What is a broker-dealer?
Definition
A broker-dealer (B‑D) is an individual or firm that buys and sells securities either for customers or for its own account. In U.S. regulatory language the same firm often wears two hats:
– Broker (agent): executes trades on behalf of clients and typically charges a commission or fee.
– Dealer (principal): trades from the firm’s own inventory, buying or selling to customers at a mark‑up or mark‑down.
Key functions
Broker-dealers perform several roles that support capital markets:
– Execute customer orders (acting as brokers).
– Provide liquidity and continuous markets by trading from inventory (acting as dealers or market-makers).
– Offer investment advice and publish research.
– Underwrite and distribute new securities offerings for issuers (investment-banking-related activities).
How a broker-dealer works — step-by-step
1. Client submits an order (buy or sell).
2. The firm determines whether to fill the order as broker (find a counterparty or route the order) or as dealer (fill from its own inventory).
3. Trade is executed, and the firm charges either a commission (broker role) or embeds a mark‑up/mark‑down in the price (dealer role).
4. If the firm is involved in underwriting, it may have bought securities from an issuer under a distribution agreement, then sell those securities to clients.
5. Settlement and post-trade reporting occur according to market rules.
Underwriting and distribution (brief)
When a broker-dealer participates in underwriting a new issue, it may:
– Act as an agent for the issuer, arranging and selling the securities to the public.
– Enter a firm-commitment arrangement, agreeing to buy a specified amount of the issue and then resell it — earning underwriting fees but taking on inventory risk.
After the offering, the underwriting broker-dealer becomes a distributor, inviting clients to purchase the new securities.
Special considerations and conflicts
Because broker-dealers can profit both from client commissions and from trading for their own account or underwriting fees, potential conflicts of interest can arise. Examples:
– Recommending a security that the firm is trying to distribute.
– Quoting a price that includes a dealer mark-up instead of showing an explicit commission.
Understanding whether a firm acted as broker or dealer on a given trade helps clarify how it was compensated.
Checklist — what to check when dealing with a broker-dealer
– Role on the trade: Was the firm acting as broker (agent) or as dealer (principal)?
– Fees and pricing: Are charges explicit commission, or an embedded mark-up/mark-down?
– Research vs. distribution: Is the firm promoting a security it helped underwrite?
– Firm size and capabilities: Small boutique or large national/ global firm — different service models.
– Disclosures: Request written details on compensation and conflicts for a transaction.
Small worked example — broker vs dealer cost comparison
Situation: You want to buy 100 shares of Company X, quoted market price $50.00.
a) Broker (agent) fills your order and charges a flat commission of $10:
– Share cost = 100 × $50.00 = $5,000.00
– Commission = $10.00
– Total cost = $5,010.00
– Effective per-share cost = $5,010 / 100 = $50.10
b) Dealer (principal) sells from inventory with a 0.5% mark‑up embedded in the price:
– Mark‑up per share = $50.00 × 0.005 = $0.25
– Dealer sale price = $50.00 + $0.25 = $50.25
– Total cost = 100 × $50.25 = $5,025.00
– Effective per-share cost = $50.25
Comparison: The dealer route in this example results in $15 higher out-of-pocket cost than the broker route ($5,025 vs $5,010), but the exact economics depend on commission schedule, mark-up, spreads and speed of execution.
Numbers to remember from the market (context)
– Broker-dealers range from small independent firms to subsidiaries of large banks.
– According to a 2023 FINRA report, there are more than three thousand broker
registered firms operating in the U.S., covering everything from solo proprietors to large bank-affiliated broker‑dealers. Below are practical items you should know next.
Regulation and registration (brief)
– Primary regulators: The U.S. Securities and Exchange Commission (SEC) supervises broker‑dealers at the federal level. FINRA (Financial Industry Regulatory Authority) is the self‑regulatory organization that conducts registration, examinations and enforcement for many broker‑dealers. States also require registration for firms and associated persons.
– Registration forms and checks: Broker‑dealers register with the SEC and report through the Central Registration Depository (CRD). Retail investors can check a firm or individual’s record through FINRA’s BrokerCheck.
– Capital and conduct rules: Broker‑dealers must meet minimum net‑capital requirements, keep required books and records, and follow rules on customer protection, anti‑money‑laundering, and order handling.
