← SIE Exam: Market Structure

SIE Securities Industry Essentials Exam Study Guide

Key concepts, definitions, and exam tips organized by topic.

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SIE Exam: Market Structure — Comprehensive Study Guide


Overview

Market structure describes how securities markets are organized, who participates in them, and how trades are executed. The SIE exam tests your understanding of the differences between exchange and OTC markets, the roles of various market participants, and the regulatory framework that governs trading activity. Mastering these concepts is essential for understanding how capital flows between issuers and investors.


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1. Exchange Markets


Summary

Exchange markets are formal, organized venues where listed securities trade under standardized rules. The most well-known example is the New York Stock Exchange (NYSE). These markets operate as auction markets, meaning prices are determined by competing bids and offers from buyers and sellers.


Key Concepts


  • • Listed Security: A security that has met an exchange's quantitative and qualitative requirements (minimum earnings, market capitalization, share price) and is approved for trading on that exchange.
  • • Auction Market: A market where buyers and sellers submit competing bids and offers; trades occur at a single price that satisfies the most participants. The NYSE is the classic example.
  • • Designated Market Maker (DMM): Assigned to specific stocks on the NYSE; obligated to maintain fair and orderly markets by:

    • - Continuously quoting bids and offers

    - Facilitating price discovery

    - Using their own capital to offset temporary supply/demand imbalances

  • • Floor Broker: An exchange member who executes buy and sell orders on the trading floor on behalf of customers or their firm, acting purely as an agent (not using their own capital).

    • Key Terms

  • • Listing Requirements — Standards a company must meet to trade on an exchange
  • • Auction Market — Price determined by competing bids and offers
  • • DMM — Obligated liquidity provider on the NYSE
  • • Floor Broker — Agent executing orders on the exchange floor

    • Watch Out For

    > ⚠️ DMM vs. Floor Broker: A DMM acts as a principal using their own capital to stabilize markets. A floor broker acts as an agent executing orders for others. Do not confuse these two roles.

    >

    > ⚠️ Listed ≠ OTC: Just because a stock trades on Nasdaq does not automatically mean it is an OTC stock. Nasdaq operates as a listed exchange with formal listing requirements.


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    2. OTC Markets


    Summary

    Over-the-Counter (OTC) markets are decentralized dealer markets where securities trade through a network of dealers rather than on a centralized exchange floor. OTC securities do not need to meet exchange listing requirements. The OTC market exists across multiple tiers, ranging from established companies to highly speculative, thinly traded stocks.


    Key Concepts


  • • Dealer Market: Dealers (market makers) buy and sell securities for their own accounts and profit from the bid-ask spread. There is no central auction; buyers and sellers transact through intermediary dealers.
  • • Market Maker: A dealer firm that continuously quotes both a bid price (willing to buy) and an ask price (willing to sell) for a specific security, providing liquidity to the market.
  • • Bid-Ask Spread: The difference between the bid price and the ask price. This is the dealer's profit. A wider spread = greater dealer compensation; a narrower spread = more liquid market.

    • OTC Market Tiers


    | Tier | Description |

    |---|---|

    | OTCQX | Highest tier; more established companies with stronger reporting standards |

    | OTCQB | Middle tier; smaller, early-stage companies with some reporting requirements |

    | Pink Sheets | Lowest tier; minimal reporting requirements; highest risk of fraud/manipulation |

    | OTCBB | Largely replaced by OTC Markets Group platforms |


    Extended Markets (Third & Fourth Markets)


  • • Third Market: Trading of exchange-listed securities in the OTC market by broker-dealers who are not exchange members. Primarily used by institutional investors trading large blocks away from the exchange floor.
  • • Fourth Market: Direct trading between institutional investors (no broker-dealers involved), often through Electronic Communication Networks (ECNs). Examples: pension funds, insurance companies trading directly with each other.

    • Key Terms

  • • Dealer Market — Trades occur through intermediary dealers, not direct buyer-seller auctions
  • • Market Maker — Continuously quotes bid and ask prices; provides liquidity
  • • Bid-Ask Spread — Dealer's compensation; difference between buy and sell prices
  • • Pink Sheets — Lowest OTC tier; high risk, minimal disclosure
  • • Third Market — Listed securities traded OTC
  • • Fourth Market — Institution-to-institution trading, no broker-dealer

    • Watch Out For

    > ⚠️ Auction vs. Dealer Market: In an auction market, buyers and sellers trade with each other. In a dealer market, all trades go through the dealer. This is a frequently tested distinction.

