Regulators and Market Participants

Before you study a single product, you need to know who makes the rules and who plays which part in the market. This chapter introduces the regulators first: the SEC, the self-regulatory organizations, the Treasury, the states, the Federal Reserve, SIPC, and the FDIC. Then it introduces the market participants, from investors and broker-dealers to transfer agents and clearing corporations. Section 1 of the SIE, which this chapter opens, accounts for 12 of the 75 scored questions, and the names you learn here appear in questions throughout the exam. Expect questions that ask which organization does something and, just as often, which one cannot.

1.1Why Securities Are Regulated

When you buy a share of stock or a bond, you hand over real money in exchange for a promise. A security is a financial instrument that represents that kind of promise, such as an ownership stake in a company, which is stock, or a loan to a borrower, which is a bond. Unlike a car or a house, you cannot inspect a security before you buy it. Everything you know about it comes from information that someone else provides.

That creates an information gap: the company selling the security knows far more about its business than you do. Without rules, a seller could exaggerate profits, hide debts, or simply invent a business that does not exist. Markets only work when investors trust that the information they receive is honest and that the people handling their money will not steal it.

Lessons from 1929

The 1920s showed what happens without that trust. Stocks were sold on rumor and hype, groups of traders manipulated prices, and many investors bought with borrowed money. When the market crashed in 1929, millions of investors were wiped out, and confidence in the markets collapsed. Congress responded in the 1930s with the federal securities laws that still form the core of the system you will study.

The federal approach rests on one central idea: disclosure. The law requires issuers and securities firms to tell investors the material facts, meaning the facts a reasonable investor would consider important, and it punishes fraud. It does not try to decide which investments are good ones, so a fully registered offering can still be a poor investment. An investor who receives accurate information is free to make a bad decision.

The Four Foundation Acts

Four federal laws form the foundation of securities regulation, and you should know the main job of each.

• The Securities Act of 1933 governs new issues, meaning securities sold by an issuer to the public for the first time in the primary market. It requires a registration statement, a detailed disclosure document filed with the SEC, and a prospectus, the disclosure document delivered to investors, and it prohibits fraud in offerings. Chapter 3 covers it in detail.
• The Securities Exchange Act of 1934 governs the secondary market, where investors trade securities with one another after they are issued. It created the SEC, requires exchanges and broker-dealers to register, requires public companies to file ongoing reports, prohibits manipulation and insider trading, and gave the Federal Reserve power over credit used to buy securities.
• The Investment Company Act of 1940 regulates companies that pool investors' money and invest it in securities, such as mutual funds. Chapter 8 covers it.
• The Investment Advisers Act of 1940 requires most people who are in the business of giving investment advice for pay to register, and it treats them as fiduciaries. You will meet it again in Lesson 1.7.

Later laws filled specific gaps. The Securities Investor Protection Act of 1970 created SIPC, and the Dodd-Frank Act of 2010 brought municipal advisors under regulation. You will meet both later in this chapter.

The Layers of Regulation

Regulation works in layers. Congress passes the laws. The SEC, a federal agency, enforces those laws and writes detailed rules under them. Below the SEC, self-regulatory organizations such as FINRA write and enforce rules for their member firms, under SEC oversight. Each firm, in turn, must supervise its own employees. Alongside this federal structure, every state has its own securities regulator, and several other agencies have specific jobs: the Treasury, the Federal Reserve, SIPC, and the FDIC.

Explore the map below now, and come back to it as you meet each organization in this chapter.

1.2The Securities and Exchange Commission

The Securities and Exchange Commission, or SEC, is the federal agency that enforces the federal securities laws. Congress created it in the Securities Exchange Act of 1934. The SEC is an independent agency, which means it is not part of a cabinet department.

The SEC is led by five commissioners. The President appoints them, and the Senate must confirm them. Commissioners serve staggered five-year terms, so the whole commission never turns over at once, and no more than three of the five may belong to the same political party. The President designates one commissioner as Chair. Its staff is organized into divisions that review company filings, oversee markets and firms, examine registrants, and investigate violations.

