ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

1
Chapter 6

• ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

2
Chapter 6 Questions

• What is the purpose and function of a market?
• What are the characteristics that determine the
  quality of a market?
• What is the difference between a primary and
  secondary capital market and how do these two
  markets support each other?
• What is the typical underwriting organization
  structure for corporate stock issues?

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Chapter 6 Questions

• What are Rules 415 and 144A and how do they
  affect corporate security underwriting?
• For secondary equity markets, what are the two
  basic trading systems?
• What are the major primary listing markets in the
  United States and how do they differ?
• What are call markets and when are they typically
  used in U.S. markets?

4
Chapter 6 Questions

• How are national exchanges around the world
  linked and what is meant by passing the book?
• What is Nasdaq and how has its growth and
  influence impacted the securities market?
• What are the regional exchanges and what
  securities do they trade?
• What is the third market?

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Chapter 6 Questions

• What are Electronic Communications Networks
  (ECNs) and alternative trading systems (ATSs) and
  how do they differ from the primary listing
  markets?
• What are the major types of orders available to
  investors and market makers?
• What are the major functions of the specialist on
  the NYSE?

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Chapter 6 Questions

• What new trading systems on the NYSE and Nasdaq
  have made it possible to handle the growth in
  U.S. trading volume?
• What are the three recent innovations that
  contribute to competition within the U.S. equity
  market?
• What are Rule 390 and the trade-through rule and
  what is their effect regarding competition on the
  U.S. equity market?

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What is a market?

• The means through which buyers and sellers are
  brought together to aid in the transfer of goods
  and services
• Does not require a physical location
• The market itself does not have to own the
  goods and services involved
• Buyers and sellers benefit from the market

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Characteristics of a Good Market

• Availability of past transaction information
• must be timely and accurate
• Liquidity sell quickly at a good price
• marketability
• price continuity
• depth
• Transaction cost are low (Internal efficiency)
• Prevailing market prices reflect all relevant
  information (External efficiency)

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Decimal Pricing

• The movement to decimal pricing is a case study
  in making a market better
• Benefits
• Ease of understanding prices for investors
• Reduction in minimum bid-ask spreads
• Lower transaction costs through enhanced global
  competition

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Organization of the Securities Market

• Primary markets
• New issues
• Secondary markets
• Outstanding securities are bought and sold

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Primary Capital MarketsGovernment Bonds

• Sold regularly through auctions
• Treasury bills one year maturity or less
• Treasury notes maturities of two to ten years
• Treasury bonds original maturities of more than
  ten years

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Primary Capital MarketsMunicipal Bonds

• Sold by three methods
• Competitive bid sales sealed bids
• Negotiated sale contractual arrangements,
  underwriter helps prepare, price, and sell the
  issue
• Private placements Issuer sells directly to
  investors
• Underwriters services
• Origination design of the issue
• Risk-bearing purchase the issue, risk reselling
• Distribution selling the issue

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Primary Capital MarketsCorporate Bonds

• Negotiated arrangement with an investment banking
  firm who maintains a relationship with the
  issuing firm
• Underwriting firm often organizes a syndicate for
  distribution

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Primary Capital Markets Common Stock

• New issues are divided into two groups
• Seasoned new issues
• New shares offered by firms that already have
  stock outstanding
• Initial public offerings (IPOs)
• Firms selling their stock to the public for the
  first time
• New issues normally underwritten by investment
  banking firms

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Relationships with Investment Bankers

• 1. Negotiated
• Most common
• Full services of underwriter
• 2. Competitive bids
• Corporation specifies securities offered, then
  seeks bids
• Reduced costs but also reduced services of
  underwriter
• 3. Best-efforts
• Investment banker acts as broker, selling all it
  can at a specified price

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Introduction of Rule 415

• Shelf registration
• Allows firms to register securities and sell them
  piecemeal over the next two years
• Increased flexibility for timing issues
• Reduces registration fees and expenses
• Mostly used for bond sales

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Private Placements and Rule 144A

• Firms sells to a small group of institutional
  investors, with some assistance of an investment
  banker
• Lower issuing costs than public offering
• Extensive registration not required
• Issues can trade among large, sophisticated
  investors

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Secondary Markets

• Involves the trading of issues that are already
  outstanding
• Provide a means obtaining cash for sellers
• Provide buyers with more investment choices

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Why Secondary Markets Are Important

• Provide liquidity to investors who acquire
  securities in the primary market
• Helps issuers raise needed funds in the primary
  market since investors want liquidity
• Help determine market pricing for new issues

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Secondary Bond Markets

• Secondary market for U.S. government and
  municipal bonds
• U.S. government bonds traded by bond dealers who
  specialize in these issues
• Banks and investment firms make markets in
  municipal bond issues
• Secondary corporate bond market
• Traded in an OTC market by bond dealers
• A much more limited market than for stock issues

21
Financial Futures

• Bond futures contracts allow the holder to either
  buy or sell a specific bond issue at a specific
  price on a future date
• Bond futures are traded in separate markets
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)

