Broker-Dealer Commissions, Markups, and Agency vs. Principal

The difference between broker-dealer commissions and markups comes down to which side of the trade your firm is on. When a broker-dealer acts as your agent, it finds someone else to take the other side of your order and charges you a commission, a fee that shows up as its own line on your confirmation. When the firm acts as a principal, it sells you a security out of its own inventory (or buys one from you into inventory) and earns a markup, a spread baked into the price you pay. One cost is visible. The other is not, unless you know where to look.

That single distinction drives almost everything else about what a trade costs you, what conflicts your broker has, and what the firm has to disclose.

Agency Trades: How Commissions Work

Acting as agent, a broker-dealer never owns the security involved in your trade. It goes into the market, finds a counterparty, and executes on your behalf. Think of a real estate agent bringing a buyer and seller together for a fee. Because the firm has no financial stake in the security’s price, its pay comes entirely from what it charges you.

Commissions used to be flat per-trade fees or a percentage of transaction value. Most major online brokerages now charge zero commissions on stock and ETF trades, though fees still apply to options contracts (commonly around $0.50 to $0.65 per contract) and to broker-assisted trades. Zero commissions did not eliminate broker-dealer compensation. It shifted it to other revenue streams, chiefly payment for order flow, discussed below. Whatever the fee structure, any commission you are charged appears as a separate line item on your trade confirmation, making the cost transparent.

Whatever the commission, the firm owes you best execution. FINRA Rule 5310 requires firms to use reasonable diligence to find the best available market so the resulting price is as favorable as possible under current conditions. The rule lists specific factors: the character of the market, the size and type of the transaction, the number of markets checked, the accessibility of quotations, and the terms of your order.¹ The obligation exists because an agent’s incentives should line up with yours: you both want the best price available.

Principal Trades: How Markups Work

In a principal transaction, the broker-dealer is the other side of your trade. It sells you a security from its own inventory or buys one from you onto its own books. This is the standard model in markets without a centralized exchange: municipal bonds, corporate bonds, and many over-the-counter securities. The firm puts its own capital at risk to give you immediate liquidity so you don’t have to wait for another investor to appear.

The compensation is embedded in the price. When a dealer sells you a bond, the price includes a markup over prevailing market value. When a dealer buys a bond from you, the price you receive reflects a markdown below market value. If a bond’s market value is $1,000 and the dealer sells it to you for $1,025, that $25 spread is the dealer’s compensation. Unlike a commission, it does not appear as a separate line item.

The risk justifies the model. A dealer holding bonds is exposed to interest rate moves, credit downgrades, and liquidity risk. If rates jump before the position clears, the inventory loses value. Dealers who hold too long often end up dumping securities through interdealer trades at a loss.² The markup pays them for absorbing that risk.

How the Base Price Gets Set

Because the markup is invisible, the number it is measured from matters enormously. For debt securities, FINRA’s default rule is that a dealer’s own contemporaneous cost is the best evidence of the prevailing market price. If a dealer bought a bond for $990 this morning and sells it to you this afternoon, the markup is measured from $990, not from a quotation screen.³

A dealer can use a different base only by showing that its own cost is no longer a reliable indicator. Three circumstances qualify: interest rates changed enough to reasonably alter pricing, the credit quality of the security shifted significantly, or material news affecting perceived value was released. When the presumption is overcome, the dealer must work through a hierarchy of alternative pricing evidence:³

Prices from contemporaneous trades of the same security between other dealers come first.
Then prices from contemporaneous trades of the same security with institutional accounts.
Then quoted bid or offer prices from interdealer systems where trades actually occur at displayed prices.
If none of those exist, the firm may look to trades in similar securities or, as a last resort, economic models such as discounted cash flow analysis.

The hierarchy constrains the dealer’s ability to inflate the base and quietly pocket a larger spread. For thinly traded bonds, where reliable market data is scarce, the pricing methodology gets scrutinized more closely.

