Capital markups

• Capital Markups
• RELATED_TERM: Commission
• TERM_CATEGORY: Market Microstructure

What Is Capital Markups?

Capital markups refer to the difference between the price a broker-dealer pays for a security and the price at which they sell it to a customer, or vice-versa for a markdown. These charges are a form of compensation for broker-dealers when they act as a principal in a transaction, buying from or selling to their own inventory. Capital markups are a critical component of market microstructure, representing the direct cost incurred by an investor in over-the-counter (OTC) transactions. Unlike a fixed commission, a capital markup is embedded within the security's price.

History and Origin

The concept of markups in securities transactions has been a subject of regulatory scrutiny for decades, particularly in the over-the-counter market, where direct price transparency has historically been limited³⁰. In the United States, the Financial Industry Regulatory Authority (FINRA), formerly the National Association of Securities Dealers (NASD), established the "5% Policy" in 1943. This policy, codified in FINRA Rule 2121, serves as a guideline, not a strict rule, to ensure that markups and commissions charged by member firms are fair and reasonable. It was based on studies indicating that the majority of customer transactions involved a markup of 5% or less²⁹. The intention was to address concerns that undisclosed markups in the OTC market could be inconsistent with the full disclosure principles found elsewhere in federal securities laws²⁸.

Over time, FINRA Rule 2121 has been refined and expanded. For example, in 2015, the rule was amended to apply to government securities, further extending the reach of fair pricing regulations²⁷. Similarly, the Municipal Securities Rulemaking Board (MSRB) implemented Rule G-30, which governs prices and commissions in municipal securities transactions, aiming to promote transparency and fairness in that market²⁶. Significant rule changes approved by the SEC in late 2016 required broker-dealers to disclose markups and markdowns on retail customer trade confirmations for certain fixed-income securities, further increasing transparency for investors²⁴, ²⁵.

Key Takeaways

• Capital markups represent the profit a broker-dealer makes on a principal transaction.
• They are embedded in the price of the security, unlike explicit commissions.
• Regulatory bodies like FINRA and MSRB have rules (e.g., FINRA Rule 2121, MSRB Rule G-30) to ensure markups are fair and reasonable.
• Recent regulatory changes have increased the transparency of capital markups for retail investors in certain fixed-income securities.
• The fairness of a markup is assessed based on various factors, including market conditions and security type.

Formula and Calculation

The capital markup is calculated as the difference between the price a broker-dealer sells a security to a customer and their contemporaneous cost to acquire that security. Conversely, a markdown is the difference between the price at which a broker-dealer purchases a security from a customer and the prevailing market price they could obtain for it.

The formula for a capital markup (or markdown) can be expressed as:

$\text{Markup} = \text{Selling Price to Customer} - \text{Dealer's Cost}$

$\text{Markdown} = \text{Dealer's Proceeds} - \text{Purchase Price from Customer}$

In these formulas:

• Selling Price to Customer refers to the price at which the broker-dealer sells the security to the investor.
• Dealer's Cost represents the price at which the broker-dealer acquired the security.
• Dealer's Proceeds is the price at which the broker-dealer sells the security to another party after purchasing it from a customer.
• Purchase Price from Customer is the price at which the broker-dealer buys the security from the investor.

The concept of "prevailing market price" is crucial in determining fair markups and markdowns, particularly for debt securities. Regulatory guidance, such as that provided by FINRA and the MSRB, often uses the dealer's contemporaneous cost or proceeds as a presumptive indicator of the prevailing market price²², ²³.

Interpreting the Capital Markup

Interpreting capital markups involves understanding their impact on an investor's total cost of ownership and the yield they receive, especially for fixed-income securities. A higher capital markup means a lower effective purchase price for the dealer (when selling to a customer) or a higher effective sale price (when buying from a customer), which translates to a less favorable transaction price for the investor.

Regulators emphasize that the markup should be "fair and reasonable," taking into account all relevant circumstances. These circumstances can include the type of security, its availability (e.g., thinly traded securities might justify a higher markup), the price of the security (lower-priced securities may have higher percentage markups), and the size of the transaction²⁰, ²¹. For instance, a small transaction amount might warrant a higher percentage markup to cover handling expenses¹⁹. Furthermore, firms must consider the impact of markups on the yield to maturity for fixed-income securities, as excessive markups can significantly reduce an investor's actual return¹⁸.

Hypothetical Example

Consider an individual investor looking to purchase a corporate bond. A broker-dealer, acting as a principal, buys 100 bonds from another dealer at a price of $990 per bond. Shortly after, the broker-dealer sells these same 100 bonds to the individual investor at $995 per bond.

