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Series 27 > Chapter 2 - BD Operations > Flashcards

Chapter 2 - BD Operations Flashcards

1
Q

Acting as an agent vs principal

A

Agent (aka Broker) = when customer wants to execute a trade, BD locates an investor to take the opposite side of the trade and arranges the best price for its customer; once trade is settled, BD receives commission on trade

Principal (aka Dealer) = BD takes on role of counter party itself, i.e. BD buys or sells stock for/from its own inventory (proprietary account); earn gain/loss on sale

Note that a BD cannot act in both capacities (conflict of interest)

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2
Q

Dual agency (aka cross trade)

A

BD acts as a conduit by serving as the broker for both buyer and seller

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3
Q

A firm acting as principal is taking more ________

A

Financial risk (could be exposed to losses on stock value)

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4
Q

Market maker

A

Firm that stands ready to buy or sell a specific security on a principal basis

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5
Q

Bid price

A

Price a market maker is willing to pay for a security

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6
Q

Ask price/offer price

A

Price at which a market maker is willing to sell a security

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7
Q

Quote

A

Bid and offer together comprise a market maker’s quote

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8
Q

Spread

A

Difference between bid and offer price

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9
Q

Size of quote

A

Amount of stock market maker is willing to trade (# shares)

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10
Q

Default quote size

A

100 shares

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11
Q

How do dealers make money?

A
  1. On the spread of a stock trade, i.e. buy at $20.00 sell at $20.05
  2. Appreciation of stock holdings
  3. Charge retail customers a markup above the wholesale (interdealer) price (conversely, markdowns on purchases from retail customers)
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12
Q

Riskless principal transaction

A

Principal trade in name only. Economic equivalent of agency trade. This is when a BD accepts an order from a customer for X shares of Y stock, buys X shares of Y for its own account, then immediately turns around and fills the customer’s order. These are treated as broker transactions for regulatory purposes.

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13
Q

Life of a trade starts when ______

A

A registered representative accepts an order from a customer

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14
Q

Order ticket

A

Contains an order’s terms and conditions; a written order ticket is required to be prepared. At each step along the way, additional information is added to the order ticket to compile a record of how the order was handled. A BD must retain a copy of the order ticket in accordance with SEC rules.

Also called an agency order memorandum. Must be prepared before an order is executed.

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15
Q

Regulation SHO

A

Adopted in 2004 to modernize short selling rules. Applies to equity securities and any security convertible into equity (i.e. convertible debt). Requires orders to be marked either long or short. Includes Rules 200, 203 and 204. Applies to exchanges, OTC, Pink Sheet.

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16
Q

Long vs short

A

Long = seller owns the security being sold (or it’s in possession of the BD and reasonably can be expected to deliver the security by the settlement date)
Short = seller is borrowing the security being sold, does not own (or it’s in possession of the BD and is not expected to deliver by the settlement date)

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17
Q

Rule 200 (Definitions, Order Marking, which securities does this rule apply to, aggregation of positions)

A

Under this rule, a person is considered to own a security if he has purchased the security; has entered into an unconditional and binding contract but has not received the security; OR has received notification that a position (convertible security, futures contract, call option) will be physically settled.

The order-marking (long vs short) requirement is part of this rule.

Also according to this rule, a BD must aggregate all of its positions of a security to determine its net position, except in instances where the BD qualifies for independent trading unit aggregation.

This rule applies to equity securities traded over any exchange (NYSE/Nasdaq, OTC)

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18
Q

Criteria for independent trading unit aggregation

A
  1. BD has a documented organization plan that identifies each aggregation unit with specified trading objectives and supports its independent identity.
  2. At the time of each sale, each aggregation unit of the firm determines its net position for every security that it trades
  3. All traders in an aggregation unit must follow the trading objectives or strategy of that unit and may not coordinate with another unit
  4. Individual traders may be assigned to only one aggregation unit at a time.
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19
Q

Rule 203 (Borrowing and Delivery Requirements)

A

If a BD knows that an order is marked long, it must make delivery by the settlement date (may not use borrowed securities)

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20
Q

Exceptions to Rule 203 (using borrowed securities to make delivery)

A

A BD may use borrowed securities to make delivery if:
1. The BD is lending a security to another BD
2. The BD knows or has been led to believe the seller owns the security being sold and will deliver by the settlement date, but fails to deliver
3. Good faith mistake but the BD used due diligence and buying another security would create undue hardship

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21
Q

Rule 203 Locate requirements

A

Prior to effecting a short sale, a BD must locate securities that can be used for delivery by settlement date. This protects against uncovered short selling abuses.

