If you’ve ever purchased stock (or any security), you likely used the services of a broker-dealer. These firms act as intermediaries between the investing public and the financial institutions that complete trade requests (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 companies, 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 comes from the two different roles the firm can play when it helps a customer trade. To see where those roles come from, start with the legal definition in the Uniform Securities Act (USA):
Even though the USA uses wording that sounds like it’s describing an individual (for example, “person” and “his”), you can treat a broker-dealer as a firm (a business). As you learned in a previous section, persons can be human beings or organizations.
Here’s the definition in plain English:
Let’s look at each capacity.
A broker, or agency transaction occurs when a professional connects a buyer and seller, typically in return for a commission. This is what the broker-dealer 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 an agent to help you buy a home, the agent finds a property and connects you with the seller. If the deal closes, the agent earns a commission.
Brokers in finance 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 the transactions they completed. Today, many large discount broker-dealers don’t charge for trades. This shift was driven in part by app-based platforms like Robinhood, which popularized $0 commission business models. Larger, well-established broker-dealers like E*Trade, Fidelity, and Charles Schwab cut many commissions to $0 in 2019 to compete.
Even though commissions are less common in practice, for test 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 broker-dealer 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 sells the car to another customer at a price slightly above its market value (a markup). The dealer earns the spread, which is the difference between the purchase price and the sale price.
Dealers in finance work the same way. When a broker-dealer acts in a dealer (principal) capacity, it buys securities from customers into its inventory at a marked-down price, then sells those securities to other customers at a marked-up price, earning the spread.
The terms broker and dealer can sound contradictory, but they describe two different ways a firm can handle a trade. A broker-dealer can’t act as both broker and dealer in the same transaction, but it can act in either capacity depending on the trade.
The following video is borrowed from Achievable’s SIE program, but the same concept applies to the Series 65. You could see the same type of question on this exam.
In summary, broker-dealers are firms that facilitate securities trades for customers. If a company helps you obtain or dispose of a security, it was most likely done through a broker-dealer. 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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