If you’re going to hang out in the neighborhood, you should know who the neighbors are. After all, stranger danger and all that…
Buying and selling publicly traded stock in the United States is made possible by an infrastructure that consists of various parties. These parties (the ‘neighbors’ I refer to above) are commonly called “market participants.”
One such party is the New York Stock Exchange (“NYSE”), which you have probably heard of even if you have never bought or sold a single share of stock. But do you have any real idea how the NYSE fits into the overall infrastructure? You will when you’re done reading this installment. Before we begin, keep in mind that the New York Stock Exchange (“NYSE”) began before the founding of the US and, thus, pre-dates most of the rest of the infrastructure and was influential in helping to develop it. Here is an except from the NYSE’s official history about itself:
In the Exchange’s early years, stock trading continued on an informal basis in nearby coffeehouses where merchants typically gathered. By 1817, the stock market was active enough to encourage the brokers to create a formal organization. A constitution was adopted on March 8, 1817, creating the New York Stock & Exchange Board, the forerunner of today’s NYSE. From the beginning, regulations governed trading. The constitution spelt out detailed rules for the transaction of business and imposed fines to keep disorderly brokers in check. The new stock exchange rented a room at 40 Wall Street where the brokers gathered twice a day to trade a list of 30 stocks and bonds. From the podium the president called out the name of each security in turn, while the brokers shouted bids and offers from the chairs assigned to them. This was the origin of the term “seat” which, ever since, has signified a membership on the NYSE.
You should read the history. It is short and will help give you context.
The SEC has the responsibility to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC supervises many, if not most, market participants (i.e., the various parties identified below). This 2013 10-pager by the SEC provides about as good a summary as I’ve seen.
A self-regulatory organization (“SRO”) oversees and manages its industry by developing rules that all members must adhere to. SROs are tasked with the enforcement of the restrictions they implement and discipline individuals that violate SRO rules. Examples of SROs include state bar associations that govern attorney conduct, the National Association of Realtors, and the Motion Picture Association of America.
More relevant examples are (1) the Financial Industry Regulatory Authority (“FINRA”), which is the largest SRO in the securities industry and the frontline regulator of broker-dealers, (2) securities exchanges, and (3) clearing agencies.
FINRA oversees broker-dealers who operate in the over-the-counter (“OTC”) market. The SEC, in turn, regulates and oversees FINRA.
FINRA is not a government agency, but it is authorized by Congress to protect investors by making sure the broker-dealer industry operates fairly and honestly. It oversees more than 624,000 brokers-dealers firms, capital acquisition brokers, and funding portals.1 A crowdfunding intermediary must register with the SEC as a broker or as a funding portal and become a member of FINRA. Here is a list of all such funding portals. To learn more about funding portals, read The (Thorough) Art of Evaluating Crowdfunding Sites and Title III Offerings or Alternative Assets and the “Average” Accredited Investor Installment #7: Crowdfunding Under Title III of the Jobs Act or Portals & Broker-Dealers: Comparing Types of Investment Intermediaries in Crowdfunding
The NYSE is an example of a “securities exchange.” Various exchanges operated by Nasdaq are other examples. A securities exchange is where securities are bought and sold. There are 15 securities exchanges registered with the SEC as national securities exchanges. You can see a full list here.
The two types of clearing agencies are clearing corporations and depositories.
Examples of clearing firms include the National Securities Clearing Corporation (“NSCC”) and the Fixed Income Clearing Corporation (“FICC”). Both are subsidiaries of the Depository Trust and Clearing Corporation (“DTCC”).
I don’t want to detour, but here is a sense of what DTCC is:
Transfer agents maintain a record of ownership, including contact information, of an issuer’s registered shareholders. Brokers, on the other hand, maintain records of beneficial shareholders.
Transfer agents’ responsibilities also include the transfer, issuance, and cancellation of an issuer’s shares. Other core services provided by a transfer agent include: dividend payments, tax reporting, annual meeting services, direct stock purchase/dividend reinvestment plan administration, escheatment and lost shareholder search and report filing, issuance for secondary offerings, stock option issuance, restricted stock transfers, communication with shareholders on behalf of the issuer.
Transfer agents may also provide additional services for shareholders and issuers, including online account access, employee equity compensation services, and corporate action services.
A transfer agent also acts as a registrar to help ensure that the corporation does not issue more shares of stock than have been authorized. While previously, the duties of a registrar were segregated from those of a transfer agent, today, the duties of a transfer agent and registrar are generally performed by one entity. In their capacity as registrar, transfer agents maintain records of the total authorized, issued, and outstanding shares and also track the issuance and cancellation of shares.
