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Question

Difficulty: MediumMarket Participants and Investor Classifications

A registered broker-dealer executes a customer's order to purchase corporate debt securities by selling the bonds directly from its own proprietary inventory. In what capacity is the firm operating, and how should it be compensated for this transaction?

  1. Acting as a principal (dealer) and charging a mark-upAnswer
  2. B
    Acting as an agent (broker) and charging a commission
  3. C
    Acting as an agent (broker) and charging a mark-up
  4. D
    Acting as a principal (dealer) and charging a commission

Answer

The firm is acting as a principal (dealer) and should be compensated by charging a mark-up.
When a broker-dealer satisfies a customer buy order using securities held in its own inventory, it acts as a dealer (principal) in the transaction. In principal transactions, the firm adds a profit margin to the price, known as a mark-up, rather than charging a commission.

Step-by-Step Solution

1
Identify the trading capacity based on the execution mechanism
Since the firm sells securities directly out of its own proprietary inventory, it is taking the opposite side of the trade as a principal (dealer).
Dealers buy and sell securities for their own account, whereas brokers act as middlemen matching buyers and sellers.
2
Determine the appropriate form of compensation for a principal trade
Principal transactions require compensation in the form of a mark-up (when selling to a customer) or a mark-down (when buying from a customer).
FINRA rules prohibit charging commissions on principal trades, reserving commissions exclusively for agency transactions.

Key Concept

Broker vs. Dealer Capacity and Compensation Rules
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Topics

Market Participants and Investor Classifications

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