Chapter Two

Security Markets:
Present and Future
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McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
 Security Markets:
Present and Future
 The Market Environment
 Market Functions
 Organization of The Primary Markets:
The Investment Banker
 Other Organized Exchanges
 Over-The-Counter Markets
 Electronic Markets
 Electronic Communication Networks (ECN)
 Institutional Trading
 Regulation of the Security Markets 2
 The Market Environment
 Dramatic Changes:
• Deregulation and other legal changes
• Global consolidation and competition
• Internet online brokerage and Electronic
communication networks (ECNs)
• Real-time quotes
• 24 hour trading and record trading volume
• Decimalization
• Terrorism
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The Market Environment

What
are
markets
supposed to do?
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 Markets:
A way of exchanging assets

Possible
Possible Characteristics of
of Markets
Markets
Efficient Primary or Secondary

Organized or
Liquid
Over-The-Counter

Competitive Spot or Future

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 Market Efficiency and Liquidity
Efficient Markets:
Rapidly absorb
and reflect current information and trading

 Prices respond quickly to new information

 Prices fluctuate little with successive trades
 High and low volumes absorbed
with little price change

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 Market Efficiency and Liquidity
Liquidity of Markets:
Speed of converting an asset to cash
at or close to its fair market value

 Greater with more participants and

continuous trading
 Greater with low cost buying and selling

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 Competition and Allocation
of Capital
 All assets compete for investor funds
 Investors choose assets to achieve a desired
return for perceived risk

If markets are efficient and liquid,

investor allocation of capital to alternative
investments changes quickly in response to
fresh information
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 Secondary Markets
Markets for existing assets currently traded

 Provides increased liquidity and a place to

convert existing assets to cash
 Provides ability to adjust capital allocation
to new information
 Provides valuation for existing assets

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 Primary Markets
Market for buying assets directly from their sources;
the first market where an asset is originally bought
and sold

 Raises funds to expand capital base of asset creator

 Once sold on a primary market, assets may trade on
secondary markets
 Price competition on secondary markets enables
primary markets to price new issues so as to fairly
reflect risk-return relationships
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 Underwriting
Guarantee provided by
an investment banker
to purchase an issuer’s securities
at a fixed price (for a fee)

Eliminates the risk of not selling a whole

issue of securities and thus raising less
cash than desired – banker usually
“makes a market”: active buying and
selling to ensure a liquid market and wider
distribution
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 Alternatives to Underwriting
 Investment banker makes “best efforts” to
sell security but issuer assumes risk of
unsold securities

 Securities may be sold directly to investors

by the issuer in a public offering or in a
private placement

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 Distribution
On large issues, investment bankers may
share the risk and burden of distribution by
forming a group called a “syndicate”

A “Tombstone” advertising a stock or bond

issue may list many underwriters distributing
a security

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Investment Banking Competition
The Herfindahl-Hirschman Index (HHI) of market concentration in
investment banking has been changing lately as mergers,
globalization, the Gramm-Leach-Bliley Act and increased use of
shelf registration alters the structure of investment banking

Please click on the link to see the DOJ and FTC guide lines for HHI
and antitrust
www.usdoj.gov

Ranking of top underwriters varies by criteria although the top ten

tend to be the same firms:
• Number of issues
• Gross proceeds
• Fees earned

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 Organized Exchanges
 National or regional
 Competition may be global
 A central trading location where securities are
bought and sold in an auction market by brokers
acting as agents for the buyer and seller
 The “open outcry” auction system is being
replaced by electronic trading -- computer
matching of buy and sell orders in many
exchanges (with the exception of NYSE)

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 Consolidated Tape
 On June 16, 1975, a consolidated ticker tape was
instituted allowing brokers on any exchange to see
prices of transactions on other exchanges in dually
listed NYSE stocks

 Such composite price data

increases market efficiency
and may keep prices competitive

 Since only NYSE stocks on the consolidated tape,

it is not truly reflective of the competitive
environment
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 Listing Requirements for Firms
 To be traded, a stock must meet listing
requirements of an exchange

 The New York Stock Exchange (NYSE)

generating the greatest dollar volume of trades in
large, well-known firms, has the most restrictive
listing requirements

