Organization & Functioning of Securities Markets.st

8/13/2019 Organization & Functioning of Securities Markets.st

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Chapter 3

Organization andFunctioning of Securities

Markets

Innovative Financial Instruments

K . Arjun Goud


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What is a MarketBrings buyers and sellers together to

aid in the transfer of goods and services

Does not require a physical location

Does not have to own the goods and

services involvedBuyers and sellers benefit from the

market


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Characteristics of a GoodMarket

Availability of informationmust be timely and accurate

Liquidity

MarketabilityPrice continuity

Depth

Transaction costs or internal efficiencylower costs make for a more efficient market

External efficiency or informational efficiencyprices rapidly adjust to new information


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Organization of the SecuritiesMarket

Primary markets

New issues

New capitalSecondary markets

Outstanding securities are bought and sold

No new capital formationProvides liquidity


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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 averageprice of accepted competitive bids


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Primary Capital Markets:Municipal Bond Issues

Sold by three methods

Competitive bid

Negotiated salesPrivate placement

Underwriters sell the bonds to investors

OriginationRisk-bearing

Distribution


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Primary Capital Markets:Corporate Bond and StockIssues

Negotiated arrangement with investmentbanking firm which underwrites the issues

and organizes a syndicate for distributionNew issues are divided into two groups:

Seasoned new issues

Initial public offerings (IPOs)


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Underwriting Relationshipswith Investment Bankers

1. Negotiated

Most common

Full services of underwriter2. Competitive bids

Corporation specifies securities offered

Reduced costs

Reduced services of underwriter

3. Best-efforts

Investment banker acts as broker


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Introduction of Rule 415

Allows firms to register securities andsell them piecemeal over the next twoyears

Referred to as shelf registrations

Great flexibility

Reduces registration fees and expensesAllows requesting competitive bids from

several investment banking firms

Mostly used for bond sales


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Private Placements and Rule144A

Firms sells to a small group of

institutional investors without

extensive registration

Lower issuing costs than public

offering


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Importance of SecondaryMarket

Provides liquidity to investors whoacquire securities in the primary market

Results in lower required returns than ifissuers had to compensate for lowerliquidity

Helps determine market pricing for newissues


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Secondary Bond Markets

Secondary market for U.S. governmentand municipal bonds

U.S. government bonds are traded bybond dealers

Banks and investment firms make upmunicipal market makers

Secondary corporate bond market

Traded through security exchanges and anOTC market


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Financial Futures

Bond futures are traded in markets

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange

(CME)


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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, Dublin3. Over-the-counter (OTC) market

Stocks not listed on organized exchange


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Trading Systems

Pure auction market

Buyers and sellers are matched by a

broker at a central locationPrice driven market

Dealer market

Dealers provide liquidity by buying andselling shares

Dealers may compete against otherdealers


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Call Versus ContinuousMarkets

Call markets trade individual stocks atspecified times to gather all orders and

determine a single price to satisfy themost orders

Used for opening prices on NYSE iforders build up overnight or aftertrading is suspended

Continuous markets trade any time themarket is open


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National Stock Exchanges

Large number of listed securities

Prestige of firms listedWide geographic dispersion of

listed firms

Diverse clientele of buyers and

sellers


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New York Stock Exchange(NYSE)

Largest organized securities market in UnitedStates

Established in 1817, but dates back to 1792Buttonwood Agreement by 24 brokers

Over 3,000 companies with securities listed

Market value over $12 trillion

Average daily volume of 791 million shares


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American Stock Exchange(AMEX)

Outdoor Curb Market

Emphasis on foreign securities

Does not trade stocks listed on NYSEWarrants traded on AMEX years before

NYSE listed any

It has also an options exchange


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Tokyo Stock Exchange(TSE)

Largest of the eight exchanges in Japan

Dominates Japanese market

Price drive systemDomestic and foreign stocks listed

Most active 150 stocks are traded on

the floor

All others are traded by computer


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London Stock Exchange(LSE)

Largest securities market in the UnitedKingdom

Trades listed and unlisted securities

2,600 companies listed

Largest listing of foreign stocks on anyexchange

Pricing system by competing dealers viacomputers similar to NASDAQ system inU.S.


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Divergent Trends

New exchanges in emergingcountries

Russia, Poland, China, Hungary,Peru, Sri Lanka

Consolidation of existing

exchanges in developed countriescapture economies of scales

provide added liquidity


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Recent Consolidations

In 1995, Germanys three largest exchanges

merged into the one in Frankfurt

NASD merged with AMEX in 1998

Philadelphia Stock Exchange merged with

NASD/AMEX

CBOE merged with Pacific Exchange

London Stock Exchange and Frankfurt Stock

Exchange merger


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Regional Exchanges

Stocks not listed on a formal exchangeListing requirements vary

Listed stocks

Allow brokers that are not members of a nationalexchange access to securities

Regional Exchanges in the United StatesChicago SE

Boston SE

Cincinnati SE


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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


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Operation of the OTC

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

OTC is a negotiated market


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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

Level 2 shows quotes by all market

makers

Level 3 is for OTC market makers to

chan e their uotes shown


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Listing Requirements for

NASDAQ

Two lists

National Market System (NMS)

Regular NASDAQFour sets of requirements

Initial listing - least stringent

Automatic NMS inclusion - up to theminute

Alternative 1 for profitable companies withlimited assets

Alternative 2 for large but less profitable


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Third Market

OTC trading of shares listed on anexchange

Mostly well known stocksGM, IBM, AT&T, Xerox

Competes with trades on exchange

May be open when exchange isclosed or trading suspended


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Fourth Market

Direct trading of securities

between two parties with no broker

intermediaryUsually both parties are institutions

Can save transaction costsNo data are available


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Exchange Membership

Specialist

Commission brokersEmployees of a member firm who buy or

sell for the customers of the firmFloor brokersIndependent members of an exchange who

act as broker for other members

Registered tradersUse their membership to buy and sell for

their own accounts


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Exchange Market Makers

U.S. Markets

Specialist is an exchange member

assigned to handle particular stocks

BrokerDealer

Specialist has two income sources

Broker commission

Dealer trading income from profit


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Changes in the SecuritiesMarkets

