Series 57 Exam Questions & Answers (SIA Instructor Verified)

Understanding the difference between a market maker and an ECN is critically important. Each plays an important role in the NASDAQ market. However, their roles and responsibilities are extremely different. Because there are no DMMs for the NASDAQ markets, bids and offers are displayed by broker dealers known as market makers. A market maker is a firm that is required to display a two-sided market. A two-sided market consists of a simultaneous bid and offer for the security quoted through the Nasdaq workstation.The market maker must be willing to buy the security at the bid price, which is displayed, as well as be willing to sell the security at the offering price, which also is displayed. These are known as firm quotes. There is no centralized location for the Nasdaq market; it is simply a network of computers that connects broker dealers throughout the world. Market makers purchase the security at the bid price and sell the security at the offering price. Their profit is the difference between the bid and the offer, which is known as the spread. Rule changes and new trading systems known as electronic communication networks, or ECNs, have narrowed the spreads on stocks significantly in recent years. Firms that act as market makers must continuously display two-sided quotes during normal business hours. Firms may remain open for extended hours trading but are not required to display quotes after the close of the market at 4:00 p.m. EST. During extended hours trading the market has greater volatility, lower liquidity, and fewer market participants than trading during the regular session. As a result, there are wider spreads and the risk of poor executions.

Electronic communication networks / ECNs are subscriber networks whose role is to match and pair off orders routed to them by broker dealers and institutions. When the ECN has an order imbalance it is allowed to display and execute third-party orders in the NASDAQ market center ECNs are widely used by both broker dealers and institutional investors to display and execute orders. ECN quotes are included in the Nasdaq quote system, but the ECN is not required to maintain a two-sided market like a market maker, and ECNs do not take positions in the security. ECNs may:

• Display 1 sided quotes.
• Enter and accept directed and nondirected orders.
• Accept automatic executions.
• Send orders for automatic execution through the NMCES

The key series 57 test points to remember are

1. Market makers must display a continuous 2 sided market. ECNs are allowed to display a bid or offer only based on customer interest.
2. Market makers may not pull their quotes. ECNS may enter and exit the market as needed.
3. Market makers take on risk and trade in a principal capacity. ECNs never take positions or risk in the security and only act as an agent.

This information will definitely be tested on your series 57 exam.

The alternative display facility or ADF was created in order to provide broker dealers with an opportunity to quote securities in a venue other than the NASDAQ. It was developed many years ago before we had countless market centers to ensure that the NASDAQ was not deemed to be a monopoly. FINRA operates the Alternative Display Facility (ADF) from 8:00 a.m. to 6:30 p.m. EST. The ADF allows market makers and unlinked ECN participants to enter and match quotes and to report trades. The quotes entered in the ADF will not appear in the NMCES. However, if the quote entered in the ADF would improve the inside market, the quote will be displayed as part of the inside market. The ADF does not provide execution capabilities. All ADF participants are required to provide direct or indirect electronic access to their quotes. Direct electronic access will allow other market participants to execute an order electronically against the firm’s quote. Indirect electronic access will allow another market participant to execute an order against the firm’s quote through the firm’s broker dealer customer. Both direct and indirect electronic access requires:

• No voice communication.
• Equivalent speed, reliability, and availability as offered to participants’ customers.
• Equivalent costs as offered to participants’ customers.
• A two-second turnaround for accepting or declining an order.
• A three-second or less turnaround for communication between market participants.

Each ADF participant must certify that it has the ability to display automated quotations during times of peak volume. Each participant is also required to display a marketable quote on each side of the market at least once every 30 days in order to meet certification standards. A firm that is unable to meet the certification standards or who experiences three unexcused outages over 5 consecutive business days will be suspended from quoting all securities in the ADF for 20 business days.

