Chapter 4 Organization and Functioning of Securities Markets

1
Chapter 4 Organization and Functioning of
Securities Markets

• Questions to be answered
• What is the purpose and function of a market?
• What are the characteristics that determine the
  quality of a market?
• What is the difference between a primary and
  secondary capital market and how do these markets
  support each other?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are the national exchanges?
• What are the regional stock exchanges and the
  over-the-counter (OTC) market?
• What are the alternative market-making
  arrangements available on the exchanges and the
  OCT market?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are the major types of orders available to
  investors and market makers?
• What are the major functions of a specialist on
  the NYSE?

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What is a market?

• Brings buyers and sellers together to aid in the
  transfer of goods and services
• Does not require a physical location?
• Both buyers and sellers benefit from the market

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Vital Economic Functions of Financial Markets

• Providing companies with capital they need to
  grow or expand
• Providing investment opportunities to investors
• Channel capital to most productive areas
• Help investors manage risk through
  diversification and risk transfer

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Characteristics of a Good Market

• Availability of past transaction information
• must be timely and accurate
• Liquidity
• marketability
• price continuity
• depth
• Low Transaction costs
• Rapid adjustment of prices to new information

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Organization of the Securities Market

• Primary markets
• Market where new securities are sold and funds go
  to issuing company
• Secondary markets
• Market where outstanding securities are bought
  and sold by investors. The issuing company does
  not receive any funds in a secondary market
  transaction

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The Underwriting Function

• The investment banker purchases the entire issue
  from the issuer and resells the security to the
  investing public.
• The firm charges a commission for providing this
  service.
• For municipal bonds, the underwriting function is
  performed by both investment banking firms and
  commercial banks

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Corporate Bond and Stock Issues

• New issues are divided into two groups
• Seasoned new issues - new shares offered by firms
  that already have stock outstanding
• Initial public offerings (IPOs) - a firm selling
  its common stock to the public for the first time

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Underwriting Relationships with Investment Bankers

• 1. Negotiated
• Most common
• Full services of underwriter
• 2. Competitive bids
• Corporation specifies securities offered
• Lower 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 and sell them
  piecemeal over the next two years
• Referred to as shelf registrations
• Great flexibility
• Reduces registration fees and expenses
• Allows requesting competitive bids from several
  investment banking firms
• Mostly used for bond sales

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Private Placements and Rule 144A

• Firms sells to a small group of institutional
  investors without extensive registration
• Lower issuing costs than public offering

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Why Secondary Financial Markets Are Important

• 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

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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,
  Dublin, Cincinnati
• 3. 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 location
• Price-driven market
• Dealer market
• Dealers provide liquidity by buying and selling
  shares
• Dealers may compete against other dealers

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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
• In a continuous market, trades occur at any time
  the market is open

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National Stock Exchanges

• Large number of listed securities
• Prestige of firms listed
• Wide 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 United
  States
• Established in 1817, but dates back to the 1792
  Buttonwood Agreement by 24 brokers
• Over 3,000 companies with securities listed
• Total market value over 13 trillion

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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
• Doesnt trade stocks listed on NYSE
• Merged with the NASDAQ IN 1998 although they
  continued to operate as separate markets

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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 securities
• Regional Exchanges in United States
• Chicago, Boston, Cincinnati, Pacific, Philadelphia

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Over-the-Counter (OTC) Market

• Not a formal organization
• Largest segment of the U.S. secondary market
• 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

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Operation of the OTC

• Any stock may be traded as long as it has a
  willing market maker to act 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 provides a single median representative
  quote for the stocks on NASDAQ
• Level 2 shows quotes by all market makers
• Level 3 is for OTC market makers to change their
  quotes shown

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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 minute
• Alternative 1 for profitable companies with
  limited assets
• Alternative 2 for large but less profitable

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Nasdaq InterMarket(formerly, Third Market)

• OTC trading of listed shares
• Mostly well known stocks
• GM, IBM, ATT, Xerox
• Competes with trades on exchange
• May be open when exchange is closed or trading
  suspended

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Fourth Market

• Direct trading of securities between two parties
  with no broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available regarding its specific size
  and growth

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INSTinet

• Instinet At A Glance
• Providing sophisticated electronic trading
  solutions for more than 30 years, our services
  enable buyers and sellers worldwide to trade
  securities directly and anonymously with each
  other, have the opportunity to gain price
  improvement for their trades and lower their
  overall trading costs. Through our electronic
  platforms, customers can access over 40
  securities markets throughout the world,
  including the Nasdaq, NYSE, London Stock
  Exchange, as well as stock exchanges in
  Frankfurt, Hong Kong, Paris, Sydney, Tokyo,
  Toronto and Zurich. Instinet is a member of the
  Reuters family of companies.

