For many investors, the financial services industry is a strange and mysterious place filled with a language all in its own. Terms like “alpha,” “beta” and “Sharpe-Ratio” don’t exactly roll off the tongue with ease, nor does their use by industry insiders serve to lift the veil and make industry less opaque. Of course, the language fits the medium, as the financial services arena is a complex word. To participate in that world, investors generally engage the services of a broker or dealer in some form or fashion, making a review of those terms an interesting place to begin exploring.
“Broker” and “dealer” are U.S. regulatory terms and, as is often the case with legal terms, they are not very intuitive to many people. While the words are often seen together, they actually represent two different entities. A broker executes orders on behalf of clients. To the regulators, this means the entity through which investors hold a brokerage account. To investors, it generally means the person who helps them buy and sell securities. A bit of confusion occurs here, as the industry also has lots of terms for a person who helps investors buy and sell securities, including “financial advisor,” “investment advisor,” and “registered representative,” For the moment, we’ll stick with the strict legal definitions to provide a baseline for further exploration.
Confused yet? Let’s try this one more time. Think of the legal entity that facilitates security trading as an “agent” acting on behalf of investors. When you want to buy or sell a security, the entity (in the case of online brokerage accounts for example) that helps you make that transaction is your agent. When you pay a commission to make a trade, you are making that payment to an agent. The terms agent and broker can be used interchangeably.
Brokers come in two general types, full service and discount. Full-service brokers provide one-on-one personal service. This includes providing specific investment recommendations in addition to planning and advice services that range from retirement planning, long-term care planning and estate planning to the formulation of personal investment strategy that will help cover the cost of child’s education, a home purchase or other financial goals. Ongoing assistance can include face-to-face meetings and periodic checkups to revisit progress toward goals. For novice investors or those too busy to plan for themselves, full service brokers offer an array of useful services and information.
Discount brokers, on the other hand, provide trade execution. Online brokers are perhaps the best example of this arrangement, as investors can log on, select a security and purchase it without ever speaking to another person. Discount brokers offer an inexpensive way to purchase securities for investors who know exactly what they what to buy. Some of these firms also offer online tool and research designed to help do-it-yourself investors generate ideas and research securities that they may be interested in purchasing. The limited service offering provided by discount brokers is significantly less expensive that the cost of working with a full-service broker.
While a broker facilitates security trades on behalf of investors, a dealer facilitates trades on behalf of itself. The terms “principal” and “dealer” can be used interchangeably. So, when you hear about big financial firms trading in their “house” accounts, they are acting as dealers.
Some of these dealers, known as “primary dealers” also work closely with the U.S. Federal Reserve to help implement monetary policy. Primary dealers are obligated to participate in the auction of debt issued by the U.S. government. By bidding on Treasury bonds and other securities, these dealers facilitate trading by creating and maintaining liquid markets. They assist in the smooth functioning of domestic securities markets as well as transactions with foreign buyers. The list of primary dealers includes some familiar names and perhaps some surprises:
- Bank of Nova Scotia, New York Agency
- BMO Capital Markets Corp.
- BNP Paribas Securities Corp.
- Barclays Capital Inc.
- Cantor Fitzgerald & Co.
- Citigroup Global Markets Inc.
- Credit Suisse Securities (USA) LLC
- Daiwa Capital Markets America Inc.
- Deutsche Bank Securities Inc.
- Goldman, Sachs & Co.
- HSBC Securities (USA) Inc.
- Jefferies LLC
- J.P. Morgan Securities LLC
- Merrill Lynch, Pierce, Fenner & Smith Incorporated
- Mizuho Securities USA Inc.
- Morgan Stanley & Co. LLC
- Nomura Securities International, Inc.
- RBC Capital Markets, LLC
- RBS Securities Inc.
- SG Americas Securities, LLC
- UBS Securities LLC.
Dealers also play a self-governing role, to ensure correct functioning of securities markets. They are regulated by the Financial Industry Regulatory Authority (FINRA), which is responsible for administering exams for investment professionals. Some of the better-known exams include the Series 7, the Series 6 and Series 63. The Series 7 permits financial services professionals to sell securities products, with the exception of commodities and futures. The primary focus of the Series 7 exam is on investment risk, tax implications, equity and fixed-income securities, mutual funds, options, retirement plans and working investors to oversee their assets. The Series 6 designation enables investment professionals to sell mutual funds, variable annuities and insurance products. And the Series 63 enable them to sell any type of securities in a specific state. Obtaining these licenses is the first step financial services professionals need to take in order to get into the securities business.
Putting it All Together
Most firms that investors envision when the words “stock brokerage” come to mind act as both brokers and dealers, and are therefore referred to as “broker-dealers” by industry regulators. These firms include the primary dealers and other traditional Wall Street organizations, as well as large commercial banks, investment banks and even small independent boutique firms that cater to the wealthy.
Broker-dealers play an important role in the financial markets, as these firms provide the infrastructure that facilitates stock trading. In fact, if you want to buy stock, you must open a brokerage account through a brokerage firm. The brokerage firm makes sure you have enough money in your account to conduct a trade, facilitates the trade by interacting with stock exchange where the stock is traded, provides the computer systems that enact the trade and keep records of the trade. It also handles the financial transaction between the buyer and the seller. And it facilitates future transactions (dividends, stock splits, corporate actions such as those that occur when preferred securities are called or stock splits take place).
The Bottom Line
With the depth and complexity of industry offerings and ever-changing nature of the industry itself, knowledge is power. The greater your grasp of the industry’s vocabulary, the more you can be sure you understand how the industry functions. This includes developing a better sense of how your investments work, the services you get in exchange for the fees that you pay, who or what provides those services and what you can expect should a dispute end up in court.
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