Agency vs. principal capacity

After a security is sold for the first time in the primary market, it begins trading in the secondary market. At that point, the issuer has already raised capital (money). Now, investors buy and sell the security with other investors at its current market price.

Financial firms can earn money by helping the public trade in the secondary market. Depending on the security and the firm’s role, a firm may handle trades on either an agency basis or a principal basis.

Definitions

Agency capacity

Acting as a broker (or agent), a firm matches a customer’s order with another market participant instead of trading from its own inventory, and earns a commission for the match.

Principal capacity

Acting as a dealer, a firm trades directly from its own inventory - selling to or buying from customers - and earns a mark-up (selling above the market price) or mark-down (buying below the market price) instead of a commission.

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 isn’t difficult for the firm to find someone willing to sell 100 shares. The trade is executed 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 earns a commission. In this role, the firm is acting as a middleman. You’ve probably seen this model in other industries - for example, real estate brokers match buyers with sellers and charge a commission when a transaction occurs. The idea is the same in securities trading.

Now consider how the same request works 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 often referred to as market makers. They stand ready to buy and sell securities with customers:

• If a customer wants to buy a security, the market maker sells it from inventory.
• If a customer wants to sell a security, the market maker buys it and adds it to inventory.

Firms acting in a principal capacity make money through mark-ups and mark-downs. This is similar to how dealers operate in other markets. For example, a used car dealership buys cars from the public at prices below their market value. When the dealership buys below market value, that difference is a mark-down. The dealership then tries to sell the car at or above market value, which is a mark-up. In other words, dealers aim to buy low and sell high. Both sides of that buy-low, sell-high pattern belong to the dealer’s principal capacity - a broker acting in an agency capacity never buys from or sells out of its own inventory, so mark-ups and mark-downs don’t apply to it.

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

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

To summarize, financial firms can operate in two capacities:

• In an agency capacity, they match buyers and sellers and earn a commission.
• In a principal capacity, they buy into and sell from inventory and earn mark-ups and mark-downs.