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Direct finance

Direct finance is a mechanism in financial systems where savers (lenders) provide funds directly to borrowers through the purchase of newly issued securities, such as stocks or bonds, in primary financial markets, bypassing financial intermediaries like banks.^[1] This contrasts with indirect finance, in which intermediaries collect funds from savers and lend them to borrowers, often transforming the nature of the assets to reduce risk and enhance liquidity.^[2] Key characteristics include the direct transfer of ownership claims on the borrower's future income or assets, with securities traded in secondary markets to provide liquidity and price discovery.^[1] In practice, direct finance facilitates capital allocation from surplus units, such as households and institutional investors, to deficit units like corporations and governments, supporting economic activities including business expansion, infrastructure development, and innovation.^[1] For example, a corporation might issue bonds to finance a new factory or stocks to fund research and development, allowing investors to directly claim a share of profits or fixed interest payments.^[1] Secondary markets, such as the New York Stock Exchange, enable the resale of these securities, which enhances their attractiveness by allowing investors to adjust portfolios without relying on the original borrower's repayment timeline.^[1] This system promotes efficiency in resource distribution but exposes participants to greater information asymmetries and risks compared to intermediated channels.^[2] The scale of direct finance underscores its centrality to modern economies; in the United States as of the second quarter of 2025, directly and indirectly held corporate equities totaled approximately $61.1 trillion, while the fixed income market outstanding reached about $47.8 trillion.^[3]^[4] Globally, direct finance markets have grown significantly, driven by deregulation, technological advancements in trading, and increasing participation from institutional investors, though they remain subject to regulatory oversight by bodies like the U.S. Securities and Exchange Commission to mitigate systemic risks.^[5]

Definition and Fundamentals

Core Definition

Direct finance refers to the process in which ultimate savers, such as investors or households, provide funds directly to ultimate borrowers, like corporations or governments, through financial markets by purchasing securities issued by the borrowers. These securities represent claims on the borrower's future income or assets, enabling a direct transfer of capital without the involvement of financial intermediaries such as banks.^[1] Key characteristics of direct finance include the issuance and subsequent trading of securities in organized markets, which facilitate a market-based allocation of capital driven by supply and demand dynamics. This approach contrasts with intermediated lending by allowing for greater transparency in pricing and potentially more efficient information flow between parties, as market participants rely on publicly available data and disclosures rather than private negotiations. In terms of economic role, direct finance plays a vital part in mobilizing savings for productive investments in free-market economies, channeling funds from surplus units to deficit units and promoting overall resource allocation efficiency.^[1]^[6] Basic examples of direct finance include a corporation issuing bonds directly to investors to fund a new factory, where buyers receive periodic interest payments backed by the company's assets, or an initial public offering (IPO) in which a company sells shares of ownership to the public to raise equity capital for expansion. These mechanisms underscore direct finance's emphasis on market transactions over intermediary facilitation.^[1]

Distinction from Indirect Finance

Indirect finance involves financial intermediaries, such as commercial banks, mutual funds, and insurance companies, that collect funds from savers in the form of deposits or shares and then allocate these resources to borrowers through loans or other credit extensions.^[1] These intermediaries perform essential functions, including absorbing credit risk by holding diversified portfolios of loans and providing maturity transformation by converting short-term liabilities (like demand deposits) into longer-term assets (such as mortgages).^[7] This process allows savers to access liquid, low-risk claims against the intermediary while enabling borrowers to obtain funding without directly negotiating with numerous individual lenders.^[2] In contrast to direct finance, where savers and borrowers transact through financial markets by trading securities like stocks and bonds, indirect finance relies on the balance sheets of financial institutions to facilitate fund transfers.^[1] Direct finance depends on organized markets for price discovery—through supply and demand dynamics that determine asset values—and liquidity, as securities can be easily bought or sold among investors.^[2] Indirect finance, however, operates via institutional intermediation, where the intermediary assumes the primary exposure to borrower default risk and issues its own standardized liabilities to savers, thereby insulating the latter from direct involvement with the borrower's creditworthiness.^[7] This structural difference means that in direct finance, investors bear the full risk of the issuer without intermediary buffers, potentially leading to higher volatility but also more transparent pricing.^[1] At a high level, direct finance offers greater efficiency for large-scale capital mobilization by minimizing intermediary fees and enabling broad market access, though it demands sophisticated participants capable of evaluating risks independently.^[2] Indirect finance, by comparison, provides convenience through professional risk management and diversification within institutions, making it more accessible for smaller savers but introducing reliance on the intermediary's stability.^[7] These approaches can be illustrated textually as distinct fund flows: in direct finance, resources move from savers directly to borrowers via securities markets (savers purchase bonds or stocks issued by borrowers); in indirect finance, savers deposit funds with intermediaries, which then extend loans to borrowers, creating a mediated chain (savers → intermediaries → borrowers).^[1]

