Brokerages exist to allow individuals to make investments into the larger market. In other words, they connect individuals to the markets as a whole.
Brokers help individuals trade securities, the security type will change depending on the broker, but they usually fall into these categories:
- Cash (including Foreign Exchange markets)
- Individual Securities
- Bonds and Debts
- Structured Products
- Mutual Funds
- Exchange Traded Funds (ETF)
- Exchange Traded Products (ETP)
- Unit Investment Trusts (UIT)
- Future Options
To actually trade these securities, an individual would need to open a brokerage account with a broker-dealer.
“Brokers” are people who bring two interested people together to make a trade, they are the “middle man” of the transaction. “Dealers,” on the other hand, are usually directly involved in the transaction. Dealers would be like a storefront, they buy goods from their own suppliers, then sell them to the final consumer.
Stock brokerages fall in the middle, and so are called “Broker-Dealers”. When you want to buy or sell an investment, they work to match you with someone who is willing to make that trade, (acting like a broker). To speed up the process, they also usually have their own reserves of the most commonly-traded stocks, so you might end up buying from (or selling to) the brokerage itself. This way, they are also acting like a dealer. The five largest broker-dealers, or firms, in the United States as of 2017 are Fidelity Investments, Charles Schwab, Edward Jones, Ameriprise Financial, and TD Ameritrade.
Selecting which firm in which to house a brokerage account depends on a number of factors, most notably:
- Types of investments and securities the investor desires to trade
- Commissions and fee costs associated with desired trades
- Level of investment guidance and research provided by the broker-dealer
- Account access interfacing services – i.e. ability to place trades online, by phone, or other means
The process, though, for purchasing and selling investments and securities has a number of activities that need to occur, both visibly and behind the scenes, in order to execute a trade correctly.
Security and Investment Operational Activities
The buy or sell process within a brokerage account is called Trade Execution. Trade execution is an investor confirming the desire to buy or sell an investment or security. Once the investor signals their intention to place a trade, it starts the Trade Capture process.
A Broker-dealer is required to record every aspect of a trade execution for both records, and to actually facilitate the transaction. The process of performing trade execution, by the broker-dealer, records what investment is to be traded, what quantity of the investment is to be traded, what price the investor seeks for the trade, and any special instructions associated with the trade.
Once the Broker-dealer has performed the trade capture the trade moves to Trade Validation. Each Broker-dealer has internal systems to check the validity of the trade that has been captured. The purpose of trade validation is to reduce the risk of erroneously filling an order. The broker-dealer will ensure that adequate funds are available for purchases or, in the case of a sale that there is enough value in the investment to liquidate for what the investor has requested. More sophisticated trade validation will also look at an investor’s trading behavior in an attempt to shut down trades that appear to be fraudulent.
Remember, a broker-dealer who holds a brokerage account for an investor is a custodian. Meaning (as a custodian) the broker-dealer simply holds an investor’s securities and investments. As such, once trade validation has occurred the trade moves into the fulfillment phase.
Trade Fulfillment is dependent on a broker-dealer’s trade agreements in place. Often broker-dealers will hold popular securities, remember securities are typically stocks (equities) and bonds (debt), and investments available in reserve; additionally, broker-dealers will have contracts in place with other broker-dealers to fill trades for items that are not held in reserve. The contracts ensure that trades requested are fulfilled at a reasonable speed that is reflective of the investment’s publicly stated value. These trade agreements will also outline the speed at which the settlement will occur.
Settlement occurs when both parties have received what each is legally entitled to receive. For example, if Investor X places a trade to sell an investment, Investor X upon fulfillment is entitled to receive cash. But, for Investor X to sell the investment, another investor would need to want to purchase the investment. Say Investor Y desired to purchase Investor X’s investment; upon fulfillment Investor Y would receive the agreed upon investment from Investor X in exchange for cash.
Once settlement has occurred, the broker-dealer then moves into the Trade Reporting phase. Each time a trade is placed, whether fulfilled or not, the broker-dealer acting as the custodian must report the trade. Internal reporting ensures that the custodian has completed the delivery of the agreed upon exchange. External reports are prepared for three different entities. The first is the owner of the brokerage account. Trades must be reported accurately for statements sent to the brokerage account owner. Second, each state in the U.S. has a trading oversight committee that the transaction is reported to. This is to ensure that all trades have abided by state law that oversees securities and investments. Lastly, the transaction is reported to the Internal Revenue Service (IRS). Reporting to the IRS ensures that all potential taxable trades have been recorded for tax collection during tax filing season.
Deviating from the listed steps is prohibited. Brokerage accounts held by broker-dealers are subject to regulation from individual states, the U.S. Securities and Exchange Commission (SEC), and the Financial Industry Regulatory Authority (FINRA). Each of these regulatory bodies requires that broker-dealers follow this pattern for securities and investment operations or face stiff penalties.
Operations of a Securities and Investment Office
Given that broker-dealers – and by extension brokerage accounts – are regulated by the SEC and FINRA, a number of other operations within the role of the broker-dealer are also highly regulated in addition to the actual trade process. These operational processes included, but are not limited to the following:
- Receipt of the customer’s funds – i.e. checks, wires, money orders, etc.
