Types of Broker-Dealers

By Malia Mon, CPA – Staff Accountant – WithumSmith+Brown, PC

A broker-dealer is a company that engages in the business of trading securities for its own account or on behalf of its customers. Seems simple doesn’t it? A broker-dealer appears to be a straightforward concept; however, there are many different types of broker-dealers, allowing them to sell different securities and generate different revenue streams. Some of the most common types of broker-dealers include introducing brokers, clearing brokers, investment brokers, and market makers. Some additional types of broker-dealers that are not seen as frequently include floor brokers, discount brokers, and high-frequency traders. There is a wide variety of types of broker-dealers, and although they are all in the same industry, the securities they sell, revenue streams they generate, and the role they play in our financial system distinguish them from each other tremendously.

To carry customer accounts and clear trades, a broker-dealer needs a high amount of capital and infrastructure. Due to the complexity of clearing, most broker-dealers do not self-clear their trades or hold customer accounts, but a clearing broker is the one form that can clear trades. A clearing broker helps to ensure that trades are settled appropriately, and the transaction is successful. Once an order is executed, the clearing broker works with a clearing corporation to make sure all funds relating to the trade are handled and transferred properly. Clearing brokers are often considered the “backbone” of the securities market because their services help make the system reliable and efficient. Many believe they are the most valuable component of any investment transaction because they make investing much simpler for investors. Outside of clearing trades, clearing brokers are also involved in researching to confirm the information they are given is exact and they also manage funds associated with a transaction.

Aside from clearing brokers, the other types of broker-dealers do not have the authority to clear transactions. Therefore, other broker-dealers will generally have one clearing broker that they work with that will clear their trades. An introducing broker helps with this process by introducing their clients to a clearing broker. In this case, the introducing broker will send their clients’ cash and securities to a clearing broker to clear the trade, and the clearing broker will also maintain the customers’ accounts. Introducing brokers earn commissions that are based on volume of trades their client makes or if they are introducing trades on a delivery versus payment basis, their revenue is earned on the spread between the buy and the sell.

Investment brokers are involved in investment banking by helping to find buyers and sellers of investment securities. They often give investment advice to their clients and earn advisory fees, which could be commission or fee based. Investment brokers are also involved in private placements, in which they receive flat fees or commissions.

Market makers are a unique type of broker-dealer that assist in stabilizing the market by providing liquidity. Market makers take the risk of holding a certain number of shares of a certain security to facilitate the trading of that particular security. The market maker brokers quote both a buy and sell price for the security that is held in their inventory, with the intent to make a profit from the turn of the security. A market maker can sell stocks that are on major stock exchanges, but they can also be involved in over the counter markets as well, which often have more than one market maker. To protect themselves from market fluctuations, market makers often maintain a spread on each stock, which is the difference between the price the market maker is willing to buy a security for and the price it is willing to sell it for. The spread represents the potential profit a market maker can make from their business, and it is meant to compensate them for the risk they take when engaging in this business.

Clearing brokers, introducing brokers, investment brokers, and market makers are some of the more common types of broker-dealers that are seen, but there are plenty of other types of broker-dealers that exist. The structure of the broker-dealer along with the revenue streams they maintain classifies each of them into their own distinguishable class of broker-dealer, all offering a different type of service or security and all playing a vital role in how our financial system operates.

If you have any questions regarding broker-dealer classification or regulation, please contact your normal WithumSmith+Brown partner.


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