Key Mechanisms

Primary Market Transactions

The primary market serves as the venue for the initial issuance of new securities, enabling issuers such as governments and corporations to raise fresh capital directly from investors without intermediaries holding the funds.^[8] In this direct finance mechanism, proceeds from the sale flow straight to the issuer to fund operations, expansions, or public projects, distinguishing it from secondary trading where ownership merely transfers between investors. The transaction process in the primary market typically involves several key steps, beginning with the issuer engaging underwriters to structure the offering. Underwriting occurs when investment banks act as facilitators, assessing demand, guaranteeing a minimum sale price in firm commitment arrangements, or exerting best efforts without such guarantees, thereby mitigating issuance risks for the issuer.^[9] Pricing follows through methods like book-building, where underwriters solicit investor bids to determine an optimal price based on interest levels, or auctions, as seen in government securities sales where competitive bidding sets the rate.^[10] Settlement concludes the process, with electronic transfer of funds from investors to issuers and delivery of securities, often within days via clearing systems.^[5] Key participants include issuers, who originate the securities; underwriters, primarily investment banks that coordinate distribution; and initial investors, comprising institutional entities like pension funds and retail individuals purchasing directly.^[8] This structure ensures direct capital infusion, as investors' payments bypass traditional banks and go immediately to the issuer. Representative examples include initial public offerings (IPOs) for equity, such as Facebook's 2012 IPO where the company raised $16 billion through underwritten shares sold directly to investors.^[10] New bond issuances illustrate debt transactions, like the U.S. Treasury's regular auctions of government securities via competitive bidding. In recent years, global primary market activity has been substantial, with long-term fixed income issuance reaching $27.4 trillion in 2024, encompassing government and corporate bonds, while global IPO proceeds totaled approximately $126 billion from 1,159 deals.^[11]^[12] These issuances provide essential capital, with secondary markets later enhancing liquidity for the traded securities.

Secondary Market Operations

The secondary market serves as a platform where investors buy and sell previously issued securities directly from one another, rather than from the original issuers, thereby facilitating the transfer of ownership without generating new capital for companies or governments.^[13] This process enhances overall market efficiency by allowing holders to liquidate assets quickly and buyers to acquire them at negotiated prices, distinct from primary market activities where new securities are created and sold.^[14] Unlike primary transactions, secondary trading focuses on existing instruments, promoting ongoing market participation and reducing the risk associated with illiquid holdings.^[1] Secondary markets operate through two primary types: organized exchanges and over-the-counter (OTC) markets. Organized exchanges, such as the New York Stock Exchange (NYSE) and NASDAQ, provide centralized, regulated platforms with electronic trading systems that match buy and sell orders automatically, ensuring transparency and standardized rules.^[15] In contrast, OTC markets involve decentralized networks of dealers who negotiate trades directly via phone, electronic systems, or alternative trading systems, often for less standardized or smaller-volume securities, without a physical location.^[16] Both types rely on advanced electronic infrastructure for order routing and execution, with exchanges typically handling higher-visibility listings and OTC markets accommodating a broader range of instruments. Key operations in secondary markets include trading mechanisms that enable efficient exchanges and price determination. Continuous auctions, prevalent on exchanges like the NYSE, allow ongoing matching of limit and market orders throughout the trading day, where prices adjust in real-time based on supply and demand.^[17] Market makers, often designated specialists or firms, play a crucial role by quoting bid and ask prices to provide liquidity, narrowing spreads, and facilitating trades during imbalances.^[18] Price discovery occurs through the interaction of these orders, reflecting collective investor assessments of value influenced by economic data, company performance, and sentiment.^[19] Post-trade, settlement is handled by clearinghouses such as the Depository Trust & Clearing Corporation (DTCC), which nets obligations, mitigates counterparty risk, and ensures delivery versus payment, typically within T+1 cycles for equities as of 2024.^[20]^[21] This infrastructure processes billions of transactions daily, minimizing operational failures. The impacts of secondary market operations are profound, primarily by enhancing liquidity, which lowers the costs of holding securities and enables investors to enter or exit positions with minimal price disruption.^[1] This liquidity supports portfolio rebalancing, allowing asset managers to adjust allocations in response to changing risk profiles or opportunities without significant penalties.^[22] Globally, secondary market turnover for equities reached approximately $124 trillion in 2023, underscoring the scale of activity and its role in capital allocation efficiency.^[23]

