Definition
A broker-dealer is an individual or a firm that operates in the buying and selling of securities. They can operate either as agents or dealers in a transaction.
How does a broker-dealer work?
Broker-dealer as an agent: A broker-dealer assists the client in buying or selling a security when they operate as an agent. The broker-dealer takes the necessary actions to facilitate the transaction. The broker-dealer does not have any of their own money at risk. They simply try to match buyers and sellers with other brokers or through other means. A commission is paid to the broker-dealer for this service.
Broker-dealer as a dealer: A broker-dealer acts as a dealer when they are one of the parties involved in a transaction. The broker-dealer is on the other side of the transaction and buys or sells a security from a client. The broker-dealer must disclose in writing that they are acting as a dealer in this situation. They must explain all fees and compensation.
Broker-dealer vs. Registered Investment Advisors
The other main classification for an individual or firm operating in the securities industry is a registered investment advisor (RIA). A broker-dealer and a registered investment advisor may seem to perform the same functions, although there are some differences.
Broker-dealer:
- Regulated under the Securities Exchange Act of 1934
- Consults clients on asset portfolio management
- Paid through commissions or by earning a profit from selling securities to clients
Registered investment advisor:
- Established under the Investment Advisors Act of 1940
- Acts as an advisor to clients in managing asset portfolios
- Paid through fees as a percentage of assets under management
For many years, broker-dealers were held to a lower standard of conduct towards their customers. They only had to justify their recommendations based on the appropriateness of the client’s needs and goals. This allowed broker-dealers to make recommendations that were in their financial interest but still suitable for clients.
On the other hand, registered investment advisors were always required to adhere to a legal fiduciary standard. Registered investment advisors and the advice they provide are governed by the U.S. Securities and Exchange Commission. A person acting as a financial advisor must act in the best interest of the person they represent or serve.
Under this standard, registered investment advisors must:
- Disclose any conflicts of interest
- Adhere to impeccable standards of conduct
- Provide investment advice that is considered the best possible advice for the client, rather than just “suitable”
However, the SEC has attempted to change this through new rules passed in 2019. The rules stipulated that whether clients work with a broker-dealer or a financial advisor, they are entitled to advice or recommendations that are in the best interest of the client, rather than the interest of the firm or the financial professional.
Do I need a broker-dealer?
Before deciding to work with a broker-dealer, consider the following points:
- Communication: Does the broker-dealer representative listen to you? Do they understand your circumstances, needs, preferences, and values?
- Fees: Are the disclosure documents clear? Do you understand what you will receive and what you will pay for it?
- Experience: Does the broker-dealer have the necessary legal and other credentials? What do you know about their investment experience and track record?
- Integrity: Does the broker-dealer or the representative have a criminal record or a history of investigations or other important facts you should be aware of? You can use the FINRA BrokerCheck system to investigate complaints filed against anyone you are considering entrusting with your money.
Many individual investors manage their own accounts. For some, the fees incurred by working with a broker-dealer may be worth the benefits of their expertise and attention.
How to become a broker-dealer?
Broker-dealers can operate either as independent businesses or as part of larger financial firms. To become a broker-dealer, you will need to follow several steps.
Licensing
Testing: To become a registered broker-dealer representative, you must pass one or more regulatory examinations such as the Securities Industry Essentials (SIE) exam and the Series 7 exam.
Company Setup: You must set up the company itself if you do not wish to operate as a sole proprietorship, which would leave you with unlimited liability. This includes a series of steps such as organizing the business as a limited liability company, obtaining all necessary business licenses from state and local authorities, opening bank accounts and funding those accounts with initial capital, drafting and signing an operating agreement, setting up an accounting system, implementing an anti-money laundering system, and agreements with clearing agents, as well as submitting a new member application and other necessary forms to FINRA.
Submission to Regulatory Authorities: Broker-dealer firms must register with a variety of regulatory bodies to operate legally. You must submit Form BD, the Uniform Application for Broker-Dealers to the Securities and Exchange Commission (SEC) and self-regulatory organizations (SROs), and the Central Registration Depository for FINRA (CRD). You must become a member of an SRO and a member of the Securities Investor Protection Corporation (SIPC). Your company must register with FINRA’s Investment Adviser Registration Depository (IARD), an electronic system that facilitates registration, submission, review, and disclosure for companies.
There are also specific registration requirements, fees, and licenses for the states that you will need to set up before your company can operate.
Source: https://www.thebalancemoney.com/what-is-a-broker-dealer-4067290
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