SIE Study Guide
Post 1 of 11
- 1.1 Regulatory organizations
- 1.2 Structure of capital markets
- 1.3 Understanding Economic factors
- 1.4 Types of security offerings
- 2.1 Securities products in capital markets
- 2.2 Various types of Investment Risk
- 3.1 Settlement, Trading and Corporate Actions
- 3.2 Complicance Considerations and Customer Accounts
- 3.3 Prohibited Activities
- 4.1 Associated Persons SRO Regulatory Requirements
- 4.2 Reportable Events and Employee Conduct
To start, let’s take a look at the various regulatory organizations and establishments that help govern capital markets.
Post 1 of 11 in the SIE Study Guide
1.1.1 SEC- Securities and Exchange Commission
Let’s first define what the SEC is and the function it serves.
The SEC’s mission is to ensure that securities laws and regulations are adhered to for all participants in capital markets.
Working together with state regulators and self-regulatory organizations, their focus is to ensure that markets run effectively and fairly.
This helps to protect participants, particularly investors.
It’s also the authority when it comes to licensing securities representatives but that is administered through FINRA.
Broker-dealers who do not adhere to the regulations set out by the SEC are liable to:
- Having their activities limited
- Having their registration rescinded
This organization has been around since 1934 and was formed under the Securities Exchange Act of that year.
Let’s look at some of the legislation that the SEC administers.
- 1933 – Securities Act
- 1934 – Securities Exchange Act
- 1940 – Investment Advisers Act
- 1940 – Investment Companies Act
1933 – Securities Act
This act governs companies who look to sell off securities to obtain capital, usually for growth.
This happens in the primary market.
The Securities Act was the first implemented to regulate the securities industry and its main aim is the protection of investors.
This is achieved through a set of rules and procedures all companies selling securities must follow, including divulging information specific to each company.
1934 – Securities Exchange Act
While the Securities Act governs the primary market, this one governs the trading of securities in the secondary market.
This market relates to securities sold, not by the company issuing them but by brokerage firms, for example.
Through the regulations in the act, all issuers of securities must divulge information about the sale thereof.
For companies with assets over $10 million and over 500 shareholders, the Act requires that some issuers provide reports relating to the securities they have issued.
Often, this is in the form of a company annual report.
1940 – Investment Advisers Act
Only certain sections of this act, for example, Regulation 206  relate to the SEC and it governs the amount of advertising that investment advisers can undertake.
In essence, this regulation rules that advertising must not be in any way manipulative or fraudulent and any limitations must be disclosed.
Section 205  of the act also bears significance, however as it describes what an accredited investor and qualified client are.
For example, an individual who earns over $200,000 for three years in a row or who has a net worth of over $1 million is considered an accredited investor.
A qualified client is someone with a net worth of over $2.2 million and assets under management of $1.1 million.
Both of these categories of investors can be charged a performance fee.
1940 – Investment Company Act
This act governs companies who work in the primary market either investing, trading securities, reinvesting, or selling securities to the public.
For example, companies trading in unit investment trusts or mutual funds are regulated by this act.
The act decrees that any investment company must provide information regarding their investment strategies as well as their current finances to potential investors.
Other information can be requested too, including how the company operates and how it is structured.
While the SEC can see that these regulations are followed, it may not at any point get involved with any company activities or investment choices.
Section 22 of this act also states that the calculation of net asset value be done daily as the redemption price is linked to that.
Also, all redemption prices must be paid within seven working days while 85% of the assets of the investment company must be liquid securities.
1.1.2 SROs – Self-regulatory Organizations
Now let’s move on to the self-regulatory organizations that are found in the securities industry.
What’s the purpose of these organizations?
Well, the name is a giveaway.
It’s how the securities industry polices itself, which makes complete sense.
That’s because SROs form part of the industry and understand exactly how it operates as well as the rules that are needed to protect investors and allow for capital markets that operate effectively.
