Chapter 4

Organization and Functioning of Securities Markets

Innovative Financial InstrumentsDr. A. DeMaskey

What is a Market?

Brings buyers and sellers together to aid in the transfer of goods and services

Does not require a physical locationDoes not have to own the goods and

services involvedBuyers and sellers benefit from the

market

Characteristics of a Good Market

Availability of information must be timely and accurate

Liquidity Marketability Price continuity Depth

Transaction costs or internal efficiency lower costs make for a more efficient market

External efficiency or informational efficiency prices rapidly adjust to new information

Organization of the Securities Market

Primary markets New issues New capital

Secondary markets Outstanding securities are bought and

sold No new capital formation Provides liquidity

Primary Capital Markets:Government Bond Issues

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

Primary Capital Markets:Municipal Bond Issues

Sold by three methods Competitive bid Negotiated sales Private placement

Underwriters sell the bonds to investors Origination Risk-bearing Distribution

Primary Capital Markets:Corporate Bond and Stock Issues

Negotiated arrangement with investment banking firm which underwrites the issues and organizes a syndicate for distribution

New issues are divided into two groups: Seasoned new issues Initial public offerings (IPOs)

Underwriting Relationships with Investment Bankers

1. Negotiated Most common Full services of underwriter

2. Competitive bids Corporation specifies securities offered Reduced costs Reduced services of underwriter

3. Best-efforts Investment banker acts as broker

Introduction of Rule 415

Allows firms to register securities and sell them piecemeal over the next two years

Referred to as shelf registrationsGreat flexibilityReduces registration fees and expensesAllows requesting competitive bids from

several investment banking firmsMostly used for bond sales

Private Placements and Rule 144A

Firms sells to a small group of institutional investors without extensive registration

Lower issuing costs than public offering

Importance of Secondary Market

Provides liquidity to investors who acquire securities in the primary market

Results in lower required returns than if issuers had to compensate for lower liquidity

Helps determine market pricing for new issues

Secondary Bond Markets

Secondary market for U.S. government and municipal bonds U.S. government bonds are traded by

bond dealers Banks and investment firms make up

municipal market makersSecondary corporate bond market

Traded through security exchanges and an OTC market

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

Trading Systems

Pure auction market Buyers and sellers are matched by a

broker at a central location Price driven market

Dealer market Dealers provide liquidity by buying and

selling shares Dealers may compete against other

dealers

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 securitiesPrestige of firms listedWide geographic dispersion of

listed firmsDiverse clientele of buyers and

sellers

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 listedMarket value over $12 trillionAverage daily volume of 791 million shares

American Stock Exchange (AMEX)

Outdoor Curb MarketEmphasis on foreign securitiesDoes not trade stocks listed on

NYSEWarrants traded on AMEX years

before NYSE listed anyIt has also an options exchange

Tokyo Stock Exchange (TSE)

Largest of the eight exchanges in Japan

Dominates Japanese marketPrice drive systemDomestic and foreign stocks listedMost active 150 stocks are traded on

the floor All others are traded by computer

London Stock Exchange (LSE)

Largest securities market in the United Kingdom

Trades listed and unlisted securities 2,600 companies listed

Largest listing of foreign stocks on any exchange

Pricing system by competing dealers via computers similar to NASDAQ system in U.S.

Divergent Trends

New exchanges in emerging countries Russia, Poland, China, Hungary,

Peru, Sri LankaConsolidation of existing

exchanges in developed countries capture economies of scales provide added liquidity

Recent Consolidations

In 1995, Germany’s three largest exchanges merged into the one in Frankfurt

NASD merged with AMEX in 1998Philadelphia Stock Exchange merged

with NASD/AMEXCBOE merged with Pacific ExchangeLondon Stock Exchange and Frankfurt

Stock Exchange merger

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 securitiesRegional Exchanges in the United States

Chicago SE Boston SE Cincinnati SE

Over-the-Counter (OTC) Market

Not a formal organization Unlisted stocks and listed stocks (third

market) Lenient requirements for listing on OTC 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 1,000 issues not on NASDAQ

Operation of the OTC

Any stock may be traded as long as it has a willing market maker to act as a dealer

OTC is a negotiated market

The NASDAQ System

Automated electronic quotation systemDealers may elect to make markets in stocksAll dealer quotes are available immediatelyThree levels of quotations provided

Level 1 shows median representative quote Level 2 shows quotes by all market makers Level 3 is for OTC market makers to change

their quotes shown

Listing Requirements for NASDAQ

Two lists National Market System (NMS) Regular NASDAQ

Four sets of requirements Initial listing - least stringent Automatic NMS inclusion - up to the

minuteAlternative 1 for profitable companies with

limited assetsAlternative 2 for large but less profitable

Third Market

OTC trading of shares listed on an exchange

Mostly well known stocks 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 costsNo data are available

Exchange MembershipSpecialistCommission brokers

Employees of a member firm who buy or sell for the customers of the firm

Floor brokers Independent members of an exchange

who act as broker for other membersRegistered traders

Use their membership to buy and sell for their own accounts

Exchange Market MakersU.S. Markets

Specialist is an exchange member assigned to handle particular stocks Broker Dealer

Specialist has two income sources Broker commission Dealer trading income from profit

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 Capital - 10,000 share or larger blocks Commitment - large risk with large blocks Contacts - Rule 113 prohibited direct contact to

offer blocks to another institutionBlock houses are investment firms to help

institutions locate other institutions interested in buying or selling blocks Have capital, commitment, and contacts

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: Centralized reporting of all transactions Centralized quotation system Centralized limit order book (CLOB) 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 tradersAll market makers and traders could

fill orders on itTechnology 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

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

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

Super DOT

Electronic order-routing systemMember 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

Display Book

Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit 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 and potential need for preopening call market

Market Order Processing

Super Dot’s postopening market order system

Rapid execution and reporting of market orders

1997 average orders executed and reported in less than 20 seconds

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

Global Market Changes

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

London Stock ExchangeOctober 27, 1986 Big Bang

Brokers can act as market makers Jobbers can deal with the public

and institutions Commissions are negotiable Gilt market was restructured like

U.S. government securities market Trades reported on Stock Exchange

Automated Quotations (SEAQ)

Effects of the Big Bang

Competitive market makers & SEAQ reduced number of people on the trading floor

More activity in the system, but profit margin has reduced from competition

Many firms have merged or been acquired by foreign firms

Tokyo Stock Exchange (TSE)

1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants

Future Developments

More specialized investment companies

Changes in the financial services industry Financial supermarkets Specialty shops

Advances in technology Computerized trading 24-hour market of the future may be

floorless, global, and highly automated

The Internet:Investments Online

www.quote.comwww.sec.govwww.nyse.comwww.nasdaq-amex.comwww.etrade.comwww.schwab.comwww.ml.com