CHAPTER 4: ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

• This chapter is about capital markets. Lots of interesting stuff that we probably do not
know about!

• Preliminaries:
 Market: A market is the means through which buyers and sellers are brought
together to aid in the transfer of goods/services.
- Need not have a physical location
- Need not own the goods and services it helps sell
- Can deal in a variety of goods and services

 Characteristics of a Good Market

o Availability of past transaction information

- must be timely and accurate
o Liquidity: must be able to buy or sell an asset at a known price.
- marketability: ability to buy/sell quickly
- price continuity: no huge jumps in prices without new information
- depth: a number of buyers and sellers present
o Transaction cost - lower is more efficient
o Informational efficiency – prices adjust quickly to new information, and
reflect all available information

 Organization of the Securities Market

o Primary markets
- New issues
o Secondary markets
- Outstanding (existing) securities are bought and sold
o Key difference:
In a primary market transaction, the issuer of the securities gets the money, in
a secondary market transaction, the issuer does not get any money; the buyer
and seller merely exchange money and security.

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 e.g. it’s like saying: When I buy my car from a GM dealer the first time, GM
gets the money (primary transaction). When I sell my car after 5 years and
100,000 miles to my friend, GM does not make any money. I get money, my
friend gets the car (secondary transaction).

• Primary Capital Markets

…where bonds or stock are sold by the government, municipalities, or companies to

acquire new capital.

 Government bond issues

1) Treasury or T-bills: maturity 1 year or less (are zero- coupon)
2) Treasury or T-notes: maturity 2 to 10 years
3) Treasury or T-bonds: maturities >10 years

- Federal Reserve System auctions

- T-bills are bid below par to imply yields
- Treasury notes and bonds bids state yields instead of prices
- Noncompetitive bids accept the average price of accepted competitive bids

 Municipal Bond Issues

Sold by three methods
- Competitive bid: By sealed bid auction (Underwritten)
- Negotiation: contractual arrangement between underwriter and issuer.
Underwriter has exclusive right to sell the issue.
- Private placement: Direct transaction between issuer and investor. No
middlemen involved.

o Underwriters are middlemen involved in competitive bid and negotiation.

These are investment banking firms, commercial banks etc.
- Origination: Design of the bond issue and initial planning
- Risk-bearing: Underwriter buys out the total issue at a specified price and
accepts the risk and responsibility of selling it at a higher price.
- Distribution: Selling these to investors.

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 Corporate Bond and Stock Issues
For stocks, there are 2 categories:
1. Seasoned new issues: Companies that already have existing stock e.g. GM
in 1995.
2. Initial public offerings (IPOs): First ever issue of stock to the public by a
company.
In almost all corporate or bond issues, underwriters (investment bankers) are
involved. This can be in one of three ways:

1. Negotiated
- Most common
- Full services of underwriter, including origination, risk-bearing and
distribution

2. Competitive bids
- Corporation specifies securities offered
- Solicits bids from investment bankers
- Reduce costs
- Reduced services of underwriter

3. Best-efforts
- Investment banker acts as broker to sell whatever it can

 Rule 415 (Shelf Registration)

- Allows firms to register securities and sell them piecemeal over the next two
years
- Referred to as shelf registrations
- Great flexibility
- Reduces registration fees and expenses
- Allows requesting competitive bids from several investment banking firms
- Mostly used for bond sales

 Private Placements and Rule 144A

- Allows firm to sell securities to a small group of institutional investors
without extensive registration
- Lower issuing costs than public offering

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• Secondary Financial Markets

… are important because they.

- provide liquidity to investors who acquire securities in the primary market
- help determine market pricing for new issues

 Secondary Bond Markets

o Secondary market for U.S. government and municipal bonds
- U.S. government and agency bonds traded by bond dealers
- Banks and investment firms make up municipal market makers
o Secondary corporate bond market
- 90% of U.S. corporate bonds trade on the Over-the-Counter (OTC)
market, which is simply a network of computers, dealers and telephones.
- NYSE fixed income market (Automated Bond System – ABS), and
AMEX bond market for the remaining small percentage.

