REGULATION OF MARKETS AND BROKERS

The micro structure of markets

1. The current market structure is dispersed and complex: (1) trading volume is dispersed among highly automated trading centers that compete for order flow in the same stocks; and (2) trading centers offer a wide range of services that are designed to attract different types of market participants with varying trading needs

2. Can we say we have one stock market? No; there are lots of markets

   1. In one market, there would be more competition between buyers and sellers everyone would be in the same room

3. Central Order Book (COB)

   1. So if you have IBM, all the shares have to go into one computer network

   2. Proposed system allows for greater transparency

      1. And reduces the spread more competition between buyers/sellers

   3. But maybe buyers/sellers don’t just want the best price maybe they want other things, like service, anonymity

4. Dark pool: allows for discrete/anonymous trading

   1. So that large investors’ trading activity will not impact the share price

5. Trade-through rule

   1. If you have a sell order or buyer order, you have to expose the order

      1. The rule prohibits an incoming market order from ignoring (trading through) a better quote in market A to trade with a poorer quote in market B

      2. There is one computer linkup for all these markets

      3. Before the broker moves to market A, it has to expose the order for a very short period of time to see if another market picks it up

6. Electronic trading benefits investors in increasing the speed and lowering the cost of trading while at the same time creating a complete audit trail that facilitates monitoring brokers

7. Consolidated audit trail

   1. Electronic trail of the trades

      1. So SEC can come in after the fact to assess whether the trade-through rule was complied with

8. Payment order flow

   1. If the broker sends the order to market x, market x will send the broker a kickback

9. Unlisted securities trade in a number of markets today, all of which are electronic. The OTC Bulletin Board, operated by FINRA, emerged as a trading site for smaller issuers, but since 1999 the OTCBB has been limited to reporting companies under the ’34 Act, which made it less attractive to issuers unwilling to take on those responsibilities

   1. The major platforms for electronic “pink sheet” trading today are operated by OTC Market Groups

10. Difference between a broker and a dealer

    1. Broker acts only as an agent

    2. Dealer actually buys

       1. So dealers want disjointed markets/lack of transparency keep the spread large, and allow for bigger profits

          1. Because the more transparency/competition, the smaller the spread less profit

Registration of Brokers and Supervision Obligation

11. Much of the day-to-day work of regulating the broker-dealer industry is done by FINRA, the industry’s “self-regulator”

12. EA §15(a): no person may act as a broker or a dealer in securities unless registered with the SEC or expressly exempted from the registration requirement must also join FINRA

    1. 3(a)(4): Broker is a person engaged in the business of effecting transactions in securities for the account of others

    2. 3(a)(5): Dealer is a person engaged in the business of buying and selling securities for his own account

    3. “In the business” = generally, engage in the activity on a regular basis and typically in a fairly public fashion

       1. Website & frequency of contracting market maker

    4. Problem 18-1: dealer; public=website + contact market maker

    5. Problem 18-2: broker: public

    6. 18-3: yes, broker-dealer

13. 15(b)(1): the SEC may deny (or subsequently revoke) a registration based on evidence of misconduct or false statements to the Commission

14. The SEC has authority with respect to setting standard for both the conduct of broker-dealers and discipline

15. Issuer can create a bulletin board for its own shares (to enhance liquidity) without being a broker

    1. But they can’t receive money for it

16. Duty to supervise

    1. Broker-dealer duty: 15(b)(4)(E)

       1. Duty to supervise subordinates to prevent them from engaging in securities violation

    2. 15(b)(6)(A)

17. “Once a person in Feuerstein’s position becomes involved in formulating management’s response to the problem, he is obligated to take affirmative steps to ensure that appropriate action is taken to address the misconduct”

    1. Once lawyer is brought in, he needs to take affirmative steps to prevent a recurrence

       1. Has to exercise ongoing obligations to ensure future compliance

    2. Once such a person has supervisory obligation by virtue of the circumstances of a particular situation, he must either discharge those responsibilities or know that others are taking appropriate action

18. SRO “just and equitable” conduct rules

Brokers’ responsibility to the customer

19. Best execution

    1. The virtue of a “centralized” system is that an order will come together with all others, so that the resulting market price will reflect the full range of supply and demand

    2. A broker has a fiduciary-like duty to seek “best execution” for the customer

       1. Best execution refers to traders receiving the most favorable terms available for their trades

       2. Best execution does not connote a single execution attribute, such as a price, but rather attaches to a vector of execution components

          1. Moreover, when markets compete in different ways with respect to different components of trade executions, it is no longer clear what “best” execution is, let alone how or when it is attained

    3. The broker-dealer, absent instructions to the contrary, is expected to use reasonable efforts to maximize the economic benefit to the client in the transaction. That means “the best reasonably available price.”

    4. Broker has obligation to expose the order, and to constantly be thinking, “Can I get a better price somewhere else?”

    5. 202(a)(11) of Investment Advisers Act

       1. Investment adviser definition

          1. Is investment advice incidental to legal service?

             1. If yes, not investment adviser

       2. Must be compensated

       3. Investment advice can’t be generic as to resource allocation

       4. So your broker may be an investment...

Buy the full version of these notes or essay plans and more in our Securities Regulations (Duke Cox) Outlines.