Markdown

Markdown is the negative spread between the price the broker charges for the security from its clients and the highest price on which the same security is traded between the brokers. It helps the market makers to consider reducing the price of the security, especially when bought in bulk, to keep the market liquid.

The difference or spread that arises between the prices the dealer charges from its retail customer for the particular security with prices on the inside market if the spread is negative. However, if the spread is positive, it arises between the prices the dealer charges from its retail customer for the particular security with prices on the inside market, known as the markup.

Markdown is a difference or spread that arises between prices that the dealer charges from its retail customer for particular security with prices on the inside market if the spread is negative. Sometimes, the dealer offers lower prices to stimulate trading with the main idea of making extra money through the additional commission on increased sales.

The range of markdowns between 5% – 10% is justifiable based on security type, prevailing market conditions, or the broader dealer pattern of markups and markdowns. Undisclosed spreads, the percentages of which are over 10 %, are to be considered fraudulent.

It is not required to disclose the markups and the markdowns in the principal transactions, so the investor can easily be unaware of differences in the price. The principal transaction occurs in case the dealer sells the securities out of his own account at his own risk.

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Example #1

A broker in the market has several clients who deal through him. Now the broker wants to increase the sales volume of some set of securities. For that, he decided to sell the security to his client at a lower price than the selling price or the highest bid prices among the brokers in the securities market. He sold the shares of A ltd company at $ 35 per share to his clients. On the other hand, he purchased the same stock in the broker market at a high price of $ 50 per share. Discuss the spread which arises due to the price difference between the selling price to the clients of the security and buying price of the same security from the broker market.

Analysis:

In the present case, a broker wants to increase the sales volume of some set of securities. For that, he decided to sell the security to his client at a lower price than the highest bid prices among the brokers in the securities market. And for that, he sold the shares of A ltd company at the price of $ 35 per share to his clients, which he bought from the broker market at the high price of $ 50 per share. As a result, there is a negative spread between the selling price to the security clients and the buying price of the same security from the broker market. Therefore, Markdown on shares that the broker sells is – $ 20 ($ 35 – $ 50).

Example #2

A dealer thought that the demand for the municipal bond issue would be very high in the market, but the actual demand was not as much as the dealer thought it to be. So, the broker might be forced to sell at a lower price to clear its inventory. The difference arising due to the lowering of the prices is the markdown.

Example #3

There is a broker who deals in securities. He believed that by reducing the prices of a security for the clients, he could generate profits through the commission, which are enough to make up for the loss, which could arise due to the lower prices. So he reduced the prices of the securities, and this reduction is known as Markdown.

The pros and cons of markdown have been shown in a tabular format below:

Advantages

• The broker can sell securities at markdown prices when by reducing the prices of a security for the clients, he can generate profits through the commission, which are enough to make up for the loss, which could arise due to lower prices. By this, he can clear his stock along with earning profits.
• The clients with the Markdown of the prices get the securities at lesser prices.

Disadvantages

The regulators consider markups and markdowns of more than 5 % excessive, but this is only the guideline and not the rule.

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The Markdown and the markup are two different terms having different meanings and should not be confused. The differences between the two have been listed below:

• When the difference in the inside market prices and the price at which dealers agree for retail customers is obtained, the spread is either positive or negative.
• If the spread is negative, it is a markdown, while it is a markup if the spread is a positive one.
• Markup is more common among market makers than markdown.
• In the common scenarios, markup markdowns because the securities are bought in bulk by the market makers. As the liquidity is more in the inside markets, they can obtain more favorable prices generally when compared with the prices the retail customers get. It is not required to disclose these in the principal transactions.