SIE Chapter 1 Knowledge of Capital Markets

Securities and Exchange Commission

Securities laws and regulations are in place to protect market participants (investors) as well as to cultivate fair and efficient markets. As a United States government oversight agency, the SEC is responsible for ensuring such laws and regulations are complied with in the U.S. The SEC was established in 1934 during the Great Depression and works alongside self-regulatory agencies, state regulators, and Congress in order to uphold and improve upon securities regulations.

The Securities Act of 1933

The first federal legislation targeted at the securities regulation industry, particularly the issuers of securities, such as companies seeking capital to fund their growth. This law requires issuers to comply with a series of rules, including disclosing all material company information, in order to protect investors from fraud. The SEC is charged with governing and enforcing this act.

The Securities Exchange Act of 1934

Regulates securities trading that takes place over the secondary market. Issuers are required by Congress to disclose information pertinent to the sale of their securities, and certain Issuers are required to file periodic reports with the SEC such as an annual report. These Issuers have over $10 million in assets and their securities are held by more than 500 owners.

The Investment Advisers Act of 1940

Limits the advertising investment advisers may engage in. The SEC's implementation regulation is SEC Regulation 206 (4), named for it being covered by Section 206(4) of the Act. This section prohibits advertising that is "fraudulent, deceptive, and manipulative", such as by referring to an external testimonial, or including an externally produced chart without providing full disclosure of limitations of its use. Another provision of this Act is the designation of "accredited investor" and "qualified client", which is described in Section 205(3).

Who is qualified as an accredited investor?

An "accredited investor" is defined as an individual/couple with net worth exceeding $1 million, or which earned in excess of $200K / $300 K for two successive years.

The Investment Company Act of 1940

Regulates the organization of companies, including mutual funds and unit investment trusts, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The motivation is to reduce conflict of interests by requiring investment companies to disclose their financial condition and investment policies to investors, information about the fund and its investment objectives, as well as its investment company structure and operations.

- This Act does not give the SEC authority to directly supervise the investment decisions or activities of these companies or judge the merits of their investments

Self-Regulatory Organizations (SROs)

Similar to the SEC, SROs—such as FINRA and the securities exchanges—exist in order to protect investors by establishing industry procedures, compliance, and enforcement. Unlike the SEC, FINRA is not a government oversight agency and instead works under the supervision of the SEC.

New York Stock Exchange (NYSE)

Created in 1792, the NYSE is the largest stock exchange in the world. In order to be listed on this exchange, companies must meet rigorous requirements that relate to their size and their finances. Once listed, they must continue to meet certain standards related to their number of stockholders, average monthly trading volume, and more. Some of the world's oldest public companies are listed on the NYSE.

Chicago Board Options Exchange (CBOE)

Created in 1973, the CBOE is the largest options exchange in the world. Through this exchange, investors are able to trade in put and call options on: publicly traded stocks, exchange-traded funds, and exchange-traded notes.

FINRA

Supervised by the SEC, FINRA is a not-for-profit organization charged with overseeing broker-dealers domiciled in the United States. Congress has authorized FINRA to protect the investing public by writing and enforcing rules, examining broker-dealers for compliance with these rules, ensuring market transparency, and providing education to investors.

Municipal Securities Regulatory Board (MSRB)

Tasked with writing and enforcing rules and procedures for investment firms and banks who sell municipal bonds, notes, and other municipal securities.

Municipal securities are issued by a state, municipality, or a county in order to fund public projects. These projects might include the construction of an airport or a power plant. Municipal bonds are exempt from federal taxes and some state and local taxes, and interest paid on these bonds is frequently tax-free as well.

Examples of SROs

FINRA, MSRB, NYSE and CBOE

United States Treasury

The United States Treasury is an executive department of the federal government that was established by Congress in 1789 to manage government revenue. They oversee the Internal Revenue Service, the United States Mint, and the Bureau of Engraving and Printing. In 2014, the Financial Crimes Enforcement Network (FinCEN) was established as a bureau within the Treasury and was given a mandate to enforce the Currency and Foreign Transactions Reporting Act of 1970, which requires U.S. financial institutions to assist U.S. government agencies with detecting and preventing money laundering.

What is FinCENs Primary role?

to detect and prevent national and international money laundering attempts. Working under the Bank Secrecy Act (BSA), they require banks and other financial institutions to abide by reporting and recordkeeping rules as well as to submit a currency transaction report (CTR) for any transaction involving $10,000 or more of currency.

Internal Revenue Service (IRS)

The IRS is a bureau of the United States Treasury and is responsible for collecting taxes and administering the tax law of the United States as required by Congress.

