As an investor, you need to be familiar with the different players in the investment arena and how they buy and sell securities. Broker-dealers, registered representatives and the others have specific roles in clearing the way for commerce in securities.
This tutorial will cover the following topics:
A broker is a person or firm that facilitates trades between customers. A broker acts as a go- between and, in doing so, does not assume any risk for the trade. The broker does, however, charge a commission. A dealer is a person or firm that buys and sells for his or her own inventory of securities and for others. A dealer therefore assumes risk for the transactions. Dealers may mark securities up or down to make a profit on their transactions.
Many publications or websites use the term broker-dealer. A broker-dealer is allowed to operate in either role, but never as both at the same time.
To be involved in the buying, selling or trading of securities, a person or firm must be registered with the National Association of Securities Dealers (NASD). The NASD is a self-regulatory organization created by the Securities and Exchange Commission (SEC). Brokers and dealers must follow all rules of the NASD and SEC, including the NASD’s Conduct Rules and its rules for arbitration, complaints and dealings with the public.
Broker-dealer status can be revoked for freely breaking securities rules; for having been expelled or suspended from any self-regulatory organization; for making misleading statements to the SEC or the NASD; or for having committed felonies or misdemeanors in the securities industry.
What Broker-Dealers Are Not Allowed to Do?
The following are practices that broker-dealers are forbidden to do:
- Churning: Excessive trading of a client’s discretionary account to increase the broker’s commissions.
- Use deception or manipulation to trade securities, or failing to state material facts
- Recommending low-priced, speculative securities without determining whether they are suitable for the customer
- Make unauthorized transactions
- Guarantee that loss will not occur
- Try to talk clients into buying mutual funds inappropriate for their means and goals
- Use fictitious accounts to disguise trades
- State that the SEC has approved or judged positively either the security or the broker
- Not promptly transmitting the client’s money or securities
Broker-dealers convicted of any of these actions may be expelled or suspended by the NASD.
Because brokers have so much control over other people’s money, their activities are highly regulated.
What Other Broker Services:
Brokers, when authorized by the client, may set up discretionary accounts. These accounts allow brokers to buy and sell securities for a client’s account without contacting the client for each transaction. The authorized broker may determine the security traded, how much of it may be traded, the price and the time of transaction.
Brokers may lend funds to customers who have margin accounts. With margin accounts, customers can buy additional securities with money borrowed from a broker.
Registered Representatives, Market Makers and Specialists
A registered representative is an individual who has passed the NASD’s registration process and is therefore licensed to work in the securities industry. The process includes an examination that tests the candidate’s knowledge of securities and markets. Further, the registration agreement requires that the candidate agree to follow the rules of the NASD.
Registered representatives sell to the public; they do not work on exchange floors.
Market makers are firms that maintain a firm bid and offer price in a given security by standing ready to buy or sell at publicly-quoted prices. The Nasdaq is a decentralized network of competitive market makers. Market makers process orders for their own customers, and for other NASD broker/dealers; all NASD securities are traded through market maker firms. Market makers also will buy securities from issuers for resale to customers or other broker/dealers. About 10 percent of NASD firms are Market Makers; a broker/dealer may become a Market Maker if the firm meets capitalization standards set down by the NASD.
Specialists keep markets for securities orderly and continuous. This means they must buy when there are others selling without buyers, and they must sell when others are buying without sellers. They must maintain their own inventories of securities that are large enough for sizable trades. Specialists both buy and sell out of these inventories and mediate between other customers.
Specialists work on the exchanges where they hold seats. Among their duties is buying and selling odd-lots (trades of less than 100 shares) for exchange members. To trade a security, a specialist must be able to keep a position on it with at least 5,000 shares. Specialists, like others, who buy and sell for the public, are subject to rules and regulations. Specialists often choose to keep inventories in multiple securities, often in more than one market sector.
This concludes our tutorial on brokers, specialists and market makers.
The Life of a Trade:
The life of a trade can vary a great deal depending on whether the trade involves a listed, Nasdaq or over-the-counter bulletin board security. The following description is intended to give you a general idea of how the process of trading stocks works.
Trading is based on supply and demand. When you buy or sell a stock, you are literally trading with another investor — someone in your city, across the country or on the other side of the world. An order from you to buy a stock must be matched with a seller’s order to sell. If you place an order on the Nasdaq, or one of the many other exchanges, this match may be done electronically.
If your order is sent to the trading room floor of one of the exchanges, the auction process begins. A member of the stock exchange walks to the appropriate trading area where your stock is traded and presents your order. Sometimes there will be a broker in the crowd with a sell order at the same price. In this case your order will be completed or filled. Brokers must often act quickly or risk missing the market. If a broker hesitates, a competitive bid could be placed, driving up the market price for the next trade.
The broker may also hand your order to a specialist. The specialist is a person in each trading area, whose job is to guarantee a fair and orderly market by matching buys and sells or by buying or selling themselves if needed. When an order is away from the market, it can be placed under a specialist’s care. From this point on the specialist is in charge of representing your order.
If you placed a GTC order with us, it would stay open until it is filled, canceled by you, or until the last day of the next calendar month. If the order is filled, the broker or specialist will report the fill to us. You can choose to be contacted by phone, fax or e-mail. Of course, if you monitor the Order Status section of the website, you can also see when the order is filled. You will also receive a U.S. Mail copy of your order confirmation and fill. You should check your order confirmation carefully no matter how it is received.
Once the order is filled another process kicks into place; one which is generally invisible to you. First the fill is reported to the Market Data System of the exchange. This system transmits the trade details such as the stock name, the number of shares traded and the price of the trade to all interested parties through the ticker tape. The trade can be seen online, TV or through other media by the investor and other interested parties. The ticker tape will also update the information (sometimes with a time lag) on your Quote Monitor.
The tickets sent to your brokerage firm and the brokerage firm of the person who bought or sold the stock from you is entered into a computer. Over the next few hours, the two trades are matched to make sure they agree. If they do not agree, the brokers meet again to settle any differences. This will not affect your fill. Once agreement is ensured, the settlement process begins. Settlement of the trade generally occurs three business days from the actual trade date. Upon settlement the brokerage firms exchange (usually electronically) the stock certificates and the money for the stock.