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Detailed Analysis ofExchange Markets

• Exchange Membership
• Major Types of Orders
• Exchange Market Makers

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Exchange Membership

• Specialist
• Commission 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 members
• Registered traders
• Use their membership to buy and sell for their
  own accounts

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Major Types of Orders

• Market orders
• Buy or sell at the best current price
• Provides immediate liquidity
• 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)

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Major Types of Orders

• Short sales
• Sell overpriced stock that you dont 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

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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

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Example

• Current market price 25
• Limit order Buy 20
• Limit price
• Sell 30
• Stop order Buy 30
• Stop price
• Sell 20
• Stop limit order
• Buy Limit price 31
• Stop price 30
• Sell Limit price 19
• Stop price 20

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Margin Transactions

• On any type order, instead of paying 100 cash,
  borrow a portion of the transaction, using the
  stock as collateral
• Interest rate on margin credit may be below prime
  rate
• Regulations limit proportion borrowed
• Margin requirements are from 50 up
• Changes in price affect investors equity

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Margin Transactions

• Initial margin requirement at least 50.
• Set up by the Fed.
• Maintenance margin
• Requirement proportion of equity to stock
• Protects broker if stock price declines
• Minimum requirement is 25
• Margin call on undermargined account to meet
  margin requirement
• If margin call not met, stock will be sold to pay
  off the loan

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Margin Transactions

• Example
• Assume an initial margin of 50 percent and
  maintenance margin of 30 percent.
• An investor buys 100 shares of stock on margin at
  60 per share.
• a) What is the actual margin if price
  subsequently drops to 50?
• Loan 60(100) - .5(60)(100) 3000
• Actual margin (5000 -
  3000)/5000
• 40
  percent
• b) The price now rises to 55. Is the account
  restricted?
• Actual margin (5500 - 3000)/5500
• 
  45.5 percent
• The account is restricted.
• c) If the price declines to 35, is there a
  margin call?
• What is the amount of the margin call?
• Actual margin (3500 - 3000)/3500
• 
  14.3 percent
• Yes, there is a margin call
• Amount of the margin call
• 3500(.30) - (3500 - 3000) 550

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Exchange Market MakersU.S. Markets

• Specialist is exchange member assigned to handle
  particular stocks
• Has two roles
• Broker to match buyers and sellers
• Dealer to maintain fair and orderly market
• Specialist has two income sources
• Broker commission, without risk
• Dealer trading income from profit, with risk

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Glossary

• Ask Price
• The quoted price at which a market maker is
  willing to sell a security
• Best Ask the lowest quoted ask price of all
  competing market makers
• Bid Price
• The quoted price at which a market maker is
  willing to buy a security
• Best Bid the highest quoted bid of all
  competing market makers

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• Bid-Ask Spread
• The difference between ask price and bid price
  covers market makers cost margin for
  risk-taking
• Inside Spread (Inside Quote)
• The difference between the best bid and best ask
• It is narrower than a market makers quoted
  spread
• Depth, Bid depth, Ask depth

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• Market Maker
• A dealer that maintains bid and ask price in a
  given security by standing ready to trade at
  quoted prices
• Alternative Trading System (ATS)
• Non-traditional, computerized trading systems
  that compete with or supplement dealer markets
  and traditional exchanges
• These private trading systems facilitate
  electronic trading in millions of shares every
  day, but do not provide a listing service

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• Electronic Communication Network (ECN)
• An electronic facility that matches buy and sell
  orders directly through a computer
• ECNs act on behalf of customers and do not trade
  on their own account
• ECNs are ATSs however, not all ATSs are ECNs
• Computer Assisted Execution System (CAES)
• Nasdaq service that automates order routing and
  execution for securities listed on domestic
  exchanges in the Intermarket Trading.

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• SuperMontage
• The next generation electronic trading system in
  both order display and execution for Nasdaq
  securities, launched by Nasdaq in mid-2002
• The new trading system provides a fully
  integrated order display and execution platform,
  aggregating quotes and orders to provide access
  to more possible trades
• Trading Halt
• The temporary suspension of trading in a security
  while material news about the issuing company is
  being disseminated.

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American Depository Receipt (ADR)

• A negotiable certificate representing shares of a
  foreign security that has been repackaged for
  trading on a US stock market
• ADRs make it easier for US investors to trade
  shares of foreign-based companies
• Certificates, transfers, and settlement practices
  for ADRs are identical to those for US securities