Chapter 5

1. Chapter 5 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

2. Chapter 5 Questions • 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 two markets support each other? • What is the typical underwriting organization structure for corporate stock issues?

3. Chapter 5 Questions • For secondary equity markets, what are the two basic trading systems? • What are the major primary listing markets in the United States and how do they differ? • What are call markets and when are they typically used in U.S. markets?

4. Chapter 5 Questions • How are national exchanges around the world linked and what is meant by “passing the book”? • What is Nasdaq and how has its growth and influence impacted the securities market? • What are the regional exchanges and what securities do they trade? • What is the third market?

5. Chapter 5 Questions • What are Electronic Communications Networks (ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets? • What are the major types of orders available to investors and market makers? • What are the major functions of the specialist on the NYSE?

6. Chapter 5 Questions • What new trading systems on the NYSE and Nasdaq have made it possible to handle the growth in U.S. trading volume? • What are the three recent innovations that contribute to competition within the U.S. equity market?

7. What is a market? • The means through which buyers and sellers are brought together to aid in the transfer of goods and services • Does not require a physical location • “The market” itself does not have to own the goods and services involved • Buyers and sellers benefit from the market

8. Characteristics of a Good Market • Availability of past transaction information • must be timely and accurate • Liquidity: sell quickly at a good price • marketability • price continuity • depth • Transaction cost are low (Internal efficiency) • Prevailing market prices reflect all relevant information (External efficiency)

9. Decimal Pricing • The movement to decimal pricing is a case study in making a market better • Benefits: • Ease of understanding prices for investors • Reduction in minimum bid-ask spreads • Lower transaction costs through enhanced global competition

10. Organization of the Securities Market • Primary markets • New issues • Secondary markets • Outstanding securities are bought and sold

11. Primary Capital Markets : Government Bonds • Sold regularly through auctions • Treasury bills: one year maturity or less • Treasury notes: maturities of two to ten years • Treasury bonds: original maturities of more than ten years

12. Primary Capital Markets : Municipal Bonds • Sold by three methods • Competitive bid sales: sealed bids • Negotiated sale: contractual arrangements, underwriter helps prepare, price, and sell the issue • Private placements: Issuer sells directly to investors • Underwriters services • Origination: design of the issue • Risk-bearing: purchase the issue, risk reselling • Distribution: selling the issue

13. Primary Capital Markets: Corporate Bonds • Negotiated arrangement with an investment banking firm who maintains a relationship with the issuing firm • Underwriting firm often organizes a syndicate for distribution

14. Primary Capital Markets : Common Stock • New issues are divided into two groups • Seasoned new issues • New shares offered by firms that already have stock outstanding • Initial public offerings (IPOs) • Firms selling their stock to the public for the first time • New issues normally underwritten by investment banking firms

15. Relationships with Investment Bankers 1. Negotiated • Most common • Full services of underwriter 2. Competitive bids • Corporation specifies securities offered, then seeks bids • Reduced costs but also reduced services of underwriter 3. Best-efforts • Investment banker acts as broker, selling all it can at a specified price The underwriting of corporate issues typically takes three forms:

16. Introduction of Rule 415 Shelf registration: • Allows firms to register securities and sell them piecemeal over the next two years • Increased flexibility for timing issues • Reduces registration fees and expenses • Mostly used for bond sales

17. Private Placements and Rule 144A • Firms sells to a small group of institutional investors, with some assistance of an investment banker • Lower issuing costs than public offering • Extensive registration not required • Issues can trade among large, sophisticated investors

18. Secondary Markets Involves the trading of issues that are already outstanding • Provide a means obtaining cash for sellers • Provide buyers with more investment choices

19. Why Secondary Markets Are Important • Provide liquidity to investors who acquire securities in the primary market • Helps issuers raise needed funds in the primary market since investors want liquidity • Help determine market pricing for new issues

20. Secondary Bond Markets • Secondary market for U.S. government and municipal bonds • U.S. government bonds traded by bond dealers who specialize in these issues • Banks and investment firms make markets in municipal bond issues • Secondary corporate bond market • Traded in an OTC market by bond dealers • A much more limited market than for stock issues

21. Financial Futures • Bond futures contracts allow the holder to either buy or sell a specific bond issue at a specific price on a future date • Bond futures are traded in separate markets • Chicago Board of Trade (CBOT) • Chicago Mercantile Exchange (CME)

22. Secondary Equity Markets • Basic Trading Systems • Pure auction market • Buyers “bid” and sellers “ask” • Buy and sell orders are matched at a central location • Price driven market: trades are made by determining the highest bid and the lowest ask • Dealer market • Dealers buy shares (at the bid price) and sell shares (at the ask price) from their own inventory • Dealers compete against each other

23. 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

24. Classification of U.S. Secondary Equity Markets • Primary Market Listings • Regional Stock Exchanges • The Third Market • Alternative Trading Systems

25. Primary Market Listings • Large number of listed securities • Listing often seen as a sign of prestige • Wide geographic dispersion of listed firms • Diverse clientele of buyers and sellers • Firms wanting to list must meet listing requirements

26. Primary Market Listings: NYSE • Largest organized securities market in United States • Established in 1817, but dates back to 1792 Buttonwood Agreement by 24 brokers • About 3,000 companies listed • Market value over $12 trillion • Accounts for about 80% of the trading volume for listed stocks

27. Primary Market Listings: 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 • Doesn’t trade stocks listed on NYSE • Merged with Nasdaq in 1998, although operations remain separate

