FINRA Exam Prep – The Role of the Broker Dealer

In this article we are going to take a look at the role of broker-dealers who operate in the NASDAQ environment. 

If I were to ask you where NASDAQ is, it would be much the same as me asking you where is the internet– it’s nowhere and it’s everywhere. It’s a computer network throughout the world and throughout the country. So NASDAQ has no centralized location. It is a network of computers, terminals that connect broker dealers throughout the United States and throughout the world, and it facilitates the quoting and trading of securities listed on the NASDAQ stock market.

The role of the market maker is to display a simultaneous bid and offer for a security at all times. The market maker must display a two-sided quote and must be willing to buy the security or sell the security simultaneously. So they’re required to display both a bid and an ask or a bid and an offer for a security at all times. And that’s how quotes over the NASDAQ market are displayed.

Level I, level II, and level III are subscription services that allow information to be viewed by registered reps, order entry firms, and market makers as the case may be. Level I is what the registered rep sees. It contains the inside market. The inside market is the best market. It is the highest bid and the lowest ask published by all broker dealers throughout the land, whoever is willing to pay the highest price for the security, Will have their quote  displayed as the inside bid. Whoever is willing to sell the security at the lowest price, will have their quote displayed as the lowest ask or offer. the highest bid and lowest offer becomes the inside market. 

Because there is no centralized location for NASDAQ and there is no price discovery by a designated market maker, the NASDAQ system has implemented an opening cross where it will route orders prior to the opening to allow for price discovery and the uniform opening price. The NASDAQ official opening price, or NOOP, is established during the opening cross.

Similarly, the NASDAQ will close all of its stock on the close of the market based on the closing cross. And once again, this is a price discovery mechanism inside the NASDAQ network that will facilitate a uniform closing price for that security.

The third market or a third market transaction is a transaction in an exchange listed security affected over the NASDAQ workstation. The NASDAQ workstation provides broker-dealers with the ability to  execute orders for exchange-listed securities via the third Market.

If, for example, we take a look at the shares of IBM, the shares of IBM are listed primarily on the New York Stock Exchange. These shares are traded on the floor of the New York Stock Exchange and they are also traded over the NASDAQ computer system in the third market.

So a broker dealer may elect to execute an order for 100, 200, or 500 shares for IBM over the NASDAQ computer because they find it easier, quicker, or cheaper than executing that order on the floor of the New York Stock Exchange. Lets try to clarify this concept by giving you a little bit of a real world example.

Let’s say you know you want to purchase two new shirts and you want to purchase them from Nordstrom, so you know exactly what you want, the size and the color, and you have the opportunity to either drive down to the mall and go to Nordstrom’s, pick up the shirts, pay for them, and leave, or you can go onto Nordstroms.com, pick out the shirts, pay for them, and have them delivered to your house. You will probably decide to purchase the shirts in the most convenient way possible. If you have no other particular reason to go to the mall, you will most likely elect to purchase the shirts nordstrom.com. if the broker-dealer could purchase the shares of IBM more quickly or easily over the NASDAQ workstation the broker-dealer will elect to execute the order for IBM in the third Market. So that’s much the reasoning behind why a broker dealer would elect to execute a transaction in exchange listed security over the counter. A third market transaction is nothing more than a transaction over the NASDAQ workstation when the security involved is primarily listed on the New York Stock Exchange.

Now let’s take a look at the fourth market. A fourth market transaction is a transaction between two large institutions without the use of a broker dealer. So a large pension fund could buy 1 million shares of XYZ from a large insurance company directly through a computer system, known as Instanet, or through other various computer systems, directly without the use of the broker dealer. Neither the pension fund nor the insurance company are broker dealers, and they’re simply trading securities among themselves. So that is a pretty good review for your exam of the third market and the fourth market.

Now we need to take a look at two other facilities available to trade securities. They’re the OTC bulletin board or OTCBB and the Pink OTC. The securities that trade on these two networks are  not listed securities, these are not exchanges. These are electronic venues where shares of unlisted securities trade.

Now shares that trade on the OTC bulletin board are pretty low quality and there are no requirements for the issuers whose stock trade there other than they file 10-Ks and 10-Qs, annual and quarterly reports respectively. If the company files 10-Ks and 10-Qs, The stock can trade on the OTC bulletin board. It’s pretty risky stuff, rarely if ever an appropriate recommendation for anyone.

Now, the Pink OTC is another electronic marketplace where shares of unlisted securities trade, and there are no listing requirements whatsoever for their company’s stock to trade there. Shares trading below $5 that have their shares exchanged or traded on the OTC bulletin board or on the Pink OTC are known as penny stocks and are usually too risky for retail investors because they are companies that are either just starting out and haven’t really done anything or companies that were once great and have been delisted from the New York Stock Exchange or from the NASDAQ market and they are kind of on their way to bankruptcy, so to speak. You do want to know that any quote priced on the OTC bulletin board or the Pink OTC is a firm quote, meaning the person who displayed that quote is liable to execute the orders presented to it at those prices.

