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Question

Difficulty: MediumMarket Participants and Investor Classifications

A broker-dealer receives an order from a retail customer to buy corporate bonds. The firm fills the order directly using bonds held in its own trading inventory and adds an additional charge to the execution price. In this transaction, in what capacity did the firm act, and how is its compensation classified?

  1. The firm acted in a principal capacity as a dealer and was compensated through a mark-up.Answer
  2. B
    The firm acted in an agency capacity as a broker and was compensated through a commission.
  3. C
    The firm acted in a clearing capacity as a depository entity and was compensated through trade netting.
  4. D
    The firm acted in an institutional capacity as a Qualified Institutional Buyer (QIB) and was compensated through an advisory fee.

Answer

The firm acted in a principal capacity as a dealer and was compensated through a mark-up.
When a securities firm fills a customer order using its own inventory, it is acting in a principal capacity as a dealer. In principal transactions, the firm takes inventory risk and receives compensation by adding a mark-up to the selling price.

Step-by-Step Solution

1
Analyze the execution mechanism described in the stem.
The firm filled the customer's purchase order directly out of its own proprietary inventory.
Trading for or from the firm's own account defines a principal transaction.
2
Determine the operational capacity and compensation form.
In a principal transaction, the firm functions as a dealer and adjusts the price with a mark-up (when selling) or mark-down (when buying).
Commissions are earned when acting as an agent (broker), whereas mark-ups/mark-downs are earned when acting as a principal (dealer).

Key Concept

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

Market Participants and Investor Classifications

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