Key roles and business models (short)
– Broker (agent): Executes trades on behalf of customers for a commission or fee. The broker does not take market risk for the client’s order.
– Dealer (principal): Buys and sells for its own inventory and profits from mark‑ups, mark‑downs, or bid‑ask spreads.
– Market maker: A type of dealer that commits to quote buy and sell prices to provide liquidity in a security.
– Clearing broker: A firm that performs custody and settlement of trades (can be the same firm or a separate clearing house).
– Introducing broker: Solicits and routes orders but uses a clearing broker to settle trades and hold assets.
Common conflicts of interest (and how they appear)
– Principal trading: When a broker‑dealer sells or buys from its inventory, the client may pay a mark‑up/mark‑down. Rule: these trades must be disclosed and fairly priced.
– Payment for order flow (PFOF): Some brokers accept payments from market makers for routing retail orders to them. That can reduce visible commissions but may affect execution quality.
– Research vs. trading: Large broker‑dealers that both underwrite securities and provide research can face pressure between investment banking and research independence.
– Internalization: Broker routes orders to a dealer within the same firm; execution may be fast but not necessarily best price for the customer.
Customer protections and limits
– Best execution: Brokers must seek the most favorable terms reasonably available for a customer’s order under the circumstances.
– Suitability vs. fiduciary standard: Registered representatives of broker‑dealers owe a suitability obligation—recommendations must fit the client’s needs. Investment advisers owe a fiduciary duty, a higher legal standard in many circumstances.
– SIPC protection: Securities Investor Protection Corporation (SIPC) protects customers if a broker‑dealer fails and client assets are missing. SIPC coverage is up to $500,000 per customer, including a $250,000 limit for cash claims. Important: SIPC protects against broker failure or missing assets, not investment losses from market declines.
Worked numeric example: SIPC coverage
– Suppose you hold $400,000 in stocks and $200,000 in uninvested cash at one broker that fails.
– Total customer claim = $400,000 (securities) + $200,000 (cash) = $600,000.
– SIPC covers up to $500,000 total per customer, with a $250,000 cash limit.
– Payout: SIPC would restore up to $500,000. If cash is $200,000 (< $250,000 cap), SIPC would cover the full $200,000 cash plus $300,000 of securities; remaining $100,000 of securities would be subject to estate proceedings and possibly recovered later. Note: some brokers carry private insurance above SIPC limits—check terms.
Practical checklist: how to vet a broker‑dealer (step by step)
1. Search BrokerCheck (FINRA) for the firm and the registered representative. Note disciplinary history, licenses and employment background.
2. Confirm SIPC membership on sipc.org or the firm’s disclosures.
3. Check whether the broker is a clearing or introducing firm; ask who holds custody of assets.
4. Review the fee schedule (commissions, spreads, mark‑ups, exchange/SEC fees, margin rates, account maintenance fees).
5. Ask about order routing: does the firm accept PFOF? How do they demonstrate best execution?
6. Read the customer agreement and margin agreement carefully; note margin interest method, rehypothecation terms (use of securities as collateral), and default remedies.
7. Verify state registration and any applicable licenses for the types of products you want (e.g., options, municipal bonds).
8. If you rely on research or advice, ask whether the firm or rep is acting in a broker capacity (suitability standard) or is a registered investment adviser (fiduciary standard).
Common fee types and a short numeric sense
– Commissions: Flat or per‑share fees (e.g., $0.005/share). For 1,000 shares at $20 with $0.005/share = $5 commission.
– Mark‑ups/mark‑downs (dealer): Typically expressed as a percentage of trade value. A 0.5% mark‑up on $50 stock × 100 shares = $25.
– Spread cost: For small cap securities, bid‑
‑ask spreads can be the dominant cost. Example: bid $19.90 / ask $20.10 → spread = $0.20. The midpoint is $20.00, so a buyer pays $0.10 above midpoint (implicit cost) = $0.10 × 100 shares = $10 implicit cost on a $2,000 trade (0.5%). For illiquid small‑cap names spreads frequently exceed several percent of trade value.
– Custody / account fees: Monthly or annual fees for holding assets, often tiered by account size. Example: $60/yr custody on accounts under $25,000.
