Dealer

Holding inventory carries risk. A dealer that buys a block of stock at fifty dollars and later finds the market has fallen to forty-eight dollars bears that loss itself. A dealer that sells a security it does not yet own, expecting to buy it back, bears the risk that the price will rise first. This is a basic difference from a broker, whose compensation does not depend on whether the security rises or falls after the trade.

Dealers quote prices in two directions. A dealer states a bid, which is the price at which it will buy, and an ask, which is the price at which it will sell. The ask is higher than the bid, and the difference between them is called the spread. When a customer sells to the dealer, the dealer pays the lower price. When a customer buys from the dealer, the dealer charges the higher price. The spread compensates the dealer for providing the market and for carrying inventory risk.

The Statutory Definition

The definition appears in Section 3(a)(5) of the Securities Exchange Act of 1934. In general terms, a dealer is any person engaged in the business of buying and selling securities for that person's own account, through a broker or otherwise. The definition does not capture everyone who ever buys or sells a security. Two groups are excluded from it. The first is banks, which have historically been excepted, although that exception is now subject to limits added by the Gramm-Leach-Bliley Act. The second is a person who buys or sells securities for its own account, either individually or in a fiduciary capacity, but not as part of a regular business.

The second exclusion is the one that separates a dealer from an ordinary investor or trader. An individual who buys shares of a company for a personal brokerage account is trading for the individual's own account, but is not engaged in the business of dealing. The statute turns on regularity and on whether the activity is a business. This entry returns to that point below, because it has been the subject of recent litigation.

The statute defines a broker separately. A broker is any person engaged in the business of effecting transactions in securities for the account of others. Placing the two definitions side by side makes the structural difference clear. A broker works for the account of others. A dealer works for its own account.

Dealer Versus Broker

The difference between a dealer and a broker is the difference between a principal and an agent. A broker is an agent. It receives an order from a customer, finds a counterparty or routes the order to a market, and charges a commission for the service. The securities involved belong to the customer, and the broker does not take title to them as part of the service. A dealer is a principal. It buys from the customer or sells to the customer out of its own inventory, and it takes title to the securities. Its compensation is built into the price rather than charged as a separate commission.

Several practical differences follow. The first concerns risk. A broker is not exposed to price changes in the securities it handles for customers, while a dealer is exposed to price changes in its inventory. The second concerns pay. A broker is paid a commission, while a dealer is paid through a markup or a markdown, which this entry describes below. The third concerns the position of the firm relative to the customer. When a firm acts as a broker, it is working on the customer's side of the trade. When it acts as a dealer, it is on the other side of the trade from the customer, and its interest in the price is opposed to the customer's interest in the price. That opposition is the reason rules governing fair pricing, trade disclosure and customer order handling apply with particular force to dealer activity.

A single firm can act in either capacity. A firm may execute one customer's order as a broker, charging a commission, and fill another customer's order as a dealer, selling from its own inventory at a marked-up price. The term broker-dealer describes a firm that is registered to do both. The capacity is determined trade by trade, and the firm has to tell the customer which capacity it used.

How a Dealer Earns Money

A dealer's income comes from three related sources. The first is the spread between its bid and its ask. A dealer that buys at the bid and later sells at the ask keeps the difference, less the cost of carrying the position.

The second is the markup. When a dealer sells a security to a customer from its own account, the markup is the amount by which the price charged to the customer exceeds the prevailing market price of the security. The third is the markdown. When a dealer buys a security from a customer for its own account, the markdown is the amount by which the price paid to the customer falls below the prevailing market price. A markup and a markdown are two views of the same compensation, one when the customer buys and one when the customer sells.

A hypothetical shows how the numbers work. Suppose the prevailing market price of a stock is twenty dollars per share, and a dealer sells one hundred shares to a customer at twenty dollars and fifty cents per share. The markup is fifty cents per share, or fifty dollars on the transaction. Whether that markup would be fair would depend on all of the circumstances described below. This is an illustration only and does not describe any actual firm or trade.

The profit is not a hidden element of the arrangement. The principle is built into the fair pricing rule. FINRA Rule 2121, titled Fair Prices and Commissions, provides that if a member buys for its own account from its customer, or sells for its own account to its customer, the member must buy or sell at a price that is fair, taking into consideration all relevant circumstances. Those circumstances include market conditions with respect to the security at the time of the transaction, the expense involved, and the fact that the member is entitled to a profit. The rule treats a dealer's profit as legitimate, but it requires that the price remain fair.

What Makes a Markup Fair

Rule 2121 does not set a fixed percentage. Its Supplementary Material states that the question of fair markups and spreads has been raised since the earliest days of the National Association of Securities Dealers, that no definitive answer can be given, and that what is fair in one transaction could be unfair in another because circumstances differ.

The Supplementary Material does give a guide. The so-called five percent policy is described as a guide, not a rule, and a markup pattern of five percent or even less may be considered unfair or unreasonable. The markup is measured over the prevailing market price, and the Supplementary Material states that a member's own contemporaneous cost is the best indication of the prevailing market price. In other words, if a dealer buys a security at a certain price and sells it to a customer moments later, the dealer's own purchase price is the starting point for judging how much it added.