The SEC's Mission

The SEC describes its mission in three parts, and the SIE expects you to recognize them.

• Protect investors. This is the reason the agency exists, and it comes first.
• Maintain fair, orderly, and efficient markets. Prices should reflect honest supply and demand, not manipulation, and trades should be completed reliably.
• Facilitate capital formation. Businesses need to raise money to grow, and good regulation makes investors willing to provide it.

Jurisdiction and Authority

The 1934 Act gives the SEC authority over nearly every corner of the securities industry. Section 3(a) of the Act supplies the definitions that frame that authority, defining terms such as broker, dealer, exchange, and self-regulatory organization. The SEC oversees the following.

• Exchanges, FINRA, the MSRB, and other self-regulatory organizations, which you will meet in the next lesson. They must register with the SEC, the SEC must approve most of their rules, and the SEC inspects them.
• Broker-dealers. Section 15 of the Act requires broker-dealers to register with the SEC.
• Public companies. Section 12 of the Act requires companies whose securities trade on an exchange, and larger companies with many shareholders, to register those securities and file ongoing reports, such as an annual report on Form 10-K and quarterly reports on Form 10-Q. Anyone can read these filings free on the SEC's EDGAR database.
• Investment companies and larger investment advisers.
• Market infrastructure and other participants, including transfer agents, clearing agencies, municipal advisors, and credit rating agencies.

The SEC also writes its own rules under the securities laws. One you will meet often is Rule 10b-5, the broad antifraud rule covered in Chapter 18.

Enforcement Powers

The SEC can investigate suspected violations, including by issuing subpoenas for documents and testimony. When it finds a violation, it can bring a civil action in federal court, where it can seek an injunction ordering the wrongdoer to stop, civil money penalties, and disgorgement, which means giving up the profits gained or losses avoided through the violation. It can also bring administrative proceedings to issue cease-and-desist orders, suspend or revoke a firm's registration, and bar individuals from the securities industry. The SEC can even suspend trading in a company's stock for up to 10 business days when it believes investors lack accurate information.

What the SEC cannot do is bring criminal charges. When conduct appears to be criminal, the SEC refers the case to the Department of Justice, which can prosecute and seek prison sentences. The two cases can proceed at the same time.

What the SEC Does Not Do

The SEC does not approve or disapprove securities, and it does not judge whether an investment is a good one. When a registration statement becomes effective, it means only that the required disclosure was filed, not that the SEC endorses the offering. Section 23 of the Securities Act of 1933 makes it unlawful to tell anyone otherwise.

The SEC also does not insure investors against losses, and it does not regulate everything financial. Commodity futures fall under the Commodity Futures Trading Commission, bank deposits fall under the banking regulators, and traditional insurance falls under state insurance departments.

1.3Self-Regulatory Organizations

A self-regulatory organization, or SRO, is a nongovernmental organization that writes and enforces rules for its own members, under the oversight of the SEC. The idea may sound odd at first, letting an industry police itself, but it has real advantages. Industry regulators understand the business in detail, they can write rules faster than Congress, they can hold members to ethical standards that go beyond the letter of the law, and the members pay for the regulation rather than taxpayers.

The Securities Exchange Act defines SROs to include the national securities exchanges, registered securities associations, registered clearing agencies, and the MSRB. The SEC keeps the system honest. An SRO must file its proposed rules with the SEC, most rules cannot take effect until the SEC approves them, and the SEC can review an SRO's disciplinary decisions.

FINRA

The Financial Industry Regulatory Authority, or FINRA, is the largest SRO and the one you will hear about most. Its history explains its structure. In 1938, the Maloney Act amended the Exchange Act by adding Section 15A, which allowed the industry to form a registered securities association. The National Association of Securities Dealers, or NASD, was formed under that law and registered with the SEC in 1939. In July 2007, the NASD combined with the member regulation, enforcement, and arbitration operations of the New York Stock Exchange to form FINRA.

