What is a dealer?
A dealer is an individual or firm that buys and sells securities for its own account. When acting as a principal, the dealer trades from inventory it owns rather than simply matching a buyer and seller. Dealers supply quotes (a bid price at which they will buy and an ask price at which they will sell) and help make markets by supplying immediately available liquidity.
Key definitions (short)
– Bid: the price a dealer is willing to pay to buy a security.
– Ask (or offer): the price a dealer is willing to accept to sell a security.
– Spread: the difference between the ask and the bid; the spread is a primary source of profit for a dealer.
– Principal vs. agent: a principal (dealer) trades for its own account; an agent (broker) executes trades on behalf of clients.
– Market maker: a dealer that continuously posts bid and ask prices to facilitate trading in a security.
– Broker-dealer: a firm that can act as either a broker (agent) or a dealer (principal) depending on the transaction.
– Fiduciary: a legal duty (applies to registered investment advisors) to act in a client’s best interests.
What dealers do
– Make markets: post bid/ask quotes so other market participants can trade without delay.
– Provide liquidity: buy when others want to sell and sell when others want to buy.
– Underwrite securities: participate in issuing new securities (in underwritings, dealers may buy inventory and resell it).
– Trade from inventory: hold positions and complete trades using their own capital.
– Provide services: some dealers also offer research, prime brokerage, and other client services when operating in broker mode.
Dealer vs. broker (clear contrasts)
– Role: Dealers trade for themselves (principal); brokers act as intermediaries for clients (agent).
– Compensation: Dealers earn markups/markdowns or the bid–ask spread; brokers typically charge commissions or fees.
– Market function: Dealers post prices and can complete trades directly; brokers arrange transactions between third parties.
– In practice: Many firms are broker-dealers and switch roles depending on the transaction.
How dealers earn profit (simple explanation)
Dealers typically try to buy at the bid and sell at the ask. The spread (ask minus bid) is the gross profit per unit before trading costs, inventory risk, and overhead. Dealers can also earn fees from underwriting, proprietary trading gains, or charging for ancillary services.
Worked numeric example (spread profit)
– Dealer posts: bid = $49.90, ask = $50.10. Spread = $50.10 − $49.90 = $0.20 per share.
– If the dealer buys 10,000 shares at $49.90 and later sells those 10,000 shares at $50.10, gross profit = $0.20 × 10,000 = $2,000.
– Note: This is gross profit. Real profit is smaller after transaction costs, financing (for margin), inventory risk, and regulatory/compliance expenses.
Dealer markets vs. broker (auction) markets
– Dealer market: many dealers trade for themselves and set transaction terms. Dealers can trade with each other using capital on hand.
– Broker (auction) market: brokers act on behalf of clients; prices may be determined by matching competing buyer and seller orders. Brokers do not trade from their own inventory in this role.
Regulation and requirements (U.S. context)
– Dealers and brokers must register with the U.S. Securities and Exchange Commission (SEC) before conducting business.
– Many dealers must become members of self-regulatory organizations (SROs) such as the Financial Industry Regulatory Authority (FINRA).
– Firms commonly join the Securities Investor Protection Corporation (SIPC) and must comply with applicable state regulations.
– Registered dealers are required to meet duties such as executing orders promptly, disclosing material information and conflicts of interest, and charging prices that are reasonable in the prevailing market.
– Dealers may not operate as dealers until regulators have approved their registration.
Practical checklist — if you’re evaluating a dealer or opening an account
– Verify registration: confirm the firm is registered with the SEC and is a FINRA member (use FINRA BrokerCheck).
– Check SIPC membership: determines basic customer protection if the firm fails.
– Review firm background: search for disciplinary history and complaints.
– Decide account type: cash account vs. margin account (margin gives borrowing capacity and involves additional risk).
– Determine authority level: will you retain control of trades or grant discretionary authority to a broker?
– Understand fees: ask whether
the firm charges explicit commissions, markups/markdowns when acting as principal, spreads (difference between bid and ask), custodial or account maintenance fees, inactivity or transfer fees, and the margin interest rate (if you open a margin account). Ask for a written fee schedule and an explanation of any fees that are variable or performance‑based.
