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Overview of the Securities Industry | 15 CHAPTER 1

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Overview of the Securities Industry

The business you are about to enter is an important cog in the machinery of the U.S. and world economies. As a financial intermediary, broker-dealers help the wheels of our free market system turn smoothly.

FINANCIAL A financial intermediary is a business that helps channel money from INTERMEDIARIES those who have an excess they wish to put to work—savers and investors—to those who need funds for some purpose, both businesses and individuals. These intermediaries include banks, broker-dealers, and insurance companies. A simple example of a financial intermediary is a bank. This institution accepts deposits (for example, savings accounts) on which it pays interest, and lends the money to borrowers (for example, someone who wants to borrow money to buy a car). The bank earns the difference (called the spread) between the interest it pays to depositors and the interest it charges to borrowers. This program, however, will focus on a different type of intermediary, the brokerage firm or broker-dealer. While banks act as intermediaries by accepting deposits and making loans, broker-dealers act as intermediaries by facilitating the purchase and sale of securities, such as bonds and common stock.

What is a Broker-Dealer? As financial intermediaries, broker-dealers (BDs) can act in one of two ways (capacities): as a broker or as a dealer (hence the name brokerdealer).

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16 | Overview of the Securities Industry

Acting as a Broker

When acting as a broker, the firm acts as a matchmaker between someone who wants to buy a security and someone who wants to sell. For example, an individual has 100 shares of stock to sell. The brokerdealer at which the individual has an account locates another person who wishes to buy 100 shares of that stock. The BD arranges the trade and charges a fee, called a commission, for its services. The BD is also said to act as the customer’s agent in the trade. The terms ‘‘broker’’ and ‘‘agent’’ are used interchangeably. A trade in which a BD acts as a broker is also called an agency trade. In reality, most agency trades involve two brokers, one representing the buyer and one representing the seller. In this way, each customer is represented by a firm looking out for their interests, much like each side in a legal dispute being represented by a lawyer.

Acting as a Dealer

Instead of acting as the customer’s agent, some BDs act as dealers in certain transactions. For example, if a BD has a customer who wishes to sell 100 shares of stock, the firm might choose to buy the stock itself, rather than finding someone else to buy the stock from the selling customer. The BD uses its own funds to purchase the stock and places the stock in the firm’s own account. The BD hopes to resell that stock to another investor at a higher price than it paid for the stock, thereby earning a profit. In this method of arranging transactions, the BD is acting as a dealer, also known as acting as a principal.


When acting as a principal, a BD hopes to earn a profit on the difference between what it paid for the stock and what it receives upon selling the stock. However, there is no guarantee the firm will be able to sell the stock for more than it paid. It might suffer a loss instead. So, acting as a dealer creates more risk to the BD than acting as a broker, but it also has the potential to be more profitable. Whether a firm acts as a broker or a dealer in particular transaction depends on a number of factors, including the type of security involved, the amount of risk the firm wishes to take, and the nature of the established method for buying and selling that particular security (the security’s market). We will be discussing many of these issues later in this course. However, one thing a BD is NOT allowed to do is act as a broker and a dealer in the same transaction. Since these roles are incompatible, it must choose one or the other.

Registered Representatives The broker-dealer employees who act on the firm’s behalf when dealing with customers or executing transactions are known as registered representatives, or RRs. Not all broker-dealer employees are RRs. Those who perform clerical or administrative duties are not required to be registered representatives. Generally, those who solicit or transact business for the firm are considered RRs. When you pass the Series 7 Examination and complete your registration process, you will be a General Securities Representative. This allows you to perform a wide range of securities activities, but most RRs

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specialize in a particular area. The tasks you will perform depend on the types of businesses your firm has chosen to enter. In the next section, we will review the types of activities in which broker-dealers engage.

COMPREHENSION 1. CHECK

Adam receives a confirmation in the mail verifying a transaction in which he bought some stock through his broker-dealer. The confirmation has a section labeled ‘‘capacity.’’ The information in this section would tell Adam A. B. C. D.

