Broker-Dealer Regulation in the U.S.: what to expect?

Broker-dealer regulation in the U.S. is tight. And rightly so. After all, whether brokers work with stocks, currencies, bonds, or other financial instruments, broker-dealers often handle large amounts of money, including other people’s. Naturally, the U.S. government wants to keep bad actors out and maintain investor confidence. So, whether you plan to start your activity as a broker-dealer or you’ve already begun, be prepared for red tape – all in a good cause, of course.

Broker-Dealer Regulation

Are You a Broker, a Dealer, or a Broker-Dealer?

If you’re wondering if you qualify, see if your professional activities match any of the following. Among other things, broker-dealers may underwrite financial securities, including initial public offerings (IPOs), do financial market research, make markets by buying and selling financial instruments, and manage customer accounts for buying and selling. The Securities Exchange Act of 1934 defines a broker as being engaged in effecting transactions in securities for others, and a dealer as a buyer and seller of securities for its own account (via a broker or otherwise). Many firms are both brokers (working for customers) and dealers (competing with customers), which makes them ‘broker-dealers’.

Important U.S. Broker-Dealer Regulation Laws and Rules

The two laws that are the cornerstones of broker-dealer regulation are the Securities Act of 1933 and the Securities Exchange Act of 1934. Since then, there have been more with others yet to come. The list below is not exhaustive but will give you an idea of the current legal framework.

• The Securities Act of 1933. Applies to the primary market (IPOs) to ensure transparency in documents and financial statements to help investors make informed decisions.
• The Securities Exchange Act of 1934. Applies to the secondary market to prevent fraud in the trading of existing securities between investors. Also created the Securities and Exchange Commission (SEC).
• Trust Indenture Act of 1939. For debt securities like bonds, debentures, and notes.
• Investment Company Act of 1940. Regulates the organization of companies investing, reinvesting, and trading in securities, including those offering their own securities.
• Investment Advisors Act of 1940. For the registration of money managers and mutual fund managers.
• Securities Investor Protection Act of 1970 (SIPA). Created the Securities Investors Protection Corporation (SIPC).
• Sarbanes-Oxley Act of 2002. Enhanced corporate responsibility and financial disclosures, combats corporate and accounting fraud.
• Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. For consumer protection, trading and financial product regulation, credit ratings, corporate governance and disclosure, and transparency.

Depending on what services you offer, different broker-dealer regulations may apply. For example, if your market includes customers in Europe, you may also need to show compliance with the recently enforced General Data Protection Regulation (GDPR).

Regulatory Organizations and Their Functions

In general, brokerage firms in the U.S. are regulated by:

• federal government,
• state government,
• self-regulatory organizations (SROs)

You will need to check the specific broker-dealer regulation for any state in which you want to exercise broker-dealer activities. Examples of organizations with a nationwide impact are:

SEC (Securities and Exchange Commission)

This federal government agency regulates broker-dealers, IPOs, and securities exchanges, working with SROs to guarantee compliance. It handles related criminal matters.

The SEC enforces the rules that all market participants must comply with. Among other responsibilities, the SEC is in charge of:

• Regulation T – broker-dealer regulation on how money should be lent to customers and used
• Newly listed companies – how IPOs should be pushed into the public market
• Reviewing filings of investment companies

Brokers have an obligation to notify the SEC about changes in capital, organizational structure, and any observed frauds.

FINRA (Financial Industry Regulatory Authority)

FINRA Building in New York City

Every broker-dealer must select a Self-Regulatory Organization (SRO). If there is one SRO you work with, it is likely to be FINRA. Before 2007 the most known SROs were:

• New York Stock Exchange(NYSE)
• National Association of Securities Dealers (NASD)

Brokers who conducted business at the NYSE have selected NYSE as their SRO; brokers who conducted business on the CBOE would choose the CBOE to be its SRO. And broker-dealers who are not a member of an exchange have chosen the NASD. In 2007, SEC approved the merger of the NYSE’s and NASD’s regulation department to form the FINRA (Financial Industry Regulatory Authority) which now is the largest Self-Regulatory Organization in the U.S.

Broker-dealer regulation of SROs follow the federal rules; and these rules include, but are not limited to:

• Days and hours of operations
• Lot size
• Membership requirements
• Required documentation
• Settlement cycles
• Procedures and policies

FINRA also performs periodic audits of broker-dealers. These audits review firms’ internal procedures and applications. The firms’ books and records are verified to be compliant with FINRA’s rules.