Financial Instruments

Equity-Based Instruments

Equity-based instruments represent ownership stakes in a company, enabling direct finance by allowing firms to raise capital straight from investors in exchange for shares. Common stock, the most prevalent form, grants shareholders proportional ownership, including voting rights on corporate matters such as board elections and mergers, along with potential dividends derived from company profits.^[24] These dividends are not guaranteed and vary based on performance, reflecting the residual claim holders have on assets and earnings after debt obligations are met.^[25] Preferred stock, in contrast, offers investors a hybrid profile with fixed dividend payments at a predetermined rate, providing more stability than common stock, and priority over common shareholders in asset distribution during liquidation.^[26] However, preferred shareholders typically lack voting rights, positioning this instrument as a less participatory but more secure equity option for those seeking predictable income streams.^[25] Issuance of these instruments occurs directly through mechanisms like initial public offerings (IPOs), where private companies first sell shares to the public to access broader capital markets, or rights offerings, which grant existing shareholders the preemptive right to purchase additional shares at a discount to maintain their ownership proportion.^[27]^[28] Valuation of equity instruments in direct finance relies on conceptual approaches such as earnings multiples, which compare a company's price to its earnings per share to gauge relative value against peers, or discounted cash flow analysis, which estimates intrinsic worth by projecting future cash flows and adjusting them to present value based on risk and time.^[29]^[30] For investors, equity holdings entail a residual claim on profits and assets, offering unlimited upside potential through capital appreciation if the company succeeds, but exposing them to full downside risk, including potential total loss in bankruptcy.^[31] A notable example is Google's 2004 IPO, which raised approximately $1.67 billion through a Dutch auction process, pricing shares at $85 and marking a pivotal tech sector event that fueled innovation and growth.^[32]^[33] Equity markets play a crucial role in direct finance by facilitating venture funding for early-stage innovation and growth capital for scaling operations, allowing high-potential firms to secure substantial investments without debt burdens.^[34] This direct access supports transformational expansions, such as entering new markets or pursuing acquisitions, particularly for mature companies exhibiting rapid revenue growth.^[35]

Debt-Based Instruments

Debt-based instruments in direct finance primarily consist of bonds and notes, which represent contractual obligations where issuers borrow funds from investors in exchange for periodic interest payments and repayment of principal at maturity. Bonds are long-term debt securities typically with maturities exceeding one year, while notes are shorter-term instruments often ranging from one to ten years. These include corporate bonds issued by companies to finance operations or expansions, government bonds such as U.S. Treasury bonds backed by sovereign authority, and municipal bonds issued by local governments to fund public projects like infrastructure.^[36]^[37] Key features encompass the face value (or par value), which is the principal amount repaid at maturity; the coupon rate, denoting the fixed interest rate applied to the face value and paid periodically; the maturity date, marking the end of the bond's term; and yield to maturity (YTM), a conceptual metric representing the total anticipated return if held to maturity, factoring in current market price, coupons, and principal repayment.^[37]^[38] The issuance of these instruments occurs directly from issuers to investors via public offerings, where securities are sold broadly through exchanges or underwriters to attract a wide investor base, or private placements, which involve targeted sales to a limited group of institutional investors without public registration. Credit ratings, assigned by agencies such as Moody's or S&P, range from investment-grade (e.g., AAA for highest quality) to speculative or junk (e.g., BB or below), significantly influencing pricing: higher-rated bonds command lower yields due to perceived lower default risk, while lower-rated ones offer higher yields to compensate for elevated risk.^[39]^[40] This direct issuance bypasses intermediaries like banks, enabling issuers to secure capital efficiently based on market demand and creditworthiness.^[41] From an investor perspective, debt instruments provide predictable income through fixed interest payments (coupons) and full principal repayment at maturity, offering a lower risk profile compared to equity due to their seniority in bankruptcy claims, though they remain susceptible to issuer default. For instance, U.S. Treasury bonds are considered virtually risk-free as they are backed by the full faith and credit of the U.S. government, yielding stable returns for conservative investors, whereas corporate debentures—unsecured bonds relying on the issuer's general credit—are riskier but often provide higher coupons to attract capital.^[42]^[43]^[44] The global bond market, the largest segment of direct finance, had outstanding debt securities exceeding $150 trillion by the end of 2024, underscoring its scale in facilitating capital allocation worldwide.^[45]

