Study guide
This chapter maps to Section 1 of the official FINRA outline, worth 16% of the SIE (12 of 75 scored questions). It covers who regulates the securities industry, who the market participants are, how the markets are structured, the economic forces that move prices, and how new securities are brought to market.
The Regulators: SEC, SROs, SIPC and FDIC
Securities regulation exists to protect investors, keep markets fair and orderly, and facilitate capital formation. At the top sits the Securities and Exchange Commission (SEC), the federal agency created by the Securities Exchange Act of 1934. The SEC oversees the securities markets, registers broker-dealers and exchanges, requires ongoing disclosure by public companies, and brings civil enforcement actions. Beneath the SEC are self-regulatory organizations (SROs), industry bodies that write and enforce rules for their own members under SEC oversight. FINRA regulates broker-dealers and their associated persons. The Municipal Securities Rulemaking Board (MSRB) writes rules for municipal securities dealers and municipal advisors but has no enforcement arm of its own; FINRA and the SEC enforce MSRB rules for securities firms, and federal banking regulators enforce them for banks. Cboe is an SRO for its options exchange members. Other bodies matter too: the Treasury Department and IRS handle tax rules; state securities regulators, coordinated through the North American Securities Administrators Association (NASAA), administer state blue-sky laws; and the Federal Reserve conducts monetary policy and sets margin rules under Regulation T. Two protection schemes are tested constantly. The Securities Investor Protection Corporation (SIPC), a nonprofit membership corporation funded by broker-dealers, protects customers when a brokerage firm fails, covering up to $500,000 per customer per separate capacity, of which no more than $250,000 may be cash. SIPC never covers losses from market declines. The Federal Deposit Insurance Corporation (FDIC) insures bank deposits up to $250,000 per depositor, per bank, per ownership category, and never covers securities, even securities purchased at a bank.
Market Participants and Their Roles
Investors come in three tested categories. Retail investors are individuals investing their own money. Institutional investors are entities such as banks, insurance companies, mutual funds and pension plans. Accredited investors meet financial thresholds under Regulation D: an individual with income over $200,000 (or $300,000 with a spouse or spousal equivalent) in each of the two most recent years, or net worth over $1 million excluding the primary residence, plus certain professional license holders and institutions. Broker-dealers execute trades, either as brokers (agents) for others or dealers (principals) for their own account. An introducing broker-dealer opens accounts and takes orders but hands custody, clearing and settlement to a clearing (carrying) firm; prime brokers consolidate custody and reporting for institutional clients like hedge funds that execute through many firms. Investment advisers are compensated for giving securities advice, typically through asset-based fees, and owe clients a fiduciary duty under the Investment Advisers Act of 1940. Municipal advisors advise state and local issuers on bond offerings. Issuers sell securities to raise capital, and underwriters (investment bankers) distribute those securities to the public. Traders and market makers buy and sell for firm accounts; a market maker stands ready to buy and sell a given security at its published firm quotes. Custodians hold assets for safekeeping, and trustees administer assets under a trust document. Transfer agents, hired by issuers, maintain shareholder records and issue and cancel certificates. The Depository Trust & Clearing Corporation (DTCC) provides clearing, settlement and depository services for most securities, while the Options Clearing Corporation (OCC) issues, guarantees and clears listed options.
Market Structure: Primary, Secondary, Third and Fourth Markets
The primary market is where issuers sell new securities to investors and the issuer receives the proceeds. Every initial public offering happens in the primary market. Suppose Orchard Robotics sells five million newly created shares to the public at $20: the company collects the money, and the sale requires registration and a prospectus. The secondary market is all trading between investors after issuance; the issuer receives nothing. If Maria later sells 100 of her Orchard shares to another investor on an exchange, that is a secondary market trade. Secondary trading takes place on physical exchange floors such as the NYSE, on electronic markets, and over the counter (OTC), a decentralized negotiated network of dealers for securities that are not exchange-listed. Exchanges operate as auction markets, matching the highest bid with the lowest offer at a central location, while the OTC market is a negotiated dealer market in which market makers quote prices. The third market refers to exchange-listed securities trading over the counter, away from the exchange, for example an institution buying NYSE-listed stock directly from a broker-dealer's inventory after hours. The fourth market is direct institution-to-institution trading with no broker-dealer intermediary, typically through electronic communication networks (ECNs) and so-called dark pools, where large blocks change hands anonymously so the orders do not move the public market. The exam rewards simply matching each market to its definition and knowing that issuer proceeds exist only in the primary market.
