FINRA Rule 2124

Rule 2124 was adopted from its predecessor NASD Rule 2441 — becoming effective October 2, 2006 — and was last amended effective December 5, 2011. Regulatory Notice 18-29 — issued September 12, 2018 — remains the most comprehensive FINRA guidance on the application of Rule 2124 in the context of OTC equity trading and trade reporting, providing detailed examples of how net transactions are structured and how the disclosure and consent requirements apply in practice.

What Is a Net Transaction — The Definition

Rule 2124(e)(2) defines a net transaction precisely — a principal transaction in which a market maker, after having received an order to buy or sell an equity security, purchases or sells the equity security at one price from or to another broker-dealer or another customer, and then sells to or buys from the customer at a different price.

The net transaction structure involves two linked but separate trades — the market maker's interdealer or intermarket transaction at one price, and the customer transaction at a different price — with the market maker's compensation being the difference between the two prices rather than a separately identified commission. This embedded compensation structure is the defining feature of net transactions — the customer pays or receives a price that reflects the market maker's markup or markdown from the interdealer transaction, but that markup or markdown is not separately disclosed as a commission would be in an agency transaction.

A concrete example illustrates the mechanics clearly. A retail customer places a market order to buy one thousand shares of an OTC equity security. The market maker buys one thousand shares from another dealer at forty dollars per share. The market maker then sells those same one thousand shares to the customer at forty dollars and ten cents per share. The ten-cent-per-share difference — totalling one hundred dollars — is the market maker's net compensation for the transaction. The customer has paid forty dollars and ten cents, not forty dollars plus a separately identified commission — the market maker's spread is embedded in the net transaction price.

The critical distinction from a riskless principal transaction is important for examination purposes. In a riskless principal transaction the member also buys and then sells in a back-to-back sequence — but in a riskless principal transaction the member's compensation is typically separately identified on the customer confirmation as a markup. In a net transaction the compensation is embedded in the price difference between the two linked trades.

Why Net Transactions Require Disclosure and Consent

The disclosure and consent requirement of Rule 2124 addresses a specific investor protection concern — customers who receive execution at a net price may not immediately recognise that the market maker has embedded its compensation in the price spread, or that the execution methodology used involves the market maker taking a principal position rather than acting as a pure agent.

Transparency about execution methodology matters to customers for several reasons. A customer who understands they are receiving a net execution knows that the market maker's compensation is embedded in the price rather than separately charged — enabling them to evaluate the true total cost of the transaction. A customer who does not understand the net execution methodology may believe they are receiving a pure agency execution at market price with no additional cost — a misunderstanding that could lead them to assess the transaction's economics inaccurately.

The consent requirement serves the additional function of ensuring the customer has actively considered and accepted the net execution methodology — rather than having it applied without their knowledge. A customer who has been properly informed about net transactions and consents to receiving net executions has made an informed decision that they accept the embedded compensation structure — whereas a customer who receives net executions without disclosure has had the execution methodology chosen for them without their knowledge or agreement.

Non-Institutional Customers — Written Order-by-Order Consent

Rule 2124(b) establishes the most demanding consent standard — applicable to all non-institutional customers who are not institutional accounts as defined in FINRA Rule 4512(c). For non-institutional customers — retail investors — the member must obtain written consent on an order-by-order basis prior to executing each net transaction.

The written requirement for non-institutional customers reflects the higher level of investor protection appropriate for retail investors who may be less familiar with execution mechanics and less equipped to assess the implications of net versus agency execution without written documentation of their understanding. The order-by-order requirement prevents a blanket consent obtained at account opening from serving as indefinite authorisation for all future net transactions — each net execution requires fresh specific consent from the retail customer.

The consent must evidence the customer's understanding of the terms and conditions of the order — not merely a checkbox acknowledging that a disclosure was received. The written consent must demonstrate that the customer actually comprehends what a net transaction is, how their execution will be structured, and what the implications are for their transaction economics. A consent that a customer clearly signed without reading or understanding — evidenced by the absence of any meaningful engagement with the disclosure content — does not satisfy Rule 2124's requirements even if it is technically in writing and obtained on an order-by-order basis.

Institutional Customers — Three Alternative Consent Methods

Rule 2124(c) provides institutional customers — defined by reference to the institutional account definition of FINRA Rule 4512(c) — with three alternative methods for satisfying the disclosure and consent requirement, reflecting the regulatory recognition that sophisticated institutional investors are better equipped to understand and manage net execution mechanics without the strictest retail safeguards.

The first method is the negative consent letter — a written disclosure document sent to the institutional customer that clearly explains the terms and conditions for handling customer orders on a net basis and gives the customer a meaningful opportunity to object. If the institutional customer does not object within the time period specified in the letter the member may reasonably conclude that the customer has consented to net executions. This negative consent mechanism — where silence constitutes consent — is not available for non-institutional customers precisely because retail investors cannot be assumed to have the sophistication to meaningfully evaluate a negative consent letter and to understand the significance of not objecting.

The negative consent letter can cover all or a portion of the customer's orders as instructed by the customer — giving institutional customers flexibility to consent to net executions for some order categories while requiring alternative execution for others. This order-category specificity ensures that institutional customers can tailor their consent to match their specific operational preferences and execution quality requirements.

The second method is oral disclosure and order-by-order consent — the market maker verbally explains the terms and conditions of the net execution to the institutional customer on each order and obtains oral consent before executing. This method requires the member to document the customer's understanding and consent on an order-by-order basis — creating a paper trail that demonstrates each individual consent was obtained. The documentation requirement for oral consent is essential — without it the claimed oral consent would be unverifiable in a subsequent examination or dispute.