Here's how the capital markup is determined:

• Dealer's Cost: $990 per bond
• Selling Price to Customer: $995 per bond

The capital markup per bond is:
$995 - $990 = $5

For the entire transaction of 100 bonds, the total capital markup would be:
$5/bond * 100 bonds = $500

This $500 represents the compensation the broker-dealer earns from this particular principal transaction, embedded within the price the investor pays. The investor's total cost for the bonds would be $99,500 ($995 * 100), rather than the $99,000 the dealer paid. This example highlights how the capital markup directly influences the effective price paid by the investor.

Practical Applications

Capital markups are primarily encountered in the trading of securities in the over-the-counter (OTC) markets, where transactions often occur directly between a broker-dealer and a customer. This is common for fixed-income products like corporate bonds, municipal bonds, and government securities, as well as certain equities that are not listed on major exchanges.

In practice, regulatory bodies like FINRA and the MSRB play a crucial role in overseeing capital markups. FINRA Rule 2121 and MSRB Rule G-30 require broker-dealers to ensure that prices charged for securities are fair and reasonable¹⁷. These rules consider various factors when assessing the fairness of a markup, including the type of security, its liquidity, and the overall market conditions¹⁶. Recent regulatory changes have significantly enhanced transparency. For instance, the SEC approved amendments in 2016 requiring broker-dealers to disclose markups and markdowns on trade confirmations for certain debt securities sold to retail customers¹⁵. This means that for applicable transactions, the customer's confirmation statement will show both the prevailing market price and the dollar amount and percentage of the markup¹⁴. This increased disclosure aims to help investors better evaluate the cost and quality of the execution service provided by firms¹³.

Limitations and Criticisms

While regulations aim to ensure fair pricing, capital markups, particularly historically, have faced criticisms related to transparency and potential for abuse. Prior to recent disclosure requirements, the embedded nature of markups made it difficult for retail investors to discern the exact compensation a broker-dealer received, leading to concerns about inflated prices¹². Critics argued that this lack of transparency could disadvantage investors, as they might not be aware of how much of the price they paid was profit for the dealer rather than the true market value¹¹.

Another limitation stems from the subjective nature of determining a "fair and reasonable" markup. While regulators provide guidelines, assessing all relevant factors for every transaction can be complex. For instance, thinly traded or illiquid securities might warrant a higher markup due to increased risk and effort involved in finding a counterparty, but defining the appropriate premium can be challenging. Some academic research suggests that despite efforts to regulate, information asymmetries can persist in OTC markets, potentially affecting pricing and the ability of investors to gauge execution quality¹⁰. Furthermore, firms relying solely on fixed markup grids without considering specific market conditions for each trade could be in violation of fair pricing rules⁹.

Capital Markups vs. Commission

Capital markups and commissions are both forms of compensation for broker-dealers, but they differ fundamentally in how they are applied and disclosed.

The primary confusion between the two often arises from their ultimate impact on the investor's total cost. Both a capital markup and a commission increase the overall cost of a transaction for the buyer and reduce the proceeds for the seller. However, understanding whether a broker is acting as a principal (implying a markup) or an agent (implying a commission) is crucial for assessing the pricing structure and regulatory oversight applicable to the trade.

FAQs

What is a "fair" capital markup?

A "fair" capital markup is a markup that is considered reasonable by regulatory bodies like FINRA and the MSRB, taking into account various factors. These factors include the type of security, its liquidity, the size of the trade, the services provided by the broker-dealer, and prevailing market conditions⁴, ⁵. There isn't a fixed percentage, but regulators evaluate if the markup is disproportionate to the circumstances of the trade.

Are capital markups always disclosed?

Previously, capital markups were often not explicitly disclosed. However, recent regulatory changes, particularly in the fixed-income market, now require broker-dealers to disclose markups and markdowns on retail customer trade confirmations for many corporate and municipal bonds², ³. This disclosure typically includes the dollar amount and percentage of the markup based on the prevailing market price.

How do capital markups affect my investment returns?

Capital markups directly impact your investment returns by increasing the effective purchase price of a security (when you buy) or decreasing the effective sale price (when you sell). For example, a high markup on a bond purchase will reduce its yield to maturity, meaning you receive less income relative to the price you paid. Understanding and scrutinizing markups can help investors manage their transaction costs.

Do capital markups apply to stock market trades?

Capital markups are most commonly associated with over-the-counter (OTC) trades, particularly in the bond market. While broker-dealers can act as principals in equity transactions not traded on exchanges, listed stock trades typically involve a commission structure when executed by an agent on an exchange. For equities traded OTC, markups would apply if the broker-dealer is acting in a principal capacity.

What is a markdown?

A markdown is the opposite of a markup. It occurs when a broker-dealer purchases a security from a customer in a principal transaction. The markdown is the difference between the prevailing market price of the security and the lower price paid to the customer. Similar to markups, markdowns are also subject to regulatory scrutiny for fairness and reasonableness¹.

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