SIE Practice Exam 7

Answer: Exchanges are centralized auction markets for listed securities, while the OTC market is a decentralized network of dealers who negotiate prices

Exchanges such as the NYSE are centralized auction markets where listed securities trade and buyers and sellers compete on price. The OTC market has no central location: it is a decentralized network of dealers, including market makers, negotiating prices electronically, and it is where unlisted stocks and most bonds trade. Choice A simply reverses the two structures. Choice B is a classic trap — listed securities may lawfully trade off the exchange, and OTC trading of exchange-listed stock is called the third market. Choice D is false because the vast majority of corporate bond volume trades OTC through dealers, not on exchange floors. One nuance worth knowing: Nasdaq operates as a dealer-driven market but is legally registered as an exchange today.

The Trap: exchange-vs-otc-structure-flip

• Exchanges are negotiated dealer markets, while OTC trading takes place through a centralized auction: Misconception: flipping the two structures — exchanges are the auction markets; the OTC market is the negotiated dealer network.
• Securities listed on an exchange are prohibited from trading anywhere other than that exchange: Misconception: listed securities cannot trade OTC — they lawfully can; listed stock trading OTC is the third market.
• Most corporate bonds trade on exchange floors rather than in the OTC market: Misconception: bonds trade on exchanges — in fact, most bond trading occurs OTC in dealer markets.

Verified against: Securities Exchange Act of 1934 - national securities exchange vs. over-the-counter dealer market structure

Answer: An investor buys newly issued shares in the company's initial public offering through the underwriting syndicate

"Follow the money" is the test: only in the primary market does the issuer receive the proceeds. When an investor buys newly issued shares in an IPO, the money (net of underwriting compensation) goes to the issuing company — primary-market activity governed by the Securities Act of 1933. In each other choice, one investor is simply paying another: a purchase on the NYSE (choice B) is an ordinary secondary-market trade; an institution buying listed shares from an OTC dealer (choice C) is a third-market trade; and two institutions crossing a block on an ECN (choice D) is a fourth-market trade. All three are secondary-market activity governed by the Securities Exchange Act of 1934, and in all three the issuer receives nothing.

The Trap: primary-vs-secondary-who-gets-proceeds

• An institution buys the company's exchange-listed shares from a dealer in the OTC market: Misconception: primary vs. secondary — this is a third-market trade; it is still investor-to-investor and the issuer receives nothing.
• Two institutions trade the company's shares directly with each other over an ECN: Misconception: primary vs. secondary — this is a fourth-market trade; no proceeds flow to the issuer.
• An investor buys the company's shares from another investor on the NYSE: Misconception: primary vs. secondary — an exchange trade between investors sends money to the selling investor, not the issuer.

Verified against: Securities Act of 1933 (primary market/issuer proceeds) vs. Securities Exchange Act of 1934 (secondary market trading)

Answer: fourth market

Direct institution-to-institution trading with no broker-dealer intermediary — typically over ECNs or similar electronic systems — is the fourth market. The full ladder: first market = listed securities trading on their exchange; second market = unlisted securities trading OTC; third market = exchange-listed securities trading OTC through broker-dealers or market makers; fourth market = institutions trading directly with each other. Choice B is the most tempting trap: third-market trades still involve broker-dealers, while the fourth market cuts them out. Choice A fails because this trade occurs off the exchange, and choice C fails because the issuer receives no proceeds — a block trade between investors is secondary-market activity no matter its size. An easy way to remember the fourth market: "no broker at the door."

The Trap: third-vs-fourth-market

• third market: Misconception: third vs. fourth market — the third market is listed stock trading OTC through broker-dealers; here no broker-dealer is involved.
• primary market: Misconception: large direct sale = primary — the issuer receives no proceeds; a block trade between investors is secondary-market activity.
• first market: Misconception: listed stock = first market — the first market is exchange trading of listed securities; this trade occurs off the exchange.

Verified against: Standard securities-industry market classification (first/second/third/fourth market terminology) - no single governing rule

Answer: It is a legal alternative trading system offering anonymity and limited pre-trade transparency, commonly used for large institutional blocks

Dark pools are alternative trading systems that register with the SEC and operate under Regulation ATS — they are legal, which eliminates choice A; there is no requirement that all listed-stock trades occur on an exchange. Their defining feature is limited pre-trade transparency: orders are not publicly displayed before execution, which is exactly why institutions use them to move large blocks without moving the price — so choice B contradicts the venue's purpose. Choice D confuses venue with market type: whether a trade happens on or off an exchange, a sale between investors is a secondary-market transaction; primary-market transactions are sales by the issuer. Note that completed dark-pool trades are still reported publicly after execution — the darkness is pre-trade, not post-trade.