The first thing to keep in mind is that a market maker never has to file form 211 when requesting to quote a NASDAQ stock. An approved market maker who wishes to quote a NASDAQ stock will simply electronically request permission to quote the stock and will receive same day approval to enter their initial quote. If a firm wants to quote an inactive unlisted OTC stock, FINRA wants to know why. SEC Rule 15C2-11 (as amended) sets the standards for non listed companies to develop a public market and for broker dealers to publish quotations for the securities. SEC 15c2-11 requires issues to be current when reporting and disclosing financial and other information. The OTC Markets Group acts as a qualified interdealer quotation service (IDQS) and monitors issuers compliance on an ongoing basis to ensure that issuers are current with their disclosures. A broker dealer wishing to quote an OTC security will be able to rely on the current information designation made by the IDQS in lieu of submitting Form 211 with FINRA. In order for an issuer to maintain its designation as being current, SEC reporting issuers must continuously make timely filings of all reports. Companies listed on the OTCQX, OTCQB and PINK Current are subject to this rule. If companies fail to meet this continuing reporting requirement, the security will be deemed ineligible for public quotes. During market hours quotes for these ineligible securities will be shown as zero (0). However, last sale data for the stock will be available at the end of the day. If the security is deemed to be inactive The issue must work with the broker dealer to file form 211 with FINRA. Rule 15c2-11 permits additional time (180 days) for Exchange Act reporting companies to continue to be eligible for public broker-dealer quotes. Accordingly, companies that make their annual or quarterly reports publicly available (via EDGAR) within 180 days of the end of the reporting period will still be eligible for broker-dealer proprietary quotes, but will be designated as “Limited Information”. Companies who have no information available may be traded on either the OTC Expert market or be forced into the Gray market. The OTC Expert market is where broker dealers may publish unsolicited quotes based on customer limit orders to obtain the best possible execution for the customer. Quotes in the Expert Market are restricted from public view. The Gray market is not an electronic market. The stock of issuers whose securities have been delisted or who are no information companies will be traded over the phone between broker dealers. The Gray market lacks the price discovery made available in electronic markets. Investors should be extremely cautious when considering purchasing securities in either the Expert or Gray market.

Market makers who take on risk in liquid securities base the mark up on the inside market for that security. Meaning the firm’s inventory cost for the security is irrelevant. For example, Let’s assume the market for a stock is: $25 bid and offered $25.20. A market maker who accumulated the stock over a number of days has an average cost of $22. If the firm receives a customer market order to buy the stock, it would base the mark up on the best offer of $25.20. The fact that the firm owns the stock at $22 per share is not considered. Nor would it matter if the firm had an average cost of $28 per share. Some small OTC securities do not have active and competitive markets because of lack of national interest in the company. As a result, the market for these securities can be dominated or controlled by one market maker. Market makers who dominate or control the market for a security must base the markup charged to the customer on their contemporaneous cost, not on the inside market for the security. All markups will be based on the price the market maker paid for the stock when it was purchased for their inventory account. On your exam if the question notes that the firm is responsible for 70 percent of the volume in the stock, this is letting you know that the firm in question is dominating the market. As a result the firm must base the mark up on their inventory cost.

When broker dealers act as underwriters and as market makers there are inherent conflicts of interest. Regulation M Rule 103 was designed specifically to address these situations. Rule 103 regulates the activity of market makers participating in a distribution. Market makers that are participating in a distribution may only act as passive market makers during the restricted period. Passive market makers may not enter a bid for their own account or buy the security at a price that exceeds the highest bid entered by an independent party. If the highest independent bid entered by a nonparticipant drops below the bid of the passive market maker, the passive market maker may remain as the highest bid until it purchases an amount equal to the lesser of its volume restriction or 2 times the minimum quote size for the security. Once this volume restriction is reached, the passive market maker must lower its bid to a price no higher than the current independent bid. If there are no independent market makers, passive market making will not be allowed. The syndicate manager must apply for passive market making status on behalf of all syndicate members by filing part of the Underwriting Activity Form no later than one business day prior to the first full trading day of the restricted period.

If a broker dealer accepts customer limit orders it is required to protect the order and may not trade for its own account at prices that would satisfy the customer’s limit order. The order protection rule is also known as the Manning rule. The Manning rule states that a firm may not compete with a customer’s limit order by executing an order for its own account at a price that would satisfy the customer’s limit. If the firm executes an order for its own account at a price that would satisfy the customer’s limit order, the firm must execute the customer’s order at the same price and for the same number of shares within 60 seconds.Broker dealers that route orders to ECNs or other firms to be displayed must still protect the customer’s limit order and are not relieved of their obligations under the Manning Rule. If the market-making desk is holding a customer’s limit order that is subject to the Manning Rule, no trading desk anywhere within the firm may knowingly execute a proprietary order that would compete with the customer’s order. If the firm has sufficient barriers between its trading desks and the other desk does not have knowledge of the customer’s order, the other desks are not bound by the Manning Rule.

This is definitely a testable question on the Series 57 exam. The timely reporting of transactions is critical for market integrity. All transactions are required to be reported as soon as practicable, but not later than 10 seconds after execution . If a transaction is executed and later cancelled under FINRA trade reporting rules the firm is required to report the transaction promptly. The trader is then required to use the ACT trade scan to cancel the transaction. The trade cancellation report should be made on the same day as the trade was reported provided the trade reporting facility is still open. This rule is in effect for transactions executed during normal business hours as well as for those trades executed during extended hours trading.

