Broker (Dealer)

The terms “broker” and “dealer” terms are often associated with real estate and card games. However, in financial services, these two terms are used together to describe a different concept.

What Is a Broker / Dealer?

In the United States, it is either a natural person or business entity (e.g. bank) that trades securities and derivatives either on behalf of their clients (broker) or for their own account (dealer). The key functions of a BD are as follows:

• Announcement of price and other essential conditions of the securities contract: minimum and a maximum number of securities to be bought or sold as well as the period when the announced price is available.

• Selling securities to end users and then hedge their risk by taking part in the interdealer market.

• All functions of a stockbroker, e.g. financial consulting and investment management.

BDs are subject to extensive regulation and must be registered with the appropriate authorities.

Broker vs Dealer

A broker-dealer can have one of the following two roles in a transaction:

• As a broker, they help a client to buy or sell securities. In this case, they do not put any of their money at risk. They are just attempting to match up a buyer and seller with other BDs the same way a real estate broker might help a client to buy or sell a home. As compensation for this activity, the broker-dealer receives a commission.

• As a dealer, they are on the other side of a transaction and are buying or selling securities from a client. In this case, they must disclose in writing that they are acting as a dealer and explain all related charges. For example, a BD may possess bonds that they have acquired from clients who wanted to sell at some point in the past. The BD will mark up the bond and earn a spread between what they paid for the bond and what they charge the client who has decided to purchase the bond.

Broker / Dealer Regulation in the United States

In the United States, BDs are controlled by the Securities and Exchange Commission (SEC) according to the Securities Exchange Act of 1934. All brokers and dealers that are registered with the SEC are required to be members of the Securities Investor Protection Corporation (SIPC) and are subject to its regulations. Many states also regulate broker-dealers under state-specific securities laws.

According to the 1934 Act, a “broker” is any person engaged in the business of effecting transactions in securities for the account of others,  and a "dealer" is any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise. When acting on behalf of their clients, BDs are obliged to achieve the best economic price under the given circumstances.

Becoming a Broker / Dealer

To become a broker-dealer, you should follow these steps:

1. Open a firm, preferably an LLC.

2. Open the bank accounts and fund them with the initial capital.

3. Write and sign the operating agreement – a contract that the investors sign between themselves.

4. Set up the accounting system and complete other related tasks.

5. Ensure that your firm meets the statutory capital requirements for becoming a broker-dealer. These requirements may be different depending on the type of your firm. For example, for an agency, it is between $50,000 and $100,000 whereas for a principal capacity – between $100,000 and $150,000.

6. Submit a Form BD to the corresponding authorities.

7. After the approval, your firm has to become a member of a self-regulatory organization such as the Financial Industry Regulatory Authority (FINRA) and of the Securities Investor Protection Corporation (SIPC).

8. Pass one or more regulatory exams such as the Series 7 in order to become a registered BD representative.

9. To receive approval by FINRA for your new broker-dealer, you have to pass the Series 63, get fingerprinted, and hire several people with the relevant roles and experience.

Broker / Dealer vs Registered Investment Advisor

BDs often provide investment advice to their clients, but in many situations, they are exempt from registration under the U.S. Investment Advisers Act of 1940. A BD is different from a registered investment advisor in the following way.

BDs are bound by a lower standard of conduct toward their clients – the suitability standard. In other words, a broker-dealer only needs to prove that security that they recommend to a customer is generally appropriate for that customer. This gives BDs the freedom to push financial products that are in their own financial interest and not the customers.

At the same time, investment advisors are bound by a fiduciary standard, which represents the highest obligation that one person can own another person under American law. In recent years, the fiduciary standard has been extended to “fee-only” services. A fee-only registered investment advisor refrains from all other material forms of compensation and makes fees their only source of profit, often as a percentage of assets under management an individually managed account.

Dually Registered Broker / Dealer

A dually registered BD is an individual or an organization that is registered both as a broker-dealer and as a Registered Investment Advisor. Such companies are sometimes called hybrid advisors. With dual registration, the representative working with the customer has to decide each time which standard they will comply with.

They can act as a fiduciary and thus in the best interest of the customer. They can also generate revenue by selling the client financial products and services that meet the suitability standard.

Summary

A broker-dealer is a person or company that trades securities and derivatives either on behalf of their clients or for their own account, i.e. taking the role of either a broker or a dealer. Broker-dealers are regulated in the United States, so to become a BD, one must undergo a range of procedures. Unlike registered investment advisors, BDs act first of all in their own interests and are bound by less strict standards than RIAs.