A riskless principal is a brokerage or dealer firm that simultaneously buys and sells a security in two separate but offsetting transactions, with the aim of facilitating a customer’s trade without taking on any market risk.
In essence, the firm acts as an intermediary between the buyer and seller without exposing itself to the risk associated with holding the security in its inventory.
A broker acts as a riskless principal if, acting at its customers’ request, it purchases an asset from the market for its own account (as principal), records that transaction in its own trading books, and more or less immediately, sells the same asset to the customer (also as principal), either at the same price (with a “commission”) or at a markup (with no commission).
This means that are two transactions;
- One between the customer and the riskless principal (the broker)
- One between the riskless principal (broker) and market (external counterparty or “liquidity provider”).
A riskless principal is compensated in one of two ways:
- A markup between what it paid for the asset “in the market” versus what it sold it for to the customer.
- A separate payment from the customer to the riskless principal, which sounds like a commission but is technically not a commission and should be called a “fee“.
It’s important to note that riskless principal transactions are subject to regulatory oversight and reporting requirements.
Brokerage firms must disclose their role as a riskless principal on trade confirmations and maintain proper records to ensure transparency and compliance with financial regulations.