Broker-dealers play a key part in the stock market, which means they have significant responsibilities and regulatory requirements.

We’ve created a comprehensive overview for brokers that are looking for a need-to-know guide on the need-to-areas of broker-dealer regulation. 

In this article, we will cover: 

  • Why broker-dealer regulations are important
  • SEC, FINRA, and their respective registration processes for dealer-brokers
  • The Securities Act of 33’, The Securities Exchange Act of 34, and what the legislation means for dealer-brokers
  • AML and KYC under SEC, with insight on potential compliance challenges for dealer-brokers 
  • Capital requirements and financial responsibility for dealer-brokers

Why are broker-dealer regulations important?

Stock broker-dealer regulations help maintain the integrity and stability of the stock market. 

Regulatory oversight ensures that brokers act in the best interests of investors and adhere to ethical practices. 

By setting standards for transparency, disclosure, and fair dealing; regulations promote investor trust and confidence. 

They also prevent market manipulation, insider trading, and fraudulent activities, along with enhancing the overall efficiency and resilience of the stock market, reducing systemic risks, and protecting investors. 

Registration & licensing for stock brokers: SEC & FINRA explained 

Let’s review the primary regulatory bodies overseeing broker-dealers, including their registration requirements for brokers. 

Securities Exchange Commission (SEC)

The SEC is a regulatory agency in the United States responsible for overseeing the securities industry. 

The SEC enforces federal securities laws, regulates key market participants, such as exchanges and broker-dealers, and ensures compliance with disclosure requirements.

Stock broker-dealer registration with the SEC

  1. Eligibility criteria

Before becoming a registered broker-dealer with the SEC, firms must meet specific eligibility criteria. 

These criteria typically include a minimum level of net capital, reputation, and employing qualified personnel.

  1. Application process

The application process for SEC registration involves submitting various forms and documentation, including detailed information about the firm’s business operations, ownership structure, financial condition, and regulatory history. 

Additionally, background checks on key personnel may be conducted to evaluate their qualifications and integrity.

  1. Ongoing compliance requirements

Registered broker-dealers are subject to ongoing compliance requirements enforced by the SEC. 

These requirements are designed to ensure that broker-dealers continue to operate in a manner that is fair, transparent, and in the best interest of their clients. 

Compliance obligations may include maintaining accurate and up-to-date records, conducting regular financial and operational audits, and filing reports with the SEC. 

Broker-dealers must demonstrate that they have implemented robust supervisory systems and procedures to monitor and address potential compliance issues. 

Financial Industry Regulatory Authority (FINRA)

FINRA is a self-regulatory organization (SRO) in the United States that oversees and regulates brokerage firms and registered securities professionals. 

It is a non-governmental organization authorized by Congress to protect investors and ensure the integrity of the securities industry. 

FINRA’s main responsibilities include enforcing compliance with securities laws, establishing rules and regulations for its members, and administering qualification exams for professionals working in the securities industry. 

FINRA conducts examinations, investigations, and disciplinary actions to enforce its rules and protect investors from fraudulent activities. 

The regulatory body also provides investor education and resources to promote informed decision-making. 

Stock broker-dealer registration with FINRA

  1. Membership process

The membership process with FINRA is an essential step for broker-dealers seeking to operate in the United States. 

The membership involves a comprehensive application and review process to ensure that firms meet the necessary regulatory requirements. 

Broker-dealers must submit detailed information about their business operations, ownership structure, financial condition, and key personnel. 

FINRA conducts thorough background checks and assesses the firm’s compliance history and qualifications. 

  1. Continuing education and qualification exams

Continuing education and qualification exams are critical to FINRA’s commitment to maintaining high professional standards in the securities industry. 

FINRA requires registered securities professionals to participate in ongoing education and training programs to keep their knowledge and skills up to date. This ensures that professionals remain well-informed about regulatory changes, industry best practices, and investor protection measures.

