Securities Regulation, Markets, and FINRA Exam Concepts

SEC

Securities and Exchange Commission: independent federal agency created by the Securities Exchange Act of 1934 to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation

How is the SEC structured?

Five commissioners appointed by the President and confirmed by the Senate, staggered 5-year terms, no more than 3 from the same political party

Can the SEC bring criminal charges?

No. It brings civil and administrative actions; criminal cases are referred to the Department of Justice

Self-regulatory organization (SRO)

Non-governmental body that writes and enforces rules for its members under SEC oversight (FINRA, MSRB, Cboe, NYSE, Nasdaq)

FINRA

Financial Industry Regulatory Authority: SRO for broker-dealers; licenses and tests reps, writes and enforces conduct rules, runs BrokerCheck, and operates arbitration and mediation

Which law authorized the creation of the national securities association that became FINRA?

Maloney Act of 1938 (Section 15A of the Securities Exchange Act of 1934)

MSRB

Municipal Securities Rulemaking Board: SRO that writes rules for municipal securities dealers and municipal advisors; it has NO enforcement power

Who enforces MSRB rules?

FINRA (for broker-dealers), the SEC, and bank regulators (for banks)

EMMA

MSRB's Electronic Municipal Market Access website: free public source of municipal disclosures and trade data

NASAA

North American Securities Administrators Association: state securities regulators; promotes uniform blue-sky laws and sponsors the Series 63, 65, and 66 exams

Blue-sky laws

State securities laws requiring registration of certain offerings, firms, agents, and advisers and prohibiting fraud

NSMIA of 1996

Preempted state registration of covered securities (for example exchange-listed stocks, investment company shares, Rule 506 offerings); states keep antifraud authority

Federal Reserve Board (FRB)

US central bank: sets monetary policy and sets initial margin requirements through Regulation T

Treasury Department and IRS

Treasury issues government securities and houses FinCEN and OFAC; the IRS administers federal tax law

SIPC

Securities Investor Protection Corporation: nonprofit funded by member broker-dealers that restores customers' cash and securities if a BD fails; not a government agency

SIPC coverage limit?

$500,000 per customer per separate capacity, including up to $250,000 in cash

Does SIPC protect against market losses?

No. It protects against BD failure and missing assets, not declines in value or bad advice

FINRA Rule 2266

BDs must give customers SIPC information (website and phone number) at account opening and at least once a year

FDIC

Federal Deposit Insurance Corporation: insures bank deposits up to $250,000 per depositor, per insured bank, per ownership category

Are securities sold through a bank FDIC insured?

No. Investment products are not FDIC insured, not bank guaranteed, and may lose value

Accredited investor (individual)

Income over $200,000 ($300,000 joint) in each of the last 2 years with the same expected, OR net worth over $1 million excluding primary residence, OR holds a Series 7, 65, or 82 license in good standing

Institutional account (FINRA Rule 4512)

Bank, savings and loan, insurance company, registered investment company, registered investment adviser, or any person with total assets of at least $50 million

Broker vs dealer

Broker acts as AGENT and earns a commission. Dealer acts as PRINCIPAL trading its own account and earns a markup or markdown

Introducing broker-dealer

Opens accounts and takes orders but sends them to a clearing firm for execution, settlement, and custody

Clearing (carrying) broker-dealer

Settles trades, holds customer cash and securities, extends margin, and sends confirmations and statements

Prime broker

Provides clearing, custody, margin financing, and securities lending to hedge funds and large institutions

Investment adviser

Paid to advise others on securities; regulated under the Investment Advisers Act of 1940; fiduciary duty; files Form ADV

Municipal advisor

Advises municipal issuers on issuing or investing in municipal securities; must register with the SEC; owes a fiduciary duty to the municipal client

Issuer

Entity (corporation, municipality, government, agency) that sells securities to raise capital

Underwriter

Investment bank or BD that helps an issuer sell new securities, often by buying them from the issuer and reselling to investors

