4.2 Capacity, Fair Prices and Best Execution

Broker-Dealer Trading Capacities & Compensation Disclosures

Under securities law, a broker-dealer can execute a trade in one of two fundamental legal capacities: Agent (Broker) or Principal (Dealer). The firm's chosen capacity governs the nature of its market risk, the compensation it may charge, and the disclosures required on customer confirmations under SEC Rule 10b-10 and FINRA Rule 2232.

1. Agent / Broker Capacity

When acting in an agency capacity, the broker-dealer acts strictly as an intermediary or broker.

• Role: The firm matches a customer's buy or sell order with another customer, an exchange specialist, or an external market maker.
• Inventory Role: The firm acts as intermediary rather than taking the ordinary principal inventory position; operational and settlement risks remain.
• Remuneration: The firm charges a commission, which must be clearly disclosed as a distinct dollar amount on the customer's trade confirmation.

2. Principal / Dealer Capacity

When acting in a principal capacity, the broker-dealer acts for its own account.

• Role: The firm sells securities to a customer from its own proprietary inventory, or buys securities from a customer into its own inventory.
• Inventory Risk: Full. The firm assumes capital risk and market exposure on the securities held in inventory.
• Remuneration: The firm charges a markup when selling shares to a customer above the prevailing market price (PMP), or a markdown when purchasing shares from a customer below the PMP.
• Confirmation Disclosure: Required remuneration disclosure depends on the security and transaction. Rule 2232’s same-day offsetting principal-trade dollar/percentage disclosure applies to specified non-institutional corporate and agency debt transactions, with exceptions. Municipal transactions have MSRB rules; equity riskless-principal disclosure follows the relevant SEC confirmation provisions.

3. Riskless Principal Transactions

A riskless principal transaction occurs when a broker-dealer receives an order to buy (or sell) from a customer, and simultaneously purchases (or sells) the security from another party in the open market to satisfy that order.

• The firm books the purchase and sale through its proprietary trading account, but holds it briefly; operational and settlement risks remain.
• Regulatory Treatment: Report the actual principal capacity and apply the security-specific confirmation provisions, including applicable remuneration disclosures. Linked trades do not convert the transaction into agency.

FINRA Rule 2121: The 5% Markup Policy

Adopted to prevent excessive charges, FINRA Rule 2121 (The 5% Markup Policy) serves as an ethical benchmark for member firms when executing transactions in equity and debt securities.

Nature and Applicability of the Policy

• Guideline, Not a Hard Rule: The 5% threshold is an industry guideline and standard of reasonableness; it is neither a statutory ceiling, an entitlement, nor a safe harbor. A markup of 3% on an actively traded large-cap equity block can be deemed fraudulent and excessive, while a markup exceeding 5% on an illiquid security requiring extensive dealer search may be justified.
• Scope: The policy applies to secondary market transactions in OTC and exchange securities, whether the broker-dealer acts as agent (commission) or principal (markup/markdown).
• Exclusions: The 5% policy does not apply to securities sold by prospectus or offering circular where prices are fixed by an underwriting agreement (e.g., Initial Public Offerings, mutual fund shares, variable annuities, and direct participation programs).

Seven Core Evaluation Factors

In determining whether a markup, markdown, or commission is fair and reasonable, FINRA reviews seven operational factors:

1. Type of Security: Pricing factors differ across debt and equity; evaluate the actual market, size, liquidity and applicable rule rather than assume a universal percentage range.
2. Availability of the Security: Securities that are illiquid, inactive, or difficult to locate in the dealer network may justify higher compensation due to the effort required to locate contra-side liquidity.
3. Price of the Security: Lower-priced stocks (e.g., shares under $10) may warrant a higher percentage markup to cover basic operational ticket processing costs.
4. Dollar Amount of the Transaction: Large transactions (block orders) warrant lower percentage markups because the gross dollar return adequately covers execution costs.
5. Pre-Execution Disclosure: Informing the customer of the markup or commission percentage prior to trade execution supports fairness, though disclosure alone does not justify an excessive fee.
6. Pattern of Markups: Regulatory surveillance examines whether a firm systematically prices its markups at or near the 5% guideline, which indicates an unfair pricing strategy.
7. Nature of the Firm's Business: Full-service firms providing research, advisory services, and portfolio monitoring may justify higher fees than automated discount execution brokers.

Duty of Best Execution: FINRA Rule 5310 & SEC Rule 606

Under FINRA Rule 5310 (Best Execution), a broker-dealer owes an affirmative duty to its customers to use reasonable diligence to ascertain the best market for the subject security and buy or sell so that the resultant price to the customer is as favorable as possible under prevailing market conditions.

Reasonable Diligence Evaluation Factors

When evaluating whether a firm fulfilled its best execution duty, regulators examine:

1. Character of the Market: Price volatility, trading volume, depth of the limit order book, and relative liquidity in the security.
2. Size and Type of Transaction: Whether the order is a standard retail odd/round lot or an institutional block order requiring specialized handling.
3. Number of Markets Checked: The breadth of primary exchanges, ATS dark pools, and market makers interrogated before routing.
4. Accessibility of the Quotation: The latency, speed of response, and likelihood of execution at the displayed price.
5. Specific Order Terms: Explicit customer conditions, such as limit price instructions, stop orders, or time-sensitive execution mandates.

Regular and Rigorous Review

Broker-dealers that route non-directed customer orders to third-party market centers or wholesale market makers must conduct a regular and rigorous review of execution quality at least quarterly. Operations and trading management compare execution metrics (price improvement percentages, execution speed, effective spreads, and fill rates) across alternative venues to ensure routing choices maximize customer benefits.

SEC Rule 606 Order Routing Disclosures

Under SEC Rule 606, broker-dealers must publish comprehensive quarterly public reports disclosing:

• The top execution venues to which non-directed customer orders were routed for equity and options orders.
• Any material relationships with routing destinations, including Payment for Order Flow (PFOF) arrangements and transaction rebate schedules.
• Applicable routing percentages, order categories and material payment/rebate disclosures. Do not confuse Rule 606 routing reports with Rule 605 execution-quality reports.

Sources checked 2026-10-20: FINRA reporting, FINRA best execution, FINRA account changes.