II. FINANCAL MARKETS, TRADING PROCESSES AND INSTRUMENTS

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II. FINANCAL MARKETS, TRADING PROCESSES AND
INSTRUMENTS
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A. Exchanges and Floor Markets

• The Securities and Exchange Act of 1934 defined
  an exchange to be
• any organization, association, or group of
  persons, whether incorporated or unincorporated,
  which constitutes, maintains, or provides a
  market place or facilities for bringing together
  purchasers and sellers of securities or for
  otherwise performing with respect to securities
  the functions commonly performed by a stock
  exchange as that term is generally understood,
  and includes the market place and the market
  facilities maintained by such exchange.
• An exchange is a physical or virtual meeting
  place drawing together brokers, dealers and
  traders to facilitate the buying and selling of
  securities.
• Exchanges include the floor-based markets as well
  as many virtual meeting sites and screen-based
  systems provided by Electronic Communications
  Networks (ECNs).

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Exchange Functions

• Exchanges are intended to provide for orderly,
  liquid and continuous markets for the securities
  they trade.
• A continuous market provides for transactions
  that can be executed at any time for a price that
  might be expected to differ little from the prior
  transaction price for the same security.
• In addition, exchanges traditionally serve as
  self-regulatory organizations (SROs) for their
  members, regulating and policing their behavior
  with respect to a variety of rules and
  requirements.

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NYSE Euronext

• NYSE Euronext, the worlds largest exchange and
  its first global exchange, lists over 8,000
  issues (excluding European structured products)
  from 55 countries on six equities exchanges and
  six derivatives exchanges in six countries.
• NYSE Euronext was launched on April 4, 2007, the
  result of a merger between the New York Stock
  Exchange Group and Euronext, NV.

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NYSE Family Tree
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U.S. Stock and Options Exchanges

• NYSE Amex LLC (formerly the American Stock
  Exchange)
• BATS Exchange, Inc.
• BATS Y-Exchange, Inc.
• NASDAQ OMX BX, Inc. (formerly the Boston Stock
  Exchange)
• C2 Options Exchange, Incorporated
• Chicago Board Options Exchange, Incorporated
• Chicago Stock Exchange, Inc.
• EDGA Exchange, Inc.
• EDGX Exchange, Inc.
• International Securities Exchange, LLC
• The Nasdaq Stock Market LLC
• National Stock Exchange, Inc.
• New York Stock Exchange LLC
• NYSE Arca, Inc.
• NASDAQ OMX PHLX, Inc. (formerly Philadelphia
  Stock Exchange)

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Futures and Partially Exempt Exchanges

• U.S. Futures Exchanges
• Board of Trade of the City of Chicago, Inc.
• CBOE Futures Exchange, LLC
• Chicago Mercantile Exchange
• One Chicago, LLC
• The Island Futures Exchange, LLC
• NQLX LLC
• Partially Exempt Exchanges
• Arizona Stock Exchange
• SWX Europe Limited (f/k/a Virt-x)

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Early Exchanges

• Precursors to modern stock exchanges might have
  existed in Egypt as early as the 11th century,
  where it is believed that Jewish and Islamic
  brokers traded a variety of credit-related
  instruments.
• 13th century Bruges (Belgium) commodity traders
  assembled in the van der Beurse family home (and
  inn), ultimately becoming the Brugse Beurse.
• The Amsterdam Stock Exchange opened in the early
  17th century, trading shares of the Dutch East
  India Company. The exchange continues to operate
  as a unit of Euronext, and as the world's longest
  continuously operated exchange.
• Several older exchanges began in coffee houses
  and taverns, where brokers and dealers would meet
  to trade securities.
• The first securities exchange to operate in the
  United States was in Philadelphia.
• The New York Stock Exchange began operations
  outdoors after the 1792 signing of the
  Buttonwood Agreement.
• Exchanges often operated outdoors so that brokers
  could call out their orders from their office
  windows to the street where transactions actually
  took place.
• The American Stock Exchange, known as the New
  York Curb Exchange until 1953, did not move
  indoors until 1921.

