Regulators and Market Participants

The statutes and the SEC

The Securities Act of 1933 governs the issuance of new securities: registration with the SEC, delivery of a prospectus, and the exemptions from both. It is the primary market act.

The Securities Exchange Act of 1934 governs trading after issuance, created the Securities and Exchange Commission, registers exchanges and broker-dealers, requires ongoing issuer reporting, and contains the general anti-fraud provisions.

The Investment Company Act of 1940 governs pooled vehicles — mutual funds, closed-end funds, unit investment trusts. The Investment Advisers Act of 1940 governs those who advise for compensation.

A workable compression: 1933 is issuing, 1934 is trading, 1940 is pooling and advising.

The SEC is a federal agency. It writes rules under those statutes, reviews registration statements for adequacy of disclosure, brings civil enforcement actions, and approves the rules of the self-regulatory organizations. It does not approve or endorse any security, and saying otherwise to a customer is a misstatement of the central fact of the 1933 Act.

The self-regulatory organizations

A self-regulatory organization is an industry body with rulemaking and disciplinary authority over its own members, operating under SEC oversight. The arrangement lets the industry write detailed conduct rules and police them while the government retains approval and appellate authority.

FINRA — the Financial Industry Regulatory Authority — is the SRO for broker-dealers. It registers and examines firms and associated persons, administers the qualification exams, writes most of the conduct rules, operates BrokerCheck and the arbitration forum, and disciplines members.

The MSRB — the Municipal Securities Rulemaking Board — writes the rules for municipal securities dealers and municipal advisors. It has no examination staff of its own: FINRA and the SEC enforce its rules against dealers.

The exchanges are also SROs. Cboe writes the options rules, and NYSE and Nasdaq write rules for their own markets.

The distinction the exam wants: the SEC is a government agency; FINRA, the MSRB and the exchanges are not. FINRA is not a government body, and its authority over a firm comes from that firm's membership.

The other agencies, and the two insurance schemes

The Federal Reserve does not regulate broker-dealer conduct, but it controls the extension of credit for securities purchases through Regulation T, and it conducts monetary policy — the subject of Module 2.

The Department of the Treasury and the Internal Revenue Service matter because taxation runs through the products: the exemption on municipal interest, the treatment of retirement accounts, capital gains and wash sales.

The states, through their securities administrators, register agents and firms doing business with their residents and enforce their own anti-fraud provisions. NASAA is the association of those administrators; it writes model laws and the uniform exams but is not itself a regulator. State law is often called blue-sky law.

Two protection schemes, and the exam relies on candidates confusing them.

The Securities Investor Protection Corporation was created by the Securities Investor Protection Act of 1970. It is a non-profit membership corporation funded by assessments on member broker-dealers, not a government agency. When a member firm fails and customer property is missing, SIPC returns securities and cash up to $500,000 per customer, of which no more than $250,000 may be for cash claims, measured per separate capacity. It never covers loss of market value, and it does not cover commodity futures, fixed annuities or unregistered investment contracts.

The FDIC is a federal agency insuring deposits at insured banks, currently to $250,000 per depositor per insured bank per ownership category. Bank deposits, not securities.

The participants

Investors divide into retail and institutional, with accredited investors — those meeting income, net worth or professional credential tests — as a category in between for private offerings.

Broker-dealers act as brokers when executing as agent for a commission, and as dealers when trading as principal from their own inventory for a markup or markdown. An introducing firm holds the customer relationship and passes the business to a clearing firm, which carries the accounts and holds the assets. A prime broker consolidates clearing and financing for an institution that executes through several firms.

Investment advisers manage assets or give advice for a fee, under the Advisers Act rather than under the broker-dealer rules. Municipal advisors advise municipal entities and owe them a fiduciary duty.

Issuers create securities; underwriters distribute them.

Traders trade for a firm's own account. Market makers quote a two-sided market and stand ready to buy at their bid and sell at their offer, earning the spread.

Custodians hold assets for safekeeping. Trustees administer a trust or a bond indenture. Transfer agents maintain the record of registered owners, issue and cancel certificates and distribute dividends; registrars audit that record so shares outstanding never exceed shares authorized.

Depositories and clearing corporations are the plumbing. The Depository Trust and Clearing Corporation holds securities in book-entry form and nets trades between firms so that thousands of transactions become one obligation. The Options Clearing Corporation does the same for listed options, and additionally guarantees every contract.