 Financial Futures
Bond futures are traded in markets
- Chicago Board of Trade (CBOT)
- Chicago Mercantile Exchange (CME)

 Secondary Equity Markets

1. Major national stock exchanges
- New York, American, Tokyo, and London stock exchanges
2. Regional stock exchanges
- Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin
3. Over-the-counter (OTC) market
- Stocks not listed on organized exchange

 Securities exchanges: A few basics

1. Auction vs. dealer market

- In a pure auction market, buyers and sellers are matched by a broker at a
central location. This is a price driven market.
- In a dealer market, dealers provide liquidity by buying and selling shares.
Dealers may compete against other dealers

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 2. Call vs. continuous market
- 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

 National Stock Exchanges

- Large number of listed securities
- Prestige of firms listed
- Wide geographic dispersion of listed firms
- Diverse clientele of buyers and sellers

o New York Stock Exchange (NYSE)

- Largest organized securities market in United States
- Established in 1817, but dates back to 1792 Buttonwood Agreement by 24
brokers
- Over 3,000 companies with securities listed
- Market value over $11 trillion in 2000.
- Do visit http://www.nyse.com

o American Stock Exchange (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
- Doesn’t trade stocks listed on NYSE
- Warrants traded on AMEX years before NYSE listed any

o Other National Exchanges

- Tokyo Stock Exchange (TSE)

- London Stock Exchange (LSE)

o Trends in national exchanges

- New exchanges in emerging countries: Russia, Poland, China, Hungary,
Peru, Sri Lanka
- Consolidation of existing exchanges. Some recent ones include:

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 1. In 1995 Germany’s three largest exchanges merged into the one in
Frankfurt.
2. NASD merger with AMEX
3. Philadelphia Stock Exchange merger with NASD/AMEX
4. CBOE merger with Pacific Exchange
5. London Stock Exchange and Frankfurt Stock Exchange merger

o 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.

THE 24-HOUR TRADING DAY

Local Time EST

TSE 09:00 - 11:00 23:00 - 01:00
13:00 - 15:00 03:00 - 05:00
LSE 08:15 - 16:15 02:15 - 10:15
NYSE 09:30 - 16:00 09:30 - 16:00

 Regional Exchanges
Stocks not listed on a formal exchange
- Listing requirements vary
Listed stocks
- Allow brokers that are not members of a national exchange access to
securities
Regional Exchanges in United States
- Chicago SE, Boston SE, Cincinnati SE

 Over-the-Counter (OTC) Market

- Not a formal organization
- Listed stocks (third market) as well as unlisted stocks
- Lenient requirements for listing on OTC

o Size of U.S. OTC Market

- 5,000 issues actively traded on NASDAQ NMS (National Association of
Securities Dealers Automated Quotations National Market System)
- 1,000 issues on NASDAQ apart from NMS

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 - 1,000 issues not on NASDAQ, quoted in the WSJ
- Total 7,000 issues (compared to 3500 issues on NYSE and 900 on
AMEX), largest in terms of numbers

o Operation of the OTC

- Any stock may be traded as long as it has a willing market maker to act a
dealer
- OTC is a negotiated market, where dealers can deal with other dealers

o The NASDAQ System

- Automated electronic quotation system
- Dealers may elect to make markets in stocks
- All dealer quotes are available immediately
Three levels of quotations provided
- Level 1 shows median representative quote: for those who do not trade
- Level 2 shows quotes by all market makers: for those who trade
- Level 3 is for OTC market makers to change their quotes shown: for those
who make a market

o Compare listing Requirements for Stocks on the NYSE and the AMEX (Table
4.1) and those for NASDAQ (Table 4.5 A and 4.5B)

o A Sample Trade on NASDAQ

Dealer Bid Ask

1 85 1/2 85 3/4
2 85 3/8 85 5/8
3 85 1/4 85 5/8
4 85 3/8 85 3/4

You want to buy 100 shares:

- You call your broker/ place an order online.
- Your broker looks at this online quote, and calls Dealers 2 and 3 (lowest
ask prices).
- As your broker was not a market-maker, the charge would be:
100 x $ 85 5/8 = 100 x $ 85.625 = $8,562.50 + commissions

You want to sell 100 shares:

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 - You call your broker/ place an order online.
- Your broker looks at this online quote, and calls Dealers 1 (highest bid
price).
- As your broker was not a market-maker, your revenue would be:
100 x $ 85 1/2 = 100 x $ 85.50 = $8,550 - commissions

 Third Market
- OTC trading of shares listed on an exchange
- Mostly well known stocks e.g. GM, IBM, AT&T, Xerox
- Competes with trades on exchange
- May be open when exchange is closed or trading suspended

 Fourth Market
- Direct trading of securities between two parties with no broker intermediary
- Usually both parties are institutions
- Can save transaction costs
- No data are available

• Detailed Analysis of Exchange Markets

 Major Types of Orders

1. Market orders
–Buy or sell at the best current price
–Provides immediate liquidity

2. 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)

3. Short sales
–Sell overpriced stock that you don’t 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

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 –Margin requirements apply

4. Special Orders
a) 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
b) Stop buy order
- Investor who sold short may want to limit loss if stock increases in
price

5. Margin Transactions
- On any type order, instead of paying 100% cash, borrow a portion of the
transaction, using the stock as collateral
- Interest rate on margin credit may be below prime rate
- Regulations limit proportion borrowed
- Margin requirements (proportion of cash payment) are from 50% up
- Changes in price affect investor’s equity

Example:

Buy 200 shares at $50 = $10,000 position.

50% initial margin requirement ⇒ Borrow 50%, investment of $5,000

Scenario 1: If price increases to $60, position value is $12,000

less: - $5,000 borrowed
leaves $7,000 equity for a
$7,000/$12,000 = 58% equity position

Return on the stock = (60-50)/50 = 20%

Return on equity = (7000-5000)/5000 = 40%

Scenario 2: If price decreases to $40, position Value is $8,000

less: - $5,000 borrowed
leaves $3,000 equity for a
$3,000/$8,000 = 37.5% equity position
Return on the stock = (40-50)/50 = -20%
Return on equity = (3000-5000)/5000 = -40%

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 - Margin trading is leverage, and it magnifies gains and losses. It is
potentially very risky.

- Maintenance margin: Minimum proportion of equity that has to be

maintained at all times. Protects broker if stock price declines. Minimum
requirement is 25%
- Margin call on undermargined account to meet margin requirement. If call
not met, stock will be sold to pay off the loan.

- In the previous example, if the stock price went down to $30, then the
position value would be 200 x 30 = $6000, and your equity would be
$6000-5000 = $1,000.
- Proportion of equity = 1000/6000 = 16.67%. Broker requires 25% margin.
You will receive (the dreaded!) margin call for $667, which makes your
equity as a proportion of the total account: i.e. 1667/6667 = 25%.

 Exchange Membership

1. Commission brokers: Employees of a member firm who buy or sell for the
customers of the firm
2. Floor brokers: Independent members of an exchange who act as broker for
other members
3. Registered traders: Use their membership to buy and sell for their own
accounts
4. Exchange Market Makers (Specialists):

U.S. Markets
- Specialist is exchange member assigned to handle particular stocks
(typically, about 15 stocks)
- Has two roles:
a) Broker to match buyers and sellers, including execution of limit orders
b) Dealer to maintain fair and orderly market by trading on his own
account, to maintain liquidity.