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Traditional NYSE Structure

• Until 2006, the NYSE was a hybrid
  corporation/partnership whose members faced
  unlimited liability.
• Only members who owned or leased seats had
  trading privileges and there were four types of
  members 
• House Broker Executed orders on behalf of
  clients submitting orders through brokerage
  firms. This and other broker roles have been
  taken over by "Trading Floor Brokers."
• Independent Broker Also called a two-dollar
  broker, executed orders on behalf of commission
  brokers when activity was high. This type of
  distinct membership no longer exists.
• Floor Trader Executed orders on their own
  trading accounts. The NYSE has created the
  "Supplemental Liquidity Provider" role, which is
  intended to enhance market liquidity by allowing
  for proprietary trading.
• Specialist Responsible for maintaining a
  continuous, liquid, orderly market for the
  securities in which he specializes. The
  specialist has been replaced by the Designated
  Market Maker (DMM).
• Now, under its new structure, one can join the
  1366 members by purchasing a license that permits
  the member to trade for one year.

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Securities Order Routing Process

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U.S. Options Exchanges Data from January 1,
through July 31, 2011

•  
• Cleared Total Avg. Daily
  of
• Exchange Contracts Premiums
  Contracts Total Contracts
• ARCA 158,529,881 36,180,176,001
  1,093,310 10.63
• BATS 50,286,898 12,952,402,034
  346,806 3.37
• BOX 49,788,089 9,882,629,258
  343,366 3.34
• C2 10,400,904 1,457,446,499
  71,730 0.70
• CBOE 316,112,979 60,812,186,839
  2,180,090 21.20
• ISE 259,516,879 45,392,864,394
  1,789,772 17.40
• NSDQ 69,144,416 16,647,189,711
  476,858 4.64
• PHLX 367,776,704 121,172,599,631
  2,536,391 24.66
• Total 1,491,204,897
  340,633,377,303 10,284,172 100.00
•  

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B. Over the Counter Markets and Alternative
Trading Systems

• The over the counter markets have traditionally
  been defined as the non-exchange markets.
• An alternative trading system (ATS) might be
  loosely defined as a securities trading venue
  that is not registered with the S.E.C. as an
  exchange.

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ATS Types

• Electronic Communication Networks (ECNs), which
  are virtual meeting places and screen-based
  systems for trading securities.
• Dark Pools and "Crossing Networks," where
  quotations for share blocks are matched
  anonymously. Participants in crossing markets
  enjoy reduced transactions costs and anonymity
  but often must wait for counterparty orders to
  accumulate before transactions can be executed.
• Internalization Crossing
• Voice-Brokered Third-Party Matching.

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Sample ATS List

• Host
• Name Country Instruments Features
• Alpha Canada Equities Continuous
  trading market
• ArcaEdge U.S. Equities NYSE ATS
• Chi-X Europe U.K. European Shares Multilateral
  Trading Facility
• Citi Match U.S. Equities Internal Crossing
  Network
• Crossfinder Global Equities Bills itself as
  the
• world's largest
• dark pool Internal
• crossing network

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ATS Definition

• Alternative trading system means any
  organization, association, person, group of
  persons, or system
• 1. That constitutes, maintains, or provides a
  market place or facilities for bringing together
  purchasers and sellers of securities or for
  otherwise performing with respect to securities
  the functions commonly performed by a stock
  exchange within the meaning of Rule 3b-16 under
  the Securities Exchange Act of 1934 and
• 2. That does not
• i. Set rules governing the conduct of subscribers
  other than the conduct of such subscribers'
  trading on such organization, association,
  person, group of persons, or system or
• ii. Discipline subscribers other than by
  exclusion from trading.
• What the ATS does not do is what distinguishes it
  from an exchange.

