A retail investor places an order with a broker-dealer to buy shares of a stock traded in the secondary market. The firm executes the order by selling the securities to the customer directly out of its own inventory. In what capacity did the firm execute this trade, and how is it compensated?
- The firm acted in a principal capacity as a dealer and is compensated by adding a mark-up to the trade price.Answer
- BThe firm acted in an agency capacity as a broker and is compensated by adding a mark-up to the trade price.
- CThe firm acted in a primary market distribution capacity as an underwriter and receives proceeds directly from the issuing entity.
- DThe firm acted in a central clearing capacity as the Depository Trust Company (DTC) and earns custody netting fees on the transaction.
Answer
The firm acted in a principal capacity as a dealer and is compensated by adding a mark-up to the trade price.
When a broker-dealer executes a trade directly out of its own proprietary inventory, it is operating in a principal (dealer) capacity. In principal transactions, the firm is compensated by applying a mark-up (when selling to a customer) or a mark-down (when buying from a customer). Under FINRA regulations, a firm cannot charge both a commission and a mark-up/mark-down on the exact same transaction.
Step-by-Step Solution
Key Concept
Broker-Dealer Capacities and Compensation (Agent/Commission vs. Principal/Mark-up)
Estimated Time:1m 30s