Broker Dealer Overview
The different types of broker-dealers in the US include clearing brokers, introducing brokers, investment brokers, market markers, floor brokers, discount brokers, wirehouse broker-dealers, independent broker-dealers, among others.
Types of Broker-Dealers
- According to Investopedia, a broker-dealer is a person or a firm that buys and sells securities on behalf of its customers or for itself.
- Broker-dealers come in many different types with have different revenue streams, and sell different securities.
- According to WithumSmith+Brown, broker-dealers in the US are distinguished by the securities they sell, their revenue streams, and the roles they play in the US financial industry.
- Wall Street Mojo, on the other hand, categorizes broker-dealers according to their mode of operation.
- There is a wide variety of broker-dealers, but the most common ones are introducing brokers, clearing brokers, investment brokers, market makers, floor brokers, discount brokers, and high-frequency traders.
1. Clearing Brokers
- A clearing broker is the only type of broker-dealer that has the authority to clear transactions. Clearing transactions and trades is complex since it requires insane capital and is infrastructure-intensive.
- Because of this reason, most broker-dealers do not clear their trades or hold customer accounts but seek the services of a clearing broker.
- A clearing broker's role is to ensure that transactions are completed successfully and all the trades settled. The clearing broker gets the green light upon the execution of an order to work with a clearing corporation to complete the transaction and ensure that all funds are transferred properly.
- According to experts, clearing brokers are the most vital component of the securities market since their services improve the reliability and efficiency of the system, thus simplifying it for investors.
- In addition to clearing trades, clearing brokers are also charged with research to verify the reliability and accuracy of the information they are given, and they also manage the transaction's funds.
2. Introducing Brokers
- The role of introducing brokers in the securities market is to introduce their clients to a clearing broker. Introducing brokers send their clients’ funds and securities to a clearing broker.
- The clearing broker will then clear the trade and maintain the customers’ accounts.
- As per WithumSmith+Brown, this type of broker-dealers earn trade volume-based commissions "or if they are introducing trades on a delivery versus payment basis, their revenue is earned on the spread between the buy and the sell."
3. Investment Brokers
- Investment brokers' main role in investment banking is to help find buyers and sellers of investment securities.
- This type of broker-dealers also earn advisory fees by giving their clients investment advice. The advisory fee is either by commission or fee-based.
- On the side, "investment brokers are also involved in private placements, in which they receive flat fees or commissions."
4. Market Markers
- According to WithumSmith+Brown, "market makers are a unique type of broker-dealers that assist in stabilizing the market by providing liquidity."
- Market makers shoulder "the risk of holding a certain number of shares of a certain security to facilitate the trading of that particular security."
- Market markers decide on the buy and sell price of the securities in their inventory so that they can profit from it.
- Market markers are multi-pronged, i.e., they sell stocks on major stock exchanges and also in over-the-counter markets. Market markers cushion themselves from market fluctuations by maintaining "a spread on each stock, which is the difference between the price the market maker is willing to buy a security for and the price it is willing to sell it for."
- The spread is the potential profit they can take home, and it compensates market markers for the business risks they take.
5. Wirehouse Broker-Dealers
- Wall Street Mojo distinguishes broker-dealers from their mode of operation.
- The wirehouse broker-dealer has a large-scale operation and has its own set of products which they further sell to their customers.
6. Independent Broker-Dealers
- These broker-dealers act like agents where they sell products they procure from outside and earn from certain margins or commissions.
Roles and Functions of Broker-Dealers in the US
- According to Wall Stree Mojo, some roles and functions of broker-dealers in the US include:
- Brokers initiate the trade on behalf of their customers and take part in the trade cycle.
- Dealers represent brokerage firms, and they initiate a trade on behalf of the account owned by the firm itself.
- Brokers ensure that the market has enough liquidity.
- Brokers are also tasked with providing their clients with effective advice on how the client can diversify their portfolio and the different avenues available.
- Broker-dealers have to maintain the confidentiality of their clients and ensure that the clients' personal and bank information is not being misused.
- Broker-dealers also publish investment research materials to give their customers an overview of their portfolio.
- Brokers also go into the free market and seek investors to raise capital for their customers.
Tips When Looking for a Broker-Dealer
- Apart from the obvious factors of consideration, such as financial strength and regulatory compliance, other factors to look for when choosing a good broker-dealer include:
- Use the FINRA BrokerCheck system to find out if the broker has a criminal history or any allegations of misconduct against them.
- Listen to your gut feeling and only work with a broker-dealer you like, admire, and trust.
- Work with broker-dealers that understand your needs, preferences, and values.
- The broker-dealer's documents should be clear and transparent.
- Broker-dealers partner with other investment firms and industry stakeholders. One case in point is the Blue Vault Partners partnership with 24 broker-dealers.
- Independent financial investors are always partnering with broker-dealers, who are considered key strategic partners that help financial investors better serve their clients.
- Smaller broker-dealer firms have gained traction in the industry and are a popular bet for independent financial advisers to partner with.
- Some of the criteria to consider before partnering with broker-dealers include:
Important Broker-Dealer Regulations in the US
- Below are some regulations in the US that apply to broker-dealers:
- The Securities Act of 1933: "applies to the primary market (IPOs) to ensure transparency in documents and financial statements to help investors make informed decisions. "
- The Securities Exchange Act of 1934: "applies to the secondary market to prevent fraud in the trading of existing securities between investors. Also created the Securities and Exchange Commission (SEC). "
- Trust Indenture Act of 1939: "for debt securities like bonds, debentures, and notes. "
- Investment Company Act of 1940: "regulates the organization of companies investing, reinvesting, and trading in securities, including those offering their own securities. "
- Investment Advisors Act of 1940: "for the registration of money managers and mutual fund managers. "
- Securities Investor Protection Act of 1970 (SIPA): "created the Securities Investors Protection Corporation (SIPC). "
- Sarbanes-Oxley Act of 2002: "enhanced corporate responsibility and financial disclosures, combats corporate and accounting fraud. "
- Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010: "for consumer protection, trading and financial product regulation, credit ratings, corporate governance and disclosure, and transparency."
- According to Ken Research, the market size of the US financial brokerage industry is expected to grow at a CAGR of 3.4% from 2018 to reach $379.4 billion in 2023.
- According to IBIS World, the current market size of the securities brokering industry in the US is $157 billion.