Last Updated on 14 October, 2021 by Samuelsson
Liquidity is very important in the financial markets as it helps for efficiency in buying and selling of securities and reduces volatility. The truth is, a lack of liquidity in the marketplace can come with adverse effects, which is why there is a need to have market participants, such as principal traders, who help to provide liquidity. But what does principal trading mean?
Principal trading refers to the trading activity of some market players, known as the principal traders, which help to provide liquidity in the market. These players frequently buy and sell assets out of their accounts, thereby serving as a consistent source of liquidity and facilitating orderly trading. While the major role of the principal traders is to provide adequate liquidity — so as to prevent the risk of the marketplace shutting down due to lack of liquidity — they also make profits in the process.
In this article, we will explore different aspects of principal trading. To make the topic easier, we will discuss it under the following subheadings:
- What is principal trading?
- Understanding principal trading: how it works
- Types of principal traders
- Is principal trading legal?
- Importance of principal trading in the real world
- Principal trading vs agency trading: what you should know
What is principal trading?
Principal trading describes a trade order where a broker-dealer or market maker buys or sells for its account instead of executing the trades of its clients. To do this, the broker-dealer buys stocks from the secondary market and keeps them in their accounts before selling them. Such trades are executed at the broker-dealer’s risk.
Apart from shouldering risk and providing liquidity, principal trading is carried out to make a profit through the smart timing of purchase and sales and by setting different prices for buying and selling the same asset, thus profiting from the spread between the two quotes.
Understanding principal trading: how it works
As stated earlier, principal trading is a special kind of trading carried out by a broker-dealer for itself rather than for its clients.
Before a broker-dealer tries out this form of trading, it must inform the exchange of its intention to carry out a principal trade to list the shares as principal orders. This would help the regulators to keep track of large trade orders and protect the everyday investor from any abusive trading activity or insider trading.
The broker then purchases the shares on the secondary markets and holds them in its account for a given period with the expectation that the share price would appreciate so the broker can sell it and make profits. The broker can also profit from the commission it gets from the sale.
In the marketplace, principal trading provides adequate liquidity, ensuring that trading does not cycle out of control or collapse entirely due to lack of liquidity. Basically, these are some of the activities principal traders are known for:
- The principal traders act as a bridge between supply and demand by adjusting their inventory to reduce potential price volatility. For example, when the demand is high, and the prices are above the roof, they may provide their own shares to the market until prices cool down
- They identify errors in the trade orders to prevent a stock from being wrongly priced.
- During periods of low liquidity in the marketplace, the principal traders help to find buyers and sellers. Where there are no bids to match the available asks, the principal traders may search for recently active traders to persuade them to induce trades
- To ensure markets are well-priced at the start and end of trading sessions, they can collaborate with other facilitators, such as the New York Stock Exchange’s Floor Brokers and Supplemental Liquidity Providers. That information is being incorporated and disseminated throughout the day.
Types of principal traders
Although all principal traders help to ensure that the markets work seamlessly, based on the services they offer and how they operate, they are of different types. The key types of principal traders include inventory traders, principal market makers, issuer market makers, and more.
The inventory traders are more concerned with the maximization of profits. As a result, they offer a supply of an asset and simply want to sell it as fast as possible at the highest possible price.
However, other types of principal traders do not place the highest priority on profit-making. Instead, they lookout for ways to purchase more assets at a fair price when the opportunity avails itself. This does not negate the fact that they are also motivated by making profit, but they have a wider scope as they are always replenishing inventory and looking at both sides of the market.
These types of principal traders are not always mainly concerned with a long-term inventory. So if there is enough liquidity in the market, they may simply facilitate trades among counterparties, carrying short-term inventory when it’s necessary to execute the buy-side of their quotes but unloading it as soon as another purchaser is available. This entails that these traders are keen on making small and steady profits than the profit on individual transactions.
The usual market makers carry an inventory and normally trade in the secondary market. They are often more interested in ensuring the availability of optimal liquidity in the marketplace. Therefore, they can be rewarded for their services through rebates or other incentives from the owners/managers of the exchanges on which they operate.
On the other hand, there are the issuer principal market makers. These types of market makers are basically the original source of an asset. Therefore, they are entitled to buy, sell and hold inventory due to being the first to provide the asset in the first place. They derive value from the original issuance — converting the asset into cash — but may be put in the position of making a market in the asset to keep the marketplace for it running fluidly. They help to ensure the sustenance and growth of the overall activity around the asset rather than necessarily profiting from individual transactions.