A BD may not accept an order to sell short unless one of the following is met:
1. BD has borrowed the security or entered into an arrangement to borrow the security
2. BD reasonably believes that it can borrow the security for delivery on the date delivery is due

The aforementioned condition must be documented.

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22
Q

Easy to borrow list

A

Provide reasonable grounds for believing a security will be available to be borrowed. Must be <24 hours old. Expedites the fulfilment of the locate provision.

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23
Q

Fail to deliver (FTD)

A

Firm did not deliver a tradeable asset (either seller doesn’t deliver security or purchaser doesn’t deliver cash)

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24
Q

Affirmative determination

A

This provision requires firms (prior to entering a short sale) to make affirmative determination of the availability of the stock to be borrowed to cover a short sale

Applies to equity securities only (not nonconvertible debt securities)

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25
Q

Threshold FTD rules of Reg SHO (under Rule 203)

A

Under Regulation SHO, if a BD has a FTD position at a clearing firm in a threshold security for a continuous period of 13 settlement days, the BD must close out the FTD by purchasing securities itself (which must take place no later than BOD day after the 13th settlement day). Must make arrangements to purchase and must not have reason to know that the other firm will not deliver.

Until the broker-dealer closes out the fail, it must borrow, or arrange to borrow (i.e., pre-borrow), the security prior to effecting an additional short sale in the security, and cannot effect a short sale for its own account.

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26
Q

Threshold security

A

Any equity security registered in accordance with Section 12 of the Securities Exchange Act of 1934 (or for which the issuer must file reports in accordance with sections 15(d) of the Act), AND:
1. There’s an aggregate FTD position for 5 consecutive settlement days at a clearing firm for 10,000 shares or more and equal to at least .5% of the total outstanding shares of the issuer
2. A SRO has included the security on a threshold securities list sent to its members (FINRA sends daily)

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27
Q

Threshold list

A

Maintained by various SROs including FINRA, listing securities which meet threshold requirements to force BDs to clear FTD positions

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28
Q

Limitations on short sales and close-out requirement caused by FTD positions are not applicable to…

A

the amount of the FTD in a threshold security if the equity position has been created by a registered options market maker that executed the short sale to establish or maintain a hedge on options positions and the hedge was created before the security became a threshold security

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29
Q

Rule 204 (Regulation SHO) - Closeout requirements

A

Unless a certain exemption applies, a BD that has a FTD (on the security side) is required to immediately purchase or borrow (or pre-borrow) the security to close out the fail. In other words, requires a BD to deliver a security by settlement date (T+2) or purchase/borrow the security by the next (settlement day) morning. If not in compliance, no short sales on this security are permitted by the BD.

Generally this will prevent the threshold security rule from having to operate (because BDs won’t have FTDs for 13 consecutive days)

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30
Q

In Regulation SHO, settlement day _____ business day

A

Is the same as

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31
Q

Exceptions to Rule 204 (close-out)

A

Long sales - closeout requirement is 3 extra days (T+5)
Bona fide market making activities (registered options market maker, etc) - closeout requirement is 3 extra days (T+5)
Similar to Rule 203, there’s an exception if the fail was the result of the sale of a security by someone who owns the security (or on behalf of), and the BD knows the person will deliver when all possible restrictions have been lifted

32
Q

Required order information

A

Short/long
Account number/name
Account type (cash/margin)
Security name/symbol
Terms and conditions (if none, assumed to be a market order)
- may include price (limit), stop-limit, good til cancelled (GTC - otherwise assumed to be a day order), etc
Discretionary order (discretion given to registered rep)/discretion not exercised
Solicited (if recommended by the firm or RR)/unsolicited (if completely initiated by customer)
**Note unsolicited =/= discretion not exercised
Cancel trade (cancel a previously entered trade)
Special instructions

Principal/agent does not need to be on order ticket

33
Q

Electronic orders

A

Now primarily used, subject to SEC standards/rules re: electronic records (must be in non-erasable format, accuracy must be automatically verified, storage must be serialized and time-dated, must be able to download records to a medium acceptable to regulators)

34
Q

Order room, aka wire room

A

Where RR sends an order ticket once it’s created. Order room routes the order to the proper market for execution.

35
Q

Listed stocks

A

Securities that trade on exchanges. Listed stocks generally must meet minimum financial and other standards (listing standards) and must apply to be listed.