28. Primary Market Listings: Global Stock Exchanges • Tokyo Stock Exchange (TSE) • London Stock Exchange (LSE) • Other National Exchanges • Frankfurt, Toronto, Paris • New exchanges in emerging countries • Russia, Poland, China, Hungary, Peru, Sri Lanka

29. Primary Market Listings: Global Stock Exchanges • Trend toward consolidation of exchanges • Economies of scale, especially in terms of the required technology • Liquidity is enhanced with more firms trading • Larger firms dual-listed on a U.S. exchange • Must meet listing requirements of both • Strong exchanges abroad enable continuous global trading for firms

30. 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 • This means that the markets are increasingly interrelated, moving toward a single world market

31. Primary Market Listings: Nasdaq NMS • Historically known as the Over-the-counter (OTC) market • Not a formal organization or a single location • Almost 3,500 issues actively traded on Nasdaq’s NMS ( National Market System) • More issues traded, but less dollar trading in terms of total value than NYSE National Quotation Bureau，NQB pink sheet market (1904) OTC NASD,1968 NASDQ (1971) NMS OCTBB (1990) Pink sheet SCM

32. Primary Market Listings: Nasdaq NMS • Operations • Any stock may be traded as long as it has a willing market maker to act a dealer • Nasdaq is a negotiated market with investors potentially dealing directly with dealers

33. Primary Market Listings: Nasdaq NMS The Nasdaq System • National Association of Security Dealers Automated Quotation system • Dealers may elect to make markets in stocks • Average of about 8 dealers per stock in 2003 • Three levels of quotations available • Level 1 shows a median representative quote • Level 2 shows quotes by all market makers • Level 3 is for Nasdaq market makers to change their quotes shown

34. Primary Market Listings: Nasdaq NMS Listing Requirements for Nasdaq • Two lists • National Market System (NMS) • Regular Nasdaq • Must meet at least one standard for initial and continued listing • See Exhibit 6.6 Making trades • Broker determines which dealer has the best price (lowest ask price/highest bid price)

35. Primary Market Listings: Nasdaq • Other Nasdaq Market Segments • The Nasdaq Small-Cap Market (SCM) • More lenient listing requirements • The Nasdaq OTC Electronic Bulletin Board • Report service for smaller stocks • The National Quotation Bureau (NQB) Pink Sheets • Price quotation sheets for smaller stocks

36. Regional Exchanges • Provide secondary markets for stocks not listed on a major exchange • Listing requirements vary • Some regional exchanges list issues also listed on a national exchange • Regional Exchanges in United States • Chicago, Boston, Pacific (San Francisco/Los Angeles), Philadelphia, Cincinnati

37. Third Market • Dealer and broker trading of shares listed on an exchange away from the exchange • Mostly well known stocks • May be important to investors particularly when the exchange is closed or when trading is suspended on the exchange • Success depends on relative costs of transactions compared to the exchange

38. Alternative Trading Systems (The Fourth Market) • Area of great innovation • Electronic Communication Networks (ECNs) • Buy and sell orders are matched via computer, mainly for retail and small institutional trading • Electronic Crossing Systems (ECSs) • Electronic means for matching larger buy and sell orders

39. Detailed Analysis of Exchange Markets Listed exchange markets have evolved into rather unique institutions; they can be described with a number of attributes: • Exchange Membership • Major Types of Orders • Exchange Market Makers

40. Exchange Membership Four categories of membership: • Specialists • Maintain an orderly market in a stock • Commission brokers • Member firm employees executing orders for clients of the firm • Floor brokers • Independent brokers who work for other brokers • Registered traders • Members who buy and sell for their own accounts

41. Major Types of Orders • Market orders • Buy or sell at the best current price • 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)

42. Major Types of Orders • Short sales • Sell overpriced stock that you don’t 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

43. Major Types of Orders • Special Orders • Stop loss • Conditional market 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

44. Major Types of Orders Buying on Margin: • On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral • Interest rate is based on the call money rate from a bank • Regulations limit proportion borrowed and the investor’s equity percentage (margin) • Margin requirements are from 50% up • Changes in price affect investor’s equity

45. Major Types of Orders Margin Example: • Buy 100 shares at $60 = $6,000 position • Borrow 50%, investment of $3,000 If price increases to $70, position Value is $7,000 Less - $3,000 borrowed Leaves $4,000 equity for a $4,000/$7,000 = 57%equity position ( Margin rate =equity/market value ) The rate of price change=(70-60)/60=16.67% The rate of return=(7000-6000)/3000=33.33%

46. Major Types of Orders Margin Example: • Buy 100 shares at $60 = $6,000 position • Borrow 50%, investment of $3,000 If price decreases to $50, position Value is $5,000 Less - $3,000 borrowed Leaves $2,000 equity for a $2,000/$5,000 = 40% equity position The rate of price change=(50-60)/60= -16.67% The rate of return=(5000-6000)/3000= -33.33% Leverage rate=1/percent margin

47. Major Types of Orders Margin Order Details • Initial margin requirement at least 50% • Lower margin requirements allow you to buy more • Maintenance margin • Required proportion of equity to stock value • Protects broker if stock price declines • Minimum requirement is at least 25% • Margin call on undermargined account to meet margin requirement • If call not met, stock will be sold to pay off the loan Question? If Buy 100 shares at $60 = $6,000 position and Minimum requirement is 25%, when the investor will receive margin call?

48. Exchange Market Makers A NYSE specialist is exchange member assigned to handle particular stocks • Has two roles: • Broker: match buy and sell orders and to process any limit orders as prices change • Dealer: buy and sell from their own account to maintain fair, liquid, and orderly market • Specialist has two income sources • Broker commission, without risk • Dealer trading income from profit, with risk, but also with significant information advantages