Chapter 4 Organization and Functioning of Securities Markets

1. Chapter 4Organization and Functioning of Securities Markets Questions to be answered: • 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?

2. Chapter 4Organization and Functioning of Securities Markets • What are the national exchanges and how are the major security markets becoming linked (what is meant by “passing the book”)? • What are the regional stock exchanges and the over-the-counter (OTC) market? • What are the alternative market-making arrangements available on the exchanges and the OCT market?

3. Chapter 4Organization and Functioning of Securities Markets • What are the major types of orders available to investors and market makers? • 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 major factors that have caused the significant changes in markets around the world in the past 10 to 15 years?

4. Chapter 4Organization and Functioning of Securities Markets • What are some of the major changes in world capital markets expected over the next decade?

5. What is a market? • Brings buyers and sellers together to aid in the transfer of goods and services • Does not require a physical location • Both buyers and sellers benefit from the market

6. Characteristics of a Good Market • Availability of past transaction information • must be timely and accurate • Liquidity • marketability • price continuity • depth • Low Transaction costs • Rapid adjustment of prices to new information

7. Organization of the Securities Market • Primary markets • Market where new securities are sold and funds go to issuing unit • Secondary markets • Market where outstanding securities are bought and sold by investors. The issuing unit does not receive any funds in a secondary market transaction

8. Government Bond Issues • 1. Treasury Bills – negotiable, non-interest bearing securities with original maturities of one year or less • 2. Treasury Notes – original maturities of 2 to 10 years • 3. Treasury Bonds – original maturities of more than 10 years

9. Municipal Bond Issues • Sold by three methods • Competitive bid • Negotiation • Private placement • Underwriters sell the bonds to investors • Origination • Risk-bearing • Distribution

10. The investment banker purchases the entire issue from the issuer and resells the security to the investing public. The firm charges a commission for providing this service. For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks The Underwriting Function

11. Corporate Bond and Stock Issues New issues are divided into two groups • Seasoned new issues - new shares offered by firms that already have stock outstanding • Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time

12. Underwriting Relationships with Investment Bankers 1. Negotiated • Most common • Full services of underwriter 2. Competitive bids • Corporation specifies securities offered • Lower costs • Reduced services of underwriter 3. Best-efforts • Investment banker acts as broker

13. Introduction of Rule 415 • Allows firms to register securities and sell them piecemeal over the next two years • Referred to as shelf registrations • Great flexibility • Reduces registration fees and expenses • Allows requesting competitive bids from several investment banking firms • Mostly used for bond sales

14. Private Placements and Rule 144A • Firms sells to a small group of institutional investors without extensive registration • Lower issuing costs than public offering

15. Why Secondary Financial Markets Are Important • Provides liquidity to investors who acquire securities in the primary market • Results in lower required returns than if issuers had to compensate for lower liquidity • Helps determine market pricing for new issues

16. Secondary Bond Market • Secondary market for U.S. government and municipal bonds • U.S. government bonds traded by bond dealers • Banks and investment firms make up municipal market makers • Secondary corporate bond market • Traded through an OTC market

17. Financial Futures Bond futures are traded in • Chicago Board of Trade (CBOT) • Chicago Mercantile Exchange (CME)

18. Secondary Equity Markets 1. Major national stock exchanges • New York, American, Tokyo, and London stock exchanges 2. Regional stock exchanges • Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati 3. Over-the-counter (OTC) market • Stocks not listed on organized exchange

19. Trading Systems • Pure auction market • Buyers and sellers are matched by a broker at a central location • Price-driven market • Dealer market • Dealers provide liquidity by buying and selling shares • Dealers may compete against other dealers

20. 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 • In a continuous market, trades occur at any time the market is open

21. National Stock Exchanges • Large number of listed securities • Prestige of firms listed • Wide geographic dispersion of listed firms • Diverse clientele of buyers and sellers

22. New York Stock Exchange (NYSE) • Largest organized securities market in United States • Established in 1817, but dates back to the 1792 Buttonwood Agreement by 24 brokers • Over 3,000 companies with securities listed • Total market value over $13 trillion

23. 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 the NASDAQ IN 1998 although they continued to operate as separate markets • Warrants traded on AMEX years before NYSE listed any

24. Tokyo Stock Exchange (TSE) • Largest of the eight exchanges in Japan • Dominates the Japanese market • Established in 1878 and reorganized in 1943, 1947, and 1949 • Price-drive system • Domestic and foreign stocks listed • Approximately 1700 stocks listed with a total market value of $2.4 trillion • Most active 150 stocks are traded on floor, others by computer

25. London Stock Exchange (LSE) • Largest securities market in the United Kingdom • Trades listed and unlisted securities • More than 2,600 companies listed • Largest listing of foreign stocks on any exchange • Total market value of more than $561billion • Pricing system by competing dealers via computers similar to NASDAQ system in U.S.

