Agency vs. principal

Financial firms make money trading with the public in the secondary market. Depending on the security being traded and the firm’s role in the transaction, a financial firm 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, 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 typically won’t be 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 requested 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.

Now consider how the customer’s request to buy 100 shares of IBM would work if the firm acts in a principal capacity. In that case, the firm sells the shares out of its own inventory. Firms acting in a principal capacity are sometimes referred to as 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 out of its inventory.
• When a customer wants to sell a security, the market maker buys the security and places it into 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’ve sold a car to a dealership, you may have experienced this.

• When the dealership buys your car below its market value, that’s a mark-down.
• When the dealership later sells the car at or above its market value, that’s a markup.

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 could drop sharply. 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. If they’re acting in an agency capacity, they match buyers with sellers and earn a commission. If they’re acting in a principal capacity, they buy into and sell from inventory and earn markups and markdowns.