The Federal Reserve ("The Fed")

The Fed was established in 1913 under the Federal Reserve Act and is the central bank of the United States. It was created by Congress with a mandate to maximize employment, stabilize prices, and moderate long-term interest rates in order to provide a safe and healthy monetary and financial system. Its duties have expanded since 1913 and now include regulating banks, maintaining the stability of the financial system, and providing financial services to depository institutions.

State Regulators

Similar to FINRA, state regulators aim to protect the investing public from fraud. They achieve this primarily through providing education to investors and ensuring market transparency. One such example of state regulators is the North American Securities Administrators Association (NASAA), which is an organization comprised of securities regulators from the United States, Canada, and Mexico. Membership in the NASAA is voluntary.

Federal Deposit Insurance Corporation (FDIC)

The FDIC is an independent U.S. government agency that provides deposit insurance to U.S bank depositors. The FDIC was created by Congress through the 1933 Banking Act as a result of thousands of bank failures that occurred throughout the prior decade. They supervise more than 5,000 banking and savings institutions and provide deposit insurance of up to $250,000 per depositor.

Securities Investor Protection Corporation (SIPC)

IPC was created by Congress in 1970 through the Securities Investor Protection Act in order to restore trust in the U.S. securities industry. Between the years of 1968 and 1970, stock prices declined significantly as a result of hundreds of broker-dealers getting acquired or going bankrupt, and many investors subsequently lost all of their cash and/or securities. Eligible investors are insured by SIPC for up to $250,000 in cash in their brokerage accounts.

Foreign Country Regulators

Most countries have their own government regulatory agencies similar to the SEC. For example, the United Kingdom has the Financial Conduct Authority (FCA) and Croatia has the Croatian Financial Services Supervisory Agency.

Retail Investors

Also known as individual investors, retail investors are individuals who buy and sell public debt and equity securities through their retirement or brokerage accounts. They invest using their own money for their own personal goals such as retirement or saving up for a house. The SEC considers retail investors to be unsophisticated and, as a result, most securities regulations are targeted at keeping this particular class of investors protected.

What is an accredited investor?

An accredited investor can be an individual or an entity that meets certain requirements related to net worth, income, qualifications, experience, or certifications.

What are the income requirements for an individual to be considered an accredited investor?

An individual must have an income in excess of $200,000 in each of the two most recent years or joint income with a spouse or spousal equivalent in excess of $300,000 in those years.

What is the net worth requirement for an individual to be considered an accredited investor?

An individual must have a net worth exceeding $1,000,000, either individually or jointly with a spouse or spousal equivalent.

What can accredited investors trade in?

Accredited investors are permitted to trade in private securities not registered with the SEC, including private placements and venture capital.

Institutional Investors

Unlike retail and accredited investors, institutional investors can only be legal entities, such as real estate investment trusts, venture capital funds, insurance companies, credit unions, banks, pension funds, hedge funds, and mutual funds. These investors trade in securities on behalf of their clients or shareholders and they buy and sell in large quantities.

Known to have "smart money", institutional investors are considered sophisticated enough to make their own investment decisions and are thus subject to fewer rules and regulations. For example, there is an exemption made for institutional investors in FINRA Rule 2111 regarding suitability requirements.

Broker

A broker is an entity that trades in securities on behalf of its clients

Introducing Brokers

do not hold client funds nor do they execute transactions. While they are able to receive orders for securities from customers, they must contract with a clearing firm to process them.

Clearing

Clearing firms hold customer accounts and are responsible for clearing trades and ensuring those trades reach settlement.

Prime Brokers

Prime brokers are unique in that they only service large financial institutions as a way for those institutions to outsource certain activities, such as trade clearing and settlement or risk and performance analysis.

Dealer/Principal

trades on behalf of itself

Investment Advisors

Registered with state regulators and/or the SEC, an investment adviser can be an individual or a company. They are paid by their clients to provide advice about securities investments, manage investment portfolios, or to provide other financial planning or brokerage services. Other common names for investment advisers include portfolio managers, wealth managers, or asset managers. Morgan Stanley Wealth Management is an example of an investment adviser. Individuals who work on behalf of the firm are known as investment adviser representatives.

Municipal Advisors

Firms that provide municipal advisory services are required to register with both the SEC and the MSRB. Section 15B of the Securities Exchange Act defines "municipal advisor" as a person that:

Provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and other similar matters concerning such financial products or issues; or

Undertakes a solicitation of a municipal entity.

Issuers

legal entities that fund their operations by selling securities (such as common stock) to investors. If an issuer sells securities to the general investing public, through an IPO for example, then they are required to make certain filings with the SEC.

