What exactly is a riskless principal transaction ?

A riskless principal transaction for regulatory purposes is treated as if the transaction was executed on an agency basis. If a brokerage firm receives a customer order to buy or sell a security and the firm does not have an inventory position in the security, the firm may still elect to execute the order on a principal basis. If the firm elects to execute the order on a principal basis, it is known as a riskless principal transaction. Because the dealer is only taking a position in the security to fill the customer’s order, the dealer is not taking on any risk. As a result, the markup or markdown on riskless transactions will be based on the dealer’s actual cost, not on the inside market. Let’s look at an example: Let’;s say the market for ABC is $10 X $10.20. A client gives the firm an order to purchase 1,000 shares of ABCD at the market. The trader goes into the market and is able to purchase the stock for the firm’s account at $10.10. The firm immediately uses the stock in its inventory account to fill the customer’s market order. The customer’s markup will be based on the firm’s actual or contemporaneous cost of $10.10. The rationale behind this is clear. The firm did not take on any risk and therefore is not entitled to earn any extra profit on the transaction.