Trading Capacity Practice Questions for the SIE

Answer: Commission

When a firm simply brings a buyer and seller together — never owning the securities itself — it acts as a broker, or agent, and its compensation is a commission. A markup (choice A) and a markdown (choice C) are the compensation of a firm acting as a dealer, or principal, trading out of its own inventory: markup when the customer buys, markdown when the customer sells. The spread (choice D) is the gap between a dealer's bid and ask quotes — a feature of principal market making, not a fee charged on an agency trade. The firm's capacity, and the commission on an agency trade, must be disclosed on the trade confirmation under SEC Rule 10b-10.

The Trap: markup-commission terminology tied to the wrong capacity

• Markup: Misconception: markup/commission terminology tied to the wrong capacity — a markup is principal (dealer) compensation when the customer buys from firm inventory, not agency compensation.
• Spread: Misconception: mixed dealer/agency vocabulary — the spread belongs to a dealer's two-sided quote (a principal activity); it is not a charge assessed on an agency trade.
• Markdown: Misconception: wrong-capacity terminology — a markdown is principal compensation when a customer sells into the dealer's inventory; it does not apply to an agency trade.

Verified against: SEC Rule 10b-10 (17 CFR 240.10b-10) — confirmation disclosure of capacity and of agency remuneration

Answer: Principal; a markup

A firm that trades with its customer out of its own inventory acts as a dealer — a principal in the trade — and its compensation is a markup added to the price the customer pays. The anchor idea is one hat per trade: a firm is either the agent arranging your trade with someone else, or the principal on the other side of it, and it is paid one way accordingly — it does not charge both a commission and a markup on the same transaction. Choice B mixes the vocabulary: a commission is compensation for agency work, and a firm selling you stock it already owns is not arranging anything, so it is paid through the price. Choice C assumes any customer order execution is agency work, but the source of the shares — firm inventory — is what makes this a dealer trade. Choice D reverses both terms; a markdown is the mirror image, applying when the customer is the seller into the dealer's inventory. Two rules worth remembering: under SEC Rule 10b-10 the confirmation must disclose the capacity in which the firm acted (here, principal), and under FINRA Rule 2121 ('Fair Prices and Commissions') the markup must be fair and reasonable.

The Trap: dealer charges commission from inventory (mixed vocabulary)

• Agent; a markdown: Misconception: double reversal of the capacity/compensation map — agency compensation is a commission, and a markdown applies when a customer sells to a dealer's inventory, not when the customer buys.
• Agent; a commission: Misconception: assuming every customer trade is an agency trade; using the firm's own inventory makes this a principal transaction.
• Principal; a commission: Misconception: 'dealer charges a commission from inventory' — mixed vocabulary. A commission is what a firm earns for agency work, arranging a trade between other parties; a firm selling stock it already owns is paid through a markup in the price instead.

Verified against: verified against FINRA Rule 2121 Supplementary Material (sale to customer from inventory = markup) and SEC Rule 10b-10 (capacity disclosure)

Answer: On the trade confirmation

SEC Rule 10b-10 requires a broker-dealer to send each customer a written trade confirmation that discloses, among other things, whether the firm acted as agent or as principal — along with the commission if it acted as agent. Choice B is wrong because the disclosure is automatic, not something a customer must ask for. Choice C confuses confirmations (trade-by-trade documents) with periodic account statements. Choice D imports the 5% policy where it does not belong: that policy is a fairness guideline for the size of charges, not a threshold that turns disclosure on or off — capacity is disclosed on every trade regardless of the charge.

The Trap: capacity disclosure treated as conditional rather than automatic on the confirmation

• Only when the firm's compensation exceeds 5% of the trade's value: Misconception: treating 5% as a regulatory trigger or hard line; the 5% policy is a fairness guideline and has nothing to do with when capacity must be disclosed.
• Only if the customer requests the information in writing: Misconception: treating capacity disclosure as on-request only; it is an automatic, affirmative disclosure obligation on every confirmation.
• On the customer's quarterly account statement: Misconception: confusing the trade confirmation with periodic account statements; capacity is a trade-by-trade disclosure made on the confirm.

