Organization and Functioning of Securities Markets

CHAPTER 3
Organization
and
Functioning of
Securities
Markets
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 3-1
3.1 What is a Market?
• A market is the means through which

buyers and sellers are brought together to
aid in the transfer of goods and/or services
• A market:
• Need not have a physical location
• Does not necessarily own the goods or services
involved
• Can deal in any variety of goods and services
3.1.1 Characteristics of a Good Market
• Characteristics of a good market:

1. Timely and accurate information on price and
volume of past transactions
2. Liquidity
• Marketability
• Price continuity
• Depth
3. Low transaction costs
• Cost of reaching the market
• Brokerage costs
• Cost of transferring the asset
4. Prices that rapidly adjust to new information
3.1.2 Decimal Pricing
• Prior to 2001, common stocks in the United

States were quoted in fractions
• Decimal pricing:
• Easy to understand and compare prices
• Decimal pricing reduces minimum variation (e.g., the
tick size)
• More competitive U.S. markets
• Decimalization has reduced spread size and
transaction costs, which has led to a decline in
transaction size and an increase in the number
of transactions
3.1.3 Organization of the Securities Market
• Principal distinction is between

• Primary markets, where new securities are
sold,
• Secondary markets, where outstanding
securities are bought and sold
• Each of these markets is further divided
based on the economic unit that issued
the security
3.2 Primary Capital Markets
• The primary market is where new issues

of bonds, preferred stock, or common
stock are sold by government units,
municipalities, or companies who want to
acquire new capital
3.2.1 Government Bond Issues
• U.S. government bond issues segments:

1. Treasury bills
• Original maturities of one year or less
2. Treasury notes
• Original maturities of two to 10 years
3. Treasury bonds
• Original maturities of more than 10 years
3.2.2 Municipal Bond Issues (slide 1 of 2)
• New municipal bond issues are sold by:

• Competitive bid
• Involve sealed bids and is sold to the bidding syndicate of
underwriters that submits the bid with the lowest interest cost
• Negotiated sales
• Involve contractual arrangements between underwriters and
issuers wherein the underwriter helps the issuer prepare the
bond issue and set the price and has the exclusive right to
sell the issue
• Private placements
• Involve the sale of a bond issue by the issuer directly to an
investor or a small group of investors
3.2.2 Municipal Bond Issues (slide 2 of 2)
• The Underwriting Function

• Investment firm purchases the entire issue at a
specified price
• Underwriter sells the issue to the investing public
• Three services:
1. Origination
• Design of the bond issue and initial planning
2. Risk-bearing function
• Underwriter acquires the total issue at a price dictated by the
competitive bid or through negotiation and accepts the
responsibility and risk of reselling it for more than the purchase
price
3. Distribution
• Selling it to investors with the help of a selling syndicate that
includes other investment banking firms and/or commercial banks
3.2.3 Corporate Bond Issues (slide 1 of 2)
• Corporate bond issues are typically sold

through a negotiated arrangement with an
investment banking firm that maintains a
relationship with the issuing firm
• Exhibit 3.1
3.2.3 Corporate Bond Issues (slide 2 of 2)
3.2.4 Corporate Stock Issues (slide 1 of 2)
• Seasoned equity issues

• New shares offered by firms that already have stock
outstanding
• Initial public offerings (IPOs)
• A firm selling its common stock to the public for the
first time
• At the time of an IPO, there is no existing public
market for the stock; that is, the company has been
closely held
• New issues (seasoned or IPOs)
• Typically underwritten by investment bankers
3.2.4 Corporate Stock Issues (slide 2 of 2)
• Introduction of Rule 415

• Allows large firms to register security issues
and sell them piecemeal during the following
two years
• Arrangement has benefited large corporations
because it provides great flexibility, reduces
registration fees and expenses, and allows
issuing firms to request competitive bids from
several investment banking firms
3.2.5 Private Placements and Rule 144A
• Rule 144A
• Allows corporations to place securities
privately with large, sophisticated institutional
investors without extensive registration
documents
• Securities can subsequently be traded among
large sophisticated investors (assets in
excess of $100 million)
3.3 Secondary Financial Markets
• Secondary markets permit trading in

outstanding issues
• Stocks or bonds already sold to the public are
traded between current and potential owners
• Proceeds from a sale in the secondary
market do not go to the issuing unit but
rather to the current owner of the security
3.3.1 Why Secondary Markets Are Important
• Provides liquidity to the individuals who

