Roles in Securities Trading

Now that you understand the language of trading (quotes, order types, and accounts), let's look at who actually makes it all happen. Four key players can work together to facilitate a securities transaction, though not every trade routes through all four.

Who Are the Four Key Players in a Trade?

What Do Broker-Dealers Do?

• Broker-dealers facilitate securities transactions for clients and/or for their own accounts
• They can act in two capacities:
  • As agent (broker): Executes trades on behalf of customers in the open market and earns a commission
  • As principal (dealer): Buys or sells securities for their own account, including from inventory, and earns a markup or markdown
• A single firm can act as a broker on one transaction and a dealer on the next, but not both on the same transaction

Think of it this way: A broker is like a real estate agent who finds a buyer for your house (and earns a commission). A dealer is like a used car lot that buys your car and resells it at a higher price (earning the markup). Same firm, different hats, but never both hats at once.

Exam Tip: Gotchas

• A firm cannot act as both broker and dealer on the same transaction. If the firm is selling from its own inventory (principal/dealer), it earns a markup. If it is executing on your behalf in the market (agent/broker), it earns a commission. Never both.

What Is the Difference Between an Introducing and a Clearing Firm?

Most retail broker-dealers do not settle their own trades. The work is split between two firms under a clearing agreement, and the exam tests which firm does what.

• The introducing firm passes the order to the clearing firm, which completes it
• The customer must be told which firm does what, so responsibility for the account is never ambiguous
• An introducing firm that never touches customer funds or securities faces lower net capital requirements. That is the usual business reason for the split

Fully disclosed vs. omnibus. In a fully disclosed arrangement, the clearing firm knows the identity of each customer and carries the accounts on its books by name. In an omnibus arrangement, it does not; the introducing firm's customers are held in a single combined account and the clearing firm sees only the introducing firm.

Think of it this way: the introducing firm is the storefront the client walks into. The clearing firm is the vault in the back. Fully disclosed means the vault has a labelled box for each client. Omnibus means it has one large box and only the storefront knows whose money is inside.

Exam Tip: Gotchas

• An introducing firm holds the customer relationship; the clearing firm holds the assets. If a question describes a firm that takes orders and recommends securities but never holds customer cash or securities, that is the introducing firm.
• Fully disclosed means the clearing firm knows each customer's identity; omnibus means it does not. Do not reverse these.
• Lower net capital requirements are the reason a firm chooses to introduce rather than clear. Not holding customer assets is what earns the lower requirement.

What Do Custodians Do?

• Custodians hold and safeguard financial assets on behalf of clients
• They do not make investment decisions; they simply protect and administer the assets
• Services include:
  • Settlement: Completing the transfer of securities and cash after a trade
  • Record-keeping: Tracking holdings, transactions, and ownership
  • Reporting: Providing account statements and tax documents
• Typically large banking institutions (e.g., BNY Mellon, State Street, JPMorgan)

Exam Tip: Gotchas

• A custodian does not make investment decisions. It only holds and safeguards assets. If an exam question describes a firm that settles trades and provides account statements, that is a custodian, not an adviser.

What Do Market Makers Do?

• Market makers are dealers that stand ready to buy and sell specific securities during market hours, providing liquidity to the market, subject to excused-withdrawal exceptions (system failures, legal/regulatory requirements, holidays)
• They generally maintain continuous two-sided quotes during market hours, posting both a bid price (willing to buy) and an ask price (willing to sell), though the specific quoting standard varies by market (equity vs. options) and allows exceptions
• Profit from the bid-ask spread (buy at the bid, sell at the ask)
• On the NYSE, each listed security is assigned one Designated Market Maker (DMM), alongside other liquidity providers such as Supplemental Liquidity Providers and floor and electronic participants
• Nasdaq is fully electronic, with multiple competing market makers and other participants trading the same security simultaneously, which can tighten spreads through competition

Exam Tip: Gotchas

• Market makers profit from the spread, not commissions. If an exam question describes a firm that maintains an inventory and quotes both bid and ask prices, it is describing a market maker (dealer), not a broker.
• NYSE assigns one DMM per security; Nasdaq supports multiple competing market makers. The exam tests this distinction directly, though the DMM is not the only liquidity provider for its security.

What Are Exchanges?

• Exchanges are regulated marketplaces where securities are listed and traded
• Key examples: NYSE, Nasdaq, Cboe (Cboe Options Exchange, formerly the Chicago Board Options Exchange)
• Exchanges provide:
  • Price transparency: Disseminates displayed bid/ask quotes and trade information (some order types remain hidden from public view)
  • Order matching: Connecting buyers with sellers efficiently
  • Regulatory oversight: Enforcing trading rules and monitoring for manipulation
• Exchanges are self-regulatory organizations (SROs) that operate under SEC oversight

Exam Tip: Gotchas

• Exchanges are SROs, not government agencies. They write and enforce their own rules, but the SEC has ultimate oversight authority.

How Do These Roles Work Together?

One common path a trade can take involves all four roles, though an order can also match against another investor's order, execute internally at the broker-dealer, or route through an electronic venue without a market maker as counterparty:

1. Investor places an order with their broker-dealer
2. The broker-dealer routes the order to an exchange (or a market maker)
3. A market maker, if involved, provides liquidity by standing ready to take the other side
4. After execution, the custodian settles the trade and updates account records

What Should You Check on Exam Day?

• A broker-dealer acts as agent (broker, earns a commission) or principal (dealer, earns a markup or markdown), never both on the same transaction; custodians hold and safeguard assets and handle settlement, record-keeping, and reporting, but do not make investment decisions.
• Market makers are dealers that generally quote two-sided bid/ask prices during market hours and profit from the spread, not commissions.
• NYSE assigns one Designated Market Maker per security while Nasdaq has multiple competing market makers, and exchanges are self-regulatory organizations under SEC oversight, not government agencies.
• An introducing firm holds the customer relationship and takes orders but does not hold assets, settle trades, issue statements, or extend margin; the clearing firm does, and the customer must be told which is which.
• Fully disclosed means the clearing firm knows each customer's identity; omnibus means it sees only the introducing firm. Lower net capital requirements are the usual reason a firm introduces rather than clears.