2.

his tax status for this trade. the stock exchange on which the trade was executed. whether the firm acted as a broker or as a dealer. how much more stock Adam can buy in the account without depositing more funds.

Adam noticed that the firm charged him a commission for arranging the stock purchase. This means the firm acted as A. an agent. B. a principal.

3.

A broker-dealer assumes greater risk when acting as a A. broker. B. dealer.

4.

For a broker-dealer, which of the following actions is a violation of industry rules? A. B. C. D.

5.

Buying stock from a customer for its own account Not charging a commission for executing a trade as an agent Refusing to act as a principal Selling a customer stock from its own inventory and charging the customer a commission

A place where securities are bought and sold is known as a(n) A. B. C. D.

center. agency. market. broker.


Answers on Next Page

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Answers 1.

C

A broker-dealer’s capacity refers to whether the firm acted as a broker or as a dealer in a transaction. Written confirmations of transactions must state (disclose) a BD’s capacity in the trade. 2.

A

The fee charged by a BD when acting in a broker (agent) capacity is called a commission. In a later chapter, we will describe in more detail how a brokerdealer makes money on dealer (principal) trades. 3.

B

When acting as a dealer, a firm buys and sells stock for its own account (inventory). Like anyone else who owns stock, a dealer might lose money if the value of the stock declines. 4.

D

A firm selling stock from its own inventory is acting as a dealer. While this in itself is acceptable, the firm cannot also charge a commission, which can be earned only if it acts as a broker. A BD cannot act as a broker and as a dealer in the same transaction. 5.

C

A place where securities are bought and sold is a market.

SERVICES OFFERED BY BROKERDEALERS

To pass the Series 7 Exam, you must be familiar with the products and services offered by broker-dealers. Many broker-dealers do not provide all of the services described in the overview provided in this section, instead choosing to specialize in one or two areas. However, some firms (full-service firms) have a wide range of departments to meet most client needs. These departments include the following.

Investment Banking The investment banking department helps businesses and other entities raise capital through the sale of securities. Companies raising capital by selling securities are called issuers. (The selling of new securities to investors is called the primary market.) In addition to organizing the sale

Overview of the Securities Industry | 21

Raising capital for corporations and other businesses is sometimes referred to as corporate finance. But there are nonbusiness entities that also need to raise capital by selling securities. For example, state and local governments issue municipal bonds to finance large projects. The area of the investment banking department that handles this specialty is known as public finance. Another area of investment banking is mergers and acquisitions (M&A), which assists businesses that are interested in combining with or purchasing other businesses.

Retail Sales While the investment banking department organizes the distribution of securities by issuers, prospecting and closing sales is the responsibility of other areas. The retail sales department handles most transactions with individual investors. The contact that most people have with broker-dealers is through the RRs who work in this area setting up and servicing customer accounts. The largest firms emphasize this aspect of the securities business, often having many branch offices located around the country. They are sometimes called wirehouses, since their branches are linked electronically to a central location, often in New York, for receiving and processing orders. Many retail customers are served by regional and local brokerage firms. Regional firms usually have smaller, more geographically concentrated branch office networks than wirehouses. Local BDs may have only a few branches or just one office. Some regional and local firms also have investment banking departments to serve the needs of local companies that are too small to use the services of larger investment banks. While the Series 7 Exam will test you on all types of services that might be provided by a broker-dealer, there is particular emphasis on the role of retail RRs and their relationships with their clients. Pay particular attention to customer-related issues, such as required disclosures and suitability of recommendations.

Institutional Sales Institutional investors are usually entities formed as corporations, partnerships, or trusts. Many (although not all) of these investors employ

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of the securities for the issuer (the distribution of the securities), investment bankers also provide the issuer with advice regarding the structure of the issue and help with regulatory requirements, such as Securities and Exchange Commission (SEC) filings.

