Trade Capacity: Principal Trading & Agency Trading

Instructor: Moses Muiga

Moses teaches finance and accounting. He holds undergraduate degree in finance, he is a certified accountant and studied general business at graduate school.

Market makers and electronic communication networks can be methods of market executions, reducing transaction costs and creating market liquidity. This lesson will go into more detail, as well as how principal trading and agency trading are two types of brokers used in executing investors' transactions.

Methods for Executing Transactions

There are several approaches that a brokerage firm can use to fill orders. The two main approaches which reduce transaction risk and increase market liquidity are a market maker and an electronic communications network

Market Maker

Carrie is a market maker, which is an individual or firm participant of a market exchange that continuously buys and sells securities at the quoted public prices. Carrie provides liquidity to the market by creating a ready market for investors to sell and buy securities. She keeps the market functioning by satisfying the supply and demand that set securities prices. The quoted price at exchange reflects public prices as driven by demand and supply.

Carrie is required to comply with specific Security and Exchange Commission (SEC) rules such as the quote rule and the limit order display rule. Carrie's transactions are referred to as principal trades because they buy from the secondary market and use the in-house inventory to fill the client's orders.

As a market maker, Carrie assumes the transaction risk by providing a continuous market for securities. Investors can smoothly execute trade without worrying about whether there are available buyers or sellers even when there's no immediate investor to assume the opposite position. Assuming the transaction risk improves market liquidity because market makers provide liquid cash to investors when they cannot sell the security to other investors.

Carrie profits by maintaining a spread between the bid price (the price at which she's willing to buy) and ask price (the price at which she's willing to sell).

Electronic Communication Network

An electronic communication network (ECN) is a network of computers used in securities trading to match buying and selling of orders. The ECN eliminates the middle man by sending bid and ask prices into a system that facilitates investors to trade against each other.

ECNs are classified by the Security Exchange Commission (SEC) as alternative trading systems (ATS), and they are required to register as broker-dealers. An ECN makes money by charging a commission for every transaction executed.

ECN trades are usually limit orders, which are posted directly for other subscribers to view and are automatically executed by matching buying and selling orders. The ECN creates market liquidity by providing investors direct access to market participants, therefore the trade can easily be executed as the demand and supply is fulfilled by matching orders. ECN reduces the erroneous risk of clearing because:

  • orders are automatically matched
  • orders reduce transaction costs
  • investors can easily manage risk using limit orders

Principal Trading

Principal trading involves a brokerage firm that behaves like a market maker. The firm buys securities from the secondary market and holds them with the expectation that they will profit by selling them to clients.

A firm uses an in-house inventory to fill client orders before submitting orders to other market participants. The SEC requires a brokerage firm to use comparable market prices when using in-house inventory to fill client orders.

Principal trading is carried by a broker-dealer who charges a spread (the difference between bid and ask price) as a fee.

Principal traders are well suited for institutions that trade in large volumes. They may require a dealer to immediately fill the order without signaling their intentions to the market, as an agency trader may not be in a position to do so.

Agency Trading

Agency trading involves a broker who represents the interest of clients, charges a commission, and has no vested interest in trading securities. As an agency broker, Janice does not own an in-house inventory. Instead, she facilitates the matching of orders between buyers and sellers.

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