1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.1 CHAPTER 13 Common Stock Market: I

2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objectives Where stocks are traded Categorization of markets in terms of exchange-listed stocks (national and regional exchanges), Nasdaq-listed over- the-counter stocks, and non-Nasdaq over- the- counter stocks Four types of markets where stocks are traded: first, second, third and fourth 2

3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Learning Objectives (continued) Structure of the NYSE and Nasdaq Alternative trading systems, ECN’s and crossing networks Alternatives available to a broker for trade execution Role and regulation of dealers in exchange and OTC markets in the USA Reasons why issuers raise equity funds outside their domestic stock market 3

4. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. There are two basic types of trading in the secondary market for equities Organized exchanges (also called central auction specialist systems) which are specific geographic locations called trading floors, where buyers/sellers meet The trading mechanism is the auction system 4

5. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) over-the-counter (OTC) trading (also called multiple market maker systems), which results from geographically dispersed traders or market makers electronically linked to one another The trading mechanism is a negotiated system whereby buyers negotiate with sellers 5

6. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) Electronic communications networks (ECN's) are independently owned and operated and have recently developed as a platform for trading common stocks 6

7. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) Major national stock exchanges New York Stock Exchange (NYSE) (about 2000 listed companies) Big Board American Stock Exchange (AMEX) (about 700 listed companies) Curb The major OTC market is Nasdaq (more listed companies than NYSE but less market capitalization) 7

8. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) Practical categorization of traded stocks Exchange listed stocks Nasdaq listed OTC stocks Non-Nasdaq OTC stocks 8

9. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) Four major types of markets on which stocks are traded First Market: trading which occurs on organized, physical exchanges Second Market: trading in the OTC market of stocks not listed on an exchange 9

10. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Overview of Trading Locations in the U.S. (continued) Four major types of markets on which stocks are traded Third Market: trading of listed stocks in the OTC market Fourth Market: institutional transactions which occur without an intermediary or exchange 10

11. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges listed stocks are those that are traded on exchanges The right to trade securities or make markets on an exchange floor is granted to individuals or firms called a member, who buys a seat on the exchange 11

12. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) stocks that are listed on regional exchanges are –stocks that could not qualify for a national exchange –dual listed stocks, which are listed on both regional and national exchanges 12

13. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) New York Stock Exchange NYSE is a hybrid market and uses both continuous auction and call auction market structure The majority of members are designated commission brokers, and they execute trades on behalf of clients via the specialist structure 13

14. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) Commission broker, an employee of one of the nearly 500 securities houses Independent floor brokers execute orders for other exchange members who have more orders than they can handle alone Registered traders individual members who buy and sell for their own account 14

15. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) A NYSE specialist is a market maker for each stock and is required to buy and sell those shares from other members and maintain an orderly market for that stock Specialists maintain the limit order book which contains the prearranged quantities and prices which the specialist receives from brokers 15

16. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) Specialists have four major functions at the exchange As a dealer, they buy and sell for their own inventory and provide liquidity if there are no investors on the other side of a new transaction They serve as agents for other exchange members, executing orders on their behalf 16

17. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) Specialists have four major functions at the exchange Given their presence in the exchange, specialists help to act as catalysts (brokers) by bringing buyers and sellers together Finally, they serve as auctioneers, quoting current bid and ask prices that are determined by market conditions 17

18. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) Specialists must always give precedence to public orders over trading for their own account. When acting as an agent, they execute customer orders When acting as a principal, they assume responsibility of maintaining a fair and orderly market 18

19. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Stock Exchanges (continued) Commissions have become negotiable Because of the ability to negotiate commissions the discount brokers have become a in increasingly popular method for executing orders in the market 19

20. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market The OTC market trades unlisted stocks Dealers make markets in stocks and trade with each other and with retail customers Bid-ask spreads are the main source of dealer profits The National Association of Securities Dealers (NASD) regulates the market 20

21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market (continued) NASDAQ Stock Market The Nasdaq (National Association of Securities Dealers Automated Quotations founded in 1971) is an ECN (electronic communication network) which links thousands of geographically dispersed market-making participants and member- dealers across the country 21

22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market (continued) NASDAQ Stock Market The Nasdaq is divided into two tiers Nasdaq National Market System (NNM) –approximately 3600 stocks traded on the NNM Small Capitalization Market –approximately 800+ stocks traded on the Small Cap Market 22

23. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market (continued) NNM dealers must Continuously post firm two-sided (bid and ask) quotes for the issues that they maintain in inventory Report trades on a timely basis Be subject to immediate execution against their posted quotes 23

24. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market (continued) NNM dealers must Integrate the limit orders of customers into their quoted prices Give precedence to customer limit orders and not place a quote on any system different from their Nasdaq quote 24

25. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The OTC Market (continued) Other OTC Markets OTC Bulletin Board, owned and operated by the NASD, is where a majority of trades occur outside of the Nasdaq Pink Sheet, a subscription service 25

26. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Third Market Third market is the trading of listed exchange stocks in the OTC market, by dealers (not members of an exchange) Dealers that make markets in the third market operate under the regulatory jurisdiction of the NASD 26

27. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Fourth Market: Alternative Trading Systems Fourth market is the direct trading of stocks between two customers without the use of a broker This is direct trading of securities among institutions, thereby avoiding brokerage and dealer costs 27

28. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Fourth Market: Alternative Trading Systems (continued) Electronic Communications Networks ECN’s are privately owned broker and dealers that operate as market participants within the Nasdaq system –Limit order book open for continuous trading to subscribers who may enter and access orders displayed on the ECN 28

29. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Fourth Market: Alternative Trading Systems (continued) The largest ECN’s Instinet, NYSE Euronext, Archipelago and Nasdaq Brut Crossing networks are batch processes that aggregate orders for execution at specified times –Provide anonymity and reduced cost, and are designed to minimize trading costs 29

30. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Execution of an Order Brokers have a choice as to which market to execute stock transactions Payment for order flow monetary inducement to route orders to regional exchanges and third market makers 30

31. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Execution of an Order (continued) Alternatively the broker may –Route the order to an ECN that automatically matches buy and sell orders at specified prices –Route the order to another division of the firm to be fulfilled from the firm’s inventory (a process called internalization) 31

32. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Other Types of Common Stock Trading Offshore Trading –Broker/dealers may trade exchange listed or Nasdaq equities offshore via foreign exchanges or trading desks –Such transactions must be reported to the U.S. marketplace the next day. 32

33. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Other Types of Common Stock Trading (continued) Rule 144A Securities –Allows trading of nonfungible unregistered securities among qualified institutional buyers (QIB) by creating a “safe harbor” from SEC registration requirements –QIBs are institutions with $100 million invested in securities 33

34. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Other Types of Common Stock Trading (continued) American Depository Receipts –(ADRs) are negotiable certificates in registered form, issued in the United States by a U.S. bank, which certify that a specified number of foreign shares have been deposited with an overseas branch of the bank that acts as a custodian in the country of origin. 34

35. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Role and Regulation of Dealers in Exchange and OTC Markets Background of Regulatory Issues –To address the problems associated with fragmentation in the 60’s and 70’s, the Securities Act of 1975 was enacted Intermarket Trading System (ITS) –electronic system that displays quotes posted on all the exchanges where a stock is listed and provides the intermarket execution 35

36. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Role and Regulation of Dealers in Exchange and OTC Markets (continued) Background of Regulatory Issues Consolidated Quotation System is a display system providing data on trades of listed stocks in different market centers NASDAQ Pricing Controversy SEC Cost Study 36

37. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. The Role and Regulation of Dealers in Exchange and OTC Markets (continued) Decimalization –In 2001, the NYSE, AMEX and NASDAQ all used actual decimal or "penny" quotes rather than the older conventions such as sixteenths or eighths Regulation FD (Full Disclosure) –In 2000, corporations were restricted from providing disclosure to only select groups of market participants 37

38. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Trading Stocks Outside the Country Where Domiciled Global Depositary Receipts –When shares are issued in other markets, banks issue documents which represent those securities American Depositary Receipts –This is the domestic form of GDR’s –Sponsored ADR’s –Non-sponsored ADR’s 38

39. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Trading Stocks Outside the Country Where Domiciled (continued) –Sponsored ADR’s A foreign corporation seeks to have its stock traded in the United States and only one depository bank issues the ADRs. –Non-sponsored ADR’s One or more banks or brokerages can assemble a large block of the shares of a foreign corporation and issue ADRs without the participation of the foreign corporations 39

40. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall. Summary Common stock represents ownership or equity on a corporation Secondary trading occurs either on the NYSE, the AMEX, five regional exchanges and the OTC Listing of international shares (GDR’s, ADR’s) reduces financing costs and broadens ownership 40