Agency vs. Principal Capacity
Overview
- Financial firms make money by trading with the public in the secondary market.
- Depending on the security being traded and the firm’s role in the transaction, a firm may trade on an agency basis or a principal basis.
Running example used throughout the chapter: a customer approaches a financial firm and wants to buy 100 shares of IBM stock.
🔑 Agency vs. principal — comparison table
| Capacity | What the firm does | What the firm earns | Associated terms | Risk to the firm |
|---|---|---|---|---|
| Agency | Works to match the customer’s order with another participant in the market — acts as a middleman matching buyers with sellers | Commission | Brokers, Agents | (None described — the firm does not hold the securities) |
| Principal | Buys into and sells from its own inventory. When a customer wants to purchase a security, the firm sells it from inventory; when a customer wants to sell, the firm buys it and adds it to inventory | Mark-ups and mark-downs | Dealer, Market maker | Yes — the value of the securities in the firm’s inventory can drop; if that happens, the firm may have to sell at lower prices and take a loss |
Disclosure requirements: this chapter does not state any disclosure requirement for either capacity. Nothing has been added from outside the page.
Agency capacity in detail
- If the firm acts in an agency capacity, it works to match the customer’s order with another participant in the market.
- On any given day, thousands of trades occur in IBM, so it usually isn’t difficult for the firm to find someone willing to sell 100 shares. The trade goes through once the firm finds a seller who meets the customer’s price and other trade specifications.
- 🔑 When a firm matches an order on an agency basis, it collects a commission. In this role, the firm is a middleman.
- Real-world analogy from the text: real estate brokers match buyers with sellers and charge a commission when a transaction occurs. The idea is the same in finance.
Principal capacity in detail
- If the firm acts in a principal capacity, it sells the shares out of its own inventory.
- Firms acting in a principal capacity are sometimes called market makers. They make themselves available to the trading public and are willing to buy and sell securities directly with customers.
| Customer action | Market maker’s action |
|---|---|
| Customer wants to purchase a security | The market maker sells the security from its inventory |
| Customer wants to sell a security | The market maker buys the security and adds it to its inventory |
- 🔑 Firms acting in a principal capacity make money through mark-ups and mark-downs.
Used car dealership analogy (mark-up vs mark-down)
| Term | What happens in the analogy |
|---|---|
| Mark-down | A used car dealership buys cars from the public at prices below their market value. If you sell your car to a dealership for less than its market value, that difference is a mark-down. |
| Mark-up | The dealership then tries to sell the car at or above its market value, which is a mark-up. |
- In other words, dealers try to buy low and sell high.
Acting in a principal capacity involves risk because the value of the securities in the firm’s inventory can drop. If that happens, the firm may have to sell at lower prices and take a loss.
Chapter summary (the text’s own wrap-up)
To summarize, financial firms can work in two different capacities:
- In an agency capacity, they match buyers with sellers and earn a commission.
- In a principal capacity, they buy into and sell from inventory and earn mark-ups and mark-downs.
Key points
Agency capacity
- Firms match buyers & sellers
- Commission earned
- Associated terms:
- Brokers
- Agents
Principal capacity
- Firms buying and selling with inventory
- Mark-ups and mark-downs earned
- Associated terms:
- Dealer
- Market maker
Sources
Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.
| # | Source | Publisher |
|---|---|---|
| 1 | Exchange Act 1934 — broker, dealer, exchange definitions | Cornell LII (15 U.S.C. 78c) |
| 2 | Nasdaq — market structure and market makers | SEC |
| 3 | Trading basics — order handling and execution | SEC |
| 4 | Achievable Series 65 — chapter 2.9.7 | Achievable (course text) |
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