As financial intermediaries, broker-dealers bridge the gap between the investing public and institutions seeking equity and debt financing. Broker-dealers, of course, have branched off into multiple classifications to serve the needs of the investing public. The Securities and Exchange Commission (SEC) regulates broker-dealers to referee Main Street versus Wall Street conflicts of interest and financial risks.
The Broker – Dealer
The broker is best described as a “middle man” or “order taker.” Brokers match buyers to sellers and earn commissions for their services. The broker does not own the asset at any time. Stockbrokers will fill orders to buy or sell investments for clients – without offering advice.
Dealers will purchase assets for their own account and carry inventory that is to be sold at a later date. These transactions are referred to proprietary trades, which are designed to improve the profitability of the overall firm. All Americans should be familiar with the automobile dealership that operates in this manner. Broker-dealer firms, of course, will fill orders for clients and trade for their own accounts.
The Securities and Exchange Commission identifies brokerages as fiduciaries that execute financial transactions upon your behalf. At first, corporations issue shares of stock to secure financing at initial public offerings (IPOs). From there, shares trade directly between investors within what is referred to as the secondary market. Broker-dealers provide the information technology and infrastructure to organize buyers and sellers together, so that they may negotiate prices between themselves. Financial markets function as large auctions, where asset prices are established at points where the highest bids and lowest sales offers intersect.
Broker-dealers may be categorized into either traditional, or discount firms. Traditional brokerages are actually full-service financial advisers that may provide investment recommendations, alongside comprehensive financial plans that help integrate client insurance, cash management and employee benefits packages. Traditional brokers may charge by the hour, or accept annual fees for these services. Alternatively, discount brokers strictly execute transactions, without offering advice. Discount brokers, such as Scottrade and E-Trade, are notable for their online presence and low trading commissions.
Broker-dealers introduce liquidity to financial markets, which lowers overall costs for all investors. Liquidity describes the ease of which any asset is converted into cash. Within seconds, investors can sell investments through broker-dealers for cash. Without brokers, buyers and sellers would be forced to either spend time and money soliciting prospects to trade investments, or buying expensive memberships at financial exchanges. Professional traders may purchase these memberships for $1 million, or more.
Conflicts of Interest and Regulation
Broker-Dealer and client relationships introduce conflicts of interest, which may lead to severe losses for savers. As dealers, firms may exploit their position to sell off their own losing investments to clients that quickly fall in value. Further, traditional brokers have been accused of churning accounts. Churning refers to recommendations that are made to encourage heavy trading, for the sole purpose of increasing brokerage commissions. The Securities and Exchange Commission does require that financial intermediaries disclose the fact that they are operating as a dealer when offering proprietary stocks to clients.