Chapter 1: Overview of Market Participants and Market Structure

Market Participants

• One of the primary purposes of the securities industry is to match investors who have money with issuers that need money

• The securities marketplaces and its participants provide the bridge between those with capital and those that need capital

Issuer

Definition: a legal entity that sells securities in order to finance its operations

Examples:

• US Treasury and other US government agencies

• Foreign governments

• State and local governments

• Corporations

• Banks

***Financial Reserve Board is not an issuer

Two primary methods that issuers use to raise capital:

• Debt securities (bonds)

• Equity securities (stocks)

Debt Securities

• Corporations and various government borrowers raise funds through the issuance of publicly traded loans

• These loans are often referred to as bonds, notes, or debt instruments

Bonds

Definition: a security that represents the amount of principal that the issuer owes to the investor

• Investors who purchase bonds are considered creditors of the issuer and lend their funds to the issuer until maturity

• The issuer is required to repay the principal balance of the bond at a future date and will typically make interest payments over the life of the loan.

Default

Definition: when an interest or principal payment is missed

Equity Securities

• Traditionally, corporations raise capital through the issuance of stock

• If an investor purchases a stock they have ownership interest in the underlying business

Stocks

Definition: a security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.

• If that company is profitable, the investor may be entitled to a portion of the profits (dividends)

• Ownership interest typically doesn't have a maturity date and the payment of any dividend is voluntary for the issuer

Broker-Dealer & Investment Advisers

Financial firms are the bridges that connect issuers and investors

Two categories:

• Broker-dealer

• Investment advisers

Broker-Dealer

Definition: the two capacities in which a firm may operate

Broker

Definition: any person that engages in the business of effecting agency transactions in securities for the account of others

• Match up buyers and sellers and earn a commission for their efforts

Dealer

Definition: any person that engages in the business of buying and selling securities for its own account

• Engage in principal transactions in which they buy securities directly from their clients and hold them in inventory, or they sell security to clients from their inventory

Broker-Dealer Departments (5)

Many brokerage firms are divided into several distinct departments:

• Investment Banking

• Research

• Sales

• Trading

• Operations

Investment Banking Department (IB)

Definition: the area that works directly with the issuers to arrange and structure their securities offerings

• Often advise an issuer that intends to raise funds through an issuance of stocks, bonds, or a combination of both

• Often referred to as the underwriters of securities

• Often assist companies with mergers and acquisitions (M&A) or those that need to restructure due to bankruptcy

Research Department (Analyst)

Definition: The area that study both the markets and individual issuers in order to issue recommendations

• The typical recommendations are to buy, sell, or hold

Sales Department

Definition: the area that typically markets individual stocks or bonds, but also packaged products (mutual funds) to both retail investors and institutions

• Historically referred to as: stock brokers or bond brokers

SIE Exam referred to as:

• Registered Representative (RRs)

• Investments Adviser Representatives (IARs)

Trading Department

Definition: the area that handles the execution of trades for both the firm's clients and the firm's own (proprietary) account

• Trades occur in electronic marketplaces (NASDAQ) or hybrid marketplaces (NYSE)

Operations Department

Definition: the area that ensures that all of the paperwork, funds, and securities transfers that are associated with a trade (or processing) are handled efficiently and according to specific industry standards

• Generating customers statements, confirmations, and tax records, as well as assisting in the transfer of securities and/or funds

• Responsible for ensuring that all firm and client assets are organized properly and safeguarded

Market Maker

When a broker-dealer chooses to display quotes into a trading system to indicate its readiness to buy and/or sell securities at specific prices, the firm is referred to as a __________.

Required to make regular bids and offers and meet specific capital requirements

Quote is two sided:

• Buy a security (bid)

• Sell a security (ask/offer)

Generally, if no size is indicated, a __________ must be prepared to buy or sell a minimum unit of trading (100 shares) at the quoted prices

The firm is willing to buy 1,000 shares (10 round lots of 100 shares) at 17.05 and/or sell 2,000 shares (20 round lots of 100 shares) at 17.08

Trader

Firms and individuals that choose to trade securities for the firm’s benefit (proprietary trading) or for the benefit of the firm’s clients (without the interest in making markets) are referred to as __________.