The third method is written order-by-order consent — the same standard applicable to non-institutional customers, available to institutional customers who prefer the certainty of written documentation for each net execution. Institutional customers may choose this method when their internal compliance requirements mandate written documentation of all execution methodology consents regardless of regulatory minimum standards.

Fiduciary Consent — Investment Advisers and Other Fiduciaries

Rule 2124(d) addresses a practically important situation — customers who have granted trading discretion to a fiduciary, such as a registered investment adviser, trust company, or other third-party manager. In these cases the member is permitted to obtain the required consent from the fiduciary rather than from the underlying customer directly.

This fiduciary consent provision recognises the operational reality of discretionary managed account relationships — the investment adviser or other fiduciary makes all trading decisions on behalf of the underlying customer and is the appropriate counterparty for execution methodology discussions. Requiring separate disclosure to and consent from the underlying customer for each net transaction in a discretionary account managed by a fiduciary would be operationally impractical and inconsistent with the fiduciary's role.

When the fiduciary itself qualifies as an institutional customer under Rule 4512(c) — which is typical for registered investment advisers managing institutional assets — the member may meet the disclosure and consent requirements using any of the three institutional customer consent methods described in Rule 2124(c). A negative consent letter sent to the investment adviser can therefore cover net executions in all discretionary accounts managed by that adviser — a significant operational simplification for market makers executing net transactions across large numbers of discretionary accounts.

The Scope Limitation — Market Makers Only

A critically important feature of Rule 2124 that is directly tested on the Series 7 examination is its application only to market makers — member firms that make markets in equity securities by standing ready to buy and sell for their own account. Regulatory Notice 18-29 explicitly confirmed that Rule 2124 does not impose disclosure and consent obligations on non-market makers.

A member firm that occasionally takes a principal position in an equity security to facilitate a customer order — but that is not registered as a market maker in that security — is not subject to Rule 2124's disclosure and consent requirements when it executes a net transaction. This is not because the firm has no disclosure obligations — it must still provide fair pricing and accurate confirmations under Rules 2121 and 2232 — but because Rule 2124's specific net transaction framework applies only within the market-making context where the two-legged net execution structure is a regular and systematic execution methodology.

This market maker limitation connects Rule 2124 directly to FINRA's market making registration requirements and to the broader distinction between market makers and other broker-dealers in equity trading — a distinction that appears throughout the FINRA rulebook in contexts ranging from short selling to trading ahead of customer orders.

Connection to Trade Reporting and Best Execution

Rule 2124 operates in close connection with FINRA's OTC equity trade reporting requirements — which require that net transactions be reported at the net price rather than at the interdealer price underlying the transaction. Regulatory Notice 18-29 addresses this trade reporting dimension explicitly — confirming that when a market maker executes a net transaction the reported price should be the net price charged to the customer, not the interdealer price at which the market maker acquired or sold the securities.

The trade reporting treatment of net transactions affects market data — the reported net price becomes part of the public price discovery record that other market participants and regulators use to assess market conditions. Accurate reporting of the net price is therefore both a regulatory compliance obligation and a market integrity requirement that ensures the public price record accurately reflects the prices at which customers are actually transacting.

Rule 2124 also connects to FINRA Rule 5310's best execution obligation — market makers executing net transactions must ensure that the net price charged to customers satisfies the best execution standard by being as favorable as the best available price in the market under prevailing conditions. A net transaction executed at a net price that is materially worse than the best available execution price in the market fails the best execution obligation regardless of whether proper disclosure and consent were obtained under Rule 2124.

Recordkeeping Requirements

Rule 2124(f) requires members to retain and preserve all documentation relating to consent obtained under the rule in accordance with FINRA Rule 4511's general books and records requirements — connecting the consent documentation directly to the six-year default retention period of Rule 4511 and the electronic storage standards of SEC Rule 17a-4.

The recordkeeping obligation ensures that FINRA examiners can verify compliance with the disclosure and consent requirements by reviewing the actual consent documentation obtained from customers — rather than relying on the member's representations about its consent practices. The retention of negative consent letters, written order-by-order consents, and documentation of oral consents creates an evidentiary record that demonstrates the member's systematic compliance with Rule 2124 across its market-making activities.

Examination Relevance and Key Takeaways

FINRA Rule 2124 is tested on the Series 7 examination in the context of net transactions, market makers, disclosure and consent requirements, and the distinction between retail and institutional customer treatment.

The key points to retain are these.

FINRA Rule 2124 — Net Transactions with Customers — applies only to market makers executing net transactions in equity securities. A net transaction is a principal transaction in which a market maker buys or sells at one price in the interdealer market and then sells to or buys from the customer at a different price — with the market maker's compensation embedded in the price difference rather than charged as a separate commission.

Before executing any net transaction the market maker must provide disclosure to and obtain consent from the customer. For non-institutional customers — retail investors — written consent on an order-by-order basis is required, evidencing the customer's understanding of the terms and conditions of each net execution. For institutional customers — accounts qualifying as institutional accounts under Rule 4512(c) — three alternative consent methods are available: a negative consent letter covering future orders where silence constitutes consent, oral disclosure and order-by-order consent with documentation, or written order-by-order consent. For customers with discretionary fiduciary managers the consent may be obtained from the fiduciary — with institutional treatment available if the fiduciary itself qualifies as an institutional customer. Rule 2124 does not apply to non-market makers. All consent documentation must be retained in accordance with FINRA Rule 4511.