One of the simplest ways to understand electronic trading is to imagine that you want to buy some stock -- perhaps a company has made an initial public offering that you're interested in. We can follow the steps of your stock trade through the system and see exactly what happens.
Before you can buy, however, you have to open a brokerage account. There are dozens of companies that allow you to do electronic trading, including eTrade, Schwab and TD Ameritrade. These companies are called broker dealers, and they give you access to the stock exchanges. Without a brokerage account, you can't trade stocks.
So, as the only entry points to the stock markets, broker dealers play a critical role in the process. As such, they're highly regulated by the SEC in order to prevent fraud and mismanagement. Here are some of the things that broker dealers do:
- Make sure you're allowed to trade stocks when you sign up for an account. That is, they check to make sure you're old enough, you have money in your account and you understand the risks of stock trading. This is part of the regulatory nature of broker dealers.
- Provide the servers that allow you do your web-based trading.
- Provide the computers systems that keep track of all the accounts. Like a bank, the broker dealer knows how much money every account has. He also keeps track of all the stocks you own and may make loans by offering margin accounts.
- Keep track of your trading to make sure you aren't doing anything illegal and aren't buying more stock than the balance of your account allows. They also make sure that appropriate tax records are kept.
- Provide stock quotes. The broker dealer knows exactly how much stocks are buying and selling for with up-to-the-minute accuracy.
- Interface with the different stock markets to make the actual trades.
The broker dealers provide a very useful simplification process for the stock exchanges: Since the dealer handles all the money, all the accounts and much of the regulatory and tax activities, the exchanges don't have to worry about any of these things. All the exchanges have to do is trade stocks, and they do so with complete assurance from the broker dealers that the traders are legitimate.