Chapter 6

1. Chapter 6 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

2. Chapter 6 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 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”)?

3. Chapter 6 Questions • What are the regional stock exchanges and the over-the-counter (OTC) markets? • What are the alternative market-making arrangements available on the exchanges and the OTC market? • What are the major types of orders available to investors and market makers?

4. Chapter 6 Questions • What are the major functions of a specialist on the NYSE and how does the specialist differ from the central market maker on other exchanges? • What are the significant changes in markets around the world in the past fifteen years? • What are some of the major changes in world capital markets expected over the next decade?

5. 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

6. 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)

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

8. Primary Capital MarketsGovernment 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

9. Primary Capital MarketsMunicipal 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

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

11. 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

12. 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

13. Private Placements • 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

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

15. 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

16. Secondary Market 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

17. National Stock Exchanges • 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

18. 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 listed • Market value over $13 trillion • Dominates other exchanges, with about 85% if all exchange-traded shares on NYSE

19. 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 • Doesn’t trade stocks listed on NYSE • Merged with Nasdaq in 1998, although operations remain separate

20. Tokyo Stock Exchange (TSE) • Largest of the eight exchanges in Japan • Dominates Japanese market • Established in 1878 and reorganized in 1943, 1947, and 1949 • Domestic and foreign stocks listed • Most active 150 stocks are traded on floor, others by computer

21. London Stock Exchange (LSE) • Largest securities market in the United Kingdom • Trades listed and unlisted securities • Largest listing of foreign stocks on any exchange • Stocks divided into three groups • Alpha - 65 most active • Betas - 500 next most active • Gamma - bids are indicative only and must be confirmed

22. Other National Exchanges • Frankfurt, Toronto, Paris • International Federation of Stock Exchanges • New exchanges in emerging countries • Russia, Poland, China, Hungary, Peru, Sri Lanka • Consolidation of exchanges in other countries • Economies of scale, especially in terms of the required technology • Liquidity is enhanced with more firms trading

23. 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

24. 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

25. Over-the-Counter (OTC) Market • Not a formal organization or a single location • Trading in unlisted stocks and listed stocks (third market) • Lenient requirements for listing on OTC • Almost 5,000 issues actively traded on Nasdaq’s NMS ( National Market System) • More issues traded, but less dollar trading in terms of total value than NYSE

26. Over-the-Counter (OTC) Market • Operations • Any stock may be traded as long as it has a willing market maker to act as dealer • OTC is a negotiated market with investors potentially dealing directly with dealers

27. Over-the-Counter (OTC) Market The Nasdaq System • National Association of Security Dealers Automated Quotation system • Dealers may elect to make markets in stocks • Average of 8.7 dealers per stock in 2000 • Three levels of quotations available • Level 1 shows a median representative quote • Level 2 shows quotes by all market makers • Level 3 is for OTC market makers to change their quotes shown

28. Over-the-Counter (OTC) Market 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 6.7 Making trades • Broker determines which dealer has the best price (lowest ask price/highest bid price)

29. 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 cancelled (GTC)

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. Changes in the Securities Markets In recent years, major changes in securities markets have largely been driven by the influence of large financial (institutional) investors. Among the impacts: • Negotiated (competitive) commission rates • Influence of block trades • Impact on stock price volatility • Development of National Market System (NMS)

37. 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

38. The Impact of Block Trades • Number and size of block trades has increased • Challenges created by block trades: • Some specialists did not have capital needed to acquire blocks of 10,000 or more shares • Rule 113 prohibited contact with another institution to acquire the block • Development of block houses in response: • Investment firms (upstairs traders) that help institutions locate other traders for a transaction

39. Institutions and Stock Price Volatility Do institutional investors contribute to greater stock price volatility? • Empirical studies have not supported the theory that institutional trading increases price volatility • Institutions provide liquidity for one another and noninstitutional investors

40. 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

41. New Trading Systems As trading volume has grown, it has become increasingly necessary to seek new technologies to assist the trading process. • Super DOT • Electronic order-routing system • Member firms transmit market and limit orders in NYSE securities to trading posts or member firm’s booth • Report of execution returned electronically • 85% of NYSE market orders enter through Super DOT system

42. New Trading Systems • Display Book • Electronic workstation that keeps track of all limit orders and incoming market 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

43. New Trading Systems • Market Order Processing • Super Dot’s postopening market order system • Rapid execution and reporting of market orders • In 2000, 94.5% of market orders executed in less than sixty seconds • Limit Order Processing • Electronically files orders to be executed when and if a specific price is reached • Updates the Specialist’s Display Book • Good-until-cancelled orders that are not executed are stored until executed or canceled

44. Global Market Changes • NYSE Off-hours trading • Several “crossing sessions” offer opportunities for after-hours trading • Listing foreign stocks on the NYSE • A goal of future growth for NYSE • Continuing challenge: Foreign accounting standards are less stringent than SEC requirements for NYSE listing

45. Global Market Changes • London Stock Exchange “Big Bang” • Brokers can now act as market makers • Commissions are negotiable • Trades reported on Stock Exchange Automated Quotations (SEAQ) International, similar to Nasdaq • Tokyo Stock Exchange “Big Bang” • 1998 rule changes to introduce more competition in trading commissions and competition among market participants

46. Future Developments • Creation and consolidation of stock exchanges • Creation of new exchanges in emerging markets where capital is needed and opportunities await • Consolidation in developed countries to effectively offer liquidity and efficiently invest in technology • More specialized investment companies • Changes in the financial services industry • Financial supermarkets & Specialty shops • Trading in Cybermarkets