Let’s look at the various SROs that perform this crucial duty.
- Financial Industries Regulatory Authority (FINRA)
- New York Stock Exchange (NYSE)
- Municipal Securities Regulatory Board (MRSB)
- Chicago Board Options Exchange (CBOE)
FINRA falls under the auspices of the SEC while operating in a non-profit capacity.
This body controls everything to do with investment banking as well as trading for the over-the-counter market, listed securities, and more.
It also oversees FINRA-member firms as well as individuals (or associates as they are known) ensuring that they operate within the rules drawn up and enforced by the organization.
FINRA is also tasked by the SEC to help provide education for those new to the world of investing.
That’s a broad look at what FINRA does.
Let’s look a little closer at the purpose of this SRO:
- FINRA will look into and help solve complaints between investors and its members as well as between members
- FINRA will draw up, implement and act upon rules that halt fraudulent actions and manipulative practices and promote fair securities trading
- FINRA provides communication channels between all parties in the securities industry
- FINRA promotes the securities industry as well as the adherence to both state and federal securities law
The rules that FINRA administers securities markets and participants through are broken down into four sections.
- Conduct Rules: This covers firms, customers, and the relationship between them including dealing fairly with investors, handling issues related to compensation, communication standards between parties, and more.
- Code of Procedure (COP): This not only relates to the application of rules but also provides the punishment options for those who break Conduct Rules. All suspected violations are investigated by FINRA’s Department of Enforcement (DOE). Those guilty of violations can be dealt with via suspension, censure, expelled from FINRA membership, or through fines. Any COP decisions can be appealed. That is carried out through the National Adjudicatory Council first, then the SEC, and finally, appellate courts, if needed.
- Uniform Practice Code (UPC): This involves trading and payment and the technical aspects related to them. These include interest charged on bonds, procedures covering payment for common stock dividends, and delivery of securities.
- Code of Arbitration (COA): This set of rules helps resolve monetary disputes.
Lastly, FINRA oversees licensing exams for those who want to become investment advisers across various categories.
The New York Stock Exchange needs little introduction.
It is both the biggest and oldest in the world and was established as far back as 1792.
Companies that are listed on the NYSE must pass meticulous regulations and requirements first.
These relate to many areas including their finances.
Various regulations govern companies once they are listed.
If those are broken, a company could have listed securities delisted and removed from the NYSE.
All stock exchanges around the world operate under similar principles.
The Municipal Securities Regulatory Board writes regulations that oversee banks and investment companies that trade municipal bonds and securities as well as notes.
It’s prudent to remind ourselves what these are:
Municipal securities are state, municipality, or government-issued securities that are offered to investors as a way to raise capital.
Municipal bonds are exempt from many taxes including federal as well as some state and local taxes.
Note, however, that the MRSB cannot enforce its own rules.
That’s carried out by regulators.
For example, in the banking industry, MRSB rules are enforced by the Federal Reserve as well as the FDIC.
The enforcement of rules regarding securities is carried out through FINRA and the SEC.
The Chicago Board Options Exchange is the largest of its kind in the world and was first formed in the early 1970s.
This exchange allows the trading of put and call options on various securities.
These include exchange-traded notes and funds as well as publicly traded stocks.
1.1.3 Agencies and other regulatory bodies
While we’ve covered the various self-regulatory bodies above, some other regulatory bodies and agencies play a role in the securities industry as well.
- Internal Revenue Service (IRS)
- The Federal Reserve
- The United States Treasury
- Securities Investor Protection Corporation (SIPC)
- Federal Deposit Insurance Corporation (FDIC)
- Various state regulators like the North American Securities Administrators Association (NASAA)
- Various foreign country regulators
Tasked with overseeing government revenue, the United States Treasury came into existence in the late 1700s.
Three critical bureaus fall under the auspices of the Treasury.
They are the IRS, the US Mint as well as the Bureau of Engraving and Printing.
Another, the Financial Crimes Enforcement Network (FinCEN) was recently established (2014).