These __________ are not obligated to enter quotes into a marketplace; instead, they execute trades against the quotes of the market making firms

Proprietary Trading

Definition: buying and selling securities for the bank’s own account rather than for clients

Investment Adviser (IA)

Many financial firms act as __________, rather than functioning as broker-dealers

• __________ come in all shapes and sizes with some managing hundreds of millions of dollars for mutual funds, while others have small practices and work exclusively with individual investors

• Regulators with whom the __________ must register with is often determined by its AUM:

  • <$100 million - register with the state(s) in which it conducts business

  • $100-$110 million - register with the SEC or the state(s)

  • >$110 million - register with the SEC

Broker-Dealer vs. Investment Adviser

Broker-dealers earn compensation (commissions) for executing transactions

IAs charge fees for providing advice to their clients

• Fees are often based on a percentage of asset under management (AUM)

• Charged regardless of whether any trades occurred in their client’s accounts

Municipal Advisors

Definition: a special type of advisor that provides advice either to or on behalf of a municipal entity, such as state, county, or city

• An advisor’s client is typically the issuer, not the investor

• Provide advice related to the structure, timing, and terms of a municipal finance offering

• The term itself is broad and includes financial advisors, third-party marketers, placement agents, solicitors, finders, and swap advisors that engage in municipal advisory activities

Types of Investors (3)

• Retail Investors

• Accredited Investors

• Institutional Investors

Asset Allocation

Definition: the process of spreading your assets among several different types of investments to reduce risk

Retail Investors

Definition: investors who directly buy stocks or bonds from broker dealers are retail investors

• AKA: “regular individuals” with limited assets and income

• Investors may hold assets in a single or joint account

• Other forms of accounts include, but are not limited to various retirement accounts, such as IRAs, or custodial accounts established for children

• Many professionals define a retail investor as a person who doesn't meet the definition of an institutional investor

Accredited Investors

Definition: investors who are viewed as more sophisticated and/or able to assume greater risk

• The Securities and Exchange Commission (the primary regulator for the securities industry) categorizes certain investors by the nature of their income or assets

These investors are referred to as __________ and include the following:

• Financial institutions, large tax-exempt pensions plans, and private business development companies

• Directors, executive officers, or general partners of the issuer

• Individuals who have attained a certain professional certification (CFP, Series 7, Series 65, or Series 82 registration that’s in good standing)

• Individuals whole meet either one of the following criteria

  • Net worth ≥$1,000,000 (excluding primary residence)

  • Gross annual income of ≥$200,000 (or ≥$300,000 combined with a spouse) for each of the past two years, with the anticipation that this level of income will continue

Institutional Investors

Definition: typically large entities that pool their money to purchase securities

Examples: banks, insurance companies, pensions plans, endowments, and hedge funds

FINRA’s definition: an account of an individual or other entity with total assets of ≥$50 million

The SEC refers to certain institutions as qualified institutional buyers (QIBs), buyers must satisfy the following three-part test:

• Certain types of investors are eligible:

  • Insurance companies

  • Registered investment companies

  • Registered investment advisers

  • Small business development companies

  • Private and public pension plans

  • Certain bank trust funds

  • Corporations, partnerships, business trust, and certain non-profit organizations

• The buyer must be purchasing for its own account or for the account of another QIB

• The buyer must own and invest ≥$100 million of securities of issuers that are not affiliated with the buyer

Qualified Institutional Buyer (QIB)

Under no circumstances is an individual considered to be a QIB

• Even if they meet the standard of being an accredited individual investor

• QIBs are not humans they’re entities (firms)

Market Structure (2)

Definition: involves the issuance of the securities in one market and the trading of the securities in another market

• Primary

• Secondary

Primary Market

Definition: where new securities are created and sold for the first time (issuer)

• Regulated by the SEC under the Securities Act of 1933

• Initial Public Offerings (IPOs) and new bond issuance

Example:

• A company is unaware of the nuances of raising capital, it works with the investment banking department of a brokerage firm. The investment banker will assume the role of the underwriter by agreeing (for a fee) to market the shares to the ultimate investors. These investors could include insurance companies, investment companies, pension funds, as well as individuals throughout the country. As the securities are sold to investors, most or all of the proceeds received will go to the issuer. Since this issuance marks the beginning of the shares' existence, this is referred to as the __________.

Secondary Market

Definition: where existing securities are bought and sold between investors

• Stock exchanges and bond markets

Example: After the primary distribution of the issuer's shares, the investors that purchased the shares from the issuer will inevitably want to sell them. The market that brings together these buyers and sellers is referred to as the __________. In the __________, the funds are no longer directed to the issuer; instead, the securities and the funds pass between investors.

