Chapter 3
The Trading Industry
Terminology

Agency vs. proprietary traders (trading)
•

Long vs. short positions
•

Brokers are agency traders
Short covering
Buy vs. sell side
•
Liquidity demanders vs. liquidity providers

People and institutions who use market services
are on the buy-side.

Those who provide market services are on the
sell-side.

These sides have nothing to do with whether you
are a buyer or seller of a specific security.
Buy-side players - Investors
Individuals
 Corporate pension
fund sponsors
 Charitable trusts
 Legal trusts
 Endowments

=> Stocks and
bonds
Investment
managers
 Corporate
investment funds
 Governmental
funds

Buy-side players – Borrowers
and Hedgers



Homeowners
Students
Corporations
=> Mortgages,
Bonds, Notes





Farmers
Manufacturers
Miners
Shippers
Financial Institutions
=> Forwards, Futures,
Swaps, and Options
Sell-side players

Dealers trade for their own accounts.
•
Day traders
• Market makers
• Floor traders

Brokers trade for other people’s
accounts.
•
Retail and institutional
• Full-service and discount

Broker-dealers do both.
•
Specialists
• Wire houses
Sell-side trade facilitators

Exchanges provide systems that help
traders arrange their trades.

Clearing houses help settle trades and
guarantee that traders will perform.

Depositories and custodians hold
securities.
A typical set of relationships
A sponsor owns funds.
 An investment manager makes portfolio
decisions.
 A broker implements trades.
 A dealer supplies liquidity.
 A clearing house guarantees trades.
 A depository holds the security.
 Consultants advise everyone.

Primary vs. secondary security sales

Primary
•
New issue
• Key factor: issuer receives the proceeds from
the sale.

Secondary
•
Existing owner sells to another party.
• Issuing firm doesn’t receive proceeds and is
not directly involved.
Primary markets: Public offerings

Public offerings: registered with the SEC
and sale is made to the investing public.
• Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs)
• Evidence of underpricing
• Performance
US primary listing market
New York Stock Exchange
 American Stock Exchange
 NASDAQ
 Over-the-Counter (OTC)

•
Nasdaq small cap
• OTCBB
• Pink Sheets
(N)
(A)
(Q)
(S)
(U)
Primary markets: Private placements
Private placement: sale to a limited
number of sophisticated investors not
requiring the protection of registration.
 Dominated by institutions.
 Very active market for debt securities.
 Not active for stock offerings.

Organization of secondary markets
Organized exchanges
 OTC market
 Third market
 Fourth market

Organized Exchanges
Auction markets with centralized order flow.
 Dealership function: can be competitive or
assigned by the exchange (Specialists).
 Securities: stock, futures contracts,
options, and to a lesser extent, bonds.
 Examples: NYSE, AMEX, Regionals,
CBOE.

NYSE

The NYSE is a hybrid market. It has:
•
•
•

floor traders (like a futures pit)
an electronic limit order book (like Euronext)
a designated dealer (the specialist) to maintain
liquidity and otherwise coordinate trading.
This mix is the outcome of political,
technological and economic forces over the
last 200 years.
NYSE
NYSE’s MarkeTrac: http://marketrac.nyse.com/mt/
NYSE
The NYSE was first a floor market (loosely
resembling the futures pits).
 Many of the trading rules reflect the “floor”
aspect of the market.
 The NYSE next evolved strong central
dealers (late 1800’s).
 The specialist, in the sense of a trader who
specializes in a particular stock.

NYSE

Beginning in the 1980’s, electronic order
entry has come to play an increasing role.
The exchange has always permitted limit
orders, but the book has become more
important over time.

The basic reading for this material is the
NYSE Floor Official Manual, abbreviated
FOM.
What does the NYSE do?
Trading and trading services.
 The NYSE charges (directly and indirectly)
for trades that occur and for software
supplied to its members.
 Listing
 To be listed on the NYSE, a corporation
must meet/maintain certain financial
standards and pay listing fees.
 http://www.nasdaq.com/about/appa.pdf

US regional exchanges
Pacific Exchange / Archipelago
 Chicago (formerly Midwestern)
Stock Exchange
 Boston Stock Exchange
 Philadelphia Stock Exchange
 Cincinnati Stock Exchange

(P)
(M)
(B)
(X)
(C)
Third markets

Trading of listed securities away from the
exchange.

Institutional market: to facilitate trades of
larger blocks of securities.

Involves services of dealers and brokers
Fourth Market

Trading in exchange-listed stocks within
Alternative Trading Systems (ATS), such
as ECNs (Instinet, Island, Archipelago)

Institutions trading directly with institutions

No middleman involved in the transaction
Major international stock markets
Europe
• London Stock Exchange (LSE)
• EuroNext (Paris/Netherlands/Belgium)
• Deutsche Borse (DB)
• Milan Stock Exchange
• Swiss Stock Exchange
Stockholm/Copenhagen/Helsinki/Oslo
(OM)
 Toronto Stock Exchange (TSX)


Asia
•
•
•
•
•
Tokyo Stock Exchange (TSE)
Taiwan Stock Exchange
Korean Stock Exchange (KSE)
Australian Stock Exchange (ASX)
Hong Kong Stock Exchange
International market structures

London Stock Exchange
•
Dealer market similar to NASDAQ
• Stock Exchange Automated Quotation
• Greater Anonymity

Tokyo Stock Exchange
•
No market making service
• Sartori provides bookkeeping service
• Feature a floor and electronic trading
KSE

http://www.kse.or.kr/
The regulators

Securities and Exchange Commission
(SEC)
•

Securities markets, equity options markets,
and cash-settled equity index options markets
Commodity Futures Trading Commission
(CFTC)
•
Commodity spot, forward, and futures
markets