Orders are routed to the marketplace with the best price (listed stocks trade on multiple exchanges as these are primarily electronic now, don’t rely on physical trading floors)

36
Q

OTC stocks

A

Securities not listed on an exchange. These are quoted on the electronic OTC Bulletin Board (OTCBB) or other OTC marketplace.

37
Q

How bonds are traded

A

Handled by a firm’s bond desk. Bond market is primarily OTC, processed through specialized systems for major categories (govt and agency bonds, corporate, municipal, asset-backed)

38
Q

Order life cycle

A

Registered representative prepares order ticket - Order room - Exchange - Execution - Execution reporting (back to order room) - Purchase and sales department (order confirmation) - Comparison - Settlement

39
Q

Exchange markets

A

Trades are executed via a single designated market maker (NYSE) or multiple market maker system (Nasdaq)

The SEC grants exchange status and permits exchanges to charge access fees

40
Q

2 most common types of orders

A

Market order
Limit order

41
Q

Market order

A

Most common type
Doesn’t specify price; executed at best price available
More likely to be executed than other types of orders, but price could be different from time the order was entered

42
Q

Limit order

A

Buyer/seller can set the price; order can only be executed at specified price or better (lower/higher for buyers/sellers respectively)
Usually these orders can’t be executed immediately, so they are given to a market maker to hold until it can be executed
Sometimes these orders are never executed because the limit price is not reached or there may be stock ahead (other orders at the same price with higher priority)

43
Q

Execution reports

A

After a trade is executed, it gets reported to information vendors and back to the order room/RR who wrote the order ticket to be sure the order was executed as ordered

44
Q

Purchase and sales department

A

Prepares a written confirmation of the transaction to send to the client
Compares trade information with the contra-broker (BD on other side of transaction) to ensure both parties agree to terms

45
Q

SEC Rule 10b-10

A

Requires BDs to send written confirmation of trades to customers, at or before the completion of the transaction

This rule is complex and varies from trade-to-trade but typically requires:
Security name and price
Number of shares/principal amount
Date and time of execution (or state this can be requested)
Capacity in which the BD acted (agent, principal, etc)
For debt securities, dollar price and yield
Settlement date
Type of call, call date and call price (if applicable)
Whether callable
Remuneration received by the firm (i.e. amount of commission)
Whether PFOF was received (per share amount not required)

46
Q

Commission

A

Charge that a BD assesses to customer for executing a trade

47
Q

Markup

A

In a principal transaction, difference in price between that charged to a customer and the prevailing intradealer price

48
Q

All commissions/markup must be _____

A

disclosed on the confirmation

49
Q

Payment for order flow

A

Fee paid by an executing firm to an originating BD for orders to be routed through them

Confirmations for transactions executed under this practice must disclose this fact (in addition to new account setup and annual disclosures)

50
Q

Requests for further information

A

Confirmations frequently contain an option for customers to request further information. If request <30 days after transaction, firm has 5 business days to respond. If >30 days, 15 days to respond.

51
Q

Errors - what to do?

A

If an error in a trade is discovered, RRs should bring to the attention of a supervisor. Resolution varies by error type.

52
Q

Control relationships

A

If a BD is under common control as an issuer and executes trades of that issuer’s stock, must disclose that fact prior to execution

Also applies to discretionary accounts

53
Q

Interest in a distribution

A

If a BD participates in a distribution of securities (syndicate member) and receives an advisory fee from a customer whom it wants to sell those securities, this conflict of interest must be disclosed

54
Q

What marks completion of a transaction?

A

Depends on timing of payment or delivery of securities by the customer:

Purchase - generally, when customer makes payment (or when bookkeeping entry is made, if payment is out of account, or if payment is done before payment is due, completion is at delivery)

Sale - at time of delivery (if BD has custody) or when security is transferred out of seller’s account (if no custody), or if delivery is made before due, completion is upon payment by the buyer

55
Q

Comparing the trade

A

Making sure selling BD records match purchasing BD records. Usually this is done through a clearing corporation like the NSCC.

BD sends info at end of trading day to NSCC - NSCC compares to contrabroker - results are returned to the BD the next day on a contract sheet

Cleared for settlement = information matched
Uncompared trades = did not match
Advisory trades = one firm submitted, other did not

BDs must reconcile uncompared and advisory trades and submit corrected information with the next report to the NSCC

56
Q

Ex-clearing

A

Transactions settled broker-to-broker, no clearing agency. Requires each party to send a written comparison to the contra-broker. Comparisons must be sent within 1 BD of trade date (or on the trade date for cash transactions settled on the trade date)

57
Q

Settlement

A

Buying BD pays the selling BD the amount owed.