Verified against: SEC Rule 10b-10 (17 CFR 240.10b-10) - confirmation disclosure of capacity (agent vs. principal)

Answer: Principal

A market maker stands ready to buy at its bid and sell at its ask using its own capital and its own inventory — that is principal (dealer) activity, and the firm profits from the spread and from price movement in its inventory. Choice B is the common flip: facilitating trading does not make a firm an agent when it is the counterparty to the trades. Choice C reflects the 'broker-dealer' name trap — the term describes what a firm is licensed to do overall, but on any single trade it acts in one capacity only. Choice D confuses secondary-market dealing with underwriting, which is a primary-market function of distributing new issues for an issuer.

The Trap: market maker mistaken for an agent

• Underwriter: Misconception: confusing secondary-market dealing with primary-market distribution; underwriting is helping an issuer sell new securities, not quoting existing ones.
• Both agent and principal at the same time: Misconception: 'broker-dealer means both at once' — a firm wears only one hat on any given trade, and market making is squarely the principal hat.
• Agent: Misconception: assuming a firm that facilitates customer trading must be acting as agent; a market maker trades for its own account, taking inventory risk — a principal role.

Verified against: Securities Exchange Act of 1934 Section 3(a)(5) - definition of 'dealer' (principal/market-maker capacity)

Answer: Markdown

Because the firm bought the shares into its own inventory, it acted as principal — and when the customer is the seller, the dealer's compensation is a markdown: the firm pays the customer slightly less than the prevailing interdealer price. Choice B has the right capacity but the wrong direction; a markup applies when the customer buys from the dealer. Choice C attaches agency vocabulary (commission) to a principal trade — a firm earns one or the other depending on its capacity, never a commission on its own inventory trade. Choice D borrows mutual fund terminology; sales loads are prospectus-disclosed charges on fund shares, an entirely different context. Markdowns, like markups and commissions, must be fair under FINRA Rule 2121.

The Trap: markup vs markdown direction when the customer is the seller

• Markup: Misconception: right capacity, wrong direction — a markup applies when the customer buys from inventory; when the customer sells, the dealer's charge is a markdown.
• Commission: Misconception: commission terminology tied to the wrong capacity — commissions belong to agency trades, and this firm traded for its own account.
• Sales load: Misconception: importing packaged-product vocabulary — sales loads are charges on mutual fund purchases disclosed in a prospectus, not dealer compensation on a secondary-market stock trade.

Verified against: FINRA Rule 2121 (Fair Prices and Commissions - markups/markdowns on principal transactions)

Answer: Prohibited, because a firm may act in only one capacity on a given trade and may not charge both a markup and a commission

On any single transaction a firm wears one hat. As a principal (dealer) it sells the customer stock out of its own inventory, and its compensation is the markup built into the price. As an agent (broker) it matches the customer with another party and is compensated by a commission. FINRA Rule 2121 treats these as alternatives: a firm dealing for its own account must trade at 'a price which is fair,' while a firm acting as agent 'shall not charge his customer more than a fair commission or service charge.' Stacking a commission on top of a markup bills the customer twice for one service, regardless of the amounts involved. Choice B falls for the 'broker-dealer' name. The term describes the firm's overall business — it can act as a broker on one trade and a dealer on the next — not permission to combine capacities on one trade. Choice C misuses the 5% policy. FINRA says plainly that it is 'a guide, not a rule,' that fairness turns on all relevant factors, and that a markup pattern of 5% or even less may still be unfair. Coming in under 5% does not legitimize a charging structure that is improper to begin with. (The policy also does not apply to securities sold by prospectus at the public offering price — mutual funds, new issues, variable annuities.) Choice D confuses disclosure with permission. SEC Rule 10b-10 requires the confirmation to state the capacity in which the firm acted and, on an agency trade, the remuneration charged; markup disclosure is required in specified principal situations, such as riskless-principal trades in equity securities. But FINRA's mark-up policy settles the point: disclosure 'does not justify a commission or mark-up which is unfair or excessive in light of all other relevant circumstances.' Disclosing an improper charge does not convert it into a permitted one.