acquired these securities
• Important to those selling seasoned
securities because the prevailing market
price of the securities (price discovery) is
determined by transactions in the
secondary market
• Affects market efficiency and price
volatility
3.3.2 Secondary Bond Markets
(slide 1 of 2)
• Secondary Markets for U.S.
Government and Municipal Bonds
• U.S. Government bonds are traded by bond
dealers that specialize in either Treasury
bonds or agency bonds
• Treasury issues are bought or sold through a
set of 35 primary dealers, including large
banks in New York and Chicago and some
large investment banking firms
• No formal set of dealers for agency securities
3.3.2 Secondary Bond Markets
(slide 2 of 2)
• Secondary Markets for U.S.

Government and Municipal Bonds
• Major market makers are banks and
investment firms
• Banks are active in municipal bond trading
and underwriting of general obligation bond
issues
• Many large investment firms have municipal
bond departments that underwrite and trade
these issues
Secondary Corporate Bond Markets
(slide 1 of 2)
• Corporate bonds are traded over the counter by
dealers who buy and sell for their own accounts
• Major bond dealers are the large investment
banking firms that underwrite the issues:
• Goldman Sachs, JPMorgan, Barclay Capital, and
Morgan Stanley
• Corporate bond dealers hold a limited number of
bonds desired by their clients, and when
someone wants to do a trade, they work more
like brokers than dealers
• Exhibit 3.2
Secondary Corporate Bond Markets
(slide 2 of 2)
3.3.4 Secondary Equity Markets
(slide 1 of 2)
• Basic Trading Systems
• Pure auction market (order-driven market)
• Interested buyers and sellers submit bid-and-ask
prices (buy and sell orders) for a given stock to a
central location where the orders are matched by a
broker who does not own the stock but acts as a
facilitating agent
• Dealer market (quote-driven market)
• Individual dealers provide liquidity for investors by
buying and selling the shares of stock for
themselves
3.3.4 Secondary Equity Markets
(slide 2 of 2)
• Call versus Continuous Markets
• Call markets
• Bids and asks for a stock are gathered at a point in time and
a single price is derived where the quantity demanded is as
close as possible to the quantity supplied
• Exchange officials specify a single price that will satisfy most
of the orders, and all orders are transacted at this designated
price
• Continuous market
• Trades occur at any time the market is open wherein stocks
are priced either by auction or by dealers
• In a dealer market, dealers are willing to buy or sell for their
own account at a specified bid-and-ask price
• In an auction market, enough buyers and sellers are trading
to allow the market to be continuous
3.3.5 Exchange Market-Makers
• Brokers
• Bring buyers and sellers together for a transaction
• Dealers
• Expedite transactions by buying and selling for their own
account and make a living based on the bid-ask spread
• The specialist (DMM)
• A member of the exchange who applies to the exchange to be
assigned stocks to handle (generally 10–15)
• DMMs have two major functions:
• Serve as brokers to match buy and sell orders and to handle special
limit orders placed with other brokers
• Maintain a fair and orderly market by providing liquidity when the
natural flow of orders is not adequate
3.4 Classification of U.S. Secondary Equity
Markets
• Different secondary equity markets

currently exist in the United States
3.4.1 Primary Listing Markets (slide 1 of 5)
• New York Stock Exchange (NYSE)

• Largest organized securities market in the United States
• Approximately 2,850 companies had their common or
preferred stock listed on the NYSE, with a total market
value of more than $14 trillion (2016)
• Average daily volume of about 3.5 billion shares (2016)
• American Stock Exchange (AMEX)
• AMEX is a major stock options exchange, including
options on interest rates and stock indexes, and
exchange-traded funds (ETFs)
• Was acquired by the NYSE in 2007 and is currently
referred to as the NYSE MKT AMEX
• Global Stock Exchanges

• Each country typically has one relatively large exchange that
dominates the market
• Examples include the Tokyo Stock Exchange, the London Stock
Exchange, the Frankfurt Stock Exchange, and the Paris Bourse
• Emerging economies have stock exchanges because of the
liquidity that secondary equity markets provide
• Several factors impact these international exchange:
• A trend toward consolidations that will provide more liquidity and
greater economies of scale to support the technology required by
investors
• Many of the larger companies in these countries can qualify for
listing on a U.S. exchange and have become dual-listed
• Strong international exchanges have made possible a global equity
market wherein stocks that have a global constituency can be
traded around the world continuously
• The Global 24-Hour Market