– Platform / data fees: Charges for advanced trading platforms or real‑time market data (e.g., $100/month for a pro terminal).
– Account transfer / ACAT fees: Outgoing transfer can be $50–$125 per account.
– Inactivity / account maintenance fees: Charged if trading volume or balances fall below thresholds (e.g., $10–$50/month after 12 months of inactivity).
– Wire and withdrawal fees: Domestic wire $20–$35; international wires higher.
– Advisory / wrap fees: For managed programs, a wrap fee often expressed as an annual percentage of assets under management (AUM). Example: 1.0% AUM on $100,000 = $1,000/yr.
– Margin interest: Interest charged on borrowed funds. Calculation: Interest = borrowed amount × APR × (days/365). Example: $5,000 borrowed at 8% APR for 30 days → 5,000 × 0.08 × (30/365) ≈ $32.88. Note margin rates are typically tiered by size and may be compounded daily.
– Payment for order flow / routing incentives: Not directly billed to customers but can affect execution quality — ask whether the broker sells order flow and how that impacts price improvement.
– Other miscellaneous fees: Options exercise/assignment, paper statement fees, returned check fees.
Conflicts of interest and disclosures (what to watch for)
– Broker versus dealer roles: A broker executes orders on behalf of customers; a dealer trades from its own inventory and may profit from mark‑ups/mark‑downs. Ask how the firm describes its role on each trade.
– Proprietary trading and PFOF: Firms trading for their own account or receiving payment for routing orders can create incentives that conflict with best execution.
– Research and product placement: Commissions or underwriting relationships can bias recommendations. Verify whether research is independent and how it is paid.
– Rehypothecation and use of client securities: If allowed by your agreement, the firm can use your securities as collateral for its own borrowings; understand limits and rehypothecation disclosure.
– Soft dollars: Arrangements where trading commissions pay for research/services — confirm the nature and value of such services.
Checklist: practical due‑diligence steps before opening an account
1. Verify registration and disciplinary history: Use FINRA BrokerCheck and the SEC/State securities regulator search.
2. Read the fee schedule and sample trade ticket: Calculate total cost examples for trades you expect to make (see worked examples below).
3. Review margin agreement and rate table: Note lowest margin requirement, interest method (daily/compound), and default remedies.
4. Check custody and protection: Is cash swept to FDIC‑insured banks? Are securities segregated? Ask about SIPC coverage and excess insurance.
5. Ask about order routing and best‑execution policy: Where are orders routed, and how is price improvement measured?
6. Confirm account types and product permissions: Options, futures, municipal bonds, and OTC trading require specific approvals.
7. Request written disclosures on conflicts of interest and whether reps are compensated by commissions, fees, or both.
8. Trial the platform and customer service: Test trade entry, settlement info, margin equity updates, and responsiveness to inquiries.
Worked numeric examples (combine costs into a single trade cost)
Example A — Equity buy (100 shares)
– Price: $20.00, trade value = $2,000
– Commission: $5 flat
– Spread implicit cost (from earlier): $10
– Clearing/other fees: $0.50
Total explicit + implicit cost = $5 + $10 + $0.50 = $15.50
Cost per share = $15.50 / 100 = $0.155 → percent of trade value = $15.50 / $2,000 = 0.775%.
Example B — Margin interest and carry cost
– Cash purchase $2,000 financed with $500 margin loan at 8% APR. Annual interest = 500 × 0.08 = $40. If held 90 days: interest ≈ 40 × (90/365) ≈ $9.86. Add trade costs from Example A (pro‑rated if partial) to estimate total carry + execution cost.
How to interpret protections and recourse
– SIPC (Securities Investor Protection Corporation) covers missing securities and cash due to broker failure up to $500,000 total per customer, including a $250,000 cash limit — it does not insure against market losses.
– FDIC protection applies only to bank deposits (e.g., sweep accounts) and has separate limits.
– Regulatory recourse: File complaints with FINRA, SEC, or state regulators
— Continue from "File complaints with FINRA, SEC, or state regulators."
If a broker‑dealer fails
– Stay calm and preserve records. Keep trade confirmations, account statements, margin agreements, and electronic correspondence.