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Equity Trading Centers Volume 2009

• NYSE 14.7
• NYSE Arca 13.2
• Nasdaq 19.4
• NASDAQ OMX BX 3.3
• Broker-Dealer (Internalization) 17.5
• Direct Edge 9.8
• BATS 9.5
• Dark Pools 7.9
• Other Exchanges 3.7
• Other ECNs 1.0

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Electronic versus Open Outcry

• Bakos et al. 2000, opened a series of accounts
  at various full-service, discount and electronic
  securities brokers.
• Their commissions for 100-share lots averaged
  7.50 for electronic brokers and 47 for
  full-service voice brokers.
• They found that full-service brokers were more
  likely to route orders to the principle exchanges
  than electronic brokers and that such orders were
  more likely to be improved.
• However, for smaller orders, these price
  improvement advantages are more than offset by
  the higher brokerage commissions. Hence,
  specialists and market makers on exchanges were
  able to provide better order executions while
  brokers using electronic markets charged smaller
  commissions.
• It appeared that smaller investors fared better
  with discount electronic brokers while larger
  transactions resulted in better after-commission
  executions on the principle exchanges.

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D. Crossing Networks and Upstairs Markets

• Slippage, associated with large transactions,
  occurs when an order forces prices against the
  trader.
• Crossing networks are alternative trading systems
  that match buyers and sellers with agreed-upon
  quantities.
• Crossing networks do not publicly display
  quotations, thereby enabling participants
  anonymity.
• Trades are priced by reference to prices obtained
  from other market. The crossing network then
  matches buy and sell orders at prices obtained
  from more traditional markets such as the NYSE.
• This crossing procedure enables institutional
  traders to execute without exposing orders to
  competitors.
• The crossing network, by having prices determined
  elsewhere, also prevents the price impact or
  pressure typically associated with auctions of
  large blocks of shares.
• Because crossing networks do not reveal prices or
  client identities, and that they represent
  non-displayed liquidity, they are sometimes
  referred to as dark pools of liquidity.
• MidPoint Match and Nasdaq Crossing provide
  traders with opportunities to match orders
  anonymously at known benchmark (e.g., the
  mid-point of the spread) or closing or other
  prices several times a day.
• The Securities and Exchange Commission 1998
  defines crossing networks as systems that allow
  participants to enter unpriced orders to buy and
  sell securities. Orders are crossed at a
  specified time at a price derived from another
  market.

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Internalization

• Internalization occurs when brokers execute their
  own client buy orders against their own client
  sell orders, representing both sides of a trade
  and without routing them to central markets.
• Internalization allows brokers to easily execute
  transactions at a lower cost.
• However, internalization
• may inhibit the brokers ability to properly
  represent the client as the clients agent
• results in fewer transactions being executed in
  the central market, which increases market
  fragmentation and reduces transparency and
  potential price competition.
• can lead to reduced liquidity and increased price
  volatility in the central market.
• can lead to violations of price and time
  priority.
• the transaction might be more susceptible to
  manipulation or may not be executed at the best
  possible prices.
• Internalization of customer orders is not
  possible for options markets transactions due to
  exchange rules.

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E. Quotation, Inter-market and Clearing Systems

• Consolidated Tape (CTA) High-speed electronic
  system maintained by SIAC for reporting
  transaction prices and volumes for securities on
  all U.S. exchanges and markets.
• Consolidated Quotations System (CQS) Provides
  traders with price quotes through SIAC from the
  various exchanges and FINRA and calculates the
  NBBO. The CQS does not time delay as the
  Consolidated Tape can during periods of heavy
  volume.
• Intermarket Trading System (ITS) Displays quotes
  in different markets and links markets for trade
  executions to facilitate investors access to the
  best quotes. This system might be considered to
  be the centerpiece of the National Market System.
  
• Securities Investors Protection Corporation
  (SIPC) analogous to FDIC in that it insures
  investors' account for up to 500,000 in
  securities and 100,000 in cash, but only when
  the investors brokerage firm fails. Thus, this
  coverage is very limited.

