Capacity, Quotes and Best Execution

Capacity

Acting as agent, the firm executes the customer's order against a third party and charges a commission, which is stated separately on the confirmation. The firm never owns the security.

Acting as principal, the firm buys from or sells to the customer out of its own inventory. When it sells to a customer it adds a markup; when it buys from a customer it applies a markdown. Because the compensation is inside the price, the customer sees a net price rather than a separate charge — and under FINRA Rule 2232, the confirmation must disclose the markup or markdown for certain retail transactions in fixed income securities, precisely because it would otherwise be invisible.

Riskless principal is the hybrid: the firm receives a customer order, buys the security in the market to fill it, and sells it to the customer, holding the position for no meaningful time and taking no market risk. It is principal in form and agency in substance, and disclosure rules treat it accordingly.

The capacity must be disclosed on the confirmation, and a firm cannot act as both agent and principal on the same transaction — it cannot charge a commission and take a markup on the same trade.

What may be charged

FINRA Rule 2121 requires that a member buying or selling as principal deal at a price that is fair, taking into consideration all relevant circumstances, and that a member acting as agent charge a commission that is fair and not unreasonable.

The long-standing interpretation attached to it is the 5 percent policy, and its most important feature is that it is a guideline rather than a rule. It does not authorize a 5 percent charge and does not prohibit exceeding one; it states that markups, markdowns and commissions should generally be evaluated against a 5 percent benchmark with the relevant circumstances taken into account. Those circumstances include the type of security, its availability, its price, the size of the transaction, the disclosure made, the pattern of the firm's markups, and the nature of the firm's business. Lower-priced securities and small transactions justify a higher percentage; a large trade in a liquid security does not.

Two specific exclusions matter. The policy does not apply to securities sold from a prospectus or offering circular — new issues, mutual funds and variable contracts have their sales charges disclosed in the prospectus instead.

The base for computing a markup is the prevailing market price, which for a dealer with an active market is generally its own contemporaneous cost. A firm cannot mark up from a stale or artificial reference price.

FINRA Rule 2122 requires that charges for services — transfers, safekeeping, appraisals, collection of dividends — be reasonable and not unfairly discriminatory. Rule 2124 governs net transactions with customers, which require the customer's consent.

On the municipal side, MSRB Rule G-30 applies the same fairness standard to dealer prices and commissions.

Quotations

A firm quotation is a price at which the dealer is committed to trade, for at least the size quoted. A quote given without qualification between dealers is a firm quote.

A subject quotation is subject to confirmation — an indication of where the dealer thinks the market is, not a commitment.

A workout quotation indicates an approximate range within which the dealer will attempt to work an order, used where the position is large or the security is illiquid.

A nominal or informational quote is given for valuation purposes only and is expressly not an offer to trade. Bid wanted and offer wanted are solicitations for a price rather than quotes.

Backing away — failing to honour a firm quote — is a violation. FINRA Rule 5220 prohibits offering a security at a stated price unless the member is prepared to buy or sell at that price and under such conditions as are stated, and Rule 5210 requires that published quotations be based on actual bona fide transactions or bona fide offers.

SEC Rule 15c2-11 governs when a broker-dealer may publish or submit a quotation for an OTC equity security: current issuer information must be publicly available and the broker-dealer must have reviewed it. The rule exists because a quoted price implies information that in the microcap market frequently did not exist.

MSRB Rule G-13 applies the analogous standard to municipal quotations: a quotation must be based on the dealer's best judgement of the fair market value and must be bona fide.

Best execution

FINRA Rule 5310 requires a member, in any transaction for or with a customer, to use reasonable diligence to ascertain the best market for the subject security and to buy or sell in that market so the resulting price to the customer is as favourable as possible under prevailing market conditions.

The factors listed as relevant to whether reasonable diligence was used: the character of the market for the security — price, volatility, relative liquidity and pressure on available communications; the size and type of transaction; the number of markets checked; the accessibility of the quotation; and the terms and conditions of the order as communicated.

Best execution is not merely best price. A large order in a thin security may be better served by a venue that can absorb it than by one showing a marginally better price for a hundred shares.

Interpositioning is prohibited: a member may not place a third party between itself and the best market in a manner inconsistent with the best execution obligation. Where a broker's broker or other intermediary is used, the burden is on the member to show the customer received a better result. Routing orders to a third party as reciprocation for services or business received is expressly not a justification — which is the rule reaching directly at the arrangement most likely to compromise a customer's execution.

The obligation runs to every customer transaction, including one where the firm acted as principal, and it applies to non-exchange-listed securities as well.

Trade reporting

Post-trade transparency comes from three systems and the exam asks which covers what.

TRACE — the Trade Reporting and Compliance Engine — is FINRA's facility for reporting transactions in eligible fixed income securities, principally corporate and agency debt. It turned an opaque market into one where a customer's price can be compared with contemporaneous trades.

RTRS — the Real-Time Transaction Reporting System — receives municipal transaction reports under MSRB Rule G-14, generally within fifteen minutes of the time of trade, and feeds the price data published on EMMA.

A Trade Reporting Facility, together with the OTC Reporting Facility, receives reports of over-the-counter transactions in equity securities, which then appear on the consolidated tape.

Each exists for the same reason: without post-trade reporting, a customer has no way to know whether the price they received was reasonable, and the fairness standards above would be unenforceable in practice.