What you will learn
- Tell a broker from a dealer and explain why one is an agent while the other is a principal
- Describe how a market maker supplies liquidity and earns the spread
- Recognize when a firm is acting for you and when it is trading against you
- Explain payment for order flow and how a commission-free broker can still make money
Brokers, dealers, and market makers can sound like three names for the same job. They are not. Each one handles your trade differently, and each gets paid in a different way. As you read, keep one question in mind: is the firm working for you, or is it the firm on the other side of your trade?
How to pick a broker: investing for beginners (Investopedia)
See what a broker does for a customer and what to consider when choosing one. Pay attention to the broker's role as your agent.
A broker works for you
A broker is your agent. You give the broker an order, and it looks for someone else willing to take the other side. The broker does not fill the trade from its own inventory. Brokers traditionally charged a commission for this service. Many retail brokers now advertise zero commissions, but they still have other ways to earn money. We will look at one of them shortly.
A dealer trades with you
A dealer is a principal, so it trades for its own account. It keeps an inventory of securities, buys from you at its bid, and sells to you at its ask. The difference between those prices is the spread. In this case, the dealer is your counterparty: you trade with the dealer itself. Many large firms are broker-dealers. The same firm may act as your agent on one trade and as the principal on another.
Key terms
- Broker
- Your agent in a trade. It places your order but does not take the other side itself.
- Dealer
- A firm that trades from its own inventory. It is your counterparty and earns the spread.
- Market maker
- A dealer that continually posts both a buy price and a sell price, making it easier for others to trade.
- Payment for order flow
- Money a market maker pays a broker to handle the broker's customer orders.
A market maker posts both prices
A market maker is a dealer that continually quotes a price to buy and a price to sell. That standing offer gives the market liquidity because you do not have to wait for another investor to show up. The market maker usually earns a small spread on each trade and repeats that process across a huge number of trades. Without market makers, finding a counterparty would often take longer and be harder.
What is a market maker?
Watch how a market maker posts prices on both sides of a trade and earns the spread. Link that process to what you learned about liquidity and bid-ask spreads.
| Role | Whose account? | Your counterparty? | How the firm earns money |
|---|---|---|---|
| Broker | Acts for you as an agent | No. It finds one for you | Commissions or other fees |
| Dealer | Trades as a principal | Yes. You trade with the dealer | The bid-ask spread |
| Market maker | Trades as a principal and keeps quoting | Yes. It stands ready to trade | Small spreads across many trades |
A broker finds you a counterparty. A dealer is your counterparty. A market maker stands ready to be one on either side.
Who is doing the job?
Match each firm with the role it plays.
Who are you dealing with?
You place an order through an app. A firm keeps a buy price and a sell price posted, then fills your order from its own inventory. What role is the firm playing?
The firm is a market maker because it quotes both sides and fills the trade from its own inventory.How a zero-commission broker gets paid
Many commission-free brokers send customer orders to a large wholesale market maker. The market maker pays the broker for the chance to fill those orders. That arrangement is called payment for order flow. It is legal and common, but people debate it. A broker may have a reason to send your order to the firm that pays the most, which raises a fair question: did you get the best available price? A trade can have a cost even when the commission says zero.
Where does the money come from?
Your broker charges no commission but accepts payment for order flow. In two or three sentences, explain how the broker earns money and why the setup concerns some people.
Write an answer before comparing it with the model response.
Model answer
The broker sends customer orders to a market maker, which pays for the right to fill them. Some people worry that this gives the broker a reason to choose the highest-paying market maker instead of the venue offering customers the best price. The commission may be zero, but that does not mean the trade has no cost.
You can now tell who routes a trade, who fills it, and how each firm may get paid. The next lesson adds another piece: when these firms and markets are open for business.