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professionals to make their investment decisions, often portfolio managers employed by investment advisory firms. Institutional investors include mutual funds pension funds endowments and charitable trusts bank trust departments The needs of institutional investors are often different from those of retail investors. They tend to execute trades for large numbers of shares at a time (block trades), which must be handled carefully or the order could cause prices to move significantly (much like dropping a large rock in a small pond). A skilled broker-dealer can execute an institutional order at a better price than a broker-dealer that is less experienced at handling large trades. As a result of these special needs, institutional customers’ accounts are normally serviced by RRs who specialize in this type of business. As we will see, many rules and regulations have exceptions or special provisions that take into account the differences between institutional and retail investors.

Trading We have seen that one method for executing a customer trade is for the brokerage firm to act as a dealer, buying the security for its own account or selling the security from its own account. The RRs who execute these transactions on behalf of the BD are known as traders. The trading department in which these RRs work is also known as the trading desk. Some firms may have separate trading areas for each type of security, e.g., a bond desk to handle bond trades. Interdealer Trading

Many of the principal transactions that occur in securities markets are between dealers. For example, Dealer X may wish to increase its inventory of ABC stock in response to a perceived increase in interest on the part of its retail customers. X would let other dealers that might have ABC stock they wish to sell know of its buying interest by communicating a bid to other dealers. A bid is a price a dealer is willing to pay to buy a security. The amount that the dealer is willing to buy is the size of the bid. For example, a dealer might bid 20 ($20 per share) for 1,000 shares of ABC common stock. A dealer that wants to sell stock announces to other dealers its interest by making an offer. For example, Dealer Q offers ‘‘500 ABC at 20.10,’’ indicating it is willing to sell 500 shares of ABC to another dealer at $20.10 per share. The offer price is also known as the ask price.


Making bids and offers is the basic method for arranging securities transactions in all markets. Markets differ in how those bids and offers are communicated to interested contra parties (the party on the other side of the trade). On the Series 7 Exam, you will be expected to be familiar with the difference between how market participants communicate on traditional exchanges (such as the NYSE) versus other markets (such as Nasdaq). Market Makers One particular type of dealer is central to how many securities markets operate—the market maker. A market maker is a dealer that stands ready to buy or sell a particular security on a continuous basis. In other words, a dealer that wants to buy ABC stock could contact a market maker in that stock, knowing the market maker is prepared to provide an offer. Likewise, any dealer that wants to sell ABC could contact the same market maker and receive a bid. So market makers will state (quote) two prices at all times: a bid price at which it will buy stock and an offer price at which it will sell stock.

Research Recommendations about which securities to buy or sell and when to buy or sell them are one of the features that attract clients to firms that provide such advice. These recommendations, and the data that backs them up, are produced by research analysts. Analysts often work in a separate area: the research department.

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The information produced by analysts is distributed in a number of ways. In some cases, the information is channeled through retail and institutional RRs to clients as a perk to those customer for their business. Some firms produce written research reports, which, these days, are often distributed electronically.

KEY CONCEPT

RRs who make recommendations to customers must have reasonable grounds for believing their recommendations are suitable.

Some of the information needed to determine when a recommendation is suitable (appropriate) for a customer will be gathered from the client by the RR, who must ‘‘Know the Customer.’’ But RRs must also ‘‘Know the Product’’ in order to be sure their recommendations are suitable. Much of this information is provided by research analysts. Since research analysts frequently have the most detailed knowledge of specific companies and industries, they are also a valuable resource for their firm’s investment banking department. The investment banking area may use a particular analyst to help it structure a deal for an issuer, or to provide advice regarding mergers or acquisitions. Since RRs must be able to understand and interpret research reports and other financial data, you should be familiar with the basic techniques used by analysts to do research. Some analysts employ technical analysis while others use fundamental analysis. Each type will be explored briefly in a later chapter.

The Back Office The back office is a term used to describe the broker-dealer departments that support the operations of the departments we have described thus far. One of the most important back office functions is clearance and settlement. Clearance refers to the process of verifying trade information to be sure that the buying and selling broker-dealers agree on the terms of the transaction. If they do, the trade is cleared for settlement, the process of exchanging securities for money to complete the trade contract. A number of departments contribute to this effort, including the following. Order Room When RRs accept orders from customers, they send the orders to this department, which then sends (routes) the order to the appropriate market for execution. The order room also tracks outstanding orders and receives execution reports back from the market to which it sent the order.


