2.7. Principal vs. Agency Transactions/Broker & Dealer Transactions

A member firm can act as either a broker or a dealer on a transaction. When the firm acts as a broker, the firm serves as the go-between for the buyer and the seller, and the broker earns a commission. Transactions where a firm is acting as a broker are also called agency transactions, since the firm is acting as an agent for the buyer and seller.

In the OTC market, a firm that helps a client execute a trade but is not a market maker in the stock would be performing in an agency capacity. In this case, the firm would earn a commission rather than a markup on the trade.

A firm that trades securities out of its own inventory is acting as a dealer. This type of transaction is known as a principal transaction. A firm must maintain an inventory of a particular security to be considered a dealer in the security.

When a firm operates as a dealer, it will often add a markup to the quoted price of the security. When a firm includes the markup in the price, it is called a net price. A firm may never charge a commission in addition to a markup or markdown on the same transaction. This is called a hidden profit and it is prohibited.

On the exchange floor, the securities professionals who operate as dealers are called designated market makers (DMMs; also called specialists) in a security. DMMs execute principal transactions. On NASDAQ and the OTC market, market makers operate as dealers and execute principal transactions.

A firm cannot act as both a broker and a dealer on the same OTC transaction. This is a violation of securities law.

The only time a non–market maker may execute a principal transaction in the OTC market is if it is a riskless principal transaction. A riskless principal transaction is when a broker or a dealer receives an order from a customer and then buys stock from a market maker to fill the order. The broker or dealer then sells the stock from its own account to the