Market maker

Dealer that continuously quotes both a bid and an ask in a security and trades from its own inventory, providing liquidity

Custodian

Bank or institution that holds securities and cash for safekeeping; does not make investment decisions

Trustee

Represents bondholders under the trust indenture and enforces its terms

Transfer agent

Maintains shareholder records, transfers ownership, and issues or cancels certificates; often pays dividends

Registrar

Tracks authorized, issued, and outstanding shares to prevent over-issuance

DTCC

Parent of DTC (holds securities in book-entry form) and NSCC (clears and settles stock and bond trades)

OCC

Options Clearing Corporation: issues and guarantees all listed options; buyer to every seller and seller to every buyer

Primary vs secondary market

Primary: issuer sells NEW securities and receives the proceeds. Secondary: investors trade existing securities and the issuer receives nothing

Exchange (auction) market vs OTC (dealer) market

Exchange: centralized auction among buyers and sellers of listed securities. OTC: negotiated trading among dealers (for example most bonds)

Third market

Exchange-LISTED securities traded in the OTC market by dealers that are not exchange floor participants (for example wholesale market makers)

Fourth market

Direct institution-to-institution trading, typically through an ECN or ATS, without a traditional broker-dealer

ECN and ATS

Electronic communication network and alternative trading system: SEC-regulated non-exchange venues that match orders automatically; dark pools hide orders before the trade

Designated Market Maker (DMM)

NYSE market maker assigned to a stock who maintains a fair and orderly market

Regulation NMS

SEC rules linking US markets: order protection (no trade-through of the best price), access, sub-penny quoting, and market data

NBBO

National Best Bid and Offer: highest bid and lowest ask across all US markets

Market-wide circuit breakers

S&P 500 down 7% (Level 1) or 13% (Level 2): 15-minute halt if before 3:25 pm ET. Down 20% (Level 3): trading halts for the rest of the day

Monetary policy

Fed actions to influence money supply, credit, and interest rates to support maximum employment and stable prices (the dual mandate)

Fiscal policy

Government use of taxation and spending, set by Congress and the President, to influence the economy

Who controls monetary policy and who controls fiscal policy?

Monetary: the Federal Reserve. Fiscal: Congress and the President

FOMC

Federal Open Market Committee: 12 voting members (7 Fed governors, the NY Fed president, and 4 rotating regional bank presidents); sets the fed funds target and directs open market operations

Open market operations

Fed buying and selling Treasury securities to adjust bank reserves and interest rates; its most frequently used tool

The Fed buys Treasury securities. What is the effect?

Adds reserves, lowers interest rates, and stimulates the economy (easing)

The Fed sells Treasury securities. What is the effect?

Drains reserves, raises interest rates, and slows the economy (tightening)

Federal funds rate

Rate banks charge each other for overnight loans of reserves; the FOMC sets the target and it is the Fed's main policy rate

Discount rate

Rate the Fed charges banks to borrow directly from it (discount window); set above the fed funds target

Prime rate

Rate banks charge their most creditworthy customers; generally about 3 percentage points above the fed funds target

Reserve requirement

Percentage of deposits banks must hold in reserve; the Fed set it to 0% in March 2020

Quantitative easing (QE) vs quantitative tightening (QT)

QE: Fed buys large amounts of securities to lower long-term rates and add liquidity. QT: Fed shrinks its balance sheet by letting securities mature or selling them

The Fed raises the fed funds rate. What generally happens to existing bond prices?