Since 1965, the growth of trading by

large financial institutions has had many

effectsNegotiated (competitive) commission rates

Influence on block trades

Impact on stock price volatility

Development of National Market System

(NMS)


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Negotiated CommissionRates

NYSE minimum commission schedule prohibited pricecutting 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 orliquidated

Th I t f Bl k


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The Impact of BlockTrades

Number and size of block trades hasincreased

This strains the exchange specialist system

Capital - 10,000 share or larger blocksCommitment - large risk with large blocks

Contacts - Rule 113 prohibited direct contact tooffer blocks to another institution

Block houses are investment firms to helpinstitutions locate other institutions interestedin buying or selling blocksHave capital, commitment, and contacts

I tit ti d St k


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Institutions and StockPrice 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

N ti l M k t S t


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National Market Systems(NMS)

NMS is advocated by financial institutionsto provide greater efficiency,competition, and lower cost of

transactionsNMS is expected to have:Centralized reporting of all transactions

Centralized quotation system

Centralized limit order book (CLOB)

Competition among all qualified marketmakers


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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 C t li d Q t ti


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2. Centralized QuotationSystem

List quotes for a stock from all marketmakers on the national exchanges,regional exchanges, and OTC

Brokers would complete trades on themarket with the best quote

Intermarket Trading System (ITS)developed by American, Boston,Chicago, New York, Pacific, andPhiladelphia Stock Exchanges and NASD

3 C t li d Li it O d


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3. Centralized Limit OrderBook

Should contain all limit orders from allmarkets

Should be visible to all traders

All market makers and traders could fillorders on it

Technology exists, but NYSE specialistsfill most limit orders and oppose CLOBbecause they do not want to share thislucrative business

4 C titi A All


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4. Competition Among AllQualified Market Makers

Market makers compete on OTC market

Competition reduces bid-ask spread

NYSE opposes competition and arguesthat central auction results in best marketand execution

NYSE Rule 390 requires members to

obtain permission of the exchange beforetrading a listed stock off the exchange,forcing transactions to the exchange tocreate a central market


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New Trading Systems

Daily trading volume has increasedfrom 5 million shares to over 420million shares

NYSE routinely handles volume over400 million shares, and had a daily highof more than 700 million in 1998

Technology has allowed the marketprocess to keep pace


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Super DOT

Electronic order-routing system

Member firms transmit market and limit

orders in NYSE securities to tradingposts or member firms booth

Report of execution returned

electronically85% of NYSE market orders enter

through Super DOT system


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Display Book

Electronic workstation that keeps trackof all limit orders and incoming market

orders, including incoming Super Dotlimit orders

O i A t t d R t


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Opening Automated ReportService (OARS)

Pre-opening market orders for Super Dotsystem

OARS automatically and continuouslypairs buy and sell orders

Presents imbalance to the specialist prior

to the opening of a stockHelps determine opening price and

potential need for preopening call market


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Market Order Processing

Super Dots postopening market ordersystem

Rapid execution and reporting ofmarket orders

1997 average orders executed and

reported in less than 20 seconds


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Limit Order Processing

Electronically files orders to beexecuted when and if a specific price is

reachedUpdates the Specialists Display Book

Good-until-cancelled orders that are not

executed are stored until executed orcancelled


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Global Market Changes

NYSE Off-hours trading

Crossing Session I provides for trading

stocks at NYSE closing prices after theregular session from 4:15 PM to 5:00 PM

Crossing Session II provides for trading acollection of at least 15 NYSE stocks with a

market value of at least $1 million from4:00 PM to 5:15 PM


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Global Market Changes

Listing foreign stocks on the NYSE

Future growth will be in foreign

countries and their stocks

Foreign accounting standards areless stringent than SEC requirements

for NYSE listing

London Stock Exchange


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London Stock ExchangeOctober 27, 1986 Big Bang

Brokers can act as market makers

Jobbers can deal with the public and

institutionsCommissions are negotiable

Gilt market was restructured like U.S.

government securities marketTrades reported on Stock ExchangeAutomated Quotations(SEAQ)


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Effects of the Big Bang

Competitive market makers &SEAQ reduced number of people on

the trading floorMore activity in the system, but

profit margin has reduced from

competitionMany firms have merged or been

acquired by foreign firms

Tokyo Stock Exchange


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Tokyo Stock Exchange(TSE)

1998 brought TSE its own Big Bangintroducing more competition in

trading commissions andcompetition among marketparticipants


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Future Developments

More specialized investment companies

Changes in the financial servicesindustry

Financial supermarkets

Specialty shops

Advances in technology

Computerized trading

24-hour market of the future may befloorless, global, and highly automated

Th I t t


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The Internet:Investments Online

www.quote.com

www.sec.gov

www.nyse.com

www.nasdaq-amex.com

www.etrade.comwww.schwab.com

www.ml.com
http://www.quote.com/http://www.sec.gov/http://www.nyse.com/http://www.nasdaq-amex.com/http://www.etrade.com/http://www.schwab.com/http://www.ml.com/http://www.ml.com/http://www.schwab.com/http://www.etrade.com/http://www.nasdaq-amex.com/http://www.nasdaq-amex.com/http://www.nasdaq-amex.com/http://www.nyse.com/http://www.sec.gov/http://www.quote.com/

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