Knowledge of Capital Markets

The Securities Markets

The securities markets form the backbone of the modern financial system. They provide a mechanism for companies to raise capital and for investors to buy and sell ownership stakes or debt instruments. Understanding how these markets function is critical for anyone working in the securities industry and is a foundational topic on the SIE exam.

Primary vs. Secondary Markets

Securities markets are divided into two broad categories based on the type of transaction that occurs:

• Primary Market: This is where new securities are created and sold for the first time. When a company conducts an Initial Public Offering (IPO) or a corporation issues new bonds, these transactions occur in the primary market. The issuer receives the proceeds from the sale. Think of it as the "first sale" of a security.
• Secondary Market: After securities have been issued in the primary market, they trade among investors in the secondary market. The New York Stock Exchange (NYSE) and Nasdaq are examples of secondary markets. The issuing company does not receive any proceeds from secondary market transactions. Instead, one investor sells to another.

Exchanges: NYSE and Nasdaq

The two most prominent U.S. stock exchanges are the New York Stock Exchange (NYSE) and the Nasdaq Stock Market. While both serve the purpose of facilitating secondary market trades, they operate differently.

The NYSE is the world's largest stock exchange by market capitalization of listed companies. Historically, it used a physical auction system on the trading floor with designated specialists (now called Designated Market Makers, or DMMs) who are responsible for maintaining fair and orderly markets in assigned securities. A DMM quotes both a bid and an ask price, facilitates price discovery, and may buy or sell from their own inventory when needed to maintain liquidity.

The Nasdaq (National Association of Securities Dealers Automated Quotations) is an entirely electronic exchange that relies on a network of market makers rather than a centralized physical floor. Multiple market makers compete to provide the best bid and ask prices for each security. This dealer-based model encourages competition, which can lead to tighter spreads. Nasdaq is the exchange of choice for many technology companies, and it has three tiers: the Nasdaq Global Select Market, the Nasdaq Global Market, and the Nasdaq Capital Market.

OTC Markets

The Over-the-Counter (OTC) market is a decentralized network where securities not listed on a major exchange are traded. OTC trading occurs through a network of broker-dealers who negotiate directly with one another, rather than through a centralized exchange. OTC securities include smaller companies that may not meet the listing requirements of major exchanges, as well as government bonds, municipal bonds, and certain derivatives.

The OTC Markets Group operates three tiers: OTCQX (highest standards), OTCQB (venture stage), and Pink Sheets (minimal requirements). Companies on the Pink Sheets may have limited financial disclosure, making them riskier investments.

ECNs and Dark Pools

Electronic Communications Networks (ECNs) are automated systems that match buy and sell orders for securities. ECNs bypass traditional market makers and exchanges by allowing orders to be executed directly. They provide access to extended-hours trading and can offer tighter spreads since they eliminate the market maker's role in the transaction.

Dark pools are private exchanges or forums for trading securities. They are called "dark" because the orders are not displayed to the public until after the trade is executed. Dark pools allow institutional investors to make large block trades without revealing their intentions to the broader market, which could otherwise move the price against them. While dark pools serve a legitimate purpose, they have attracted regulatory scrutiny regarding transparency.

Market Makers vs. Specialists (DMMs)

A market maker is a firm that stands ready to buy and sell a particular security on a regular and continuous basis at a publicly quoted price. Market makers earn the bid-ask spread (the difference between the price they will buy at and the price they will sell at). On Nasdaq, multiple market makers compete for each security.

A Designated Market Maker (DMM), formerly called a specialist, performs a similar role but operates exclusively on the NYSE floor. Each listed security on the NYSE is assigned one DMM. The DMM has a unique obligation to step in and buy or sell from their own inventory when there is an imbalance between supply and demand, helping to prevent excessive volatility.

Regulatory Agencies

The U.S. securities industry operates under a layered regulatory framework. Multiple federal and self-regulatory organizations work together to protect investors, ensure market integrity, and maintain confidence in the financial system. This section covers the key regulatory bodies you need to know for the SIE exam.

The SEC (Securities and Exchange Commission)

The SEC is the primary federal regulatory agency responsible for enforcing federal securities laws. Created by the Securities Exchange Act of 1934, the SEC's mission has three parts:

1. Protect investors
2. Maintain fair, orderly, and efficient markets
3. Facilitate capital formation

The SEC has the authority to bring civil enforcement actions against individuals and companies for violations of securities laws, including insider trading, accounting fraud, and providing false or misleading information about securities. The SEC is led by five commissioners appointed by the President, each serving staggered five-year terms. No more than three commissioners may belong to the same political party.

