Lecture 4

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T
SHTR
E APTLHACCLEY DOEF BUUSSEIFNUELS S
International Financial
Markets and Banking
L ESACRHNOI N
OGL
Juliane Thamm
SW 3.07, Ext.: 3889, juliane.thamm@strath.ac.uk

Office hours: see myplace for details and/or email for an appointment
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S T R AT H C LY D E B U S I N E S S S C H O O L
Lecture 4
Equity Capital Markets
© Juliane Thamm – University of Strathclyde

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Additional Reading
Chapter 15 of Brealey and Myers covers the new issue of shares process in
outline (other corporate finance text books do too)
Ibbotson & Ritter (1995) ‘Initial Public Offerings’ is an excellent summary of the
evidence on IPOs (see workshop 4)
You might also like to look at the websites of stock exchanges such as the
London Stock Exchange, the New York Stock Exchange and Euronext.

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Equity Capital Markets

A key distinction is between:
Primary Markets - where companies sell new shares to

investors
and
Secondary Markets - where investors trade already issued
shares with other investors

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Business Finance
A business can be financed by:
Internal funds
Bank loans
Bond issues
Equity issues
The initial founders of a business may lack enough capital to develop

the business to the point of profitability
With limited capacity to borrow, many new companies turn to venture

capital firms for initial funding

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Equity funding sources

Pre-seed
• Founders funding
• Family members
Stage of company development

start-up • Friends
Seed funding
• Angel investors
• Venture Capital
early
• Venture Capital
• Private Equity
growth
• Initial Public Offering

(IPO)
maturity

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Venture Capital
Venture capital firms provide early stage financing to businesses in return for a share
of the equity
VC is a ‘hands on’ business with the VC firm closely monitoring investee companies,
providing advice and often taking a seat on the board
VC is risky, with many investments losing money, in some cases all of the initial
investment
However, some deals go spectacularly well, generating enough profits to offset the
losses
VC firms seek to realise their investments after a few years, either through a trade sale
or by selling shares on the market - “going public”

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Initial Public Offerings (IPOs)

When a company sells its shares to investors for the first time, this is
called in “initial public offering” or “IPO”
The IPO can be used to:

Raise new money for the company
Allow VC firms to realise their investment
Allow the founders to realise their investment
Or, some combination of these three
The IPO is a costly and complex process involving a number of

specialist advisers
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Listing Requirements
In most markets, companies have to meet certain criteria in order to have their shares
traded on the market
In the UK, the Financial Conduct Authority (FCA) is responsible for setting these
“listing requirements”
The main requirements are:

A three year trading history
An expected minimum market value of £30 million
At least 10% of shares made available to the public
A junior market exists for newer companies that don’t meet these requirements - the
“Alternative Investment Market” (AIM)

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United Kingdom Listing Authority (UKLA)

old name for part of the FCA that administers the listings process
responsible for approval of the prospectuses and admission to the Official List
maintains details of all listed companies and updates its list daily with
additions, cancellations, suspensions and restorations
it rigorously enforces a set of demanding rules regarding the conduct of the

company and its officials in the years following the listing
In Primary Market Bulletin 20 (February 2019), the FCA announced that, over
time, it will be phasing out the UKLA name. It will instead refer to the FCA's
primary market functions.
For further details, see https://www.fca.org.uk/publication/newsletters/primary-market-bulletin-20.pdf
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London Stock Exchange, September 2022

Distribution of Companies by Equity Market Value
Source: London Stock

Exchange Main Market
Fact Sheet September
2022
http://www.londonstoc
kexchange.com/statisti
cs/markets/main-
market/main-
market.htm

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Underwriters
an investment bank usually plays a key role in the IPO process as the
“underwriter” or “sponsor”
the bank will provide the company with procedural and financial advice
it will then take on the responsibility for distributing the shares to investors
the bank may act as principal, buying the shares to resell to investors, or it
may act as agent, selling to investors on behalf of the company

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The IPO Process

the company applies to have its shares listed on the market
the investment bank does ‘due diligence’ and prepares a “prospectus” that
outlines key facts about the company and the share issue
the investment bank markets the shares to investors, then sets the price for
the issue and distributes the shares to investors
the shares are admitted to the market and trading begins

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The Prospectus
-Details of the offering (xxx,xxx shares)

