What Is a Broker-Dealer?

An Introduction to Registered Broker-Dealers for New Investors

What Is a Broker-Dealer?
A broker-dealer is a type of firm that helps facilitate the buying and selling of securities by filling one of two roles, acting in an agency or principal capacity. Tetra Images / Getty Images

In the United States, the regulatory term "broker-dealer" refers to a natural person (an individual) or a firm (a general partnership, limited partnership, limited liability company, corporation, or other entity) that is in the business of buying and selling securities.  A broker-dealer conducts the business of buying and selling securities by filling one of two roles in a transaction:

  1. In the first situation, the broker-dealer acts in an agency capacity as a broker.  This means the broker-dealer helps a customer buy or sell a security or securities by undertaking action necessary to facilitate the trade.  The broker-dealer does not have any of his, her, or its money at risk and is simply attempting to match up a buyer and seller with other broker-dealers or through some other means the same way a real estate broker might help a client buy or sell a home.  In exchange for this function, the broker-dealer is paid a commission.
  1. In the second situation, the broker-dealer acts as a dealer by being one of the principals in a transaction.  This means the broker-dealer is on the other side of a transaction and is buying or selling a security from a customer.  When acting as a principal, the broker-dealer must disclose, in writing, that he, she, or it is acting as a dealer and explain all charges and compensation.  For example, a broker-dealer might have an inventory of municipal bonds that it has acquired from customers who wished to sell at some point in the past.  The broker-dealer will mark up the bond and earn a spread between what he, she, or it paid for the bond and what he, she, or it charges the customer who ultimately comes along and decides to buy the bond.  Another famous example of broker-dealers acting as dealers, or principals, is a market maker.  For more information on market makers, read What is a Market Maker and How Do They Make Money? to learn how this activity adds liquidity to a market, benefiting both buyers and sellers.

    Broker-dealers are subject to extensive regulation.  In fact, you might hear a broker-dealer referred to as a “registered broker-dealer” due to the requirement that such a person or business register with the appropriate federal and/or state authorities; a requirement that came out of the Section 15 of the Securities Exchange Act of 1934 following reforms that emerged in the aftermath of the 1929-1933 collapse of both the economy and capital markets.

      For example, broker-dealers are forbidden from charging both a commissions and a markup on the same transaction.  That is, for any given trade, they can act either in their capacity as a broker (agency) or a dealer (principal) but not both.

    How to Become a Broker-Dealer

    The actual steps involved with starting a broker-dealer are far too exhaustive to cover here but the short, summary version sufficient for a layman is as follows.  First, you have to setup the firm itself as you probably aren’t going to want to operate as a sole proprietorship due to the unlimited liability to which it would expose you.  This means having the business organized, most likely as a limited liability company unless you have some compelling reason to use another legal entity structure, getting a business license, opening the bank accounts and funding those accounts with the initial contributed capital, writing and signing the operating agreement, setting up your accounting system, and the numerous tasks that accompany such as an undertaking.

    Next, you are going to need to make sure you meet the statutory capital requirements for a broker-dealer, which will vary based upon the precise nature of your firm.  If you are only going to act in an agency capacity, you’ll need to come up with somewhere between $50,000 and $100,000.

      If your broker-dealer is going to also act in a principal capacity, you are going to need to come up with $100,000 to $150,000.  With that squared away, you’re going to need to get entitled with FINRA so you can get your firm in the IARD and CRD systems.  Through these systems, you will submit a Form BD to the applicable regulatory bodies.  If approved, you will need to become a member of an SRO, which is short for a self-regulatory organization.  You’ll need to have your firm become a member of the Securities Investor Protection Corporation, which provides SIPC insurance to customers who hold their brokerage account with your new business.  You’re going to need to become a registered broker-dealer representative (even if you own the broker-dealer firm, you still have to become a broker-dealer representative of the firm), which requires passing one or more regulatory exams such as the Series 7 which is a six-hour test that covers a wide range of questions about securities trading and other topics.

    The list is exhaustive.  You need an anti-money laundering system in place.  You need agreements with clearing agents.  If you want to get the greenlight from FINRA for your new broker-dealer, you have to pass the Series 63, get fingerprinted, and must keep several people on staff with specific roles and who have specific levels of experience.  Suffice it to say, opening your own registered-broker is not something you do on a whim.

    The Largest Independent Broker-Dealers in the United States

    According to Investment News, the top twenty-five independent broker dealers in the United States generate more than $20 billion in combined revenue per annum.  The largest, a company called LPL Financial, generates roughly $4.3 billion in revenue, the next largest independent broker-dealer, Ameriprise Financial, generates more than $3.7 billion, and the third largest, Raymond James Financial, generates more than $1.5 billion.

    Other broker-dealers include the giants; household names that often are part of a financial conglomerate such as the broker-dealer divisions of financial powerhouses such as Charles Schwab & Company, TD Ameritrade, Fidelity Investments, Scottrade, and Interactive Brokers, just to name a few.  Charles Schwab & Company, to provide one illustration, has approximately $2.5 trillion in client assets held in custody.  Fidelity isn’t far behind with more than $1.5 trillion in client assets held in custody.  Companies like Charles Schwab also own banks and other subsidiaries to enable them to provide all-encompassing service to do-it-yourself investors.

