Agency vs. principal

Financial firms make money by trading with the public in the secondary market. Depending on the security being traded and the firm’s role in the transaction, a firm may trade on an agency basis or a principal basis.

Assume a customer approaches a financial firm and wants to buy 100 shares of IBM stock.

If the firm acts in an agency capacity, it works to match the customer’s order with another participant in the market.

On any given day, thousands of trades occur in IBM, so it usually isn’t difficult for the firm to find someone willing to sell 100 shares. The trade goes through once the firm finds a seller who meets the customer’s price and other trade specifications.

When a firm matches an order on an agency basis, it collects a commission. In this role, the firm is a middleman. You’ve probably seen this model in other markets: for example, real estate brokers match buyers with sellers and charge a commission when a transaction occurs. The idea is the same in finance.

How would the customer’s request to buy 100 shares of IBM work differently?

If the firm acts in a principal capacity, it sells the shares out of its own inventory. Firms acting in a principal capacity are sometimes called market makers. They make themselves available to the trading public and are willing to buy and sell securities directly with customers:

• When a customer wants to purchase a security, the market maker sells the security from its inventory.
• When a customer wants to sell a security, the market maker buys the security and adds it to its inventory.

Firms acting in a principal capacity make money through mark-ups and mark-downs. This is similar to how dealers operate in other settings. For example, a used car dealership buys cars from the public at prices below their market value. If you sell your car to a dealership for less than its market value, that difference is a mark-down. The dealership then tries to sell the car at or above its market value, which is a mark-up. In other words, dealers try to buy low and sell high.

Acting in a principal capacity involves risk because the value of the securities in the firm’s inventory can drop. If that happens, the firm may have to sell at lower prices and take a loss.

Here’s a video breaking down a practice question on this topic:

To summarize, financial firms can work in two different capacities. In an agency capacity, they match buyers with sellers and earn a commission. In a principal capacity, they buy into and sell from inventory and earn mark-ups and mark-downs.