KEY CONCEPT

Know the sequence in which an order is processed through a BD’s back office. The sequence is Order Room Purchase & Sales Margin Dept. Cashiering. To remember this, think Other People’s Money is Capital.

Efficient back office operations are essential to the financial health of a broker-dealer. More than one BD has failed because of inadequate recordkeeping. RRs also play a part in creating and maintaining a broker-dealer’s records, such as collecting new account information from customers. As you progress through this program, pay particular attention to the recordkeeping responsibilities of registered representatives. As you can imagine, setting up all of the operations required in a broker-dealer’s back office can be complex and expensive. Many firms therefore hire other broker-dealers to perform their back office functions. For example, Broker-Dealer J wants to use its capital to make markets in several stocks and does not want the expense of setting up a back office. It contracts Broker-Dealer N to provide these services. N, in fact, provides back office services for many other broker-dealers as well. N is a clearing broker-dealer, while J is called an introducing broker-dealer.

COMPREHENSION In questions 6 - 10, choose the most appropriate broker-dealer department as the CHECK answer. (A choice might be used once, more than once, or not at all.) A. Retail Sales B. Purchase & Sales C. Research

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Purchase & Sales Department This area is responsible for clearing the trade. It sends written confirmations of transactions to customers and verifies trade information with the contra broker. Margin Department This area is responsible for customer accounting. It posts money and securities purchases and sales to customer records and determines how much money is due on a particular trade. Cashiering Department Also known as “the cage” from the days when this department was protected by iron bars, the cashiering department is responsible for receiving and delivering securities and money, both in transactions with customers and with other brokerdealers.

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D. Investment Banking E. Trading F. Institutional Sales G. Cashiering 6.

A client says she has not yet received a confirmation for some stock she sold recently. With what department would the RR check to see if the confirm was sent?

7.

Sara works for HiTop Advisors, an investment advisory firm. Sara’s job is to manage the pension funds of several corporations. Which department is most likely to have Sara as a client for her personal account?

8.

Ratchets, Inc. would like to acquire another company with products that would compliment its existing product line. Which broker-dealer department would most likely provide advice to Ratchets?

9.

A customer has sent a check to a broker-dealer to pay for some recently purchased municipal bonds. Which department will most likely receive and process this check?

10. Broker-Dealer L is a market maker in XYZ stock. Jack is the RR who buys and sells XYZ for L’s account. Jack works in which department?

11. What is a market maker? A. An organization that operates a stock exchange or an electronic trading system B. A dealer that is prepared to buy or sell a specific security on a continuous basis 12. Arrange the following back office departments in the sequence in which they process orders. I. II. III. IV. A. B. C. D.

Margin Department Cashiering Department Order Room Purchase & Sales Department I, III, IV, II III, I, IV, II III, IV, I, II IV, II, I, III


Answers on Next Page

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Answers 6.

B

The purchase & sales department is responsible for sending written confirmations to customers. 7.

A

While Sara probably has the most contact with institutional sales in her professional role as a portfolio manager, her personal account is most likely the responsibility of an RR in retail sales. 8.

D

Providing advice on mergers and acquisitions is usually a function of the investment banking area, although M&A might be a separate department in some firms. While it is true that an analyst in the research department might have the most detailed knowledge in the firm about companies like Ratchets, analysts typically provide input on mergers and acquisitions by supporting the investment banking department. 9.

G

The cashiering department handles money and securities received into and delivered out of the broker-dealer, while the margin department would determine how much the customer owed the firm. 10. E RRs in the trading department execute transactions for the firm’s account. 11. B A market maker is a dealer that stands ready to buy or sell a specific security on a continuous basis (which usually means during normal trading hours for that security). To indicate their willingness to buy or sell, market makers quote both a bid and an offer (ask) price for that security. The bid price is the price at which the market maker is willing to buy the security. The offer or ask price is the price at which it is willing to sell the security. 12. C Remember, Other People’s Money is Capital stands for Order Room, Purchase & Sales, Margin, Cashiering.


