Market Participants and Their Roles

Every securities trade passes through several hands. The exam describes a job and asks which player does it. This lesson names each player and gives it one defining job.

Investors: who puts up the money

An investor buys securities to make money. The exam sorts investors three ways.

• A retail investor is an individual who invests for their own account, usually in small amounts.
• An institutional investor is an organization that invests large pools of money. Examples include a pension fund, mutual fund, insurance company, or university endowment.
• An accredited investor is a person or entity that passes an SEC test for income, net worth, or professional credentials.

FINRA treats an account as institutional when the entity holds at least $50 million in total assets. An individual is accredited with a net worth above $1 million, not counting the home. Income of $200,000 in each of the last two years also works, or $300,000 with a spouse. So does a Series 7, 65, or 82 license in good standing.

These labels overlap. A wealthy doctor is both a retail investor and an accredited investor. Accredited status opens private offerings that are closed to everyone else. The logic is simple: the more money and knowledge you have, the fewer protections the SEC gives you.

Broker-dealers: who takes the order, who holds the assets

A broker-dealer is a firm that trades securities. As a broker it acts as agent for a customer and earns a commission. As a dealer it trades its own inventory for a markup. Most firms do both, which is why the two words are joined.

The exam splits broker-dealers by who holds the customer's money.

• An introducing broker-dealer takes customer orders and owns the customer relationship. It holds no customer cash or securities.
• A clearing broker-dealer, or carrying firm, holds the customer cash and securities, settles trades, and sends confirmations and statements.
• A prime broker gives one large client, usually a hedge fund, a single place for custody, margin lending, and reporting. The client still trades at other firms, called executing brokers.

Advisers: investment advisers and municipal advisors

An investment adviser is a firm or person paid to advise others about securities. Advisers register under the Investment Advisers Act of 1940.

An adviser with $110 million or more under management must register with the SEC. An adviser with $100 to $110 million may choose the SEC or its state. Below $100 million, an adviser registers with its state.

Two differences from a broker-dealer show up constantly.

• Pay. An investment adviser charges a fee, often a percentage of assets. A broker-dealer earns a commission per trade.
• Duty. An investment adviser owes a fiduciary duty at all times. A broker-dealer must meet Regulation Best Interest when it recommends a security to a retail customer.

A municipal advisor advises a state or local government on issuing municipal securities. Municipal advisors register with the SEC and follow MSRB rules. MSRB Rule G-42 gives them a fiduciary duty to their municipal entity clients.

The exam loves this trap: the underwriter on the same bond deal owes the issuer no fiduciary duty. The underwriter buys the bonds to resell them, so its interest sits opposite the issuer's. MSRB Rule G-17 makes the underwriter disclose that.

Issuers, underwriters, traders, and market makers

An issuer is the entity that creates and sells a security to raise money. Corporations, cities, and the US Treasury are all issuers.

An underwriter is a broker-dealer that brings the issuer's securities to market. It prices the deal, forms a syndicate, and distributes the securities. In a firm commitment the underwriter buys the whole issue and carries the resale risk. In a best efforts deal it sells as an agent and carries no risk.

A trader buys and sells securities, either for customers or for the firm's own account. A market maker is a dealer that quotes both sides of a market. Its bid is what it will pay; its ask is what it will sell for. It stands ready to trade at those quotes, which supplies liquidity, and earns the spread.

Who holds it, who records it

• A custodian holds cash and securities for safekeeping and handles settlement. Banks and clearing broker-dealers do this work. A custodian makes no investment decisions.
• A trustee holds and manages assets for someone else's benefit under a trust document, and owes a fiduciary duty. The Trust Indenture Act of 1939 requires a trustee on a public bond issue from a corporation. The trustee must enforce the indenture for the bondholders.
• A transfer agent works for the issuer. It keeps the record of who owns the securities, processes transfers, pays dividends and interest, and mails proxies. Transfer agents register with the SEC.

DTCC and OCC: the plumbing

The Depository Trust & Clearing Corporation (DTCC) is the parent of the main US post-trade companies. Its depository, DTC, holds securities in book-entry form. Ownership moves by ledger entry instead of paper certificates.

Its clearing corporation, NSCC, nets trades between broker-dealers and guarantees settlement. Settlement runs T+1, one business day after the trade, since May 2024.

The Options Clearing Corporation (OCC) does that job for listed options and one thing more. It issues every listed option contract and guarantees performance. If the writer of your call walks away, the OCC still delivers. That is why nobody checks the credit of the other side of an options trade.

How this gets tested

Most questions give you a job and want the player. Who keeps the shareholder list? The transfer agent. Who holds the securities in an introduced account? The clearing firm. Who guarantees a listed option? The OCC.

Three pairs the exam likes to swap:

• Investment adviser (fee, fiduciary) against broker-dealer (commission, Regulation Best Interest).
• Municipal advisor (fiduciary to the issuer) against underwriter (no such duty).
• DTC, which holds securities, against NSCC and the OCC, which settle and guarantee.