FINRA administers qualification exams such as the Series exams, which assess the competence and expertise of individuals entering the industry or pursuing specific roles. 

  1. Supervision and compliance obligations

Broker-dealers are required to establish and maintain robust supervisory systems and procedures to ensure that their operations are conducted in accordance with legal and ethical standards. 

FINRA conducts routine examinations and inspections to evaluate firms’ compliance with regulatory requirements, ensuring that they adhere to fair dealing practices, maintain proper records, and address any issues promptly. 

Broker-dealer legislation: What are the 33’ and 34’ Securities Acts? 

Securities Act of 1933

The introduction of the Securities Act of 1933 followed the stock market crash of 1929, also known as Black Tuesday. A speculative boom and market bubble caused the crash. 

The Securities Act of 1933, also known as the “Truth in Securities Act” or the “Federal Securities Act,” was enacted to restore investor confidence and promote fair and transparent practices in the securities market.

The 1933 Act requires companies issuing securities to register with the Securities and Exchange Commission (SEC) and disclose essential financial and business information through a prospectus. 

This registration process ensures that investors have access to relevant information before making investment decisions, reducing the risk of fraudulent activities and misrepresentations.

The Securities Act imposes strict liability for false or misleading statements in the offering documents. This holds companies accountable for the accuracy and completeness of the information provided to potential investors. 

Learn more about the Securities Act of 1933 on the SEC’s website here.

Securities Exchange Act of 1934

The Securities Exchange Act of 1934 expanded upon the initial regulatory framework established by the Securities Act of 1933. 

The act aimed to establish comprehensive regulation and supervision of the securities industry, with the creation of the Securities and Exchange Commission (SEC) as its central regulatory body.

The act introduced various provisions to achieve its goals:

  • Mandated the registration of securities exchanges, brokers, and dealers, ensuring they adhere to regulatory requirements and standards. 
  • Imposed reporting obligations on publicly traded companies, requiring them to disclose essential financial information periodically. 
  • Addressed insider trading, prohibited manipulative and fraudulent activities, and established rules for tender offers and proxy solicitations.

Review the full SEC Securities Exchange Act here. 

What are the implications of the Securities Acts for dealer-brokers? 

Anti-fraud provisions

Six anti-fraud provisions fall under the Acts (Securities Act of 1933, and the The Securities Exchange Act of 1934). 

  1. The duty to disclose all material information obliges companies to provide the information required by the SEC and any additional data that prevents the company’s statements from being misleading.
  2. Liability for false and misleading statements establishes accountability for inaccurate and deceptive statements in documents submitted to the SEC.
  3. Exchange Act section 10(b) and Rule 10b-5 broadly prohibit fraudulent and deceptive practices and untrue statements or omissions of material facts in connection with the purchase or sale of any security. Unlike Section 18, these provisions apply to any information released to the public by the issuer and its subsidiaries, including press releases and annual and quarterly reports to shareholders.
  4. Executive officer certification of reports and financial statements has a wide scope, forbidding fraudulent and deceptive practices, as well as the withholding of crucial facts, concerning the buying or selling of any security. In contrast to Section 18, they extend to all information disclosed to the public by the issuer and its subsidiaries, encompassing press releases and regular reports to shareholders, such as annual and quarterly filings.
  5. Control person liability means that a person who exercises control over an individual held accountable under the SEC’s laws may share joint and several liabilities and be held equally responsible for violations of the Exchange Act or the Securities Act, just like the controlled individual.
  6. Liability for securities offerings pertains to any significant misrepresentations or omissions associated with registered offerings. The Securities Act forbids the use of any prospectus that fails to meet the SEC’s stipulated requirements. Additionally, it prohibits any registered sale of a security unless the security is preceded or accompanied by a prospectus that fulfills the SEC’s requirements. 

The official and full regulatory protections that include anti-fraud provisions can be found here.

