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Understanding FINRA Rule 2232: Customer Confirmations

Instructor: Bryant Trombly

Bryant has taught graduate finance and has an MBA and master's degree in information technology.

In this lesson you will learn about the concept of markup on fixed income securities and when and how that markup must be communicated to customers in their trade confirmations.

Buying Bonds

Laura is an account owner at Big House Brokerage and has been investing on bonds for many years. She's recently started receiving confirmations with some of her bond transactions that lists a value of either markup or markdown on her trades. Laura wonders what this value is, why she has started receiving a report of it, and why she sees it on some of her trade confirmations but not others.

Laura gives her account advisor Stephen a call to ask him these questions.

Markups and Markdowns

Laura starts with what seems to her the most straightforward questions, what is markup? Stephen explains that when Laura buys or sells a bond there are two sources she might buy or sell that bond from. One of the sources are the various bond exchanges where lots of buyers and sellers get together and bid and offer on transacting bonds.

When Laura buys a bond from an exchange, she pays the lowest price a seller is willing to accept for it or sells for the highest price a buyer is willing to pay.

Other times Laura is buying a bond from or selling a bond to Big House Brokerage itself. Big House may have purchased a large volume of bonds to make available to its clients in smaller quantities. When Laura buys 10 bonds of ABC Company from Big House, they may have bought 1000 of these bonds originally.

Big House might also buy small amounts of bonds from its customers and sell them off in a larger quantity to other brokerages or larger investors. This is known as a principal trade or a trade where the brokerage is the other party.

Brokerage houses like Big House make money from these principal trades by charging a markup or markdown. A markup is when a brokerage sells bonds directly to a customer in a principal trade at a higher price than it paid to buy the bonds. In this case, the difference in cost between the lower price Big House bought the 1000 ABC Company bonds for and the higher price they sold the 10 ABC Company bonds to Laura for.

A markdown is when a brokerage buys bonds from a customer in a principal trade for one price and then sells it to another brokerage at a higher price. In this case, when Laura sells the bonds to Big House and Big House takes those bonds and sells them again to someone else for a higher price. Laura would have wanted to have sold the bonds directly for the highest price herself and not let Big House take a cut.

Markup and markdown can often be confusing because it's a point of view situation. In both cases the brokerage is buying low and selling high. For a markup the process starts with the brokerage buying from the market low and selling to the customer high. For a markdown the process begins with the brokerage buying from the customer low and then selling to the market high.

FINRA Rule 2232: Customer Confirmations

Laura never realized that Big House might make money beyond the commission, or fee for the transaction, when she bought or sold a bond. Laura asks Stephen if this markup is new since she just started seeing it on some of her confirmations.

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