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Riskless principal: Difference between revisions
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Depending on how you look at it, when it comes to [[equity brokerage]], a [[riskless principal]] is a kind of weird half-way house between a [[principal]] and an [[agent]]. | Depending on how you look at it, when it comes to [[equity brokerage]], a [[riskless principal]] is a kind of weird half-way house between a [[principal]] and an [[agent]]. | ||
*'''The legal view''': Legally, a [[riskless principal]] is just a [[principal]] with a feeble constitution: one of those indoorsy types who gets migraines and likes chess, and who only contracts with clients once he has arranged a contract with the market. Being a sookie, he arranges his life so that he bears no risk if the transaction goes wrong. | *'''The legal view''': Legally, a [[riskless principal]] is just a [[principal]] with a feeble constitution: one of those indoorsy types who gets migraines and likes chess, and who only contracts with clients once he has arranged a contract with the market. Being a sookie, he arranges his life so that he bears no risk if the transaction goes wrong. | ||
*'''The economic view''': A [[riskless principal]] is an [[agent]], but not the usual bookish sort | *'''The economic view''': A [[riskless principal]] is an [[agent]], but not the usual bookish sort: one who doesn’t mind getting her shoes wet, picks up hitch-hikers, goes mountaineering and gets in bar-fights. Even though she doesn’t take any risk when she fills a customer order, she’s happy to hold the stock as it passes through. | ||
===What is the difference between [[agency]] and [[riskless principal]]?=== | ===What is the difference between [[agency]] and [[riskless principal]]?=== | ||
'''[[Agency]]''': A [[broker]] acts as [[agent]] if, acting at a client’s request and on its behalf, it purchases an asset from the market, separately charging the client a commission. As there is only one transaction (between client and market) an agent [[cannot]] charge a mark-up or mark-down. <br> | '''[[Agency]]''': A [[broker]] acts as [[agent]] if, acting at a client’s request and on its behalf, it purchases an asset from the market, separately charging the client a [[commission]]. As there is only one transaction (between client and market) an agent [[cannot]] charge a [[mark-up]] or [[mark-down]]. <br> | ||
'''[[Riskless principal]]''': A [[broker]] acts as [[riskless principal]] if, acting at its client’s request, it purchases an asset from the market for its own account (as [[principal]]), records that transaction in its own trading books and more or less immediately, sells the same asset to the client (also as [[principal]]), either at the same price (with a “[[commission]]”<ref>Actually, it's odd for a [[principal]] to charge a [[commission]]. Normally, this is indicative of an agency arrangement. It is better to describe the remuneration paid to a riskless principal as a [[fee]].</ref>) or at a mark-up or mark-down (with no [[commission]]). Therefore there are two transactions; one between client and riskless principal; one between riskless principal and market. | '''[[Riskless principal]]''': A [[broker]] acts as [[riskless principal]] if, acting at its client’s request, it purchases an asset from the market for its own account (as [[principal]]), records that transaction in its own trading books and more or less immediately, sells the same asset to the client (also as [[principal]]), either at the same price (with a “[[commission]]”<ref>Actually, it's odd for a [[principal]] to charge a [[commission]]. Normally, this is indicative of an agency arrangement. It is better to describe the remuneration paid to a riskless principal as a [[fee]].</ref>) or at a [[mark-up]] or [[mark-down]] (with no [[commission]]). Therefore there are two transactions; one between client and riskless principal; one between riskless principal and market. | ||
*As against the market, a [[riskless principal]] acts on its own behalf and not for its client. | *As against the market, a [[riskless principal]] acts on its own behalf and not for its client. | ||
*As against the client, a [[riskless principal]] acts on its own behalf and not for the market. | *As against the client, a [[riskless principal]] acts on its own behalf and not for the market. | ||
*A riskless principal may be remunerated by means of either (i) a mark up or mark down between the Principal Purchase and the Principal Sale or (ii) a separate payment from Buyer to Riskless Principal which resembles a commission but is in fact not a commission. | *A riskless principal may be remunerated by means of either (i) a mark up or mark down between the Principal Purchase and the Principal Sale or (ii) a separate payment from Buyer to Riskless Principal which resembles a [[commission]] but is in fact not a [[commission]]. | ||
*There is no | *There is no [[commission]] payable on a Riskless Principal contract. | ||
===The way the Americans look at it=== | ===The way the Americans look at it=== | ||
There are four ways an investment advisor might purchase securities for a client. | There are four ways an investment advisor might purchase securities for a client. | ||