FINRA (Financial Industry Regulatory Authority)

FINRA is the largest self-regulatory organization (SRO) in the United States. It is a non-governmental organization authorized by Congress to regulate broker-dealer firms and their registered representatives. Key FINRA functions include:

• Writing and enforcing rules governing broker-dealer activities
• Examining firms for compliance
• Administering qualification examinations (including the SIE exam)
• Providing dispute resolution (arbitration and mediation)
• Providing investor education
• Operating market regulation through surveillance technology

FINRA was created in 2007 through the consolidation of the National Association of Securities Dealers (NASD) and the regulatory arm of the NYSE. All broker-dealers that do business with the public must register with FINRA.

MSRB (Municipal Securities Rulemaking Board)

The MSRB writes rules for firms and individuals involved in the municipal securities market. However, unlike FINRA, the MSRB does not have enforcement authority. Instead, enforcement of MSRB rules is carried out by FINRA (for broker-dealers) and by bank regulators (for banks dealing in municipal securities).

Other Key Regulators

The Federal Reserve (the Fed) is the central bank of the United States, responsible for monetary policy. While not primarily a securities regulator, the Fed's actions on interest rates directly impact securities markets. We will discuss the Fed in detail in the next section.

The FDIC (Federal Deposit Insurance Corporation) insures bank deposits up to $250,000 per depositor, per insured bank, for each account ownership category. The FDIC does NOT insure securities investments such as stocks, bonds, or mutual funds, even if purchased through a bank.

The SIPC (Securities Investor Protection Corporation) protects customers of broker-dealers that fail financially. SIPC coverage protects up to $500,000 per customer, of which up to $250,000 may be in cash. SIPC does NOT protect against market losses, bad investment decisions, or fraud by an adviser. It only covers the loss of securities and cash held by a failed brokerage firm.

The Federal Reserve and Monetary Policy

The Federal Reserve System ("the Fed") is the central bank of the United States, established by the Federal Reserve Act of 1913. Its primary goals are to promote maximum employment, stable prices, and moderate long-term interest rates. While the Fed is not a securities regulator per se, its monetary policy decisions profoundly influence the securities markets.

Structure of the Federal Reserve

The Federal Reserve System consists of:

• Board of Governors: Seven members appointed by the President and confirmed by the Senate, serving 14-year terms. The Chair is appointed to a 4-year renewable term.
• 12 Federal Reserve Banks: Located in major cities across the country, each serving a specific district.
• Federal Open Market Committee (FOMC): The 12-member body that sets monetary policy. It consists of the 7 Board members plus 5 of the 12 Reserve Bank presidents (the New York Fed president always serves; the other four rotate).

Monetary Policy Tools

The FOMC meets approximately eight times per year to review economic conditions and decide on monetary policy. The Fed has several tools at its disposal:

1. Open Market Operations (OMO): The buying and selling of U.S. Treasury securities in the open market. This is the Fed's most frequently used tool. When the Fed buys Treasuries, it injects money into the banking system (expansionary). When the Fed sells Treasuries, it drains money from the system (contractionary).
2. The Discount Rate: The interest rate the Fed charges commercial banks for short-term borrowing at the "discount window." Lowering the discount rate makes borrowing cheaper, encouraging banks to lend more (expansionary). Raising the discount rate has the opposite effect (contractionary).
3. Reserve Requirements: The percentage of deposits that banks must hold in reserve. Lowering the requirement frees up more money for lending (expansionary). Raising it restricts lending (contractionary). Note: as of 2020, the Fed set reserve requirements to zero, but this concept is still tested.
4. Federal Funds Rate: The rate at which banks lend reserves to each other overnight. The FOMC sets a target range for this rate. Changes in the federal funds rate ripple through the entire economy, affecting everything from mortgage rates to credit card interest.
Key Takeaway

Expansionary (loose) policy = Fed buys securities, lowers rates, lowers reserve requirements. Goal: stimulate growth, increase money supply. Generally bullish for stocks, bearish for bonds (rates fall, but inflation expectations can push long-term rates up).

Contractionary (tight) policy = Fed sells securities, raises rates, raises reserve requirements. Goal: slow inflation, decrease money supply. Generally bearish for stocks, can raise bond yields.

How Fed Actions Affect Securities Markets

When the Fed lowers interest rates, borrowing becomes cheaper for businesses and consumers. Companies can invest in growth at lower cost, and consumer spending tends to increase. This is generally positive for stock prices. Lower interest rates also mean that existing bonds with higher coupon rates become more valuable, so bond prices rise.

Conversely, when the Fed raises rates, borrowing costs increase, business expansion may slow, and the appeal of fixed-income investments rises relative to equities. Higher rates also mean newly issued bonds offer better yields, making existing bonds with lower coupons less attractive (prices fall).

