A broker-dealer is a person or firm in the business of buying and selling securities for its own account or on behalf of its customers. The term broker-dealer is used in U.S. securities regulation parlance to describe stock brokerages, because most of them act as both agents and principals. A brokerage acts as a broker (or agent) when it executes orders on behalf of clients, whereas it acts as a dealer, or principal, when it trades for its own account.
Broker-dealers fulfill several important functions in the financial industry. These include providing investment advice to customers, supplying liquidity through market making activities, facilitating trading activities, publishing investment research and raising capital for companies. Broker-dealers range in size from small independent boutiques to large subsidiaries of giant commercial and investment banks.
By definition, broker-dealers are buyers and sellers of securities, and they are also distributors of other investment products. As the name implies, they perform a dual role in carrying out their responsibilities. As dealers, they act on behalf of the brokerage firm, initiating transactions for the firm’s own account. As brokers, they handle transactions, buying and selling securities on behalf of their clients. In their dual roles, they perform a couple of vital functions; they facilitate the free flow of securities on the open market, and they buy or sell securities in their own accounts to ensure there is a market in those securities for their clients. In this regard, broker-dealers are essential, and they are also well-compensated, earning a fee on either or both sides of a securities transaction.
Broker-dealers that are tied directly to investment banking operations also engage in the underwriting of securities offerings. When a broker-dealer acts as an agent of the issuing company, either as a principal underwriter of the stock or bond offering, or as a member of the underwriting syndicate, they enter into a contractual arrangement, acting on a “firm commitment” with the issuer that obligates them to distribute a certain amount of the securities offered to the public in exchange for an underwriting fee. They may also acquire a piece of the securities offering for their own accounts, and may be required to do so if they are unable to sell all of the securities.
Once the underwriting process is completed and the securities are issued, the broker-dealers then become distributors, and their clients are typically the target of their distribution efforts. In that effort, the financial advisors of the firms then act as brokers to solicit their clients and recommend the purchase of the security for their accounts. In this regard, the broker-dealers are facilitating the interests of the issuer, themselves (in the collection of a distribution fee), and their clients, although their only contractual obligation is to the issuer.