The Trap: broker-dealer = both capacities at once on one trade

• Permitted, because the firm is registered as a broker-dealer and may use both sides of its registration: Misconception: 'broker-dealer' means both capacities at once. The label describes the firm's overall business — it may act as broker on one trade and dealer on the next — but it is not permission to combine capacities, or charges, on a single trade.
• Permitted, as long as the markup and commission combined do not exceed 5% of the trade's value: Misconception: treating 5% as a safe-harbor ceiling that legitimizes any charging structure. FINRA states the '5% Policy' is 'a guide, not a rule,' and that 'a mark-up pattern of 5% or even less may be considered unfair or unreasonable.' It sizes a single charge for fairness; it does not authorize stacking two.
• Permitted, provided both charges are clearly disclosed on the trade confirmation: Misconception: disclosure cures the violation. Confirmations must show the firm's capacity, but FINRA's mark-up policy is explicit that 'disclosure itself... does not justify a commission or mark-up which is unfair or excessive.' Printing an improper dual charge on the confirmation does not make it proper.

Verified against: FINRA Rule 2121 (Fair Prices and Commissions) and Supplementary Material .01 — .01(a)(1) '5% Policy is a guide, not a rule'; .01(a)(4) pattern of 5% or less may still be unfair; .01(b) disclosure does not justify an unfair commission or mark-up; .01(d) policy inapplicable to prospectus-offered securities sold at the public offering price. SEC Rule 10b-10(a)(2) (confirmation disclosure of capacity; agency remuneration; markup disclosure in specified principal transactions).

Answer: It is a fairness guideline, not a strict rule — depending on the relevant factors, a charge above 5% may be fair and a charge below 5% may be excessive

The 5% policy, found in FINRA Rule 2121, is a guideline for judging whether a firm's charge is fair — not a fixed limit. Fairness turns on the relevant circumstances: the type and availability of the security, its price, the size of the trade, and the firm's cost of execution. That means a 6% charge on a hard-to-find, low-priced security could be fair, while a 4% charge on an actively traded stock could be excessive — which is why choice B's 'hard cap' framing fails. Choice C is misled by the policy's name: it covers commissions, markups, and markdowns. Choice D applies the policy to mutual funds, but securities sold by prospectus — mutual funds, new issues, variable annuities — are excluded, with their sales charges disclosed and regulated separately.

The Trap: 5% treated as a hard ceiling

• It is a binding rule that caps all commissions and markups at 5% of the trade's value: Misconception: 5% as a hard ceiling — there is no fixed maximum; 5% is a benchmark for evaluating fairness, and lower charges can still be unreasonable.
• It sets the maximum sales charge a customer can pay when purchasing mutual fund shares: Misconception: applying the 5% policy to prospectus offerings — mutual funds are sold by prospectus and are excluded from the policy; their sales charges are governed separately.
• It applies only to markups on principal trades, not to commissions or markdowns: Misconception: scope narrowed by the policy's name — despite being called the 'markup policy,' it applies to commissions, markups, and markdowns alike.

Verified against: FINRA Rule 2121 (Fair Prices and Commissions - 5% Markup Policy)

Answer: A customer's secondary-market purchase of an exchange-listed stock on which the firm charges a commission

The 5% policy under FINRA Rule 2121 is a fairness guideline for charges on secondary-market transactions — and it covers agency commissions along with principal markups and markdowns, so a commission on an exchange-listed stock trade is squarely within its reach. The other three choices share one disqualifying feature: each security is sold by prospectus. Mutual funds (choice A), new issues such as IPO shares (choice B), and variable annuities (choice D) carry sales charges that are disclosed in the prospectus and governed by separate rules, so the 5% policy does not apply to them. Remembering 'sold by prospectus = outside the 5% policy' resolves this frequently tested exclusion.

