Principal Orders

What Is a Principal Order?

The term principal order refers to an order in which a broker-dealer buys or sells for its own account as opposed to carrying out trades for the brokerage's clients. Principal orders are done at the broker-dealer's own risk. The broker-dealer must provide notification to the exchange where the trade. These are registered on exchanges as principal orders in order to protect investors from possible insider trading activity.

Key Takeaways

  • A principal order is an order in which a broker-dealer buys or sells for its own account rather than carrying out trades for its clients.
  • Brokerages must register their principal orders on the exchanges on which shares are traded before transactions are executed.
  • Broker-dealers purchase shares on the secondary market and hold them in their own accounts before selling them.
  • These types of trades are almost exclusively an institutional investment matter.

Understanding Principal Orders

Principal orders are also referred to as principal trades. These are special trades that involve a broker-dealer acting on its own behalf. Instead of executing transactions on behalf of its clients, the broker acts as a dealer to make trades within its own account.

Here's how it works. Before executing the trade, the broker must advise the exchange where the shares trade that it will be making a principal order. The exchange then lists the trade as such. This helps regulators keep track of large trade orders and protect the everyday investor from any abusive trading activity or insider trading.

Once registered, the broker buys shares on the secondary market and holds them in its own account for a certain period of time. Principal trades are often done in the hopes that share prices will appreciate. When shares reach that point, the broker can then sell its inventory and make a profit. It can also collect a commission from the sale. In some cases, the broker may also sell large block orders to an institutional investor from its own account through a principal order. More on this is noted below.

Special Considerations

Principal orders are almost exclusively an institutional investment matter—rarely would a retail client need the features of a principal trade. The benefits of a principal trade largely include trade execution and trade costs. For specialized orders or orders that require immediate execution—or a mixture of both—an agency trade may not meet a client's needs. To help serve the client best, or even in their best interest, it may make the most sense for a securities dealer to also act as a broker, and buy/sell from internal inventory.

For instance, if a large institutional client wants to buy a certain company's stock in a hurry, it may not be able to fulfill a large block order without signaling intentions to the market. Here, a broker-dealer that values the relationship can sell the wanted stocks directly to the client in a semi-private transaction. The broker-dealer makes it clear it is selling from its inventory and, if the client is fine with it, there's no breach of confidence.

Principal trades are almost exclusively for institutional investors, which means retail investors need to conduct agency trades.

Principal Orders vs. Agency Orders

There are two primary types of trades—a principal trade order and an agency trade order. With an agency trade order, a broker trades for the benefit of a client rather than itself. The broker is compensated by a commission. In the case of a principal trade, a dealer will act as a broker as well, trading from their inventory they charge a spread as a fee. Most retail or individual investors who execute trades do so through agency trades.

This is how agency trading works. Say you're an investor who wishes to buy stock. You go through your broker, who will then go to the market looking for someone who wants to sell the same number of shares at your desired price. If all goes well and the broker secures a seller, they execute the trade. Once settled, the exchange records the and both parties exchange the cash and securities.

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