Underwriting vs. Principal Roles: An Overview

When people think of a brokerage firm, they might think of a financial services company that provides retail investors access to markets with the ability to buy and sell securities on their behalf. The brokers provide additional trade-related functionality including research tools, news, analysis, and price quotes.

However, most brokerage firms also have plenty of other business roles that do not always involve retail trades. The firm’s underwriting and principal trading divisions may indeed form the largest portion of its ongoing business.

Here we look at what these other two activities are and how they function in the process of issuing securities.

Underwriting: The Primary Market

Often the most lucrative aspect of the brokerage business is selling brand new securities issues by companies seeking to raise capital. The sale of new issues is what constitutes the so-called primary market.

Originally, only securities firms were involved in primary market activity, which involves the processes of underwriting or financing, and for a long time it did not involve a retail broker whatsoever. Things have changed and today most integrated brokerage firms now have robust underwriting and brokering departments.

In its function as an underwriter, a brokerage handles the initial issuance and distribution of securities—in the form of common or preferred stock, or corporate bonds—from a firm or other issuing body. The underwriter takes a fee for this service and can further earn profit from an initial public offering (IPO). Perhaps the most prominent role of an equity underwriter through the IPO process, where shares that exist on the primary market are made available to the public on stock exchanges, i.e. the secondary market.

In negotiating the terms of the primary securities issue, the underwriting firm uses all of its expertise in trading in the secondary market. The firm gains a sense of the nature of the market to which the new issue of securities will be released (i.e., the security’s current attractiveness to investors and the market valuation of close competitors). One of the reasons investment firms became involved in both aspects of the market around the mid-20th century is they possessed expertise in the secondary market, which aids in primary market sales.

Risk vs. Reward

Underwriting therefore involves understanding the risks of the new securities issued, and then figuring out the most effective way to market and sell them to investors. The company issuing new securities and its brokerage firm work together to determine the initial price for the issue, its timing, and other marketability factors that will help attract investors.

In general, the underwriting arm is most concerned that the price of the securities might deteriorate while they are still in the broker’s inventory, which would erode profits or even turn potential profits into losses. To deal with the large risks involved, a consortium of like-minded investment firms will form to mitigate some of the individual risks and ensure a speedy distribution of securities among all of the firms’ clients, instead of those of only one firm.

Principal Role: Brokering and Trading

Once a new security is issued and sold, that security is considered marketable and it begins to trade on the secondary market. Investment firms participate in the secondary market in one of two ways: as principals, holding securities for sale in their own inventory, or as agents, acting on behalf of a buyer or seller but not owning the security at any point during the transaction and earning a commission for that service.

In principal trading, the investment firm hopes to profit from buying securities in the open market using the firm’s money, holding them in its own inventory for a certain period of time, and selling them later for a higher price. As mentioned earlier, it is advantageous for investment firms to engage in principal trading because they’re well acquainted with current trends and market conditions and, therefore, they have the expertise to devise suitable benchmarks for pricing primary market issues or the yields on new bond issues. Moreover, trading desks at brokerages are often equipped with state-of-the-art automated trading platforms and other technological advantages not readily available to most retail traders.

Market Making

Another source of income an investment firm gains from principal trading activities is through providing liquidity. Because the broker has a large inventory of securities, the broker need not wait for simultaneous matching of buy and sell orders from its clients to complete a transaction. Instead, they can engage in market-making (MM) activities.

This advantage of principal trading greatly adds to the liquidity of the market and ensures there will typically be a buyer for almost every security, even if retail investors are generally not active in trading that security.

Intermingling of Principal and Agency Functions

Sometimes the distinction between brokerage firms working solely in the primary market and those working solely in the secondary market blurs, where the functions of principal and agency roles become intermingled. There are several examples of principal activities resembling agency roles and vice versa. As a result, certain measures must be taken to keep in compliance with various regulations.

In certain circumstances, underwriting firms will not be able to take ownership of a new issue and will instead issue it on a best efforts basis. The dealer will sell as much of the issue to its clients as it can at the best possible price and then return any unsold portion back to the issuing company. A best efforts placement is suitable when a full placement may not be possible due to poor market conditions or to the speculative nature of the issuing company – or if the underwriter is restricted from owning the issuer’s securities directly due to a conflict of interest elsewhere within the firm.

Another variation on principal vs. agency roles occurs when a company issues new securities directly to the secondary market, supplementing the existing lot of issued and outstanding shares that began trading after the original issue was completed. In some instances, such a secondary issue may be classified as a private placement offered only to pre-selected investors and institutions rather than on the open market. If the issuer has a sufficiently solid reputation, the dealer takes very little risk in distributing the quality issue to a few large institutions. In other situations, there is no central marketplace for the firm’s principal activities; the transactions are conducted on the over-the-counter (OTC) market, now comprised of computer systems linking dealers and large institutions directly to one another.

The Bottom Line

Brokerage firms were not always the large, multifaceted business entities that we know today. In times past, individual securities firms conducted business in only one area, but in the early 20th-century investment dealers began acting as principals on new securities issues and as agents for the trading of securities on the secondary market. Now the roles of principal and agent have intermingled, as investment firms are involved in both the primary and secondary markets.