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Question

Difficulty: MediumBroker-Dealers, Investment Advisers, and Intermediaries

A financial services firm is reviewing its trade execution procedures and client confirmation disclosure requirements under FINRA and SEC rules. Which of the following statements regarding broker-dealer capacities and compensation models are correct? (Select all that apply.)

  1. When executing a transaction in an agency capacity, the firm acts as a broker matching buyers with sellers and receives a commission.Answer
  2. When executing a transaction in a principal capacity, the firm buys or sells securities from its own inventory and charges a markup or markdown.Answer
  3. C
    A firm may execute a single customer trade in both an agency and principal capacity to charge both a commission and a markup.
  4. D
    Acting as a dealer in a principal capacity automatically obligates the firm to charge asset-based advisory fees rather than transaction-based pricing.

Answer

The correct statements are that when executing a transaction in an agency capacity, the firm acts as a broker matching buyers with sellers and receives a commission; and when executing a transaction in a principal capacity, the firm buys or sells securities from its own inventory and charges a markup or markdown.
Broker-dealers operate in two distinct capacities on trade executions: as an agent (broker) matching buyers and sellers for a commission, or as a principal (dealer) trading for their own account with a markup or markdown.

Step-by-Step Solution

1
Examine agency capacity and fee structures.
In an agency trade, the firm functions as a broker connecting two parties and receives commission-based compensation.
Agency transactions do not involve proprietary inventory, making commissions the standard compensation model.
2
Examine principal capacity and fee structures.
In a principal trade, the firm functions as a dealer buying into or selling out of its proprietary inventory and receives markup or markdown compensation.
Principal transactions involve taking an inventory risk, which is compensated via price adjustments (markups/markdowns).
3
Evaluate the restrictions on dual capacity and advisory fee structures.
Firms cannot act as both broker and dealer on the same trade to charge dual fees, nor do dealers charge ongoing asset-based advisory fees.
Regulatory disclosure rules prohibit dual-capacity fee stacking on a single trade, and asset-based fees are specific to registered investment advisers.

Key Concept

Broker-Dealer Capacities and Compensation (Agency vs. Principal)
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Topics

Broker-Dealers, Investment Advisers, and Intermediaries

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