Which One Am I Paying? Reading the Confirmation

Federal law requires your broker-dealer to tell you which hat it wore. SEC Rule 10b-10 requires a written trade confirmation delivered at or before the completion of each transaction, and the confirmation must state whether the firm acted as your agent, as a principal trading from its own account, or as an agent for both you and the other party.⁴

What has to appear on the confirmation depends on the role. In agency trades, the confirmation must show the exact dollar amount of the commission, along with the execution date, time, price, and quantity. For principal trades in certain equity securities, markup disclosure is also required. Those details create an audit trail so you can verify what you were charged.⁴

Agency Cross Trades

Sometimes a firm acts as agent for both sides of the same trade, matching one client’s buy against another’s sell internally. In that case the confirmation must specifically say the firm represented both parties. It must reveal the name of the person on the other side, or state that this information will be provided on written request. The compensation received from both sides must be disclosed, along with any payment-for-order-flow arrangements.⁴ Cross trades create an obvious conflict because the firm has a financial reason to favor one client over the other, which is why the disclosure obligations are heavier.

How Fair Pricing Gets Policed

Whether you pay a commission or absorb a markup, the charge has to be fair and reasonable. FINRA Rule 2121 makes it a violation to execute any customer transaction at a price not reasonably related to the current market, or to charge a commission that isn’t reasonable.³

The rule’s supplementary material contains what the industry calls the Five Percent Policy, adopted in 1943 after studies showed the large majority of customer transactions carried markups of 5% or less. It is a guide, not a ceiling. A markup below 5% can still be unfair, and a markup above 5% can be justified depending on the circumstances.³

FINRA weighs several factors when evaluating fairness:

Common stocks typically carry lower markups than bonds of the same transaction size, and direct participation programs carry higher markups still.
Inactive securities that take more effort to source or sell may justify a wider spread.
Lower-priced securities tend to involve a higher percentage markup because they require more handling relative to the dollar amount.
Small-dollar transactions may warrant a higher percentage to cover fixed overhead.
Telling the customer about the markup beforehand is a factor, but disclosure alone never justifies an excessive charge.
Regulators look at the firm’s overall pricing pattern, not just individual trades.
The cost of providing ongoing services and facilities can be considered, if those costs aren’t themselves excessive.

For principal transactions specifically, the OCC has noted that markups on riskless principal trades rarely exceed the amount of the dealer concession, and for securities purchased from customers, a reasonable markup seldom exceeds 2% and rarely exceeds 4% of market value.² Firms that consistently charge unfair prices face fines, mandatory restitution, and suspension or permanent bars for the individuals who oversaw the pricing. In severe fraud cases, criminal prosecution is possible. Regulators monitor pricing across both agency and principal transactions, so a firm cannot simply switch to principal trading to escape scrutiny of its commissions.

Regulation Best Interest

Both compensation structures create conflicts, and Regulation Best Interest is the SEC’s primary tool for policing how those conflicts affect the advice you get. The rule applies whenever a broker-dealer makes a recommendation to a retail customer and imposes four obligations that all must be satisfied:⁵

Full and fair written disclosure of all material fees, costs, service scope and limitations, and conflicts tied to the recommendation, delivered before or at the time of the recommendation.
Reasonable diligence to understand the risks, rewards, and costs of any recommendation, plus a reasonable basis to believe it is in your best interest based on your investment profile. The firm cannot put its own financial interest ahead of yours.
Written policies to identify and disclose or eliminate conflicts. Conflicts that create incentives to favor the firm’s interest over yours must be mitigated. Sales contests, quotas, and bonuses tied to selling specific securities within a limited time period must be eliminated entirely.
Written procedures designed to achieve compliance with all three obligations above.

