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Introduction

The capital markets exist to solve one problem: businesses and governments need money to build, hire, and operate, while households and institutions have savings they want to put to work. The markets connect the two, moving capital from those who have it to those who can use it, and pricing the risk of that transfer. This chapter builds the map you will use for the rest of the exam — how securities come into existence and then change hands, who oversees the system, and how the wider economy pushes prices up and down. None of it is hard, but it is foundational: the products in Chapter 2 and the trading in Chapter 3 all live inside the structure you learn here.

The single most important distinction in the whole chapter — and one the exam returns to again and again — is between the primary market, where a security is born and the issuer gets the money, and the secondary market, where that same security is later traded among investors and the issuer gets nothing more. Hold onto that difference; everything else hangs off it.

Primary vs. secondary markets

A security has a life cycle. It is created and sold for the first time in the primary market, and after that it trades between investors in the secondary market.

• The primary market is where the issuer raises capital. When a corporation or government sells a brand-new security, the money paid by buyers goes directly to the issuer. This is the only point in a security's life where the issuing company actually receives funds from it. An initial public offering (IPO) — a private company's first sale of stock to the public — is a primary-market event, as is any later sale of newly created shares (an additional or follow-on offering).
• The secondary market is where investors trade with each other. Once a security exists, investors buy and sell it among themselves on exchanges or over the counter. The issuer is not a party to these trades and receives none of the proceeds; the money moves from one investor to another. When you buy 100 shares of a long-public company through your brokerage, you are in the secondary market, and the company whose name is on the stock never sees your money.
• Why the distinction matters. New-issue (primary) transactions come with a prospectus and are governed mainly by the Securities Act of 1933. Secondary trading is governed mainly by the Securities Exchange Act of 1934. The exam loves to test whether a given transaction is primary or secondary, because the rules, the disclosure, and even the party who gets the money all depend on the answer.

The participants

A working securities market is a cast of specialized players, each with a defined job. Knowing who does what makes the rest of the exam far easier.

• Issuers are the entities that create and sell securities to raise capital: corporations (selling stock or bonds), the U.S. Treasury and federal agencies, and state and local governments (selling municipal securities).
• Broker-dealers are firms that stand between investors and the market. As you will see in Chapter 3, the same firm acts as a broker (agent) when it arranges a trade for a customer and charges a commission, and as a dealer (principal) when it trades from its own inventory and earns a markup. "Broker-dealer" is the umbrella term.
• Investment bankers (underwriters) are the broker-dealers that help issuers bring new securities to market — pricing the deal, handling the paperwork, and distributing the shares.
• Institutional vs. retail investors. A retail investor is an individual investing for a personal account. An institutional investor is a large entity — a mutual fund, pension plan, insurance company, or bank — that trades in large size and is presumed to be more sophisticated. Some rules treat the two differently.
• Transfer agents and clearing corporations handle the plumbing: a transfer agent keeps the issuer's record of who owns its securities, cancels and issues certificates, and handles name changes; a clearing corporation stands between the buying and selling firms after a trade to guarantee and settle it (Chapter 3).

The underwriting process and the prospectus

When an issuer wants to sell securities to the public, the Securities Act of 1933 requires it to register the offering with the SEC and give buyers a document that discloses the material facts and risks. The 1933 Act is often called the "paper act" or the "new-issues act" because it governs the issuance of securities.

• Underwriters and the syndicate. The issuer hires one or more investment banks — the underwriters — to advise on price and distribute the shares. For a large deal, the lead underwriter forms a syndicate, a group of firms that share the work and the risk of selling the issue. In a firm-commitment underwriting, the syndicate buys the entire issue from the issuer and resells it, taking on the risk of any unsold shares; in a best-efforts underwriting, the underwriters only agree to try to sell the shares and act as agents, returning whatever they cannot sell.
• Registration and the cooling-off period. The issuer files a registration statement with the SEC. A mandatory cooling-off period (a waiting period) then runs while the SEC reviews the filing. During the cooling-off period the securities may not be sold and no final confirmations may be sent, but the underwriters may gauge interest.
• The preliminary prospectus (red herring). During the cooling-off period, only a preliminary prospectus — nicknamed a red herring for the red-ink legend on its cover — may be circulated to prospective buyers. It contains most of the offering's information but omits the final public offering price and the proceeds to the issuer. It is used to solicit indications of interest, which are not binding orders.
• The final prospectus. Once the registration is effective, buyers must receive the final prospectus, which discloses the material facts, the risks, and the final offering price. Delivering the prospectus is what satisfies the 1933 Act's disclosure requirement.
• What SEC "clearance" does not mean. When the SEC clears a registration to become effective, it is not approving the security, guaranteeing the disclosures, or judging the investment's merit. The SEC only confirms that the required disclosures appear to have been made. Claiming the SEC "approved" a security is itself a violation — a favorite exam trap.

Exempt securities and exempt transactions

Not every sale of securities must go through full registration. Some securities are exempt from registration by their nature, and some transactions are exempt because of how or to whom they are sold.