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Clearing and Settlement

• The general clearing process involves two primary
  tasks trade comparison (matching of trades) and
  settlement (delivery of securities or book
  entry).
• Clearing refers to activities resulting in the
  settlement of claims of financial institutions
  against other financial institutions.
• The operations department of a financial
  institution, often referred to as the
  institutions back office, is responsible for
  handling or overseeing the clearing and
  settlement processes.
• A clearing firm is authorized by a clearing house
  to manage trade comparisons and other back office
  operations.
• Leading clearing firms include Pershing, LLC,
  JPMorgan Clearing Corp. and National Financial
  Services, LLC.
• A clearing house clears transactions for a market
  such as the NYSE. A clearing house facilitates
  the trade settlement between two clearing firms
  and seeks to ensure that the clearing firms honor
  their trade settlement obligations. The clearing
  house will typically guarantee the obligations of
  its member firms.
• The clearing house steps into a transaction to be
  settled by its members and assumes the settlement
  obligations of both counterparties to the
  transaction, in effect becoming the counterparty
  to both sides of every transaction, a process
  known as novation. Thus, the clearinghouse,
  acting as a central counterparty, acts as the
  counterparty for each party to every transaction,
  and assumes all credit risk.

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Clearing

• In the United States, the National Securities
  Clearing Corporation (NSCC, a division of the
  Depository Trust and Clearing Corporation) is the
  major clearing agent for equity markets.
• Its primary facility for clearing is the
  Securities Industry Automated Corporation (SIAC).

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Clearing Process

• Confirmation is the first step of the clearing
  process.
• Buyers and sellers record trade details.
• Brokers and dealers receive confirmations that
  the trade has been executed and pass on details
  to clients.
• The typical confirmation document received by the
  client reports the stock's name and CUSIP number
  (the securitys 9-character alpha-numeric
  identifier issued by the Committee on Uniform
  Security Identification Procedures), the number
  of units traded, the security price, the broker
  commission and other fees, along with trade and
  settlement dates.
• Trade comparison is the second step in the
  clearing process.
• Comparison matches counterparties in
  transactions.
• Trades are compared and are said to be cleared
  when the counterparties records are identical.
• Out-trades in futures markets or DKs (Dont
  Knows) in other markets, which are trade reports
  with discrepancies.
• Netting is the simplification process used by
  clearing firms, which is the process of adding
  all of an institutions purchases of each
  security, adding the sales of each security,
  deducting sells from buys to determine the net
  change in holdings of that security for the
  institution and computing the net cash flows
  associated with all transactions.
• The NSCC uses an automated system through the
  Securities Industry Automation Corporation (SIAC)
  to net down or reduce the number of trading
  obligations that require financial settlement. At
  the end of the netting process, the NSCC delivers
  to each brokerage firm settlement instructions.

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Settlement Details

• Trade settlement occurs when buyers receive
  securities and sellers receive payment.
• The Depository Trust Clearing Corporation
  (DTCC), holds stock certificates of member firms,
  registering them in member names.
• As of year-end 2006, the DTCC was holding over
  5.5 million stock certificates worth over 36
  trillion and had processed over 8.5 billion
  transactions during the year.
• The DTCC settled more than 1.48 quadrillion in
  securities transactions in 2009, including
  equities, fixed income instruments, mutual funds,
  insurance products, etc.
• Equity securities are held in street name,
  meaning that securities are held in the names of
  brokers, who, in turn, maintain their own records
  of ownership in client accounts.
• Settlement of a trade is completed when the DTCC
  transfers the ownership of the shares from the
  selling firm to the buying firm in its automated
  book-entry recordkeeping system and transfers
  money between firms with net credits and net
  debits.
• Federal law requires that settlement occur within
  three days after the transaction.
• The DTCC provides clearing services at low cost,
  averaging approximately .0000066 per share.
• In the 1960s, clearing involved the physical
  transfer of paper securities and checks.
• The Depository Trust Corporation (DTC) was set up
  in 1973 to mechanize the clearing business for
  the major stock exchanges.

