International Finance

1. International Finance Week 7 Class 1 Stock Market Competition Professor Diamond

2. International Finance Differences In Market Types

3. Trading Venues in U.S. • Exchanges: e.g., NYSE, Amex, regional exchanges • Nasdaq: Began as an “OTC” market of individual market maker connected by computer • SEC approves exchange status on January 13, 2006, previously owned by NASD • OTC Bulletin Board (less active, but registered)—indications of interest, not orders (second market), operated by Nasdaq • Pink Sheets: privately owned (unregistered shares)—indications of interest not orders (second market) • Electronic Communication Networks (ECNs): electronic matching systems, e.g. Posit (fourth market)

4. The Big Board: NYSE • Largest market, $19.7 trillion market capitalization (Nasdaq $3.5 trillion) • Merged with Archipelago, public electronic exchange, February 2006, and became public (Kuan and Diamond 2006) • Floor auction system involving traders plus an automatic execution system—a hybrid evolving into a more automated system, NYSE hybrid automated auction • Participants are floor brokers (commission brokers employed by brokerage house members and independent members who handle orders for other brokers) and specialists • The floor auction (80% of orders) centers around the specialists (7 firms) who are arranged around 18 trading posts with 400 trading positions dedicated to the trading of particular securities.

5. The Big Board: NYSE • Maintain “fair and orderly market” which implies “the maintenance of price continuity, with reasonable depth, and the minimizing of the effects of temporary disparity between supply and demand” [NYSE Rule 104] • 1987 market crash? • Execute commission orders for brokers • Conduct auctions in stocks for which registered as specialist • Must yield to public orders at same price or better

6. NYSE Specialist system • 7 total: concentrated, top 3 (LaBranche, Spear Leeds (GS), Bank of America), 80.1 percent of dollar volume • 9% of the total buy and sell volume, 80% of which is for market stabilization • Trading ahead scandal, $241.8 million settlement in March 2004: manual trading has abuse potential • Did they “capture” Grasso and trigger governance crisis?

7. International Finance Electronic versus Floor-based Auction Markets: Which is Better?

8. Electronic v. Auction • Price improvement versus speed: auction-floor can give price improvement as compared with speed automatic matching, but maybe NYSE hybrid can do both • Less room for human mischief on electronic systems • Electronic cheaper • Human system less likely to automatically spiral out of control (at least need humans when electronic spirals out of control. • Back-up easier for electronic, see 9/11

9. International Finance Market Structure, Governance and Regulation

10. One nation, one market? • 1975 Congressional mandate to SEC: develop an integrated national market system for U.S. exchanges • Goal • increase liquidity, • Allow investors to see and access the best price • SEC initiatives for all exchanges: • Tape consolidating price & volume of every trade • Composite quote system identifies national best bid and offer prices (NBBO) • Inter-market trading system (ITS), so brokers can route orders to market with the best prices automatically • Trade-through rule for NYSE stocks (best price in any market)

11. New SEC NMS Rules • Trade Through: market receiving order for NYSE or Nasdaq stocks must send it to market with better price. • If Market A receives market bid order (customer wants to buy at market price, not at a limit) and its best ask is 101, must send to Market B with best ask of 100.50 (customer gets to buy at lower pice) • SEC Rule permits “fast” (usually an ECN)) receiving market to execute, ie, “trade through” the better price of (non-automated) market if fast market price is close, e.g. for orders over $100 within 5 cents—SEC rejects investor opt-out • Fast market must still send to another fast market with better price (“immediate or cancel”) • Cost of implementation may be $1 billion

12. Reg NMS • Access: Any market (aimed at ECNs) with 5% of trading in stock must display BBOs and allow all market participants to access those orders at a maximum charge of $0.003 per share (ECNs charge order takers and pay order suppliers) • No sub-penny pricing • Data Fees: New system for dividing revenue among markets from supply of quote and trade data

13. Reg NMS • A dissenting voice on SEC • Conservative free market member Paul Atkins dissented in April 05 speech • Argued for “Invisible Hand” of investor choice to develop best system, not government regulation • Trade-through not a huge problem (1 in 40 trades) • But fear that a dominant market will impede data access won the day • SEC did not want to wait for a “market” solution to emerge

