Organization and Functioning of Securities Markets

Innovative Financial Instruments

K . Arjun Goud

Chapter 3

What is a Market?
Brings 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 involved

Buyers 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 registrations Great flexibility Reduces registration fees and expenses Allows requesting competitive bids from several investment banking firms Mostly 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 makers

Secondary 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 securities
Prestige of firms listed

Wide geographic dispersion of listed firms Diverse 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 listed Market value over $12 trillion Average daily volume of 791 million shares

American Stock Exchange (AMEX)

Outdoor Curb Market Emphasis on foreign securities Does not trade stocks listed on NYSE Warrants traded on AMEX years before NYSE listed any It has also an options exchange

Tokyo Stock Exchange (TSE)

Largest of the eight exchanges in Japan Dominates Japanese market Price drive system Domestic and foreign stocks listed Most 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 Lanka

Consolidation of existing exchanges in developed countries

capture economies of scales provide added liquidity

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

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 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 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 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 minute
Alternative 1 for profitable companies with limited assets Alternative 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 costs

No data are available

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

Exchange Market Makers U.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 institution

Block 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 traders All market makers and traders could fill orders on it Technology 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 system Member firms transmit market and limit orders in NYSE securities to trading posts or member firms 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 Dots 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 Specialists 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 Exchange October 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.com www.sec.gov www.nyse.com www.nasdaq-amex.com www.etrade.com www.schwab.com www.ml.com