Broker-Dealer Compensation Methods

Every securities transaction pays the broker-dealer through one of these channels. Which channel applies depends entirely on the capacity the firm takes in the trade.

How Does Capacity Determine Compensation?

Every securities transaction involves a broker-dealer acting in one of two capacities. This distinction determines how the broker-dealer gets paid.

Exam Tip: Gotchas

• A broker-dealer cannot charge both a commission and a markup on the same transaction. It is always one or the other. Agent = commission. Principal = markup/markdown.
• Capacity (agent vs. principal) determines compensation type (commission vs. markup), which determines disclosure method (separate line item vs. embedded in price).

How Are Commissions Charged in Agency Transactions?

• A commission is the fee charged when a broker-dealer acts as an agent: finding a counterparty for the customer's order
• The broker-dealer does not own the securities; it simply facilitates the trade
• Commissions apply to both buy and sell transactions
• The commission must be separately disclosed on the trade confirmation

How Do Markups and Markdowns Work in Principal Transactions?

• A markup is the amount added to the current market price when a broker-dealer sells securities from its own inventory to a customer
• A markdown is the amount subtracted from the current market price when a broker-dealer buys securities from a customer into its own inventory
• In both cases, the broker-dealer is the counterparty; it trades for its own account
• The markup/markdown is embedded in the price and is not separately itemized on the confirmation (unless specific rules require it)
• The trade confirmation must disclose whether the broker-dealer acted as agent or principal

Think of it this way: The customer sees only the final price in a principal transaction. The markup or markdown is the broker-dealer's profit margin, built into that price.

Exam Tip: Gotchas

• Markups are embedded in price; commissions are separately disclosed. The confirmation always states whether the broker-dealer acted as agent or principal, but only agency trades show the compensation as a separate line item.
• A markdown is not a discount. It is the broker-dealer's profit when buying securities from a customer (the customer receives less than the current market price).

What Non-Transaction Fees Can a Broker-Dealer Charge?

Broker-dealers may also charge fees that are not tied to specific trades:

• Account maintenance fees: periodic charges for maintaining the account
• Inactivity fees: charges when the account has little or no trading activity
• Transfer fees: charges for moving assets to another firm
• Wire fees: charges for wire transfers
• Custodial fees: charges for holding securities
• Account closing fees: charges when the customer closes the account

Fee-based brokerage accounts charge a flat or asset-based fee instead of per-transaction commissions, which changes the incentive structure since the fee does not depend on the number of trades.

All non-transaction fees must be reasonable and disclosed. Charging unreasonable fees for services is a dishonest business practice under NASAA rules.

How Do Wrap Fee Programs Flip the Conflict?

A wrap fee program bundles investment advice, trade execution, and administrative costs into one asset-based fee instead of charging separate advisory fees and per-transaction commissions. Wrap fee programs are regulated as investment advisory programs.

The sponsor must deliver a wrap fee program brochure (Form ADV Part 2A, Appendix 1) that discloses whether the bundled fee could cost the client more or less than paying for advisory and brokerage services separately.

The distinctive compensation incentive:

• In a commission account, the broker-dealer earns more by trading more. That pushes toward churning: excessive trading to generate commissions.
• In a wrap fee account, execution is already paid for out of the flat fee. An extra trade costs the sponsor money without adding any revenue, so the incentive flips: the sponsor benefits from trading less, even when a trade is needed.
• This is called reverse churning: continuing to collect the same bundled fee while needed trades go undone.
• Both the churning conflict in commission accounts and the reverse-churning conflict in wrap accounts must be disclosed to the client.

Suitability considerations:

• The adviser must evaluate whether a wrap fee arrangement is appropriate given the client's trading frequency and investment needs, not simply offer it as a pricing option.
• A wrap account can be a poor fit for a client who trades infrequently, since the client pays the same fee regardless of activity.
• A wrap account can be a good fit for an active trader, since the bundled fee may cost less than paying commissions on frequent trades.

Exam Tip: Gotchas

• Wrap fees create the opposite conflict from commissions. Commission accounts push toward more trading (churning); wrap fee accounts push toward less trading (reverse churning). Both conflicts must be disclosed, and heavy trading activity is the wrong signal to look for when checking a wrap account for reverse churning.

What Should You Check on Exam Day?

• Agent = commission, separately disclosed; principal = markup/markdown, embedded in price. Never both on one trade.
• The confirmation always discloses agent or principal capacity, even though only agency trades itemize the compensation.
• A markdown is the broker-dealer's profit when buying from a customer, not a discount to the customer.
• Non-transaction fees (maintenance, inactivity, transfer, wire, custodial, closing) must be reasonable and disclosed.
• Wrap fees flip the churning incentive: commission accounts reward more trading, wrap accounts reward less trading (reverse churning). Both conflicts must be disclosed, and the adviser must evaluate whether the wrap arrangement fits the client's trading frequency.