• Exempt securities include U.S. government securities, municipal securities, and securities of certain banks and other regulated issuers. Because their issuers are governments or heavily regulated entities, they are not required to register under the 1933 Act the way a corporate stock offering is.
• Regulation D — private placements. Reg D permits an issuer to sell securities privately, mainly to accredited investors, without full SEC registration, in exchange for limits on general advertising and on the resale of the securities. Private placements are how many companies raise capital without an IPO.
• The accredited investor. An accredited investor is an individual or entity presumed able to bear the risk of an unregistered offering because it meets an income or net-worth threshold (for an individual, an income or net-worth test) or holds certain professional credentials. The exact dollar thresholds are set by SEC rule and can change; teach the concept, and confirm the current numbers. [See Facts to Verify.]
• Regulation A — smaller public offerings. Reg A allows smaller public offerings under a simplified disclosure document, sometimes called a "mini-registration." It has tiers with different size ceilings and disclosure requirements; the ceilings are set by rule and can change. [See Facts to Verify.]
• Rule 147 — intrastate offerings. An issuer doing business entirely within one state can raise money from investors in that same state under the intrastate offering exemption without federal registration.
• Rule 144 — resales of restricted and control stock. An exemption covers the original private sale; reselling those shares later is its own regulated event. SEC Rule 144 lets holders of restricted stock (acquired in a private placement) and control stock (held by officers, directors, and other affiliates) resell into the public market only after meeting holding-period, volume, and notice conditions set by the rule. The SIE tests the concept: restricted and control shares cannot simply be dumped on the market like ordinary registered stock.

The regulators and self-regulatory organizations

A layered system of federal agencies and self-regulatory organizations (SROs) governs U.S. securities activity. Each body owns a defined slice of authority. The exam expects you to match the regulator to its job.

• The SEC (Securities and Exchange Commission) is the top federal securities regulator, created by the Securities Exchange Act of 1934. It enforces the securities laws, reviews registrations, oversees the markets and the SROs, and can bring civil enforcement actions. Every SRO rule must be filed with and approved by the SEC.
• FINRA (Financial Industry Regulatory Authority) is the principal SRO for broker-dealers. It writes conduct rules for member firms and their registered representatives, administers the qualification exams (including the SIE), operates the CRD licensing system, and disciplines members that break the rules. FINRA operates under SEC oversight — it is not a government agency.
• The MSRB (Municipal Securities Rulemaking Board) writes rules for firms and professionals dealing in municipal securities. Importantly, the MSRB makes rules but does not enforce them on broker-dealers; enforcement is carried out by FINRA and the SEC.
• The Federal Reserve Board regulates the extension of credit in securities transactions (Regulation T, in Chapter 3) and conducts monetary policy (below). The U.S. Treasury issues government debt and, through its bureaus, oversees parts of the AML framework.
• State regulators (blue-sky laws). Each state has its own securities administrator and registration requirements, historically called blue-sky laws. A firm and its representatives may need to register at the state level in addition to the federal level.
• SIPC vs. FDIC — a classic trap. The FDIC insures bank deposits. SIPC (Securities Investor Protection Corporation) protects a customer's cash and securities held at a failed brokerage firm, up to set limits. Neither insures you against investment losses from the market falling — SIPC replaces missing assets when a broker-dealer fails, not money you lost because a stock went down. The coverage limits are set by statute; confirm current figures. [See Facts to Verify.]

The Federal Reserve and monetary policy

The Federal Reserve is the nation's central bank. It manages the money supply to pursue stable prices and maximum sustainable employment, and it does so by making credit either easier or harder to obtain. Its rate-setting arm is the Federal Open Market Committee (FOMC).

• Open market operations — the main tool. The Fed buys government securities from banks to add money to the banking system, which pushes interest rates down (an easing move); it sells government securities to drain money, pushing rates up (a tightening move). Open market operations are the Fed's most-used tool.
• The discount rate. The discount rate is the rate the Fed charges banks that borrow directly from it for short-term needs. Lowering it signals easier credit; raising it signals tighter credit.
• The reserve requirement. Banks must hold a fraction of deposits in reserve. Raising the requirement leaves banks less to lend (tighter); lowering it frees money to lend (easier). This is a powerful but bluntly used tool.
• Easy money vs. tight money. Easing (loosening) lowers rates to encourage borrowing, spending, and growth. Tightening raises rates to cool an overheating economy and fight inflation. When you see a policy move on the exam, translate it into "more money, lower rates" or "less money, higher rates."

Fiscal policy and economic indicators

Monetary policy is the Fed's job; fiscal policy belongs to Congress and the President, who use taxing and spending to influence the economy. Do not confuse the two — a frequent exam trap swaps them.

• The business cycle. The economy moves through repeating phases: expansion, peak, contraction (recession), and trough, then recovery. A common rule of thumb defines a recession as two consecutive quarters of declining GDP (gross domestic product).
• Inflation and the CPI. Inflation is a general rise in prices that erodes purchasing power; it is commonly measured by the Consumer Price Index (CPI). Deflation is a general fall in prices.
• Leading, coincident, and lagging indicators. Leading indicators (like building permits and stock prices) tend to move before the economy; coincident indicators move with it; lagging indicators (like the unemployment rate) move after it. The exam may ask you to classify one.