SEC and FINRA rules:

• SEC Rules – SEC.gov
• FINRA Rules – FINRA.org

Other SROs are:

MSRB (Municipal Securities Rulemaking Board) that makes broker-dealer and other trading municipal securities.

CBOE (Chicago Board Options Exchange) which regulates options trading.

NFA (National Futures Association) is the self-regulatory organization for the U.S. derivatives industry, including on-exchange traded futures, retail off-exchange foreign currency and OTC derivatives.

Steps to Becoming a Registered Broker-Dealer in the US

In general, a company will need to accomplish the following steps before it can do business as a broker-dealer:

• File Form BD and be granted registration by the SEC
• Become a member of an SRO (such as FINRA, but check which SRO(s) will meet your needs better)
• Become a member of SIPC
• Meet all relevant requirements for the state(s) in which you want to be a broker-dealer
• Ensure your staff/’associated persons’ have met the requirements (may include certification, fingerprinting, declarations of any prior prosecutions/criminal records, and more).

Most SROs require that associated persons of broker-dealer companies pass one or more exams related to their specific financial activities, before they can do business with investors (individual or corporate):

• Series 7. Must pass this to become a general securities registered representative.
• Series 63. Relates to state ‘blue-sky laws’ and is the next step after the Series 7 exam to be able to do business.
• Series 65. Pass this to become a Registered Investment Advisor (RIA), authorized to use professional money management service platforms.
• Series 66. Combines the Series 63 and 65 exams.
• Series 3. Must pass this to sell commodities futures contracts.
• Series 31. Must pass this to sell managed futures funds.

And there are others! In addition, note that to uphold their license to operate, brokers may need to complete education classes periodically to stay up to date in regulatory matters and new securities offerings and client services.

Ongoing Broker-Dealer Responsibilities

Getting registered is just the start. Broker-dealers also have ongoing duties of financial responsibility, customer protection, and good conduct. Here are a few highlights:

• Customer protection rule. Customer funds and securities must be segregated from the broker-dealer’s proprietary business operations.
• Record-keeping. Basic bookkeeping requirements include records of trades, receipts, positions held in different securities, trial balances, complaints, and compliance, together with reports to be filed periodically.
• Fair dealing. Execute client orders promptly, disclose information relevant to investors, charge prices in line with market conditions, and disclose conflicts of interest.
• Suitability of clients. Only recommend investments or strategies that are suitable for the clients concerned.
• Communication. Be fair, balanced, and not misleading in communications with clients, seeking approval before communication as needed.
• Gifts and contributions. Observe rules concerning maximum value of gifts made to clients and political contributions.
• Suspicious Activity Reports (SARs). File reports of any suspicious activities noted by the broker-dealer, including investments over predefined monetary limits.

Technology for Enhanced Compliance and Security

Broker Back Office Technology

With the the development of technologies and the rise of self-directed online investors, broker-dealer regulation activities are being automated too. Technology can help reduce workloads, accelerate reporting and, last but not least, eliminate human error. It can also help broker-dealers to stay safe in the face of mounting cyber threats on their IT systems and networks.

• Automation. Use software to automatically run checklists on customer suitability, generate reports for SARs and other cases, and monitor basic regulatory compliance and system security.
• Artificial intelligence. Smart systems using machine learning can offer recommendations on new situations by learning about patterns and outcomes from past data. They can spot gaps and inconsistencies in Know Your Customer (KYC) records and processes. They can also help identify high-risk clients or cases needing special screening for Anti-Money Laundering (AML). Cyber security systems using machine learning can detect abnormal IT and network activity (possible breaches) and raise alarms for security teams to investigate.

There is a whole industry nowadays for regulatory technology, often known as RegTech. It includes separate applications for specific processes like reports generation, KYC or AML, or it can be all built in the broker back office application.

Next Steps

We can only give an overview here of the U.S. broker-dealer regulation rules and laws. Federal and state government organizations, SROs, and other regulatory bodies have detailed descriptions of the rules to be followed. Be sure to determine all the regulations that apply to you and seek professional advice as needed. Fortunately, there are outsourced regulatory compliance consultants that specialize on providing expert help to financial services firms.

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