The Supplementary Material lists factors that bear on whether a markup is fair. These include the type of security, since a higher percentage markup customarily applies to a common stock transaction than to a bond transaction; the availability of the security, since the effort and cost involved in an inactive security may justify a higher markup; the price of the security, since the percentage generally increases as the price decreases; the amount of money involved, since a small transaction may warrant a higher percentage; the pattern of the member's markups; and the nature of the member's business, including the cost of providing services. The Supplementary Material also states that disclosure does not by itself justify a markup that is unfair or excessive. A dealer cannot cure an excessive markup by telling the customer about it.

Telling the Customer Which Capacity Applies

Because the capacity of the firm affects the customer's interests, the federal confirmation rule requires disclosure. SEC Rule 10b-10 requires a broker-dealer to give or send a customer written notification at or before the completion of a transaction. The notification has to state, among other things, whether the broker-dealer is acting as agent for the customer, as agent for some other person, as agent for both the customer and some other person, or as principal for its own account. If the broker-dealer is acting as principal, the notification must also state whether it is a market maker in the security, other than by reason of acting as a block positioner. A customer reading a confirmation should therefore be able to tell whether the firm was working for the customer or trading against the customer.

The rule also addresses the markup in a particular kind of principal transaction. Under paragraph (a)(2)(ii)(A) of Rule 10b-10, where a broker-dealer that is not a market maker in an equity security receives a customer's order and then buys or sells the security with another person to offset a contemporaneous sale to or purchase from the customer, the confirmation must disclose the difference between the price to the customer and the broker-dealer's contemporaneous purchase or sale price. Other principal transactions in NMS stocks, and in certain other equity securities, carry their own pricing disclosures under paragraph (a)(2)(ii)(B). These provisions give the customer information with which to judge the dealer's compensation.

Market Makers as Dealers

A market maker is a dealer that holds itself out as willing to buy and sell a particular security for its own account on a regular or continuous basis. By posting a bid and an ask and standing ready to trade at them, it supplies liquidity to the market. The important point for this entry is that market making is dealer activity. The SEC's guide to broker-dealer registration states that a firm that advertises publicly that it makes a market in securities is obviously a dealer. A market maker holds inventory, trades for its own account and profits from the spread, which are the defining features of a dealer.

Market makers are subject to the same fair pricing and firm quotation principles as other dealers, and the firm quotation rule described below applies directly to the prices they publish.

Firm Quotations

A dealer's published price is a commitment. FINRA Rule 5220, titled Offers at Stated Prices, provides that no member shall make an offer to buy from or sell to any person any security at a stated price unless the member is prepared to purchase or sell at that price and under the conditions stated at the time of the offer. That rule is the basis for the regulatory treatment of backing away, which means failing to honor a quotation. Its Supplementary Material states that a member making a firm trading market is expected, under normal circumstances, to buy or sell at least a normal unit of trading at its prevailing quotations, unless the quotation was clearly designated as not firm or as firm for less than a normal unit when supplied.

Fair Treatment of Customer Orders

A dealer trades for its own account, and a customer who sends an order to a firm that is also a dealer is dealing with a firm that has its own position and its own interest. Several FINRA rules address the resulting conflicts.

FINRA Rule 5310, titled Best Execution and Interpositioning, requires that in any transaction for or with a customer, a member use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resulting price to the customer is as favorable as possible under prevailing market conditions. Paragraph (a)(2) of that rule adds that no member or person associated with a member shall interject a third party between the member and the best market for the security in a manner inconsistent with paragraph (a)(1).

FINRA Rule 5320, titled Prohibition Against Trading Ahead of Customer Orders, addresses the most direct conflict. A member that accepts and holds a customer order in a security is prohibited from trading that security on the same side of the market for its own account at a price that would satisfy the customer order, subject to the exceptions in the rule. The rationale is plain. A dealer that sees a customer's order to buy at a given price should not buy for itself first at that price and leave the customer unfilled.

Alongside these specific rules sits FINRA Rule 2010, which requires members, in the conduct of their business, to observe high standards of commercial honor and just and equitable principles of trade. A dealer that engages in conduct that violates other FINRA rules can also be found to have violated this general standard.

The Dealer and the Trader

The statute excludes a person who buys or sells securities for its own account, either individually or in a fiduciary capacity, but not as part of a regular business. That exclusion is commonly described as the trader exception. A trader trades for its own account but does not meet the definition of a dealer, because the activity is not part of a regular business of dealing. The SEC's guide to broker-dealer registration describes the key factor that separates the two as the regularity of the activity: a dealer is engaged in the business of buying and selling securities, while a trader is not.

The line matters because dealers have to register. Section 15(a)(1) of the Exchange Act makes it unlawful for a broker or dealer to use the mails or any means of interstate commerce to effect transactions in, or to induce or attempt to induce the purchase or sale of, securities unless the broker or dealer is registered. Section 15(b)(8) requires a registered broker-dealer to become a member of a self-regulatory organization before it begins business, and for most broker-dealers that organization is FINRA. A dealer that is required to register but has not done so is in violation of the statute, so deciding who is a dealer is a question with legal consequences.