FINRA is a private, not-for-profit corporation, not a government agency. It is the only registered national securities association, and nearly every broker-dealer that does business with the public must be a member. FINRA's authority reaches its member firms and their associated persons, which are the people who work in a member's securities business, including its owners, officers, and registered representatives.

FINRA's main functions are these.

• Rulemaking. FINRA writes rules for member conduct, such as its rules on gifts, communications, and sales practices, and the SEC approves them.
• Registration and qualification. FINRA registers firms and individuals and administers the qualification exams, including the SIE.
• Examinations and surveillance. FINRA examines member firms and watches the markets for manipulation and insider trading.
• Enforcement. FINRA brings disciplinary cases. Its sanctions include censure, fines, suspension, expulsion of a firm, a bar of an individual from the industry, and restitution to harmed customers.
• Dispute resolution. FINRA runs the main arbitration and mediation forum for disputes between investors and firms and among industry members.
• Investor information. FINRA operates BrokerCheck, a free tool for researching firms and representatives.

FINRA's power has limits. It cannot jail anyone or impose criminal penalties, and it refers suspected crimes to the SEC and other authorities. Because its authority comes from membership, it has no jurisdiction over banks, insurance companies, or investment advisers that are not also broker-dealers.

The MSRB

The Municipal Securities Rulemaking Board, or MSRB, was created by Congress in 1975 to write rules for the municipal securities market. Its rules apply to the firms that underwrite, trade, and sell municipal securities, which include broker-dealers and the municipal securities departments of banks. Since the Dodd-Frank Act of 2010, its rules also apply to municipal advisors. Most MSRB rules carry a letter G and a number, such as Rule G-37 on political contributions. The MSRB also runs EMMA, the Electronic Municipal Market Access website, where anyone can find official disclosure documents and trade prices for municipal securities.

The key testable fact is that the MSRB writes rules but has no power to examine firms or enforce its rules. Enforcement belongs to others. FINRA enforces MSRB rules for its member broker-dealers, the federal bank regulators enforce them for banks, and the SEC can enforce them against anyone subject to them, including municipal advisors that are not broker-dealers. The MSRB also does not regulate the states and cities that issue municipal bonds; it regulates the professionals who deal in them.

Exchanges as SROs

Every national securities exchange registered with the SEC is an SRO for its own members. An exchange lists securities, writes rules for trading on its market, watches that trading, and disciplines members who break its rules.

• Cboe, originally the Chicago Board Options Exchange, opened in 1973 as the first exchange to list standardized options. Today its parent company, Cboe Global Markets, operates several options, stock, and futures exchanges. As an SRO, Cboe writes and enforces rules for the firms and traders who trade on its markets.
• The New York Stock Exchange, or NYSE, sets the listing standards that companies must meet to have their stock traded there and writes rules for trading on its market. Since 2007, FINRA has handled much of the day-to-day regulation of NYSE member firms, but the NYSE remains an SRO. Nasdaq is also a registered exchange and an SRO.

1.4The Treasury, the IRS, and State Regulators

Beyond the SEC and the SROs, several other bodies shape the markets. This lesson covers the Treasury and its bureaus, the state securities regulators, and the association that connects them.

The Department of the Treasury

The Department of the Treasury is the federal government's finance department. It collects revenue, pays the government's bills, and manages the national debt. When the government spends more than it collects, the Treasury borrows by issuing Treasury securities, which are bills, notes, and bonds sold to investors at auction. These securities are backed by the full faith and credit of the U.S. government, and they are exempt from registration under the Securities Act of 1933. Chapter 5 covers them in detail.

Keep one distinction straight: the Treasury issues Treasury securities, while the Federal Reserve buys and sells existing Treasury securities to carry out monetary policy. You will meet the Fed in the next lesson.

Several Treasury bureaus and offices matter to a securities professional.

