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Difficulty: MediumTypes of Markets and Trading Venues

A broker-dealer fills a customer's order to buy 500 shares of a technology stock by selling the security directly out of its own trading inventory account. In what capacity did the broker-dealer execute this secondary market trade, and how is its compensation structured?

  1. The firm acted as a principal (dealer) and was compensated through a mark-up.Answer
  2. B
    The firm acted as an agent (broker) and was compensated through a commission.
  3. C
    The firm acted as an underwriter in the primary market and was compensated through an underwriting spread.
  4. D
    The firm acted as a central depository and was compensated through a settlement netting fee.

Answer

The firm acted as a principal (dealer) and was compensated through a mark-up.
When a securities firm fills a customer order using its own inventory, it takes the opposite side of the trade as a principal (dealer). For principal transactions, the firm's compensation is built into the trade price as a mark-up (when selling to a customer) or mark-down (when purchasing from a customer).

Step-by-Step Solution

1
Identify the party providing the shares for the trade.
The firm filled the order directly from its own proprietary inventory rather than matching the customer with another buyer or seller on an exchange.
Trading from proprietary inventory defines the principal capacity.
2
Determine the legal role (capacity) of the broker-dealer.
When buying for or selling from its own account, the firm acts as a dealer (principal).
A broker (agent) brings two parties together, while a dealer (principal) takes the opposite side of the transaction.
3
Determine the corresponding compensation structure.
Principal transactions are executed with a mark-up (when selling to a customer) or a mark-down (when buying from a customer).
Commissions apply to broker/agency trades, whereas mark-ups/mark-downs apply to dealer/principal trades.

Key Concept

Broker-dealer capacities and compensation in trading venues (Principal/Dealer vs. Agent/Broker)
Estimated Time:1m 0s
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Topics

Types of Markets and Trading Venues

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