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The Securities Markets and their Governance

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Derivatives represent a form of quasi-security that are highly popular in the current economic environment and have come to be accepted as a financial instrument to the same extent as stocks and bonds. Derivatives, as the name implies, have their economic value created from (derived from) an actual security; typically a stock. There are five common categories of derivatives: Puts, Calls, Forwards, Options, and Swaps. Each of these instruments represents a specific form of transaction whereby a buyer and a seller trade some form of financial risk in an exchange that is not unlike a bet on whether the event described in the transaction will actually occur. Ultimately, a derivative does not represent an actual interest in the company or in its debt. The derivative simply serves as a means for investors to bet on, in most cases, whether the value of the underlying security will go up or down.

Whenever a broker-dealer organizes a transaction between investors and prices the securities involved in the transaction, that process is known as “market-making.”

Pink Sheets: 
A private service that is organized and created to help broker-dealers price securities in the “over the counter” stock market. The sheets, which have historically been printed on pink paper but which are now largely electronic, indicate the history of transactions in a company’s securities and provide a quick means of attempting to price a security to complete an exchange.

Overview to the Securities Markets

Whenever a security – whether it be a stock, bond, or other derivative security - is traded, that trade must occur in some location. The location of the trade need not be a physical location, but the information upon which the trade is based and where it is recorded needs to allow for the trade to be constructed and legally documented as a transfer of ownership. The “place” where such trades happen, in the bulk of such transactions, is a "securities market."

In this section, we will discuss the nature of the main securities markets and their operation. Understand that Securities Trading is a huge area of study in its own right. However, this section is intended to provide a basic introduction to the markets and their oversight.

Oversight of the Securities Market

As is the case with the regulation of securities themselves, the regulation of the securities markets is also a task that is left in the hands of the SEC. The authority for regulating the markets comes from the Securities Exchange Act of 1934. The ’34 Act, now codified as section 78 of Title 15 of the United States Code, covers the basic regulation and registration of various securities markets that trade on a national level. The broker-dealers   who procure and orchestrate the trades conducted on those markets are likewise subject to SEC regulation.

The ’34 Act is a fairly straightforward act that does a thorough job of setting forth the guidelines for the markets and their administration. The ’34 Act might be generally divided into two categories. On the one hand, the ’34 Act provides many logistical provisions that regulate the creation of the securities markets and the registration of broker-dealers. The other part of the ’34 Act covers the various processes and punishments that are associated with broker-dealers and their constituent clients who engage in rule breaking with respect to the Act.

In addition to the ’34 Act, it is also important to note that the securities markets themselves have their own internal oversight regulations. In particular, these rules, specific to each exchange, are geared to regulating the companies that are listed on the exchange. Thus, the exchange will set certain requirements – such as the size of the company, its shareholder float, the organization and management of its board, etc. – that must be met for the firm to continue trading its stock on the market. See 15 USCS § 78f.

The Big Players

The vast majority of companies in the United States, and in the world for that matter, are not publicly traded. However, for those that are traded publicly, many aspire to be eligible for listing on the New York Stock Exchange (NYSE). The NYSE is the market on which many of the country’s biggest public firms trade their securities. In order to be eligible for a NYSE listing, the company must have a public float in the billions of shares. Additionally, the NYSE has very stringent rules regarding the operations of corporate boards for companies listed on its exchange, all with the goal of ensuring that only the highest caliber firms trade on the NYSE.

EXAMPLE: MegaCo. has been successfully operating for the past thirty years. The company has a long track record of strong and consistent earnings and has been trading its securities on a regional market for the last fifteen years. The company, given its strong position, has elected to step up to what it sees as the “big-time” and requests a listing on the NYSE. In order complete the listing, the company was forced to modify its board in order to comply with the NYSE’s listing requirements. In addition, it had to report more information about the option pool and fully reform its financial statements to comply with the generally accepted accounting methods (GAAP).

The primary runner up in terms of exchanges – though it is not technically an exchange - is the National Association of Securities Dealers’ NASDAQ (National Association of Securities Dealers Automated Quotation) system. The reason why the NASDAQ is not technically a market is that, instead of choosing to register as a market with the SEC, the NASDAQ has instead chosen to run its markets electronically and without meeting some of the requirements the SEC places on “true” market operations. The NASDAQ is typically noted for being the place where most new companies, and in particular, new high-tech companies, are listed. The reason for this is that the size requirement for companies listed on NASDAQ is not as large as that for NYSE companies and the National Association of Securities Dealers continues to be slightly more liberal in terms of its requirements for listed companies’ boards and management than is the NYSE. 

After the two big players discussed above, there are a series of smaller markets. Historically, the American Stock Exchange (AMEX) has been a fairly large market. However, that market has recently lost much volume and is likely to be sold to a bigger market in the near future. Additionally, certain specialty markets exist to cover a variety of more specialized investing and investors. The Chicago Board of Options operates a form of exchange for the sale and trading of “derivative securities.” There are also markets dedicated solely to bond trading, and other markets which only list securities for companies incorporated or headquartered in the state in which the market operates.

EXAMPLE: Techotronics, an up and coming technology firm, has decided that it would like to make a public offering and have its shares listed on a public exchange. The company quickly discovers that the NYSE is not a place that is appropriate for their listing as the firm only plans a small issuance of stock and does not have a long enough track record of financial data and operations to meet the requirements of the NYSE. Additionally, there is no local securities market in the state where Techno is located, nor would the company wish to list there in any case, as they hope to gain added notoriety for their listing by listing on a national exchange. Ultimately, the firm decides that the optimal place to list their shares is on the NASDAQ electronic market, as that market covers many similarly sized companies, along with many of Techno's competitors that have previously listed shares.

Over the Counter

What happens when a firm, either through a choice of its management or simple inability to meet the requirements of any exchange, chooses to take its shares public, but does not offer its shares for sale on an organized market? In this situation, companies may decide to list their shares “over the counter” ("OTC").

OTC trading is much as its name indicates. A person interested in buying a security locates a broker-dealer who advertises himself as a seller of that security. Subsequently, the buyer, via the broker, locates the shares that he   or she requires in the hands of other investors who own and are willing to sell the shares. In pricing the shares, the broker-dealer engages in what is known as “market making” by using a service known as the “Pink Sheets” for approximating the appropriate value for the transaction.

Ultimately, OTC trading is not for all companies. The problem with OTC trading is that it generally does not provide the kind of liquidity and active trading that many companies desire in publicly offering their shares. Thus, OTC is a good market for companies that, while public, do not expect or want a lot of turnover in their investor pool. Additional candidates for over the counter trading may be foreign companies that do not want to comply with the stringent requirements that the SEC has established (see 15 USCS § 78j-1), and which are prerequisites for selling shares on any registered exchange.

EXAMPLE: Hambourg HighEnd, SA, is a company based and organized in Germany. The company is very well respected by investors both in Europe and the U.S. and is listed for trading on a European exchange. The company, however, would like to see more of its shares traded in the U.S. However, at the same time, the company is unwilling to alter its board and finances in order to comply with the SEC’s requirements for listing its shares on a U.S. exchange. As a result, the company begins to identify a large number of broker-dealers in the U.S. who are willing to act as market-makers for the over the counter trading of the company’s shares.