- Specialist has two income sources

a) Broker commission, without risk
b) Dealer trading income from profit, with risk

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  Anatomy of a trade: Visit http://www.nyse.com/floor/floor.html

• Changes in the securities markets

 Since 1965, the growth of trading by large financial institutions has had many
effects
- Negotiated (competitive) commission rates
- Influence on block trades
- Impact on stock price volatility
- Development of National Market System (NMS)

 Negotiated Commission Rates

- NYSE minimum commission schedule prohibited price cutting since 1792.
- No price break for large orders
- Initial reaction was “give-ups” paid to a designated firm - soft dollars paid for
market research
- Third market competed with flexible commissions and grew
- Fostered development of the fourth market
- 1970 SEC began phasing in negotiated commissions
- Commission rates have fallen
- Discount brokerage firms compete openly
- Many brokerage and research firms have merged or liquidated

 The Impact of Block Trades

- Number and size of block trades has increased
- This strains the exchange specialist system in terms of the “3 Cs”:
Capital - 10,000 share or larger blocks
Commitment - large risk with large blocks
Contacts - Rule 113 prohibited direct contact to offer blocks to another
institution
- Block houses (upstairs traders) are investment firms to help institutions locate
other institutions interested in buying or selling blocks
Have capital, commitment, and contacts

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 Institutions and Stock Price Volatility
- Empirical studies have not supported the theory that institutional trading will
increase price volatility
- Where trading is dominated by institutions, actively involved institutions may
provide liquidity for one another and noninstitutional investors

 National Market Systems (NMS)

- NMS is advocated by financial institutions to provide greater efficiency,
competition, and lower cost of transactions
- NMS is expected to have:
1. Centralized reporting of all transactions
2. Centralized quotation system
3. Centralized limit order book (CLOB)
4. Competition among all qualified market makers

1. Centralized Reporting: Should record all transactions of a stock, regardless

of location. NYSE started a central tape in June 1975 covering all NYSE
stocks traded on other exchanges and OTC

2. Centralized Quotation System: List quotes for a stock from all market
makers on the national exchanges, regional exchanges, and OTC. Brokers
would complete trades on the market with the best quote. Intermarket
Trading System (ITS) developed by American, Boston, Chicago, New
York, Pacific, and Philadelphia Stock Exchanges and NASD

3. Centralized Limit Order Book: Should contain all limit orders from all
markets. Should be visible to all traders. All market makers and traders
could fill orders on it. Technology exists, but NYSE specialists fill most
limit orders and oppose CLOB because they do not want to share this
lucrative business

4. Competition Among All Qualified Market Makers (Rule 390): Market

makers compete on OTC market. Competition reduces bid-ask spread
NYSE opposes competition and argues that central auction results in best
market and execution. NYSE Rule 390 requires members to obtain
permission of the exchange before trading a listed stock off the exchange,
forcing transactions to the exchange to create a central market.

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 New Trading Systems

Daily trading volume has increased from 5 million shares to over 420 million
shares. NYSE routinely handles volume over 400 million shares, and had a daily
high of more than 700 million in 1998. Technology has allowed the market
process to keep pace.

1. Super DOT: Electronic order-routing system. Member firms transmit market

and limit orders in NYSE securities to trading posts or member firm’s booth.
Report of execution returned electronically. 85% of NYSE market orders
enter through Super DOT system

2. Display Book: Electronic workstation that keeps track of all limit orders and
incoming market orders, including incoming Super Dot limit orders

3. 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 and potential
need for preopening call market

4. Market Order Processing: Super Dot’s postopening market order system.

Rapid execution and reporting of market orders

5. Limit Order Processing: Electronically files orders to be executed when and if

a specific price is reached. Updates the Specialist’s Display Book. Good-until-
cancelled orders that are not executed are stored until executed or cancelled

 Global Market Changes

NYSE Off-hours trading

–Crossing Session I provides for trading stocks at NYSE closing prices after the
regular session from 4:15 PM to 5:00 PM
–Crossing Session II provides for trading a collection of at least 15 NYSE stocks
with a market value of at least $1 million from 4:00 PM to 5:15 PM

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 Listing foreign stocks on the NYSE
–Future growth will be in foreign countries and their stocks
–Foreign accounting standards are less stringent than SEC requirements for NYSE
listing

 Future Developments

1. Continued consolidation of exchanges

2. More specialized investment companies
3. Changes in the financial services industry
–Financial supermarkets
–Specialty shops
4. Advances in technology
–Computerized trading
–24-hour market of the future may be floorless, global, and highly automated

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