Riskless Principal

Riskless principal is a trade in a security that involves two orders, with the execution of one order dependent upon the receipt or execution of the other. It is a trade in which a member who has received a customer order immediately executes an identical order in the marketplace, while taking on the role of principal, in order to fill the customer order.

A buy order from a customer would therefore require the member firm to execute an identical buy order in the market as principal, 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.

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.

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.

The NASD's Special Notice on "Compensation and Mixed Capacity Trading" offers a 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.