The transfer agent and registrar are generally appointed by a resolution of a company’s board of directors.
The duties of a transfer agent and registrar may be performed by an issuer in-house. However, in most corporations with widely held share ownership, keeping track of stock issuance and ownership is a considerable task in this increasingly complex regulatory environment. As a result, the vast majority of issuing companies outsource this function to a commercial transfer agent.
What is a broker? Taking a step back from the topic of investing, a broker is someone who buys and sells something for third parties or who connects buyers and sellers so they can do business directly. The word “intermediary” means the same thing (if you take the time to do your own research, you will see that some sources agree with me, but some draw a distinction). You may be familiar with business brokers, real estate brokers, insurance brokers, etc.
It’s probably pretty obvious what a broker does in the context of investing: a broker, as defined by US securities laws, is “any person engaged in the business of effecting transactions in securities for the account of others.”3 The Securities Exchange Act of 1934 (“Exchange Act“) governs the way in which the US’s securities markets and its brokers and dealers operate. The definition of “broker” is contained in Section 3(a)(4)(A) of the Exchange Act. So, a person who executes transactions for others (that is, who acts as an agent for others) on a securities exchange clearly is a broker, though there are lots of other activities that will cause one to be a broker.
A dealer, on the other hand, acts as a principal and is defined by Section 3(a)(5)(A) of the Exchange Act as “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.”4 Note that the definition of “dealer” does not include a “trader,” that is, a person who buys and sells securities for his or her own account, either individually or in a fiduciary capacity, but not as part of a regular business. Individuals who buy and sell securities for themselves generally are considered traders and not dealers. As a practical matter, most brokers are also dealers, and most dealers are also brokers, thus the term “broker-dealer.” The SEC’s Guide to Broker-Dealer Registration is a good resource if you want to read a little more about this subject.
Section 15(a)(1) of the Exchange Act generally makes it unlawful for any broker or dealer to use any means of interstate commerce to “effect any transactions in or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the Commission in accordance with Section 15(b) of the Act.
Electronic Communications Networks (“ECNs”) are automated electronic trading systems that will find, purchase, and sell orders at a price as indicated by users. ECNs are registered with the SEC as broker-dealers which is apt, given that they eliminate the need to use any other broker-dealer.
Investment advisors are individuals or firms that offer advice about making investments to investors or deliver reports or analyses about securities.
Don’t confuse a broker-dealer with an investment advisor; there is a world of difference between these two professions. Read The Doctor and the Drug Dealer: A Parable of Registered Investment Advisers and Broker-Dealers and 5 Questions to Ask a Financial Advisor Before Hiring to understand these crucial distinctions.
As noted above, FINRA oversees broker-dealers who operate in the OTC. So what’s the OTC? The end of Installment #1 goes into some detail (in the section titled, “Not All Public Companies Trade on a National Securities Exchange”). Here’s a little more technical detail. Go read that, and then come back here and read what follows.
Welcome back. You now know that more than 12,000 stocks, including Adidas, Bayer, Daimler, Mitsubishi, Nestle, and Volkswagen trade on the OTC. But what is the OTC? As I say in Installment #1, when a stock is bought or sold OTC, the transaction does not take the form of an auction. Rather, each transaction takes the form of a contract between seller and buyer. What this means is that dealers (as in broker-dealers discussed above) act as market makers by quoting prices at which they will sell (“ask” or “offer”) or buy (“bid”) shares of particular stocks. Again, as explained above, dealers buy and sell on their own account, and they make their money the same way any other buyer or seller does- by selling for more than they buy. That markup or “spread” is how a dealer makes its money. If you want to dive deeper into this, read Markets: Exchange or Over-the-Counter by Randall Dodd, writing for the International Monetary Fund.
A good argument can be made that stocks that trade OTC are inherently riskier than those that trade on an exchange. It’s true that, generally speaking, smaller, less established companies trade OTC and that, in many cases, they do so because they cannot satisfy the listing requirements of an exchange. A good argument can also be made, however, that it is possible to find companies that trade OTC which have far more growth potential as compared to companies that trade on an exchange.
Just as consumer credit rating agencies (like Equifax, TransUnion, and Experian) rate peoples’ creditworthiness, corporate credit rating agencies rate the creditworthiness of companies. And investors can use these ratings to help them decide what securities to buy and sell. Thus, corporate credit rating agencies play an important role in investing.
The top corporate credit rating agencies are Moody’s Investor Services, Standard and Poor’s (S&P), Fitch Group, and Morningstar Inc. A very good quick read to learn more is Corporate credit ratings: a quick guide by Rothschild. Each assesses the credit risk of specific debt securities as well as the credit risk of the entity issuing those debt securities.
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer”, by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
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