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Secondary Equity Markets

• Basic Trading Systems
• Pure auction market
• Buyers bid and sellers ask
• Buy and sell orders are matched at a central
  location
• Price driven market trades are made by
  determining the highest bid and the lowest ask
• Dealer market
• Dealers buy shares (at the bid price) and sell
  shares (at the ask price) from their own
  inventory
• Dealers compete against each other

23
Call Versus Continuous Markets

• Call markets trade individual stocks at specified
  times to gather all orders and determine a single
  price to satisfy the most orders
• Used for opening prices on NYSE if orders build
  up overnight or after trading is suspended
• Continuous markets trade any time the market is
  open

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Classification of U.S. Secondary Equity Markets

• Primary Market Listings
• Regional Stock Exchanges
• The Third Market
• Alternative Trading Systems

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Primary Market Listings

• Large number of listed securities
• Listing often seen as a sign of prestige
• Wide geographic dispersion of listed firms
• Diverse clientele of buyers and sellers
• Firms wanting to list must meet listing
  requirements

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Primary Market Listings NYSE

• Largest organized securities market in United
  States
• Established in 1817, but dates back to 1792
  Buttonwood Agreement by 24 brokers
• About 3,000 companies listed
• Market value over 12 trillion
• Accounts for about 80 of the trading volume for
  listed stocks

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Primary Market Listings AMEX

• Started by a group who traded unlisted stocks at
  the corner of Wall and Hanover Streets in New
  York as the Outdoor Curb Market
• Emphasis on foreign securities
• Doesnt trade stocks listed on NYSE
• Merged with Nasdaq in 1998, although operations
  remain separate

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Primary Market Listings Global Stock Exchanges

• Tokyo Stock Exchange (TSE)
• London Stock Exchange (LSE)
• Other National Exchanges
• Frankfurt, Toronto, Paris
• New exchanges in emerging countries
• Russia, Poland, China, Hungary, Peru, Sri Lanka

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Primary Market Listings Global Stock Exchanges

• Trend toward consolidation of exchanges
• Economies of scale, especially in terms of the
  required technology
• Liquidity is enhanced with more firms trading
• Larger firms dual-listed on a U.S. exchange
• Must meet listing requirements of both
• Strong exchanges abroad enable continuous global
  trading for firms

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The Global Twenty-four Hour Market

• Investment firms pass the book around the world
  to maintain nearly continuous trading by
  utilizing markets at Tokyo, London, and New York
• This means that the markets are increasingly
  interrelated, moving toward a single world market

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Primary Market Listings Nasdaq NMS

• Historically known as the Over-the-counter (OTC)
  market
• Not a formal organization or a single location
• Almost 3,500 issues actively traded on Nasdaqs
  NMS ( National Market System)
• More issues traded, but less dollar trading in
  terms of total value than NYSE

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Primary Market Listings Nasdaq NMS

• Operations
• Any stock may be traded as long as it has a
  willing market maker to act a dealer
• Nasdaq is a negotiated market with investors
  potentially dealing directly with dealers

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Primary Market Listings Nasdaq NMS

• The Nasdaq System
• National Association of Security Dealers
  Automated Quotation system
• Dealers may elect to make markets in stocks
• Average of about 8 dealers per stock in 2003
• Three levels of quotations available
• Level 1 shows a median representative quote
• Level 2 shows quotes by all market makers
• Level 3 is for Nasdaq market makers to change
  their quotes shown

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Primary Market Listings Nasdaq NMS

• Listing Requirements for Nasdaq
• Two lists
• National Market System (NMS)
• Regular Nasdaq
• Must meet at least one standard for initial and
  continued listing
• See Exhibit 6.6
• Making trades
• Broker determines which dealer has the best price
  (lowest ask price/highest bid price)

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Primary Market Listings Nasdaq

• Other Nasdaq Market Segments
• The Nasdaq Small-Cap Market (SCM)
• More lenient listing requirements
• The Nasdaq OTC Electronic Bulletin Board
• Report service for smaller stocks
• The National Quotation Bureau (NQB) Pink Sheets
• Price quotation sheets for smaller stocks

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Regional Exchanges

• Provide secondary markets for stocks not listed
  on a major exchange
• Listing requirements vary
• Some regional exchanges list issues also listed
  on a national exchange
• Regional Exchanges in United States
• Chicago, Boston, Pacific (San Francisco/Los
  Angeles), Philadelphia, Cincinnati

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Third Market

• Dealer and broker trading of shares listed on an
  exchange away from the exchange
• Mostly well known stocks
• May be important to investors particularly when
  the exchange is closed or when trading is
  suspended on the exchange
• Success depends on relative costs of transactions
  compared to the exchange

38
Alternative Trading Systems (The Fourth Market)

• Area of great innovation
• Electronic Communication Networks (ECNs)
• Buy and sell orders are matched via computer,
  mainly for retail and small institutional trading
• Electronic Crossing Systems (ECSs)
• Electronic means for matching larger buy and sell
  orders