The Trap: dark-pools-are-illegal

• Dark pools are illegal because all trades in listed stocks must occur on a registered exchange: Misconception: dark pool = illegal venue — dark pools are legal, SEC-regulated alternative trading systems, and listed stocks may trade off-exchange.
• The dark pool must publicly display the fund's order before it can be executed: Misconception: all orders must be displayed pre-trade — limited pre-trade transparency is the defining feature of a dark pool.
• The sale will be a primary market transaction because it occurs away from an exchange: Misconception: off-exchange = primary market — a sale between investors is secondary-market activity regardless of venue; primary transactions are sales by the issuer.

Verified against: SEC Regulation ATS (17 CFR 242.300-304) governing alternative trading systems/dark pools

Answer: No — their net worth excluding the primary residence is below $1 million, their joint income is below $300,000, and a Series 6 registration is not a qualifying credential

Run each accredited-investor test from Rule 501 of Regulation D. Income: an individual needs more than $200,000, and a couple relying on joint income needs more than $300,000, in each of the last two years with a reasonable expectation of the same in the current year. Here neither spouse's $135,000 comes close to the individual test, and $270,000 jointly falls short of $300,000 — choice B applies the wrong (individual) threshold to joint income. Net worth: more than $1 million excluding the value of the primary residence; counting only the $700,000 of other assets, the couple misses the mark, and choice C makes the classic error of including the home. Professional credentials: since a 2020 SEC expansion, holders in good standing of the Series 7, Series 65, or Series 82 qualify — the Series 6 is not on that list, defeating choice D. Because no test is met, the couple is not accredited and generally could not purchase in offerings limited to accredited investors, such as Rule 506(c) private placements.

The Trap: primary-residence-in-net-worth-test

• Yes — their total net worth, including the home, exceeds $1 million: Misconception: counting the primary residence — the $1 million net-worth test excludes the value of the primary residence.
• Yes — the Series 6 registration qualifies the household under the professional-license category: Misconception: any securities license qualifies — the professional-certification category covers only the Series 7, Series 65, and Series 82 in good standing.
• Yes — their joint income exceeds the $200,000 income threshold: Misconception: applying the individual income threshold to a couple — $200,000 is the single-person test; a couple relying on joint income needs more than $300,000.

Verified against: current-fact warning: 2020 license additions)

Answer: Establishing a prime brokerage arrangement, in which executing brokers trade for the fund while the prime broker provides centralized custody, clearing, and recordkeeping

This is the textbook use of prime brokerage: an institutional customer — often a hedge fund — trades through multiple executing brokers to access their liquidity and research, while a single prime broker provides centralized custody, clearing, margin lending, and consolidated records for all of that activity. Choice A reverses the introducing/clearing structure: an introducing firm holds no customer assets at all; it routes business to its designated clearing firm and cannot consolidate trades done at unrelated firms. Choice C misunderstands the fourth market — trading directly over ECNs removes the broker-dealer from execution, but the fund's assets still need custody and its trades still need clearing. Choice D misassigns the transfer agent's role: transfer agents keep shareholder records for issuers, not consolidated accounts for investors.

The Trap: introducing-vs-prime-brokerage

• Opening a fully disclosed account with an introducing broker-dealer, which will consolidate the assets from all the executing firms: Misconception: reversing introducing/clearing roles — an introducing firm holds no customer assets; it routes business to its own clearing firm and cannot consolidate activity done at unrelated firms.
• Trading only in the fourth market through ECNs so that no broker-dealer custody is required: Misconception: fourth market eliminates the need for custody — ECNs remove the intermediary from execution, but the fund's assets still must be custodied and its trades cleared somewhere.
• Directing each issuer's transfer agent to consolidate the fund's holdings into a single record: Misconception: transfer agent as investor custodian — transfer agents maintain shareholder records for issuers; they do not provide custody or consolidated reporting for investors.

Verified against: introducing vs. clearing)

Answer: The practice is prohibited: in a single transaction the firm may act as an agent charging a commission or as a principal charging a markup, but not both

A firm may be registered as both a broker and a dealer, but in any single transaction it must choose one capacity: act as agent and charge a commission, or act as principal and charge a markup (or markdown). Charging both a markup and a commission on the same trade compensates the firm twice for one transaction and violates FINRA's fair-dealing standards — so choice A is wrong; dual registration does not permit dual compensation. Choice C is wrong because disclosure does not cure the violation: SEC Rule 10b-10 requires the confirmation to disclose the capacity in which the firm acted, and that framework assumes one capacity per trade. Choice B overcorrects — principal trades with customers are entirely lawful, and dealers fill customer orders from inventory routinely, provided the markup is fair and the capacity is disclosed.