They fall (prices and interest rates move inversely)

Keynesian economics

Government fiscal policy (spending and taxes) should manage aggregate demand and smooth the business cycle

Monetarism

Money supply growth is the main driver of economic activity and inflation (Milton Friedman); favors steady, rules-based money growth

Business cycle phases

Expansion, peak, contraction (recession), trough, then expansion again

Recession (common definition)

Two consecutive quarters of declining GDP

Leading indicators

Change BEFORE the economy does: stock prices, building permits, new orders, initial jobless claims, consumer expectations, yield curve slope

Coincident indicators

Move WITH the economy: GDP, industrial production, personal income, nonfarm payrolls

Lagging indicators

Change AFTER the economy does: unemployment rate, CPI and inflation, prime rate, outstanding business loans

GDP

Gross Domestic Product: total market value of all final goods and services produced within a country's borders in a period

GNP

Gross National Product: total output produced by a country's residents and companies anywhere in the world

CPI

Consumer Price Index: tracks price changes of a basket of consumer goods and services; the most common inflation measure (a lagging indicator)

PPI

Producer Price Index: tracks wholesale prices; can foreshadow consumer inflation

Inflation

Sustained general rise in prices that reduces purchasing power

Deflation vs disinflation

Deflation: falling price level. Disinflation: prices still rising but at a slower rate

Stagflation

Stagnant growth and high unemployment combined with high inflation

Yield curve shapes

Normal: long-term yields above short-term. Flat: similar. Inverted: short-term above long-term (often a recession warning)

Balance of payments

Record of all economic transactions between a country and the rest of the world

Trade deficit

Imports exceed exports

The US dollar weakens. Who benefits?

US exporters (goods are cheaper abroad); imports and foreign travel become more expensive

Cyclical vs defensive stocks

Cyclical: earnings track the economy (autos, airlines, luxury). Defensive: stable demand in downturns (utilities, staples, healthcare)

Growth vs value stock

Growth: above-average earnings growth, high P/E, little or no dividend. Value: trades cheaply relative to earnings or book value

Balance sheet

Snapshot at a point in time: Assets = Liabilities + Shareholders' equity

Income statement

Revenues minus expenses over a period, ending in net income (profit and loss)

Working capital

Current assets minus current liabilities

Current ratio and quick ratio

Current ratio = current assets / current liabilities. Quick (acid-test) ratio = (current assets - inventory) / current liabilities

EPS

Earnings per share = (net income - preferred dividends) / weighted average common shares outstanding

P/E ratio

Price per share / earnings per share

A stock has EPS of $5 and trades at $60. What is its P/E?

12

Debt-to-equity ratio

Total liabilities (debt) / shareholders' equity; measures leverage

Securities Act of 1933

Governs the PRIMARY market: new offerings must be registered with the SEC and sold with a prospectus; prohibits fraud ("truth in securities")

Securities Exchange Act of 1934

Governs the SECONDARY market: created the SEC; regulates BDs, exchanges, and SROs; requires periodic reports from public companies; antifraud Rule 10b-5; proxies; margin

Does the SEC approve a security or guarantee its accuracy?

No. It reviews disclosure only; stating that the SEC approved or endorsed a security is unlawful (Securities Act Section 23)

Registration statement

Filing with the SEC (for example Form S-1 for an IPO) describing the issuer's business, financials, risks, and management

Cooling-off period

Period after filing (at least 20 days) while the SEC reviews; no sales allowed, only indications of interest

What may underwriters do during the cooling-off period?

Distribute the preliminary prospectus, gather non-binding indications of interest, and publish tombstone ads; no sales or binding orders

Preliminary prospectus (red herring)

Prospectus used during cooling-off; lacks final price and effective date and carries a red legend stating it is subject to completion

Final prospectus

Contains final price and terms; must be delivered at or before the confirmation of sale

Tombstone ad

Simple announcement of an offering (issuer, security, underwriters); not an offer; offers are made only by prospectus

Securities Act Section 11

Civil liability for material misstatements or omissions in a registration statement (issuer, directors, underwriters, accountants); due diligence is a defense

Primary vs secondary offering

Primary: issuer sells new shares and receives the proceeds. Secondary (distribution): existing holders sell and receive the proceeds

IPO vs follow-on offering

IPO: first public sale of stock. Follow-on: additional shares sold by an already-public company

Firm commitment

Underwriter buys the whole issue and resells it; bears the risk of unsold shares