The main goal of FinCEN is to not only uncover both national and international money laundering endeavors but to stop them too through the execution of the Currency and Foreign Transactions Reporting Act (1970).
As mentioned above, the IRS is an organization that forms part of the US Treasury.
The primary duty of the IRS revolves around tax collection as well as enforcing the tax laws that govern both individuals and companies.
Originating in 1913, the Federal Reserve is the United States’ central bank.
The primary aim of the Federal Reserve is to maintain a safe, healthy financial and monetary system.
It does this by:
- Controlling long-term interest rates
- Balancing prices
- Optimizing employment
- Keeping inflation under control
The Federal Reserve maintains all of the above through its monetary policy which ultimately manages money supply or the amount of cash in the economy of the United States.
It’s a tricky balancing act.
While expanding money supply means jobs are created and the economy grows, inflation can rise quickly if the economic expansion happens too fast.
And to establish all of this, the Federal Reserve Board (FRB) uses various tools.
These tools can understand the current standing of the economy as well as directly influence it.
When it comes to understanding the current state of the economy, the FRB uses three diagnostic tools:
- M1: This can determine the current availability of money to spend – in terms of cash – and DDAs – or money in demand deposit accounts. This is a critical factor as this is money that’s entering economic activity soon.
- M2: This tool incorporates all the M1 measures but also includes consumer savings deposits. These can easily be moved into DDAs to enter economic activity with little effort. An example of this is a savings account or a money market fund.
- M3: The final diagnostic tool incorporates M1 and M2 measures as well as large time deposits. These are trickier to move into DDAs and therefore unlikely to enter economic activity soon. This includes negotiable CDs, multiday repurchase agreements, or other large-denomination time deposits.
The FRB can also control money supply using active tools such as:
- Federal open-market operations: While acting as a Treasury Department agent, the FRB can buy and sell U.S. government securities to control money supply. These include notes, bonds, and Treasury bills. Depending on whether these are bought or sold, the money supply will contract or expand.
- Regulations T: This determines the smallest amount an investor can deposit if buying securities using credit. It determines that the initial deposit must be 50% of the purchase price at its current level but that can be changed. Lowering and raising this level can actively affect the economy. Lower it expands the economy and increasing it slows it down. The current level has not changed since 1974.
- Discount rate: To meet reserve requirements, banks often need to borrow money from the Federal Reserve. To do this, a repurchase agreement is used. Here, bank assets are held by the Federal Reserve for the collateral on short-term loans, but not for long. In fact, it’s often only overnight. and the cash reserves of the bank are increased. Of course, there is an interest rate charge and this is known as the discount rate. Raising the discount rate sees interest rates generally increase and while if it drops, rates generally drop too.
- Reserve requirement: This defines the amount of money a bank must keep on deposit with the Federal Reserve. If it’s lowered, the economy expands as banks can now fund extra loans. If it is raised, the economy shrinks as there is now less money for credit. It’s rarely changed, however.
The Securities Investor Protection Corporation (SIPC) began life in the early 1970s.
Put in place by Congress, the primary aim of the SIPC was to restore public faith in the securities industry and stock market trade in general.
That’s because, in the late 1960s, stock prices fell significantly as broker-dealerships across the United States failed or were acquired.
This led to many investors losing out on their investments.
So how does the SIPC work then?
Well, it offers protection for eligible investors.
This comes in the form of insurance through the SIPC and it covers up to $250,000 in their brokerage accounts.
This government agency works with U.S. bank depositors and provides deposit insurance options for them.
It was first created as part of the Banking Act (1933) following bank failures in the 1920s and throughout the Depression years in the United States.
Over 5,000 savings and banking establishments are presided over by the FIDC through deposit insurance.
This insurance covers up to $250,000 per depositor.
While FINRA oversees the regulation of the securities industry in the United States, other regulators are found in States across America.
