1. Securities Markets and Market Mechanics
Chapter 1
Securities Markets and Market Mechanics

2. Primary Market vs. Secondary Market
Sale of new securities to raise money for issuer
Secondary
Resale of securities
Issuing company not involved

3. Go public
process in which start-up or heretofore private firm sells its shares in public offering
Initial Public Offering (IPO)
offering to public of securities in firm previously privately held
Red Herring
Registration statement that initiates a public offering; front page contains a paragraph in red ink

4. Investment banker
firm that advises on and/or brings new issues to the market
Underwrite
to agree to buy a new security issue, with intention to sell securities to public at higher price

5. Prospectus
Official document that all companies offering new securities to the public must file with SEC
Spells out in detail
financial position of offering company
what new funds will be used for
qualifications of corporate officers
risk factors
nature of competition
other material information

6. Best-effort basis
a securities offering in which underwriter acts as agent for issuer but is not obligated to purchase securities
Firm-commitment basis
underwriter purchases securities from issuer and commits to selling them to public

7. Shelf Registration
SEC provision allowing pre-registration of amount of security to be sold over a 2-year period without specific registration of each sale
permitted by SEC Rule 415

8. Private Placement
Direct sale of securities to one or small number of large buyers without registration requirements of public offering
Legal restrictions on
who may purchase
resale of securities purchased in a private placement

9. Lettered Stock Newly issued
Sold at discount to large investors in private placement prior to a public offering of same issue
Restricted
Buyers agree not to sell their shares for specified period (SEC Rule 144)

10. Secondary Offering or Distribution
Large public securities offering
Made outside the usual exchange or OTC market
Allows more time for absorption of large quantity than usual channels

11. Secondary Market: The Players
Brokerage firms
Registered representatives (brokers)
Dealers
Floor Brokers
Specialists
Registered competitive market makers

12. Brokerage firm
Offers various financial services including
access to the securities markets
account management
margin loans
investment advice
underwriting
Registered Representative
Employee of registered brokerage firm qualified to serve as account executive for customers, a.k.a. broker
– must be licensed to sell securities and pass series 7 exam
– individuals who have passed the series 6 exam are licensed to sell products such as mutual funds and initial offerings of closed-end investment companies

13. Dealer
Security trader
Acts as principal rather than as agent
Considered a specialist or a market maker
NOT a broker
Floor Broker
Employees of firms who execute trades on an exchange floor on behalf of their firm’s clients
Specialist
Exchange member who makes a market in listed securities

14. Registered Competitive Market Maker (RCMM)
Holds a seat on exchange
Trades for his or her own account
Also called floor traders
Gramm-Leach-Bliley Act
Accelerated the erosion of the lines between brokerage firms and other financial services firms

15. Roles of the Specialist
Auctioneer: establishes the opening price for a security and maintains a fair and orderly market
Agent: executes orders for floor brokers
Catalyst: conduit of order flow
Provider of capital: uses firm’s capital to minimize any imbalance between public demand and supply for a security
Stabilizes prices: buy and sell stock to cushion temporary imbalances and avoid unreasonable price variations

16. The Secondary Market: The Institutions
Stock exchanges
National
Regionals
Over-the-counter
Third and fourth markets
Consolidated tape

17. NYSE (New York Stock Exchange)
Largest based on Wall Street
Lists large- to mid-capitalization stocks
Toughest for listing standards
A membership is referred to as a Seat
AMEX (American Stock Exchange)
Deals in small- to mid-capitalization stocks
Merged with NASDAQ

18. Regional Exchanges Chicago Stock Exchange Pacific Exchange
Boston Stock Exchange
Philadelphia Stock Exchange
Cincinnati Stock Exchange

19. Dual Listing
Security listed for trading on more than one organization, usually the NYSE and in over-the-counter market
OTC (Over-the-Counter)
Market in unlisted securities and off-board trading in listed securities

20. NASDAQ
Automated information system that provides brokers and dealers with price quotations on securities traded over-the-counter
Formerly National Association of Securities Dealers Automated Quotations

21. Three Categories of NASDAQ OTC Quotations
National Market Issues (NMI): largest and most actively traded stocks
SmallCap List: smaller firms
Bulletin Board: much smaller issues

22. NASDAQ Quotations
Level 1: subscribers receive only the highest bid and lowest ask prices on a security
Level 2: subscribers can receive all prices but can not enter quotes
Level 3: subscription entitles users to enter their own bid and ask prices

23. Pink Sheets
Quotation source for most publicly traded OTC issues
Third Market
Over-the-counter trading of exchange-listed securities
Fourth Market
Direct trading of listed securities between institutions

24. The Secondary Market: The Transactions
Costs of trading
Types of Orders
SuperDot and PERS
Selling Short
Large Secondary Market Trades

25. Cost of Trading
Commissions (explicit): fees charged by brokers for handling investment transactions
– May Day: SEC abolished fixed-commission
schedule on May 1, 1975
Bid-ask spread (implicit): price difference between bid price and ask price for an asset
Price concession (implicit): only on large orders

