Riskless Principal

What Is Riskless Principal?

Riskless principal is a party who, upon receipt of an order to buy or sell a security, buys or sells that security themselves as they fill the order. It is where a broker, who has received a customer order, immediately executes an identical order in the marketplace for their account, taking on the role of principal, in order to fill that customer order.

Key Takeaways

  • Riskless principal is a party who, upon receipt of an order to buy or sell a security, buys or sells that security themselves as they fill the order.
  • It is where a broker, who has received a customer order, immediately executes an identical order in the marketplace for their account, taking on the role of principal, in order to fill that customer order.
  • To qualify for riskless principal trades, FINRA stipulates that the trades should be executed at the same price, exclusive of a markup/markdown, commission, or other fees.

Understanding Riskless Principal

An order from a customer would therefore require the member firm to execute an identical order in the market as principal before executing the customer's order, So, a customer's buy order would necessitate that the member firm executes an identical buy order in the market, while a sell order would require the member firm to execute an identical sell order in the market. In order to qualify for riskless principal trades, the Financial Industry Regulatory Authority (FINRA) stipulates that the trades should be executed at the same price, exclusive of a markup/markdown, commission, or other fees.

For example, a broker-dealer who is a FINRA member and receives a customer order to buy 10,000 shares of Widget Co. at the prevailing market price of $10 would immediately buy the 10,000 shares from another member at $10. Since both trades were executed at the same price (excluding commissions), this would qualify as a riskless principal transaction.

On March 24, 1999, the SEC approved amendments to FINRA, then the National Association of Security Dealers (NASD), rules regarding the reporting of riskless principal transactions by market makers in NASDAQ and OTC securities. The rule change, which was effective Sep. 30, 1999, permitted market makers to only report one leg of a riskless principal transaction, rather than both legs, as was the requirement previously.

While market makers are always deemed to be "at-risk" when trading from their principal accounts, the amendment was an acknowledgment of the fact that trades undertaken to offset customer orders are riskless. One of the significant benefits of this rule change was a reduction in transaction fees levied by the SEC.

NASD Notice on Riskless Principal

The NASD's Special Notice on "Compensation and Mixed Capacity Trading" offers FAQ guidance, and defined a riskless principal trade as such:

"In NASDAQ, a riskless principal trade is one in which a broker/dealer, after having received an order to buy (sell) a security, purchases (sells) the security as principal, at the same price, to satisfy that order. The broker/dealer generally charges its customer a markup, markdown, or commission equivalent for its services, which is disclosed on the confirmation required by Securities Exchange Act (Exchange Act) Rule 10b-10. For further guidance on riskless principal trade reporting obligations for NASDAQ securities, see Notice to Members 99-65, Notice to Members 99-66 and Notice to Members 00-79."

Article Sources
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  1. Financial Industry Regulatory Authority. "Trade Reporting Frequently Asked Questions." Accessed March 8, 2021.

  2. Financial Industry Regulatory Authority. "NASD Notice to Members 99-65," Page 427. Accessed March 8, 2021.

  3. Financial Industry Regulatory Authority. "NASD Notice to Members 99-65," Page 428. Accessed March 8, 2021.

  4. Financial Industry Regulatory Authority. "Compensation and Mixed Capacity Trading," Page 778. Accessed March 8, 2021.

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