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What is a Broker?

Kathleen ChaykowskiApril 29, 2020
Covered finance and business at Forbes and The Wall Street Journal. BA, Stanford University.
definition

A broker is a person or a brokerage firm that usually charges a commission (a fee) for matching investors who want to buy or sell securities (like stocks or bonds) with the other side of the transaction. (Robinhood Financial LLC is a brokerage firm, and doesn’t charge buyers or sellers a commission for executing orders.)

🤔 Understanding a broker

Brokers are the most common “transaction machines” investors use to trade stocks, as well as bonds, options, mutual funds, and more. To conduct business with publicly traded stocks, brokers must be licensed businesses (they must register with the Securities Exchange Commission and the Financial Industry Regulatory Authority) that pair people who want to buy or sell a specific amount of a security with the other side of the transaction. Brokers, which can run electronically as well as in brick and mortar offices, usually generate revenue in part by charging a fee (aka a commission), for each security it moves from person A to person B. (Robinhood Financial LLC doesn’t charge a commission). FYI, they’re required by law to execute the trade at the best price available.

example

There are dozens of brokerage firms in the US. You’ve got Robinhood (of course) as well as others like Charles Schwab, E*Trade, Interactive Brokers, and TD Ameritrade, which vary in terms of services offered and commission rates. To buy 100 shares of a stock, you could connect with a broker, who finds an investor who wants to sell 100 shares of the same stock. For his/her work, the broker could charge a commission fee.

Takeaway

Brokers are like professional matchmakers - they find two people who want to connect, and usually charge a fee for their work...

They can be a fast, easy, and efficient way to place trades compared to more cumbersome alternatives. They’re registered representatives and firms that link investors who want to buy or sell stocks, bonds, and other securities with the other side of the transaction — and typically, they charge a commission for the service. They’re one of the main ways investors buy and sell securities.

Tell me more...

What’s the difference between full-service and discount brokers?
How do brokers complete trades?
What is clearing?
How are brokers different than dealers?
What’s the difference between brokerage firms and investment advisers?
How are brokers regulated?
Brokers and a technology evolution

What’s the difference between full-service and discount brokers?

The types of services brokers offer can range drastically from firm to firm. But generally, brokers fall into two main categories: full-service and discount firms.

  1. Full-service brokerage firms: Typically, full-service brokerage firms charge more per transaction, but they often have extensive research resources that their registered salespeople can use to help guide their recommendations. These brokerage firms have other financial licenses and registrations, so they can offer just about any type of financial transaction you’d like to make, and they may also offer other financial services like investment planning.
  2. Discount brokers: By contrast, discount brokers are often cheaper per transaction, but may leave investment research up to the customer, or make research available only on their site.

Full-service and discount brokers do share some key attributes. The people they employ to sell stocks, bonds, options, mutual funds, and other securities, must register with the Financial Industry Regulatory Authority (FINRA), and might have titles like financial or investment consultant. FINRA is not part of the government. FINRA is a not-for-profit organization authorized by Congress to protect America’s investors by making sure the broker-dealer industry operates fairly and honestly, according to FINRA.

The types of securities a rep can sell depends on which FINRA exams they’ve passed. A registered rep with a Series 6 exam, for example, can sell mutual funds, variable annuities (a tax-deferred annuity contract), and some other similar products, while someone with a Series 7 license can sell a much wider range of securities.

A nifty fact — beyond brokers, there are other ways to buy stock. For example, directly through a company, which sometimes offers that service. But generally, brokers are the easiest and fastest way to buy and sell shares

Learn more:

FINRA has a number of resources available to help people learn more about the background and experience of investment professionals and firms. FINRA has a tool called BrokerCheck that’s publicly available on its site, which offers information on both SEC and state-registered investment advisors. People can also reach FINRA on a toll-free number (800) 289-9999, as well. Information is also available on the SEC’s Investment Adviser Public Disclosure database.

How do brokers complete trades?

Brokers, whether full-service or discount, typically strike deals with firms known as market makers, which buy and sell securities for their own accounts. Why? Brokerage firms can usually get better deals for customers when they place trades with market makers versus trading directly on an exchange.

Market makers sometimes pay brokers to receive their trade volume, typically based on a combination of the value and volume of securities. Market makers make their money by taking a cut on what’s known as the market-maker spread of a trade — the gap between the price at which a market maker is willing to sell a stock or other security to an investor (the ask price) and the price at which the market maker is willing to purchase the stock from an investor (the bid). Take note: brokers are legally required to seek the best execution reasonably available for their customers' orders. Some of the factors a broker must consider when seeking best execution of customers' orders include: the opportunity to get a better price than what is currently quoted, the speed of execution, and the likelihood that the trade will be executed.