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G. Fixed Income Securities and Money Markets

• Types of debt securities include
• Bonds
• Notes
• Mortgage-backed instruments
• Treasury instruments
• Many of the fixed income securities with shorter
  terms to maturity are considered to be money
  market instruments.

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U.S. Treasury Securities and Markets

• The United States Treasury is the largest issuer
  of debt securities in the world.
• In 2010, the U.S. Treasury (technically, the Fed)
  auctioned 8.4 trillion in Treasury instruments.
• Treasury issues are fully backed by the full
  faith and credit of the U.S. government, which
  has substantial resources due to its ability to
  tax citizens, create money and borrow more. Thus,
  these securities are generally expected to have
  the lowest default risk and should generally be
  safer than the safest of corporate bonds or
  short-term notes.
• Treasury Bills typically mature in less than one
  year (13, 26 or 52 weeks). These issues are sold
  as pure discount debt securities, meaning that
  their purchasers receive no explicit interest
  payments.
• Strips are issued through the U.S. Treasurys
  Separate Trading of Registered Interest and
  Principle Securities (STRIPS) program. Strips are
  portfolios of single payment instruments sold by
  the Treasury in blocks with varying maturities.
• Treasury Notes (T-Notes) have maturities ranging
  from one to ten years and make semi-annual
  interest payments.
• Treasury Bonds (T-Bonds) typically range in
  maturity from ten to thirty years and make
  semi-annual interest payments. These T-Bonds are
  frequently callable, meaning that the Treasury
  maintains an option to repurchase them from
  investors at a stated price.
• More than half the marketable Treasury debt
  outstanding as of 2000 was in the form of notes,
  while bills and bonds each represented about 20
  percent.

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Agency Issues

• The U.S. Federal Government sponsors agencies
  that enable it to make funds available for
  policy-related functions.
• The Federal National Mortgage Association (FNMA
  or Fannie Mae)
• Created in 1938 to expand the flow of money to
  housing markets during the Great Depression, spur
  investment into real estate, improve employment
  to help enable people to purchase homes.
• Functions of Fannie Mae are to purchase, hold,
  and sell FHA-insured (and, after World War II, VA
  Administration-insured loans) mortgage loans
  originated by private lenders.
• Privatized in 1968, FNMA had shares traded on
  the New York Stock Exchange and other security
  holders as well.
• FNMA was taken over by the Federal Government
  during the Financial Crisis of 2008.
• The firm received a bail-out package from the
  Federal Government to support it until 2012.
• FNMA facilitates capital acquisition in the
  mortgage industry through the creation of
  mortgage-backed securities.
• These portfolios of mortgage-backed securities
  are also called pass- through securities.
• FNMA can obtain money directly from the U.S.
  Treasury should it need to do so.
• The Government National Mortgage Association
  (GNMA or Ginnie Mae)
• Established 1968 as a spin off of FNMA, is a
  corporation owned by the U.S. Federal Government.
• GNMA guarantees mortgage-backed securities for
  the FHA, VA and other agency mortgage issues.
• Many mortgages issued by these agencies are
  targeted towards particular groups such as
  families in lower-income brackets or veterans,
  and experience relatively high default rates.
• The mortgages issued by these agencies are full
  faith and credit instruments.
• The Federal Home Loan Mortgage Corporation (FHLMC
  or Freddie Mac)
• A stockholder-corporation created in 1970 by the
  Federal Government, also creates, insures,
  services and sells pass-through securities
  related to single family and multi-family
  residential mortgages.
• Freddie Macs creation was essentially to provide
  competition in the secondary mortgage market to
  the virtual monopoly enjoyed by Fannie Mae.
• Freddie Mac was also placed in conservatorship by
  the Federal Government during the Financial
  Crisis of 2008-09.