• The Internal Revenue Service, or IRS, administers and enforces federal tax law. It sets the tax rules for investments and for retirement accounts such as IRAs, and it requires broker-dealers to collect each customer's taxpayer identification number and report proceeds, dividends, interest, and cost basis to customers and the IRS on Forms 1099.
• The Financial Crimes Enforcement Network, or FinCEN, administers the federal anti-money-laundering laws and receives the reports firms file about suspicious activity and large cash transactions. Chapter 16 covers those reports.
• The Office of Foreign Assets Control, or OFAC, enforces U.S. economic sanctions and maintains a list of individuals and entities that U.S. persons and firms may not do business with, also covered in Chapter 16.
• The Office of the Comptroller of the Currency charters and supervises national banks. Its initials are also OCC, which can cause confusion later in this chapter.

State Securities Regulators

States regulated securities before the federal government did. Kansas passed the first state securities law in 1911, and other states quickly followed. These state laws are called blue-sky laws, after promoters said to sell investments backed by nothing more than the blue sky.

Each state has a securities regulator, usually called the state securities administrator, although the exact title varies. Many state securities laws are based on the Uniform Securities Act, a model law that states can adopt and adapt. A state securities administrator typically does the following.

• Registers securities offered in the state, unless they are exempt or federally covered.
• Registers broker-dealers, their agents, which is the state-law term for registered representatives, as well as investment advisers and investment adviser representatives doing business in the state.
• Investigates and enforces the state's law by denying, suspending, or revoking registrations, issuing cease-and-desist orders, imposing fines, and referring crimes to state prosecutors.

To reduce duplicate regulation, Congress passed the National Securities Markets Improvement Act of 1996. It created covered securities, such as exchange-listed stocks and mutual fund shares, which states may not require to register. States may still require a notice filing and a fee for some covered securities, and they keep full power to pursue fraud. Chapter 3 explains how state registration works.

NASAA

The North American Securities Administrators Association, or NASAA, was organized in 1919 and is the oldest international organization devoted to investor protection. Its members are the securities administrators of the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, the Canadian provinces and territories, and Mexico.

NASAA is an association of regulators, not a regulator itself. It proposes model rules and policy statements that states may choose to adopt, coordinates multistate investigations, trains state regulators, educates investors, and develops the state-law qualification exams, the Series 63, 65, and 66, which FINRA administers. What it cannot do is register anyone, enforce any law, or discipline anyone. Only the individual state administrators have those powers.

1.5The Federal Reserve, SIPC, and the FDIC

The last three organizations in the regulatory map have narrower jobs. The Federal Reserve manages the nation's money and credit. SIPC and the FDIC protect customers when a financial firm fails, and the exam loves to test the differences between them.

The Federal Reserve

The Federal Reserve System, usually called the Fed, is the central bank of the United States, created in 1913. It is led by a Board of Governors in Washington, made up of seven governors whom the President appoints and the Senate confirms to 14-year terms, and it operates through 12 regional Federal Reserve Banks.

The Fed's main job is monetary policy, which means managing the supply of money and credit to promote maximum employment and stable prices. Its Federal Open Market Committee, or FOMC, sets a target for short-term interest rates and buys or sells Treasury securities to move rates toward that target. Chapter 2 covers these tools. The Fed also supervises bank holding companies and many banks.

The Fed's direct link to the securities business is credit. The 1934 Act gave the Fed authority over loans used to buy securities, because borrowed money had fueled the speculation before 1929. Under Regulation T, the Fed sets how much credit broker-dealers may extend to customers. Today Regulation T requires a customer to deposit 50% of the purchase price when buying securities in a margin account. FINRA and individual firms, not the Fed, set the ongoing maintenance requirements for those accounts, which Chapter 15 covers.

SIPC

In the late 1960s, a surge in trading overwhelmed brokerage back offices, and a number of firms failed. Some customers discovered that the securities and cash their firm was supposed to be holding were missing. Congress responded with the Securities Investor Protection Act of 1970, or SIPA, which created the Securities Investor Protection Corporation, or SIPC.

