What is a Markup?
Markup is the difference between an investment's lowest current offering price among broker-dealers and the price charged to the customer for said investment. Markups occur when brokers act as principals, buying and selling securities from their own accounts at their own risk rather than receiving a fee for facilitating a transaction. Most dealers are brokers and vice versa; therefore, the term broker-dealer is common.
Markups occur when certain securities are available for purchase by retail investors from dealers who sell the securities directly from their own accounts. The dealer's only compensation comes in the form of the markup, the difference between the security's purchase price and the price the dealer charges to the retail investor. The dealer assumes some risk as the market price of the security could drop before being sold to investors.
[Important: In lieu of charging a flat fee, brokers acting as principals can be compensated from the markup (gross profits) of securities held and later sold to customers.]
Benefits of Markups
Markups are a legitimate way for broker-dealers to make a profit on the sale of securities. Securities, such as bonds, bought or sold on the market are offered with a spread. The spread is determined by the bid price, what someone is willing to pay for the bonds, and the ask price, which is what someone is willing to accept for the bonds. When a dealer acts a principal in the transaction, he can mark up the bid price, which creates a wider bid-ask spread. The difference between the market spread and the dealer’s marked-up spread is the profit.
[Fast Fact: A markdown occurs when a broker purchases a security from a customer at a price lower than its market value.]
Special Considerations for Markups
The dealer is only required to disclose the transaction fee, which is typically a nominal cost. In doing so, the buyer isn’t privy to the dealer’s original transaction or the markup. From the buyer’s perspective, the only cost for the bond purchase is the small transaction fee. Should the bond buyer try to immediately sell the bond on the open market, he would have to make up the dealer’s markup on the spread or incur a loss. The lack of transparency places the burden on the bond buyers to determine whether they are receiving a fair deal.
Dealers compete with each other by reducing the amount of their markups. It is possible for bond buyers to compare the price the dealer paid for the bond with its actual price. Bond buyers can have access to bond transaction details through various sources, such as Investinginbonds.com, which reports all information related to bond transactions daily.
- A markup is the difference between the market price of a security personally held by a broker-dealer and the price paid by a retail customer.
- Dealers are not required to disclose the markup to customers.