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Difficulty: MediumTypes of Markets and Trading Venues

A member firm fills a customer's purchase order for equity securities by selling the shares directly out of its own inventory. In what capacity is the broker-dealer acting in this secondary market transaction, and how is the firm compensated?

  1. A
    As an agent, compensated by charging a commission.
  2. As a principal, compensated by charging a mark-up.Answer
  3. C
    As an underwriter, compensated by receiving the primary issuer spread.
  4. D
    As a clearing entity, compensated by collecting a National Securities Clearing Corporation (NSCC) trade fee.

Answer

The firm acts as a principal (dealer) and is compensated by charging a mark-up on the trade.
In secondary market trading, when a broker-dealer sells securities to a customer out of its own inventory, it acts as a dealer (principal) for its own account. Dealer compensation in principal sales takes the form of a mark-up added to the prevailing market price.

Step-by-Step Solution

1
Identify the transaction capacity based on the source of the securities.
Because the firm sold the shares directly from its own proprietary inventory, it acted as a principal (dealer) taking the opposite side of the transaction.
Firms trading for their own account act in a principal capacity, whereas firms connecting two independent parties act in an agency capacity.
2
Determine the form of compensation corresponding to a principal trade.
Principal transactions involve charging a mark-up (when selling to a customer) or a mark-down (when buying from a customer).
Commissions are strictly reserved for agency transactions, while mark-ups/mark-downs reflect dealer pricing adjustments on inventory.

Key Concept

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

Types of Markets and Trading Venues

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