The term broker dealer– Morgan Stanley’s a broker dealer, JP Morgan’s a broker dealer, Merrill Lynch is a broker dealer, Raymond James is a broker dealer. What does this term broker dealer mean? Well, the term broker dealer refers to the two capacities in which these firms may act.

The firm may act as a broker for the customer, and they simply execute the customer’s order and they charge them a fee. They act as the customer’s agent when buying or selling securities on behalf of the customer. A dealer acts as a principal and charges the customer a profit, known as a mark up or mark down, on the transaction.

When a broker dealer is acting in the capacity of a dealer, it’s trading for its own account. If the customer wants to buy the security, the firm is selling that security to the customer. If the customer wants to sell the security, the broker dealer is acting as a principal and buying that security from the customer.

So the dealer acts as principal, charges a profit, and participates in the transaction with the customer, effectively taking the other side to the transaction– perfectly legitimate. A broker merely executes the customer’s order and charges the customer a fee known as a commission. They act as the individual’s agent.

Now if someone lists their house for sale, they enter into an agreement with a real estate broker, and their real estate broker finds someone who wants to buy their house from them. When they sell their house, they charge them a commission or a fee. The real estate company does not buy the person’s house from them– they merely find someone who wants to buy the house from them. So that’s a little bit of a real world example of someone acting as a broker or as an agent.

If you’ve ever seen in the internet listings for homes for sale, home for sale by owner “principals only”, it means they only want to talk to the person that is going to actually buy the house, and participate in the transaction,  So that would be in a dealer capacity, so the term broker dealer refers to the two capacities in which a firm can act in representing the customer’s order or in transacting business with the customer. They cannot act as both an agent and a dealer or both a broker and a dealer in the same transaction– it is one or the other.

Let’s take a look at some guidelines regarding the fairness of commissions and markups and markdowns. FINRA considers a markup or markdown or a commission of 5% of the value of the transaction to be a good guideline to determine what is reasonable. So if an investor was selling 1,000 shares of stock at $10 per share, that would be a $10,000 investment and FINRA figures that a $500 commission would be a fair and reasonable amount to charge a client in light of the services charged by a broker dealer.

Now keep in mind, this is a guideline, it’s not a hard fast rule, and there are certain exemptions that you want to be on the lookout for. One of the things that’s exempt from the 5% markup policy is anything that is being offered under a prospectus. Anything offered under a prospectus, such as an open end mutual fund or an offering of securities, is exempt from the 5% markup policy because the commissions and charges are all detailed in the prospectus.

Another exemption from the 5% markup policy would be a scenario where someone wanted to buy 1,000 shares of a $1 stock. If someone wants to buy 1,000 shares of a stock at $1 and your firm’s minimum commission is $100, well, that would represent 10% of the order value, but FINRA feels that because of the low dollar value of the transaction, your firm’s minimum commission in that scenario would not be a violation.

A similar scenario would exist when perhaps a new grandmother wants to buy five shares of Disney for their new granddaughter. Five shares of Disney would be worth approximately $500, and if your firm’s minimum commission was $100, well, that would be in the boundaries of the rules and would be not seen as a violation of the rules of fair practice and the 5% markup policy.

A special situation can arise with a transaction known as a riskless principal transaction, we need to take a look at the riskless principal transaction to ensure you understand the rules for your upcoming exam.. An example of a riskless principal transaction would be where a broker dealer receives a customer’s order to buy a security  and the broker-dealer purchases the stock for their own account merely to fill the customer order it already has.. Perhaps a customer enters in order to buy the stock and the broker dealer goes into the marketplace when the stock is $10 bid and it’s offered at $10 15.

If the broker dealer was successful in buying the shares of stock in the middle, maybe they buy the shares of stock at $10.10, and they take those shares into their own account, only to immediately sell  the shares to a customer, the broker dealer is not taking on risk and the markup needs to be based on the broker dealer’s actual cost in this scenario. So the 5% markup policy on a riskless principal transaction is always going to be based on the broker dealer’s actual cost in this scenario.

Now another special situation can arise with a proceeds transaction– with a proceeds transaction, the customer wants to liquidate one stock and use those proceeds on the same day to purchase stock of another company. So if a customer calls up and wants to sell 10,000 shares of XYZ and use those funds to buy $10,000 worth of another security, you could charge that customer 2 and 1/2% on the sale side and 2 and 1/2% on the buy side, but you couldn’t charge them 5% on the sale and 5% on the buy because that would represent 10% of the total value of that particular transaction.

So the proceeds transaction, the entire amount may only amount up to 5% of the total, not 5 and 5. It could be zero on the sell side and 5 on the buy side, or 5 on the sell side and zero on the buy side, but the total amount cannot exceed 5% 

This has been an excellent review of the role of the broker-dealer when transacting business over the NASDAQ Market. This article provides the foundation for the information you will need to know for most FINRA exams.

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