Broker-dealers
If you’ve ever purchased stock (or any security), you probably utilized the services of a broker-dealer. These organizations act as the intermediary between the investing public and the financial institutions that complete trade requests (e.g. market makers, clearing houses). In 2020, these were the largest broker-dealers as measured by assets under management:
You probably have heard of at least a few of these companies, and might also have an account with one of them. These companies make it easy for investors to buy and sell various types of securities. Their name - broker-dealer - refers to how they facilitate trades with their customers. Before we go through the specifics, let’s look at the legal definition of a broker-dealer according to the Uniform Securities Act (USA):
Although the USA uses language that most would interpret as a reference to a human being (e.g. ‘person,’ ‘his’), you can safely assume a broker-dealer is always a firm (business). As we learned in a previous section, persons can be human beings or organizations.
Let’s translate the definition into plain English. ‘Effecting transactions in securities’ means broker-dealers help their customers buy and sell securities. The end of the definition - ‘for the account of others or for his own account’ - refers to the two different capacities a broker-dealer can operate in when facilitating securities transactions: broker and dealer. Let’s explore each of these capacities further.
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 legal definition refers to as ‘trading for the account of others.’ Broker/agency capacities are not specific to finance; real estate brokers, for example, work this way. If you hire a real estate agent (broker) to help you buy a home, their job is to find a property you’re interested in, and connect you with the seller. If a transaction occurs, they’ll be paid a commission.
Brokers in finance work the same way. If a broker-dealer operates in a broker or agency capacity, they connect their 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, thanks largely to the growth of broker-dealers with app-based platforms like Robinhood that began the trend of $0 commission business models. Larger, well-established broker-dealers like E*Trade, Fidelity, and Charles Schwab slashed their commissions to $0 in 2019 in order to compete with Robinhood. Although commissions for trades seem to be fading away, you can still safely assume brokers earn commissions for test purposes.
A dealer, or principal transaction, occurs when a professional trades directly with a customer utilizing their own inventory. This is what the broker-dealer legal definition refers to as trading ‘for his own account.’ Dealer/principal capacities are not specific to finance; car dealerships, for example, operate this way. If it was in good shape, you could sell your used car to a local dealership, typically at a price just below its market value (known as a markdown). The dealership would probably clean up the car and perform some maintenance, then put the car on their lot for sale. Another customer would then buy the car from the dealership, typically at a price just above its market value (known as a markup). The dealer earns the spread, which is the difference between the price they bought the car at and the price they sold the car at.
Dealers in finance work the same way. If a broker-dealer operates in a dealer or principal capacity, they buy securities from customers into their inventory at a marked-down price, then sell those securities to other customers at a marked-up price, earning the spread.
Together, the terms broker and dealer are an oxymoron (two contradictory terms). Broker-dealers can’t operate in a broker and dealer capacity simultaneously (at the same time during any one transaction), but they may operate in either capacity in any given transaction. One trade could be accomplished in a broker (agency) capacity, earning a commission after connecting a buyer and a seller, and the next trade could be a dealer (principal) transaction while selling securities out of inventory at a marked-up price.
The following video is borrowed from Achievable’s SIE program, but the same concept applies to the Series 65. In fact, you could see the same type of question on this exam.
In summary, broker-dealers are companies that facilitate securities trades on behalf of their customers. If a company helps you obtain or dispose of a security, it was most likely performed by a broker-dealer. We’ll discuss the people that work for broker-dealers in the next section.
The following video summarizes the key points from this chapter:
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