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Question

Difficulty: MediumTypes of Markets and Trading Venues

A retail investor places an order to purchase shares of an over-the-counter (OTC) equity security. The broker-dealer fills the order directly from its own proprietary account inventory rather than routing it to another market participant. In what capacity is the firm acting, and how is its compensation structured for this transaction?

  1. As a principal, compensated by adding a mark-up to the sale priceAnswer
  2. B
    As an agent, compensated by charging a commission on the trade execution
  3. C
    As an underwriter, compensated by transferring primary issue proceeds to the issuer
  4. D
    As a clearing entity, compensated by netting trades through the National Securities Clearing Corporation (NSCC)

Answer

The broker-dealer acts as a principal and is compensated by adding a mark-up to the transaction.
When a firm acts as a dealer/principal in a secondary market transaction, it trades directly with the customer using its own inventory. When selling to a customer from inventory, the firm adds a mark-up to the prevailing market price as its compensation.

Step-by-Step Solution

1
Identify the trading capacity based on order execution details.
The firm sells securities directly out of its own inventory, which defines the principal (dealer) role.
Firms taking proprietary position risk and trading directly against customers act as dealers/principals.
2
Determine the corresponding compensation structure for a principal transaction.
Principal transactions use mark-ups (when selling to a customer) or mark-downs (when buying from a customer).
Commissions are reserved for agency transactions where the firm acts strictly as a middleman broker.

Key Concept

Broker-Dealer Capacities: Principal (Dealer) vs. Agent (Broker)
Estimated Time:1m 0s
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Topics

Types of Markets and Trading Venues

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