Chapter Two

1. Chapter Two Security Markets: Present and Future McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. Security Markets: Present and Future • The Market Environment • Market Functions • Organization of The Primary Markets: The Investment Banker • Other Organized Exchanges • Over-The-Counter Markets • Electronic Markets • Electronic Communication Networks (ECN) • Institutional Trading • Regulation of the Security Markets

3. The Market Environment • Dramatic Changes: • Deregulation and other legal changes • Global consolidation and competition • Internet online brokerage and Electronic communication networks (ECNs) • Real-time quotes • 24 hour trading and record trading volume • Decimalization • Terrorism

4. The Market Environment What are markets supposed to do?

5. Markets: A way of exchanging assets Possible Characteristics of Markets

6. Market Efficiency and Liquidity Efficient Markets: Rapidly absorb and reflect current information and trading • Prices respond quickly to new information • Prices fluctuate little with successive trades • High and low volumes absorbed with little price change

7. Market Efficiency and Liquidity Liquidity of Markets: Speed of converting an asset to cash at or close to its fair market value • Greater with more participants and continuous trading • Greater with low cost buying and selling

8. Competition and Allocation of Capital • All assets compete for investor funds • Investors choose assets to achieve a desired return for perceived risk If markets are efficient and liquid, investor allocation of capital to alternative investments changes quickly in response to fresh information

9. Secondary Markets Markets for existing assets currently traded • Provides increased liquidity and a place to convert existing assets to cash • Provides ability to adjust capital allocation to new information • Provides valuation for existing assets

10. Primary Markets Market for buying assets directly from their sources; the first market where an asset is originally bought and sold • Raises funds to expand capital base of asset creator • Once sold on a primary market, assets may trade on secondary markets • Price competition on secondary markets enables primary markets to price new issues so as to fairly reflect risk-return relationships

11. Underwriting Guarantee provided by an investment banker to purchase an issuer’s securities at a fixed price (for a fee) Eliminates the risk of not selling a whole issue of securities and thus raising less cash than desired – banker usually “makes a market”: active buying and selling to ensure a liquid market and wider distribution

12. Alternatives to Underwriting • Investment banker makes “best efforts” to sell security but issuer assumes risk of unsold securities • Securities may be sold directly to investors by the issuer in a public offering or in a private placement

13. Distribution On large issues, investment bankers may share the risk and burden of distribution by forming a group called a “syndicate” A “Tombstone” advertising a stock or bond issue may list many underwriters distributing a security

14. Investment Banking Competition The Herfindahl-Hirschman Index (HHI) of market concentration in investment banking has been changing lately as mergers, globalization, the Gramm-Leach-Bliley Act and increased use of shelf registration alters the structure of investment banking Please click on the link to see the DOJ and FTC guide lines for HHI and antitrust Ranking of top underwriters varies by criteria although the top ten tend to be the same firms: • Number of issues • Gross proceeds • Fees earned www.usdoj.gov

15. Organized Exchanges • National or regional • Competition may be global • A central trading location where securities are bought and sold in an auction market by brokers acting as agents for the buyer and seller • The “open outcry” auction system is being replaced by electronic trading -- computer matching of buy and sell orders in many exchanges (with the exception of NYSE)

16. Consolidated Tape • On June 16, 1975, a consolidated ticker tape was instituted allowing brokers on any exchange to see prices of transactions on other exchanges in dually listed NYSE stocks • Such composite price data increases market efficiency and may keep prices competitive • Since only NYSE stocks on the consolidated tape, it is not truly reflective of the competitive environment

17. Listing Requirements for Firms • To be traded, a stock must meet listing requirements of an exchange • The New York Stock Exchange (NYSE) generating the greatest dollar volume of trades in large, well-known firms, has the most restrictive listing requirements • Stocks may be delisted for failing to meet criteria such as total market valuation

