What it means
When a client asks a firm to buy shares, the firm can act in two ways. As an agent, it goes into the market and buys on the client's behalf for a separate fee.
As a principal, it sells the client shares from its own holdings and makes money from the difference between its cost and the price it charges. This difference is called a markup when the client buys and a markdown when the client sells.
It is shown in the price and not as a separate commission, which makes it harder for clients to notice. For that reason regulators require firms to treat clients fairly, to charge prices that are reasonable compared with the prevailing market price and often to disclose the capacity in which they acted.
Principal trading is common in markets where there is no central exchange, such as many bond markets and some foreign exchange dealings. A dealer holds an inventory so that clients can trade promptly without waiting for another buyer or seller to appear.
The service has value, but the client should know that the dealer's interests are not identical to its own. For the firm, principal orders mean risk.
If it holds a large position and the market moves against it, the firm loses money, which is why it needs capital and risk controls. The same risk is why dealers often quote wider prices on large or unusual trades.
Finance teams buying securities or currency through a dealer should compare quotes from more than one firm. Asking for the trade confirmation, which shows whether the dealer acted as principal or agent, and checking the price against independent market data helps ensure that the markup is fair.
Some jurisdictions also set guidelines on how large a markup can reasonably be, depending on the type of security, the size of the trade and how easy it is to find the price elsewhere. Illiquid bonds or small trades tend to carry wider markups than heavily traded shares.
Knowing the typical range helps a treasurer judge whether a quote is acceptable.
In practice
Real-world examples.
Example
A corporate treasurer buys $2,000,000 of bonds from a bank that holds them in inventory. The bank is acting as principal, and the price includes its margin. She asks a second bank for a price before accepting the offer.
Example
A small investor places an order with an online broker that fills it from its own stock of shares. The investor sees no commission, but the price includes a small spread in the broker's favour.
Example
A company needs to convert $5,000,000 into another currency and calls two banks for quotes. Both act as principal, and the treasurer chooses the one offering the better rate. The difference between the two quotes is worth thousands of dollars.
Formula
Calculation
Markup per share = Price charged - Prevailing market price, and Markup % = Markup per share / Prevailing market price.
A client buys 1,000 shares through a dealer acting as principal and is charged $50.50 per share, while the prevailing market price at that moment is $50.00. The markup per share is $50.50 - $50.00 = $0.50. The total markup is $0.50 x 1,000 = $500.
The markup percentage is $0.50 / $50.00 = 0.01, or 1%. If the same trade had been done as an agency order at $50.00 plus a commission of $0.02 per share, the client would have paid $50.00 x 1,000 + $0.02 x 1,000 = $50,020 in total, compared with $50.50 x 1,000 = $50,500 as principal.Case study
Seen in the real world.
Greystone Foods is a fictional company that invested surplus cash in corporate bonds through a single dealer. The finance director noticed in an illustrative review that the dealer always acted as principal and never showed the markup separately.
She asked two other firms to quote on the next purchase of $1,000,000 and compared the prices with a public market data screen. The first dealer's price was 0.8% above the reference, while the others were within 0.2%.
The fictional company shifted its business to a competitive quote process and saved several thousand dollars a year. The case shows that principal orders are not wrong, but that comparing quotes keeps the markup honest.
Watch out
Common mistakes.
- Assuming that a trade with no commission is free, when the dealer may be earning its margin in the price.
- Not checking the trade confirmation to see whether the firm acted as principal or agent.
- Accepting a single quote on a large trade without checking it against market data.
Questions
People also ask.
What is the difference between a principal and an agency order?
In a principal order the firm trades from its own account and profits from the price, while in an agency order it acts for the client and earns a commission.
How do I know if the markup is fair?
Compare the price with independent market data and quotes from other dealers at the same time.
Why do dealers act as principal?
It lets them provide immediate execution and earn a return for taking on the risk of holding inventory.
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