CHAPTER 4
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
I.
What is a Market?
A. A market is a means through which buyers and sellers are brought together
to aid in the transfer of goods and/or services.
B. Characteristics of a "Good" Market
1. Timely and accurate information on price and volume of past transactions
2. Liquidity (ability to buy or sell quickly at a price close to prior price)
a. Price continuity – prices do not change much from one transaction to
another unless significant new information becomes available
b. Depth – several potential buyers and sellers must be willing to trade at
prices above and below the current market price
3. Low transaction costs (internal efficiency)
4. Rapid adjustment of price to new information (external efficiency or
informational efficiency)
C. Organization of the Securities Markets
1. Primary markets are those where new securities are sold and funds go to
issuing unit
2. Secondary markets are those where outstanding securities are bought and
sold by investors. The issuing unit does not receive any funds in a
secondary market transaction
II.
Primary Capital Markets
A. 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
B. Municipal Bond Issues
1. Method of sale
a. Competitive bid – usually involves sealed bids
b. Negotiated sale – involves contractual arrangements between
underwriters and issuers
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c. Private placement – involves sale of securities directly to a small
group of investors or institutional investors
2. Underwriting function – 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
a. Origination – involves the design of the bond issue and initial
planning
b. Risk-bearing – refers to the underwriter’s risk of reselling the
securities to the investing public
c. Distribution – selling to investors with the help of selling syndicate
consisting of other investment banking firms and/or commercial banks
if the issue is very large
3. Types of municipal bonds
a. General obligation (GO) bonds – backed only by the full faith and
credit of the issuer and not by any specific revenue source
b. Revenue bonds – specific revenue source backs the bonds
C. Corporate Bond and Stock Issues
1. Types of new issues
a. Seasoned new issues – new shares offered by firms that already have
stock outstanding
b. Initial public offerings (IPOs) – a firm selling its common stock to the
public for the first time
D. Relationship with investment bankers
1. Negotiated arrangement
2. Competitive bid arrangement
3. Best-efforts arrangement
E. Introduction of Rule 415 (Shelf registration) – allows large firms to register
security issues and sell them piecemeal during the following two years
F. Private Placement and Rule 144A – the company designs an issue of
securities with the assistance of an investment banker and sells it to a small
group of investors (individual or institutional)
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III.
Secondary Financial Markets
A. Importance of Secondary Markets – enhances liquidity of the securities
B. Secondary Bond Markets
1. Secondary Markets for U.S. Government and Municipal Bonds – market
makers are banks and investment firms
2. Secondary Corporate Bond Market – OTC (over-the-counter market)
C. Financial Futures Markets
D. Secondary Equity Markets
1. Securities Exchanges
a. Alternative Trading Systems
 Pure auction market
 Dealer market
b. Call versus Continuous Markets – In a call market, trading for
individual stocks takes place at specified times, while, in a continuous
market, trades occur at any time the market is open
2. National Stock Exchanges (see Exhibit 4.3 for volumes)
a. New York Stock Exchange (NYSE)
b. American Stock Exchange (AMEX)
c. Tokyo Stock Exchange (TSE)
d. London Stock Exchange (LSE)
3. Trends
a. New Exchanges in Emerging Economies such as Russia, China,
Hungary, Peru, etc.
b. Consolidations in Developed Markets - driven by economies of scale
and technology
c. The Global Twenty-Four-Hour Market – made possible by advances
in technology
E. Regional Exchanges and the Over-the-Counter Market
1. Regional Securities Exchanges
2. Over-the-Counter (OTC) Market
a. Size of the OTC market – largest segment of the U.S. secondary
market
b. Operation of the OTC – referred to as a negotiated market in which
investors directly negotiate with dealers
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c. The NASDAQ system – automated, electronic quotation system for
the OTC market
d. Listing Requirements for NASDAQ – less stringent than that of the
NYSE
e. A Sample Trade
f. Changing Dealer Inventory
3. Third Market – OTC trading of shares listed on an exchange
4. Fourth Market – direct trading of securities between two parties with no
broker intermediary
IV. Detailed Analysis of the Exchange Market
A. Exchange Membership
1. Specialists (will be discussed later)
2. Commission brokers – employees of a member firm who buy or sell for
the customers of the firm
3. Floor brokers – independent members of an exchange who act as brokers
for other members
4. Registered traders –members of the exchange who buy and sell for their
own account
B. Types of Orders
1. Market orders
2. Limit orders
3. Short sales
4. Special orders
a. Stop loss order
b. Stop buy order
5. Margin Transactions
a. Initial margin
b. Maintenance margin
c. Margin call
C. Exchange Market Makers
1. U.S. Markets (Specialists)
a. Functions of the specialist
 broker for limit orders and special orders
 dealer to maintain "orderly" market (market maker)
b. Specialist income
 Income derived from both functions depends upon the type of
stocks.
 Rates of return are large.
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2. Tokyo Stock Exchange (TSE)
a. Regular Members
b. Saitori
3. London Stock Exchange (LSE)
a. Brokers
b. Jobbers
V.
Changes in the Securities Markets – prompted by the significant and rapid
growth of trading by large financial institutions
A. Evidence and Effect of Institutionalization
1. Average Size of Trades
2. Growth of Block Trades (see Exhibit 4.10)
3. Major effects of institutionalization
a. Negotiated (competitive) commission rates
b. The influence of block trades
c. The impact on stock price volatility
d. The development of a National Market System (NMS)
B. Negotiated Commission Rates
1. Background
a. Minimum commission schedule
b. Reaction to high commissions (give-ups & the use of the third and
fourth market)
2. Negotiated Commissions (allowed on all transactions as of May 1, 1975)
C. The Impact of Block Trades
1. Block Trades on the Exchanges
2. Block Houses
3. Example of a Block Trade
D. Institutions and Stock Price Volatility
(No empirical support for the relationship between trading by large financial
institutions and stock price volatility)
E. National Market System (NMS)
1. Centralized Reporting of all Transactions
2. Centralized Quotation System
a. Intermarket Trading System (ITS)
3. Central Limit Order Book (CLOB)
4. Competition Among Market Makers (Rule 390)
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F. New Trading Systems
1. Super Dot
2. Display Book
3. Opening Automated Report Service (OARS)
4. Market Order Processing
5. Limit Order Processing
6. Global Market Changes
a. London Stock Exchange (LSE) - Effects of the "Big Bang"
b. Tokyo Stock Exchange (TSE) – more competition
G. Global Market Changes
1. NYSE Off-Hours Trading – prompted by erosion of NYSE’s market
share
2. Listing Foreign Stocks on the NYSE – a priority for the NYSE
H. Future Developments
1. Continuing Consolidation of Security Exchanges
2. More Specialized Investment Companies
3. Changes in the Financial Services Industry
a. Financial supermarkets
b. Financial boutiques
2. Trading in Cybermarkets
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