What it means
When a broker-dealer sells securities from its own inventory, it usually charges a markup, which is the difference between its cost and the price charged to the customer. In the opposite direction, when it buys from a customer, the equivalent is a markdown.
Where it acts as an agent for the customer, it charges a commission instead. The industry's self-regulatory body developed a guideline known as the 5% policy to help judge whether charges are reasonable.
Generally, a markup, markdown or commission above 5% on an ordinary transaction is a warning sign that regulators may view as excessive. It is a guide, not a hard cap, and the facts of each trade matter.
Several factors affect how reasonableness is judged. These include the type of security, how easy it is to buy or sell, the size of the trade, the value of any services provided and the amount of work the firm did.
A small trade in a thinly traded stock may justify a higher charge in percentage terms than a large trade in a popular stock. Because the guideline is about fairness to customers, firms must also disclose their charges and be able to justify them.
Advertising low-cost trading while charging steep markups can lead to enforcement action. Investors should check confirmations carefully, since the markup may not be shown as a separate line in the way a commission is.
The phrase five percent rule is also used in other contexts, such as personal finance rules of thumb on housing costs or withdrawal rates, so the context matters. In this entry the term refers to the broker-dealer pricing guideline.
Anyone applying it should check the latest regulatory text.
In practice
Real-world examples.
Example
A small broker sells 1,000 shares of a stock from its own inventory at a price 3% above the prevailing market. The charge is within the guideline and well documented, so the compliance team is comfortable.
Example
A customer notices on a trade confirmation that a bond was sold to him at $1,060 per $1,000 when similar bonds were quoted at $1,000. The 6% difference leads him to complain to the firm's compliance department.
Example
A brokerage reviews its pricing on small trades in thinly traded stocks. It documents why a charge slightly above 5% is justified for very small orders requiring extra effort, and sets a clear internal approval step for such cases.
Formula
Calculation
The markup percentage compares the price charged with the prevailing market price, which is normally based on the dealer's own cost or the current quotes.
Markup (%) = (Price charged to customer - Prevailing market price) divided by Prevailing market price x 100
Worked example: a dealer buys shares at a prevailing market price of $50.00 and sells them to a customer at $51.50.
Markup = $51.50 - $50.00 = $1.50
Markup % = $1.50 divided by $50.00 = 0.03, or 3.0%
At 3.0% the charge is inside the 5% guideline. If the dealer had sold at $53.00, the markup would be $3.00 divided by $50.00 = 6.0%, above the guideline and likely to attract questions.Case study
Seen in the real world.
Summit Ridge Securities is a fictional broker-dealer that sold thinly traded shares to retail clients at prices around 7% above its cost. A compliance review found that no one had checked these markups against the 5% guideline and that the charges were not explained to customers.
In this illustrative case, the firm reviewed its pricing, refunded customers the excess over a reasonable level, trained its sales team and added an automated alert for markups over 5%. Regulators noted the corrective steps. The story shows that a simple guideline, applied consistently, can prevent expensive disputes and protect clients.
Watch out
Common mistakes.
- Treating 5% as a safe harbour. A charge below 5% can still be unreasonable in some circumstances, and one a little above can be justified with good reasons.
- Calculating markup on the wrong base. It should be measured against the prevailing market price, not simply against the price the customer paid.
- Thinking only commissions count. Markups and markdowns hidden in the price are covered too, so total charges to the customer matter.
Questions
People also ask.
Is the 5% policy a law?
No. It is a guideline issued by the industry's self-regulatory body, although regulators can treat charges far above it as a breach of fair dealing duties.
Does it apply to every product?
It was designed for ordinary secondary market transactions in securities, and other products or offerings can be treated differently. Check the current rules for your product.
How can an investor check the markup?
Compare the price paid with contemporaneous quotes for the same security and read the confirmation, which may disclose the markup for certain transactions.
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