Underwriters

facilitate the sale and distribution of an issuer's securities by pricing the securities, purchasing the securities directly from the issuer, and then finally selling the securities to investors.

Custodians

is the entity (typically a bank or brokerage firm) that actually holds the assets for safekeeping.

Trustees

A trustee is an individual, broker, bank, or other similar organization charged with governing a trust. They manage and administer investments or other assets on behalf of the beneficiary of the trust and generally have a fiduciary responsibility to the trust.

Transfer Agents

Typically a bank or a trust company, transfer agents act as intermediaries between securities issuers and securities holders. They are primarily responsible for maintaining security holder records and distributing dividends on behalf of the issuing company.

In some cases, companies might elect to act as their own transfer agents.

Transfer agents are required to be registered with the SEC. If the transfer agent is a bank, then they are required to be registered with a bank regulatory agency.

Depository Trust & Clearing Corporation (DTCC)

The DTCC manages the daily clearing and settlement processes for most securities transactions in the United States. A good way of thinking about this is that when you write a check, it is not 'good' until it 'clears.' Similarly in the stock market, your purchase isn't 'good' until it clears through the DTCC.

The largest options clearing house is the Options Clearing Corporation (OCC) which is governed by the Commodities Futures Trading Commission (CFTC) and the SEC.

The Primary Market

The primary market refers broadly to newly created debt and equity securities. For example, companies will often generate cash by offering shares of ownership (stock) to public investors for the first time through initial public offerings (IPOs). The investment banks who underwrite these IPOs price the shares and then issue them directly to investors. It's important to keep in mind that investors do not trade securities between each other in the primary market; they purchase securities directly from issuers.

The Secondary Market

Following an IPO, the shares of a publicly traded corporation are bought and sold during trading hours on stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq. The secondary market (typically referred to as the stock market) facilitates these transactions in securities that are not sold directly by the issuer. Investors purchase securities from other investors through trading accounts held by brokerage firms such as Fidelity or Charles Schwab.

The Third Market

The third market facilitates the over-the-counter (OTC) trading of exchange-listed securities between institutional investors and broker-dealers. Investors who engage in third-market trading are able to bypass broker fees and the involvement of a formal exchange like the NYSE. OTC refers to trading that is done through a broker-dealer network rather than a centralized exchange; outside of the third market, securities that are traded OTC are typically not listed on an exchange.

The Fourth Market

Allows for institutional investors to trade large blocks of securities directly between each other. These trades are processed through the Electronic Communications Network (ECN) and can include both exchange-listed and OTC securities. Fourth market trading is permitted to occur after hours and does not carry any reporting requirements. Retail investors are unable to access this market.

American Depositary Receipts (ADRs)

Certificates that represent shares of a foreign company's stock. Just like domestic shares, ADRs trade on stock exchanges in the United States and are priced in U.S. dollars rather than foreign currency.

Regulation S Offerings

An offering of securities by a U.S. or foreign corporation wherein the offering takes place outside of the United States and only non-U.S. investors participate. These offerings are exempt from SEC registration.

The Federal Reserve (The Fed)

The Fed is responsible for keeping the economy in good health by using a variety of financial techniques to maintain high employment and low inflation, and interest rates within reasonable parameters.

Monetary policy

Refers to actions taken by the Fed to maintain or promote the health of the U.S. economy, separate from Congress and the President. Within the Fed is the Federal Open Market Committee (FOMC) which meets eight times a year to review economic conditions and evaluate any necessary policy changes.

The most typical policy change is an increase or decrease in the federal funds rate which will in turn affect interest rates on credit cards, bank loans, mortgages, and more. When the Fed wishes to stimulate the economy, they lower the federal funds rate which then encourages consumer spending.

Fiscal policy

refers to actions taken by Congress and the President in setting tax rates and policies. An example of taxation policy would be making retirement savings advantageous, which is currently supported by Congress for pre-tax 401(k) and IRA accounts and their post-tax Roth equivalents.

Prime Rate

Base interest rate offered by commercial banks for consumer loans, including credit cards. It has a direct relationship with the discount rate—if the discount rate goes up then so does the prime rate, and vice versa.

Discount Rate

Rate offered to member banks who borrow money from the Fed in order to keep their reserves up.

Federal Funds Rate

Target rate set by the Fed in order to control inflation.

Balance Sheet

A financial statement that reports assets, liabilities, and owner's equity on a specific date.

Income Statement

A financial statement showing the revenue and expenses for a fiscal period.