-What the company does
-Management
-Use of the offer proceeds
-Risks faced by the company
-Who is selling shares (VC and founders)
-Who is managing the issue (sponsor)
-Full financial statements
-Legal and audit opinions
-Pricing range (e.g. “share price expected to be between 200p and 250p”)

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IPO Methods
There are several types of IPO:
Placings
The sponsor purchases the shares from the company and distributes them to
investors
Offer for sale by tender

Investors are invited to bid for the shares and a ‘strike price’ is set to clear the
issue
Offer for sale

The sponsor purchase the shares at a fixed price and invites investors to
purchase them
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LSE main market Jan. – Sept. 2022

New companies
number of companies total money raised (£m)

Public offer 24
Introductions & others 18 1,091.38
Source:
http://www.londonstockexchange.com/statistics/markets/main-market/main-market.htm

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Pricing an IPO
The investment bank will set the price with reference to the valuation of comparable
shares, e.g. using P/E ratio
The bank will also discuss the issue with investors in order to gauge the likely level of
demand (book-building)
There is substantial evidence that IPOs are, on average, underpriced - i.e. the issue
price is below the price that holds on the first day of trading (Ritter 1998)
Average Initial Return

US - Ibbotson et al 1960-96 15.8%
UK - Dimson & Levis 1959-90 12.0%
India- Krishnamurti & Kumar 1992-93 35.3%
China - Datar & Mao 1990-96 388.0%
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Underpricing
Why do companies undertaking IPOs “leave money on the

table” by pricing their shares at less than the market clearing
price?
Think about the incentives that exist for:

The issuing company
The investment bank

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Explanations of Underpricing
The Winner’s Curse
Investment bank monopsony power
Lawsuit avoidance
Signaling
Spinning
see Ibbotson & Ritter (1995) for more detail on all of these © Juliane Thamm – University of Strathclyde
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Post-listing obligations
Continuing obligations
Price-sensitive information
‘Full and accurate disclosure’
Detailed financial statements within six months of the year-end
Preliminary profit announcements
Interim reports for the first half of each accounting year are also required
(within four months of the end of the half-year)
Model Code for Director Dealings
Images on next two slides from: https://www.bloomberg.com/news/articles/2022-08-

25/london-s-stock-market-misery-grows-as-delistings-add-to-ipo-woes
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Secondary Markets
In a secondary market investors trade securities that are already in issue. The
company gets no new capital.
Investors would be reluctant to commit capital in primary markets if there were

no secondary markets in which they could sell on their shares.
Secondary markets also allow us to observe what investors think is the right
valuation for a company’s securities.
Well functioning secondary markets help in the process of ensuring capital is

allocated efficiently in the economy.
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Tasks for stock exchanges

supervision of trading to ensure fairness and efficiency

authorisation of market participants such as brokers and market
makers
creation of an environment in which prices are formed efficiently
and without distortion (price discovery or price formation)
organisation of the settlement of transactions
regulation of the admission of companies to the exchange and
the regulation of companies on the exchange
dissemination of information
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This slide
Global stock markets by market capitalisation 2016
Image: http://www.visualcapitalist.com/wp-content/uploads/2016/02/exchanges-share.png
More optional information:
http://www.visualcapitalist.com/all-of-the-worlds-stock-exchanges-by-size/
Next slide:
Relative size of global stock markets 1899 v 2020
Credit Suisse (2020) “Credit Suisse Global Investment Returns Yearbook 2020 Summary
Edition”, online report. Available at: https://www.credit-suisse.com/about-us/en/reports-
research/studies-publications.html (graphic is on page 20 of the report)

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London Stock Exchange (LSE)

Until 1986 the LSE had many restrictive practices:

Jobbers made markets in shares
Brokers dealt on behalf of investors Image:
http://i.telegraph.co.uk/multi
Investors paid fixed commissions (Avg 0.4%) media/archive/00973/money-
graphics-2006_973053a.gif
‘Big Bang’ in 1986 brought sweeping changes:
Abolition of fixed commissions (Avg 0.2%)
Dual capacity allowed (broking and market making)
Rules on ownership of brokers were relaxed
Big bang brought large US, European and Japanese

firms into the London market

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Variety of financial instruments sold on LSE

