Chapter 6
ORGANIZATION AND
FUNCTIONING OF SECURITIES
MARKETS
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”)?
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?
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?
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
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)
Organization of the
Securities Market
Primary markets

New issues
Secondary markets

Outstanding securities are bought and sold
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
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
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
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
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
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
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
Secondary Markets
Involves the trading of
issues that are
already outstanding
Provide a means
obtaining cash for
sellers
Provide buyers with
more investment
choices
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
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
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)

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
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
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 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
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
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
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
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 - 500 next most active
Gamma - bids are indicative only and must be
confirmed
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
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
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
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
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

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
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)
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
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
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
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
Major Types of Orders
Market 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)
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

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
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
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
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
Major Types of Orders
Margin Order Details
Initial margin requirement at least 50%

Lower margin requirements allow you to buy more
Maintenance margin


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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
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
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



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Hundreds of employees on trading floor
Intermediary clerks
Brokers among members
Maintain limit orders
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

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
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)
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
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
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
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
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
New Trading Systems
Display Book

Electronic workstation that keeps track of all limit
orders and incoming market orders
Opening Automated Report Service (OARS)



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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
New Trading Systems
Market 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
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

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
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