Cash Flow Statement

A summary that shows total income and spending for a given time period

Statement of Shareholder Equity

Details the changes in the equity found on the balance sheet either year-to-date or from one year to the next. Which might include purchasing shares back from investors (treasury stock) or issuing new common shares. Accounts typically found on the statement are preferred stock, common stock, treasury stock, additional paid-in capital, retained earnings, and noncontrolling (minority) interests.

First Stage of The Business Cycle:

Expansion: The economy is growing. Gross Domestic Product (GDP) shows healthy growth in the 2% to 3% range.

Second Stage of The Business Cycle

Peak: The economy can be said to be "overheated." Prices hit their highest level and economic indicators stop growing.

Third Stage of The Business Cycle

Contraction (Recession): Economic growth weakens and GDP growth falls below 2 percent. When GDP declines for two or more consecutive quarters, then the economy has entered a recession. Layoffs make headline news and unemployment rate begins to rise. Consumers and businesses find it hard to secure credit.

Fourth Stage of The Business Cycle

Trough: The economy reaches its lowest point before transitioning from the contraction phase to the recovery phase.

Fifth Stage of The Business Cycle

Recovery: Low prices help foster demand. Employment and production begin to rise, and lenders are more willing to lend.

Economic Indicators: Leading

Indicate where the economy is headed in the short term. These can be useful when trying to predict the next phase of the business cycle. Examples include stock market returns, index of consumer expectations, building permits, and the money supply.

Economic Indicators: Lagging

Reveals trends in the economy after major economic, financial, or business events have occurred. The unemployment rate is the most prominent lagging indicator, since employment tends to increase for two or three quarters following an upswing in the economy. Other examples include corporate profits and the consumer price index (CPI).

Economic Indicators: Coincident

Statistics that tell analysts how the economy is currently. Examples include gross domestic product, industrial production, personal income, and retail sales.

Inflation

Occurs when the purchasing power of money declines. For example, if the prices of goods and services increase but earnings remain the same, then those earnings can no longer purchase as much as they used to. They have lower purchasing power. During periods of inflation, stock prices are generally volatile.

Cyclical

Businesses that follow the standard business cycle, thus the name 'cyclical.' Think of the leisure, luxury, and cruises/travel industries, which do well in a good economy but poor in a down economy.

Defensive

Businesses that make goods we use as a part of our daily lives and are not impacted in a material way by how the economy is doing. Examples would be public utilities, basic food and clothing, consumer goods such as soap, shampoo, cosmetics, etc. You don't use more electricity when you get a raise at work, and you don't use less if your hours get cut. That's what defensive refers to.

Growth

Industries expected to grow faster than the economy in general. Examples include technology, health care, and biomedical.

Keynesian

Theorizes that an increase in government expenditures and a decrease in taxes can prevent or repair an economic recession.

The government's role is significant.

Monetarist

Theorizes that controlling the money supply and letting the market work itself out can curb inflation and is essential for a healthy economy.

The government's role is minimal.

Balance of Payments

refers to the net transactions completed between one country's government bodies, companies, and individuals, and those of outside countries. For example, let's say U.S. consumers and businesses purchase goods worth 500 billion dollars from Japan in the year 2021, and these expenditures are offset by consumers and businesses in Japan buying goods worth 400 billion dollars from the U.S. The difference would be referred to as a trade 'deficit' for the U.S. and a trade 'surplus' for Japan. Viewed another way, there is a 100-billion-dollar trade imbalance.

Gross Domestic Product (GDP)

The total value of all goods and services produced within a country by its nationals and foreigners alike. It is one measurement that economists and analysts use to determine the rate at which an economy is growing from one year to the next.

Gross National Product (GNP)

The total value of all goods and services produced by the citizens of a country, no matter where they live.

Follow-on offering/ APO

a subsequent offering of shares to the investing public. Both IPOs and APOs must meet strict SEC registration requirements under the Securities Act of 1933.

Regulation A

Large public offerings are those exceeding $50 million. Small offerings enjoy certain relaxed SEC paperwork/filing requirements under Regulation A (Reg A), which provides an exemption from registration for public offerings up to $20 million (Tier 1) or $50M (Tier 2) in any 12-month period. Tier 1 offerings require the issuer to file with state regulators in each state it plans to sell its securities.

Intrastate Offerings — Rule 147

When a corporation goes public but the sales are confined to residents of one state. State registration is required but SEC registration is not. Also known as single state offerings.

Interstate

The shares are being offered to residents of multiple states.

