A broker-dealer is a financial firm or individual that acts as both a broker and a dealer in securities transactions. As a broker, they facilitate buying and selling on behalf of clients, while as a dealer, they buy and sell securities for their own accounts. Broker-dealers are central players in the investment world, handling trades for individual investors, institutions and their own inventory. They are typically regulated by bodies such as the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) in the United States, ensuring compliance with financial laws and industry standards.
Consider working with a financial advisor as you evaluate which firms to work with on your investments.
What Does a Broker-Dealer Do?
Essential to keeping the market liquid, broker-dealers can be firms, banks or individual people. And as you may be able to guess from the hyphenated name, they serve two distinct roles.
Sometimes they act as a broker. This means they help clients buy or sell a security, like a stock. As a middleman, they help you buy the shares from whomever is selling them, and in return you pay a brokerage commission.
At other times, they act as a dealer. This means they are actual participants or principals in a sale of securities. (Note that traders buy and sell for themselves – and not as part of a regular business.) This is how broker-dealers help keep markets liquid (by taking securities onto their books before they’ve found buyers) – and build their own portfolios. Here, the broker-dealers will make sure to sell the securities for more than they paid, earning money for their firm’s account. Broker-dealers must disclose to clients when they are acting as a principal in a transaction. (By law, they can’t profit from both ends of the same transaction.)
Generally, the larger broker-dealers are called wirehouses, which refers to the time when brokerages used the wires to communicate with their branches. Large firms would pass along key price or offering information to their offices across the country. Four of the biggest wirehouses still standing are Morgan Stanley, Bank of America Merrill Lynch, UBS and Wells Fargo. They may sell their own products, while independent firms like Edward Jones, LPL Financial and Raymond James only sell other companies’ products.
Meanwhile, discount broker-dealers like Charles Schwab and E*Trade do not offer as much advice as the full-service brokerages (wirehouses and independent brokerages).
How Do Broker-Dealers Make Money?
One of the main ways broker-dealers make money is through brokerage fees. These are fees charged for executing trades for clients. A brokerage fee can be calculated in a few different ways. Some fees are a flat fee per transaction. Others are a percentage of total sales. Some fees are a mix of the two.
The amount you pay will also depend on the type of broker-dealer you use. A full-service broker will offer a large number of services and generally charge between 1% to 2% of the money involved in a trade. Discount and online brokerages have much lower brokerage fees, oftentimes charging flat rates of between $0 and $30 for each trade.
On the “dealer” side of the equation, a broker-dealer makes a profit from what’s called the bid-ask spread. This follows the same logic of how any business makes money. A broker-dealer buys securities, such as bonds and stocks. They then sell the securities to another investor at a price higher than the buying price. The difference between the two prices is known as the dealer’s spread, and it represents the profit that the broker-dealer makes on the transactions.
Broker-Dealers and Conflicts of Interest
Until recently, large broker-dealers generally had affiliated investment advisor firms. This kept the different roles clearly delineated and minimized potential conflicts of interest. Your advisor recommends you buy a stock, you say yes, your advisor puts in the order with their affiliated broker-dealer. Your advisor only gets paid for giving you good advice and the broker-dealer gets paid for fulfilling the order.
But increasingly, broker-dealers are dually registering as investment advisors or vice versa. While this streamlines their processes, it can make it harder for customers to know when their advisor is acting as a fiduciary or in a sales capacity as their broker.
This matters because broker-dealers and investment advisors operate under different standards, which can impact the way they serve clients. Investment advisors are held to the fiduciary standard, meaning they are legally required to put their clients’ best interests ahead of their own. This includes providing advice that is transparent and free from conflicts of interest, ensuring that clients receive the most appropriate recommendations for their unique financial situations.
Broker-dealers, on the other hand, follow a standard known as Regulation Best Interest (Reg BI). Reg BI mandates that broker-dealers must act in their clients’ best interest when making recommendations, but it is not as stringent as a fiduciary obligation. Critics of Reg BI have said that the rule doesn’t go far enough in protecting investors.
Bottom Line
A broker-dealer is what most of us think of as a brokerage. It acts as the middleman between buyers and sellers of securities. The dealer part comes into play when the firm is buying or selling for its own account. Your wealth advisor may also serve as your broker-dealer, but this presents a potential conflict of interest you should be aware of.
Investment Tips
- If you’re in the market for a financial advisor to help you invest, the ones who call themselves “fee-nly” typically have fewer potential conflicts of interest than those who are “fee-based.” Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now
- Curious how the buying power of your money will change over time? Use SmartAsset’s free inflation calculator to see the project impacts of inflation.
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