SIPC is a nonprofit membership corporation funded by assessments on its member broker-dealers, and the SEC oversees it. It is not a government agency. Most broker-dealers registered with the SEC are required to be members.

SIPC acts when a member firm fails and customer assets are missing. A trustee takes over the firm, returns customers' securities and cash where possible, and SIPC's fund replaces what is missing, up to its limits. SIPC protects each separate customer up to $500,000, of which no more than $250,000 may be cash. A separate customer means a separate capacity in which accounts are held, such as an individual account, a joint account, an IRA, a trust account, or a corporate account. Two individual accounts in the same name at the same firm are combined and share one limit, while an individual account and an IRA each get their own limit. If a customer's missing assets exceed the limits, the customer becomes a general creditor of the failed firm for the rest and may recover some of it.

SIPC replaces missing assets. It does not protect against a decline in market value, and it does not cover commodity futures, fixed annuities, unregistered investment contracts, or currency.

The FDIC

The Federal Deposit Insurance Corporation, or FDIC, is an independent agency of the federal government, created in 1933 after thousands of banks failed. It insures deposits at member banks up to $250,000 per depositor, per insured bank, per ownership category, and its insurance is backed by the full faith and credit of the U.S. government.

FDIC insurance covers bank deposits, such as checking accounts, savings accounts, money market deposit accounts, and certificates of deposit. It does not cover stocks, bonds, mutual funds, money market mutual funds, or annuities, even when a customer buys them at a bank branch.

1.6Investors: Retail, Institutional, and Accredited

Investors supply the money that the entire market runs on. The law sorts them into categories because a retiree investing her savings needs more protection than a pension fund with a staff of analysts. The three categories the SIE names are retail, institutional, and accredited investors, and one investor can fit more than one category.

Retail Investors

A retail investor is an individual investing his or her own money, usually for personal, family, or household purposes. Maria, the nurse saving in her IRA, is a retail investor. Retail investors receive the most protection. For example, the best interest standard that applies when a broker-dealer makes a recommendation is written for retail customers, and FINRA's communications rules impose the strictest requirements on material sent to retail investors. Under those communications rules, a retail investor is anyone who is not an institutional investor. Chapter 17 covers both topics.

Institutional Investors

An institutional investor is an organization that invests large sums, often on behalf of others. Examples include banks, insurance companies, pension plans, mutual funds, endowments, and hedge funds. Institutions trade in large size, negotiate prices, and usually have professional staff, so some rules designed for retail investors are relaxed for them.

FINRA's account rules define an institutional account as the account of a bank, savings and loan association, insurance company, registered investment company, or registered investment adviser, or of any other person, including an individual, with total assets of at least $50 million. The largest institutions may also qualify as qualified institutional buyers, generally institutions that own and invest at least $100 million in securities, which may buy certain privately placed securities that Chapter 3 discusses.

Accredited Investors

An accredited investor is an investor that the SEC considers wealthy or sophisticated enough to buy private placements, which are securities sold without the full protection of SEC registration. The definition appears in SEC Rule 215 and in Regulation D, which Chapter 3 covers. A natural person qualifies by meeting any one of three tests.

1. Income test. The person had income above $200,000 in each of the two most recent years, or joint income with a spouse or spousal equivalent above $300,000 in each of those years, and reasonably expects the same level this year.
2. Net worth test. The person's net worth, alone or together with a spouse or spousal equivalent, is above $1 million, not counting the value of the primary residence.
3. Professional test. The person holds a Series 7, Series 65, or Series 82 license in good standing.

Many organizations are also accredited, including banks, broker-dealers, insurance companies, and registered investment companies, as well as corporations, partnerships, and similar entities with more than $5 million in assets that were not formed just to buy the offering. Directors, executive officers, and general partners of the company selling the securities are accredited for that company's offering.

1.7Broker-Dealers, Investment Advisers, and Municipal Advisors

Most investors reach the markets through professionals, and the SIE expects you to know what each kind does and which standard of conduct applies to it.