Exam Tip

The SIE exam loves to ask about the most frequently used Fed tool. The answer is Open Market Operations. The FOMC conducts these almost daily. Also remember: the Fed sets the discount rate directly, but the federal funds rate is a target that the Fed influences through open market operations.

Economic Factors

Securities markets are influenced by a broad range of economic factors. Understanding these macroeconomic indicators helps investment professionals assess the health of the economy and make informed decisions. The SIE exam tests your knowledge of key economic concepts and their relationship to the markets.

Gross Domestic Product (GDP)

GDP measures the total value of all goods and services produced within a country's borders during a specific period (usually quarterly or annually). It is the broadest measure of economic activity. GDP growth signals a healthy, expanding economy. Two consecutive quarters of negative GDP growth is the informal definition of a recession.

Inflation

Inflation is a general increase in the price level of goods and services over time, resulting in a decrease in purchasing power. Two key inflation measures include:

• Consumer Price Index (CPI): Measures changes in the price of a basket of consumer goods and services. It is the most widely reported inflation measure and directly affects cost-of-living adjustments.
• Producer Price Index (PPI): Measures changes in selling prices received by domestic producers. PPI tracks inflation at the wholesale level and is sometimes viewed as a leading indicator of CPI.

Moderate inflation (around 2%) is generally considered healthy. High inflation erodes the purchasing power of fixed-income investments like bonds and savings accounts. Deflation (falling prices) can signal weak demand and economic contraction.

Unemployment

The unemployment rate measures the percentage of the labor force that is jobless and actively seeking employment. High unemployment suggests economic weakness, while low unemployment indicates a strong labor market. The Fed closely monitors employment data when making monetary policy decisions.

The Business Cycle

The economy moves through recurring phases known as the business cycle:

1. Expansion: Economic activity is increasing. GDP grows, employment rises, consumer confidence improves, and business investment increases. Stock markets generally perform well during expansions.
2. Peak: The economy has reached its highest point of growth. Inflation may begin to rise, and the Fed may tighten monetary policy to prevent overheating.
3. Contraction (Recession): Economic activity declines. GDP falls, unemployment rises, and business profits decrease. The stock market typically declines during contractions.
4. Trough: The lowest point of the business cycle. From here, the economy begins to recover, and a new expansion begins.

Economic Indicators

Economists classify indicators based on their timing relative to the business cycle:

• Leading indicators change before the economy changes direction. Examples: building permits, stock market returns, manufacturers' new orders, money supply (M2), consumer expectations. These help predict future economic activity.
• Coincident indicators change at the same time as the economy. Examples: GDP, personal income, employment levels, industrial production.
• Lagging indicators change after the economy has already begun to follow a particular trend. Examples: unemployment rate, CPI, corporate profits, bank prime rate, average duration of unemployment.

Interest Rates and Bond Prices

One of the most fundamental relationships in finance is the inverse relationship between interest rates and bond prices. When interest rates rise, existing bond prices fall. When interest rates fall, existing bond prices rise. This is because investors will only buy an existing bond at a discount if newer bonds offer higher yields, and vice versa. We will explore this in much greater depth in Chapter 3 on Debt Securities.

The IPO Process

When a company decides to "go public" by issuing stock to the public for the first time, it undertakes an Initial Public Offering (IPO). This is a primary market transaction, and the process is heavily regulated under the Securities Act of 1933 ("The Paper Act") to protect investors from fraud.

Types of Underwriting

The investment bank that helps a company issue securities acts as the underwriter. There are several types of underwriting commitments:

• Firm Commitment: The underwriter purchases the entire issue from the issuer and resells it to the public. The underwriter assumes the risk of unsold shares. This is the most common type for large IPOs.
• Best Efforts: The underwriter agrees to use its best efforts to sell the securities but does not guarantee the entire issue will be sold. Unsold shares are returned to the issuer. The underwriter bears no financial risk.
• All-or-None: A type of best efforts underwriting where the entire issue must be sold, or the deal is cancelled and all funds are returned to investors.
• Mini-Max: A variation where a minimum amount must be sold for the deal to proceed, but the underwriter will continue selling up to a maximum amount.

The Syndicate and Selling Group

For large issues, the lead underwriter (also called the managing underwriter or book-running manager) forms a syndicate — a group of investment banks that share the risk and responsibility of distributing the new issue. Members of the syndicate commit to purchasing a portion of the issue.

Beyond the syndicate, the lead underwriter may also invite additional broker-dealers to join a selling group. Selling group members help distribute the securities but do not assume underwriting risk. They earn a selling concession (a portion of the underwriting spread) for each share they sell.

The IPO Timeline