Trade Capacity: Principal vs. Agency

Now that you understand bid-ask pricing, you can see how a firm's role in the trade determines its compensation. A broker-dealer can execute trades in two distinct capacities, and the distinction directly affects how the customer pays.

Two Capacities

CapacityRoleCompensationKey Rule
Principal (dealer)Trades from its own inventory; the firm is the counterparty to the customerMarkup (on sales to customer) or markdown (on purchases from customer)Must disclose capacity on confirmation
Agency (broker)Acts as intermediary between buyer and seller, matching the customer with another partyCommissionMust disclose commission on confirmation

The simple rule:

  • Commission = agency capacity (broker)
  • Markup/markdown = principal capacity (dealer)

Exam Tip: Gotchas

  • Compensation type reveals capacity. If the scenario mentions a commission, the firm acted as agent. If it mentions a markup or markdown, the firm acted as principal.

Principal Transactions

When a firm acts as principal:

  • The firm buys or sells securities from its own inventory
  • The firm is on the opposite side of the trade from the customer
  • Compensation is embedded in the price as a markup (when selling to the customer) or markdown (when buying from the customer)
  • The customer pays the security's price plus the hidden markup. It is not listed as a separate line item the way a commission is

Agency Transactions

When a firm acts as agent:

  • The firm connects the customer with another buyer or seller
  • The firm is not a counterparty to the trade
  • The firm charges a commission that is separately disclosed
  • The firm has a best execution obligation to get the most favorable terms reasonably available

Riskless Principal

A riskless principal transaction is a hybrid:

  • A dealer receives a customer order, buys the security in the market for its own account, and immediately sells it to the customer
  • Technically a principal transaction, but the firm takes on virtually no market risk
  • The firm charges a markup or commission equivalent
  • Must be disclosed as a principal transaction on the confirmation

Exam Tip: Gotchas

  • Riskless principal is technically a principal transaction even though it functions like agency.

Dual Capacity Prohibition

A firm cannot act as both principal and agent on the same transaction without:

  • Full disclosure to the customer
  • Customer consent

This prevents a conflict of interest where the firm profits from both sides of the same trade.

Exam Tip: Gotchas

  • Dual capacity requires explicit consent. A firm acting as both principal and agent on the same trade needs customer disclosure and approval first.