Securities Markets and Market Mechanics

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Chapter 1

• Securities Markets and Market Mechanics

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Primary Market vs. Secondary Market

• Primary
• Sale of new securities to raise money for issuer
• Secondary
• Resale of securities
• Issuing company not involved

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• Go public
• process in which start-up or heretofore private
  firm sells its shares in public offering
• Initial Public Offering (IPO)
• offering to public of securities in firm
  previously privately held
• Red Herring
• Registration statement that initiates a public
  offering front page contains a paragraph in red
  ink

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• Investment banker
• firm that advises on and/or brings new issues to
  the market
• Underwrite
• to agree to buy a new security issue, with
  intention to sell securities to public at higher
  price

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• Prospectus
• Official document that all companies offering new
  securities to the public must file with SEC
• Spells out in detail
• financial position of offering company
• what new funds will be used for
• qualifications of corporate officers
• risk factors
• nature of competition
• other material information

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• Best-effort basis
• a securities offering in which underwriter acts
  as agent for issuer but is not obligated to
  purchase securities
• Firm-commitment basis
• underwriter purchases securities from issuer and
  commits to selling them to public

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• Shelf Registration
• SEC provision allowing pre-registration of amount
  of security to be sold over a 2-year period
  without specific registration of each sale
• permitted by SEC Rule 415

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• Private Placement
• Direct sale of securities to one or small number
  of large buyers without registration requirements
  of public offering
• Legal restrictions on
• who may purchase
• resale of securities purchased in a private
  placement

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Lettered Stock

• Newly issued
• Sold at discount to large investors in private
  placement prior to a public offering of same
  issue
• Restricted
• Buyers agree not to sell their shares for
  specified period (SEC Rule 144)

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• Secondary Offering or Distribution
• Large public securities offering
• Made outside the usual exchange or OTC market
• Allows more time for absorption of large quantity
  than usual channels

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Secondary Market The Players

• Brokerage firms
• Registered representatives (brokers)
• Dealers
• Floor Brokers
• Specialists
• Registered competitive market makers

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• Brokerage firm
• Offers various financial services including
• access to the securities markets
• account management
• margin loans
• investment advice
• underwriting
• Registered Representative
• Employee of registered brokerage firm qualified
  to serve as account executive for customers,
  a.k.a. broker
• must be licensed to sell securities and
  pass series 7 exam
• individuals who have passed the series 6
  exam are licensed to sell products such as
  mutual funds and initial offerings of closed-end
  investment companies

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• Dealer
• Security trader
• Acts as principal rather than as agent
• Considered a specialist or a market maker
• NOT a broker
• Floor Broker
• Employees of firms who execute trades on an
  exchange floor on behalf of their firms clients
• Specialist
• Exchange member who makes a market in listed
  securities

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• Registered Competitive Market Maker (RCMM)
• Holds a seat on exchange
• Trades for his or her own account
• Also called floor traders
• Gramm-Leach-Bliley Act
• Accelerated the erosion of the lines between
  brokerage firms and other financial services
  firms

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Roles of the Specialist

• Auctioneer establishes the opening price for a
  security and maintains a fair and orderly market
• Agent executes orders for floor brokers
• Catalyst conduit of order flow
• Provider of capital uses firms capital to
  minimize any imbalance between public demand and
  supply for a security
• Stabilizes prices buy and sell stock to cushion
  temporary imbalances and avoid unreasonable price
  variations

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The Secondary MarketThe Institutions

• Stock exchanges
• National
• Regionals
• Over-the-counter
• Third and fourth markets
• Consolidated tape

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• NYSE (New York Stock Exchange)
• Largest based on Wall Street
• Lists large- to mid-capitalization stocks
• Toughest for listing standards
• A membership is referred to as a Seat
• AMEX (American Stock Exchange)
• Deals in small- to mid-capitalization stocks
• Merged with NASDAQ

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Regional Exchanges

• Chicago Stock Exchange
• Pacific Exchange
• Boston Stock Exchange
• Philadelphia Stock Exchange
• Cincinnati Stock Exchange

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• Dual Listing
• Security listed for trading on more than one
  organization, usually the NYSE and in
  over-the-counter market
• OTC (Over-the-Counter)
• Market in unlisted securities and off-board
  trading in listed securities

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• NASDAQ
• Automated information system that provides
  brokers and dealers with price quotations on
  securities traded over-the-counter
• Formerly National Association of Securities
  Dealers Automated Quotations

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Three Categories of NASDAQ OTC Quotations

• National Market Issues (NMI) largest and most
  actively traded stocks
• SmallCap List smaller firms
• Bulletin Board much smaller issues

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NASDAQ Quotations

• Level 1 subscribers receive only the highest bid
  and lowest ask prices on a security
• Level 2 subscribers can receive all prices but
  can not enter quotes
• Level 3 subscription entitles users to enter
  their own bid and ask prices

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• Pink Sheets
• Quotation source for most publicly traded OTC
  issues
• Third Market
• Over-the-counter trading of exchange-listed
  securities
• Fourth Market
• Direct trading of listed securities between
  institutions

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The Secondary MarketThe Transactions

• Costs of trading
• Types of Orders
• SuperDot and PERS
• Selling Short
• Large Secondary Market Trades

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Cost of Trading

• Commissions (explicit) fees charged by brokers
  for handling investment transactions
• May Day SEC abolished fixed-commission
• schedule on May 1, 1975
• Bid-ask spread (implicit) price difference
  between bid price and ask price for an asset
• Price concession (implicit) only on large orders