REGULATION OF If you do not realize it just yet, there is a fact that will become clear to THE SECURITIES you soon—the securities industry is a highly regulated business. The INDUSTRY fact that you are now studying for the Series 7 Exam is a consequence of some of those regulations, and to pass the exam, you must be familiar with the rules that affect you as an RR.

Federal Securities Laws The securities industry is regulated in the U.S. by both the federal government and by the states. State regulation is the subject of a separate exam that you may have to take, Series 63. The Series 7 Exam focuses on federal regulations. The Securities and Exchange Commission

The Securities and Exchange Commission (SEC) is an independent government agency responsible for interpreting and enforcing federal securities laws. The federal securities laws themselves were created and passed by Congress, but many parts of the laws require or allow the SEC to pass rules providing more specific guidance to the securities industry as to what procedures to follow and what practices to avoid. The Commission consists of five members appointed by the President and confirmed by the Senate. No more than three Commissioners may be from the same political party. Much of the day-to-day work of the SEC is carried out by its permanent staff. Part of the SEC’s staff investigates possible violations of federal laws and SEC rules. Securities Act of 1933

The Securities Act of 1933, also known as the Securities Act or the ’33 Act, was the first piece of federal legislation to regulate the sale of securities. However, the only sales it regulates are sales of new issues of securities to the public (the primary market), such as those in which a broker-dealer’s investment banking department would be involved. The purpose of the Act is to correct abuses that were perceived to have contributed to the stock market crash of 1929. The focus of the ’33 Act can be seen in its original name: the Truth in Securities Act. It attempts to accomplish this by requiring issuers to tell the truth about new securities they are selling to raise capital. The issuer must register the new securities with the SEC and must disclose any material information about the offering. Material information is information that would be considered relevant to a typical customer’s decision about whether to buy the new issue. How this is done, and how the law affects the investment banking and sales activities of broker-dealers, will be discussed in detail later.

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Note that disclosure is a basic principle of federal securities law. Under the disclosure approach, important information is made available to investors, who can then make informed investment decisions.

KEY CONCEPT

As long as the issuer fully discloses all material information about the offering, it is up to the investor to decide whether to buy the offering. The SEC does not make judgments about the investment merits of securities registered with it, and the document given to customers describing the new issue (the prospectus) contains a prominent statement (the no approval clause) to that effect.

Note that not all new issues must be registered. Some are exempt from registration. Many of these exemptions will be described later. Securities Exchange Act of 1934

While the Securities Act of 1933 focuses on the sale of new issues, its sequel, the Securities Exchange Act of 1934, governs the sale of ‘‘old’’ issues—securities that have already been issued and are being traded between investors. This is known as the secondary market. Stock exchanges are examples of places where secondary market trading occurs. They were brought under federal regulation by the Exchange Act, hence its name. Additional provisions of the Act include: Prohibits fraudulent or manipulative activity in the secondary market, such as insider trading Requires issuers with securities trading in the secondary market to file periodic financial information with the SEC Regulates and requires registration of broker-dealers Authorizes the Federal Reserve Board to regulate the use of credit to purchase securities (margin rules) Created the Securities and Exchange Commission (Q: So if the SEC was created in 1934, who administered the ’33 Act in its first year? A: The Federal Trade Commission. Use that at the water cooler.)

KEY CONCEPTS

You should remember the main purposes of the ’33 and ’34 Acts. The Securities Act of 1933, which was created first, regulates the primary market. The Securities Exchange Act of 1934, which was created second, regulates the secondary market.