Advantages and Challenges

Benefits

Direct finance promotes efficient capital allocation by enabling market prices to reflect supply and demand for funds, directing resources toward the most productive uses without the filtering of financial intermediaries.^[1] This mechanism reduces intermediation costs compared to indirect finance, where banks impose spreads and fees.^[1] For issuers, direct finance provides access to diverse and large-scale funding sources, allowing corporations to raise substantial capital through equity or debt securities for expansions or projects without the collateral requirements typical of bank lending.^[1] This flexibility enables tailored terms, such as varying maturities or covenants, directly negotiated via market mechanisms, as seen when firms like major automakers issue bonds to finance new factories.^[2]^[46] Investors benefit from higher potential returns through direct exposure to issuer performance, alongside opportunities for portfolio diversification across numerous securities.^[1] Secondary markets enhance liquidity, permitting quick sales of holdings without relying on intermediary redemption processes, which supports broader participation by institutional and retail investors.^[46] On a broader scale, direct finance fosters innovation by channeling funds to high-growth sectors and encourages competition among issuers to attract capital, driving economic dynamism.^[46] In developed markets like the United States, post-1930s regulatory reforms strengthened capital market efficiency, leading to widespread household equity ownership (direct or indirect)—reaching 62% as of 2025—and sustained wealth creation, further boosted by technological platforms enabling retail access.^[46]^[47]

Limitations and Risks

Direct finance, while offering direct access to capital markets, imposes significant limitations on participants due to the need for high levels of investor sophistication. Unlike indirect finance, where financial intermediaries screen and monitor borrowers, direct finance requires investors to independently assess the viability and risks of issuers, demanding substantial financial knowledge and analytical capabilities.^[48] This barrier often excludes less experienced or retail investors, limiting broader market participation.^[49] A core limitation stems from information asymmetry between issuers and investors, where issuers possess superior knowledge about their operations and financial health, potentially leading to adverse selection or moral hazard issues.^[50] This asymmetry heightens the risk of mispriced securities and investor losses, as buyers must rely on available data without the due diligence typically provided by banks.^[51] Additionally, certain direct finance markets, such as private placements, suffer from illiquidity, as these securities lack active secondary trading venues, making it difficult for investors to sell holdings without substantial price concessions.^[52] Key risks in direct finance include market risk from price volatility, credit risk from issuer defaults, and liquidity risk from inability to exit positions promptly.^[53] For instance, during the 2008 financial crisis, corporate bond markets— a primary venue for direct finance—experienced severe liquidity shortages, with bid-ask spreads widening dramatically and trading volumes plummeting, amplifying losses for holders.^[54] Systemically, direct finance can foster bubbles or crashes through herd behavior, where investors mimic others' actions amid information gaps, exacerbating volatility in equity and debt markets.^[55] Small investors face disproportionately higher transaction costs, including search and monitoring expenses, which further deter participation compared to larger institutions.^[49] To mitigate these risks, disclosures play a vital role by enhancing transparency and enabling better investor decision-making, thereby supporting greater direct financing activity.^[56] However, even with improved disclosures, the inherent vulnerabilities of direct finance persist, underscoring the need for cautious engagement by participants.