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Types of Orders

• Market Order
• Order to buy or sell at market price that
  requires immediate execution
• Limit Order
• Order to buy or sell at prespecified price
• Stop-Loss Order
• Order to sell or buy at market when certain price
  is reached
• Stop-Limit Order
• Order to implement limit order when market price
  reaches certain level
• (continued)

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Types of Orders (continued)

• MIT Order
• Becomes a market order if a specified price or
  better is reached
• Day Order
• Executable only during day order placed
• Fill-or-Kill Order
• Canceled if not immediately executed
• GTC Order
• Remains in effect until executed or canceled
• Versus Purchase
• sale that specifies purchase date of securities
  to be delivered for sale

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• SuperDot (Super Designated Order Turnaround
  System)
• Used at NYSE
• Transmits member firms market and day limit
  orders through common message switch to proper
  trading floor workstation
• Largest market order that can be handled is
  30,099 shares
• Used particularly for program trading
• PERS (Post Execution Routing System)
• Used on the AMEX
• Same as the SuperDot

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Selling Short

• Selling asset not owned with commitment to
  purchase asset in future
• Can now be done on uptick or downtick
• Must be able to borrow necessary securities

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Bear Raid

• Attempt to drive prices down by selling short

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• Block Trade
• trade involving 10,000 shares or more
• usually handled by block house

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• Special Offerings
• Large block of stock offered for sale on exchange
  with special incentive fees paid to purchasing
  brokers
• Also called spot secondary

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Tender Offer

• Offer to purchase a large block of securities
• Made outside the general market (exchanges, OTC)
• Tender offer may be part of an effort to take
  over company

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Security Markets Regulation

• Securities Act of 1933
• Securities Exchange Act of 1934
• Investment Company Act of 1940
• Investment Advisor Act of 1940
• SIPC Act of 1970
• Securities Act Amendments of 1975
• Sarbanes-Oxley Act of 2002
• Banking Act of 1933

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• Securities Act of 1933
• Deals with issuance of securities
• Addresses the registration process, disclosure
  requirements, and related matters
• Securities Exchange Act of 1934
• Deals with existing securities
• Addresses filing of periodic reports, regulation
  of exchanges and brokerage firms, ongoing
  disclosure requirements
• Prohibits certain unethical practices, such as
  market manipulation and insider trading

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• Investment Company Act of 1940
• Requires that investment companies disclose
  their financial
• condition and investment policies to
  investors when stock is
• initially sold and, subsequently, on a
  regular basis
• Investment Advisors Act of 1940
• Requires that firms or sole practitioners
  compensated for
• advising others about securities investments
  must register with
• SEC and conform to regulations designed to
  protect investors
• Securities Investor Protection Act of 1970
• Created the federal agency Securities
  Investor Protection
• Corporation
• Guarantees the safety of brokerage accounts
  up to
• 500,000, no more than 100,000 of which may
  be in cash

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• Securities Act Amendments of 1975
• Calls for national competitive system for
  securities trading
• Ended fixed brokerage commission rates
• Sarbanes-Oxley Act of 2002
• Mandates reforms to
• Enhance corporate responsibility
• Enhance financial disclosures
• Combat corporate and accounting fraud
• Creates the Public Company Accounting Oversight
  Board, also known as the PCAOB
• Oversees the activities of the auditing
  profession.
• Banking Act of 1933
• Created the FDIC, provider of deposit insurance

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Practical Issues

• Street Name
• Stock Certificates
• Types of Accounts
• Cash
• Margin
• Option
• Wrap

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• Street Name
• securities held in customer accounts at brokerage
  houses but registered in firms name

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Advantages of Street-Name Registration

• Offers secure storage
• Lets securities be traded without new
  certificates being issued or certificates
  delivered in a timely manner
• Allows customers who move frequently to file only
  one change of address with brokerage firm instead
  of notifying all companies separately
• Only single Form 1099 needs to be filed

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Disadvantages of Street-Name Registration

• Assets may be tied up during the reorganization
  of bankrupt brokerage firm
• Dividends and interest may be credited to an
  improper account
• Properly credited dividends may be retained by
  broker in a non-interest-bearing account for a
  few days before being sent to shareholder
• Discount coupons and sample products not sent to
  street-name accounts

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• Stock Certificates
• Document showing ownership of specified number of
  shares of companys stock

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Types of Accounts

• Cash Account
• Type 1 account
• Must have sufficient cash at time of purchase
• Margin Account
• Type 2 account
• Can borrow up to margin limit
• Short sales in this account only
• Option Account
• Special paperwork required

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• Discretionary Account
• Account over which broker is authorized to
  exercise FULL discretion with regard to purchases
  and sales
• Limited Discretionary Account
• Gives broker authority to make only certain types
  of trades without prior consent

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Wrap Accounts

• Advantages
• Customization Tailored to individuals specific
  needs. Clients may choose not to hold a
  particular company or industry for personal,
  ethical, or economic reasons.
• Tax efficiency Optimal tax treatment can be
  achieved.
• Simple fee structure wrap fee makes cost of
  account clear and explicit
• Disadvantage
• Total fee may be higher than that paid by most
  accounts

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• Portfolio Turnover Rate
• Measures trading activity in an account by
  showing the percentage of the portfolio that has
  been replaced during a given time period