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 (e.g., market makers, 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.
Before getting into those roles, it helps to start with the legal definition of a broker-dealer under the Uniform Securities Act (USA):
Even though the USA uses wording that sounds like it’s describing an individual (e.g., “person,” “his”), you can treat a broker-dealer as a firm (a business). As covered earlier, persons can be human beings or organizations.
Here’s the definition in plain English:
A broker (also called an agency transaction) is when a professional brings together 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: they connect a buyer and a seller, and if a transaction happens, they earn a commission.
In securities markets, a broker-dealer acting in a broker/agency capacity 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, largely due to competition from app-based firms like Robinhood that 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 exam purposes you can still assume brokers earn commissions.
A dealer (also called a principal transaction) is 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:
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 describe two different capacities, and a broker-dealer can use either one in a given transaction. It can’t act as both broker and dealer at the same time in the same trade.
For example:
The following video is borrowed from Achievable’s SIE program, but the same concept applies to the Series 66. 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, a broker-dealer most likely handled the transaction. 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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