Chapter 2 - BD Operations Flashcards
Acting as an agent vs principal
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)
Dual agency (aka cross trade)
BD acts as a conduit by serving as the broker for both buyer and seller
A firm acting as principal is taking more ________
Financial risk (could be exposed to losses on stock value)
Market maker
Firm that stands ready to buy or sell a specific security on a principal basis
Bid price
Price a market maker is willing to pay for a security
Ask price/offer price
Price at which a market maker is willing to sell a security
Quote
Bid and offer together comprise a market maker’s quote
Spread
Difference between bid and offer price
Size of quote
Amount of stock market maker is willing to trade (# shares)
Default quote size
100 shares
How do dealers make money?
- On the spread of a stock trade, i.e. buy at $20.00 sell at $20.05
- Appreciation of stock holdings
- Charge retail customers a markup above the wholesale (interdealer) price (conversely, markdowns on purchases from retail customers)
Riskless principal transaction
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.
Life of a trade starts when ______
A registered representative accepts an order from a customer
Order ticket
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.
Regulation SHO
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.
Long vs short
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)
Rule 200 (Definitions, Order Marking, which securities does this rule apply to, aggregation of positions)
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)
Criteria for independent trading unit aggregation
- BD has a documented organization plan that identifies each aggregation unit with specified trading objectives and supports its independent identity.
- At the time of each sale, each aggregation unit of the firm determines its net position for every security that it trades
- All traders in an aggregation unit must follow the trading objectives or strategy of that unit and may not coordinate with another unit
- Individual traders may be assigned to only one aggregation unit at a time.
Rule 203 (Borrowing and Delivery Requirements)
If a BD knows that an order is marked long, it must make delivery by the settlement date (may not use borrowed securities)
Exceptions to Rule 203 (using borrowed securities to make delivery)
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
Rule 203 Locate requirements
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.
Easy to borrow list
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.
Fail to deliver (FTD)
Firm did not deliver a tradeable asset (either seller doesn’t deliver security or purchaser doesn’t deliver cash)
Affirmative determination
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)