Quick Answer
A firm acting as principal trades for its own account, usually from inventory, and earns a markup or markdown; a firm acting as agent matches buyer and seller and earns a commission instead. A riskless principal transaction buys and immediately resells to the customer but is still disclosed as principal. Acting as both requires customer disclosure and consent.
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
| Capacity | Role | Compensation | Key Rule |
|---|---|---|---|
| Principal (dealer) | Trades for its own account, usually from its own inventory; the firm is the counterparty to the customer | Markup (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 party | Commission | Must 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 markup is built into the price the customer pays rather than charged as a separate fee the way a commission is
- Built in does not always mean undisclosed: for a retail (non-institutional) customer's principal trade in a corporate or agency bond that the firm offset in at least the same size on the same trading day, the confirmation must show the markup as a dollar amount and as a percentage of the prevailing market price
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
Exam Tip: Gotchas
- Best execution applies in both capacities. FINRA's best execution rule covers any transaction for or with a customer, so whether it acts as agent or as principal, the firm must use reasonable diligence to find the best market and get the customer a price as favorable as possible under prevailing market conditions.
- Interpositioning breaks best execution. A firm may not place a third party between itself and the best market for a security when doing so keeps the customer from the most favorable price 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.
What Should You Check on Exam Day?
- Can you state which compensation type, markup or commission, matches agency capacity?
- Do you know why a firm must disclose its capacity on every confirmation?
- Can you explain why a riskless principal transaction is still classified as principal?
- Do you know what a firm needs before acting as both principal and agent?
- Can you explain the difference between how a principal and an agent get paid?