26. Types of Orders Market Order
Order to buy or sell at market price that requires immediate execution
Limit Order
Order to buy or sell at prespecified price
Stop-Loss Order
Order to sell or buy at market when certain price is reached
Stop-Limit Order
Order to implement limit order when market price reaches certain level
(continued)

27. Types of Orders (continued)
MIT Order
Becomes a market order if a specified price or better is reached
Day Order
Executable only during day order placed
Fill-or-Kill Order
Canceled if not immediately executed
GTC Order
Remains in effect until executed or canceled
Versus Purchase
sale that specifies purchase date of securities to be delivered for sale

28. SuperDot (Super Designated Order Turnaround System)
Used at NYSE
Transmits member firms’ market and day limit orders through common message switch to proper trading floor workstation
Largest market order that can be handled is 30,099 shares
Used particularly for program trading
PERS (Post Execution Routing System)
Used on the AMEX
Same as the SuperDot

29. Selling Short
Selling asset not owned with commitment to purchase asset in future
Can now be done on uptick or downtick
Must be able to borrow necessary securities

30. Bear Raid
Attempt to drive prices down by selling short

31. Block Trade
trade involving 10,000 shares or more
usually handled by block house

32. Special Offerings
Large block of stock offered for sale on exchange with special incentive fees paid to purchasing brokers
Also called spot secondary

33. Tender Offer Offer to purchase a large block of securities
Made outside the general market (exchanges, OTC)
Tender offer may be part of an effort to take over company

34. Security Markets: Regulation
Securities Act of 1933
Securities Exchange Act of 1934
Investment Company Act of 1940
Investment Advisor Act of 1940
SIPC Act of 1970
Securities Act Amendments of 1975
Sarbanes-Oxley Act of 2002
Banking Act of 1933

35. Securities Act of 1933
Deals with issuance of securities
Addresses the registration process, disclosure requirements, and related matters
Securities Exchange Act of 1934
Deals with existing securities
Addresses filing of periodic reports, regulation of exchanges and brokerage firms, ongoing disclosure requirements
Prohibits certain unethical practices, such as market manipulation and insider trading

36. Investment Company Act of 1940
Requires that investment companies disclose their financial
condition and investment policies to investors when stock is
initially sold and, subsequently, on a regular basis
Investment Advisors Act of 1940
Requires that firms or sole practitioners compensated for
advising others about securities investments must register with
SEC and conform to regulations designed to protect investors
Securities Investor Protection Act of 1970
Created the federal agency Securities Investor Protection
Corporation
Guarantees the safety of brokerage accounts up to
$500,000, no more than $100,000 of which may be in cash

37. Securities Act Amendments of 1975
Calls for national competitive system for securities trading
Ended fixed brokerage commission rates
Sarbanes-Oxley Act of 2002
Mandates reforms to
Enhance corporate responsibility
Enhance financial disclosures
Combat corporate and accounting fraud
Creates the “Public Company Accounting Oversight Board,” also known as the PCAOB
Oversees the activities of the auditing profession.
Banking Act of 1933
Created the FDIC, provider of deposit insurance

38. Practical Issues Street Name Stock Certificates Types of Accounts Cash
Margin
Option
Wrap

39. Street Name
securities held in customer accounts at brokerage houses but registered in firm’s name

40. Advantages of Street-Name Registration
Offers secure storage
Lets securities be traded without new certificates being issued or certificates delivered in a timely manner
Allows customers who move frequently to file only one change of address with brokerage firm instead of notifying all companies separately
Only single Form 1099 needs to be filed

41. Disadvantages of Street-Name Registration
Assets may be tied up during the reorganization of bankrupt brokerage firm
Dividends and interest may be credited to an improper account
Properly credited dividends may be retained by broker in a non-interest-bearing account for a few days before being sent to shareholder
Discount coupons and sample products not sent to street-name accounts

42. Stock Certificates
Document showing ownership of specified number of shares of company’s stock

43. Types of Accounts Cash Account Margin Account Option Account
Type 1 account
Must have sufficient cash at time of purchase
Margin Account
Type 2 account
Can borrow up to margin limit
Short sales in this account only
Option Account
Special paperwork required

44. Discretionary Account
Account over which broker is authorized to exercise FULL discretion with regard to purchases and sales
Limited Discretionary Account
Gives broker authority to make only certain types of trades without prior consent

45. Wrap Accounts Advantages:
Customization: Tailored to individual’s specific needs. Clients may choose not to hold a particular company or industry for personal, ethical, or economic reasons.
Tax efficiency: Optimal tax treatment can be achieved.
Simple fee structure: wrap fee makes cost of account clear and explicit
Disadvantage:
Total fee may be higher than that paid by most accounts

46. Portfolio Turnover Rate
Measures trading activity in an account by showing the percentage of the portfolio that has been replaced during a given time period