Chapter 2 Organization 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?
 Chapter 2
Organization 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?
 Chapter 2 Organization 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?
 Chapter 2
Organization and Functioning of
Securities Markets
• What are some of the major changes in
world capital markets expected over the
next decade?
 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
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
Functions of Financial Markets
• A financial market is a market in which financial
assets (securities) can be purchased or sold
• Financial markets facilitate transfers of funds from
person or business without investment
opportunities (i.e., “Lender-Savers”, or “Surplus
Unit”) to those who have them (i.e., “Borrower-
Spenders”, or “Deficit Unit”)

7
Functions of Financial Markets…
• Financing
– Financial markets transfer funds from those
who have excess funds (surplus units) to those
who need funds (deficit units).
– Deficit units issue securities to surplus units.
These securities can be debt securities (paying
interest for a specific duration) or equity
securities.
– Deficit units: College students, Government,
Households, Businesses etc.
8
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
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
 Municipal Bond Issues
• Sold by three methods
– Competitive bid
– Negotiation
– Private placement
• Underwriters sell the bonds to investors
The 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
Corporate Bond and Stock Issues
New issues are divided into two groups
1. Seasoned new issues - new shares offered
by firms that already have stock
outstanding
2. Initial public offerings (IPOs) - a firm
selling its common stock to the public for
the first time
 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
 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
Private Placements and Rule 144A
• Firm sells to a small group of
institutional investors without
extensive registration
• Lower issuing costs than public
offering
 Why Secondary Financial
Markets Are Important
• Provide liquidity to investors who acquire
securities in the primary market
• Result in lower required returns than if
issuers had to compensate for lower
liquidity
• Help determine market pricing for new
issues
 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
 Financial Futures

Bond futures are traded in

• 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, Cincinnati
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
• In a continuous market, trades occur at any
time the market is open
 National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed
firms
• Diverse clientele of buyers and sellers
 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
 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
 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
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.
 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
 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
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 TimeEST
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
 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
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
 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

 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
 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
 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 costs
• No data are available regarding its specific
size and growth
 Detailed Analysis of
Exchange Markets
• Exchange Membership

• Major Types of Orders

• Exchange Market Makers

 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
 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)
 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
 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
 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
 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
 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
 Exchange Market Makers
U.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
 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
– Hundreds of employees on trading floor
– Intermediary clerks
– Brokers among members
– Maintain limit orders
 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
 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
 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
Negotiated Commission Rates
• In 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 institution
 The Impact of Block Trades
• Block houses are investment firms that help
institutions locate other institutions interested in
buying or selling blocks of stock
• A good block house has
1. The capital required to position a large block
2. The willingness to commit this capital to a block
transaction, and
3. Contacts among institutions
 Institutions and Stock Price
Volatility
• Empirical studies have not supported the
theory that institutional trading increases 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 has been advocated by financial
institutions to provide greater efficiency,
competition, and lower cost of transactions
• NMS is expected to have:
– 1. Centralized reporting of all transactions
– 2. Centralized quotation system
– 3. Centralized limit order book (CLOB)
– 4. 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 traders
• All market makers and traders could fill
orders on it
• Technology 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 (Rule 390)
• 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 a billion shares
• NYSE routinely handles days with volume
over a billion shares
• Technology has allowed the market process
to keep pace
 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
 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 is designed to accept member firms’
postopening market orders up to 3 million
shares
• Rapid execution and reporting of market
orders
• In 2000, orders executed and reported in
15-16 seconds on average
 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
 London Stock Exchange
October 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
 Paris Bourse
• The big brokerage house monopoly on stock
trading has been opened up to French and
foreign banks
• Investment firms are merging with banks to
acquire capital needed to trade in world
market
• Continuous auction market introduced to
replace call market
 Future Developments
• Continuing consolidation of security exchanges
• More specialized investment companies
• Changes in the financial services industry
– Financial supermarkets
– Financial boutiques
• Advances in technology
– Computerized trading
– 24-hour market of the future may be floorless,
global, and highly automated
 The Internet
Investments Online
www.quote.com
www.sec.gov
www.nyse.com
www.nasdaq-amex.com
www.etrade.com
www.schwab.com
www.ml.com