chapter 4 organization and functioning of securities markets innovative financial instruments dr. a....
TRANSCRIPT
Chapter 4
Organization and Functioning of Securities Markets
Innovative Financial InstrumentsDr. A. DeMaskey
What is a Market?
Brings buyers and sellers together to aid in the transfer of goods and services
Does not require a physical locationDoes not have to own the goods and
services involvedBuyers and sellers benefit from the
market
Characteristics of a Good Market
Availability of information must be timely and accurate
Liquidity Marketability Price continuity Depth
Transaction costs or internal efficiency lower costs make for a more efficient market
External efficiency or informational efficiency prices rapidly adjust to new information
Organization of the Securities Market
Primary markets New issues New capital
Secondary markets Outstanding securities are bought and
sold No new capital formation Provides liquidity
Primary Capital Markets:Government Bond Issues
Federal Reserve System auctions
T-bills are bid below par to imply yields
Treasury notes and bonds bids state yields instead of prices
Noncompetitive bids accept the average price of accepted competitive bids
Primary Capital Markets:Municipal Bond Issues
Sold by three methods Competitive bid Negotiated sales Private placement
Underwriters sell the bonds to investors Origination Risk-bearing Distribution
Primary Capital Markets:Corporate Bond and Stock Issues
Negotiated arrangement with investment banking firm which underwrites the issues and organizes a syndicate for distribution
New issues are divided into two groups: Seasoned new issues Initial public offerings (IPOs)
Underwriting Relationships with Investment Bankers
1. Negotiated Most common Full services of underwriter
2. Competitive bids Corporation specifies securities offered Reduced costs Reduced services of underwriter
3. Best-efforts Investment banker acts as broker
Introduction of Rule 415
Allows firms to register securities and sell them piecemeal over the next two years
Referred to as shelf registrationsGreat flexibilityReduces registration fees and expensesAllows requesting competitive bids from
several investment banking firmsMostly used for bond sales
Private Placements and Rule 144A
Firms sells to a small group of institutional investors without extensive registration
Lower issuing costs than public offering
Importance of Secondary Market
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
Secondary Bond Markets
Secondary market for U.S. government and municipal bonds U.S. government bonds are traded by
bond dealers Banks and investment firms make up
municipal market makersSecondary corporate bond market
Traded through security exchanges and an OTC market
Financial Futures
Bond futures are traded in
markets
Chicago Board of Trade (CBOT)
Chicago Mercantile Exchange
(CME)
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
3. Over-the-counter (OTC) market Stocks not listed on organized exchange
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
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
National Stock Exchanges
Large number of listed securitiesPrestige of firms listedWide geographic dispersion of
listed firmsDiverse clientele of buyers and
sellers
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 with securities listedMarket value over $12 trillionAverage daily volume of 791 million shares
American Stock Exchange (AMEX)
Outdoor Curb MarketEmphasis on foreign securitiesDoes not trade stocks listed on
NYSEWarrants traded on AMEX years
before NYSE listed anyIt has also an options exchange
Tokyo Stock Exchange (TSE)
Largest of the eight exchanges in Japan
Dominates Japanese marketPrice drive systemDomestic and foreign stocks listedMost active 150 stocks are traded on
the floor All others are traded by computer
London Stock Exchange (LSE)
Largest securities market in the United Kingdom
Trades listed and unlisted securities 2,600 companies listed
Largest listing of foreign stocks on any exchange
Pricing system by competing dealers via computers similar to NASDAQ system in U.S.
