Section 1.2: Market Participants and How Markets Work

Estimated study time: 45 minutes

Content:

Securities markets function because of a cast of specialized participants, each playing a distinct role. Understanding these roles — and the relationships between them — is essential for the SIE exam.

Broker-dealers occupy the center of the market structure. A broker-dealer is a firm (or individual) registered with the SEC and FINRA to both execute securities transactions on behalf of customers (acting as a broker/agent) and trade securities from its own account (acting as a dealer/principal). When a firm acts as a broker, it earns a commission — a fee for executing the customer's order. When acting as a dealer, the firm buys or sells from its own inventory and profits from the markup (when selling to a customer) or markdown (when buying from a customer). The firm must disclose which capacity it is acting in for each transaction.

Investment advisers (IAs) provide investment advice for compensation. They owe their clients a fiduciary duty — the highest legal standard of care — requiring them to always act in the client's best interest, disclose conflicts of interest, and avoid self-dealing. This fiduciary standard is stricter than the broker-dealer suitability standard. IAs with $110 million or more in assets under management (AUM) must register with the SEC. Those with less than $100 million in AUM register with state regulators. The $100 million to $110 million band allows either.

Registered representatives (sometimes called stockbrokers or agents) are individuals associated with FINRA member broker-dealers who are licensed to solicit and accept securities orders, provide recommendations, and open and service customer accounts. To become registered, an individual must: (1) associate with a FINRA member firm, (2) pass the SIE, (3) pass a top-off exam (Series 7, Series 6, etc.), and (4) register with FINRA and applicable states. If a registered rep leaves a firm, their registrations become inactive until they join another firm.

Market makers are broker-dealers that continuously quote both bid prices (prices at which they will buy) and ask prices (prices at which they will sell) for specific securities. They profit from the bid-ask spread and provide liquidity — ensuring buyers can always find sellers and vice versa. On the NYSE, specialists are called Designated Market Makers (DMMs); in OTC markets (like those operated by FINRA), market makers are called market makers.

Clearing corporations ensure that trades settle properly. The DTCC (Depository Trust & Clearing Corporation) handles the vast majority of U.S. securities clearing and settlement through its subsidiaries: the NSCC (equities clearing), FICC (fixed income clearing), and DTC (the central securities depository). Securities transactions in the U.S. settle on a T+1 basis — one business day after the trade date.

Transfer agents work for the issuing company — they maintain the official records of who owns what shares, process transfers of ownership, handle dividend distributions, and manage corporate actions like stock splits. They are distinct from custodians, who hold and safeguard securities on behalf of investors.

Key Terms:

• Broker (agent): Executes trades on behalf of customers; earns commissions; does not trade for its own account in this capacity.
• Dealer (principal): Trades from its own inventory; earns markup or markdown instead of commission.
• Markup/Markdown: A dealer's profit when selling to customers (markup) or buying from customers (markdown) from its own inventory.
• Investment Adviser (IA): Entity providing investment advice for compensation; subject to fiduciary duty; registered with SEC ($110M+ AUM) or state.
• Fiduciary duty: Highest legal standard of care; requires acting in the client's best interest at all times, disclosing conflicts, and avoiding self-dealing.
• Market maker: Broker-dealer that continuously quotes bid and ask prices in specific securities to provide liquidity.
• Bid-ask spread: The difference between what a market maker will pay for a security (bid) and what it will sell it for (ask); represents the market maker's profit.
• DTCC: Depository Trust & Clearing Corporation; clears and settles the majority of U.S. securities transactions.
• T+1 settlement: Standard settlement cycle for most U.S. equity trades; trade settles one business day after the trade date.
• Transfer agent: Records and maintains the official list of security holders for the issuing company.
• Custodian: Holds and safeguards securities on behalf of investors; distinct from transfer agents who work for issuers.
• Designated Market Maker (DMM): NYSE specialist responsible for maintaining fair and orderly markets in assigned securities.

Quiz Questions:

Q1. A broker-dealer sells 500 shares of ABC stock to a customer from its own inventory. The firm is acting as:

A) An agent, earning a commission B) A principal, earning a markup C) A custodian, holding the shares D) A transfer agent, recording the sale

Answer: B — When a broker-dealer sells securities from its own inventory to a customer, it is acting as a dealer/principal and earns a markup. Acting as an agent/broker means executing a customer's order in the market and earning a commission. Custodians hold assets; transfer agents record ownership.

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Q2. An investment advisory firm manages $125 million in client assets. With which regulator must it register?

A) FINRA B) State securities regulators only C) The SEC D) Both FINRA and the SEC

Answer: C — Investment advisers with $110 million or more in AUM must register with the SEC. FINRA does not regulate investment advisers (only broker-dealers). State regulators handle IAs below the $100 million threshold. There is no dual FINRA/SEC registration requirement for IAs.

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