Other Federal Securities Laws

In addition to the ’33 and ’34 Acts, there are several other federal securities laws we will mention during this program, including:


Protects investors who buy corporate bonds by requiring issuers to appoint a trustee to look after their interests and to describe the rights of bondholders in a written document (the trust or bond indenture). Investment Company Act of 1940 Regulates the structure and activities of pooled investments, such as mutual funds and variable annuities. Investment Advisers Act of 1940 Regulates the activities of firms that charge fees for providing investment advice to clients. Regarding the last act, note that investment advisory firms must register with the SEC just as broker-dealers must register. Some firms operate only as an investment adviser or only as a broker-dealer, but many operate, and register, as both.

Self-Regulatory Organizations One additional feature of the Securities Exchange Act of 1934 is especially noteworthy when preparing for the Series 7 Exam. The ’34 Act allows the brokerage industry to regulate itself through self-regulatory organizations (SROs). Self-regulation is another important principle of U.S. securities laws. Although the SEC is the government agency with the overall authority for supervising the securities industry, it delegates many of the day-to-day supervisory activities to SROs. These are entities organized by their broker-dealer members with the authority to create sales practice and other rules that are binding on members. The SROs also inspect their member BDs to ensure they are following both SEC rules and the rules of the self-regulatory organization. SROs have the authority to discipline their members and RRs through fines, suspensions, and other sanctions. There are a number of securities industry SROs. Exchanges

To use the facilities of a stock exchange, a broker-dealer must be a member of that exchange. Member firms are required to follow that exchange’s rules, as are the RRs who work for those member firms. Although each exchange is a separate SRO, the most important for Series 7 Exam purposes is the New York Stock Exchange (NYSE). When discussing stock exchange rules in this program, assume we are talking about the NYSE, with one exception—rules for options exchanges will generally be those for the Chicago Board Options Exchange (CBOE), the first and largest options market.

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Trust Indenture Act of 1939

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NASD

Broker-dealers that are not members of the NYSE or any other exchange have the National Association of Securities Dealers (NASD) as their primary SRO. The NASD is the BD regulator for most transactions that do not occur on an exchange. This is known as the over-the-counter (OTC) market. Since new issues are not sold on exchanges, regulating brokerdealers in the primary market is one of the NASD’s responsibilities. The administration and enforcement of the SRO’s rules is the responsibility of NASD Regulation (NASDR), the regulatory arm of the NASD. TEST TAKING TIP

The good news is that most SROs have similar rules that apply to RRs. The bad news is that there are a few exceptions. Where these differences are relevant, a question might read ‘‘Under the rules of the NYSE...’’ or ‘‘According to MSRB rules....’’ As we review SRO rules, we will compare and contrast any important differences.

MSRB

As recently as 1975, broker-dealers that operated in the municipal bond market were not subject to regulation by an SRO. That changed with the creation of the Municipal Securities Rulemaking Board (MSRB). Broker-dealers that engage in municipal bond transactions for themselves or on behalf of customers must join and follow the rules of the MSRB. Note that the MSRB does not have the authority to regulate the state and local governments that issue municipal bonds; they may only regulate the firms that buy and sell them. Many broker-dealers operate in a number of markets and are subject to the rules of the SRO that regulates that market. For example, BrokerDealer X is an NYSE member, makes markets in OTC stocks, and operates a public finance department. For its exchange transactions, it follows NYSE rules. When operating in the OTC market, NASD rules govern, except for municipal bonds transactions, where MSRB rules are in force. The SEC has oversight authority over securities industry SROs. This means that SROs must submit most changes in their rules to the SEC for review and approval. The SEC also reviews the enforcement efforts of the SROs to make sure they are supervising their members with sufficient vigilance. If the SEC finds that an SRO’s enforcement efforts are inadequate, it can sanction the self-regulator through fines and other disciplinary measures.

COMPREHENSION For questions 13 – 17, match the description with the corresponding securities CHECK law. (A choice might be used once, more than once, or not at all.) A. Trust Indenture Act of 1939 B. Investment Adviser Act of 1940 C. Securities Exchange Act of 1934


E. Securities Act of 1933 13. Regulates the operation of the Abstract Common Stock Fund (a mutual fund)

14. Requires Fossil Corp. to tell investors all relevant facts about a new offering of bonds it is selling to the public 15. Authorized the creation of the SEC 16. AssetMax Financial, which sells portfolio management services to institutional investors, must register with the SEC because of this act. 17. Allows the Federal Reserve Board to limit the amount of money brokerdealers can lend to customers who wish to buy securities on credit.