– SIPC process: When a registered broker‑dealer is insolvent, SIPC typically appoints a trustee to recover and transfer customer securities and cash. SIPC protection is restorative, not insurance: it aims to return customer property that is missing because of broker theft or failure. The statutory limits are up to $500,000 per customer, including a $250,000 limit for cash. Actual recovery of amounts above SIPC limits can occur via liquidation of estate assets, but timing and amounts are uncertain.
– Practical example: If you held $750,000 total (stocks + $300,000 cash) and the trustee determines $250,000 of your securities are missing, SIPC may cover up to $500,000 toward restoring your account. The $300,000 cash counts toward the $500,000 limit. In this scenario you might recover $500,000 through SIPC and then a pro rata share of any remaining estate distributions; you could still have an uncovered shortfall.
– FDIC sweep accounts: Bank sweep deposits are FDIC‑insured subject to FDIC limits and ownership rules; confirm whether client cash is swept to an FDIC‑insured bank and who holds title.
How broker‑dealers make money (common revenue sources and simple calculations)
– Commissions
– Definition: a fixed or percentage fee charged per trade.
– Example: $5 commission per trade. A buy plus sell (round trip) = $10 total fees.
– Bid‑ask spread (market makers)
– Definition: difference between the ask (sell) price and the bid (buy) price. Market makers profit by buying at bid and selling at ask.
– Formula (per share profit) = Ask − Bid.
– Example: Bid 49.98 / Ask 50.02 → spread = $0.04. If a market maker transacts 10,000 shares, gross spread revenue = 10,000 × $0.04 = $400.
– Markup / markdown (dealers in OTC or principal trades)
– Formula: Markup% = (Customer Price − Dealer Cost) / Dealer Cost × 100.
– Example: Dealer buys at $9.80 and sells to customer at $10.00 → markup = (10.00 − 9.80)/9.80 ≈ 2.04%.
– Payment for Order Flow (PFOF)
– Definition: a routing firm receives a small payment from a market‑making venue for routing retail orders to that venue.
– Example: PFOF = $0.00005 per share. For a 1,000‑share trade the broker earns 1,000 × $0.00005 = $0.05.
– Note: PFOF can reduce explicit commissions but may raise execution quality conflicts;
– Margin interest (credit extended to customers)
– Definition: interest charged on loans a broker‑dealer makes to customers who borrow to buy securities (margin loans).
– Formula: Interest = Loan Balance × Annual Rate × (Days / 365).
– Example: Customer borrows $20,000 at an annual margin rate of 8% for 45 days → Interest = 20,000 × 0.08 × (45/365) ≈ $197.26. That interest is revenue for the broker‑dealer (net of funding costs).
– Note: Margin rates vary by size of loan and firm; they are a common, recurring revenue stream.
– Asset‑based fees (advisory / managed accounts)
– Definition: fees calculated as a percentage of assets under management (AUM) for advisory or discretionary services.
– Formula: Fee = AUM × Fee Rate.
– Example: A $100,000 managed account with a 1.0% annual fee generates $1,000/year. If the firm manages $10 billion, that 1% fee yields $100 million in annual revenue (before expenses).
– Note: Often billed quarterly or monthly; conflicts can arise if products paying higher resale commissions are favored.
– Underwriting, underwriting spreads, and investment banking fees
– Definition: fees earned when a broker‑dealer (or underwriting syndicate) helps firms issue new securities (IPOs, bonds). The underwriting spread is the difference between what investors pay and what the issuer receives.
– Typical structure (illustrative): For an IPO priced at $20 with a $0.80 spread, underwriter revenue per share = $0.80.
– Example: 5 million shares offered at a $0.80 spread → gross underwriting revenue = 5,000,000 × $0.80 = $4,000,000 (then shared among syndicate members and net of expenses).
– Proprietary trading (prop trading)
– Definition: trading with the firm’s own capital to earn trading profits.
– Example: A firm allocates $50 million to a systematic strategy and earns a 6% annual return → profit before costs = $3 million.
– Note: Prop trading can be high-margin but increases firm market risk and regulatory scrutiny (post‑Volcker/market conduct rules vary by jurisdiction).
– Soft dollars and research arrangements
– Definition: "Soft dollars" are arrangements where a broker‑dealer provides research or other services in exchange for client trading commissions rather than direct cash payment.