    >

    > ⚠️ Third vs. Fourth Market: Third Market = exchange-listed stocks traded OTC. Fourth Market = direct institutional trading without any broker-dealer. Don't mix these up.

    >

    > ⚠️ Pink Sheets Risk: The primary risk of Pink Sheet stocks is lack of financial disclosure requirements, making them prime targets for pump-and-dump schemes.


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    3. Market Participants


    Summary

    Understanding who operates in the market and in what capacity is critical. The SIE exam frequently tests the distinction between brokers and dealers, the role of ECNs, and the difference between institutional and retail investors.


    Key Concepts


  • • Broker (Agent): Acts on behalf of a customer, does not use own capital, earns a commission.
  • • Dealer (Principal): Buys and sells securities for its own account, profits from the bid-ask spread (called a markup when selling or markdown when buying).
  • • Broker-Dealer: A firm that can act as either broker or dealer depending on the transaction. Most securities firms are broker-dealers.
  • • Registered Representative (RR): A licensed individual employed by a broker-dealer who is authorized to buy and sell securities for customers. Must register with FINRA.
  • • ECN (Electronic Communication Network): An automated system that directly matches buy and sell orders electronically, bypassing traditional broker-dealers. Associated with the Fourth Market and offers speed and lower costs.

    • Investor Types


    | Type | Description | Examples |

    |---|---|---|

    | Institutional Investor | Large organizations trading large volumes | Pension funds, mutual funds, hedge funds, insurance companies |

    | Retail Investor | Individual person investing personal funds | Individual account holders |


    Key Terms

  • • Agent — Executes trades for others; earns commission
  • • Principal — Trades for own account; earns markup/markdown
  • • Broker-Dealer — Can act as either agent or principal
  • • Registered Representative — Licensed individual registered with FINRA
  • • ECN — Electronic order-matching system; no traditional intermediary

    • Watch Out For

    > ⚠️ Commission vs. Markup: When a firm acts as a broker (agent), it charges a commission. When it acts as a dealer (principal), it charges a markup (on sells) or markdown (on buys). These are different forms of compensation.

    >

    > ⚠️ Broker-Dealers must disclose their capacity (agent or principal) in each transaction — this is a legal requirement.


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    4. Trading Mechanics


    Summary

    Understanding where and how securities are issued and traded is fundamental to market structure. The SIE exam distinguishes between primary and secondary markets and tests knowledge of specific transaction types like IPOs and dark pools.


    Key Concepts


  • • Primary Market: Where new securities are issued for the first time. Proceeds go directly to the issuer. Examples: IPOs, new bond offerings.
  • • Secondary Market: Where previously issued securities are bought and sold between investors. No proceeds go to the issuer. Examples: Trading shares on NYSE after an IPO.
  • • IPO (Initial Public Offering): A private company's first sale of stock to the public in the primary market. After the IPO, shares trade on the secondary market.
  • • Seasoned (Follow-On) Offering: When an already-public company issues additional new shares to raise more capital. The company's stock is already trading; this is still a primary market transaction (new shares are issued).
  • • Dark Pool: A private trading venue where large institutional orders are matched anonymously without public quote display. Allows execution of large block trades without signaling intentions to the broader market.

    • Primary vs. Secondary Market Comparison


    | Feature | Primary Market | Secondary Market |

    |---|---|---|

    | Who sells? | The issuer | Existing investors |

    | Proceeds go to? | The issuing company | The selling investor |

    | Examples | IPO, follow-on offering | NYSE, Nasdaq trading |

    | Price determined by? | Underwriter/book-building | Supply and demand |


    Key Terms

  • • Primary Market — New issuance; proceeds to issuer
  • • Secondary Market — Existing securities; proceeds to seller
  • • IPO — First public offering of company stock
  • • Seasoned Offering — Additional shares from already-public company
  • • Dark Pool — Private, anonymous institutional trading venue

    • Watch Out For

    > ⚠️ Primary vs. Secondary: A seasoned offering (follow-on offering) is still a primary market transaction because new shares are being created and proceeds go to the issuer — even though the company is already public.

