Chapter 4

Organization and Functioning of

Securities Markets

Analysis of Investments & Management of Portfolios

10th Edition
by

Frank K. Reilly & Keith C. Brown

Questions to be answered (Pg. 87) :

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?

What are the national exchanges and how are the major security markets becoming
linked (what is meant by passing the book)?

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?

What are the major types of orders available to investors and market makers?

What new trading systems on the NYSE and on NASDAQ have made it possible to
handle the growth in the U.S. Trading volume ?

What are three recent innovations that contribute to competition within the U.S.
Equity market ?

What are the factors causing a global consolidation of stock, bond, and derivative
exchanges ? What will this global market place look like ?

What is a securities market ?

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

and/or services.

Does not require a physical location.

Does not necessarily own the goods and services involved.

Both buyers and sellers benefit from the existence of a market.

Characteristics of a Good Market

Availability of past transaction information and prevailing buy and sell

orders must be timely and accurate.

Liquidity
a.

marketability

b.

price continuity

c.

depth

Internal efficiency: Transaction cost - lower is more efficient

External efficiency: Reflect all information

Organization of the Securities Market:

Primary Capital Markets
a. Government Bond Issues
- Subdivided into 3 segments: Treasury bills, treasury notes and treasury bonds.
- Federal Reserve System auctions.

b. Municipal Bond Issues

- Sold by three methods: Competitive bid, negotiation, or private placement.
- Underwriters sell the bonds to investors: Origination, risk-bearing, distribution.

c. Corporate Bond and Stock Issues

- Negotiated arrangement with investment banking firm which
issues
and organizes a syndicate for distribution.
- New issues are divided into two groups:
1. Seasoned new issues
2. Initial public offerings (IPOs)

underwrites the

Underwriting
Relationships with
1. Negotiated
Investment
Most common Bankers

Full services of underwriter

2. Competitive bids

Corporation specifies securities offered

Reduce 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

Secondary Financial Markets

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

Secondary Bond Markets

Secondary market for U.S. government and municipal

bonds

U.S. government bonds 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

(CME)

Mercantile Exchange

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 $8 trillion

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

Warrants traded on AMEX years before NYSE listed any

Listing Requirements for

Stocks on the NYSE and the
NYSE
AMEX
AMEX
a

Pretax income last year

Pretax income last two years
Net tangible assets
Shares publicly held
Market value of publicly held shares
Minimum number of holders of
round lots (100 shares or more)

$ 2,500,000
2,000,000
18,000,000
1,100,000

$ 750,000

18,000,000

3,000,000

2,000

800

Table 4.1

4,000,000
500,000
c

For AMEX, this is net income last year

This minimum required market value varies over time, depending on the value of the NYSE
Common Stock Index. For specifics, see the 1998 NYSE Fact Book, 31-34
c

The AMEX only has one minimum

Sources: NYSE Fact Book (New York: NYSE, 1998); and AMEX Fact Book
(New York: AMEX 1998). Reprinted by permission.

Tokyo Stock Exchange

(TSE)
Largest of the eight exchanges in Japan

Dominates Japanese market

Established in 1878 and reorganized in 1943, 1947, and

1949

Price drive system

Domestic and foreign stocks listed

Most active 150 stocks are traded on floor, others by

computer

London Stock Exchange

(LSE)
Largest

securities market in the United

Kingdom
Trades listed and unlisted securities
2,600

Largest

companies listed

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

exchanges

of existing

Recent Consolidations
In

1995 Germanys three largest

exchanges merged into the one in
Frankfurt
NASD merge with AMEX
Phildelphia Stock Exchange merge with
NASD/AMEX
CBOE merge with Pacific Exchange
London Stock Exchange and Frankfurt
Stock Exchange merger

The Global Twenty-four Hour

Market
Investment firms pass the book around the
world to maintain nearly continuous trading
by utilizing markets at Tokyo, London, and
New York
THE TRADING DAY

Local Time
EST
TSE
09:00 - 11:00
23:00 - 01:00
13:00 - 15:00
03:00 - 05:00
LSE
08:15 - 16:15
02:15 - 10:15
NYSE
09:30 - 16:00
09:30 - 16:00

Regional Exchanges

Stocks not listed on a formal exchange

Listed stocks

Listing requirements vary

Allow brokers that are not members of a national exchange

access to securities

Regional Exchanges in 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 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

A Sample Trade on
NASDAQ

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

Buy From the Lowest

Dealer

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

Sell to the Highest Dealer

Dealer
1
2
3
4

Bid
851/2
853/8
851/4
853/8

Ask
85 3/4
85 5/8
85 5/8
85 3/4

Third Market
OTC

trading of shares listed on an

exchange

Mostly
GM,

well known stocks

IBM, AT&T, Xerox

Competes
May

with trades on exchange

be open when exchange is

closed or trading suspended

Fourth Market
Direct

trading of securities
between two parties with no broker
intermediary

Usually
Can
No

both parties are institutions

save transaction costs

data are available

Detailed Analysis of
Exchange Markets
Exchange
Major

Membership

Types of Orders

Exchange

Market Makers

Exchange Membership

Specialist
Commission brokers

Floor brokers

Employees of a member firm who buy or sell for the

customers of the firm
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

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)

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

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

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

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position

Value is $12,000

Less

Leaves

$7,000/$12,000 = 58% equity position

- $5,000 borrowed
$7,000 equity for a

Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position

Value is

$8,000

Less

Leaves

$3,000/$8,000 = 37.5% equity position

- $5,000 borrowed
$3,000 equity for a

Margin Transactions

Initial margin requirement at least 50%

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 call not met, stock will be sold to pay off the loan

Exchange Market Makers

U.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

Exchange Market Makers

Tokyo Stock Exchange
Regular members
(TSE)Several employees allowed on trading floor

Trading clerks for customers accounts

Buy and sell for own accounts

Saitori member

Hundreds of employees on trading floor

Intermediary clerks

Brokers among members

Maintain limit orders

TSE Membership

Membership requires corporate license

Four types of license are available and may be

combined

1. Trade securities as a dealer

2. Trade as a broker

3. Underwrite new securities on secondary offerings

4. Handle retail distribution of securities

Capital requirements vary by license

London Stock Exchange

Brokers

trade on behalf of their

customers

Jobbers

buy and sell as principals

Membership

based on experience
and competence

Membership

revenues

fee 1% of gross

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

Negotiated Commission
Rates

NYSE minimum commission schedule prohibited price

cutting since 1792

No price break for large orders

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

The Impact of Block

Trades

Number and size of block trades has increased

This strains the exchange specialist system

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:

1. Centralized reporting of all transactions

2. Centralized quotation system

3. Centralized limit order book (CLOB)

4. 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 (Rule 390)

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

Paris Bourse

The big brokerage house monopoly on stock

trading has been opened up to French and
foreign banks

Investment firms are merging with banks to

acquire capital needed to trade in world market

Continuous auction market introduced to

replace call market

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