Source: Arnold (2012, p.355)
Access via our library's ebook collection: Modern Financial Markets &
Institutions
https://www.dawsonera.com/readonline/9780273778028/startPage/63
Source: Arnold (2012) © Juliane Thamm – University of Strathclyde

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Interesting facts about the LSE:

The Exchange is the most international of all the world’s stock exchanges,
with nearly 2000* companies from over 45* countries admitted to trading
on its markets.
Having started life in the coffee houses of 17th century London, the
Exchange is one of the world’s oldest stock exchanges and can trace its
history back more than 300 years.
Share of cash equities trading (lit markets): 73.3% in UK cash equities**
*Source: http://www.londonstockexchange.com/statistics/companies-and-issuers/companies-and-issuers.htm
** Source: https://docs.londonstockexchange.com/sites/default/files/reports/LSEG%20market%20report%20September%202020.pdf

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This side:
http://news.bbc.co.uk/nol/shared/spl/hi/pop_ups/06/business_enl_1161936310/im
g/1.jpg
Next slide:
http://newsimg.bbc.co.uk/media/images/42243000/gif/_42243984_ftse_topten_41
6.gif

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Electronic Trading
Following Big Bang LSE was still a “quote driven” market

Dealers place on screens the prices at which they are prepared to buy or sell
specific securities
Brokers or investors call the dealer to trade
In 1997 trading moved to an electronic system called Stock Exchange

Electronic Trading System (SETS)
SETS is an “order driven’ system
Brokers place orders into the system and the system seeks to match them
against other orders
SETS operates for FTSE 100, FTSE250, FTSE Small Cap Index constituents,
as well as other liquid AIM shares and some Exchange Traded Funds (ETFs).
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Benefits of e-trading
Access via our library's ebook collection: Modern Financial Markets & Institutions
Source: Arnold (2012) © Juliane Thamm – University of Strathclyde

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Trading on the LSE

SETSqx (Stock Exchange Electronic Trading Service – quotes and crosses) is

used for securities less liquid than those traded on SETS.
Since October 2007 all Main Market and AIM equities not traded on a full order
book are traded here. SETSqx is a hybrid system that combines a periodic
electronic auction book with standalone non-electronic quote driven market
making.
Smaller, even less liquid shares still operate on a market making, quote driven
basis known as SEAQ (Stock Exchange Automated Quotations), used for AIM
shares not traded on SETS or SETSqx.
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Trading on the LSE

An Intra-day auction for equities on SETS at 12:00pm was introduced

on 21 March 2016. It consists of a two minute period and is a price
forming auction mechanism for trading larger sized orders. (see:
https://www.lseg.com/markets-products-and-services/our-markets/london-stock-exchange/equities-markets/trading-
services/trading-services-video-resources/new-sets-intra-day-auction)
More details on all the trading mechanisms on the LSE can be found at:
Overview:
https://www.lseg.com/sites/default/files/content/documents/LSEG_CM_LSE_TRADING_SERVICES_GUIDE_03.pdf
Technical detail: https://docs.londonstockexchange.com/sites/default/files/documents/MIT201%20-

%20Guide%20to%20the%20Trading%20System%20Issue%2015.1.pdf
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LSE equity trading

See p. 29: http://www.londonstockexchange.com/products-and-services/millennium-exchange/millennium-exchange-migration/mit201guide14october2016.pdf
Trading service coverage

SETS Order book with Executable FTSE100, FTSE250 and the FTSE
Quotes Small Cap Index constituents as
well as other liquid AIM, Irish,
London secondary listed securities
and EUI settled ETFs and ETPs
SETSqx – with Non electronically - executable quotes Main Market securities not traded
(Firm Quotes*) with electronic order on SETS or less liquid AIM
Market Makers securities that have registered
book auctions at 8am,
Market Makers
9am,11am, 2pm & 4:35pm
SETSqx – no Electronic order book auctions at Main Market securities not traded
8am, 9am,11am, 2pm & 4:35pm on SETS
Market Makers and AIM securities that are not
supported by a registered Market
Maker
SEAQ Non electronically -executable quotes Less liquid AIM securities with at
(Firm Quotes) least 2
market makers
*Firm Quotes: Only for use by participants that are registered in individual SETSqx or SEAQ securities as a market maker.
Fully visible, non-electronically executable, named, dual sided quotes that must meet a prescribed entry size
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SETS screen example – this slide

