Let’s be honest—a lot of the arcane knowledge about financial transactions that Wall Street professionals need to know is absolutely irrelevant to today’s markets. That doesn’t mean you don’t need to know these rules, and if you don’t, you’ll never make money in finance.
Some of these rules seem absolutely bizarre, like rules on transferring paper coupons on corporate bonds. But the rules of America’s financial system are what helped it become the most dominant financial system in the world and the most active securities markets on Earth. Plus, knowing the history of how Wall Street operates helps a lot to understand why it is the way it is today.
Consider transaction rules, a big topic on the Series 7 that is also central to a lot of the value created by Wall Street firms. You may think you know what happens when you buy or sell a stock on an online brokerage—a database is edited and the shares are credited to a new account—but what actually happens is much more complicated.
It starts with the order ticket, which the SEC officially calls the order memorandum. This used to be a paper ticket, but online order forms on discount brokerages follow the same rules. The order ticket has to include the obvious details you’d expect (account number, registered rep’s ID number, type of trade, security being traded, etc), but there are two details that surprisingly aren’t on the ticket: the current market price of the security and the client making the order’s name (or other personal details). Yes, when you make an order for a stock your order ticket doesn’t have your name on it.
If the order memorandum has an error, an error report is necessary, and that is reported to the designated recipient of such reports in the firm, who must be a principal. These must be made immediately in writing and retained for three years, and the facts surrounding the error must be fully documented.
There can be misunderstandings or confusion between brokers, and sometimes a transaction goes unrecognized or seems to have errors by one party—in that case, a Don’t Know (DK) notice must be made. This applies to interdealer trades (remember interdealer confirmations must be sent no later than the next business day). Similarly, if there’s an error in submitting dividend, interest, or rights to a buyer because of a discrepancy on the settlement date, brokers can send Due Bills to the seller’s broker. Confirmations are sent for trades on or before the settlement date to avoid these kinds of problems.
Ultimately, it is the transfer agent’s job to determine whether a security has good delivery and, if it does, there shouldn’t be an issue with the transaction. Good delivery depends on the physical condition of the certificates, having the correct lot sizes (lots must be made into lots of 100 if there are odd lots), and being signed by the right people. For bonds, good delivery means the bonds are in denominations of $1000 or $5000 for bearer or coupon bonds, with fully registered bonds delivered in $1000 denominations up to $100,000.
To facilitate the trade, bonds and stocks can be submitted with a security power that shows ownership and allows the transfer of ownership to the seller. When signatures are made on this or the certificate directly, a Medallion imprint or stamp is required by a financial instiution, usually a bank. Invalid signatures can also be a risk for broker-dealers, and minors’ signatures are unacceptable on securities transactions. The certificates need to be in good physical form as well, although mutilated certificates can be transacted if connected to a surety bond and approved by the transfer agent, who is responsible for failed transactions. Muni bonds have to have their legal opinions on them if they aren’t ex-legal, and all assets have a CUSIP number.
If the trade is successful and error-free, as almost all are these days, the order memorandum will transmit the order to either a floor broker if not held, and held orders go to the order book. OTC orders can be executed as an agent or principal.
When the trade is executed, an execution report is made, the trade is reported to the consolidated tape or Nasdaq, the customer receives a confirmation, and the trade settlement is processed either through the margin or cashiering department of the firm.
For Nasdaq trades, prices are quoted in three levels, and these levels are pretty easy to remember. Level 1 (which looks kind of like an “i”) is for the inside market (which starts with an “i”). Level 2 is for all price/size quotes from market makers, which involves two M’s, hence it’s the Level 2 market. Level 3 is the level where market makers input, change, and update quotes—three changes to the level 3 market.
Note that the 3 levels, while tested, apply only to the Nasdaq because it’s an OTC marketplace. For other OTC securities like bonds, these three levels don’t apply.
What does apply for those securities is the ATS, the alternative trading system sometimes called dark pools. These are just trading desks for institutions that can execute large orders without affecting public prices, offering liquidity where public markets cannot. Despite the name, trades are reported if they involve FINRA members (which they almost always will in such a market).
Another system is used for reporting secondary OTC bond trading: TRACE. This is a reporting system only and it can be used to trace trades (hence the name) since it includes reports from both sides of each transaction of bonds within 15 minutes of execution or earlier, and they include all of the details you’d expect, including price and yield of the bond traded.
Almost all debt instruments are TRACE eligible, but foreign sovereign debt and money market instruments are not—and you can easily see why the rules would be different for both groups. Additionally, debt that isn’t depositary trust eligible (things like private placements and bonds that exist as physical certificates only—a rarity). TRACE is for reports only, it isn’t an execution or quotation system.
Additionally, all equity trades in exchanges (whether NYSE or OTC) must be reported in a Trade Reporting Facility. This includes Rule 144A trades and secondary resales of DPPs and other unlisted securities.
When trades occur, they aren’t always from trader to trader—especially today, market makers tend to be an essential function between the two. These designated market makers (DMMs) are required to make a market in the stock they trade, and they need to do this in a fair and orderly way during trading hours by displaying their best bid and ask prices on an exchange or OTC quote service like Nasdaq Level 3. DMMs lower volatility and lower the spread between bid and ask, and they can trade as agents or principals.
These trades occur on markets that exist after the primary market, which is when an issuer sells securities direct (well, most likely through an underwriter and syndicate if we want to be technically accurate) to buyers. When those buyers resell those shares, it’s in the secondary market.
The third market is when exchange-listed securities are sold OTC, typically from market makers and through broker-dealers.
The fourth market is when institutional investors buy and sell to one another through an electronic communication network. Remember that ECNs mean the fourth market; this topic shows up on the test a lot.
Finally, the grey market is as risky as it sounds, containing pink OTC securities that are traded without publicly quoted prices because of a lack of interest or demand for the securities.
When operating in this process of trading securities, a registered representative needs to follow the Uniform Practice Code, which ensures that transactions, disputes, and misunderstandings can be handled with as little friction as possible. As a result, there are a lot of rules firms must follow.
Good delivery is the standard for a successful transaction, which means the security is in good deliverable form and delivered on time. Regular way settlement is now t+1 for all securities (thankfully, this used to be much harder to remember!). Cash settlement occurs no later than 2:30 pm ET if executed before 2 pm and within 30 minutes if done afterwards (and remember trading stops at 4pm according to SEC rules). These terms can be modified by a customized seller’s or buyer’s option contract.
Muni bonds are a bit different and settle on a when-issued basis for new issues, meaning that they’re sold before issued and buyers must accept the terms. When-issued contracts can be confirmed with the security’s purchase price and yield as well as the trade date, but not before. This can be an issue because order confirmations can’t include a total dollar amount of settlement date since these are unknown until the bonds are issued—they also can’t include accrued interest. When the bond is issued, investors receive a new confirmation with the purchase price and settlement date—while this suggests risk in a municipal bond transaction, the low volatility of the market makes this a non-issue.