Can occur once firms have matched trade data. Trade information is sent to the margin department to determine money or securities owed by the customer and to the cashier’s department (or the cage) which is responsible for receiving/delivering securities/money

58
Q

Broker to broker settlement

A

Cashiers dept of one firm delivers directly to cashiers dept of other firm

59
Q

Standard settlement date

A

T+2 aka 2 business days after trade date. Also called regular-way settlement

60
Q

Exceptions to standard settlement

A

Cash trades (same day settlement)
Seller’s option trades (seller can delay settlement if he cannot make timely delivery)

61
Q

Cash trade

A

Trade bought or sold for cash instead of margin or borrowed capital

62
Q

Trade doesn’t settle as expected - what’s the usual cause?

A

Typically when selling customer hasn’t supplied the security to selling BD, so it cannot deliver the security to purchasing BD. This results in a fail to deliver (for selling BD) and fail to receive (for purchasing BD). However, does not negate the contract; delivery is still required.

63
Q

Accounting for fails

A

Purchaser:
Dr Security (bc it has purchased and now owns)
Cr. FTR

Upon eventual settlement:
Dr. FTR
Cr. Cash payment

Thus FTR is considered an liability (still owe the cash)

Opposite for selling BD - FTD is considered an asset (receivable)

Dr. FTD
Cr. Security (selling)

Dr. Cash
Cr. FTD

64
Q

A large number of fails can create ____ for a BD

A

financial risk, because the BD could be forced to purchase stock on the open market to deliver to the contra-broker, and holding stock inventory exposes a BD to price movement

65
Q

Continuous net settlement

A

Book-entry settlement through a securities depository, eliminating physical delivery. This method has simplified settlement and reduced the number of fails.

An example is DTC (Depository Trust Corporation), operates in conjunction with the NSCC. Physical securities are held at DTC and delivery between BDs is accomplished by a book-entry transfer.

Called continuous net settlement because NSCC nets all receipts/deliveries of securities and money at the end of each business day

66
Q

Close-outs (buy-in or sell-out)

A

If the BD causing the fail doesn’t rectify, the contra-broker may need to close out the trade itself.

Buy-in = buy the securities it’s supposed to be buying
Sell-out = (when other BD refuses to pay for the securities) sell in the open market to pay its customer

67
Q

Stock record department

A

Maintains a record of each security position of the BD (list separately long and short). Includes owners names and location of the shares (DTC or vault).

Long position = shows ownership (customers or BD’s account has a claim to these securities, securities borrowed, or FTD)
Short position = shows location of the securities (vault, bank loan, box, transfer, securities loaned, FTR)

Double entry system… 100 shares in to the customer’s claim record (long), 100 shares in to FTR (short), then when shares are delivered 100 shares out of FTR, into vault

68
Q

Stock record break

A

Long position =/= short position in the stock record in a particular security

69
Q

Fully disclosed basis

A

For firms which work together (introducing and clearing brokers for example), this means information about all customers will be shared between the two. Executing broker sends confirmations.

70
Q

Omnibus accounts

A

Single account set up by one BD at another BD to execute its customers trades without being fully disclosed

71
Q

Order allocation

A

A service offered by BDs to institutional clients like investment advisors where they accept large orders and then must allocate shares to multiple accounts (allocation info must be received by noon the next business day)

72
Q

Broker’s broker

A

A municipal bond dealer who specializes in executing orders for other dealers who are not active in the municipal bond market

Under SEC Rule 15c3-1, the Net Capital Rule, a broker’s broker is required to maintain a minimum net capital of $150,000. The firm may only transact business in municipal (not government) securities, and it may not maintain a proprietary account.

73
Q

Subsidiary ledger

A

Examples of records in subsidiary ledgers include:
- Securities in transfer, dividends and interest received, securities borrowed and securities loaned
- Funds borrowed and funds loaned (together with a record of the collateral as well as any substitutions in such collateral)
- Securities failed to receive and failed to deliver
- All long and all short securities record differences
- Repurchase and reverse repurchase agreements

74
Q

Exceptions to Rule 203 locate requirements

A
  • BD A has accepted a short sale from BD B. BD B must meet the locate requirement.
  • BD knows or has been led to believe that the seller owns the security being sold but the seller will not be able to deliver the security by the scheduled settlement date, BD must buy or borrow to close out the short position. This close-out must take place within 35 days after the trade date.
  • Bona fide market making activities
75
Q

Left vs right side of stock record

A

Left = long positions, stock borrowed
Right = FTR, stock loaned, bank loans, vault, box

Series 27 (9 decks)

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