A discretionary range order gives the trader the ability to execute a customer’s limit order within an acceptable range of prices. Discretionary range orders provide flexibility to the trader to adjust the order to current market conditions. Providing a range of acceptable limit prices rather than 1 firm fixed limit price increases the chances that the customer’s order will be executed. It is important to remember that a customer’s limit order may never be executed at an inferior price. For example If a customer placed an order to sell 5,000 shares of TRY at $42, the firm would not be able to execute that order at a price less than the stated limit price. This is true even if the trader feels that doing so would be in the best interest of the client. A discretionary range order would provide the trader with the ability to execute the order within a range of prices which are inferior to the desired limit price. If in our example the customer who wants to sell the TRY at $42 provided the trader with discretionary trading range of 25 cents, the trader would be allowed to execute the order at any price of $41.75 or higher. The trader may enter the discretionary range order as a limit order. It will be displayed at the limit price of $42. When entering the order in the NASDAQ system, the trader will append the discretionary range of 25 cents to the order. If a contra bid shows up within the range of acceptable prices the NASDAQ system will execute the order. Using our example, if a bid of $41.80 appeared in the market place the order would be executed at that price.

The operation of the CATS system is definitely an area you want to have down cold. CATS plays a vital role in market surveillance and it is heavily tested on the series 57 exam. In order to ensure that customer orders are transmitted to the marketplace in a timely manner, FINRA developed the Consolidated Audit Trail system (CATS). CATS tracks an order through each stage of its life, from receipt to execution or cancellation. The CATS system has replaced the Order Audit Trail or OATS system previously used to track customer order information. The CATS system is often still referred to as OATS in the industry and may appear as OATS on your exam. Each firm is required to synchronize clocks used for electronic order events to within 50 milliseconds of the National Institute of Standardized Time’s atomic clock. These clocks must display and record military time in hours, minutes, seconds and milliseconds. Each clock used solely for manual order events may be synchronized to a tolerance within 1 second of the NIST clock. Each member may record and submit manual order events and allocation reports to the Central Repository in increments of 1 second. Firms are only requested to collect and submit data in nanoseconds if the firm collects the data. Firms are required to submit daily electronic CATS reports to FINRA’s Central Repository. The business day for CATS is 4:150:00:01 p.m. to 4:15 p.m. the following business day. CATS reports must be made by 8 a.m. on T+1 on the business day following the trade date. For trades executed on Friday, CATS reports may be submitted on Saturday but must be submitted by 8 a.m. Monday morning. Daily CATS reports must be made for each order and include the following information:

• Customer name, account number, date of birth, address and tax ID.
• Date and time of receipt.
• Order ID.
• Terms of the order (i.e. buy, sell, long, short, security, price, shares, account type and handling instructions).
• If the order was received manually or electronically.
• If the order was routed manually or electronically
• Where the order was routed for execution.
• Any modifications to the order, including the date and time of any modifications.
• Execution information, including partial executions, price, date, time, and capacity in which the firm acted in the trade.

The NASDAQ and the OTC markets have multiple venues for executing orders. Each of these require trades to be reported using the proper “input screen". These are user interfaces. It will help you to think of the TRF, ORF and TRACS as nothing more complicated than the order screen you use when placing an order online. The vast majority of transactions will be reported using the Trade Reporting Facility or TRF. The FINRA/Nasdaq Trade Reporting Facility (TRF) is a trade comparison service operated on the ACT platform. It has been designed to greatly reduce questionable trades and trades that one party does not know (DKs). The TRF facilitates the reporting and clearing of trades in Nasdaq and the NYSE listed stocks executed off the floor in the third market. Trades executed on the exchanges do not get reported using the TRF and are NOT reported to the ACT system.

The order reporting facility (ORF) is used to report trades in OTC MKT, OTC PINK and trades in restricted stock under Rule 144A to the NSCC. The “O” in the ORF is a great way to remember the ORF is used for OTC non nasdaq transactions.

The Trade Reporting and Comparison Service (TRACS) collects trade information for market participants who use the ADF. FINRA established TRACS to assist in the reporting of trades for ADF market participants who are not eligible to use the Nasdaq Market Center Trade Reporting Service or ACT. ADF market participants who are also market makers may choose to report trades executed through the ADF either through ACT or the TRACS systems. The TRACS system works in much the same way as ACT. However, the TRACS system will allow ADF market participants to report a three-party trade to assist in the reporting of riskless principal trades. The TRACS system reports trades to the Depository Trust Clearing Corporation (DTCC) and reports the trade to the appropriate securities information processor for public dissemination. FINRA may terminate the TRACS service upon notice to members who fail to abide by the rules of FINRA or the TRACS service.