Agency versus principal: commission versus markup

Two ways a firm can fill the same order

When a firm acts as agent it arranges the trade and stands aside from it. The customer’s money goes to whoever sold the security and the firm takes a commission for the service. The firm never owns the security, never has capital at risk in it, and earns the same fee whether the price rises or falls the following morning. This is the broker half of broker-dealer.

When a firm acts as principal it is the other side of the trade. It sells the customer a security out of its own inventory, or buys the customer’s security into that inventory. It earns the difference between what the security cost it and what it charged, which is a markup on a sale to a customer and a markdown on a purchase from one. This is the dealer half.

The market context is the quote. A dealer publishes a bid, the price at which it will buy, and an ask or offer, the price at which it will sell. The gap between them is the spread, and it is the dealer’s compensation for holding inventory and being willing to trade when nobody else is. A markup is measured from the prevailing market price rather than from whatever the dealer happens to have paid. FINRA’s markup policy treats 5% as a guide, not a rule. A markup of 5% or even less can still be unfair. The policy does not apply to securities sold at a fixed public offering price with a prospectus.

The two capacities cannot be mixed on the same side of the same trade: a firm is either arranging it or taking the other side of it. The customer confirmation must disclose which capacity was used, and a commission and a markup are shown differently, which is why an exam question can hand you a confirmation and expect you to name the capacity from it.

Exam terms

Agency trade

The firm arranges a trade for a customer with someone else and charges a commission.

Principal trade

The firm takes the other side from its own inventory.

Commission

The fee an agent charges for arranging a trade.

Markup

The amount added when a dealer sells to a customer from inventory.

Markdown

The amount deducted when a dealer buys a security from a customer.

Bid and ask

The prices at which a dealer will buy and sell; the gap is the spread.

Worked example

A customer wants 500 shares of a security quoted 24.10 bid, 24.40 ask, and two firms fill the order in different capacities.

1. The first firm has none of the stock. It goes to the market, buys 500 shares at the offer of $24.40 for the customer’s account and charges a commission of $50.
2. The confirmation shows a price of $24.40 and a commission of $50 stated separately. The firm acted as agent and never owned the shares.
3. The second firm holds the stock in inventory. It sells 500 shares to the customer at $24.50, which is the prevailing market offer of $24.40 plus a markup of ten cents a share.
4. That confirmation shows a price of $24.50 and no commission line, because the firm’s pay of $50 is inside the price. It acted as principal.
5. The customer paid the same amount both times, and the two trades are still different in law. The capacity determines what must be disclosed and how the charge is measured.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Long vs short positions and capacityPractice this