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Chapter 
4
Organization andFunctioning of Securities Markets*
After you read this chapter,you should be able to answer the following questions:
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What is the purpose and function of a market?
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What are the characteristics that determine the quality of a market?
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What is the difference between a primary and secondary capital market and how do thesemarkets support each other?
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What are the national exchanges and how are the major securities markets around the worldbecoming linked (what is meant by “passing the book”)?
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What are regional stock exchanges and over-the-counter (OTC) markets?
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What are the alternative market-making arrangements available on the exchanges and theOTC market?
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What are the major types of orders available to investors and market makers?
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What are the major functions of the specialist on the NYSE and how does the specialistdiffer from the central market maker on other exchanges?
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What are the significant changes in markets around the world during the past 15 years?
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What are the major changes in world capital markets expected over the next decade?The stock market,the Dow Jones Industrials,and the bond market are part of our everydayexperience. Each evening on the television news broadcasts,we find out how stocks and bondsfared; each morning we read in our daily newspapers about expectations for a market rally ordecline. Yet most people have an imperfect understanding of how domestic and world capitalmarkets actually function. To be a successful investor in a global environment,you must knowwhat financial markets are available around the world and how they operate.In Chapter 1,we considered why individuals invest and what determines their required rateof return on investments. In Chapter 2,we discussed the life cycle for investors and the alterna-tive asset allocation decisions by investors during different phases. In Chapter 3,we learnedabout the numerous alternative investments available and why we should diversify with securi-ties from around the world. This chapter takes a broad view of securities markets and provides adetailed discussion of how major stock markets function. We conclude with a consideration of how global securities markets are changing.We begin with a discussion of securities markets and the characteristics of a good market.Two components of the capital markets are described:primary and secondary. Our main empha-sis in this chapter is on the secondary stock market. We consider the national stock exchangesaround the world and how these markets,separated by geography and by time zones,are becom-ing linked into a 24-hour market. We also consider regional stock markets and the over-the-counter markets and provide a detailed analysis of how alternative exchange markets operate.
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*The authors acknowledge helpful comments on this chapter from Robert Battalio and Paul Schultz of the University of Notre Dame.
 
106 CHAPTER 4
O
RGANIZATIONAND
F
UNCTIONINGOF
S
ECURITIES
M
ARKETS
The final section considers numerous historical changes in financial markets,additional currentchanges,and significant future changes expected. These numerous changes in our securities mar-kets will have a profound effect on what investments are available to you from around the worldand how you buy and sell them.
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This section provides the necessary background for understanding different securities marketsaround the world and the changes that are occurring. The first part considers the general conceptof a market and its function. The second part describes the characteristics that determine thequality of a particular market. The third part of the section describes primary and secondary cap-ital markets and how they interact and depend on one another.A
market
is the means through which buyers and sellers are brought together to aid in thetransfer of goods and/or services. Several aspects of this general definition seem worthy of emphasis. First,a market need not have a physical location. It is only necessary that the buyersand sellers can communicate regarding the relevant aspects of the transaction.Second,the market does not necessarily own the goods or services involved. For a good mar-ket,ownership is not involved; the important criterion is the smooth,cheap transfer of goods andservices. In most financial markets,those who establish and administer the market do not ownthe assets but simply provide a physical location or an electronic system that allows potentialbuyers and sellers to interact. They help the market function by providing information and facil-ities to aid in the transfer of ownership.Finally,a market can deal in any variety of goods and services. For any commodity or servicewith a diverse clientele,a market should evolve to aid in the transfer of that commodity or ser-vice. Both buyers and sellers will benefit from the existence of a smooth functioning market.Throughout this book,we will discuss markets for different investments,such as stocks,bonds,options,and futures,in the United States and throughout the world. We will refer to these mar-kets using various terms of quality,such as
strong,active,liquid,
or
illiquid.