    >

    > ⚠️ Secondary Market ≠ Secondary Offering: "Secondary market" refers to where all trading happens after issuance. A "secondary offering" can sometimes refer to when existing shareholders sell previously issued shares (proceeds go to shareholders, not the company) — this is distinct from a seasoned offering.

    >

    > ⚠️ Dark Pools: While legal, dark pools raise concerns about price transparency and market fairness. Know that they are used primarily by institutional investors to avoid market impact.


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    5. Regulatory Framework


    Summary

    Securities markets are regulated at both the federal government level (SEC) and the self-regulatory organization (SRO) level (FINRA). Regulation NMS is the key rule governing how orders must be handled across trading venues.


    Key Concepts


  • • SEC (Securities and Exchange Commission): The federal government agency responsible for:

    • - Enforcing federal securities laws

    - Regulating markets and participants

    - Protecting investors from fraud and manipulation

    - Setting overall regulatory framework


  • • FINRA (Financial Industry Regulatory Authority): A self-regulatory organization (SRO) that:

    • - Regulates broker-dealers and their registered representatives

    - Writes and enforces rules governing securities firms

    - Oversees market activity

    - Administers licensing exams (including the SIE)

    - Reports to and is overseen by the SEC


  • • Regulation NMS (National Market System): An SEC rule designed to ensure investors receive the best available price for their orders across all trading venues. Key component:

    • - NBBO (National Best Bid and Offer): The highest available bid price and the lowest available ask price across all exchanges and trading venues at any given moment. Broker-dealers are required to execute customer orders at or better than the NBBO.


    SEC vs. FINRA Comparison


    | Feature | SEC | FINRA |

    |---|---|---|

    | Type | Federal government agency | Self-regulatory organization (SRO) |

    | Authority | Broad regulatory and enforcement | Broker-dealer and RR oversight |

    | Scope | All market participants and markets | Broker-dealers and registered reps |

    | Relationship | Oversees FINRA | Regulated by SEC |


    Key Terms

  • • SEC — Federal regulator; enforces securities laws
  • • FINRA — SRO; regulates broker-dealers and RRs
  • • SRO — Self-regulatory organization operating under SEC oversight
  • • Regulation NMS — Rule ensuring best price execution across venues
  • • NBBO — Best bid and best offer consolidated across all venues

    • Watch Out For

    > ⚠️ SEC vs. FINRA Authority: The SEC has broader authority over all markets. FINRA specifically regulates broker-dealers and their employees. FINRA operates under SEC oversight.

    >

    > ⚠️ NBBO is a requirement: Broker-dealers are legally obligated under Regulation NMS to execute orders at or better than the NBBO. This is not optional.

    >

    > ⚠️ FINRA administers the SIE: Know that FINRA is both a regulator and the organization administering the exam you're preparing for.


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    Quick Review Checklist


    Use this checklist to confirm you can answer each point before exam day:


  • • [ ] Explain the difference between a listed security and an OTC security
  • • [ ] Describe an auction market vs. a dealer market
  • • [ ] Explain the role of a DMM on the NYSE and how it differs from a floor broker
  • • [ ] Define market maker, bid price, ask price, and bid-ask spread
  • • [ ] Identify the three tiers of OTC markets: OTCQX, OTCQB, and Pink Sheets
  • • [ ] Distinguish between the Third Market and Fourth Market
  • • [ ] Explain the difference between a broker (agent) and a dealer (principal)
  • • [ ] Define broker-dealer and registered representative
  • • [ ] Describe how an ECN works and where it fits in market structure
  • • [ ] Distinguish between institutional and retail investors
  • • [ ] Explain the difference between the primary market and secondary market
  • • [ ] Define an IPO and a seasoned (follow-on) offering
  • • [ ] Explain what a dark pool is and why institutions use them
  • • [ ] Describe the roles of the SEC and FINRA and their relationship
  • • [ ] Explain Regulation NMS and the NBBO requirement

    • ---


    Focus your study time on the broker/dealer distinction, auction vs. dealer market differences, primary vs. secondary market mechanics, and the SEC/FINRA regulatory hierarchy — these are among the most frequently tested topics in the SIE market structure section.

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