The care obligation is where compensation meets the rule most directly. A broker who earns a larger commission (or markup) by recommending Product A over Product B still must have a reasonable basis to believe A is in your best interest. Reg BI does not ban conflicted compensation; it requires the firm to show the conflict didn’t drive the recommendation. The rule also looks at patterns: even if each individual trade passes muster, a sequence that generates excessive total costs can violate the care obligation.⁵

Churning: The Commission-Model Abuse

Churning is the most direct abuse of a commission-based model. A broker trades excessively in your account mainly to generate fees rather than pursue your goals. Two elements are required. First, the broker must have actual or effective control over the account, either through formal discretionary authority or because you routinely follow recommendations without exercising independent judgment. Second, the trading volume must be excessive relative to your profile and objectives.

Regulators flag potential churning with quantitative measures. The turnover rate, calculated by dividing total purchases by the average monthly investment, is a primary indicator. Turnover rates between three and six have triggered liability, and a rate above six creates a presumption that the trading was excessive. The cost-to-equity ratio, which measures the annual return the account would need just to break even on commissions and expenses, is another key metric. Ratios as low as 8.7% have been found excessive, and ratios above 12% are viewed as very strong evidence.⁶

When the Commission Is “Free”: Payment for Order Flow

If your brokerage advertises zero commissions on stock trades, it is still being paid. The main revenue mechanism behind commission-free trading is payment for order flow. Market makers pay your broker for the right to execute your orders. The market maker profits from the spread between bid and ask, and the broker profits from a per-share rebate. Firms describe this as a standard industry practice used to offset transaction processing costs.⁷

The conflict is straightforward: a broker might route your order to whichever venue pays the highest rebate rather than the one offering the best execution price. SEC Rule 606 addresses this by requiring every broker-dealer to publish quarterly reports disclosing where it routes non-directed orders. For each of the top ten venues and any venue receiving at least 5% of orders, the report must break down net payment for order flow received, transaction fees paid, and rebates received, reported both as a total dollar amount and per share, across different order types.⁸ These reports must be posted on a free, publicly accessible website within one month after each quarter ends and kept available for three years.

The SEC proposed reforms to the payment-for-order-flow model in December 2022, including a possible order-by-order auction requirement for retail equity trades. As of early 2026, those proposals have not been finalized. Payment for order flow remains legal, and Rule 606 disclosure is the primary regulatory check.

Mutual Funds Work Differently

If you are comparing costs on mutual funds rather than stocks or bonds, the commission-versus-markup framework does not really apply. Fund charges are governed by FINRA Rule 2341 and built into the share class, disclosed in the prospectus. For funds without an asset-based sales charge, the maximum front-end and deferred sales charge combined cannot exceed 8.5% of the offering price, with lower caps if the fund does not offer certain investor protections. Funds that charge ongoing asset-based sales fees (commonly called 12b-1 fees) face tighter limits, and a fund cannot describe itself as “no load” if its total sales-related charges and service fees exceed 0.25% of average net assets per year.⁹ Read the prospectus for the specific numbers on any fund you own.

Back on the stock and bond side, the practical takeaway is short. Check your trade confirmation for the capacity indicator. If it says “agent,” look for the commission line and compare it against what similar trades cost elsewhere. If it says “principal,” the cost is inside the price, and your leverage is asking the firm what prevailing market value it used and how that number was determined. Either way, the firm owes you a price and a total cost that a regulator would call fair.

1
FINRA. FINRA Rule 5310 – Best Execution and Interpositioning
2
Office of the Comptroller of the Currency. Comptrollers Handbook – Bank Dealer Activities
3
FINRA. FINRA Rule 2121 – Fair Prices and Commissions
4
eCFR. 17 CFR 240.10b-10 – Confirmation of Transactions
5
eCFR. 17 CFR 240.15l-1 – Regulation Best Interest
6
FINRA. FINRA Rule 2111 Suitability FAQ
7
Charles Schwab. Order Routing
8
eCFR. 17 CFR 242.606 – Disclosure of Order Routing Information
9
FINRA. FINRA Rule 2341 – Investment Company Securities