Traditionally, stock markets were broken down into two categories:

• Physical trading venues (NYSE)

• Over-the-counter (OTC) marketplaces

Exchange Market

Definition: a centralized trading venue that functions as an open outcry auction market

• Over time, exchanges began to shift to hybrid trading methods

Designated Market Maker (DMM)

Definition: the auctioneer who controls trading in a given stock

Listed Securities

Definition: any equity security that meets the standards for trading on a national exchange

NASDAQ

Expanded: The National Association of Securities Dealers Automated Quotation System

Primary Market vs. Secondary Market

Primary

• IPO

• Regulated by Securities Act of 1933

• Investment Bankers to issue these securities

Secondary

• After security is issued, it trades in the secondary market

• Regulated by the Securities Exchange Act of 1934

• Security can be listed on the NYSE, NASQAQ, or OTC/OCTBB/PINK

Dealer-to-Dealer Market

Definition: A part of the financial system where dealers trade securities directly with other dealers, rather than with regular investors

• When stocks don’t qualify for listing on either a physical or electronic exchange, they’re considered to be trading OTC and are referred to as OTC equities or unlisted securities

• Most corporate, municipal, and US government bonds don't have organized exchanges like equity securities

• Most bonds are traded in the OTC market through dealer-to-dealer networks

Unlisted Exchange Markets (3)

• Over-The-Counter Market (OTC)

• Over-The-Counter Bulletin Board (OCTBB)

• OTC Pink Markets

Over-The-Counter Market (OTC)

Definition: a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange

Over-The-Counter Bulletin Board (OTCBB)

Definition: quotation service operated by FINRA for unlisted securities

• Corporations too small to be listed on OTCBB may sell securities in the Pink Market

OTC Pink Market

Definition: a part of the OTC market where thinly traded, volatile stocks change hands

• AKA: non-NASDAQ OTC

• Not required to meet listing requirements or file with the SEC

Securities Act of 1933

The first major federal law regulating the securities industry. It requires firms issuing new stock in a public offering to file a registration statement with the SEC.

Securities Exchange Act of 1934

A federal law dealing with securities regulation that established the Securities and Exchange Commission to regulate and oversee the securities industry.

Other Execution Methods and Venues

• In recent years, market participants have created alternatives to the NYSE and Nasdaq for trading listed securities.

• Many broker-dealers have abandoned their market making operations on the traditional exchanges and directed orders to high frequency trading firms.

Alternatives Include:

• The Third Market

• The Fourth Market

• Electronic Communication Networks (ECNs)

• Dark Pools

The Third Market

Definition: refers to exchange-listed securities being traded over-the-counter or away from traditional exchanges, directly between large investors and dealers

• Brings together investors and also accommodates after-hours trading.

• Transactions between dealer-brokers and large institutions

The Fourth Market

Definition: refers to direct institution-to-institution trading and doesn't involve the public markets or exchanges.

• While some of this trading involves different portfolio managers contacting one another by phone, most true __________ trades are internal crosses set up by broker-dealers that execute trades for institutional accounts.

• These proprietary trading systems (PTSs) are established to facilitate the institution-to-institution trading are often considered a part of the __________.

• Transactions between large institutions

Electronic Communication Networks (ECNs)

Definition: market centers (exchanges) that allow for both the quoting and trading of exchange listed securities

Objective: to provide an electronic system for bringing buyers and sellers together (matching)

• Allow subscribers to disseminate information about orders, execute transactions both during the trading day and after-hours, and buy and sell anonymously

• Charge subscribers a fee for using their systems and act in only an agency (broker) capacity.

Dark Pools

Definition: a system that provides liquidity for large institutional investors and high frequency traders, but it doesn’t disseminate quotes

Objective: to allow investors to trade with the least amount of market impact and with low transactions costs

• The name is derived from the fact that the details of the quotes are concealed from the public

• The system may be operated by broker-dealers or exchanges, and it allows these specific investors to buy and sell large blocks of stock anonymously

• Some dark pools provide order-matching systems and may also allow participants to negotiate prices

Clearing and Settlement - An Overview (What happens after a trade occurs?)

