Every investor who wishes to transact business in the securities market will need the services of a brokerage firm unless such an investor is a member of an organized exchange or a registered dealer in securities.
TYPES OF BROKERAGE FIRMS
Brokerage firms and dealers insecurities can be classified according to the three broad functions they perform. They function as:
Brokerage firms act as investment bankers because they sell securities to the public without using the facilities of an exchange. Investment bankers normally buy new issue from the issuer at an agreed price and hope to resell it at a higher price to the general public. In this capacity, investment bankers are said to underwrite an issue. Sales through an investment banker can take the form of best-efforts or agency agreement. In this case, the investment banker does not underwrite the issue but use his best effort to sell it. Any unsold securities will be returned to the issuer. This best-efforts activity will normally be used in the sale of new and small companies‟ shares that are thought to be highly risky.
As Buyers And Sellers Of Securities On Behalf Of Customers
A brokerage firm functions as a buyer and seller of securities for customers. It is this function that most brokerage firms are known by the investing public and the function with which the individual investor comes in contact with the broker. A broker trading in listed securities is acting as an agent on behalf of a client. Compensation for this service is in the form of commission. It is important that the brokerage firm exercises care and demonstrate a reasonable amount of skill in filling customers orders. The brokerage firm may be liable for any losses that result from its mistake.
The care with which brokerage firm issues orders is determined by what is reasonable practice in the brokerage business. The exercise of broker’s skill requires that instructions are followed and the order placed in the market where the securities are traded fastest possible time. The broker is required to refrain from making secret profits or crossing orders in its office by acting as both dealers and brokers in the same transaction. The brokerage firm cannot act as dealer and broker in the same transaction because there could be a conflict of interest and this could result in the client paying double commission. All Securities listed on an exchange must be traded on the floor of that exchange. They cannot be executed off the floor by the broker except in certain circumstances.
As Principal-Making Markets in Securities
The broker functions as a principal and makes markets in securities. The broker’s main principal activity is to bring sellers and buyers together. Thus, the brokerage firm is a middleman. As a true intermediary, brokers bring sellers and buyers together, thus creating a market. This is generally done through over-the-counter issue, but can also take place in listed securities. If the securities to be traded are not listed on an exchange but traded in over the-counter market, the broker might own the shares himself.He/she will be acting as a principal or dealer in the transaction. Many brokerage firms specialize in making a market in a certain securities. In this case the brokerage firm will sell the security to the customer at the asking price and will not charge a commission for handling the transaction. The brokerage firm makes its fee from the difference between the price it pays for the securities for its own account and the price it sells them to the investor. The difference between the asked and the bid price is called the spread and is the compensation for making a market in that security.