 Stocks may be delisted for failing to meet criteria

such as total market valuation
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Membership for Market Participants
Five types of market participants are members of (have “seats” on)
exchanges:
• Commission Brokers
 Execute orders for customers of a retail brokerage house such as Merrill
Lynch
• Floor Brokers
 Trade on exchanges but are not employees of a member firm, provide
services for a fee
• Registered Traders
 Trade for themselves on exchanges to earn a profit
• Odd-Lot Dealers
 Buy and sell odd lots (trades of less than 100 shares) for their own accounts
• Specialists
 About ¼ of exchange membership
 Each stock has a specialist assigned to it
 Most specialists are responsible for more than one stock
 Handle special orders such as “limit” bids or offers
 Maintain a continuous, liquid, and orderly market in assigned
19 stocks
 The American Stock Exchange
(AMEX)
 Generally trades in securities of smaller firms
than NYSE
 Primarily a market for individual investors since
many listed firms do not meet the liquidity needs
of large institutional investors
 One of largest markets for put and call options
on stocks and indexes
 The central market for Exchange Traded Funds
(EFTs) such as SPYDERS and DIAMONDS
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 The Chicago Board Options
Exchange

 Competes with AMEX in trading options

 Standardized call options

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 Futures Markets
Trade the right to buy a certain amount of a commodity or
stock at a set price for a specified period

 As the future contract expires, it normally is reversed

(closed out)

 The Chicago Board of Trade (CBOT) and Chicago

Mercantile Exchange (CME) are two of the largest futures
exchanges

 Future exchanges are becoming publicly-traded firms,

consolidating, and computerizing operations
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 Over-The-Counter Markets
 No central location
 Trades by telephone or electronic device
 Dealers buy and sell specific securities for their
own account rather than just act as agents
processing orders
 Dealers belong to The National Association of
Security Dealers (NASD)
• a self-policing organization
• requires at least two market makers (dealers) for each
security
• Often 5 – 10 market makers for a security,
even 20 market makers for government securities
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 Over-The-Counter Markets cont’d
OTC Markets
Federal government
Stocks
securities
Corporate bonds State and local bonds
Mutual funds Negotiable CDs
Commercial paper Other securities

 OTC is the largest securities market in the

United States in dollar volume
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 Over-The-Counter Markets Cont’d
The “spread”
• The difference between bid and asked price
• Profit the dealer earns by making a market

Example:

XYZ common stock is bid 10 and asked 10.50

Dealer will buy at least 100 shares at $10 per share
or Dealer will sell 100 shares at $10.50 per share

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 Debt Securities Traded
Over-the-Counter
 Government securities
• Largest dollar volume on the OTC
• Billions of dollars in trades each week
• Government security dealers trade such securities
 Make a market in
• Treasury bills
• Treasury bonds
• Federal agency securities
 Federal National Mortgage Association issues (FNMA)

 Government National Mortgage Association (GNMA)

 Student Loan Marketing Association (Sallie Mae)
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Continued
 Debt Securities Traded
Over-the-Counter

• Associated with large financial institutions or

brokerage houses
• Specialized municipal bond dealers trade
state and local government municipal bonds
• Finance companies or dealers specializing in
the industrial companies trade commercial
paper (unsecured short-term corporate debt)

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 Electronic Communication
Networks (ECNs)
Electronic trading systems that automatically
match buy and sell orders at specified prices

 Also known as Alternative Trading Systems (ATSs)

 Can act as broker-dealer or as an exchange
 Subscribers to the systems may include retail
and institutional investors, market makers,
and broker-dealers
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 Electronic Communication
Networks (ECNs) Cont’d
 If no sell orders match a buy order
• The order cannot be executed
 The ECN can wait for a matching sell order to arrive, or

 If order received during normal trading hours, it may be

routed to another market for execution

 Best bid and ask prices are shown in Nasdaq’s
quotation montage
 Some ECNs let subscribers see order books and
some post order books on the internet
 Institutions can trade among themselves and bypass
broker and trading fees 29
 Advantages of
Electronic Communication
Networks (ECNs)
 ECNs integrate markets
 Allow anonymity in trading
 Lower the cost of trading
• Create better executions
• Create more price transparency
 Permit “after-hours” trading, longer trading hours
 Facilitate more competition
 Facilitate smaller spreads
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 Regulation of Security Markets
 Organized exchanges are regulated by
the Securities and Exchange Commission
(SEC) and self-regulated
 The OTC market is controlled by the
National Association of Security Dealers
(NASD)
 Three major laws govern the sale and
subsequent trading of securities:
• Securities Act of 1933
• Securities Exchange Act of 1934
• Securities Acts Amendments of 1975
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 Securities Act of 1933
The “Truth in Securities” Act