*A “'''riskless principal transaction'''” arises where an adviser (acting through an affiliated [[broker-dealer]]) purchases or sells a security for an advisory client. In executing the transaction, the adviser simultaneously buys or sells the security for the client through an offsetting transaction in the account of an affiliated [[broker-dealer]]. In this way, the security notionally, passes through the account of the affiliate broker-dealer who charges a small markup or markdown rather than a commission. Although resembling agency transactions, the SEC treats riskless principal transactions as principal transactions fully subject to Section 206(3) of the [[Investment Advisers Act of 1940|40 Act]]. The SEC has brought a number of enforcement actions involving riskless principal transactions under Section 206(3). | *A “'''riskless principal transaction'''” arises where an adviser (acting through an affiliated [[broker-dealer]]) purchases or sells a security for an advisory client. In executing the transaction, the adviser simultaneously buys or sells the security for the client through an offsetting transaction in the account of an affiliated [[broker-dealer]]. In this way, the security notionally, passes through the account of the affiliate broker-dealer who charges a small markup or markdown rather than a [[commission]]. Although resembling agency transactions, the SEC treats riskless principal transactions as principal transactions fully subject to Section 206(3) of the [[Investment Advisers Act of 1940|40 Act]]. The SEC has brought a number of enforcement actions involving riskless principal transactions under Section 206(3). | ||
*A “'''cross transaction'''” is a transaction in which an adviser causes the purchase and sale of a security between two advisory client accounts without charging a fee for effecting the transaction. Where the client accounts are not owned by the adviser, a cross transaction is not a principal transaction subject to Section 206(3) because the adviser would not be “acting as broker” (assuming that neither no fee is charged for effecting the trade. If the adviser charges a fee the transaction would be deemed an “agency cross transaction” as discussed below). The {{tag|SEC}} has cautioned that cross transactions are nevertheless subject to Sections 206(1) and (2) of the Advisers Act and that an adviser may need to disclose information about cross transactions. | *A “'''cross transaction'''” is a transaction in which an adviser causes the purchase and sale of a security between two advisory client accounts without charging a fee for effecting the transaction. Where the client accounts are not owned by the adviser, a cross transaction is not a principal transaction subject to Section 206(3) because the adviser would not be “acting as broker” (assuming that neither no fee is charged for effecting the trade. If the adviser charges a fee the transaction would be deemed an “agency cross transaction” as discussed below). The {{tag|SEC}} has cautioned that cross transactions are nevertheless subject to Sections 206(1) and (2) of the Advisers Act and that an adviser may need to disclose information about cross transactions. | ||
*An “'''agency cross transaction'''” is where an investment adviser acts in relation to a transaction in which an affiliated broker-dealer acts as broker for both an advisory client and another person on the other side of the transaction and the affiliated broker-dealer charges a transaction fee for effecting the trade. Section 206(3) applies to agency cross transactions, even though neither the adviser nor the affiliated broker-dealer acts as principal with respect to the trade because the affiliate is “acting as broker for a person other than such client”. | *An “'''agency cross transaction'''” is where an investment adviser acts in relation to a transaction in which an affiliated broker-dealer acts as broker for both an advisory client and another person on the other side of the transaction and the affiliated broker-dealer charges a transaction fee for effecting the trade. Section 206(3) applies to agency cross transactions, even though neither the adviser nor the affiliated broker-dealer acts as principal with respect to the trade because the affiliate is “acting as broker for a person other than such client”. | ||
However, Rule 206(3)-2, permits an investment adviser to effect agency cross transactions based on prospective, blanket consent from an advisory client. The rule contains a number of conditions, including certain disclosure and reporting obligations and is not available where (a) the adviser or its affiliated broker-dealer recommend the transaction to both sides of the trade or (b) when a security trades on a principal basis (which would typically result in a riskless principal transaction, as discussed above). | However, Rule 206(3)-2, permits an investment adviser to effect agency cross transactions based on prospective, blanket consent from an advisory client. The rule contains a number of conditions, including certain disclosure and reporting obligations and is not available where (a) the adviser or its affiliated broker-dealer recommend the transaction to both sides of the trade or (b) when a security trades on a principal basis (which would typically result in a riskless principal transaction, as discussed above). | ||
*“'''Agency Transactions'''” are where an adviser executes a securities transaction through a broker-dealer who acts as agent on behalf of the adviser’s client. The broker-dealer charges a commission for representing the adviser’s client in effecting the trade. Section 206(3) does not apply to agency transactions, even if the broker-dealer is an affiliate of the adviser (and assuming that the affiliate broker-dealer does not also represent the person on the other side of the transaction). However, in these circumstances, an adviser has a general obligation to disclose that it may use an affiliated broker-dealer and that the adviser will indirectly benefit from any | *“'''Agency Transactions'''” are where an adviser executes a securities transaction through a broker-dealer who acts as agent on behalf of the adviser’s client. The broker-dealer charges a [[commission]] for representing the adviser’s client in effecting the trade. Section 206(3) does not apply to agency transactions, even if the broker-dealer is an affiliate of the adviser (and assuming that the affiliate broker-dealer does not also represent the person on the other side of the transaction). However, in these circumstances, an adviser has a general obligation to disclose that it may use an affiliated broker-dealer and that the adviser will indirectly benefit from any [[commission]]s paid to the affiliated broker-dealer. | ||
{{seealsoagent}} | {{seealsoagent}} | ||
{{ref}} | |||