Chapter 2 - BD Operations Part I

Question 1

Acting as an agent vs principal

Answer 1

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)

Question 2

Dual agency (aka cross trade)

Answer 2

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

Question 3

A firm acting as principal is taking more ________

Answer 3

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

Question 4

Market maker

Answer 4

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

Question 5

Bid price

Answer 5

Price a market maker is willing to pay for a security

Question 6

Ask price/offer price

Answer 6

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

Question 7

Quote

Answer 7

Bid and offer together comprise a market maker’s quote

Question 8

Spread

Answer 8

Difference between bid and offer price

Question 9

Size of quote

Answer 9

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

Question 10

Default quote size

Answer 10

100 shares

Question 11

How do dealers make money?

Answer 11

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)

Question 12

Riskless principal transaction

Answer 12

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.

Question 13

Life of a trade starts when ______

Answer 13

A registered representative accepts an order from a customer

Question 14

Order ticket

Answer 14

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. Order ticket must be marked as either long or short.

Question 15

Regulation SHO

Answer 15

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.

Question 16

Long vs short

Answer 16

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)

Question 17

Rule 200 (Definitions, Order Marking, When someone is considered to own a security, which securities does this rule apply to, aggregation of positions)

Answer 17

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)

Question 18

Criteria for independent trading unit aggregation

Answer 18

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.

Question 19

Rule 203 (Borrowing and Delivery Requirements)

Answer 19

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

Question 20

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

Answer 20

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

Question 21

Rule 203 Locate requirements

Answer 21

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.

Question 22

Easy to borrow list

Answer 22

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.

Question 23

Fail to deliver (FTD)

Answer 23

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

Question 24

Affirmative determination

Answer 24

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)

Question 25

Threshold FTD rules of Reg SHO (under Rule 203)

Answer 25

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.