Broker-Dealer Compensation Methods
Before diving into the rules governing fair compensation, you need to understand the three primary ways broker-dealers earn money from customer transactions.
Agency vs. Principal: The Core Distinction
Every securities transaction involves a broker-dealer acting in one of two capacities. This distinction determines how the broker-dealer gets paid.
| Capacity | Role | Compensation | Disclosure |
|---|---|---|---|
| Agent (agency transaction) | Intermediary matching customer with counterparty | Commission | Separately disclosed on confirmation |
| Principal (principal transaction) | Counterparty trading from own inventory | Markup or markdown | Embedded in price; capacity disclosed |
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).
Commissions (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 commissions affect the customer:
| Transaction | Customer Pays/Receives |
|---|---|
| Buy | Market price + commission |
| Sell | Market price - commission |
Markups and Markdowns (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).
Non-Transaction Fees
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. This changes the incentive structure (more on this in the wrap fee section).
All non-transaction fees must be reasonable and disclosed. Charging unreasonable fees for services is a dishonest business practice under NASAA rules.