14. Who should regulate the Exchanges? • Government? • E.g., SEC, E.U. Commission/member states • Exchanges? • Self-regulatory organizations (SROs) • Note NYSE creation of NYSE-R, sub of NYSE Group, with all independent board (minority from public NYSE)) • New NASDAQ will also have a reg. body • Industry SRO, e.g. NASD (current dispute with NYSE over member firm regulation)

15. “Ringing the Bell” • Kuan and Diamond paper (2006) • How has the NYSE been organized historically? • What are the advantages of that system? • What economic theory do the authors rely on? • What organizational theory do they rely on? • How do those theories apply to the pre-IPO NYSE? • What will happen to the NYSE now?

16. “Ringing the Bell” • NYSE has been a mutually governed non profit for 200 years • Members owned and governed the exchange • Authors suggest that this enables a “hostage” system to emerge

17. “Ringing the Bell” • Similar to structure of VC world: • VC A invests in company X as lead investor; asks VC B to co-invest. • VC B needs assurance that he can trust VC A’s management of firm • So VC B says, ok, I will invest, but you must invest in my company Y. • They “exchange” hostages in the form of cross-investing • Very common on east coast in early 70s

18. “Ringing the Bell” • How is a hostage exchange created on the NYSE? • Key players are the investment banks • They offer new CEO’s (IPO firms) the opportunity to invest in other firms • IPO allocations create network of cross-holdings • “Friends of Frank” - hostage system run amok

19. “Ringing the Bell” • Hostage system helps police bad behavior • IPO allocations create “mutual dependency” between CEO’s • Citigroup, parent of SalomonSmithBarney, revealed details of its IPO allocations in 2002 in response to Congressional inquiry • Records showed consistent allocations to major customers many of whom were CEO’s of other publicly traded companies • In non-bubble period, CEO’s hold on to shares and are vulnerable to bad management

20. “Ringing the Bell” • Investment banks dominate exchange ownership through board seats and ownership of specialist firms • Thus, they are (were) highly motivated to insure quality - to solve a lemons problem through gatekeeping and hostages • Better quality attracts more issuers and traders thus improving liquidity and value of exchange to investors

21. “Ringing the Bell” • What happens on a “for profit” corporate exchange? • Governance mechanism is different • Outside shareholders own the Exchange, managed by a board and officers • Now, direct profits from trading volume matter - each trade generates revenue • “Quality” is an indirect value because investor confidence less central

22. “Ringing the Bell” • What are the implications of this argument? • Why did the NYSE go this route? • Competitive pressures • New technology drives new revenue possibilities • Off-exchange world of private equity maintains hostage system? • I-banks setting up private trading venues • Investing public stuck with deteriorating quality in main exchanges? • Exchanges behave like other corporations - CEO egos drive value destroying M&A?

23. The next step: a merger wave? • Consolidation of European exchanges • Formation of Euronext (2000) • combines Paris, Brussels and Amsterdam, • each exchange is separate subsidiary of Euronext and separately regulated • The Failed LSE-Deutsche Börse Merger (2000) • Both exchanges publicly traded • Blue Chips Traded in London, Technology Stocks in Frankfurt • German Banks Biggest Shareholders of Combined Entity • Regulation of Trading in London Under U.K. Rules and • Trading in Germany Under German Rules

24. A merger wave? • The Failed LSE-Deutsche Börse Merger (2005) • Market caps: LSE £2.1T; DB £.8T • Owners of DB thought bid price ($2.5 billion) was too high, want share buy-back • Concern of LSE traders that would be forced to use DB’s more expensive clearing and settlement system • Failed NASDAQ bid for LSE (2006) • Bid of $16.60 (£ 9.50) per share, $4.1 billion total (£ 5.80 bid from Macquarie, an Australian bank, three months earlier) • Nasdaq trades at P/E of 65 compared to LSE of 30 (2006) • Key Issues • merger of trading systems • merger of clearing and settlement • merger of regulation (SOX or not)