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Question

Difficulty: MediumBroker-Dealers, Investment Advisers, and Intermediaries

A market maker receives a retail customer buy order for 500 shares of a publicly traded equity. The firm fills the order directly out of its own proprietary inventory account and includes a mark-up on the customer trade confirmation. In what capacity did the market maker execute this trade, and how is its compensation categorized?

  1. The firm acted as a principal (dealer) and was compensated via a mark-up.Answer
  2. B
    The firm acted as an agent (broker) and was compensated via a mark-up.
  3. C
    The firm acted as an agent (broker) and was compensated via a commission.
  4. D
    The firm acted as an investment adviser and was compensated via an asset-based fee.

Answer

The market maker acted as a principal (dealer) and earned compensation through a mark-up on the execution price.
When a broker-dealer executes a transaction using its own inventory, it acts as a dealer (principal) in the trade. In principal transactions, the firm's compensation is built into the trade price as a mark-up (for customer buys) or a mark-down (for customer sells).

Step-by-Step Solution

1
Identify the source of the shares executed for the transaction.
The shares came directly from the broker-dealer's own proprietary inventory account.
Trading from inventory establishes that the firm participated as a counterparty to the trade.
2
Determine the firm's capacity based on inventory participation.
Participating as a counterparty from inventory defines a principal (dealer) capacity.
Firms act as dealers/principals when buying into or selling out of their own inventory.
3
Determine the correct compensation structure associated with principal capacity.
Principal transactions involve adding a mark-up to a retail customer's purchase price or taking a mark-down on a sale price.
Commissions apply strictly to agency (broker) transactions where the firm acts as a middleman.

Key Concept

Broker-Dealer Execution Capacities (Broker/Agent vs. Dealer/Principal)
Estimated Time:1m 15s
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Topics

Broker-Dealers, Investment Advisers, and Intermediaries

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