ORGANIZATION AND

FUNCTIONING OF
SECURITIES MARKETS
 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
 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)
 Organization of the
Securities Market
Primary markets
 New issues
Secondary markets
 Outstanding securities are bought and sold
Primary Capital Markets
Government 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
Primary Capital Markets
Corporate Bonds
Negotiated arrangement with an
investment banking firm who maintains
a relationship with the issuing firm
Underwriting firm often organizes a
syndicate for distribution
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
Secondary Markets
Involves the trading of
issues that are
already outstanding
Provide a means
obtaining cash for
sellers
Provide buyers with
more investment
choices
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
 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
 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)
 Secondary Equity
Markets
Stock Exchanges (First Market)
 Major national stock exchanges
 New York, American, Tokyo, and London
 Regional stock exchanges
 Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin
Over-the-counter market (Second Market)
 Stocks not listed on organized exchange
Third Market
Fourth Market
 Secondary Market
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
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
 National Stock
Exchanges
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
 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 listed
Market value over $13 trillion
Dominates other exchanges, with about 85%
if all exchange-traded shares on NYSE
 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
Merged with Nasdaq in 1998, although
operations remain separate
Tokyo Stock Exchange
(TSE)
Largest of the eight exchanges in Japan
Dominates Japanese market
Established in 1878 and reorganized in
1943, 1947, and 1949
Domestic and foreign stocks listed
Most active 150 stocks are traded on
floor, others by computer
London Stock Exchange
(LSE)
Largest securities market in the United
Kingdom
Trades listed and unlisted securities
Largest listing of foreign stocks on any
exchange
Stocks divided into three groups
 Alpha - 65 most active
 Betas - 500 next most active
 Gamma - bids are indicative only and must be
confirmed
 Other National
Exchanges
Frankfurt, Toronto, Paris
International Federation of Stock Exchanges
New exchanges in emerging countries
 Russia, Poland, China, Hungary, Peru, Sri Lanka
Consolidation of exchanges in other countries
 Economies of scale, especially in terms of the
required technology
 Liquidity is enhanced with more firms trading
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
 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
Over-the-Counter (OTC)
Market
Not a formal organization or a single location
Trading in unlisted stocks and listed stocks
(third market)
Lenient requirements for listing on OTC
Almost 5,000 issues actively traded on
Nasdaq’s NMS ( National Market System)
More issues traded, but less dollar trading in
terms of total value than NYSE
Over-the-Counter (OTC)
Market
Operations
 Any stock may be traded as long as it has
a willing market maker to act a dealer
 OTC is a negotiated market with investors
potentially dealing directly with dealers
 Over-the-Counter (OTC)
Market
The Nasdaq System
National Association of Security Dealers
Automated Quotation system
Dealers may elect to make markets in stocks
Average of 8.7 dealers per stock in 2000
Three levels of quotations available
 Level 1 shows a median representative quote
 Level 2 shows quotes by all market makers
 Level 3 is for OTC market makers to change their
quotes shown
 Third Market
OTC trading of shares listed on an exchange
Mostly well known stocks
 GM, IBM, AT&T, Xerox
Represents competition between the OTC
market and the organized exchanges
May be important to investors particularly
when the exchange is closed or when trading
is suspended on the exchange
 Fourth Market
Direct trading of securities between two
parties with no broker involved
Both parties typically large, institutional
investors making large trades
Savings in transaction costs can be
large for such investors to deal directly
with one another
 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
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)
Major Types of Orders
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

 Margin requirements apply

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
 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
investor’s equity percentage (margin)
 Margin requirements are from 50% up
Changes in price affect investor’s equity
 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
 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
 Changes in the
Securities Markets
In recent years, major changes in securities
markets have largely been driven by the
influence of large financial (institutional)
investors. Among the impacts:
 Negotiated (competitive) commission rates
 Influence of block trades
 Impact on stock price volatility
 Development of National Market System (NMS)
 Future Developments
Creation and consolidation of stock
exchanges
 Creation of new exchanges in emerging markets
where capital is needed and opportunities await
 Consolidation in developed countries to effectively
offer liquidity and efficiently invest in technology
More specialized investment companies
Changes in the financial services industry
 Financial supermarkets & Specialty shops
Trading in Cybermarkets