To provide full disclosure of all pertinent

investment information whenever a corporation
sold a new issue of securities

•All offerings except government bonds and

bank stocks that are sold in more than one
state must be registered with the SEC *

* The Federal Trade Commission had many of these

responsibilities before the formation of the SEC
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
 Securities Act of 1933 Cont’d
• The registration statement must be filed 20
days in advance of the sale and include
detailed corporate information
 SEC will delay offering if information is found
to be misleading, incomplete, or inaccurate
 SEC does not certify that the security is fairly

priced
 Under certain circumstances, shelf registration

is being used to modify 20-day waiting period

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
 Securities Act of 1933 Cont’d
 All new issues must be accompanied by a
prospectus
• A detailed summary of registration statement
• Includes list of directors and officers; their
salaries, stock options, and shareholdings;
financial reports certified by a certified public
accountant (CPA); a list of underwriters; the
purpose and use of funds to be provided from
the sale of securities; any other reasonable
information that investors may need to know
before they can wisely invest their money
 34
 Securities Act of 1933 Cont’d
 Officers of the company and other experts
preparing the prospectus or registration
statement can be sued for penalties and
recovery of realized losses if any
information presented was fraudulent or
factually wrong or if relevant information
was omitted

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 Securities Exchange Act of 1934
Created the Securities and Exchange Commission
to enforce the securities laws
 Established guidelines for insider trading
 Board of Governors of the Federal Reserve
became responsible for setting margin
requirements
 Manipulation of securities by conspiracies
between investors prohibited
 SEC given control of proxy procedures
 Required periodical reports from companies
traded on exchanges
 Required all exchanges to register with
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the SEC
 Securities Exchange Act of 1975

 Directed SEC to supervise development of a

national securities market
 Assumed any national market would make
extensive use of computers and electronic
communication devices
 Prohibited fixed commissions on public transactions
 Prohibited banks, insurance companies, and other
financial institutions from buying stock exchange
memberships to save commission costs for their
own institutional transactions

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 Other Legislation
A number of other acts deal directly with investor protection

 Investor Advisor Act of 1940 to protect public

from unethical investment advisors
• Any adviser with more than 15 public clients
(excluding tax accountants and lawyers) must register
with the SEC
• Registered advisers must file semi-annual reports
 Investment Company Act of 1940
• Provides similar oversight for mutual funds
and investment companies dealing with small
investors
• Amended in 1970, now gives NASD authority to
supervise and limit commissions and investment
advisory fees on certain types of mutual38
funds
 Other Legislation Cont’d
 Securities Investor Protection Act of 1970
• Securities Investor Protection Corporation (SIPC)
established to oversee liquidation of brokerage firms
and to insure investors’ accounts to a maximum value
of $500,000 in case of bankruptcy of a brokerage firm
• Resulted from problems on Wall Street from 1967 to
1970 when surging share volume caused a back-
office paper crunch and an inability to process orders
fast enough
• SIPC does not insure market value losses suffered
while waiting to get securities from bankrupt
brokerage firms
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 Insider Trading
 The Securities Exchange Act of 1934 established
initial restrictions on insider trading
 The definition of “insider” has been expanded to
include anyone with special non-public information
 Punitive measures attempt to discourage the
illegal use of insider information for profits
 Insiders are permitted to make proper long-term
investments in corporations
 The 1980s and early years in the new century saw
a rash of insider scandals tarnishing the image of
fairness on Wall Street

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 Program Trading, Rule 80A,
and Market Price Limits
 Program trading occurs where software establish trigger
points for large volumes of trades by institutional investors
 Program trading may increase market volatility and has been
blamed for the 508-point market crash on October 19, 1987
 Rule 80A by the NYSE, as amended by the SEC, tried to
limit volatility after the crash of 1987 by restricting trades
after 50 point movements by the Dow-Jones Industrial
Average (DJIA) in any day on the NYSE
 In 1989, “circuit breakers” were also put in place to shut
down the market briefly when there are specified dramatic
drops in stock prices on the NYSE
 Nasdaq, the American Stock Exchange, and the Chicago
Board of trade have also agreed to discontinue trading if
there is a halt on the NYSE 41
 Exploring the Web
Website Address Comments
Provides information on
www.nyse.com regulations and market
operations
Provides information about
www.nasdaq.com
the Nasdaq market
Provides information about
www.cboe.com options traded on the Chicago
Board Options Exchange

http://biz.yahoo.com/reports/ipo.html Recent IPO news

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