– Example: A money manager routes trades to a broker that provides research valued at $100,000; the broker funds research via slightly higher commissions.
– Note: Soft‑dollar use must be disclosed and comply with fiduciary standards; conflicts exist because research quality and commission costs are not always transparent.
– Clearing, custody, and prime brokerage fees
– Definition: fees for clearing trades, holding securities, recordkeeping, and providing prime services to hedge funds (lending, financing).
– Example: Clearing fees might be charged per transaction (e.g., $0.003/share) or as a flat per‑account fee; prime brokerage often charges financing spreads, custody fees, and securities lending revenue.
– Account and administrative fees
– Definition: various recurring or one‑time fees: account maintenance, inactivity fees, wire transfer fees, paper statement fees, transfer‑out fees.
– Example: A $25 transfer‑out fee or a $2 monthly paper statement fee. Individually small, but volume across many accounts produces steady revenue.
Regulatory framework and key requirements
– Registration and supervision
– Broker‑dealers offering services in the U.S. must register with the SEC and become members of FINRA (Financial Industry Regulatory Authority) as applicable. Many also register with state regulators.
– Useful checks: SEC broker‑dealer registration pages and FINRA BrokerCheck to view a firm’s disclosures and disciplinary history.
– Net capital and financial responsibility (SEC Rule 15c3-1)
– Purpose: requires broker‑dealers to maintain minimum capital to reduce failure risk.
– Effect: limits leverage and ensures liquidity to meet customer obligations.
– Customer protection (SEC Rule 15c3-3)
– Purpose: requires firms to safeguard customer funds and securities, limiting improper use of customer assets.
– Disclosure obligations
– Firms must disclose material conflicts of interest (e.g., payment for order flow, soft‑dollar arrangements, principal trading).
Common conflicts of interest and how they appear
– Payment for order flow can create execution quality conflicts if routing prioritizes fees over best execution.
– Principal trading (firm buys/sells from its own inventory) can create temptation to trade at prices that favor the firm.
– Research and underwriting ties may bias recommendations. Always check firm disclosures and research policies.
Practical checklist for retail traders and students when evaluating a broker‑dealer
1. Registration: Verify SEC and FINRA registration (use FINRA BrokerCheck).
2. Business model: Is the firm agency (broker only), dealer (principal), or broker‑dealer hybrid? That affects conflicts.
3. Fees: Compare commissions, margin rates, asset‑based fees, and incidental charges (wire, transfer, custody).
4. Execution quality: Ask for or find statistics on fill rates, average trade execution price vs. NBBO (national best bid and offer).
5. Disclosures: Read PFOF, soft‑dollar, and principal trading disclosures.
6. Capital adequacy and protections: Confirm SIPC (Securities Investor Protection Corporation) coverage and understand what it covers (custody against broker failure, not market losses).
7. Complaint and disciplinary history: Review BrokerCheck or regulator enforcement pages.
Worked numeric summary (combined example)
– A retail account: 1,000 shares trade at $25.00 with a $0.005 PFOF per share, and the broker charges $2.95 commission total.
– PFOF revenue = 1,000 × $0.005 = $5.00.
– Commission revenue = $2.95.
– If the execution price has an effective spread cost (market impact + price improvement) of $0.015/share = $15.00, total implicit + explicit cost = $2.95 + $15.00 = $17.95. Net firm revenue visible to the broker = $7.95 (PFOF + commission) before any payment to execution venue or internal cost allocations.
– Note: This illustrates how visible fees and invisible costs (price improvement/impact) interact.
Sources (for further reading)
– U.S. Securities and Exchange Commission (SEC) — Broker‑Dealer Registration and Rules: https://www.sec.gov/divisions/marketreg/bdguide.htm
– Financial Industry Regulatory Authority (FINRA) — BrokerCheck and Regulatory Notices: https://www.finra.org
– Securities Investor Protection Corporation (SIPC) — Protection Overview: https://www.sipc.org
– Investopedia — Broker‑dealer definition and revenue sources: https://www.investopedia.com/terms/b/broker-dealer.asp
– SEC — Customer Protection Rule (15c3-3
Practical implications for customers and how to evaluate broker‑dealers
Even when visible fees appear low, the total cost to an investor includes both explicit fees (commissions, platform fees, clearing fees) and implicit costs (effective spread, market impact, delay/opportunity cost). Because some broker‑dealers earn revenue from order routing (payment for order flow, internalization) or from principal trading, customers should treat stated commission rates as only one input when comparing brokers.