Source: p.7 in “A Guide to London Stock Exchange trading services for equity
securities”, available at:
https://www.lseg.com/sites/default/files/content/documents/LSEG_CM_LSE_TRAD
ING_SERVICES_GUIDE_03.pdf
SEAQ quote-driven system – next slide

Access via our library's ebook collection: Modern Financial Markets &
Institutions
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Clearing and settlement

Clear the trade:

The exchange ensures that all reports of the trade are reconciled to make sure all
parties are in agreement as to the number and the price of shares traded
The exchange also checks that the buyer and seller have the cash and securities to
do the deal
Also the company registrar is notified of the change in ownership
Settlement:
The transfer of ownership from seller to buyer
‘Central counterparty’ (CCP)

Many equity markets introduced CCPs when they went from floor trading to
electronic trading, where the system matches orders and each firm lost the ability to
choose the party it transacts with. A CCP centrally manages counterparty default
risk and gives firms more confidence to trade.
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Central counterparty (CCP)

a CCP undertakes the following principle tasks:

-Ensuring post-trade anonymity
-Eliminating bilateral counterparty risk between trade execution and settlement (novation)
-Settlement netting
-Risk management
The traditional description of a CCP as a ‘buyer to every seller and seller to every
buyer’ is based on the practice of a single CCP clearing for a trading venue. A number
of equities trading venues have appointed several CCPs to clear for them concurrently.
The term ‘central’ counterparty remains unchanged but it can acquire a new meaning –
if a trading firm is able to concentrate all its equities transactions to be cleared by a
CCP of its choice, then that CCP is the firm’s “central” counterparty.
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Central counterparty (CCP)

in the EU, CCPs are regulated by the EMIR regulation*

providers of CCP services to the LSE’s SETS and SETSqx order books are:
LCH.Clearnet Ltd http://www.lch.com/home
SIX x-clear Ltd https://www.six-securities-services.com/en/home/clearing/about.html
European Central Counterparty N.V (EuroCCP) https://euroccp.com/
these three CCPs have entered into interoperability agreements in the

European equity market
* Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade
repositories.
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CCP interoperability
in interoperable clearing, two CCPs enter into an agreement to participate in clearing of the
other party’s transactions
each market participant is able to use its in a transaction cleared between two CCPs, there
preferred CCP, while still benefiting from netting is counterparty risk between the participant and
the CCP, but also between the two CCPs
reduces exposures – and thus risk – between
participants across marketplaces a CCP’s default could potentially cause contagion
to the other CCP
participants only need to participate in one CCP,
only post margin and contribute to the clearing operational risk increases, since a cross-CCP
fund of this CCP transaction cannot be completed in case of
communication errors between them
helps to increase competition as several CCPs
are able to clear transactions on the same
marketplace without impairing the netting effect
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Trends in Equity Trading

Competition amongst exchanges
Takeover & consolidation activity amongst exchanges

Euronext (Paris, Brussels, Amsterdam exchanges)
October 2007: LSE merges with Borsa Italiana
NASDAQ merged in 2007 with OMX, the Scandanavian and Baltic group of
exchanges (Stockholm, Helsinki, Copenhagen and Iceland, and Estonia,
Latvia, Lithuania and Armenia) and with the Boston and Philadelphia
exchanges
LSE attempted merger with TMX of Canada in 2011
Blocked NYSE-Euronext & Deutsche Börse merger
£24bn tie-up between the London Stock Exchange and Deutsche Börse failed
in 2017
£32bn bid for LSE by Hong Kong stock exchange (HKEX) rejected in
September 2019
October 2020: LSE agrees sale of Borsa Italiana to Euronext
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Trends in Equity Trading

New stock exchanges are being established

e.g. Aquis Stock Exchange in the UK in 2001 https://www.aquis.eu/aquis-stock-exchange
Investors Exchange (IEX) in the US in 2012 https://iextrading.com/
Sept. 2020: MEMX in the US https://memx.com/
Alternatives to exchanges have been set up

e.g. ‘crossing networks’ set up by investment managers
BATS Europe (rebranded Cboe Europe Equities in 2017)
Chi-X (merged with BATS Europe in 2011)
Turquoise https://www.lseg.com/areas-expertise/our-markets/turquoise/who-we-are
De-materialisation - dealing and settlement is electronic, there are no paper certificates
rapidly advancing electronic trading technologies

