A broker-dealer is the regulatory term for what most of us just call a brokerage. Technically, the person who takes our calls (to buy or sell) is a registered representative of a broker-dealer, though you probably just refer to the person as your broker. Wirehouses like Morgan Stanley and Wells Fargo, discount brokerages like Charles Schwab and TD Ameritrade and independent firms like LPL Financial and Raymond James are all broker-dealers. Robo-advisors like Betterment and Sofi have affiliated broker-dealers (Betterment Securities and Sofi Securities). In fact, the bigger financial advisor and wealth management firms tend to be either dually registered as investment advisors and broker-dealers or affiliated with a broker-dealer.
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 what’s called wirehouses. The name, as you probably guessed, 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 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 also as investment advisors. Or financial advisors are also working as registered representatives of broker-dealers. This streamlines their processes, but makes it harder for customers to know when their advisor is acting as a fiduciary (which is required of investment advisors) or a broker (who only has to recommend suitable products). You advisor recommends you buy a stock, but is he doing this as your advisor who works in your best interest or as your broker? The only way to know for sure is to ask.
The 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.