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Municipal Securities and Markets

• U.S. federal taxation code permits investors in
  municipal instruments to omit from their taxable
  income any interest payments received on most
  G.O. municipals.
• Several types of municipal issues are offered by
  state and local governments.
• General Obligation Bonds are full faith and
  credit bonds.
• Limited Obligation Bonds provide backing only by
  specific claims.
• Many municipals are rated for default risk by
  agencies such as Fitch.
• Some municipal issues are insured by private
  insurance institutions.
• Insurance enables issuers to offer bonds with
  reduced interest rates.
• Among the larger insurers of municipal bonds are
  the Ambac Financial Group, MBIA, the Financial
  Guaranty Insurance Company (FGIC) and the
  Financial Security Assurance, Inc. (FSA).
• Collectively, these insurers are often known as
  "the Big Four."

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Financial Institution Instruments

• Federal Funds markets depository institutions to
  borrow from one another to meet Federal Reserve
  requirements.
• Excess reserves of one bank are loaned to other
  banks for satisfaction of reserve requirements.
• The rate at which these loans are extended is
  referred to as the Federal Funds Rate.
• The Negotiable Certificates of Deposit (a type of
  Jumbo C.D.) is a tradable depository institution
  C.D. with a denomination or balance exceeding
  100,000.
• The amounts by which jumbo C.D.s exceed 250,000
  are not FDIC insured.
• Negotiable CDs are often purchased by H.N.W.
  individual investors, financial institutions,
  corporate treasuries and by Money Market Mutual
  Funds, which are created by banks and investment
  institutions for the purpose of pooling together
  depositor or investor funds.
• Banker's Acceptances are originated when a bank
  accepts responsibility for assuming some
  financial responsibility on behalf of a client.
  Because the bank is likely to be a good credit
  risk, acceptances are usually marketable.
• Repurchase Agreements (Repos) are issued by
  financial institutions acknowledging the sale of
  assets and a subsequent agreement to re-purchase
  at a higher price in the near term. This
  agreement is essentially the same as a
  collateralized short-term loan.

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Corporate Issues

• Corporations are also important issuers of debt
  securities.
• Commercial paper.issued by large, well-known,
  credit-worthy firms needing to borrow for short
  periods of time
• Corporate bonds normally issued with longer
  terms to maturity
• Callable bonds may be called, meaning that the
  issuing institution has the right to pay off the
  callable bond before its maturity date. The
  callable bond typically has a call date and a
  call price.
• Convertible bonds can be convertible by
  bondholders into equity or other securities.
• Sinking fund provisions provide additional safety
  for bondholders by placing money into a fund that
  will be accumulated to ensure full satisfaction
  of the firms obligation.
• The terms of the bond will be specified in a
  contract known as a bond indenture.
• Debentures are not backed by collateral.
• Serial bonds are issued in series with staggered
  maturity dates.
• Floating rate bonds have coupon rates that rise
  and fall with market interest rates reverse
  floaters have coupon rates that move in the
  opposite direction of market interest rates.
• Indexed bonds have coupon rates that are tied to
  the price level of a particular commodity like
  oil or some other value like the inflation rate.
• Catastrophe bonds make payments that depend on
  whether some disaster occurs.
• These catastrophe bonds provide a sort of
  insurance for issuers against the occurrence of
  the disaster.

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Corporate Bond Markets

• The predecessor to the New York Stock Exchange
  was established in 1792 as a venue for trading
  bonds.
• While over 1000 bonds trade on "NYSE Bonds," the
  largest centralized corporate bond market in the
  U.S., the majority of trades for corporate bonds
  occur in the over-the-counter markets.
• FINRA TRACE (Trade Reporting and Compliance
  Engine) provides corporate bond trading data to
  the public as all FINRA member broker/dealers are
  required to report OTC corporate bond
  transactions data to TRACE.