Economic Factors and the Federal Reserve
Monetary policy is conducted by the Federal Reserve; fiscal policy is taxation and government spending decided by Congress and the President. The Fed's most-used tool is open market operations, directed by the Federal Open Market Committee: buying securities injects money into the banking system, easing credit and pushing interest rates down, while selling securities drains money and pushes rates up. The discount rate is the rate the Fed itself charges banks that borrow from it. The federal funds rate is the market rate banks charge one another for overnight loans; the Fed sets a target for it, and it is the most sensitive indicator of policy direction. Reserve requirements and Regulation T margin levels are additional tools. The business cycle runs expansion, peak, contraction, trough; a common shorthand for recession is two consecutive quarters of declining GDP. Leading indicators such as stock prices, building permits and initial unemployment claims predict activity; coincident indicators such as industrial production and personal income confirm it; lagging indicators such as the average duration of unemployment and the prime rate trail it. Inflation, a general rise in prices measured by the CPI, erodes purchasing power. Cyclical industries (autos, homebuilders, luxury goods) track the cycle; defensive industries (utilities, food, pharmaceuticals) resist downturns; growth companies reinvest earnings rather than pay dividends. Keynesians emphasize government spending to manage demand; Monetarists emphasize steady money supply growth. GDP measures output within U.S. borders, while GNP measures output of U.S. nationals wherever produced. A strong dollar makes imports cheaper but hurts U.S. exporters; a weak dollar does the opposite.
Offerings: How Securities Come to Market
The Securities Act of 1933 requires that new issues be registered with the SEC and sold with a prospectus unless an exemption applies. The issuer files a registration statement; during the roughly 20-day cooling-off period no sales or advertising may occur, though a preliminary prospectus (red herring), which lacks the final offering price, may be used to gauge interest. In a firm commitment underwriting, the syndicate buys the entire issue from the issuer as principal and resells it, bearing the risk of unsold shares; in a best efforts deal the underwriter acts only as agent, with all-or-none and mini-max variations, leaving the risk with the issuer. An IPO is the first public sale; a follow-on offering is a later primary offering; a secondary offering is existing shareholders selling their shares, so the selling shareholders, not the issuer, receive the proceeds. A shelf registration under Rule 415 lets an issuer register securities once and sell portions over time, generally up to three years. Exempt securities include U.S. government and municipal securities, bank securities, and commercial paper maturing in 270 days or less. Exempt transactions include Regulation D private placements (unlimited accredited investors plus up to 35 sophisticated non-accredited investors under Rule 506(b)); Rule 144, which governs resales of restricted stock (six-month holding period for reporting issuers) and control stock subject to volume limits; Rule 144A resales to qualified institutional buyers; and Rule 147 intrastate offerings. Municipal offerings use an official statement rather than a prospectus and are sold through competitive bidding or negotiated underwriting. State blue-sky laws add state-level filing requirements.
Key terms
- Securities and Exchange Commission (SEC)
- — The federal agency created by the Securities Exchange Act of 1934 that oversees the securities markets, registrants and disclosure.
- Self-regulatory organization (SRO)
- — An industry body such as FINRA, the MSRB or Cboe that writes and enforces rules for its members under SEC oversight.
- SIPC
- — A nonprofit membership corporation that protects customers of failed broker-dealers up to $500,000 per separate capacity, including up to $250,000 in cash, but never against market losses.
- FDIC
- — The federal corporation insuring bank deposits up to $250,000 per depositor, per bank, per ownership category; it never covers securities.
- Accredited investor
- — A person with income over $200,000 ($300,000 joint) in each of the last two years or net worth over $1 million excluding the primary residence, or a qualifying institution.
- Broker-dealer
- — A firm that executes securities transactions as agent (broker) for customers or as principal (dealer) for its own account.
- Market maker
- — A dealer that stands ready to buy and sell a specific security at its published firm quotes.
- Transfer agent
- — An issuer-hired firm that maintains shareholder records and issues and cancels stock certificates.
- Primary market
- — The market where issuers sell new securities and receive the sale proceeds.
- Fourth market
- — Direct institution-to-institution trading without a broker-dealer, often through ECNs or dark pools.
- Monetary policy
- — The Federal Reserve's management of money supply and interest rates through tools like open market operations.
- Firm commitment
- — An underwriting in which the syndicate buys the whole issue from the issuer as principal and bears the risk of unsold shares.
Exam tips
- Classic SIPC vs. FDIC trap: SIPC covers brokerage-firm failure ($500,000 including $250,000 cash) and never market losses; FDIC covers bank deposits ($250,000) and never securities, even those bought at a bank.
- Monetary vs. fiscal: the Federal Reserve conducts monetary policy; anything involving taxes or government spending is fiscal policy set by Congress and the President.
- Follow the money: the issuer receives proceeds only in the primary market; in a 'secondary offering' the selling shareholders receive the proceeds even though a prospectus is used.
- Firm commitment means the underwriter acts as principal and bears the risk; best efforts means the underwriter is only an agent and the issuer bears the risk. Watch for the words 'agent' and 'principal' in answer choices.
- Rate distinctions: the discount rate is set by the Fed and charged to banks; the federal funds rate is a market rate between banks that the Fed only targets, and it is the most sensitive indicator of policy direction.