given priority. The broker executes the order at a different price than the one it records for the client.
Clients send their trade orders to the broker with the belief that the broker will seek out the best available prices when executing their trades. In the case of a buy order, this means obtaining the lowest price possible at the time the order was placed, while for a sell order, it should be the highest available price at the time of order placement.
In essence, bucketing works by exploiting the trust held by the client toward the broker. The brokers engaged in bucketing exploit this expectation by lying to the client: when processing buy orders, they will buy at a certain price but tell the client that they have bought at a price much higher than what they actually bought. In the case of a sell order, the broker will tell the customer they sold at a given price when in fact they sold at an even higher price. Whatever the case, the broker pockets the difference between the actual price and the one recorded for the client. This is basically stealing from the client’s own profits.
How bucketing works in real-world trading
Let’s consider the case of XYZ brokerage firm, which often engages in bucketing. The broker gets an order from one of the clients named Bill who trusts that the broker would execute his trades without a conflict of interest.
Bill placed an order to purchase 250 shares of ABC Energies Ltd at the best market price. Since the stock was trading between $19.00 and $20.00 per share, Bill expects the broker to get him the best price at the moment. The broker responds shortly thereafter and tells Bill that the trade was executed at a price of $20 per share. But this is a lie; the trade was actually executed at $19.00 per share and not $20.00 per share the broker claimed.
The broker kept that difference of $1 per share as their own profit, without letting Bill know. When you consider that 250 shares were bought, then the $1.00 per share would amount to $250. So, the broker just stole $250 from Bill — the money that would have gotten Bill another 23 more shares.
Are bucket shops and bucketing legal?
In many U.S. states, the operations of bucket shops have been criminalized. Typically, the criminal law definition refers to a bucket shop as “an operation in which the customer is sold what is supposed to be a derivative interest in a security or commodity future, but there is no transaction made on any exchange” — that is, the transaction goes “in the bucket” and never gets executed. Since no trading of actual securities occurs, the customer is essentially betting against the bucket shop operator in a game based on abstract security prices.
Trading in a legitimate exchange also provides a similar game or wagering aspect, but the primary characteristic of a bucket shop is the simulation of trading securities when no actual securities are traded. The game played by bucket shop is a fiction; the parties just imagine themselves as following the events occurring in a real exchange. Just like a gambling house, the bucket shop operator plays the bank against the customer. The U.S. Supreme Court has criminalized bucket shops.
Similarly, bucketing of orders violates several provisions of U.S. securities law, and even legitimate brokerages can be penalized for engaging in such practices.
How to avoid being a victim of bucketing
These are some of the ways to avoid becoming a victim of fraudulent brokers:
Research a broker before registering with them
Before you register with a broker, do some research to know about the broker and how it operates. Find out whether the broker is a market maker or not. Market makers are more likely to trade against their clients, which is a strong ground for a conflict of interest.
If the asset you want to trade is an exchange-traded instrument, such as a stock, be sure the broker is registered with the exchange. Most importantly, be sure that the broker is regulated by the relevant financial authorities, such as the SEC, FCA, ASIC, and so on.
Check online reviews
Apart from your own research findings, check other people’s opinions about the broker. You do this by checking online reviews of the broker. Don’t just check the ratings — 5 stars, 4 stars, or whatever — even though that can help too; study the individual comments about the broker’s services: order execution methods and speed, payment methods, customer support, etc.
Compare trade quotes
After doing the above two and probably register with the broker, compare their quotes with what is in the market. This is the easiest way to know whether a broker is bucketing orders. A broker that is engaged in such practices tends to use remote quotes most of which do not coincide with what other brokers in the market are providing. And the quotes may not show any conformity to the market situation.
When the broker sends you a confirmation slip that tells you the price your orders were executed, use the time of execution to trace the quote history of the market to know whether the price conforms to what was quoted in the market. If there are discrepancies, report to the relevant authorities.
Other meanings of bucketing
- Retirement strategy: As we mentioned earlier, bucketing is also a term that describes a retirement strategy where retirees divide up their assets into different “buckets” and use them when needed, which is different from the traditional method of receiving retirement income, with regular distributions from their portfolio to cover expenses. For instance, a retiree can have near-term, medium-term, and long-term buckets, with a specific amount of assets that would be used during each period.
- Financial planning: Bucketing is also used to describe a three-step process of financial planning. The individual tries to achieve each of the buckets one after another. For example, the first bucket might be creating an emergency fund; the second bucket, reaching specific financial goals; and the third bucket would be saving for retirement.