Perhaps the best known of the state regulatory agencies is the North American Securities Administrators Association (NASAA).
Regulators in other countries
When investors buy securities in foreign markets, it’s important to remember that they too have government regulatory agencies.
So investors wanting to buy shares in a company in the United Kingdom would have to follow the rules and regulations as stipulated by the Financial Conduct Authority (FCA), for example.
1.1.4 Participants in capital markets and the roles they play
Many parties play a role in capital markets.
Often called market participants, in this section, we are going to look at who these parties are and the various parts that they play.
Let’s start by looking at who those participants are:
- Investment advisers
- Municipal advisers
- Issuers and underwriters
- Traders and market makers
- Transfer agents
- Custodians and trustees
- Depositories and clearing corporations
Investors come in three distinct groups: Retail, accredited, and institutional.
It’s critical to note that for the most part, retail and institutional investors deal with securities in secondary markets while an accredited investor designation occurs solely with primary market transactions.
Retail investors use either their retirement or brokerage accounts to buy or sell equity securities and public debt.
They are often called individual investors as they take part in trading to reach personal goals.
This can be anything from saving money for a large capital purchase, such as a business, or towards their retirement years.
Retail investors don’t always have intimate knowledge when it comes to capital markets and it’s this group that the SEC enforces various security regulations to protect.
This includes efficient communication with these investors, especially when to disclosure expectations.
Both individuals and organizations can be considered as accredited investors including some retail and all institutional investors.
Accredited investors are recognized when they meet several requirements such as:
- Their overall net worth
- Their income
- Their qualifications
- What certifications they hold
An accredited investor is allowed to trade in private securities.
These securities don’t need to be registered through the SEC and include venture capital and private placements.
Individual investors can reach accredited status as long as they meet one of these two criteria:
- Income over $200,000 for the past two years (as one person) or $300,000 (with a spouse or partner) and who should meet those income levels again in the current year.
- Individual or joint net worth of over $1,000,000.
Institutional investors are very different from the first two in the fact that only legal entities can be considered as such.
- Mutual, hedge, pension, and venture capital funds
- Banks and credit unions
- Insurance companies
- Real estate investment trusts
Institutional investors work on behalf of shareholders or clients and usually trade securities in large amounts.
Qualified institutional buyers (QIBs) are a class of institutional investors.
An institution needs to invest a minimum of $100 million of its own money to be considered to be a QIB.
Institutional investors are seeing to understand capital markets so fewer regulations and rulings pertain to them in terms of protection.
All investment advisers are registered through the SEC or with state regulators and can either be a company or in many cases, an individual.
They are often called by various other names in the industry including asset managers, wealth managers, or portfolio managers while those who work for a company are known as investment adviser representatives.
These important players in the world of securities have clients that they provide with security investment advice, control their investment portfolios, help with financial planning or provide brokerage services.
Investment advisers act as fiduciaries.
This means that the rules and regulations set out in the securities industries compel them to always act with the client’s best interests at heart.
First up, broker and dealers are two distinct terms that are often written together.
So what’s the difference between them then?
Well, a broker is a person or entity that has clients and trades securities on capital markets for them.
A dealer also called a principal, doesn’t have clients but trades securities for itself.
The thing is, many companies operate on both levels and that’s why the term broker-dealer came about.
Note that if an organization is operating as a broker, dealer, or as both, they are subject to rules and regulations as set out by FINRA.
There are three forms of broker-dealers.
- Prime brokers: These work with massive financial institutions only and perform outsourced activities such as performance and risk analysis as well as trade clearing and settlement, for example.
- Introducing brokers: These brokers get orders for various securities from clients and then work through a clearing firm to process them. At no point will they obtain client funds or perform any transactions themselves.
- Clearing brokers: These brokers are tasked with clearing trades on client accounts that they hold as well as seeing that they reach a settlement.
Issuers and underwriters
Let’s start with issuers first.
These are legal organizations that sell securities to investors to fund their operations.