- Handling of customer complaints
- Adherence to state level regulations, referred to as Blue Sky Laws
- How new securities and investments are offered to the public
- Properly reviewing and documenting reviews of both transactions and customers
- Ensuring that compensation to advisors and consultants is fair and within market norms
- Procedures for prohibiting insider trading
- Sales practices
- Advertising practices
The bulk of operational regulations to which broker-dealers are subject, stem from the Securities Act of 1933, Securities Exchange Act of 1934, Investment Company Act of 1940, and Investment Advisers Act of 1940. The purpose of each of these regulations is to promote fairness and transparency with investors from securities and investments being offered by broker-dealers. Reexamining each of the operational processes through the lens of these laws is aimed at clients of broker-dealers receiving the due diligence that is needed to make informed decisions about securities and investments.
Broker-Dealer Commission Arrangements & Environments in Which Security and Investment Services are Offered
All securities and investments have a cost. The cost may come in the following forms:
- 12b-1 – annual marketing and distribution fee
- Flat Fee
- Fund expenses
- Advisory Fees
Each of these potential securities and investment costs may be applicable to a brokerage account and are how broker-dealers earn a profit and pay their employees. Understanding how each of these costs manifest will guide investors to which investments are appropriate within a brokerage account to meet state goals and objectives.
Front Load Commission
Commission arrangements come in four typical forms: front-load, back-load, 12b-1, and flat fees. A front-load commission arrangement is where an investor will pay upfront a percentage of money placed into an investment. Normal front-loads for packaged structured products range from 0% to 5.75% depending on the total dollar amount entering the investment. For example, say an investor desires to purchase a front-loaded investment with $100,000 and the broker-dealer charges 4% to enter. The customer will pay the broker-dealer $4,000 to enter into the investment and have $96,000 actually placed into the investment.
Back Load Commission
A back-load commission on the other hand charges an amount of money as a percentage of the investment when the investor exits a structured product. For example, if an investor desires to purchase a back-loaded investment with $100,000; the broker-dealer will charge nothing when money is placed into the investment. However, when the investor sells the investment, the sale is subject to typically 1% to 3% of the total sale. So, if the investor were to sell $100,000 from a back-loaded investment, $1,000 to $3,000 will be paid to the broker-dealer.
12b-1 and Fund Expenses
On the surface, a back-loaded investment may appear more attractive. However, two additional costs exist within commissioned products – Both fund expenses and 12b-1 fees. Fund expenses are found in any structured product and are necessary to perform the day-to-day functions of managing the investments within the product. However, 12b-1 fees are reoccurring commission arrangements between structured products and broker-dealers. Front-loaded investments often have 0.10% to 0.25% in embedded 12b-1 fees. Whereas back-loaded investments often have 0.65% to 1.00% in embedded 12b-1 fees.
To the investor, utilizing a back-loaded investment often means giving up 0.75% in returns each year. For $1,000,000 brokerage account, that is $7,500 annually in additional commissions paid. FINRA recommends always comparing total costs of front-loaded and back-loaded investments with the FINRA Fund Analyzer.
In response to both client demand, and new regulations, many broker-dealers are now opting instead for a flat commission fee. In doing so, loads are done away in lieu of a stated fee. 12b-1 fees frequently disappear as well. For example, amongst the largest broker-dealers initially listed a number of them offer stocks and non-loaded mutual funds for between $5 and $40 per trade – both buy and sell trades. The benefit to a flat commission fee is more transparency in costs, and often times lower overall costs in larger balanced brokerage accounts.
Spreads are another indirect way in which a broker-dealer can profit and are often in addition to a flat commission fee transaction. In lieu of a load, a spread is a small change from the publicly traded price of a security that a broker-dealer keeps. For example, say Stock Z is publicly selling for $32.33 and an investor wishes to sell 100 shares of Stock Z. The investor’s broker-dealer may offer to purchase Stock Z for $32.30 knowing that the stock can be resold to another dealer for the $32.33. The three-cent difference is the broker-dealer’s spread. In effect, the broker-dealer has made an additional $3.00 on the transaction through the use of a spread. Spreads can likewise be assessed to buy trades.
For investors looking to avoid commission arrangements entirely and seek a high level of assistance in either investment guidance or day-to-day investment management may seek out an advisory arrangement – referred to as an advisory fee account; it is worth noting that fund expenses do still exist with this arrangement. These fee-only arrangements are done in one of two ways: the first fee-only arrangement is an agreed upon fee as a percentage of assets under management (AUM). For example, if $100,000 is on deposit in a brokerage account and the advisor fee is 0.50%, the broker-dealer will charge $500 annually to manage the account. The broker-dealer is impartial to security and investment selection, as compensation does not change.
Conversely, a fee-only arrangement can also be arranged as a flat fee solely. Rather than a percentage of AUM, a flat fee of $250 to $1,500 is charged regardless of the balance in question. Again, the broker-dealer is impartial to security and investment selection, as compensation does not change.
Each of the cost arrangements – commission, spreads, and advisory fee arrangements (fee-only) – are available through either a Register Investment Advisor (RIA) or a broker-dealer directly. When held through a broker-dealer directly, an investor is either self-directing investments and securities, or utilizing a computer model for guidance, (also called a robo-advisor). Which fee structured is deployed is largely dependent on level of investment guidance and research is provided and the types of investments that are desired.
Utilizing a RIA should yield the highest level of investment guidance, research, and investments but also tends to carry the highest price tag. Self-directing within a brokerage account will reduce overall investment expenses, but often at the sacrifice of investment guidance, research, and investment choice. Computer guided models straddle the middle and continues to gain popularity for investors who do not desire face-to-face servicing. An investor should always select which channel is most closely aligned with their investment goals and objectives.