Is principal trading legal?
Principal trading is legal. In fact, in the stock markets, the Securities and Exchange Commission (SEC) oversees the activity of principal traders.
The main purpose of principal trading is to allow firms to profit from their portfolios when the price rises. It occurs when a brokerage purchases securities in the secondary market, holds these securities for some time, and then sells them. So, when an investor buys and sells stock through a brokerage firm that acts as the principal, the firm will use its inventory on hand to fill the order for the client. With this method, brokerage firms earn extra income from the spread. For example, when a trader wants to purchase 200 shares of XYZ at $20, the firm that is acting as the principal trader would first check its own inventory to see whether or not the shares are available to sell to the trader. If they are available, the firm would sell the shares to the trader and then report the transaction to the necessary exchange.
While principal trading is legal, it is imperative to note that the Securities and Exchange Commission (SEC) and exchanges require that the brokerage firms complete the trades at prices that are comparable to those of the market.
Importance of principal trading in real world
In the real world, principal trading comes with a lot of benefits. Principal traders ensure the availability of adequate liquidity and enhancement of orderly trading through the purchase and sale of assets out of their own accounts.
Also, the principal traders help to curb risk by carrying out inventory at their own expense by shouldering the risk. By holding their own inventory in an asset, these traders act as dealers of the asset in question, unlike agency brokers who represent and trade on behalf of clients.
Other essential functions of principal traders in the real world include the following:
- Carrying out necessary adjustments using their own inventory and acting as a bridge between supply and demand to reduce potential price volatility. For example, when the market is bullish, principal traders may provide their own shares to the market until prices cool down
- Identifying errors in trade orders and correcting errors that would otherwise cause a stock to be mispriced or experience a “flash crash”.
- They help to match sellers with buyers who are willing to buy. However, if bids and asks can’t be matched, the principal traders may seek out recently active investors to induce trades
- Running the opening/closing auctions on an exchange, working with other facilitators, for example, the New York Stock Exchange’s Floor Brokers and Supplemental Liquidity Providers, to ensure markets are well-priced at the start and end of trading sessions and that information is being incorporated and disseminated throughout the day.
Principal trading vs agency trading: what you should know
Two things can happen when you are trading on your computer via your broker’s platform: you are either trading with another person through an exchange or only making a trade with your broker. These two main types of trades are known as principal and agent transactions. While principal trades deal with the brokerage’s own inventory of securities, the agency trading involves trading with another investor, potentially from another brokerage, on the security exchange.
An easy way to grasp the concept of agency trading is that the stockbroker takes your transaction request and then seeks another party, via the security exchange, that is looking for a similar transaction on the opposite end. For instance, if your transaction request to your stockbroker is for a sell order at a certain price, the stockbroker will seek a transaction request on the exchange for a buy order at that price. Once both of these parties are found, and the transaction is concluded, it is documented as an agency trade on the appropriate exchange. So, in this case, the broker is merely an agent that helps to facilitate the transaction.
In principal trading, on the other hand, the broker, who in this case is a dealing desk market maker (a dealer), executes clients’ trades from its own inventory. As expected, there are some major differences between principal trading and agency trading. The major difference between the two types of trades is the question of who benefits from the trades and who bears the risk. In principal trading, trades are executed entirely for the benefit of the stockbroker (a dealer) and for its own portfolios. This also means that principal trades are executed at the risk of the stockbroker and not its clients. On the other hand, in agency trading, trades are executed solely on behalf of the clients. And as such, the risk of the trades is borne by the individual investor and not the stockbroker.
Another significant difference between principal trading and agency trading is the matter of who they are largely conducted for. In the case of agency trading, it is mostly conducted for individual investors trading in the stock market. The stockbroking firm executes each transaction, and the goal is to fill the client’s order by seeking order requests from other investors.
With an agency trade order, a broker trades for the benefit of a client rather than itself and only gets compensated by a commission. But with a principal trade, a dealer will act as a broker as well, and they carry out trading from their inventory while charging a spread as a fee. Most retail or individual investors who execute trades do so through agency trades.
Putting it all together, principal trades are very useful for the market. The benefits of a principal trade largely include trade execution and trade costs. An agency trade may not meet a client’s needs for specialized orders or orders that require immediate execution — or a mixture of both. To help serve the client best, or even in their best interest, it may make the most sense for a securities dealer to also act as a broker and buy/sell from internal inventory.