11.5 Market Participants
Key Takeaways
- A broker acts as agent for a commission; a dealer acts as principal for a markup or markdown, and no single trade carries both.
- Market makers must post continuous two-sided quotes and honor them up to displayed size, earning the spread.
- FINRA registers, examines, and enforces; the MSRB writes municipal rules but does not enforce them.
- Transfer agents keep ownership records while custodians safeguard assets and process income and corporate actions.
- DTCC subsidiaries DTC, NSCC, and FICC provide depository and clearing services, with netting reducing settlements.
Broker-Dealers: Agent vs. Principal
A broker-dealer is a firm in the business of buying and selling securities. The capacity in which it acts on a given trade controls its compensation and its risk.
| Capacity | Role | Compensation | Market risk |
|---|---|---|---|
| Broker (agent) | Arranges a trade for a customer | Commission | None |
| Dealer (principal) | Trades from its own inventory | Markup/markdown | Bears it |
Most firms do both, hence "broker-dealer." A bedrock Series 7 rule: a firm cannot charge both a commission and a markup on the same transaction—it is one capacity per trade. When a firm sells from inventory it adds a markup; when it buys into inventory it takes a markdown.
Registration requirements: file Form BD with the SEC, join an SRO (FINRA), register in each state of business ("blue-sky"), and register associated persons.
Market Makers
Market makers supply liquidity by continuously quoting both a bid and an offer.
| Obligation | Detail |
|---|---|
| Continuous two-sided quotes | Always a bid and an ask |
| Honor quotes | Trade at posted prices up to displayed size |
| Minimum size | Generally 100 shares for equities |
Market makers earn the spread—buy at the bid, sell at the ask. They are not required to guarantee investors a profit; investors can still lose. Tighter spreads signal more competition and deeper liquidity.
Self-Regulatory Organizations
SROs are non-governmental bodies that write and enforce rules for members under SEC oversight.
FINRA (Financial Industry Regulatory Authority) is the primary broker-dealer SRO:
| Function | Description |
|---|---|
| Registration | Licenses firms and individuals |
| Qualification exams | Administers the Series 7 (125 scored + 5 pretest questions, 225 minutes, 72% to pass, $395 fee) |
| Rulemaking | Conduct rules for members |
| Enforcement | Investigates and disciplines |
The MSRB (Municipal Securities Rulemaking Board) writes rules for municipal dealers and advisors and operates EMMA, but it does not enforce its own rules—enforcement falls to FINRA (for broker-dealers) and bank regulators or the SEC. Exchanges such as the NYSE, NASDAQ, and the Cboe also act as SROs.
Transfer Agents and Custodians
Transfer agents keep the official ownership records for an issuer: they process transfers, issue and cancel certificates, distribute dividends, and handle corporate actions such as splits and mergers. They are regulated by the SEC.
Custodians safeguard customer securities and cash. Their duties include settlement (receive/deliver), income collection (dividends and interest), processing corporate actions, and reporting to beneficial owners. Bank custodians serve institutions; broker-dealers custody retail accounts. The exam trap: the transfer agent keeps the record of who owns the shares, while the custodian holds the assets.
Clearing Corporations
Under the DTCC holding company:
| Subsidiary | Function |
|---|---|
| DTC | Securities depository; book-entry ownership |
| NSCC | Equity and corporate bond clearing; central counterparty |
| FICC | Government and mortgage-backed securities clearing |
Netting dramatically reduces settlement volume. Example: Firm A owes Firm B 1,000 shares while Firm B owes Firm A 800 shares. Without netting, two deliveries occur (1,000 and 800). With NSCC netting, Firm A delivers a net 200 shares to Firm B—one obligation instead of two.
Investment Advisers
An investment adviser gives securities advice for compensation, governed by the Investment Advisers Act of 1940.
| Feature | Investment adviser | Broker-dealer |
|---|---|---|
| Standard | Fiduciary | Regulation Best Interest (Reg BI) |
| Pay | Fees, often a percentage of AUM | Commissions/markups |
| Registration | SEC if AUM > $100 million, otherwise state | SEC + FINRA |
| Core activity | Advice | Transactions |
The fiduciary standard requires the adviser to place the client's interest first; broker-dealers operate under Reg BI, a best-interest standard at the time of a recommendation.
SIPC and Customer Protection
The Securities Investor Protection Corporation (SIPC) protects customers if a member broker-dealer fails. It covers up to $500,000 per separate customer, of which a maximum of $250,000 may be cash. SIPC restores missing securities and cash, not market losses—it does not insure against a decline in a security's value. Membership is mandatory for nearly all registered broker-dealers, and "SIPC member" status must be disclosed.
Clearing vs. Introducing Firms
Broker-dealers split into two operational roles the Series 7 tests:
| Firm type | Role |
|---|---|
| Introducing (correspondent) firm | Handles the customer relationship and orders; does not hold customer assets |
| Clearing (carrying) firm | Holds customer cash/securities, clears and settles, sends confirmations and statements |
This division is documented in a clearing agreement, and customers must be told which firm carries their account.
Common Exam Traps
- Agent = commission, no risk; principal = markup/markdown, bears risk. A firm cannot charge both on the same trade.
- Market makers must post two-sided quotes and honor them up to size; they never guarantee investor profit.
- FINRA enforces; the MSRB only writes rules and runs EMMA—the MSRB has no enforcement power.
- Transfer agent = ownership records; custodian = safekeeping of assets. Do not merge these roles.
- SIPC covers $500,000 total / $250,000 cash per customer for a failed broker-dealer, not market losses.
- An investment adviser owes a fiduciary duty; a broker-dealer owes Reg BI, a recommendation-time best-interest standard.
A broker-dealer fills a customer's buy order by selling shares out of its own inventory. In this trade the firm acts as a:
Which statement about the MSRB is correct?
Which entity maintains the official record of who owns an issuer's shares and processes ownership transfers?