Historical and Regulatory Context

Historical Evolution

Direct finance, characterized by the direct issuance and trading of securities between issuers and investors without intermediaries like banks, traces its origins to the 17th and 18th centuries in Europe, where joint-stock companies first enabled public participation in equity funding. The Dutch East India Company (VOC), established in 1602, marked a pivotal milestone as the world's first publicly traded company, issuing shares to the general public through an initial public offering (IPO) that raised capital for long-distance trade voyages.^[57] This innovation allowed investors to buy transferable shares, fostering the emergence of secondary markets in Amsterdam, where shares were actively traded. Concurrently, early bond markets developed in the same city during the 17th century, with government and municipal bonds traded informally among merchants, laying the groundwork for formalized debt securities that supported public infrastructure and trade.^[58] The 19th and early 20th centuries saw significant growth in direct finance, particularly in the United States, as expanding economies demanded large-scale capital for infrastructure. The New York Stock Exchange (NYSE), founded in 1792 through the Buttonwood Agreement signed by 24 brokers, formalized stock trading on Wall Street, initially focusing on government bonds and bank stocks but evolving into a hub for corporate equities.^[59] By the mid-19th century, railroads became a cornerstone of direct finance, with companies issuing bonds to fund expansive networks; for instance, U.S. railroads raised billions through bond sales on exchanges, shifting from equity-heavy financing to debt instruments that attracted institutional and retail investors.^[60] Following World War II, direct finance expanded further with the rise of institutional investing, as pension funds, mutual funds, and insurance companies increased their equity holdings; by the 1950s, institutions accounted for about 25% of stock trades, driving market liquidity and volume amid postwar economic recovery.^[61] Modern developments in direct finance accelerated in the late 20th century through deregulation and technological advancements, enhancing accessibility and efficiency. The repeal of the U.S. Glass-Steagall Act in 1999, via the Gramm-Leach-Bliley Act, dismantled barriers between commercial and investment banking, allowing financial conglomerates to expand securities underwriting and trading activities.^[62] The 1990s witnessed the rise of electronic trading platforms, such as electronic communication networks (ECNs), which automated order matching and reduced costs, with algorithmic trading gaining prominence and capturing a growing share of market volume by the decade's end.^[63] Post-2010, fintech innovations integrated direct finance further, exemplified by crowdfunding platforms like Kickstarter and Indiegogo, which democratized equity and reward-based funding for startups and projects, raising billions globally by enabling direct investor-issuer connections online.^[64] The global spread of direct finance has been particularly notable in emerging markets during the 2010s, with China's bond market undergoing rapid development as part of broader financial reforms. From 2010 onward, China's onshore bond market expanded from approximately $3 trillion to over $17 trillion by 2020, driven by government initiatives to diversify funding sources and include corporate and local government issuers, attracting international investors through programs like the Bond Connect scheme.^[65] As of the end of 2024, the market had grown to RMB 177 trillion (approximately USD 25 trillion), continuing its role in supporting economic expansion in developing economies.^[66]

Regulatory Frameworks

Direct finance, involving the issuance and trading of securities such as stocks and bonds directly between issuers and investors, is subject to stringent regulatory frameworks designed to promote transparency, prevent fraud, and maintain market integrity. In the United States, the Securities Act of 1933 mandates the registration of securities offerings with the Securities and Exchange Commission (SEC) and requires detailed disclosures to protect investors from fraudulent practices.^[67] Complementing this, the Securities Exchange Act of 1934 regulates secondary trading, establishes the SEC's authority over securities exchanges, and prohibits manipulative and deceptive practices in securities transactions.^[68] Internationally, the International Organization of Securities Commissions (IOSCO) provides foundational principles for securities regulation, emphasizing three core objectives: protecting investors, ensuring fair and efficient markets, and reducing systemic risk, with 38 specific principles covering areas like licensing, inspections, and information sharing among regulators.^[69] Key regulatory bodies enforce these standards regionally; the SEC in the U.S. oversees registration, disclosure, and anti-fraud enforcement for direct finance activities.^[70] In the United Kingdom, the Financial Conduct Authority (FCA) supervises securities markets, including issuance and trading, to ensure fair treatment of investors and market stability.^[71] The European Securities and Markets Authority (ESMA) coordinates EU-wide supervision, focusing on investor protection, market transparency, and preventing market abuse in cross-border securities transactions.^[72] In China, the 2020 amendment to the Securities Law enhanced transparency, investor protection, and market stability, aligning with global trends.^[73] Specific rules under these frameworks include prospectus requirements, which obligate issuers to provide comprehensive documents detailing financials, risks, and terms before public offerings to enable informed investor decisions.^[74] Insider trading prohibitions, enforced globally, ban the use of material nonpublic information for trading securities, with the SEC's Regulation Fair Disclosure (Reg FD) requiring issuers to disseminate such information broadly to avoid selective disclosure.^[75] Post-2008 financial crisis reforms, notably the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enhanced oversight by expanding SEC rulemaking authority, improving derivatives regulation, and strengthening investor protections in securities markets.^[76] Global variations reflect efforts toward harmonization alongside regional differences; IOSCO principles and Basel Committee standards promote consistent risk management and supervisory cooperation across borders, though the EU imposes stricter protections for retail investors under the Markets in Financial Instruments Directive (MiFID II), mandating assessments of investor knowledge and suitability of products.^[69]^[77]^[78]

