Agency vs. principal

Financial firms make money trading with the public in the secondary market. Depending on the security traded and its role in the market, financial firms may trade on an agency or 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, they work to match the customer’s order with another participant in the market.

On any given day, thousands of trades occur in IBM, so it shouldn’t be difficult for the firm to find someone willing to sell 100 shares of IBM. Depending on the price and trade specifications requested by the firm’s customer, the trade goes through when the firm finds a seller meeting those specifications.

When a firm matches an order on an agency basis, they collect a commission. In essence, a firm is acting as a middleman. You’ve probably heard of several different types of brokers in the world, all of which act in an agency capacity. For example, real estate brokers match buyers with sellers and charge a commission when a real estate transaction occurs. This is no different than how it works in finance.

How would our customer’s request to buy 100 shares of IBM stock work differently? If the firm acts in a principal capacity, they sell the shares out of their inventory. Firms acting in a principal capacity are sometimes referred to as market makers. They open themselves up to the trading public and are willing to buy and sell securities with their customers. When a customer wants to purchase a security, the market maker sells the security out of their inventory. When a customer wants to sell a security, the market maker buys the security and places it into their inventory.

Firms acting in a principal capacity make money through mark-ups and mark-downs. You’ve heard of different types of dealers in the world, all of which act in a principal capacity. With a used car dealership, cars are bought from the public at prices lower than their market value. You may have experienced this yourself if you’ve sold your car to a dealership. When they buy your car below its market value, this is known as a mark-down. Next, the dealership attempts to sell the car at or above its market value, which is known as a markup. Essentially, dealers are trying to buy low and sell high, just like every other investor.

Acting in a principal capacity involves risk, as the value of the securities in the firm’s portfolio could drop drastically. If this occurs, they’ll lose money as they try to sell the security at lower prices.

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

To summarize, financial firms can work in two different capacities. If they’re acting in an agency capacity, they’re matching buyers with sellers and earning a commission. If they’re acting in a principal capacity, they’re buying into and selling from inventory and earning markups and markdowns.