Suitability requirements

When a broker advises clients to purchase or sell a specific security, they must have a reasonable basis to believe that the recommendation is suitable for a client’s circumstances. 

To make this assessment, a broker takes into account factors such as a client’s income, net worth, investment goals, risk tolerance, and existing holdings of securities.

The major self-regulatory organizations in the securities industry have established suitability rules. You can find FINRA’s suitability rule here.

Stock brokers must recommend investments that are suitable for their clients’ financial circumstances, investment objectives, and risk tolerance. 

This obligation ensures that brokers make recommendations aligned with their client’s needs and objectives, preventing the sale of unsuitable or overly risky investments.

Best execution obligations

Best execution mandates that brokers execute client orders in a way that achieves the most favorable terms reasonably available under the prevailing market conditions.

This means brokers should seek to obtain the best possible price, speed, and likelihood of execution for their clients’ trades. 

While brokers are not required to get the absolute best price for every trade, they must demonstrate a diligent effort to secure the most advantageous terms possible.

Brokers are also expected to consider factors such as transaction costs, market liquidity, and the size of the order when seeking the best execution.

AML and KYC (SEC) explained

Let’s take a look at Anti Money Laundering (AML) and Know Your Customer (KYC) regulations, and explore what they mean for dealer-brokers under the SEC rules. 

What are AML and KYC regulations? 

AML regulations establish and implement policies and procedures to detect and report suspicious activities related to money laundering and other financial crimes. 

KYC regulations are integral to the broader framework of securities regulations. They emphasize the importance of broker-dealers having reasonable policies and procedures to verify the identity of their customers. 

What are the key areas of AML and KYC under the SEC rules? 

Customer Identification Program (CIP)

SEC Rule 17a-8 mandates broker-dealers to implement a comprehensive CIP to verify the identity of customers. The CIP should include procedures for collecting customer information, checking against government-issued identification, and maintaining records of the verification process.

Suspicious Activity Reporting (SAR)

Broker-dealers must establish and implement policies and procedures for detecting and reporting suspicious activities. The filing of SARs is essential when broker-dealers have reason to believe that a transaction or series of transactions may involve illicit activities.

Record-keeping

Broker-dealers must maintain and preserve certain records, including customer identification information and transaction history. Compliance with record-keeping requirements is crucial for audits and regulatory examinations.

Robust risk assessment

Broker-dealers should assess the risk associated with each customer and transaction, focusing on high-risk clients who may require enhanced due diligence.

Complying with AML and KYC regulations: The challenges 

Complying with these regulations can be challenging, especially due to technological advances, global operations, and cost implications. 

Brokerages must navigate these challenges strategically and prioritize high-impact compliance measures while optimizing operational processes to ensure sustainable compliance and maintain a reputation for integrity and customer trust.

Failing to comply with AML and KYC regulations is like opening a can of worms for financial institutions, especially stock brokerages. 

The severe consequences can lead to regulatory penalties, substantial fines, license revocation, and legal action. Moreover, it can damage the institution’s reputation, leading to a loss of trust, negative publicity, and diminished client relationships.

Broker-dealers may wish to proactively consider the following: 

Technological advances

  • Data security concerns: The sensitive nature of customer information and transaction data calls for stringent measures to prevent unauthorized access, data breaches, and cyber threats.
  • Integration challenges: Brokerages often face the challenge of seamlessly integrating new technologies for AML and KYC compliance with their existing systems. Incompatibility with legacy systems can lead to a disjointed and non-interoperable framework, posing significant challenges to maintaining operational efficiency and data accuracy.

Global operations

The diversity of regulatory frameworks across different jurisdictions demands a nuanced understanding of local requirements. 

Brokerages must establish scalable and adaptable compliance protocols that can accommodate the intricacies of each region while ensuring a unified approach to global standards.

Alignment with global standards involves staying up-to-date with international regulatory developments, participating in collaborative efforts with global financial institutions, and proactively adjusting internal compliance procedures to reflect emerging best practices.

