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Difficulty: EasyBroker-Dealers, Investment Advisers, and Intermediaries

Which of the following statements correctly describe the capacities in which a broker-dealer operates and how it is compensated? Select all that apply.

  1. When executing trades as an agent (broker), the firm matches buyers with sellers and charges a commission.Answer
  2. When executing trades as a principal (dealer), the firm buys or sells from its own inventory and applies a markup or markdown.Answer
  3. C
    When acting in a principal capacity, the firm acts purely as a middleman and earns a commission.
  4. D
    A firm may act as both an agent and a principal in the exact same transaction, charging both a commission and a markup.

Answer

The correct statements are that broker-dealers acting in an agency (broker) capacity match buyers with sellers for a commission, and broker-dealers acting in a principal (dealer) capacity buy or sell from their own inventory for a markup or markdown.
A broker-dealer acts in an agency (broker) capacity when matching buy and sell orders between customers, taking no inventory position, and receiving a disclosed commission. A broker-dealer acts in a principal (dealer) capacity when it buys securities from or sells securities to a customer using its own inventory, receiving compensation through a markup on sales or a markdown on purchases.

Step-by-Step Solution

1
Identify the features of agency capacity execution.
Agent capacity means the broker-dealer acts as a broker/middleman, does not trade from proprietary inventory, and earns a commission.
Agency transactions facilitate trades between third parties without taking inventory risk.
2
Identify the features of principal capacity execution.
Principal capacity means the broker-dealer acts as a dealer/market maker, trades out of its own inventory account, and earns compensation via markups (when selling to clients) or markdowns (when buying from clients).
Principal transactions put the firm's capital at risk through proprietary positioning.
3
Evaluate dual capacity rules.
A firm can never act in both capacities in a single trade.
Regulators prohibit dual agency/principal capacity in the same transaction to protect clients from double charging and conflicts of interest.

Key Concept

Broker-Dealer Operating Capacities (Agency vs. Principal)
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Topics

Broker-Dealers, Investment Advisers, and Intermediaries

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