For the trade to be completed, it then needs to be cleared, which means funds are transferred from the buyer to the seller, securities move to the buyer, and the transaction is recorded. Most brokerage firms hire third-party clearing houses to settle their trades.

What is clearing?

Clearing is the process that trades must go through to get settled, which means to actually transfer funds to the seller and stocks or securities to the buyer and record the transaction. In order for trades to clear, buyers need to have the appropriate amount of funding in their accounts, and the orders of buyers and sellers need to be consistent. If trades don’t clear, there’s a potential that they could result in a monetary loss.

Brokerage firms usually work with external companies that do clearing, known as clearing houses. (Robinhood is an exception in this way, along with a few other brokerage firms, and built its own clearing house firm and technology.)

In addition to most brokerage firms, stock exchanges that process trades also use external clearing firms.

How are brokers different than dealers?

Brokers and dealers both buy and sell stocks, bonds, and other investment products (securities), but they differ in some key ways:

  1. Their role in a transaction: A broker pairs buyers and sellers looking to trade the same type of security, and then buys and sells securities on behalf of customers. By comparison, a dealer can also do this, but what makes a dealer a dealer is that at least part of its business is based on buying and selling on behalf of its own account.
  2. How they make money: While brokers usually charge a fee known as a commission for matching buyers and sellers, dealers take what’s called a markup or markdown. If a dealer purchased a bond for its own inventory, and then sold that bond to a customer, the markup is the difference between what the broker paid for the bond and what the customer paid for the bond. Likewise, a markdown happens when a dealer buys a stock or other security from a customer at a price that’s lower than the security’s market value. Dealers are usually required to disclose the markup or markdown to customers. Also, it’s illegal for dealers to charge both a commission and a markup.
  3. Titles: When acting as dealers, firms are typically known as principals, whereas firms acting as brokers are usually known as agents.

A simplified way of looking at it — a broker is more like a real estate broker — it pairs interested buyers and sellers together, and typically takes a fee for doing so. Whereas a dealer is more like a car dealership — it buys and sells cars for its own lot, interacting with one buyer or seller in a transaction instead of linking buyers or sellers together.

That said, most brokers also sometimes function as dealers, and most dealers also sometimes operate as brokers (hence the term "broker-dealer").

What’s the difference between brokerage firms and investment advisers?

Brokers and investment advisers may sound like the same thing, but they have some key differences — brokers help match buyers with sellers to execute trades and can’t manage customers’ investment portfolios without additional licensing. Meanwhile, investment advisers are firms that are licensed to offer investment advice, and in some cases, can make decisions about how to manage a customer’s wealth on behalf of the customer.

Usually investment advisers are paid for their work through an advisory fee. The advisory fee can be a fixed fee or a percentage of the total assets they manage. The employees of registered investment advisers (RIAs) are called investment advisory representatives (IARs).

More on investment advisers — they typically specialize in helping individual clients set up an overarching wealth management plan. This could include everything from retirement planning, investment strategy, and college funding planning, to estate planning services. Sometimes these advisers (also called investment managers, wealth managers, or asset managers) also directly manage investment accounts. They’re registered and regulated by the Securities and Exchange Commision (SEC), and also a state regulatory body. Wealth managers are required by law to act in the best interests of their clients, known as their fiduciary responsibility.

How are brokers regulated?

Brokers need to be registered with the SEC, as well as a self-regulating organization, which is typically FINRA. The SEC officially defines brokers as “any person engaged in the business of effecting transactions in securities for the account of others.” It’s a broad enough definition that the term "person" includes entities as well as individuals.

Brokers and a technology evolution

Before the era of online brokerage firms, buying and selling stocks was largely completed by phone or with representatives in physical offices. Commission fees associated with placing trades often meant that trading individual securities was only really accessible to affluent clients.

The proliferation of online brokerage firms has helped lower commissions (or remove commissions, in the case of Robinhood), making trading more readily available to people regardless of their income or financial status. Some brokerage firms have been able to lower their fees by using technology to help reduce their costs.

More resources from FINRA on brokers and investment advisers: https://www.finra.org/investors/brokers https://www.finra.org/investors/investment-advisers

Please be advised that by clicking a third-party URL or hyperlink, you’ll be accessing a third-party website. Robinhood Financial LLC is not implying that any monitoring is being done by Robinhood Financial LLC of any information contained on the third-party website. Robinhood Financial LLC is not responsible for the information contained on the third-party website or your use of or inability to use such site. Nor do we guarantee their accuracy and completeness. Brokerage services are offered by Robinhood Financial LLC. Clearing services are offered by Robinhood Securities, LLC. Robinhood Financial LLC and Robinhood Securities, LLC are affiliated companies and members of FINRA/SIPC. 20190627-884511-2668350

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