18. Broker-dealers and RRs are only bound to follow SEC rules. The rules of selfregulatory organizations are merely recommendations for good business practices. A. True B. False 19. Which SRO is the main regulator for broker-dealers selling new issues? A. B. C. D.

NYSE NASD MSRB SEC

20. Broker-dealers are allowed to belong to only one self-regulatory organization. A. True B. False

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D. Investment Company Act of 1940

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Answers 13. D Mutual funds are a type of investment company and are regulated by the Investment Company Act of 1940. 14. E Although the Trust Indenture Act of 1939 requires Fossil to create a written bond indenture describing the rights of bondholders, it is the Securities Act of 1933 that requires full disclosure of all material (relevant) facts about the offering. 15. C Provisions of the Securities Exchange Act of 1934 created the Securities and Exchange Commission. 16. B Firms that charge fees for investment advice, such as portfolio management, must register with the SEC as investment advisers under the Investment Advisers Act of 1940. 17. C While the SEC is the main securities regulator, the ’34 Act gave the Federal Reserve Board the power to regulate purchases of securities on credit. 18. B SRO rules have teeth. Member firms and their RRs can be fined, suspended, or have their license revoked by a self-regulatory organization for SRO rule violations. 19. B New issues are sold in the over-the-counter market, making the NASD the SRO for that area (except for municipals). NOTE: The golden rule for dealing with Series 7 Exam questions is RTFQ (Read The Full Question). In this item, one might think “Doesn’t the SEC regulate new issues through the ’33 Act?” True, but the question asks which SRO is the main regulator for new issues. The SEC is not a self-regulatory organization; the NASD is. Any word in the stem of a question could be the clue to the correct answer, or could help you eliminate incorrect answers (called “distractors” in test jargon). 20. B If a broker-dealer chooses to enter a particular area of the securities business, it must follow the rules of the SRO that governs that area. This might require it to belong to more than one SRO.


PASSING THE SERIES 7 EXAM

We have painted the preceding overview of the securities industry to provide a background for the many details to come in the remainder of the course. But before we go on, its time to get personal for a minute and discuss how you should go about preparing to pass the Series 7 Exam.

Applying for Registration Taking and passing the Series 7 Exam is only one step in the process of registering as a representative of your broker-dealer. Through the registration department of your firm, you should have filled out a Uniform Application For Securities Industry Registration or Transfer, better known as Form U-4. You cannot arrange an appointment to take your Series 7 Exam until this form has been processed, so if you have not completed this task yet, do so as soon as possible. The information on your completed U-4 will be submitted by your broker-dealer to the Central Registration Depository (CRD), which processes these forms for all industry SROs. Once your form has been processed, an exam enrollment period will open for you. This period lasts 120 days and you may take the Series 7 Exam anytime during that period.

Making an Appointment to Take the Series 7 Exam The Series 7 Exam is given at Sylvan Prometric Technology Centers. To make an appointment, you must call the Sylvan Prometric Registration Center at (800) 578-6273. A list of test center locations can be found on the NASDR Web site at http://www.nasdr.com/exam/userlistlocations.asp, or call the Sylvan Prometric Registration Center. At the test center, the exam is presented on the PROCTOR system, a computer-based system that delivers most of the securities industry exams. For more information on the PROCTOR system and the testing process, see http://www.nasdr.com/2630d.asp#1.

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TEST TAKING TIP

This is a long exam that can be very tiring. If you are not wellrested, you may find it difficult to concentrate toward the end of the test and this can lead to avoidable mistakes. Make sure you get a good night’s sleep before your test session. Don’t pull an allnighter just before the exam. To get an idea of the energy level you will need for the Series 7 Exam, take the Simulated Series 7 Exam at the end of this program in the manner recommended.