Brokers and Dealers

The Securities Exchange Act defines a broker as a person in the business of effecting securities transactions for the account of others. A broker acts in an agency capacity, meaning it acts on the customer's behalf, connecting the customer with the other side of a trade, and it earns a commission. A dealer is a person in the business of buying and selling securities for its own account. A dealer acts in a principal capacity, trading from its own inventory, and earns a markup when it sells to a customer above its cost or a markdown when it buys from a customer below the market price.

Most firms do both and are called broker-dealers. In any single transaction, however, a firm acts in only one capacity, so it cannot charge both a commission and a markup on the same trade. A broker-dealer must register with the SEC, join FINRA, register in the states where it does business, and in most cases become a SIPC member.

Introducing, Clearing, and Prime Brokers

Broker-dealers also divide the work of serving customers.

• An introducing broker deals with customers directly. It opens accounts, makes recommendations, and takes orders, but it does not hold customer cash or securities. It passes its customers' trades and accounts to a clearing firm.
• A clearing firm, also called a carrying firm, handles the back office. It settles trades, holds customers' cash and securities, extends margin loans, and sends confirmations and account statements. Because it holds customer assets, it must keep more capital than an introducing firm. A firm that settles its own customers' trades is called self-clearing.
• A prime broker provides a bundle of services to large, active clients, mainly hedge funds. It holds the client's assets, settles its trades, lends it money, lends it securities for short sales, and provides consolidated reporting. The client can execute trades through many different brokers, and those trades are then delivered to the prime broker, which keeps all the positions in one place.

The most common introducing arrangement is fully disclosed, in which the clearing firm carries each customer's account in the customer's own name. In an omnibus arrangement, the introducing firm's customer trades are combined in a single account at the clearing firm in the introducing firm's name, and the clearing firm does not know who the individual customers are.

Investment Advisers

Under the Investment Advisers Act of 1940, an investment adviser is anyone who, for compensation, is in the business of advising others about securities, either directly or through publications or reports. All three elements must be present: advice about securities, being in the business, and compensation. The Act excludes banks; lawyers, accountants, teachers, and engineers whose advice is only incidental to their profession; broker-dealers whose advice is only incidental to their brokerage business and who receive no special compensation for it; and publishers of general-circulation publications.

Advisers are usually paid a fee, such as a percentage of assets under management, an hourly rate, or a flat fee. They are fiduciaries, which means they owe their clients duties of care and loyalty. An adviser must act in the client's best interest throughout the relationship and must fully disclose its conflicts of interest. Advisers register by filing Form ADV, and they give clients a brochure from that form describing their services, fees, and conflicts. The individuals who give advice on an adviser's behalf are investment adviser representatives.

Advisers are split between federal and state oversight by size. Generally, an adviser with at least $110 million of assets under management must register with the SEC, an adviser with at least $100 million may register with the SEC, and smaller advisers register with their home state instead. An adviser to a registered investment company, such as a mutual fund, registers with the SEC regardless of size.

Municipal Advisors

States, cities, and school districts raise money by issuing municipal bonds, and many hire outside experts to help. A municipal advisor is a person or firm that advises a municipal entity, or an obligated person, on the issuance of municipal securities, such as the structure, timing, and terms of a bond issue, or on municipal financial products, such as how to invest bond proceeds. An obligated person is a borrower, such as a nonprofit hospital, that is responsible for repaying bonds a municipality issues on its behalf.

Before 2010, municipal advisors were largely unregulated, and during the 2008 financial crisis some municipalities suffered heavy losses on complex products recommended by advisors with conflicts of interest. The Dodd-Frank Act of 2010 changed that. Municipal advisors must now register with the SEC and the MSRB, individual advisors must pass a qualification exam, and the advisors must follow MSRB rules. Most important, a municipal advisor owes a fiduciary duty to its municipal entity clients.

Contrast the municipal advisor with the underwriter. An underwriter buys bonds from the issuer to resell them, so it sits on the other side of the deal. It must deal fairly with the issuer, but it is not the issuer's fiduciary. For that reason, MSRB rules generally bar a firm that has advised an issuer on a bond issue from switching roles and underwriting that same issue.

