Principal vs. Agency Trading: Which Strategy is Right for You?

When it comes to trading securities, investors have two main options: principal trading vs. agency trading. Principal trading involves a trader buying or selling securities on their own account, with the goal of profiting from price movements. On the other hand, agency trading involves a trader acting as an intermediary between buyers and sellers, executing trades on behalf of clients.

Both principal and agency trading have their own advantages and disadvantages, and there is no one-size-fits-all answer. It's important to carefully weigh the pros and cons of each strategy and consider how they align with your investment objectives before making a decision.

Principal Trading Overview

Principal traders primarily work for their own profits and hold commodities in inventory for others to trade. Here's how principal trading works.

What is Principal Trading?

In principal trading — a form of proprietary trading — the brokerage owns the securities it sells, keeping it in inventory. When an investor places a buy order, the brokerage checks its inventory. If it has the commodity on hand, it sells it for its preferred price, pocketing the difference between its purchase price and the investor's requested price.

If the brokerage doesn't have shares in inventory, it seeks shares from other entities, using the firm's capital to buy shares. It holds shares for resale, seeking a profitable selling price.

The difference between the original purchase price and the seller's final price is called the bid-ask spread. Principal traders try to buy low when ordering shares and sell high by timing the market.

Advantages of Principal Trading

Some of the pros of principal trading include:

• Quicker Transactions: When the brokerage uses its own capital, there's no need to wait for the client's funds to clear.
• More Liquidity: Frequent transactions can lead to tighter bid-ask spreads, driving more market activity and increasing the chance of a profit.
• Lower Costs and Fees: The brokerage doesn't earn commissions and charges little (if anything) in the way of fees.

Disadvantages of Principal Trading

A few drawbacks could arise in principal trading, including:

• Possible Conflicts of Interest: The brokerage trades to earn profits for itself first.
• Little Transparency: An individual investor doesn't have a lot of insight into the brokerage's actions and can't be certain they're getting the best deal.
• Wider Bid-ask Spreads: When a principal trader makes frequent transactions to stimulate liquidity, the bid-ask spread may widen when markets are less liquid.

Example of Principal Trading

Let's say an individual investor wants to buy 50 shares in Airstar Airlines for $20 per share. The investor requests their prop-trading brokerage to make that purchase.

First, the brokerage checks its holdings to see whether it has enough Airstar shares to sell to the investor. If so, it executes the order, the investor gets Airstar shares and the transaction closes.

If the brokerage does not have enough Airstar shares, it obtains them from other institutions. For example, it could purchase the shares at $15 each and sell them back to the investor for $20. As a result, the investor gets Airstar shares at the price they wanted, and the brokerage profits $5 per share.

Agency Trading Overview

Agency traders have a clear duty: to represent the interests of their clients above their own. Here's what agency trading entails.

What is Agency Trading?

Agency traders put their clients' needs over their company's needs without the double motive of earning income for their firm. To the investor, the process of agency trading isn't that different from principal trading. The investor requests their brokerage to execute a trade.

The agency enters the market on behalf of the client, looking for deals on the securities for the best price and lowest transaction fees. When the brokerage finds acceptable commodities, it buys them and sells them back to the client.

Advantages of Agency Trading

There are a few benefits to agency trading.

• Best Interests of the Client: Agency traders, like fiduciaries, must put their clients' interests above their own.
• Transparency of Operations: The agency trader is more transparent about its pricing and activity.
• Cost-Efficient Trading: Agents often have networks of potential trading partners, allowing trading to happen more quickly and keeping transaction costs low.

Disadvantages of Agency Trading

Some of the potential pitfalls of agency trading include:

• Limited Profit Prospects: With agency trading, the brokerage has less leverage than if they owned the shares, limiting the chances of a big payday for the client.
• No Control Over Timing: When backed up with large market orders, an agency trader may bundle securities for efficiency, delaying some trades from executing.
• Adverse Market Impact: Large orders from brokers could alter the marketplace, possibly hindering liquidity and lowering commodities' values in illiquid markets.

Example of Agency Trading

Let's return to the Airstar Airlines example. An investor wants to buy 100 shares at $17 each, so they call their brokerage to set up an agency trade. The agent acts as a go-between for the investor and the party selling Airstar stock.

The agency searches to find someone selling Airstar shares for $17. It places the order on the client's behalf. After the shares are traded, the investor takes ownership of them. The investor pays the agency the requisite fees, and the transaction concludes.

Principal Trading vs. Agency Trading: Key Differences

Is principal trading or agency trading the structure that fits your needs? Here are the factors to consider.

Role of Traders

Agency traders are intermediaries working strictly on behalf of their clients. To them, everything is for the investor's benefit. Principal traders' primary motivation, by contrast, is to earn profits for the company.

Level of Risk

Principal traders working for their profit motives are essentially playing with house money. They may take on riskier positions to generate higher payouts. Agency traders working for clients tend to limit their clients' exposure to risk.

Cost

Both principal and agency traders may charge transaction and commission fees. Since principal traders fund their own transactions to make profits, they usually target certain points in the bid-ask spread to generate high earnings. The client could end up paying for the volatility, especially if the trader's activity is impacting the commodity's price.

Agency traders charge fees for trade executions. They seek to earn profits for their clients at the prices those clients are willing to sell. Agency traders are more transparent about where their investors' funds are going.

How to Choose Between Principal vs. Agency Trading

Deciding what kind of trader will work for your purposes depends on a few factors. Here are some of the most pertinent ones:

• Volatile Markets: In volatile markets, principal trading entails more risk but could turn a sizable profit, while agency traders seek favorable execution prices.
• Slow or Illiquid Markets: Principal traders may struggle to sell in a stagnant market, forcing them to act at prices less favorable to clients.
• Objectives and Risk Tolerance: Principal traders make short-term transactions on quick sales; agency traders aim to grow and meet long-term investor goals.
• Regulatory Compliance: Agency traders are subject to more industry regulations because they work on their clients' behalf.
• Expertise: Principal traders know more about investing for their experienced clients, while agency traders may be better for novice investors.

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Principal vs. Agency Trading: Choose Carefully

Where you land in the comparison of principal vs. agency trading depends on the goals you have, your risk tolerance, and your investment objectives. Take time to learn the differences and choose the style that best aligns with your needs.

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