26. Trends • New exchanges in emerging economies such as Russia, Poland, China, Hungary, Peru, Sri Lanka • Consolidation of existing exchanges in developed countries • Global twenty-four-hour market – made possible by advances in technology

27. Recent Consolidations • In 1995, Germany’s three largest exchanges merged into the one in Frankfurt • NASD merged with AMEX • Philadelphia Stock Exchange merged with NASD/AMEX • CBOE merged with Pacific Exchange • The Amsterdam, Brussels and Paris exchanges formed an alliance • The Stockholm, Copenhagen, and Oslo exchanges formed an alliance called the Nordic Country Alliance

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 THE TRADING DAY Local Time EST TSE 09:00 - 11:00 23:00 - 01:00 13:00 - 15:00 03:00 - 05:00 LSE 08:15 - 16:15 02:15 - 10:15 NYSE 09:30 - 16:00 09:30 - 16:00

29. Regional Exchanges • Stocks not listed on a formal exchange • Listing requirements vary • Listed stocks • Allow brokers that are not members of a national exchange access to securities • Regional Exchanges in United States • Chicago, Boston, Cincinnati, Pacific, Philadelphia

30. Over-the-Counter (OTC) Market • Not a formal organization • Largest segment of the U.S. secondary market • Unlisted stocks and listed stocks (third market) • Lenient requirements for listing on OTC • 5,000 issues actively traded on NASDAQ NMS (National Association of Securities Dealers Automated Quotations National Market System) • 1,000 issues on NASDAQ apart from NMS • 1,000 issues not on NASDAQ

31. Operation of the OTC • Any stock may be traded as long as it has a willing market maker to act a dealer • OTC is a negotiated market

32. The NASDAQ System • Automated electronic quotation system • Dealers may elect to make markets in stocks • All dealer quotes are available immediately • Three levels of quotations provided • Level 1 provides a single median representative quote for the stocks on NASDAQ • Level 2 shows quotes by all market makers • Level 3 is for OTC market makers to change their quotes shown

33. Listing Requirements for NASDAQ • Two lists • National Market System (NMS) • Regular NASDAQ • Four sets of requirements • Initial listing - least stringent • Automatic NMS inclusion - up to the minute • Alternative 1 for profitable companies with limited assets • Alternative 2 for large but less profitable

34. Third Market • OTC trading of shares listed on an exchange • Mostly well known stocks • GM, IBM, AT&T, Xerox • Competes with trades on exchange • May be open when exchange is closed or trading suspended

35. Fourth Market • Direct trading of securities between two parties with no broker intermediary • Usually both parties are institutions • Can save transaction costs • No data are available regarding its specific size and growth

36. Detailed Analysis ofExchange Markets • Exchange Membership • Major Types of Orders • Exchange Market Makers

37. Exchange Membership • Specialist • Commission brokers • Employees of a member firm who buy or sell for the customers of the firm • Floor brokers • Independent members of an exchange who act as broker for other members • Registered traders • Use their membership to buy and sell for their own accounts

38. Major Types of Orders • Market orders • Buy or sell at the best current price • Provides immediate liquidity • 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 • 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. Margin Transactions • On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral • Interest rate on margin credit may be below prime rate • Regulations limit proportion borrowed • Margin requirements are from 50% up • Changes in price affect investor’s equity

42. Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price increases to $60, position • Value is $12,000 • Less - $5,000 borrowed • Leaves $7,000 equity for a • $7,000/$12,000 = 58% equity position

43. Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price decreases to $40, position • Value is $8,000 • Less - $5,000 borrowed • Leaves $3,000 equity for a • $3,000/$8,000 = 37.5% equity position

44. Margin Transactions • Initial margin requirement at least 50%. Set up by the Fed. • Maintenance margin • Requirement proportion of equity to stock • Protects broker if stock price declines • Minimum requirement is 25% • Margin call on undermargined account to meet margin requirement • If margin call not met, stock will be sold to pay off the loan

45. Exchange Market MakersU.S. Markets • Specialist is exchange member assigned to handle particular stocks • Has two roles: • Broker to match buyers and sellers • Dealer to maintain fair and orderly market • Specialist has two income sources • Broker commission, without risk • Dealer trading income from profit, with risk

46. Exchange Market MakersTokyo 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. TSE Membership • Membership requires corporate license • Four types of license are available and may be combined • 1. Trade securities as a dealer • 2. Trade as a broker • 3. Underwrite new securities on secondary offerings • 4. Handle retail distribution of securities • Capital requirements vary by license

48. London Stock Exchange • 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 • Since 1965, the growth of trading by large financial institutions has had many effects • Negotiated (competitive) commission rates • Influence on 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 • Initial reaction was “give-ups” paid to a designated firm - soft dollars paid for market research • Third market competed with flexible commissions and grew • Fostered development of the fourth market