18. Membership for Market Participants Five types of market participants are members of (have “seats” on) exchanges: • Commission Brokers • Execute orders for customers of a retail brokerage house such as Merrill Lynch • Floor Brokers • Trade on exchanges but are not employees of a member firm, provide services for a fee • Registered Traders • Trade for themselves on exchanges to earn a profit • Odd-Lot Dealers • Buy and sell odd lots (trades of less than 100 shares) for their own accounts • Specialists • About ¼ of exchange membership • Each stock has a specialist assigned to it • Most specialists are responsible for more than one stock • Handle special orders such as “limit” bids or offers • Maintain a continuous, liquid, and orderly market in assigned stocks

19. The American Stock Exchange (AMEX) • Generally trades in securities of smaller firms than NYSE • Primarily a market for individual investors since many listed firms do not meet the liquidity needs of large institutional investors • One of largest markets for put and call options on stocks and indexes • The central market for Exchange Traded Funds (EFTs) such as SPYDERS and DIAMONDS

20. The Chicago Board Options Exchange • Competes with AMEX in trading options • Standardized call options

21. Futures Markets Trade the right to buy a certain amount of a commodity or stock at a set price for a specified period • As the future contract expires, it normally is reversed (closed out) • The Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) are two of the largest futures exchanges • Future exchanges are becoming publicly-traded firms, consolidating, and computerizing operations

22. Over-The-Counter Markets • No central location • Trades by telephone or electronic device • Dealers buy and sell specific securities for their own account rather than just act as agents processing orders • Dealers belong to The National Association of Security Dealers (NASD) • a self-policing organization • requires at least two market makers (dealers) for each security • Often 5 – 10 market makers for a security, even 20 market makers for government securities

23. Over-The-Counter Markets cont’d OTC Markets • OTC is the largest securities market in the United States in dollar volume

24. Over-The-Counter Markets Cont’d The “spread” • The difference between bid and asked price • Profit the dealer earns by making a market • Example: • XYZ common stock is bid 10 and asked 10.50 Dealer will buy at least 100 shares at $10 per share or Dealer will sell 100 shares at $10.50 per share • If price is too low, more buyers than sellers will appear and dealer will run out of inventory unless she raises price to attract more sellers and balances supply and demand • If price is at equilibrium, she will match an equal number of shares bought and sold and for her market-making activity, she will earn 50¢ per share traded

25. Debt Securities Traded Over-the-Counter • Government securities • Largest dollar volume on the OTC • Billions of dollars in trades each week • Government security dealers trade such securities • Make a market in • Treasury bills • Treasury bonds • Federal agency securities • Federal National Mortgage Association issues (FNMA) • Government National Mortgage Association (GNMA) • Student Loan Marketing Association (Sallie Mae) Continued

26. Debt Securities TradedOver-the-Counter • Associated with large financial institutions or brokerage houses • Specialized municipal bond dealers trade state and local government municipal bonds • Finance companies or dealers specializing in the industrial companies trade commercial paper (unsecured short-term corporate debt)

27. Electronic Communication Networks (ECNs) • Also known as Alternative Trading Systems (ATSs) • Can act as broker-dealer or as an exchange • Subscribers to the systems may include retail and institutional investors, market makers, and broker-dealers Electronic trading systems that automatically match buy and sell orders at specified prices

28. Electronic Communication Networks (ECNs) Cont’d • If no sell orders match a buy order • The order cannot be executed • The ECN can wait for a matching sell order to arrive, or • If order received during normal trading hours, it may be routed to another market for execution • Best bid and ask prices are shown in Nasdaq’s quotation montage • Some ECNs let subscribers see order books and some post order books on the internet • Institutions can trade among themselves and bypass broker and trading fees

29. Advantages of Electronic Communication Networks (ECNs) • ECNs integrate markets • Allow anonymity in trading • Lower the cost of trading • Create better executions • Create more price transparency • Permit “after-hours” trading, longer trading hours • Facilitate more competition • Facilitate smaller spreads

30. Regulation of Security Markets • Organized exchanges are regulated by the Securities and Exchange Commission (SEC) and self-regulated • The OTC market is controlled by the National Association of Security Dealers (NASD) • Three major laws govern the sale and subsequent trading of securities: • Securities Act of 1933 • Securities Exchange Act of 1934 • Securities Acts Amendments of 1975