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Dec 13, 2006 · Scattered references in the orphanage's cash registers during the first half of the seventeenth century suggest its regents began to buy bonds ...
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The Buttonwood Agreement was a 1792 compact to create a stock exchange in New York City, signed by 24 stockbrokers and merchants on Wall Street.
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Dec 30, 2019 · America's greater reliance on capital markets for raising debt capital dates to the railway boom of the mid-19th century.
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Transformation & Regulation: Equities Market Structure, 1934 to 2018
From 1946 to 1952, institutional investors bought two-fifths of all new issues. And by 1958, one quarter of all purchases and sales of stocks were by ...
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The Glass-Steagall Act effectively separated commercial banking from investment banking and created the Federal Deposit Insurance Corporation.
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[PDF] The Rise of Computerized High Frequency Trading
32 The growth of these ECNs in the late 1990's led to the wider use of algorithmic trading and eventually the rise of independent high frequency trading firms.
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https://tontinecoffeehouse.com/2019/12/30/railroads-and-the-bond-market/
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[PDF] Chinese Bond Market and Interbank Market Marlene Amstad and ...
Over the past twenty years, especially the past decade, China has taken enormous strides to develop its bond market as an integral step of financial reform.
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All securities offered in the United States must be registered with the SEC or must qualify for an exemption from the registration requirements.
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Sep 30, 2013 · The securities laws broadly prohibit fraudulent activities of any kind in connection with the offer, purchase, or sale of securities.
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[PDF] IOSCO Objectives and Principles of Securities Regulation
The paper is divided into three parts. Part I provides an introduction to the paper and a statement of the objectives and the principles of securities ...
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Securities Regulation in the Interconnected, Global Marketplace
Sep 21, 2016 · As a securities regulator, the SEC oversees and enforces a robust disclosure regime, one of the fundamental premises of which is that public ...
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Jul 28, 2018 · The securitisation regulation aims to make the UK securitisation market work more effectively. We want to make sure that firms operating in the financial ...<|separator|>
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| European Securities and Markets Authority
ESMA Strategic priorities 2023-2028 & Work Programme 2026 ESMA will focus on strengthening supervision, enhancing the protection of retail investors, fostering ...Guidelines, Recommendations... · ESMA News · Careers · Contact Information
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Unofficial Consolidation: Companion Policy 41-101CP General ...
Mar 8, 2017 · 2.3 Securities legislation prohibits a person from distributing a security unless a prospectus is filed and receipted or the distribution is ...<|separator|>
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Selective Disclosure and Insider Trading - SEC.gov
The Securities and Exchange Commission is adopting new rules to address three issues: the selective disclosure by issuers of material nonpublic information.
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Sep 9, 2014 · The Dodd-Frank Act gave the SEC significant new responsibilities, requiring the agency to undertake the largest and most complex rulemaking ...
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Dec 1, 2010 · International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including ...
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Article 24 General principles and information to clients
Investment firms shall inform retail clients or potential retail clients that they have the option of receiving the information on paper. Investment firms shall ...