The Trap: dual-capacity-same-transaction

• The practice is permissible because the firm is registered as both a broker and a dealer: Misconception: dual registration permits dual compensation — a firm may be both a broker and a dealer as a business, but must act in only one capacity per transaction.
• The practice is prohibited because broker-dealers may not fill customer orders from their own inventory: Misconception: principal trades with customers are illegal — they are lawful when the markup is fair and the capacity is disclosed; the violation here is charging both forms of compensation.
• The practice is permissible as long as the firm discloses both charges on the trade confirmation: Misconception: disclosure cures the violation — SEC Rule 10b-10 requires capacity disclosure, but disclosing double compensation does not make it permissible.

Verified against: FINRA Rule 2010 (fair dealing) and SEC Rule 10b-10 (confirmation disclosure of capacity) — a broker-dealer may act as agent (commission) or principal (markup) in a trade, not both

Answer: The firm acted as a dealer (principal) and was compensated by a markup included in the price.

When a firm fills a customer order from its own inventory, it acts as a dealer (principal) and is compensated by a markup built into the price the customer pays. Had it merely arranged the trade between the customer and another party, it would have acted as a broker (agent) and charged a commission. A broker-dealer can operate in either capacity, but only one capacity per trade — it cannot charge both a markup and a commission on the same transaction. Under SEC Rule 10b-10, the trade confirmation must disclose which capacity the firm acted in. The bid-ask spread describes how principals such as market makers profit; it is not agent compensation.

The Trap: broker-commission-vs-dealer-markup

• The firm may charge both a markup and a commission because it both owned the bonds and arranged the trade.: Misconception: that a firm can act in both capacities on the same trade — it must act as either broker or dealer in a given transaction, not both.
• The firm acted as a broker (agent) and charged the customer a commission.: Misconception: reversing the broker/commission vs. dealer/markup pairing — a firm selling from its own inventory is acting as principal, not agent.
• The firm acted as the customer's agent and earned the spread between the bid and ask prices.: Misconception: mixing agency capacity with principal-style spread compensation — the spread/markup belongs to principal trading; agents earn commissions.

Verified against: SEC Rule 10b-10 - confirmation disclosure of dealer (principal/markup) vs. broker (agent/commission) capacity

Answer: It is an investment adviser owing clients a fiduciary duty, and it registers with the SEC or a state regulator depending primarily on its assets under management.

A firm compensated by fees (often a percentage of assets under management) for giving ongoing advice is an investment adviser under the Investment Advisers Act of 1940. Advisers owe clients a continuous fiduciary duty and register with the SEC (generally the larger firms, around $100 million or more under management) or with state regulators — FINRA does not regulate investment advisers. By contrast, a broker-dealer's registered representatives typically earn transaction-based commissions, and the firm answers to FINRA and the SEC. Asset-based advisory fees are not commissions, and an adviser's duty is not limited to individual trades.

The Trap: finra-regulates-investment-advisers

• It owes clients a duty only at the moment each trade is executed, like a broker-dealer making a recommendation.: Misconception: applying the broker-dealer's transaction-by-transaction standard to an adviser — an adviser's fiduciary duty is ongoing across the whole relationship.
• It is regulated by FINRA because it is in the business of advising customers about securities.: Misconception: that FINRA regulates investment advisers — FINRA's jurisdiction covers broker-dealers and their associated persons, not advisers.
• It is a broker-dealer, because compensation based on account value is a form of commission.: Misconception: conflating the fee-based advisory model with transaction-based brokerage compensation — asset-based advisory fees are not commissions.

Verified against: IA-vs-BD misconception pair)

Answer: Her cash and securities are held by Bluewater, the carrying firm, and remain there unaffected by Kestrel's closing.

In a fully disclosed introducing arrangement, the carrying (clearing) firm — here Bluewater — holds the customer's cash and securities, clears and settles the trades, and issues confirmations and statements; the introducing firm opens accounts and takes orders but does not have custody. If the introducing firm closes, customer assets sit safely at the carrying firm. SIPC protection (up to $500,000 per customer in a separate capacity, including a maximum of $250,000 in cash) is triggered when a firm holding customer assets fails and assets are missing — and it does not cover declines in market value. Customer assets are also not available to the introducing firm's business creditors. Knowing who actually carries the account is the key to this entire family of questions.

The Trap: introducing-firm-holds-customer-assets

• Her account will be frozen until Kestrel's business creditors have been paid.: Misconception: treating customer assets as part of the introducing firm's estate — customer cash and securities are held at the carrying firm and are not assets of the introducing firm.
• SIPC will reimburse her for any decline in the market value of her holdings during the wind-down.: Misconception: that SIPC covers market losses — SIPC protects custody of assets when a carrying firm fails; it does not cover investment losses.
• Her securities were held at Kestrel, so she should file a SIPC claim immediately.: Misconception: that the introducing firm holds customer assets — an introducing firm opens accounts and routes orders but does not have custody of cash or securities.

Verified against: SIPC linkage)