ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS Chapter 6 ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

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 two markets support each other? What is the typical underwriting organization structure for corporate stock issues?

Chapter 6 Questions What are Rules 415 and 144A and how do they affect corporate security underwriting? 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?

Chapter 6 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?

Chapter 6 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?

Chapter 6 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? What are Rule 390 and the trade-through rule and what is their effect regarding competition on the U.S. equity market?

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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

Major Types of Orders Market orders Limit 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)

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

Major Types of Orders Special Orders Stop loss Stop buy order 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

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

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

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

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

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

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

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

New Trading Systems Market Order Processing Limit Order Processing Super Dot’s postopening market order system Rapid execution and reporting of market orders In 2003, 94.5% of market orders executed in less than thirty 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

New Trading Systems Nasdaq Small-Order Execution System (SOES) Helps to ensure the execution of smaller orders (up to 1000 shares) SelectNet A computer order-routing and execution service for institutional investors

Innovations for Competition Two competing models Order-driven market (Exchanges) Quote-driven market (Nasdaq dealers) SEC has encouraged competition Consolidated Quotation System (CQS) Allows subscribers to see quotations from both exchanges and dealers simultaneously Intermarket Trading System (ITS) Centralized quotation system between Nasdaq and regional exchanges

Future Developments Continued competition of ECNs with the order-driven and quote-driven markets NYSE has sought to protect itself against such competition through regulations They argue that they offer many investors the best price even if the other platforms offer better speed of execution