The Trap: applying the 5% policy to mutual funds, IPOs, and other prospectus offerings

• A customer's purchase of a variable annuity contract: Misconception: applying the 5% policy to prospectus products — variable annuities are sold by prospectus and are excluded from the policy.
• A customer's purchase of open-end mutual fund shares: Misconception: applying the 5% policy to prospectus offerings — mutual funds are sold by prospectus, so their sales charges fall outside the policy.
• A customer's purchase of shares in an initial public offering: Misconception: applying the 5% policy to new issues — IPO shares are sold by prospectus at a stated public offering price, excluded from the policy.

Verified against: FINRA Rule 2121 (Fair Prices and Commissions - 5% Markup Policy; excludes securities sold by prospectus)

Answer: A broker (agent), and it may charge the customer a commission

The firm's role here is pure matchmaking: it accepted the order, routed it to a marketplace, and let it execute against another investor — it took no inventory position and no market risk. That is agency (broker) capacity, and the proper compensation is a commission, disclosed on the confirmation under SEC Rule 10b-10. Choice B assumes execution alone creates dealer status, but principal capacity requires the firm to trade for its own account. Choice C describes market making, which means continuously quoting and committing the firm's own capital — not routing an order elsewhere. Choice D is the classic 'broker-dealer' trap: the name describes the firm's registration, while every individual trade is done in one capacity with one form of compensation.

The Trap: executing a customer order mistaken for dealer (principal) activity

• A market maker, and it earns the bid-ask spread: Misconception: mixed dealer vocabulary — market making requires quoting and trading for the firm's own account; routing an order to an exchange involves neither.
• A dealer, and it may charge the customer a markup: Misconception: assuming that executing a customer order makes the firm a dealer; without trading from its own account, the firm is not acting as principal and earns no markup.
• Both a broker and a dealer, so it may charge a commission plus a markup: Misconception: 'broker-dealer' means both capacities on one trade — a firm acts in a single capacity per trade and may not stack a commission and a markup.

Verified against: Securities Exchange Act of 1934 Section 3(a)(4) - definition of 'broker' (agency capacity); confirmation disclosure under SEC Rule 10b-10

Answer: The firm sold the shares to the customer from its own account, and the price paid reflected any markup

A confirmation marked 'principal' tells the customer the firm itself was the seller: the shares came from the firm's own account, and the firm's compensation — the markup — was built into the price the customer paid. Choice B describes the hallmark of an agency trade, where the firm arranges the trade between other parties and adds a commission as a separate charge; when the firm acts as principal, its compensation is instead embedded in the price as a markup, so a commission line is not what this confirmation reports. Remember the mapping the exam tests: agent earns a commission, principal earns a markup (or a markdown when the customer sells). Choice C converts the 5% policy into a legal ceiling, but FINRA Rule 2121 states plainly that the 5% Policy is a guide, not a rule — fairness depends on all relevant circumstances, and a markup pattern of 5% or even less can be judged unfair, just as a charge above 5% can sometimes be reasonable. Choice D shrinks SEC Rule 10b-10, which requires every customer confirmation to state whether the firm acted as agent or as principal for its own account — capacity disclosure applies to principal and agency trades alike.

The Trap: agency traits (separate commission line item) attributed to a principal trade

• Stating the firm's capacity was optional for this trade, because disclosure is required only on agency transactions: Misconception: narrowing SEC Rule 10b-10 — capacity must be disclosed on every customer confirmation, whether the firm acted as agent or as principal.
• The firm's total compensation on the trade was legally capped at 5% of its value: Misconception: 5% as a hard legal ceiling — FINRA Rule 2121 calls the 5% Policy a guide, not a rule; fairness turns on all relevant circumstances, not a fixed percentage.
• The firm charged a commission, shown as a separate line item on the confirmation: Misconception: attaching agency compensation to a principal trade — a separately stated commission is the signature of an agency trade, where the firm arranges the trade between other parties. When the firm acts as principal, its compensation is a markup embedded in the price the customer paid, so nothing here establishes that a commission was charged.

Verified against: FINRA Rule 2121 and Supplementary Material .01 ('The 5% Policy is a guide, not a rule'). Absolute 'never charges both' claim removed per FINRA NTM 01-85 (mixed capacity trading; commission equivalents permitted in principal/riskless principal capacity).