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Credit Ratings and Credit Agencies

• Corporations pay credit rating agencies such as
  Standard Poors and Moodys to rate the risk of
  their issues, though a few credit agencies still
  receive revenues from investor-subscribers.
• Other agencies include Fitch, A.M. Best, Duff
  Phelps (now, merged into Fitch), Egan-Jones and
  Dun Bradstreet.
• Bonds without ratings assigned by these agencies
  are difficult to sell in fact, many institutions
  face restrictions on purchasing unrated or
  low-rated bonds.
• International and federal government regulatory
  agencies including the SEC and the Fed sanction
  these agencies, and constrain or limit banks and
  other institutions investment in low-rated
  instruments.
• Basel II guidelines allow for "External Credit
  Assessment Institutions" ratings for assessing
  bank risk.
• The S.E.C. allows investment banks and
  broker-dealers to use credit ratings from
  NRSROs
• FDIC can prohibit banks from purchasing bonds
  with ratings below investment grade (BBB or
  higher).
• While ratings in the past have been almost
  universally accepted, there have been problems
• Many rating agencies are paid by the firms that
  issue debt instruments, creating potential
  conflicts of interest.
• Rating services have provided consulting services
  to issuing firms, advising them on strategies to
  improve their ratings. However, such services
  have been restricted by Dodd-Frank legislation.
• Credit agencies have been accused of
  strong-arming clients and potential clients. For
  example, Moody's published an "unsolicited"
  rating of Hannover Re, a German re-insurance
  firm. It sent a letter indicating that "it looked
  forward to the day Hannover would be willing to
  pay" (Klein 2004). Hannover management refused
  payment. Moody's continued to rate Hannover debt.
  Moody's cut Hannover ratings to junk, despite
  high ratings given by other agencies.
• Agencies are often too slow in responding to
  dramatic shifts in market conditions and traders
  are often much faster at responding to such
  shifts. For example, Enron bonds were rated
  triple-A by both major agencies until only a few
  days before the company filed for bankruptcy
  protection.

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Standard Poors and Moodys Corporate Bond
Ratings

• Description Standard Poor
  Moodys
• Least likely to default AAA Aaa
• High quality AA Aa
• Medium grade investment quality A A
• Low grade investment quality BBB Baa
• High grade speculative quality BB Ba
• Speculative B B
• Lower grade speculative CCC Caa
• Highly speculative CC Ca
• Likely bankruptcy C C
• Already in default D D

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Eurocurrency Instruments and Markets

• Eurodollars are freely convertible
  dollar-denominated time deposits outside the
  United States.
• Eurodollar markets began after World War II when
  practically all currencies other than the U.S.
  dollar were perceived as unstable.
• Most foreign trade between countries was
  denominated in U.S. dollars
• The Soviet Union and Eastern European
  institutions were concerned that their dollars
  held in U.S. banks might be attached by U.S.
  residents in litigation with these countries
• Thus, they dealt not with actual U.S. dollars,
  but merely denominated their debits and credits
  with dollars
• Monies owed to them were simply offset by monies
  that they owed.
• In a sense, they dealt with "fake" euro-dollars,
  but since their trading partners did also, and
  their accounts tended to "zero out" over time,
  this did not create significant problems.
• During the 1960s and 1970s, these markets thrived
  due to regulations imposed by the U.S. government
  such as Regulation Q (interest ceilings),
  Regulation M (reserve requirements), the Interest
  Equalization Tax imposed beginning in 1963 to tax
  interest payments on foreign debt sold in the
  U.S. and restrictions placed on the use of
  domestic dollars outside the U.S.
• More generally, eurocurrencies are loans or
  deposits denominated in currencies other than
  that of the country where the loan or deposit is
  created. Roughly 65 of eurocurrency loans are
  denominated in dollars.
• Eurocredits (e.g., Eurodollar Credits) are bank
  loans. They are attractive due to very low
  interest rate spreads made possible by the large
  size of the loans and the lack of reserve, FDIC
  and other requirements.
• Euro-Commercial paper are short-term (less than
  six months) notes issued by large, credit-worthy
  institutions.
• Euro-Medium Term Notes (EMTN's), unlike
  Eurobonds, are usually issued in installments.
• Eurobonds are generally underwritten, bearer
  bonds. Eurobonds often have call and sinking fund
  provisions as well as other features found in
  bonds publicly traded in American markets.
• Euro-Medium Term Notes (EMTN's) are
  interest-bearing instruments usually issued in
  installments.
• It is important to note that eurodollars and
  eurocurrencies are not euro, the currency used in
  the EU.

