Risklessprincipal

What Is a Riskless Principal? Key Concepts and NASD Rules

Key Takeaways

A riskless principal trade involves a broker executing an identical order in the marketplace as principal to fulfill a customer’s order at the same price.
This type of transaction is risk-free for brokers, as they immediately execute the market trade, making it effectively riskless.
FINRA requires that riskless principal trades be at the same price without additional costs like markups or commissions for regulation compliance.
SEC amendments in 1999 allowed market makers to only report one side of a riskless principal transaction, reducing transaction costs.
For investors seeking efficient trade execution, understanding riskless principal trades ensures awareness of brokerage processes.

What Is Riskless Principal?

A riskless principal is a broker who, after receiving a customer's order to buy or sell a security, immediately executes an identical order in the market for their own account to fulfill the customer’s request. This ensures that the broker assumes no risk because both transactions are executed at the same price, excluding any additional costs such as markups, markdowns, or commissions.

Understanding these transactions is crucial for both brokers and investors because they impact how trades are reported and the fees involved. We'll explore how riskless principal transactions work, their benefits, and regulatory guidelines set by the Financial Industry Regulatory Authority (FINRA).

How Riskless Principal Trades Work

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.1

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.2

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.3

NASD Guidelines for Riskless Principal Transactions

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."4

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

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

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

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

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