What is the Series 7 Exam Like? The Series 7 Exam is a 250-item test (The exam will also contain unidentified 10 trial questions that do not count toward your score, so you will actually see 260 items.) The exam is divided into two 125-item halves. Three hours and five minutes of testing time is allowed for each half, for a maximum total time of six hours and ten minutes. The items on the Series 7 Exam are four-choice, multiple-choice questions. They are similar in style to the items on the Practice Exams at the end of this course. As we progress through this program, we will discuss the types of items you will see on the test and provide some test-taking tips for dealing with them, some of which you have already encountered. Topics Covered

There are a variety of ways to break out the topics that are tested on the Series 7 Exam, but the following categories seem to be the most useful when planning out a program of preparation for the test. The figure following each topic represents the approximate number of items on that topic on the 250-question Series 7 Exam. Options (50) Municipal Bonds (50) Bonds (other than municipals) (25) Handling Customer Accounts (25) Regulations (25) Processing Orders (15) Packaged Products (15) Markets (15) Research (10) Taxation (10) Direct Participation Programs (5) Equities (5) Confidentiality

While the SROs provide guidance regarding which topics are covered on the Series 7 Exam and the item formats used, the items you will see on the exam are copyrighted and may not be reproduced. In addition, you may not divulge these items to anyone, including other candidates, RRs, or even a supervisor. Violations of the confidentiality of the exam can result in disciplinary action against a person associated with a broker-dealer.

Preparing for the Exam The Series 7 is a difficult examination—only about 2/3 of those taking the test pass it. However, your chances of passing Series 7 Exam are


1. A solid understanding of the topics covered on the test The text material will provide you with a sound base of knowledge in the topics tested. Note that the Comprehension Checks and Answers within each chapter are an essential part of the learning experience. They will teach you new material and also help you attain objective #2 discussed below. Even if you find you have answered a question correctly, do not skip over the explanation—it may contain new information or a tip for you. 2. Good test taking skills As you progress through this program, you will encounter a number of tips designed to improve your testtaking skills. Good test-taking skills can have a significant impact on your Series 7 Exam test score, and could mean the difference between passing and failing. The tests in this course have been carefully constructed to maximize your chances of success on Series 7 Exam. Each of the four types of tests has specific objectives. The Comprehension Checks within each chapter are designed to help illustrate the concepts you need to know for the exam, and to check your comprehension of the material you have just read. While some of these questions will have the same four-choice format as those on the Series 7 Exam, many have alternative formats to help you learn the material. There are five Unit Exams spaced at intervals throughout the program. Starting at 25 questions in length, the exams increase in size by 25 items with each test. The exams focus on the material just covered in the previous unit, but also include questions from all previously covered material, to help you review and retain that information. The items will have the same formats as the questions you will encounter on the Series 7 Exam, and they will help to hone your test-taking skills. After completing the text material and the five Unit Exams, you will take three Special Exams (Customer Accounts Exam, Municipal Bonds Exam, and Options Exam), followed by six Practice Exams. Although half as long as a Series 7 Exam, the Practice Exams will be weighted to provide a distribution of topics similar to that on the actual exam. We recommend taking each Special Exam and each Practice Exam twice—once in the Learning Mode and once in the Testing Mode. • When taking an exam in the Learning Mode, you should check the key for each item immediately after answering that item. Also,

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much better than average if you follow this program as designed. Since your goal—and ours—is a passing score on your Series 7 Examination, being able to successfully handle the types of questions you will encounter on the test is the main focus of this program. This requires you to attain two important objectives.

CHAPTER 1


immediately read the explanation, even if you chose the correct answer. This will help you review and retain the material. • When taking an exam in the Testing Mode, answer all test items before checking your answers. This provides you with practice in conditions that are more like those of the actual Series 7 Exam. The last step in your study program is the Simulated Series 7 Exam. This is a 250-question test, administered in two 125-question sections. Each section has a 3-hour time limit. You should take both sections on the same day, with a one-hour break between them, to mimic even more closely the conditions under which you will take the Series 7 Exam.

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