1.8Issuers, Underwriters, Traders, and Market Makers

This lesson covers the participants who create securities, bring them to market, and keep them trading. Chapters 2 and 3 return to these roles in more depth, so focus here on who does what.

Issuers

An issuer is an entity that creates and sells securities to raise money. Issuers include corporations, which sell stock and bonds; the U.S. Treasury; federal agencies and government-sponsored enterprises; municipalities, such as states, cities, counties, and school districts; and investment companies, since a mutual fund continuously issues new shares to investors. The type of issuer affects the rules. A corporation generally must register a public offering under the Securities Act of 1933, while Treasury and municipal securities are exempt from that registration.

Underwriters

An underwriter is a broker-dealer, often called an investment bank, that helps an issuer bring new securities to market. It advises the issuer on the type, price, and timing of the offering, investigates the issuer as part of its due diligence, helps prepare the offering documents, and distributes the securities to investors. In a firm commitment underwriting, the underwriter buys the entire issue from the issuer and resells it, so it bears the risk of any unsold securities. In a best efforts underwriting, the underwriter acts as an agent and sells only what it can. Large offerings are handled by a syndicate, a group of underwriters led by a managing underwriter. Chapter 3 covers underwriting in detail.

Traders

A trader buys and sells securities in the secondary market. At a broker-dealer, some traders execute customers' orders as agents, seeking the best available price, while proprietary traders trade the firm's own money for profit. Individual investors who buy and sell frequently are also called traders.

Market Makers

A market maker is a dealer that stands ready to buy and sell a particular security on a continuous basis, at publicly quoted prices, for its own account. It posts a two-sided quote. The bid is the price at which it will buy, and the ask, also called the offer, is the price at which it will sell. The difference between them is the spread, which compensates the market maker for the risk of holding inventory that could fall in value.

Market makers provide liquidity, which is the ability to buy or sell quickly at a fair price. Because a market maker is always willing to trade, an investor can sell even when no other investor happens to be buying at that moment. On the NYSE, a designated market maker plays this role for its assigned stocks, as Chapter 2 explains. To keep quotes independent, FINRA Rule 5250 prohibits a firm from accepting payment from an issuer for making a market in the issuer's stock.

1.9Custodians, Trustees, Transfer Agents, and Clearing Corporations

Behind every trade sits the market's plumbing: the organizations that hold assets, keep ownership records, and make sure that buyers get their securities and sellers get their money.

Custodians and Trustees

A custodian is an institution that holds and safeguards securities and cash for someone else. Custodians keep records, collect dividends and interest, process corporate actions, and settle trades. Banks and trust companies are the most common custodians, and broker-dealers act as custodians for their customers' accounts. The Investment Company Act generally requires a mutual fund to keep its assets with a qualified custodian, usually a bank, so that the fund's manager never has the assets in its own hands. An IRA must likewise be held by a bank or other approved trustee or custodian. Be aware that the word custodian has a second meaning: in a custodial account for a minor, the custodian is the adult who manages the account, as Chapter 15 explains.

A trustee holds legal title to assets and manages them for the benefit of others, called beneficiaries, as a fiduciary. A family trust has a trustee. Most publicly offered corporate bonds have an indenture trustee, required by the Trust Indenture Act of 1939, which watches whether the issuer keeps its promises and acts for the bondholders if the issuer defaults. When a SIPC member fails, a court-appointed trustee liquidates the firm.

Transfer Agents and Registrars

A transfer agent is hired by an issuer to keep the official record of who owns its securities. It records transfers of ownership, issues and cancels certificates, replaces lost or stolen certificates, and often distributes dividends and sends proxy materials and reports to registered owners. Mutual funds use transfer agents to process purchases and redemptions. Transfer agents register with the SEC, or with a bank regulator if they are banks.

A registrar keeps track of the number of shares issued and outstanding and makes sure the issuer never has more shares outstanding than its charter authorizes. Today one company often performs both jobs.