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Detailed Analysis of Exchange Markets

• Listed exchange markets have evolved into rather
  unique institutions they can be described with a
  number of attributes
• Exchange Membership
• Major Types of Orders
• Exchange Market Makers

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Exchange Membership

• Four categories of membership
• Specialists
• Maintain an orderly market in a stock
• Commission brokers
• Member firm employees executing orders for
  clients of the firm
• Floor brokers
• Independent brokers who work for other brokers
• Registered traders
• Members who buy and sell for their own accounts

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Major Types of Orders

• Market orders
• Buy or sell at the best current price
• Limit orders
• Order specifies the buy or sell price
• Time specifications for order may vary
• Instantaneous - fill or kill, part of a day, a
  full day, several days, a week, a month, or good
  until canceled (GTC)

42
Major Types of Orders

• Short sales
• Sell overpriced stock that you dont own and
  purchase it back later (at a lower price)
• Borrow the stock from another investor (through
  your broker)
• Can only be made on an uptick trade
• Must pay any dividends to lender
• Margin requirements apply

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Major Types of Orders

• Special Orders
• Stop loss
• Conditional order to sell stock if it drops to a
  given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
• Stop buy order
• Investor who sold short may want to limit loss if
  stock increases in price

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Major Types of Orders

• Buying on Margin
• On any type order, instead of paying 100 cash,
  borrow a portion of the transaction, using the
  stock as collateral
• Interest rate is based on the call money rate
  from a bank
• Regulations limit proportion borrowed and the
  investors equity percentage (margin)
• Margin requirements are from 50 up
• Changes in price affect investors equity

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Major Types of Orders

• Margin Example
• Buy 100 shares at 60 6,000 position
• Borrow 50, investment of 3,000
• If price increases to 70, position
• Value is 7,000
• Less - 3,000 borrowed
• Leaves 4,000 equity for a
• 4,000/7,000 57 equity position

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Major Types of Orders

• Margin Example
• Buy 100 shares at 60 6,000 position
• Borrow 50, investment of 3,000
• If price decreases to 50, position
• Value is 5,000
• Less - 3,000 borrowed
• Leaves 2,000 equity for a
• 2,000/5,000 40 equity position

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Major Types of Orders

• Margin Order Details
• Initial margin requirement at least 50
• Lower margin requirements allow you to buy more
• Maintenance margin
• Required proportion of equity to stock value
• Protects broker if stock price declines
• Minimum requirement is at least 25
• Margin call on undermargined account to meet
  margin requirement
• If call not met, stock will be sold to pay off
  the loan

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Exchange Market Makers

• A NYSE specialist is exchange member assigned to
  handle particular stocks
• Has two roles
• Broker match buy and sell orders and to process
  any limit orders as prices change
• Dealer buy and sell from their own account to
  maintain fair, liquid, and orderly market
• Specialist has two income sources
• Broker commission, without risk
• Dealer trading income from profit, with risk, but
  also with significant information advantages

49
New Trading Systems

• As trading volume has grown, it has become
  increasingly necessary to seek new technologies
  to assist the trading process.
• Super DOT
• Electronic order-routing system
• Member firms transmit market and limit orders in
  NYSE securities to trading posts or member firms
  booth
• Report of execution returned electronically
• 85 of NYSE market orders enter through Super DOT
  system

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New Trading Systems

• Display Book
• Electronic workstation that keeps track of all
  limit orders and incoming market orders
• Opening Automated Report Service (OARS)
• Pre-opening market orders for Super Dot system
• OARS automatically and continuously pairs buy and
  sell orders
• Presents imbalance to the specialist prior to the
  opening of a stock
• Helps determine opening price

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New Trading Systems

• Market Order Processing
• Super Dots postopening market order system
• Rapid execution and reporting of market orders
• In 2003, 94.5 of market orders executed in less
  than thirty seconds
• Limit Order Processing
• Electronically files orders to be executed when
  and if a specific price is reached
• Updates the Specialists Display Book
• Good-until-cancelled orders that are not executed
  are stored until executed or canceled

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New Trading Systems

• Nasdaq
• Small-Order Execution System (SOES)
• Helps to ensure the execution of smaller orders
  (up to 1000 shares)
• SelectNet
• A computer order-routing and execution service
  for institutional investors

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Innovations for Competition

• Two competing models
• Order-driven market (Exchanges)
• Quote-driven market (Nasdaq dealers)
• SEC has encouraged competition
• Consolidated Quotation System (CQS)
• Allows subscribers to see quotations from both
  exchanges and dealers simultaneously
• Intermarket Trading System (ITS)
• Centralized quotation system between Nasdaq and
  regional exchanges

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Future Developments

• Continued competition of ECNs with the
  order-driven and quote-driven markets
• NYSE has sought to protect itself against such
  competition through regulations
• They argue that they offer many investors the
  best price even if the other platforms offer
  better speed of execution