Private Offering/ Private Placement

In a private offering, the issuer does not sell its securities to the investing public but rather to a narrowly defined group of investors who meet strict wealth and sophistication requirements

SEC Regulation D (Reg D)

contains the rules for exemptions from registration, allowing some companies to offer and sell their securities without having to register them with the SEC. A Reg D offering provides access to the capital markets for smaller companies that otherwise couldn't afford the costs of a standard SEC registration.

secondary market offering

a block of public company shares is sold by the present holder of the shares rather than the issuing company. No new shares are being created in the transaction.

-If the number of shares offered is large, to the extent their sale could influence the issuing company's stock price, then the sale will need to be registered with the SEC.

Restricted and Control Securities — Rule 144 Limitations

Securities acquired in private, unregistered sales by an issuer or an affiliate of the issuer are called restricted securities. Affiliates are generally defined as an issuer's officers, directors, and investors owning 10% or more of the voting stock of the issuer.

The SEC has strict rules for those who wish to sell restricted securities in the public marketplace; shareholders must satisfy certain conditions under Rule 144 in order to be exempt from registering the sale with the SEC. For example, they must hold the securities for a minimum length of time known as the holding period, often six months or one year.

Company Buy-Back Programs

A stock buyback, or share repurchase, occurs when a company buys back its shares from the market using company funds. It is one way for a company to re-invest in itself. The repurchased shares are referred to as treasury stock and may be re-sold to the investing public later or used for a variety of other purposes such as conversions of convertible bonds.SEC Rule 10B-18 prohibits share repurchases during the last 30 minutes of the trading day

Firm Commitment

The investment bank commits to purchase all the securities in an offering from the issuer and then resell them to the public. They assume the financial responsibility for these securities; any unsold shares are paid for and held by the investment bank.

Best Efforts

The investment bank agrees only to use its best professional efforts to market and sell the issuer's securities and any unsold shares are returned to the issuer.

All or None

This is a variation on best efforts. In this instance, if 100% of the shares don't sell, then the entire offering is nullified and the shares are returned to the issuer.

Minimum-Maximum (Mini-Max)

This is a variation on all or none. In this instance, instead of having to sell 100% of the shares, a lesser minimum percentage is set, such as 50%. As long as that percentage is sold to the public, then the deal goes through.

Initial Public Offering Participant Roles

here will typically be an underwriting syndicate comprised of more than one investment bank or broker-dealer, with one of these firms acting as the lead underwriter and the others acting as syndicate members. By forming a temporary syndicate, the lead underwriter is able to spread out the risk of the deal.

Municipal Bond Offering

Municipal bonds are typically offered under a negotiated sale or a competitive sale.

In competitive sales, issuers advertise that their bonds are for sale by releasing a notice of sale to the public. This advertisement contains terms of both the sale and the bond issue. From there, broker-dealers and/or banks (the underwriters) place bids on the bonds at a specified time on a specified date and the bidder offering the lowest interest rate wins.

In negotiated sales, issuers are allowed to select the underwriter(s), with whom they directly negotiate the terms of the bonds and the terms of the sale in a "two-party" process. Additionally, investors are able to submit indications of interest (IOIs) in negotiated sales which then help the underwriter(s) finalize the offering price and sell the bonds.

shelf registration

register the offer and sale of securities on a delayed (future) basis or on a continuous basis; the registered shares that aren't sold right away are said to be "sitting on the shelf."

A shelf registration statement is the filing made by the issuer with the SEC that can cover multiple future primary offerings, secondary offerings, or both. By filing this statement, an issuer can take securities "off the shelf" and then offer them for sale relatively quickly, such as when market conditions are favorable.

Prospectus

Document filed with the SEC for public securities offerings, including stocks, bonds, and mutual funds. The prospectus discloses relevant information about the issuer and the investment, such as the company's summary, the number and type of securities being offered, names of the underwriters, and the risks involved in the investment. Companies are required to file both a preliminary prospectus and a final prospectus, with the latter containing the offering price.

Private Placement Memorandum (PPM)

Document provided to potential investors in a private placement that discloses relevant issuer information as well as the objectives, terms, and risks of the offering. Though private placements are exempt from SEC registration, the PPM is still required to comply with federal securities laws.

Official Statement

Document prepared for (or on behalf of) a state or local government in relation to a municipal bond offering. It contains information such as interest rate, timing of interest and principal payments, tax considerations, and more.

Program Disclosure Document

Document containing information about 529 plans such as fees and expenses.

exempt securities

When securities are not required to be registered with the SEC

Blue Sky Laws

most states require registration of issuers and/or securities offerings unless an exemption is available. These requirements can be found in each state's securities laws—commonly known as Blue Sky Laws