Most investors do not appear on the transfer agent's records at all. Their shares are held in street name, meaning registered in the name of a nominee for the industry's central depository, while the investor's broker-dealer keeps records showing the investor as the beneficial owner, the person entitled to the benefits of ownership.

DTCC: The Depository and Clearing Corporations

The Depository Trust & Clearing Corporation, or DTCC, is an industry-owned holding company at the center of the U.S. post-trade system. Two terms explain its work. Clearing is the process of confirming the details of a trade and calculating what each side owes. Settlement is the final exchange of securities for cash, which for most securities happens one business day after the trade, as Chapter 14 explains. DTCC's main subsidiaries are these.

• The Depository Trust Company, or DTC, is the central securities depository. It holds securities for its participant firms in electronic form and transfers ownership between them by book entry, meaning computer records rather than paper certificates. Its nominee name is Cede & Co., the name in which most street-name shares are registered.
• The National Securities Clearing Corporation, or NSCC, clears trades in stocks, corporate and municipal bonds, and unit investment trusts. It acts as the central counterparty, becoming the buyer to every seller and the seller to every buyer, so trades are completed even if one firm fails. It also nets each firm's trades, combining all of its buys and sells in a security into one net amount to settle.
• The Fixed Income Clearing Corporation, or FICC, clears and settles U.S. government securities and mortgage-backed securities.

The Options Clearing Corporation

The Options Clearing Corporation, or OCC, is the clearinghouse for all exchange-listed options in the United States. It issues and guarantees every listed option contract, so an option buyer's contract is effectively with the OCC rather than with the particular investor who wrote the option. That guarantee means option buyers do not need to worry about whether the seller will perform. When a holder exercises an option, the OCC assigns the exercise to a firm whose customers wrote that option, and the firm then assigns it to one of those customers. The OCC, together with the options exchanges, also publishes the Options Disclosure Document, which customers receive before trading options. Chapter 7 covers options in detail.

Chapter Summary

• Federal securities regulation is built on disclosure, not on approval. The Securities Act of 1933 covers new issues, the Securities Exchange Act of 1934 covers trading and created the SEC, and the two 1940 Acts cover investment companies and investment advisers.
• The SEC's mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. It is led by five commissioners and brings civil and administrative cases, but it refers criminal cases to the Department of Justice and never approves securities.
• Self-regulatory organizations write and enforce rules for their members under SEC oversight. FINRA, formed in 2007 from the NASD and NYSE member regulation, regulates member broker-dealers and their associated persons but cannot impose criminal penalties.
• The MSRB writes rules for municipal securities dealers and municipal advisors but does not enforce them. FINRA, the SEC, and the bank regulators enforce MSRB rules.
• The Treasury issues Treasury securities and houses the IRS, FinCEN, and OFAC. State securities administrators enforce blue-sky laws, while NASAA is an association of regulators with no enforcement power.
• The Federal Reserve conducts monetary policy and sets securities credit rules under Regulation T, which requires 50% initial margin.
• SIPC, a nonprofit created by SIPA in 1970, protects customers of failed broker-dealers up to $500,000, including up to $250,000 in cash, per separate customer. The FDIC, a government agency, insures bank deposits up to $250,000 per depositor, per bank, per ownership category.
• Investors are retail, institutional, or accredited. An individual is accredited with income over $200,000, or $300,000 jointly, in each of the last two years, net worth over $1 million excluding the primary residence, or a Series 7, 65, or 82 license in good standing.
• Brokers act as agents for commissions, and dealers act as principals for markups and markdowns. Introducing brokers serve customers, clearing firms hold assets and settle trades, and prime brokers serve large clients such as hedge funds. Investment advisers and municipal advisors owe fiduciary duties to their clients.
• Market makers quote a bid and an ask and provide liquidity. Custodians hold assets, transfer agents keep ownership records, DTCC's subsidiaries hold, clear, and settle securities, and the OCC issues and guarantees listed options.

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