Understanding the functioning of the financial market is essential before investing in stocks. The broker with whom you have a demat and trading account sometimes acts as a trader while sometime act as a simple broker. They are both known by the terms Principal Trading and Agency Trading.
In today’s blog post, we will give you an overview of principal trading and agency trading, along with their key differences.
What is Principal Trading?
Principal trading is a type of trading activity in which a financial institution, such as a brokerage firm, investment banker, etc., buys and sells securities itself rather than executing them on behalf of a client by using its own capital. In this manner, the firm itself becomes the buyer or seller and takes full ownership. The key objective of these organisations is to earn profit from price fluctuations by making a strategic market position.
Key Features of Principal Trading
The key features of principal trading are as follows:
- Capital: In principal trading, the firm uses its own capital to buy and sell securities. The client’s funds are not in use.
- Direct Ownership: In principal trading, the ownership of the stocks or securities remains with the firm.
- Zero client involvement: There is no client involved in principal trading. The firms primarily trade for their own benefit.
- High Risk: As the firm uses its own capital in trades, it involves high market risk. Any sharp fluctuation in price can significantly reduce the value of securities purchased by firms.
Example of Principal Trading
Let’s see a brokerage firm thinks that the share of a particular company is currently undervalued and is trading around 1000 INR per share. The firm introduces their own fund and purchased 100 shares using 1,00,000 INR capital. In this case, the firm takes the entire risk, and after a month, the price increased to 1200 INR per share. The firm will earn the entire profit.
What is Agency Trading?
Agency trading is a type of trading in which a financial institution, including a brokerage firm, executes trades on behalf of clients without using their funds. In agency trading, the firm acts as an agent between the buyers and sellers and does not take any ownership in the securities; instead, they charge a commission or brokerage for its services.
Key Features of Agency Trading
The key features of agency trading are as follows:
- Client Fund: In agency trading, the client’s funds are used by the broker instead of the broker’s own funds.
- No Ownership: The broker in agency trading does not own the security; the ownership remains with the client.
- No Risk: As the broker’s funds are not used in agency trading, any profit or loss from the trade belongs to the client, and the broker faces zero risk.
- Earning: The broker in agency mode of trading earns only the commission on every trade executed by the client.
Example of Agency Trading
Suppose a client of a firm wishes to invest in the shares of ABC Limited, which is trading at INR 100, and he wants to purchase 1000 shares. In agency trading, the client introduced funds and instructed their broker to purchase 1000 shares. For this transaction, the broker charges a commission. In this case, the broker is not trading for itself.
Difference Between Principal Trading and Agency Trading
The key difference between Principal Trading and Agency Trading is as follows:
| Particulars | Principal Trading | Agency Trading |
|---|---|---|
| Importance of Broker | In principal trading, the broker acts as a trader. | In this type of trade, the broker acts as a middleman. |
| Fund | The firm uses its own money in principal trading. | In agency trading, the firm does not use its own capital; instead, they use client’s money. |
| Owner of Security | The firm owns the security in principal trading. | In agency trades, the securities are owned by the client. |
| Revenue of the Firm | In principal trading, the firm earns a profit on the trades executed by them; this acts as their major revenue source. | The key source of revenue in agency trading is the commission or brokerage paid by the client on every trade. |
| Objective | The key objective of the principal trade is to earn profit for the firm. | In agency trade, the firm only executes the trades on behalf of clients. |
| Conflict of Interest | There are high chances of conflict of interest in principal trade. | There are minimal chances of conflict of interest. |
| Decision Making | The power to take decision lies with the firm itself. | The client can make all the decisions in agency trading. |
| Involvement of Client | The clients have zero involvement in principal trading. | The agency trading is fully driven by the clients. |
Which One is Better: Principal Trading and Agency Trading
Choosing between principal trading and agency trading depends on the choice of the firm and how they want to earn its revenues. If the firm is looking to earn higher returns by taking high risk, then they can opt for principal trading, but it requires firms to use their own capital to purchase stocks and securities. On the other hand, agency trading is a more stable manner of earning revenue with limited risk. The firm does not need to introduce its own capital; instead, they just charge brokerage fees or fees to facilitate clients to execute their trades.
Read Also: Straddle vs Strangle: Key Differences
Conclusion
On a concluding note, there are two fundamental ways in which a financial market operates: principal trading and agency trading. Principal trading is a more aggressive way to earn profits by taking on higher risk by using the firm’s own capital. On the other hand, agency trading focuses on a more stable way to earn profit by only executing trades on behalf of clients and getting revenue only through brokerage or commission. Principal trading is often used by institutions that have a dedicated research team and resources. Therefore, for an investor, it is advisable to understand the functioning of institution and agency trading to have a clear picture of how a market works. for more Market Information & Learning Download Pocketful offers Zero Brokrage on Delivery, Mutual Funds & IPOs easy to use platform.
Frequently Asked Questions (FAQs)
What is Principal Trading?
Principal trading is a mode in which a firm executes trades by itself using its own funds and earns a profit.
Can a firm buy and sell securities?
Yes, a firm can use its own capital to buy and sell securities. This helps a firm to earn a higher profit by taking advantage of the market opportunities.
Can a firm do both principal and agency trading?
Yes, a firm can be engaged in both principal and agency trading. They can execute a trade on their own using their fund and execute trades for clients.
Can a firm be involved in both principal and agency trading?
Yes, a firm can be involved in both principal and agency trading. They can act as a principal, along with this, they can also facilitate client trade.
How does a firm earn money through agency trading?
A firm can earn money through brokerage or commission for the trades executed on behalf of clients, irrespective of whether the client makes a profit or a loss.