These securities include common stock, for example.
Should the sale of securities be to the general investing public, for example via an initial public offering (IPO), they have to make various filings as stated by the SEC.
What are underwriters, then?
Well, they will help organize the sale and then the distribution of an issuer’s securities.
They do this by pricing them, purchasing them from the issuer, and finally, selling them to interested investors.
Depending on the underwriting agreement, various levels of commitment are required from underwriters.
Best effort underwriting
With this form of underwriting, underwriters must purchase securities from the company issuing them not as a principal but instead as an agent.
They are therefore not a risk because they do not have to purchase the shares on their own accord.
Deals like this are finalized when client funds are collected in an escrow account which means none of the underwritten capital can ever be at risk.
The risk falls with the issuer, however, and if all the shares put up for sale aren’t sold, they will not raise their necessary capital.
There are two categories of best effort underwriting:
- All-or-none (AON): Here, the company issuing shares wants an agreement with the underwriter that if all shares issued are not sold, the underwriting is canceled. This means the funds generated are kept in an escrow account and returned to investors if not all shares are sold.
- Mini-max: This underwriting agrees to set a value for the least amount of shares that can be sold – the least amount of capital the issuer needs – as well as the most the issuer will sell. It is then the task of the underwriters to find the buyers to at least meet that minimum amount before expanding towards the ceiling amount.
Firm commitment underwriting
A popular form of underwriting, the underwriter buys the shares from the issuer.
They are then sold to the public at a higher price, called the public offering price (POP), with the differential between the two going to the underwriter.
In this capacity, underwriters are principals rather than agents.
If a company gives a municipal advisory service, it must be registered with the SEC as well as the MSRB.
But what is a municipal advisor defined as?
Well, this role is covered by the Securities Exchange Act (Section 15B) which says that municipal advisors:
- Advise on behalf of or to obligated persons or municipal entities regarding municipal financial products or issuing municipal securities. This advice can relate to terms, timing, structure, and other matters related to these products or issues. This includes issuers involved with raising capital, bond features, and structuring of debt.
- Solicit municipal entities
While municipal advisors may help with certain underwriting functions – drawing up an official notice for example – they aren’t allowed to receive remuneration for that.
Traders and market makers
Brokerage firms that sell stocks and bonds day-to-day and provide them to public investors are known as traders and market makers.
By buying or selling securities from a predetermined set of companies to broker-dealers, market makers maintain sales liquidity.
Transfer agents act as a go-between for securities issuers and holders and are usually either a trusted company or a bank.
Their main role is to manage security holder records as well as hand out dividends for the issuing company.
From time to time, companies can act as transfer agents for themselves although any company acting in this capacity requires SEC registration.
For banks acting as transfer agents, further registration with a bank regulatory agency is a must too.
Custodians and trustees
In the securities industry, a custodian is usually a bank or brokerage firm that keeps assets safely for others.
A trustee can be an organization, including banks, or an individual such as a broker tasked with the government of a certain trust.
On behalf of the trust beneficiary, they will oversee investments as well as any other assets belonging to the trust.
All their actions must be carried out with a fiduciary responsibility to that trust, as well.
Often, broker-dealers will form a syndicate to share risk as well as profits, especially in large firm commitment underwriting.
One of those broker-dealers will take the lead in the venture and is commonly called the managing underwriter.
Other broker-dealers can be brought in to help with securities sales as part of what is called a selling group.
Anybody who joins the selling group doesn’t have to commit capital and does not take responsibility if shares are not sold.
They are only there to help the selling process.
DTTC – Depositories and clearing corporations
Most securities transactions occurring in the United States are managed through DTTC.
Part of that managed process includes daily clearing and settlement.
So any securities traded on the stock market need to be cleared through the DTCC.
There are a number of options clearing houses too that are important to know about including the Options Clearing Corporation (OCC).
The Commodities Futures Trading Commission (CFTC), as well as the SEC, govern the OCC.