Cost implications

Establishing and maintaining a robust compliance infrastructure, implementing advanced technological solutions, and conducting thorough due diligence contribute to the overall costs. Striking a balance between allocating adequate financial resources for compliance and maintaining competitiveness in a highly dynamic market requires strategic planning. 

Brokerages must carefully weigh compliance costs against the benefits of maintaining a reputation for integrity and fostering customer trust.

The costs associated with hiring skilled compliance professionals, investing in technology, and conducting regular audits can strain budgets. Strategic resource allocation is critical to prioritizing high-impact compliance measures while optimizing operational processes to ensure sustainable compliance without undue financial strain.

Capital requirements and financial responsibility for dealer-brokers

In this section, we’ll explore what’s required of stock brokerages in terms of capital and their financial responsibility.

Net capital rule

All brokers and dealers registered with the SEC under Section 15(b) of the Securities Exchange Act of 1934 must comply with this rule to ensure uniform net capital standards across the board. 

This liquidity standard applies to almost all registered broker-dealers, except broker-dealer’s holding companies or unregulated subsidiaries or affiliates.

The goal of this regulation is to ensure that registered broker-dealers always hold a sufficient amount of readily available assets for two purposes:

  1. To promptly meet their obligations, i.e. customer claims, debts to creditors, and obligations to other broker-dealers.
  2. To act as a safety net of liquid assets with liabilities, to provide a buffer against potential market, credit, and other risks that might require asset liquidation.

To fulfill this objective, the regulation employs a liquidity assessment. 

Broker-dealers are required to maintain either a specific minimum monetary value or a specified percentage of their net capital. 

This requirement is calculated concerning two key metrics: aggregate indebtedness, which encompasses all of the broker-dealer’s liabilities, or customer-related receivables, representing funds owed to the broker-dealer by its customers, as determined by the reserve requirements laid out in Rule 15c3-3. 

If you’d like to know how broker-dealers calculate their net capital, follow this link.

Customer protection rule

This rule restricts how broker-dealers can use customer securities and funds.

The rule can be broken into two parts:

  1. Physical possession or control of all fully paid and excess margin customer securities

Broker-dealers need to physically hold the securities in a place where they can be identified as belonging to the customer and not the broker-dealer.

The word ‘control’ refers to securities being held by a broker-dealer at certain specified locations, for example, a clearing agency or a bank.

Fully paid securities are securities in a customer’s account that have been completely paid for, while excess margin securities are those that have a value above the total loan value on margin.

Broker-dealers are required to conduct daily computations to determine if they comply with the possession or control requirements, and if they determine that they are not in possession or control of certain securities, they are required to initiate procedures to get possession or control of them.

  1. Segregation of customer assets

Broker-dealers must keep customer securities and funds completely separate from their own. 

This separation ensures that the assets are protected and can be returned to the customers if the broker-dealer faces financial difficulties or goes bankrupt.

Regulatory reporting and auditing

Broker-dealers must submit:

  1. Regular reports to regulators detailing the status of customer account segregation
  2. Computation records that show they have enough funds to repay customers
  3. Documents to demonstrate their compliance with the SEC’s financial responsibility rules.

Conclusion 

To be prepared for broker-dealer regulations, brokers need to cover a lot of ground. 

Although it can seem overwhelming, there is plenty of information available so that you can work through the obligations step by step. Proactive adherence benefits everyone in the industry, from the brokers to the traders, and all the providers in between. 

Devexperts has more than 20 years of experience in the industry, which helps us to build our products in line with current regulatory body guidelines. 

If you are looking for a platform with sophisticated and professional functionality and design to boost compliance adherence, check out DXtrade, our industry-preferred trading platform solution. 

If you have any questions or would like to demo DXtrade, please feel free to reach out to us here. Our team of experts are always on hand to help!