1. ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
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 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

9. 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

10. 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

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. 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

14. 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

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

16. 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

17. 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

18. 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)

19. Secondary Equity Markets
Stock Exchanges (First Market)
Major national stock exchanges
New York, American, Tokyo, and London
Regional stock exchanges
Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin
Over-the-counter market (Second Market)
Stocks not listed on organized exchange
Third Market
Fourth Market

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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 next most active
Gamma - bids are indicative only and must be confirmed

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. 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)

34. Third Market OTC trading of shares listed on an exchange
Mostly well known stocks
GM, IBM, AT&T, Xerox
Represents competition between the OTC market and the organized exchanges
May be important to investors particularly when the exchange is closed or when trading is suspended on the exchange

35. Fourth Market
Direct trading of securities between two parties with no broker involved
Both parties typically large, institutional investors making large trades
Savings in transaction costs can be large for such investors to deal directly with one another

36. 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

37. 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

38. 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)

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. Exchange Market Makers
Tokyo Stock Exchange (TSE)
Regular members
Several employees allowed on trading floor
Trading clerks for customers accounts
Buy and sell for own accounts
Saitori member
Hundreds of employees on trading floor
Intermediary clerks
Brokers among members
Maintain limit orders

47. Exchange Market Makers
Tokyo Stock Exchange (TSE)
TSE Membership
Membership requires corporate license
Four types of license are available and may be combined
Capital requirements vary by license

48. Exchange Market Makers
London Stock Exchange (LSE)
Brokers trade on behalf of their customers
Jobbers buy and sell as principals
Membership based on experience and competence
Membership fee 1% of gross revenues

49. 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)

50. 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

51. 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

52. 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

53. 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

54. 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

55. 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

56. New Trading Systems Market Order Processing Limit 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

57. 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

58. 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

59. 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