Investment dealers: principal versus agent
◈ 5 cardsOne firm, two hats, two ways of being paid — tell a principal trade from an agency trade by who bears the price risk and how the dealer earns.
What an investment dealer is
An investment dealer is a firm registered to trade in securities and to underwrite them. In Canada that registration is under National Instrument 31-103, in the investment dealer category, and the firm is a member of the self-regulatory organisation, CIRO. One firm does both halves of the market: it brings new issues to market (underwriting — the primary market) and it trades existing securities for clients and for itself (the secondary market).
The CSC lists the dealer's functions as six: underwriting, secondary trading, advice, research, custody (holding clients' securities) and margin lending (lending clients part of the purchase price). One thing a dealer does not do is take deposits — that is the bank's business, and the two are regulated by different levels of government (Lesson 3).
Two hats
In a secondary trade the dealer wears one of two hats, and the paper's favourite question is which.
As principal, the dealer trades from its own inventory. It buys the security from one client at its bid and later sells it to another at its ask. Its income is the spread between the two, and while it holds the position it bears the price risk — if the market drops before it resells, the loss is the dealer's.
As agent (the person doing this is a broker), the dealer executes a client's order against the market and charges a commission. It never owns the security; the client bears the price risk from the moment the order fills.
Worked example — Northshore Securities, one afternoon
Trade A. Northshore buys $100,000 par of a Prairie Grid Energy bond from a client at 98.50 and, an hour later, sells the same bond to another client at 98.90, both from its own book. Bond prices are quoted per 100 of par, so the profit is
In Excel: =(ask-bid)/100*par. Northshore acted as principal: it earned the spread, and for that hour it owned a bond whose price could have fallen.
Trade B. A client asks Northshore to buy $10,000 of Tamarack Foods shares. Northshore routes the order to the exchange, it fills, and Northshore charges 1 %: $0.01 \times 10{,}000 = \mathbf{\$100}$ (=rate*value). Northshore acted as agent: it earned a commission, it never owned the shares, and if Tamarack falls tomorrow the client wears it.
The quote tells you the hat
When you see a dealer's own bid and ask — "98.50 – 98.90" — the dealer is offering to trade as principal, and the spread is its fee. When you see the market's best bid and ask plus a commission line on your confirmation, the dealer acted as agent. Bonds in Canada trade mostly the first way (an over-the-counter dealer market); listed shares mostly the second.
Four transactions to classify
(1) A dealer sells a client 500 shares out of a block it bought yesterday — principal. (2) A dealer routes a client's limit order to the TSX for a $9.95 commission — agent. (3) A dealer buys a new issue from the issuer and resells it to the public — principal in the primary market, called underwriting (Lesson 2). (4) A dealer holds a client's shares in its nominee name — neither: that is custody, one of the six functions and not a trade at all.