If you’ve ever purchased stock (or any security), you likely used the services of a broker-dealer. Broker-dealers act as intermediaries between investors and the financial institutions that help complete trades (for example, market makers and clearing houses). In 2020, these were the largest broker-dealers as measured by assets under management:
You’ve probably heard of at least a few of these firms, and you might even have an account with one. Broker-dealers make it easy for investors to buy and sell many types of securities. The name broker-dealer reflects the two different roles the firm can play when handling a transaction.
Before getting into the details, here’s the legal definition of a broker-dealer under the Uniform Securities Act (USA):
The USA uses wording that sounds like it’s describing an individual (for example, “person” and “his”), but for practical purposes you can treat a broker-dealer as a firm (a business). As you saw earlier, persons can be human beings or organizations.
Now let’s translate the definition into plain English:
A broker-dealer can act in either capacity, depending on the trade. Here’s what each one means.
A broker, or agency transaction, occurs when a professional connects a buyer and a seller, typically in return for a commission. This is what the definition means by trading “for the account of others.”
This idea isn’t unique to finance. Real estate brokers work the same way: if you hire a real estate agent (a broker) to help you buy a home, the agent finds a property and connects you with the seller. If the transaction happens, the agent earns a commission.
Securities brokers follow the same basic model. When a broker-dealer acts in a broker (agency) capacity, it connects its customer with another party to buy or sell a security, sometimes in return for a commission.
For decades, it was standard for securities brokers to earn commissions on trades. Today, many large discount broker-dealers charge $0 for many trades. This shift was driven in part by app-based firms like Robinhood, which popularized $0 commission business models. Larger firms such as E*Trade, Fidelity, and Charles Schwab reduced many commissions to $0 in 2019 to compete.
Even though commissions are less common in practice, for exam purposes you can still assume brokers earn commissions.
A dealer, or principal transaction, occurs when a professional trades directly with a customer using the firm’s own inventory. This is what the definition means by trading “for his own account.”
This also isn’t unique to finance. Car dealerships operate this way. You might sell your used car to a dealership at a price slightly below its market value (a markdown). The dealership then prepares the car for sale and sells it to another customer at a price slightly above its market value (a markup). The dealership earns the spread, which is the difference between the purchase price and the sale price.
Dealers in securities work similarly. When a broker-dealer acts in a dealer (principal) capacity, it buys securities from customers into its inventory at a marked-down price and sells securities to customers out of its inventory at a marked-up price, earning the spread.
The terms broker and dealer describe two different roles. A broker-dealer can’t act as both broker and dealer in the same transaction, but it can act as either one depending on the trade. One trade might be an agency transaction (connecting a buyer and seller and earning a commission), while the next trade might be a principal transaction (selling from inventory at a marked-up price).
The following video is borrowed from Achievable’s SIE program, but the same concept applies to the Series 63. You could see a similar question on this exam.
In summary, broker-dealers are firms that facilitate securities trades for customers. If a company helps you buy or sell a security, a broker-dealer was almost certainly involved. We’ll discuss the people who work for broker-dealers in the next section.
The following video summarizes the key points from this chapter:
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