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Question

Difficulty: HardTypes of Markets and Trading Venues

A retail investor submits a market order to purchase 500 shares of an exchange-listed equity security through their broker-dealer. Rather than routing the order to the exchange floor, the firm fills the customer's trade off-exchange directly out of its proprietary inventory while charging a mark-up. Which of the following correctly identifies both the market venue in which this transaction was executed and the capacity in which the broker-dealer acted?

  1. The transaction took place in the third market, and the broker-dealer acted in a principal capacity.Answer
  2. B
    The transaction took place in the third market, and the broker-dealer acted in an agency capacity.
  3. C
    The transaction took place in the primary market, and the broker-dealer acted as an underwriter.
  4. D
    The transaction took place in the fourth market, and the broker-dealer acted as a clearing depository.

Answer

The transaction took place in the third market, and the broker-dealer acted in a principal capacity.
The transaction took place in the third market because an exchange-listed equity security was traded off-exchange in the over-the-counter (OTC) market. Furthermore, the broker-dealer operated in a principal (dealer) capacity because it filled the customer's order directly from its own inventory and compensated itself via a mark-up.

Step-by-Step Solution

1
Identify the trading market venue for exchange-listed stocks traded over-the-counter (OTC).
Trading exchange-listed securities in the OTC market is defined as the Third Market.
The third market specifically refers to OTC trading of exchange-listed equities.
2
Determine the capacity in which the broker-dealer executed the trade.
Executing a trade out of firm inventory and charging a mark-up means the firm acted as a dealer (principal).
When a firm buys for or sells from its own inventory account, it acts as a principal/dealer and charges a mark-up or mark-down rather than a commission.

Key Concept

Third Market Trading and Broker-Dealer Execution Capacities
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Topics

Types of Markets and Trading Venues

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