Checklist: what to ask and verify before opening an account
– What are all explicit fees? (commissions, per‑trade ticket charges, platform or data fees, routing/ECN fees, and margin interest.)
– Do you accept payment for order flow (PFOF) or internalize orders? If yes, how much revenue do you receive per share or per order on average? Is routing disclosure available?
– What is the firm’s best‑execution policy and how often do they publish reports on routing and execution quality?
– Where are customer securities held (custodian)? Are accounts protected by SIPC or additional private insurance? What are the coverage limits and exclusions?
– What are the margin requirements and how is margin interest calculated?
– How do you handle trade allocations, block trades, and conflicts between proprietary desks and agency customers?
– Can I get sample trade confirmations and monthly statements that show fills, execution time, and sell/buy prices?
Step‑by‑step method to compare two brokers on cost and execution quality
1. Gather the explicit per‑trade costs for each broker: fixed commission per trade and per‑share commissions (if any), platform or data fees, and typical margin rates.
2. Examine each broker’s public order‑routing disclosures and any published execution quality reports. Look for metrics such as average execution price vs. national best bid/offer (NBBO) and reported price improvement.
3. Estimate implicit cost (effective spread) using: effective spread per share = 2 × |execution price − midpoint of NBBO at time of order|. Note: the factor 2 expresses full‑spread cost relative to the midpoint; some academic definitions vary.
4. Compute total cost per share = explicit cost per share + implicit cost per share.
5. Multiply by trade size to get total dollar cost; compare across brokers on the same hypothetical trades.
Worked numeric example
Assumptions:
– Trade: buy 500 shares of XYZ at displayed market price $20.00.
– Broker A: no commission; reports average price improvement of $0.005/share (i.e., execution on average $19.995 vs midpoint $20.00), but effective spread (market impact + slippage) averages $0.015/share.
– Broker B: commission $0.002/share; reports average price improvement $0.00; effective spread $0.010/share.
Calculations:
– Broker A explicit cost per share = $0.00.
– Broker A implicit cost per share = effective spread = $0.015.
– Broker A total cost per share = $0.015 → total dollar cost = 500 × $0.015 = $7.50.
– Broker B explicit cost per share = $0.002.
– Broker B implicit cost per share = $0.010.
– Broker B total cost per share = $0.012 → total dollar cost = 500 × $0.012 = $6.00.
Interpretation: Although Broker A charges no visible commission and reports modest price improvement, Broker B’s lower implicit cost makes it cheaper on this trade. Always run a trade‑specific calculation rather than assuming “zero commission” means lower total cost.
Other practical considerations (short bullets)
– Order type matters: limit orders can reduce effective spread but may not execute; market orders execute immediately but accept full implicit cost.
– Trade size relative to liquidity: large orders increase market impact; splitting an order or using algorithms may reduce impact but can increase explicit fees or execution risk.
– Settlement and custody: most U.S. equity trades settle T+2 (trade date plus two business days). Understand how settled cash affects margin, withdrawals, and free credit balances.
– Recordkeeping and statements: check that confirmations include execution time, execution venue, price, and any fees. Compare monthly statements to trade confirmations.
– Complaints and discipline history: use FINRA BrokerCheck and the SEC’s enforcement database to review a firm’s disciplinary record.
Regulatory duties and protections
– Best execution: broker‑dealers owe a duty to seek best execution — an obligation to use reasonable diligence to obtain the most favorable terms for a customer’s order, considering price, speed, and likelihood of execution. FINRA and the SEC enforce this duty and require certain disclosures.
– Custody protections: SIPC (Securities Investor Protection Corporation) protects customers if a member brokerage firm fails financially, up to limits (generally $500,000 per customer, including $250,000 for cash). SIPC does not insure market losses or protect against bad investment advice; separate private insurance may apply.
– Disclosure rules: broker‑dealers must register with the SEC and FINRA, disclose material conflicts