• The buyer and seller must agree on the terms of the transaction

• The buyer is expected to pay for the security, and the seller is expected to deliver the security

Settlement

Definition: the simultaneous payment and delivery process between two parties

The Depository Trust & Clearing Corporation (DTCC)

Definition: a securities depository and a national clearinghouse for the settlement of transactions in equities, corporate, municipal, and US government bonds, mortgage-backed securities, money-market instruments, and OTC derivatives

• Has also expanded its ability to process transactions in mutual funds and insurance products.

• Most major financial institutions in the U.S. are members of the DTCC system.

• DTCC is a non-profit, industry owned corporation

Function: to automate and centralize the clearing and settlement of trades among its (owners) members.

Objective: eliminate physical securities in order to increase the speed and reduce the cost of clearing and settling trades

Depository Trust & Clearing Corporation Subsidiaries (2)

• National Securities Clearing Corporation (NSCC)

• Fixed Income Clearing Corporation (FICC)

National Securities Clearing Corporation (NSCC)

Definition: clears equity trades for both US and foreign issuers

Fixed Income Clearing Corporation (FICC)

Definition: clears bond trades

Processing the Trade - Clearing and Introducing Firms

Due to the cost and complexity of creating and maintaining a fully functional trade processing area, many smaller broker-dealers (introducing firms) choose to hand off all or part of their trade processing and clearing functions to larger broker-dealers (clearing or carrying firms)

The costs of clearing include a significant investment in hardware, software, and personnel

Clearing Firms

Definition: perform order execution, clearing, and settlement functions

• __________ interface with the DTCC directly for both their own transactions as well as those of any other broker-dealers that choose to clear through them.

• A step below the DTCC on the trade processing hierarchy

• AKA: full-service firms

Introducing Firms

Definition: contract with clearing firms to perform trade processing services

• While customers of an __________ consider that firm to be their broker-dealer, customer funds and securities are actually physically held at the clearing firm, from which they generally also receive statements and confirmations

  • Client Trade > Introducing Firm > (Contracted) Clearing Firm

Overview of clearing process involving both introducing and clearing firms

• DTCC > Clearing Firms > Introducing Firms

Introducing Firms - Fully Disclosed vs. Omnibus Accounts

• A clearing broker may provide introducing firms with back office and related record keeping functions on either a fully disclosed or omnibus basis

• The differences between these two arrangements involve the level of detail the clearing firm will have regarding the customer as well as which entity will be responsible for providing trade details to the customer

Accounts Include:

• Full Disclosed Accounts

• Omnibus Accounts

Introducing Firms - Fully Disclosed Accounts

Definition: clearing firm knows each individual customer and maintains separate accounts for each one

• Operate through a clearing firm on a fully disclosed basis

• This means that information about each of the individual customers of the introducing firm will be transmitted to the clearing firm and the clients' assets are held at the clearing firm

• The clearing firm establishes separate accounts for each client and is responsible for all of the paperwork associated with the accounts, such as the delivery of confirmations and statements

• The paperwork will be identified as coming from the clearing firm, but it will contain additional identifying information so that the client can determine to which introducing firm the paperwork is related.

Example: a client's statement may list ABC Clearing at the top of the document, but will also contain the name and contact information for XYZ Brokers, the introducing firm.

• Information about each individual customer of the introducing firm will be transmitted to the clearing firm

• Client's assets are held at the clear

Summary: a fully disclosed arrangement, the clearing firm knows each customer, holds their assets, and handles the paperwork, while the introducing firm focuses on the client relationship.

Introducing Firms - Omnibus Accounts

Definition: a single account that combines (aggregates) many customers into one account at the clearing firm

• Not all of the relationships between introducing and clearing firms are fully disclosed.

Example: ABC Bond Brokers, Inc. is a fixed-income broker-dealer that has a complete back-office operation for clearing its bond trades and holding customer positions. However, the firm will occasionally accept an order from a customer for common stock. Since the firm doesn't want to set up clearing operations to handle these infrequent accommodation transactions, it has arranged for DEF Clearing to execute and clear its customers' stock trades. ABC doesn't provide DEF Clearing with details regarding the individual clients. Instead, ABC uses a single omnibus account that's specifically designated by the clearing firm for customers of ABC Bond Brokers. In this type of arrangement, since the clearing firm doesn't have information on each individual customer, the record keeping responsibilities belong primarily to the ABC Bond Brokers, the introducing firm.

• Handles infrequent accommodation transactions