There are manyfinancial markets,but they are not all equal—some are active and liquid; others are relativelyilliquid and inefficient in their operations. To appreciate these discussions,you should be awareof the following characteristics that investors look for when evaluating the quality of a market.One enters a market to buy or sell a good or service quickly at a price justified by the pre-vailing supply and demand. To determine the appropriate price,participants must have timelyand accurate information on the volume and prices of past transactions and on all currentlyoutstanding bids and offers. Therefore,one attribute of a good market is
timely and accurateinformation
.Another prime requirement is
liquidity
,the ability to buy or sell an asset quickly and at aknown price—that is,a price not substantially different from the prices for prior transactions,assuming no new information is available. An asset’s likelihood of being sold quickly,sometimesreferred to as its
marketability,
is a necessary,but not a sufficient,condition for liquidity. Theexpected price should also be fairly certain,based on the recent history of transaction prices andcurrent bid-ask quotes.
1
Characteristics of a Good Market
1
For a more formal discussion of liquidity,see Puneet Handa and Robert A. Schwartz,“How Best to Supply Liquidity toa Securities Market,”
 Journal of Portfolio Management 
22,no. 2 (Winter 1996):44–51. For a recent set of articles thatconsider liquidity and all components of trade execution,see
 Best Execution and Portfolio Performance
(Charlottesville,Va.:Association for Investment Management and Research,2000).
 
A component of liquidity is
price continuity
,which means that prices do not change muchfrom one transaction to the next unless substantial new information becomes available. Supposeno new information is forthcoming and the last transaction was at a price of $20; if the next tradewere at $20.05,the market would be considered reasonably continuous.
2
A continuous marketwithout large price changes between trades is a characteristic of a liquid market.A market with price continuity requires
depth,
which means that numerous potential buyersand sellers must be willing to trade at prices above and below the current market price. Thesebuyers and sellers enter the market in response to changes in supply and demand or both andthereby prevent drastic price changes. In summary,liquidity requires marketability and pricecontinuity,which,in turn,requires depth.Another factor contributing to a good market is the
transaction cost
. Lower costs (as a per-cent of the value of the trade) make for a more efficient market. An individual comparing the costof a transaction between markets would choose a market that charges 2 percent of the value of the trade compared with one that charges 5 percent. Most microeconomic textbooks define anefficient market as one in which the cost of the transaction is minimal. This attribute is referredto as
internal efficiency.
Finally,a buyer or seller wants the prevailing market price to adequately reflect all the infor-mation available regarding supply and demand factors in the market. If such conditions changeas a result of new information,the price should change accordingly. Therefore,participants wantprices to adjust quickly to new information regarding supply or demand,which means that pricesreflect all available information about the asset. This attribute is referred to as
external effi-ciency
or
informational efficiency
. This attribute is discussed extensively in Chapter 6.In summary,a good market for goods and services has the following characteristics:1.Timely and accurate information is available on the price and volume of past transactionsand the prevailing bid and ask prices.2.It is liquid,meaning an asset can be bought or sold quickly at a price close to the pricesfor previous transactions (has price continuity),assuming no new information has beenreceived. In turn,price continuity requires depth.3.Transactions entail low costs,including the cost of reaching the market,the actual broker-age costs,and the cost of transferring the asset.4.Prices rapidly adjust to new information; thus,the prevailing price is fair because itreflects all available information regarding the asset.Common stocks in the United States have always been quoted in fractions prior to the change inlate 2000. Specifically,prior to 1997,they were quoted in eighths (e.g.,1/8,2/8,...7/8),witheach eighth equal to $0.125. This was modified in 1997 when the fractions for most stocks wentto sixteenths (e.g.,1/16,2/16,...15/16) equal to $0.0625. The Securities and ExchangeCommission (SEC) has been pushing for a change to decimal pricing for a number of years andeventually set a deadline for the early part of 2001. The NYSE started the transition with sevenstocks as of August 28,2000,included an additional 52 stocks on September 25,and added 94securities effective December 4,2000. The final deadline for all stocks on the NYSE and theAMEX to go “decimal”was April 9,2001. The Nasdaq market deferred the change until lateApril 2001.
Decimal Pricing
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2
You should be aware that common stocks are currently sold in decimals (dollars and cents),which is a significant changefrom the pre-2000 period when they were priced in eighths and sixteenths. This change to decimals is discussed at theend of this subsection.
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