31. Securities Act of 1933 The “Truth in Securities” Act To provide full disclosure of all pertinent investment information whenever a corporation sold a new issue of securities • All offerings except government bonds and bank stocks that are sold in more than one state must be registered with the SEC* *The Federal Trade Commission had many of these responsibilities before the formation of the SEC 

32. Securities Act of 1933 Cont’d • The registration statement must be filed 20 days in advance of the sale and include detailed corporate information • SEC will delay offering if information is found to be misleading, incomplete, or inaccurate • SEC does not certify that the security is fairly priced • Under certain circumstances, shelf registration is being used to modify 20-day waiting period 

33. Securities Act of 1933 Cont’d • All new issues must be accompanied by a prospectus • A detailed summary of registration statement • Includes list of directors and officers; their salaries, stock options, and shareholdings; financial reports certified by a certified public accountant (CPA); a list of underwriters; the purpose and use of funds to be provided from the sale of securities; any other reasonable information that investors may need to know before they can wisely invest their money 

34. Securities Act of 1933 Cont’d • Officers of the company and other experts preparing the prospectus or registration statement can be sued for penalties and recovery of realized losses if any information presented was fraudulent or factually wrong or if relevant information was omitted

35. Securities Exchange Act of 1934 Created the Securities and Exchange Commission to enforce the securities laws • Established guidelines for insider trading • Board of Governors of the Federal Reserve became responsible for setting margin requirements • Manipulation of securities by conspiracies between investors prohibited • SEC given control of proxy procedures • Required periodical reports from companies traded on exchanges • Required all exchanges to register with the SEC

36. Securities Exchange Act of 1975 • Directed SEC to supervise development of a national securities market • Assumed any national market would make extensive use of computers and electronic communication devices • Prohibited fixed commissions on public transactions • Prohibited banks, insurance companies, and other financial institutions from buying stock exchange memberships to save commission costs for their own institutional transactions

37. Other Legislation A number of other acts deal directly with investor protection • Investor Advisor Act of 1940 to protect public from unethical investment advisors • Any adviser with more than 15 public clients (excluding tax accountants and lawyers) must register with the SEC • Registered advisers must file semi-annual reports • Investment Company Act of 1940 • Provides similar oversight for mutual funds and investment companies dealing with small investors • Amended in 1970, now gives NASD authority to supervise and limit commissions and investment advisory fees on certain types of mutual funds

38. Other Legislation Cont’d • Securities Investor Protection Act of 1970 • Securities Investor Protection Corporation (SIPC) established to oversee liquidation of brokerage firms and to insure investors’ accounts to a maximum value of $500,000 in case of bankruptcy of a brokerage firm • Resulted from problems on Wall Street from 1967 to 1970 when surging share volume caused a back-office paper crunch and an inability to process orders fast enough • SIPC does not insure market value losses suffered while waiting to get securities from bankrupt brokerage firms

39. Insider Trading • The Securities Exchange Act of 1934 established initial restrictions on insider trading • The definition of “insider” has been expanded to include anyone with special non-public information • Punitive measures attempt to discourage the illegal use of insider information for profits • Insiders are permitted to make proper long-term investments in corporations • The 1980s and early years in the new century saw a rash of insider scandals tarnishing the image of fairness on Wall Street

40. Program Trading, Rule 80A,and Market Price Limits • Program trading occurs where software establish trigger points for large volumes of trades by institutional investors • Program trading may increase market volatility and has been blamed for the 508-point market crash on October 19, 1987 • Rule 80A by the NYSE, as amended by the SEC, tried to limit volatility after the crash of 1987 by restricting trades after 50 point movements by the Dow-Jones Industrial Average (DJIA) in any day on the NYSE • In 1989, “circuit breakers” were also put in place to shut down the market briefly when there are specified dramatic drops in stock prices on the NYSE • Nasdaq, the American Stock Exchange, and the Chicago Board of trade have also agreed to discontinue trading if there is a halt on the NYSE

41. Exploring the Web