The 2024 Dealer Rule and Why It Was Vacated

The SEC attempted to clarify the line in 2024. In February 2024 the Commission adopted Exchange Act Rules 3a5-4 and 3a44-2, which further defined the phrase as part of a regular business in the definitions of dealer and government securities dealer. The rules were aimed at market participants that take on significant liquidity-providing roles and engage in trading consistent with de facto market making. Under the rules, a person engaged in the described activity would have been treated as a dealer and required to register and join a self-regulatory organization.

The rules did not take effect. On November 21, 2024, the United States District Court for the Northern District of Texas, in a decision by Judge Reed O'Connor, vacated them in National Association of Private Fund Managers v. Securities and Exchange Commission and in a companion case brought by the Blockchain Association and the Crypto Freedom Alliance of Texas. The court held that the SEC had exceeded its statutory authority, reasoning that the Commission had disregarded the long-standing distinction between brokers and dealers that existed when the Exchange Act was enacted. The SEC later voluntarily dismissed its appeals in February 2025.

The practical result is that the statutory definition and the traditional regular-business analysis continue to govern the question. The expanded rules do not apply. A reader studying the definition of dealer should know both the 2024 effort and its outcome, because it shows how contested the boundary between a dealer and a trader remains.

Registration and Oversight

A dealer that falls within the statutory definition registers with the SEC under Section 15 of the Exchange Act and joins a self-regulatory organization. For most dealers that organization is FINRA, which writes and enforces rules for member firms and their associated persons. Dealers dealing in particular markets are also subject to the rules specific to those markets. Municipal securities dealers are subject to the rules of the Municipal Securities Rulemaking Board, and government securities dealers are subject to the separate framework that applies to the government securities market.

Dealers are also subject to financial responsibility requirements. SEC Rule 15c3-1, the net capital rule, sets minimum net capital requirements for broker-dealers. Because a dealer commits its own capital to inventory, the level of that capital is a matter of regulatory concern.

A Worked Example

Consider a hypothetical firm that is registered as a broker-dealer. A customer calls and asks to buy one hundred shares of a thinly traded stock. The firm has no matching sell order, but it holds shares in its own inventory. It sells the shares to the customer from that inventory at thirty dollars and twenty cents per share. The firm had bought those shares shortly before at thirty dollars per share, and that cost is a reasonable measure of the prevailing market price. The markup is twenty cents per share, which is about two thirds of one percent of the price.

In this transaction the firm acted as a dealer. It was a principal, the shares came from its own account, and its compensation was the markup rather than a commission. The confirmation sent to the customer should state that the firm acted as principal. The price would need to satisfy the requirement of FINRA Rule 2121 that it be fair, taking all relevant circumstances into account. If instead the firm had received the customer's order first and then bought the shares from another person to offset the sale, and the firm was not a market maker in the stock, the confirmation would also have to disclose the difference between the customer's price and the firm's contemporaneous purchase price under paragraph (a)(2)(ii)(A) of the SEC's confirmation rule.

Now change the facts. The customer asks the firm to buy the same shares in the market, and the firm finds a seller, completes the purchase on the customer's behalf and charges a commission. The firm acted as a broker. It was an agent, the shares never entered its inventory, and its compensation was the commission. The same firm acted in two different capacities on two different days. This hypothetical illustrates the concept only and does not describe any actual firm or trade.

Common Misunderstandings

One misunderstanding is that a dealer is simply a large broker. The two are defined by capacity, not by size. A small firm that trades from its own inventory is acting as a dealer, and a large firm that executes only customer orders for a commission is acting as a broker.

A second misunderstanding is that an ordinary investor who trades frequently becomes a dealer. The statutory exclusion for persons who trade for their own account but not as part of a regular business is the source of the distinction. A person who trades for the person's own account is not automatically a dealer, and whether frequent trading crosses the line depends on whether it amounts to a business of buying and selling securities.

A third misunderstanding is that a markup is improper in itself. Rule 2121 states that a member is entitled to a profit. What the rule requires is that the price be fair under all the relevant circumstances, and that is a question of degree and pattern, not an on-off test.

Key Points

A dealer buys and sells securities as a principal, for its own account, as part of a business. The Securities Exchange Act of 1934 defines the term in Section 3(a)(5) and excludes banks and persons who trade for their own account but not as part of a regular business.

A broker acts as an agent for the account of others and is paid a commission. A dealer acts as a principal and is paid through the spread, the markup or the markdown. A firm that is registered as a broker-dealer can act in either capacity, trade by trade.

FINRA Rule 2121 requires a dealer's price to a customer to be fair, and recognizes that the member is entitled to a profit. SEC Rule 10b-10 requires the confirmation to tell the customer whether the firm acted as agent or principal. FINRA Rule 5220 holds a dealer to the quotations it publishes. A dealer must register under Section 15 of the Exchange Act and join a self-regulatory organization. The SEC's 2024 attempt to broaden the definition through Rules 3a5-4 and 3a44-2 was vacated by a federal court in November 2024, and the SEC dropped its appeal in February 2025.