    Understanding the Difference Between a Broker-Dealer and a Registered Investment Advisor

    Broadly speaking, besides a broker-dealer, the other major classification of registration for a natural person (an individual) or a firm (a general partnership, limited partnership, limited liability company, corporation, or other entity) operating in the securities industry is something called a Registered Investment Advisor.  Whereas broker-dealers were required to be registered following the Securities Exchange Act of 1934, Registered Investment Advisors, or RIAs as they are sometimes called, first came into their present form with the passing of the Investment Advisers Act of 1940.  Though the public sometimes confuses broker-dealers and Registered Investment Advisors, they are very different things.  (It is important to recognize that the term “registered” in Registered Investment Advisor is not a title nor does it represent any specific level of knowledge, skill, or expertise.  It is simply a designation indicating that the firm has met the minimum requirements necessary to engage in the business.)

    First, broker-dealers are bound by a lower standard of conduct toward their customers, needing to justify a recommendation based upon something known as suitability.  That is, the broker-dealer only needs to be able to prove that a security recommended to a client was appropriate in a general sense for that client; e.g., the broker-dealer’s representative didn’t have a 93-year old widow sell off all of her bonds to invest everything in leveraged exchange traded funds as that would be clearly improper.  The criticism of this standard is that it allows broker-dealers to push financial products and services that are in their own financial interest, not the interest of the client, including having the client buy load less-than-ideal-for-the-client’s-circumstances mutual funds, some carrying sales loads of 5.75%.  These mutual funds also tend to have higher expense ratios, as well.  The Department of Labor decided to take on this standard, at least as it pertained to retirement accounts, and passed a rule that has been fiercely contested.  This new rule requires broker-dealers handling a retirement account, such as a Roth IRA, to act as a fiduciary bound by a fiduciary standard.

    A fiduciary standard is a much bigger deal because it represents the highest obligation one person can owe another person under American law.  Someone acting as a fiduciary must act in the best interest of the person he or she is representing or serving.  Conflicts of interest must be disclosed.  Standards of conduct must be impeccable.  Investment advice given must be more than suitable; e.g., you’d have a difficult time explaining yourself if you had a client invest in a fund that offered the exact same underlying holdings but that was several times more expensive if you were a fiduciary.  The fiduciary standard is such a big deal that there have been cases in which a parent gifts a child money via a UTMA account – a type of title that is governed by the Uniform Transfers to Minor Act of a given state in which a custodian, often the gift giver, holds property, such as stocks in a brokerage account, for a minor child under a fiduciary duty until the minor child reaches the age of maturity, often 21 but with some states setting the optional limit as high as 25 - and then used the money to pay for a child’s medical emergency only to have the court order that the parent must pay all of the money back with interest

    In recent years, some Registered Investment Advisors have taken the fiduciary duty even further by declaring themselves to be “fee-only”.  A fee-only Registered Investment Advisor eschews all other material forms of compensation and generates its sole source of revenue for from fees, often as a percentage of assets under management for something like an individually managed account, paid to the firm directly by the client.  The argument goes that this significantly reduces the conflicts of interest between the firm and the client because the firm should have no financial incentive other than helping the client grow his or her wealth as the more money the client has under management, the more money the firm gets paid.  As I explained in an article called Asset Management Companies for Beginners, this tends to be more common among firms geared toward the affluent and high net worth as it can be challenging to service smaller accounts in a way that is economically sensible.

    What Is a Dually-Registered Broker-Dealer?

    A dually-registered broker-dealer is a natural person (an individual) or a firm (a general partnership, limited partnership, limited liability company, corporation, or other entity) that is registered both as a broker-dealer and as a Registered Investment Advisor.  Despite its rising popularity, dual registration can be tricky because it can be difficult for a customer or client to separate in his or her mind the capacity in which he or she is dealing with a representative at any given moment. Firms that fall into this category are sometimes called “hybrid” advisors.  In effect, the representative with which the client works has to switch between two hats, deciding if he or she is required to act as a fiduciary, behaving in a way that is in the best interest of the client, or a broker-dealer, which allows him or her to generate income by selling the customer financial products that meet the suitability standard.  Regulators seem to have taken a much closer look as the number of dually-registered broker-dealers has increased in recent years despite being what is still an objectively small percentage of the overall financial industry.  To put a finer point on it, the Wall Street Journal ran a story on March 26, 2015 called Dually Registered Investment Advisers Blur the Broker-Fiduciary Line by Mattias Rieker that stated, “The number of dual registered advisers remains small but has increased by 50% between 2008 and 2013, to more than 24,000 out of a total adviser workforce of more than 285,000 according to data research firm Cerulli.”

    What Should an Investor Look for in a Broker-Dealer?

    If you are thinking about working with a broker-dealer, there are a few things you should consider aside from obvious factors such as financial strength and proper regulatory and other credentials.

    1. Does the broker-dealer or broker-dealer representative have a criminal history, a history of allegations of misconduct, or other material facts about which you should be aware?  To find out the answer, use the FINRA BrokerCheck system to investigate complaints filed against the broker-dealer you are considering entrusting with your money.
    2. Are you comfortable?  Listen to your gut and, to borrow a concept from a famous investor, only work with someone you “like, admire, and trust”.  If that still, small voice in the back of your head or heart is telling you to walk away, don’t ignore it.  You can always find a broker-dealer.  You don’t have to work with someone in particular, or even a specific firm.  Never forget that it is your money.
    3. Does the broker-dealer representative listen to you?  Does he or she understand your circumstances, needs, conditions, wants, preferences, and values?
    4. Are the disclosure documents clear?  Do you understand what you will be getting and what you will be paying for it?