Who does what: customers, reps and firms

The customer, the rep, the firm and FINRA

Once you pass the Series 7, who do you work for, and who makes the rules? There are four players. A customer is a person who wants to buy or sell investments, like stocks and bonds. The industry calls these investments securities.

A broker-dealer is the firm that buys and sells securities, for customers and for itself. Your customers open their accounts with the firm. Think of a car dealership. The dealership is the business, and the salesperson works for it.

Here, the salesperson is the registered representative, or rep. A rep works for a broker-dealer and serves its customers. That's you, after the exam. The fourth player is FINRA, the Financial Industry Regulatory Authority. FINRA writes the rules for firms and reps, and it enforces them.

FINRA is a self-regulatory organization, or SRO. An SRO is an industry group that polices its own members. The SEC, a government agency, oversees FINRA. The common slip is calling FINRA a government agency. FINRA is the industry's own SRO, and the SEC sits above it.

The firm is the broker-dealer. The rep works for the firm. FINRA writes and enforces the rules for both.

Broker or dealer: the two ways a firm trades

A broker-dealer is the firm that buys and sells securities. On any trade, it plays one of two roles. The first role is broker. Acting as a broker means acting as the customer's agent. An agent does a job on your behalf.

Think of a real estate agent. She finds a buyer for your house and charges a fee. She never owns the house. A broker does the same with securities. It finds the other side of your trade and charges a commission, a fee for doing the trade.

The second role is dealer. Acting as a dealer means trading from the firm's own account, as principal. The firm is the other side of the trade. Think of a used car lot. It sells you cars it owns, for more than it paid.

Selling to you, a dealer adds a markup above the market price. Buying from you, it pays less, and that's a markdown. The exam loves to swap these. On one trade, the firm plays one role, and each role has its own pay.

A broker acts as the customer's agent and earns a commission. A dealer trades as principal and earns a markup or markdown.

Worked example: selling from the firm's own inventory

1. A firm sells a customer 100 shares from its own inventory. Is it acting as a broker or a dealer, and how is it paid?
2. Start with one word. Inventory is the securities the firm holds in its own account. So the shares belong to the firm.
3. If the firm sells you its own shares, the firm is the other side of your trade. It isn't finding a seller for you.
4. Trading from its own account means the firm is acting as principal. Acting as principal is acting as a dealer.
5. A dealer that sells to a customer adds a markup to the price. That's how it's paid on this trade.
6. The answer is dealer, with a markup. A commission would mean the firm acted as the customer's agent, which it didn't.

Common mistakes

Agent earns a commission, principal earns a markup

You swapped broker and dealer. Ask one question: whose shares are they? If the firm finds someone else to trade with you, it's a broker. It acts as agent and earns a commission. If the firm trades from its own account, it's a dealer. It acts as principal and earns a markup or markdown.

FINRA is the industry SRO, and the SEC oversees it

You picked a government agency. The rules for firms and reps come from FINRA. FINRA is a self-regulatory organization, or SRO. That means the industry polices its own firms and reps. The SEC is the government agency above FINRA. It oversees FINRA's work.