35
H. Markets around the World

•  
• Exchange USD bill.
• Year end-2010
• 1 NYSE Euronext (US) 13,394
• 2 NASDAQ OMX (US) 3,889
• 3 Tokyo Stock Exchange Group 3,828
• 4 London Stock Exchange Group 3,613
• 5 NYSE Euronext (Europe) 2,930
• 6 Shanghai Stock Exchange 2,716
• 7 Hong Kong Exchanges 2,711
• 8 TMX Group (Toronto) 2,170
• 9 Bombay SE 1,632
• 10 National Stock Exchange India 1,597
• Table 6 Major Exchanges of the World

36
I. Currency Exchange and Markets

• Exchange rates denote the number of units of one
  currency that must be given up for one unit of a
  second currency.
• Foreign exchange rates are determined by supply
  and demand conditions. A variety of factors will
  affect these supply and demand conditions,
  including
• Governmental policies
• Supply and demand conditions for commodities in
  the two countries
• Income levels in the two countries
• Interest rates in the two countries
• The perceived risk of engaging in trade with the
  two countries

37
Cross Rates

• Cross rates refer to the price of a currency in
  terms of the price of any other currency.
• The price of the Swiss franc in terms of dollars
  is given by Table 7 to be .80205. The price of a
  U.S. dollar in terms of the UK pound is .5256.
  These two rates imply that the price of a Swiss
  franc in terms of the UK pound is .80205 ?
  .5256 .42156.

38
Exchange Risks

• Rate risk Exchange rates may change in
  directions opposite to those anticipated by
  participants.
• Credit risk the other party to the contract may
  default by not delivering the currency specified
  in the contract. In many instances, an
  intermediary such as a large reputable commercial
  bank may act to ensure that one or both
  contracting parties will honor their agreements.
  Dealer reputation is key.
• Liquidity risk The market participant may have
  difficulty obtaining the currency he must
  deliver he may be "stuck" with a currency that
  will be difficult to sell. Again, a number of
  intermediaries may improve liquidity by trading
  and making markets for various currencies.
• Trading system risk The trading platform, ECN,
  exchange and other communication systems are all
  subject to malfunction or failure.

39
Currency Trading

• Professional currency traders participate in
  inter-bank and inter-dealer markets as well as
  exchange markets for a variety of types of
  contracts on currencies.
• The most important currency trading centers are
  located in
• London, with about 37 of total volume
• New York, 18
• Tokyo, 6
• Frankfurt, Zurich, Hong Kong and Singapore with
  somewhat less
• Note that the dispersion of markets implies that
  forex markets operate around the clock.
• Transactions can be executed between any two
  counterparties that agree to trade via the
  telephone or electronic network or trade through
  an exchange. To a large extent, currency trading
  is decentralized.
• Dealers can post or advertise their exchange
  rates bids and offers using an information or
  distribution network, such as Reuters and ICAP.
• Many OTC trades proceed through a three-step
  process similar to the following 
• A trader communicates by phone or electronically
  the currency pair and the amount he would like to
  trade with a given counterpart in trade.
• The counterparty responds with both a bid and an
  ask quotation.
• The trader responds to the bid and ask quotations
  by either buying, selling or passing on both.
• The transaction is executed if the trader agrees
  to buy or sell.