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Difficulty: MediumBroker-Dealers, Investment Advisers, and Intermediaries

An investor submits an order to buy 1,000 shares of a publicly traded corporation. The brokerage firm fills the order by selling shares to the investor directly from its own inventory. In what capacity did the brokerage firm act in this transaction, and how must its compensation be disclosed on the trade confirmation?

  1. The firm acted in a principal capacity as a dealer and must disclose a mark-up.Answer
  2. B
    The firm acted in an agency capacity as a broker and must disclose a commission.
  3. C
    The firm acted as an underwriter distributing primary market securities and must provide a prospectus.
  4. D
    The firm acted as a central clearing depository and must net the trade prior to trade settlement.

Answer

The brokerage firm acted in a principal capacity as a dealer trading from its own inventory and must disclose a mark-up on the trade confirmation.
When a broker-dealer fills a customer's order using its own inventory, it acts as a principal (dealer) in the transaction. In principal transactions, the firm earns revenue by adding a mark-up to the selling price (or deducting a mark-down from the buying price), which must be clearly disclosed on the customer's trade confirmation.

Step-by-Step Solution

1
Determine the execution capacity of the brokerage firm.
Because the firm sold securities directly out of its own proprietary inventory, it acted as a principal (dealer).
Firms trading for their own account operate as dealers (principals), whereas firms matching third-party buyers and sellers operate as brokers (agents).
2
Identify the appropriate compensation structure and disclosure.
As a principal in a sales transaction, the firm charges a mark-up over the prevailing market price.
Commissions are charged on agency trades, while mark-ups or mark-downs are applied to principal transactions and must be disclosed on trade confirmations.

Key Concept

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

Broker-Dealers, Investment Advisers, and Intermediaries

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