What is Markup
Markup is the difference between an investment's lowest current offering price among dealers and the higher price a dealer charges a customer. Markups occur when dealers act as principals, buying and selling securities from their own accounts at their own risk, as opposed to brokers receiving a fee for facilitating a transaction.
BREAKING DOWN Markup
Markup comes about 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 for the sale comes in the form of the markup, the difference between the price at which the security was purchased and the price the dealer charges to the retail investor. The dealer assumes some risk by acting in this capacity, as the market price of the security in his inventory could drop before he is able to sell to investors. Note that most dealers are also brokers and vice versa, so the term broker-dealer is common.
How a Markup Works
Markups are a legitimate way for broker-dealers to make a profit on the sale of securities. When securities such as bonds are bought or sold on the market, they are offered with a spread, which is determined by the bid price, or 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 its profit.
The dealer is only required to disclose the transaction fee, which is typically a very nominal cost, 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 be able to make up the dealer’s markup on the spread, or he could incur a loss. The lack of transparency in the complete transaction places the burden squarely on the bond buyers to ascertain 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 sources such as Investinginbonds.com, which reports all information related to bond transactions on a daily basis.