1.2 Foundational knowledge
This chapter covers foundational concepts that the Series 9 exam builds upon. You likely initially learned this material when you first prepared for a FINRA exam, and may have gained real world experience related to these topics. There is no quiz for this chapter, but we recommend you review and retain this information to understand topics covered in future chapters.
At this point in your career, you’re probably well acquainted with the definition of a security. In layman’s terms, securities are investments initially sold to the public by issuers. Issuers are organizations that raise capital (money) through selling securities. Investors purchase securities, effectively funding that issuer’s activities.
From a small start-up company to the government, issuers come in all shapes and sizes. Issuers raise capital when a need is identified. Needs could range from expanding a business, hiring a significant amount of employees, or paying for deficit spending (like our government does). Real-world examples of issuers include:
Issuers raise capital by selling securities to the public. Legally speaking, a security is an investment of money into a common enterprise that is managed by a third party. For example, Coca-Cola Company stock (ticker: KO) is a security. If an investor purchases KO stock, they are investing in a ‘common enterprise’ (Coca-Cola) that is managed by a third party (Coca-Cola’s Board of Directors and management team).
All of the following investments, which are detailed later in this chapter, are considered securities:
Securities are first offered by investors in the primary market. “Issuer transactions” occur in this market, which involve the sale of a security with the proceeds collected by the issuer. For example, Instacart (ticker: CART) was offered to investors in the primary market via an initial public offering (IPO) in September 2023. Instacart (the company) sold 14.1 million shares at $30 per share, resulting in roughly $423 million in sales proceeds collected by the company.
After a security is first offered to investors by issuers in the primary market, the security trades between investors in the secondary market. Trades occurring in the secondary market are “non-issuer transactions,” which involve the sale of a security with the proceeds being collected by a party other than the issuer. For example, investors holding CART stock can sell the security to other investors in the stock market. If a sale occurs, the selling investor collects the sales proceeds (not the issuer).
Common stock is an equity security that represents ownership in a company. Investors purchase common stock for one of two reasons. First, the stock may experience growth (capital appreciation) if the stock price rises. Stock prices fluctuate in the secondary market based on demand. If a stock’s price rises (typically because the company is performing well), investors may liquidate (sell) their position at a higher price, locking in a capital gain (buy low, sell high). Second, investors may also collect dividend income if the issuer elects to share profits with its shareholders.
Preferred stock is another prominent equity security that represents ownership in a company. This type of security provides one primary benefit - dividend income. While only a small portion of issuers pay dividends on their common stock, dividend payments are expected by preferred stock investors.
A debt security represents a loan made to an issuer. When a debt security is offered in the primary market, the issuer collects capital (money) from investors in return for a pledge to pay back the borrowed funds with interest. Governments (U.S. and municipal) and corporations issue debt securities frequently to finance their operations.
Investment companies issue securities that are tied to pooled investment vehicles. For example, a mutual fund collects capital from investors (shareholders), which it then invests according to the fund’s stated objectives. A growth stock fund invests shareholder capital into stocks picked by the fund manager.
A hedge fund is similar to an investment company but is privately offered to wealthy individuals and financial institutions. This type of investment is usually not available to the general public, resulting in few rules or regulations imposed on the issuer. Conversely, investment companies are actively regulated because they’re available to all investors.
A broker-dealer is an entity engaged in the business of effecting transactions in securities for the account of others or for its own account. These are firms that act as intermediaries between investing customers and the securities markets. If a customer wants to buy or sell a security, a broker-dealer can facilitate the transaction.
A broker, or agency transaction occurs when a professional connects a buyer and seller, typically in return for a commission. This is what the broker-dealer legal definition refers to as ‘trading for the account of others.’ Broker/agency capacities are not specific to finance; real estate brokers, for example, work this way. If you hire a real estate agent (broker) to help you buy a home, their job is to find a property you’re interested in, and connect you with the seller. If a transaction occurs, they’ll be paid a commission.
Brokers in finance work the same way. If a broker-dealer operates in a broker or agency capacity, they connect their customer with another party to buy or sell a security, sometimes in return for a commission.
A dealer, or principal transaction, occurs when a professional trades directly with a customer utilizing their own inventory. This is what the broker-dealer legal definition refers to as trading ‘for his own account.’ Dealer/principal capacities are not specific to finance; car dealerships, for example, operate this way. If it was in good shape, you could sell your used car to a local dealership, typically at a price just below its market value (known as a markdown). The dealership would probably clean up the car and perform some maintenance, then put the car on their lot for sale. Another customer would then buy the car from the dealership, typically at a price just above its market value (known as a markup). The dealer earns the spread, which is the difference between the price they bought the car at and the price they sold the car at.
Dealers in finance work the same way. If a broker-dealer operates in a dealer or principal capacity, they buy securities from customers into their inventory at a marked down price, then sell those securities to other customers at a marked up price, earning the spread.
Together, the terms broker and dealer are an oxymoron (two contradictory terms). Broker-dealers can’t operate in a broker and dealer capacity simultaneously (at the same time during any one transaction), but they may operate in either capacity in any given transaction. One trade could be accomplished in a broker (agency) capacity, earning a commission after connecting a buyer and a seller, and the next trade could be a dealer (principal) transaction while selling securities out of inventory at a marked up price.
The following video is borrowed from Achievable’s SIE program, but you may encounter Series 9 test questions on the same topic.
The Securities and Exchange Commission (SEC) is the primary regulator in the securities markets. The SEC has three primary goals:
Protecting investors should be self-explanatory. In almost every instance we’ve discussed the SEC in this material, the organization intends to shield investors from fraud and unethical actions. Generally speaking, the SEC is most concerned with protecting retail investors. Institutions have access to significant legal and financial resources, making it unlikely for these professional investors to be victims of bad actors.
Maintaining fair, orderly, and efficient markets relates to ensuring confidence in the financial markets. This goal applies primarily to the secondary market.
Facilitating capital formation involves maintaining and regulating a system that allows issuers to raise capital (money) by selling securities.
The Financial Industry Regulatory Authority (FINRA) is the primary regulator representatives encounter while in the industry. Technically formed as a private organization, FINRA is a self-regulatory organization (SRO) that’s granted regulatory power (by the industry and the SEC) over securities professionals (member firms and representatives).
Generally speaking, FINRA handles “lower level” priorities related to firms and representatives, while the SEC oversees securities markets (primary and secondary markets). FINRA enforces its own rules and the rules of other SROs (e.g., the MSRB - discussed below).
The Options Clearing Corporation (OCC) is the primary options clearinghouse in the securities industry. As most clearinghouses operate, the OCC’s main priority is ensuring transactions are facilitated and executed properly. In 2022 alone, it cleared over 10 billion options contract trades. The OCC operates under the SEC’s jurisdiction.