Chapter 2 - Knowledge of Capital Markets

 

Knowledge of Capital Markets is the first section of the SIE exam. This section accounts for 16% of the overall exam and comprises 12 questions. This study topic is subdivided into four subsections.

 

.1 Regulatory Entities, Agencies, and Market Participants

1.1.1 The Securities and Exchange Commission (SEC)

The High-level Purpose and Mission of Securities Regulation

 

The government did not regulate the securities industry until the infamous Stock Market crash of 1929 and the subsequent Great Depression of the 1930s.

 

The behavior of traders, investors, and financial organizations was a world away from what is allowed today. To say it was a free-for-all would be something of an understatement! These practices, in part, contributed to the crash of 1929.

 

After 1929, the federal government stepped in to exercise some control over financial activities in general, the securities industry, and the behavior of its participants through oversight and governance.

 

Fast-forward to the 1930s, two pieces of legislation were created and passed by the US Congress: the Securities Act of 1933 (also known as the "Prospectus" or "Paper Act") and the Securities Exchange Act of 1934 (also known as the "People and Places Act"). The 1934 Act created the SEC.

 

The Definition, Jurisdiction, and Authority of the SEC

 

The SEC's original purpose was, and remains to this day, the creation and implementation of regulations and laws designed to protect retail investors from theft and fraud in the public securities markets. A retail investor is defined later in this chapter but is, in simple terms, not a sophisticated or professional investor.

 

In More Detail: The 1933 Securities Act

 

This piece of legislation took the power away from individual states and vested it firmly in the hands of the federal government.

 

The most important provision of the 1933 Act is that it introduced the requirement for corporations to register with the SEC using a prospectus document (hence the name, the "Prospectus Act") before issuing securities to the general public on the primary market regardless of whether they were issuing stocks (equity securities) or bonds (debt securities).

 

However, this regulation only applies to corporations: municipal and federal government issues are legally allowed to bypass these registration regulations.

 

In More Detail: The 1934 Securities Exchange Act

 

This companion act, passed a year after the Securities Act in 1934, was designed to regulate securities trading on the secondary market (the 1933 Act controlled trading in securities on the primary market).

 

The Act also created the SEC, vesting in it the jurisdiction and interpretation of all laws relevant to the domestic securities market.

 

The 1934 Securities Exchange Act controls the actions of broker-dealers, investors, corporations, and financial professionals regarding publicly traded corporations.

1.1.2 Self-Regulatory Organizations (SROs)

Purpose and Mission of an SRO

 

FINRA is the financial services sector's central SRO. Alongside the SEC, FINRA regulates the securities industry.

 

FINRA was created following the merger of the National Association of Security Dealers (NASD) and the regulatory element of the New York Stock Exchange (NYSE).

 

Jurisdiction and Authority of SROs

 

FINRA sets four primary standards for financial professionals as follows:

 

• The Code of Arbitration - last stop and binding arbitration in disputes
• The Code of Procedure - for trade practice complaints
• The Code of Conduct - defining ethical standards of behavior
• Uniform Practice Code - to ensure consistent trading in the secondary market

 

FINRA is the main but not the only organization regulating the trade in securities in the USA.

The Municipal Securities Rulemaking Board (MSRB) is an SRO that oversees municipal bonds in the municipal securities market. The Chicago Board Options Exchange (CBOE) is another example of an SRO and the largest options exchange in the USA. The CBOE covers listed securities, individual stocks, and exchange-traded funds. However, the SIE exam does not include or test individual rules from the CBOE.

1.1.3 Other Regulators and Agencies

Treasury Department/Internal Revenue Service (IRS)

 

Legislation exists to prevent money laundering. Money laundering is the process of taking so-called "dirty" money obtained through crime and illegal activities and subjecting it to a process that legitimizes it and makes it clean. Money laundering consists of three actions - placement, layering, and integration - none of which are detectable by the IRS.

 

Under the 1970 Currency and Foreign Transactions Reporting Act (also commonly referred to as the "Bank Secrecy Act"), financial institutions and banks must file the following:

 

• Currency Transaction Reports (CTRs) - CTRs are filed for currency transactions over $10,000. Individuals and organizations can try to avoid a CTR by breaking down a lump sum into smaller payments that don't trigger this requirement.
• Suspicious Activity Reports (SARs) - SARs are filed when an institution receives a transaction described as "commercially illogical," essentially something that doesn't make sense.

 

Reports are filed with FinCEN, the Financial Crimes Enforcement Network, a bureau within the US Treasury Department.

 

The financial services industry is regulated at the federal level and by state governments, with regulations differing from one state to another. The rules that cover the sale of securities within states are called "blue sky" laws.

 

NASAA, the North American Securities Administrators Association, is a body of state administrators that links with FINRA. NASAA has a set of exams called the 60 Series licenses, which follow the SIE and Series 6 and 7 examinations covering the process of filing securities with state administrators.

 

The purpose of "blue sky" laws and organizations like NASAA is to protect investors from fraud and deception in capital markets.

 

The Federal Reserve

 

The Federal Reserve is the central bank of the United States. Congress created it in December 1913 and signed it into law by the Federal Reserve Act to provide America with a safe, flexible, and stable financial system. It is often referred to simply as "the Fed."

 

The Fed stipulates the reserve requirements for banks to protect their liabilities and the amount they can lend to other financial institutions (called the federal fund rate). This is a direct reference to the Stock Market crash of 1929, when investors made a run to clear their accounts, and overstretched banks collapsed as a result.

 

The Federal Reserve also oversees broker-dealers' credit and borrowing behavior, known as Regulation T. The Federal Reserve took this power from individual firms under the 1934 Securities Exchange Act.

 

Federal Deposit Insurance Corporation (FDIC)

 

The FDIC's remit covers standard bank and savings accounts with a value of up to $250,000. The federal government secures individual accounts up to this sum. It includes multiple accounts, but they must be with different financial institutions.

 

Securities Investment Protection Corporation (SIPC)

 

The SPIC performs a similar service for investment accounts up to a value of $500,000, with a split of $250,000 to cash and the rest in securities. It's invaluable if a broker-dealer ceases trading due to bankruptcy and cannot issue promised shares to a customer. The SIPC can step in and run the liquidation process and try to reclaim funds to cover the investor's outlay with the liquidation proceeds.

1.1.4 Market Participants and Their Roles

Investors - Retail, Accredited, Institutional, Qualified Institutional Buyers (QIBs)

 

Investors are often referred to in this context as "retail investors"; this simply means they are not professionals for the purposes of the law and the protection offered. Accredited investors are different; they have access to private funds that are not open to retail investors and the public.

 

The government distinguishes between retail and accredited investors on the basis that accredited investors with more net worth and/or higher incomes are better able to survive significant losses and are less vulnerable to fraud and certain market risks.

 

To become an accredited investor, an individual must have an annual income of more than $200,000 for the past two years and reasonably expect this to continue. If a person is married, a joint annual income of $300,000 or higher will allow accreditation, but again, this income must be stable and likely to continue for the foreseeable future. Any individual with a net worth of $1 million+, excluding the main home, can become an accredited investor.

 

Institutional investors are classed as companies, pension funds, governments, firms, and other organizations that purchase and sell securities. A non-natural person can also be an institutional investor.

 

QIBs are a subgroup of institutional investors who...