Divergent Trends
New exchanges in emerging countries Russia, Poland, China, Hungary,
Peru, Sri LankaConsolidation of existing
exchanges in developed countries capture economies of scales provide added liquidity
Recent Consolidations
In 1995, Germany’s three largest exchanges merged into the one in Frankfurt
NASD merged with AMEX in 1998Philadelphia Stock Exchange merged
with NASD/AMEXCBOE merged with Pacific ExchangeLondon Stock Exchange and Frankfurt
Stock Exchange merger
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 securitiesRegional Exchanges in the United States
Chicago SE Boston SE Cincinnati SE
Over-the-Counter (OTC) Market
Not a formal organization 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
Operation of the OTC
Any stock may be traded as long as it has a willing market maker to act as a dealer
OTC is a negotiated market
The NASDAQ System
Automated electronic quotation systemDealers may elect to make markets in stocksAll dealer quotes are available immediatelyThree levels of quotations provided
Level 1 shows median representative quote Level 2 shows quotes by all market makers Level 3 is for OTC market makers to change
their quotes shown
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
minuteAlternative 1 for profitable companies with
limited assetsAlternative 2 for large but less profitable
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
Fourth Market
Direct trading of securities between two parties with no broker intermediary
Usually both parties are institutions
Can save transaction costsNo data are available
Exchange MembershipSpecialistCommission 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 membersRegistered traders
Use their membership to buy and sell for their own accounts
Exchange Market MakersU.S. Markets
Specialist is an exchange member assigned to handle particular stocks Broker Dealer
Specialist has two income sources Broker commission Dealer trading income from profit
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)
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
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
The Impact of Block Trades
Number and size of block trades has increased
This strains the exchange specialist system Capital - 10,000 share or larger blocks Commitment - large risk with large blocks Contacts - Rule 113 prohibited direct contact to
offer blocks to another institutionBlock houses are investment firms to help
institutions locate other institutions interested in buying or selling blocks Have capital, commitment, and contacts
Institutions and Stock Price Volatility
Empirical studies have not supported the theory that institutional trading will increase price volatility
Where trading is dominated by institutions, actively involved institutions may provide liquidity for one another and noninstitutional investors
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
1. Centralized Reporting
Should record all transactions of a stock, regardless of location
NYSE started a central tape in June 1975 covering all NYSE stocks traded on other exchanges and OTC
2. Centralized Quotation System
List quotes for a stock from all market makers on the national exchanges, regional exchanges, and OTC
Brokers would complete trades on the market with the best quote
Intermarket Trading System (ITS) developed by American, Boston, Chicago, New York, Pacific, and Philadelphia Stock Exchanges and NASD
3. Centralized Limit Order Book
Should contain all limit orders from all markets
Should be visible to all tradersAll market makers and traders could
fill orders on itTechnology exists, but NYSE
specialists fill most limit orders and oppose CLOB because they do not want to share this lucrative business
4. Competition Among All Qualified Market Makers
Market makers compete on OTC market
Competition reduces bid-ask spread NYSE opposes competition and argues
that central auction results in best market and execution
NYSE Rule 390 requires members to obtain permission of the exchange before trading a listed stock off the exchange, forcing transactions to the exchange to create a central market
New Trading Systems
Daily trading volume has increased from 5 million shares to over 420 million shares
NYSE routinely handles volume over 400 million shares, and had a daily high of more than 700 million in 1998
Technology has allowed the market process to keep pace
Super DOT
Electronic order-routing systemMember 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
Display Book
Electronic workstation that keeps track of all limit orders and incoming market orders, including incoming Super Dot limit 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 and potential need for preopening call market
Market Order Processing
Super Dot’s postopening market order system
Rapid execution and reporting of market orders
1997 average orders executed and reported in less than 20 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 cancelled
Global Market Changes
NYSE Off-hours trading Crossing Session I provides for trading
stocks at NYSE closing prices after the regular session from 4:15 PM to 5:00 PM
Crossing Session II provides for trading a collection of at least 15 NYSE stocks with a market value of at least $1 million from 4:00 PM to 5:15 PM
Global Market Changes
Listing foreign stocks on the NYSE Future growth will be in foreign
countries and their stocks Foreign accounting standards
are less stringent than SEC requirements for NYSE listing
London Stock ExchangeOctober 27, 1986 Big Bang
Brokers can act as market makers Jobbers can deal with the public
and institutions Commissions are negotiable Gilt market was restructured like
U.S. government securities market Trades reported on Stock Exchange
Automated Quotations (SEAQ)
Effects of the Big Bang
Competitive market makers & SEAQ reduced number of people on the trading floor
More activity in the system, but profit margin has reduced from competition
Many firms have merged or been acquired by foreign firms
Tokyo Stock Exchange (TSE)
1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants
Future Developments
More specialized investment companies
Changes in the financial services industry Financial supermarkets Specialty shops
Advances in technology Computerized trading 24-hour market of the future may be
floorless, global, and highly automated
The Internet:Investments Online
www.quote.comwww.sec.govwww.nyse.comwww.nasdaq-amex.comwww.etrade.comwww.schwab.comwww.ml.com