Agency vs. principal capacity
Also known as: broker vs. dealer capacity
Agency and principal capacity describe the two ways a firm can execute a customer's trade: as an agent (broker) matching the customer with another party for a commission, or as a principal (dealer) trading from its own inventory for a markup or markdown.
When a brokerage firm executes a customer order, it must act in one of two capacities. In an agency capacity, the firm acts as a broker — a middleman that arranges the trade between the customer and another buyer or seller. The firm never owns the security during the trade and is compensated with a disclosed commission.
In a principal capacity, the firm acts as a dealer, trading for its own account. If a customer wants to buy, the firm sells shares out of its own inventory and adds a markup to the price; if the customer sells, the firm buys the shares into inventory at a price reduced by a markdown. Market makers operate this way constantly, profiting from the spread between their bid and ask prices.
Two rules follow from this framework. First, a firm must disclose on each trade confirmation which capacity it acted in, along with the commission when acting as agent. Second, a firm cannot act in both capacities on the same trade — charging a customer both a markup and a commission on a single transaction is prohibited. Whether acting as broker or dealer, the firm's compensation must be fair and reasonable.
The agency-versus-principal distinction underpins how the secondary market works and appears across the securities exams. The SIE tests it directly in secondary market fundamentals, and the Series 9 revisits capacity issues in the context of options exchanges and best-interest obligations.
Key takeaways
- Acting as an agent (broker), a firm arranges a trade between other parties and charges a commission.
- Acting as a principal (dealer), a firm trades from its own inventory and earns a markup or markdown.
- A firm must disclose its capacity on the trade confirmation and cannot charge both a commission and a markup on the same trade.
- Market makers are dealers by definition — they continuously quote bids and offers from their own inventory.
- The SIE and Series 9 both test how capacity affects compensation and disclosure.