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Further information (optional)

Information on AIM : https://www.londonstockexchange.com/raise-finance/equity/aim
Trading blocs - What next for the stock exchanges?, 2011 PWC publication:
https://www.pwc.lu/en/banking/docs/pwc-flyer-trading-blocs.pdf
FT Special report “Risk Management: Exchanges, Trading and Clearing”: https://www.ft.com/reports/risk-

management-exchanges-trading-clearing
Otchere, I.K. and K. Abukari (2020) “Are Super Stock Exchange Mergers Motivated by Efficiency or Market
Power Gains?”, Journal of International Financial Markets, Institutions and Money 64, forthcoming. Available at:
https://doi.org/10.1016/j.intfin.2019.101164
Aziza, R. (2020) “Developing Securities Markets in Sub-Saharan Africa: Does it Matter?“, Working Paper
Faculty of Law, University of Oxford. Available at: https://ssrn.com/abstract=3664380
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next steps
Please review the lecture 4 material and complete the week 4 required
reading, then attempt to answer the workshop 4 questions.
Try self-assessment quiz 4 and don’t forget about the Survey home work
and check out podcase 2.
Vote for next Tuesday’s lecture topic and e-mail topic suggestions for
future Tuesdays.
You’ll find all details on the AG991 myplace page.
… and attend tomorrow’s session!

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further help:
Come to any office hours – these are drop-in sessions, no appointment

needed! All details are on the AG991 myplace page.
Send any questions you may have by e-mail.
If you wish to see me outside of office hours, please e-mail to make

arrangements.
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SW 3.07, Ext.: 3889, juliane.thamm@strath.ac.uk

© Juliane Thamm – University of Strathclyde

© Juliane Thamm – University of Strathclyde

Equity Capital Markets

A key distinction is between:

Primary Markets - where companies sell new shares to

© Juliane Thamm – University of Strathclyde

A business can be financed by:

The initial founders of a business may lack enough capital to develop

With limited capacity to borrow, many new companies turn to venture

© Juliane Thamm – University of Strathclyde

Equity funding sources

Stage of company development

• Initial Public Offering

© Juliane Thamm – University of Strathclyde

© Juliane Thamm – University of Strathclyde

Initial Public Offerings (IPOs)

The IPO can be used to:

The IPO is a costly and complex process involving a number of

The main requirements are:

© Juliane Thamm – University of Strathclyde

United Kingdom Listing Authority (UKLA)

it rigorously enforces a set of demanding rules regarding the conduct of the

London Stock Exchange, September 2022

Distribution of Companies by Equity Market Value

Source: London Stock

© Juliane Thamm – University of Strathclyde

© Juliane Thamm – University of Strathclyde

The IPO Process

the company applies to have its shares listed on the market

the shares are admitted to the market and trading begins

© Juliane Thamm – University of Strathclyde

-Details of the offering (xxx,xxx shares)

© Juliane Thamm – University of Strathclyde

There are several types of IPO:

Offer for sale by tender

Offer for sale

LSE main market Jan. – Sept. 2022

number of companies total money raised (£m)

© Juliane Thamm – University of Strathclyde

Average Initial Return

Why do companies undertaking IPOs “leave money on the

Think about the incentives that exist for:

© Juliane Thamm – University of Strathclyde

The Winner’s Curse

Investment bank monopsony power

Images on next two slides from: https://www.bloomberg.com/news/articles/2022-08-

Investors would be reluctant to commit capital in primary markets if there were

Well functioning secondary markets help in the process of ensuring capital is

Tasks for stock exchanges

supervision of trading to ensure fairness and efficiency

© Juliane Thamm – University of Strathclyde

London Stock Exchange (LSE)

Until 1986 the LSE had many restrictive practices:

Big bang brought large US, European and Japanese

© Juliane Thamm – University of Strathclyde

Variety of financial instruments sold on LSE

Source: Arnold (2012, p.355)

Source: Arnold (2012) © Juliane Thamm – University of Strathclyde

Interesting facts about the LSE:

Share of cash equities trading (lit markets): 73.3% in UK cash equities**

© Juliane Thamm – University of Strathclyde

© Juliane Thamm – University of Strathclyde