Additional practical checklist items
– Confirm trading capacity: ask whether the firm will act as agent (broker) executing trades on your behalf or as principal (dealer) selling from its own inventory. An agent earns a commission; a principal earns a markup or markdown.
– Ask about execution quality and best execution practices: how does the firm route orders, and how do they measure execution quality (price improvement, speed, fill rate)?
– Order routing and payment for order flow: request disclosure on whether the firm routes orders to market makers that pay for order flow and how that might affect execution price. (“Payment for order flow” is compensation received by an intermediary for directing orders to a particular venue.)
– Trade confirmations and statements: confirm you will receive timely trade confirmations and periodic account statements showing positions, cost basis, realized/unrealized gains, and fees.
– Custody and protection: verify whether customer assets are held in segregated accounts, whether the firm is a member of the Securities Investor Protection Corporation (SIPC), and what SIPC covers and does not cover. SIPC does not protect against market losses.
– Margin terms and collateral: if using margin (borrowing to trade), get the margin agreement and the firm’s margin interest rate schedule, maintenance margin requirements, and margin call procedures.
– Conflicts of interest and disclosures: ensure the firm will disclose material conflicts (proprietary trading, affiliated research, payment arrangements) and how those conflicts are managed.
– Dispute resolution: read the customer agreement for mandatory arbitration clauses, forum selection, and compliance with regulatory arbitration forums.
– Technology and operational reliability: test order entry, confirmations, mobile/web interfaces, and ask about backup systems and settlement procedures.
– Onboarding checks: identity verification (KYC = Know Your Customer), source-of-funds questions, and suitability assessments for non‑institutional accounts.
Worked numeric examples (how dealer fees affect cost)
Example 1 — markup and spread (principal trade)
– Market mid-price for a thinly traded stock: $10.00. Dealer offers to sell (ask) at $10.50 (markup = $0.50). Dealer will buy (bid) at $10.20.
– You buy 1,000 shares at $10.50 → cash outflow = $10,500. You later sell 1,000 shares to the dealer at $10.20 → cash inflow = $10,200.
– Round‑trip trading cost = $10,500 − $10,200 = $300, which equals 2.86% of the initial purchase value ($10,500). That cost reflects the dealer’s markup/markdown and the bid‑ask spread; it is separate from commissions or taxes.
Example 2 — margin interest cost
– You buy $5,000 of securities using $2,500 cash and $2,500 borrowed on margin. Annual margin interest rate = 8% (simple).
– Annual interest = 0.08 × $2,500 = $200. Monthly interest ≈ $16.67. If the holding period is 3 months and no repayments are made, interest ≈ $50. This cost reduces net return and compounds if unpaid.
Red flags to watch for
– Vague or missing fee disclosures, refusal to provide a written fee schedule.
– Large, unexplained differences between quoted market prices and execution prices.
– Excessive concentration in proprietary products without clear rationale.
– Frequent trading that generates outsized commissions relative to account size (churning).
– Poor or missing trade confirmations and delayed statements.
Next steps — quick action checklist
1. Use FINRA BrokerCheck to verify registration and check history.
2. Confirm SIPC membership and read SIPC’s coverage details.
3. Request the written fee schedule, margin agreement, and customer agreement.
4. Ask for recent execution quality reports and order‑routing disclosures.
5. Start with small test trades to confirm execution, settlement, and reporting before committing larger amounts.
Resources
– U.S. Securities and Exchange Commission (Investor.gov) — https://www.investor.gov/
– FINRA BrokerCheck — https://brokercheck.finra.org/
– SIPC (Securities Investor Protection Corporation) — https://www.sipc.org/
– Investopedia — Dealer definition and overview — https://www.investopedia.com/terms/d/dealer.asp
Educational disclaimer
This information is educational and does not constitute individualized investment advice, tax advice, or a recommendation to buy or sell any security. Evaluate your circumstances and consider consulting a qualified, licensed professional before acting.