• Major markets in New York, London, and Tokyo, can
be envisioned to represent the major segments of a
worldwide 24-hour stock market wherein investment
firms “pass the book” around the world
• For example, consider the individual trading hours for
each of the three exchanges, translated into a 24-
hour eastern standard time (EST) clock:
• The NASDAQ Market

• An over-the-counter (OTC) and dealer market
• Trading takes place via computer communication rather than on
a trading floor
• Has a set of requirements for a stock to be traded on the
NASDAQ National Market System (NMS)
• The largest U.S. secondary market in terms of the number of
issues traded
• A total of over 3,000 companies on the NASDAQ stock market
(2015)
• An estimated 650 issues of NASDAQ were either foreign stocks
or American Depository Receipts (ADRs) (2017)
• Approximate value of average daily equity trading is about $80
billion
• Listing Requirements for NASDAQ

• Quotes and trading volume for the NASDAQ market
are reported in two lists:
• National Market System (NMS) list
• A regular NASDAQ list
• There are alternative standards for initial listing and
continued listing on the NASDAQ NMS
• The standards for the NMS listing are significant but
not as onerous as for the NYSE
• For stocks on NASDAQ, the trading reports are
similar to those on the NYSE
3.4.2 The Significant Transition of the U.S.
Equity Markets (slide 1 of 13)
• The Initial Setting
• The NYSE and its members dominated the prosperous listed stock
market—a “seat” (membership) on the NYSE had a peak price of $3.25
million in 2005
• The NYSE had only one competitor—the NASDAQ OTC market, which
was basically an electronic dealer market
• The Transition Begins
• U.S. equity market began to change in 1994 with the publication of a
study that documented that the dealers apparently were colluding to
maintain wide bid-ask spreads to ensure high profits
• In 1996 there were convictions for “anticompetitive behavior,” and in
early 1997 new order-handling rules were specified that required that
electronic communications networks (ECNs) make their quotes
available to the public markets
• Private quotes were made available to the total market, including
several small electronic trading markets
• Legislation allowed existing and new ECNs to compete with the major
exchanges and gain significant market share
• The Move to Decimal Pricing
• In 2000 the SEC required decimal pricing (pennies)
• The impact was significantly smaller spreads
• The NYSE responded by creating an electronic order routing
system that transformed how large orders were executed
• Innovations made it possible to do large trades using multiple
small orders
• Firms developed computer programs (algorithms) to divide the
large orders into small orders—the initiation of algorithmic
trading
• Led to many competing ECNs creating “smart order routing”
algorithms that selected where to send orders to minimize
transaction costs and impact
• The National Market System (NMS)
• The trend toward electronic trading accelerated when
the SEC passed Regulation NMS in 2007:
1. Rule 610—Access Rule:
• Provides complete access to all market prices for these
stocks
• Prohibits any trading system from discriminating
against other participants in the market
• Limits the fees
• As a result, quotations on the exchanges are available
to all market participants
2. The Order Protection Rule
• Protects displayed quotations at the best bid or best
offer (the national best bid and offer [NBBO])
• Brokers or dealers who are internalizing trades must
match or beat the prevailing NBBO
3. The Sub-Penny Rule
• Prevents exchanges, broker/dealers, or other traders
from accepting orders priced in increments less than
one cent for stocks priced over $1.00
• Transactions can be executed in sub-penny increments
4. Market Data Rules
• Rules govern revenue allocation between markets that
contribute trade data to the consolidated tape
• Stock Exchanges
• Because of numerous mergers, there are currently
three major exchange groups:
• The New York Stock Exchange
• The NASDAQ Stock Exchange
• The CBOE Stock Exchanges
• There are several non-exchanges that provide
what is referred to as “dark liquidity” because
they do not provide pre and post-trade
transparency, as will be described
• Exhibit 3.3
• Electronic Communication Networks
(ECNs)
• ECNs were structured as limit order book
markets with pre and post-trade transparency
but were regulated as ATSs that involved less
surveillance and oversight
• Eventually applied to become registered
exchanges or were acquired by the large
exchanges
• There is currently only one significant ECN:
Lava Flow
• Dark Pools
• Orders put into dark pool are not displayed to other
market participants in order to reduce information
leakage and minimize market impact costs
• Participants on both sides of the trade are generally in
the pool by invitation, and high-frequency traders
(HFTs) are not allowed into the pools
• The advantage to participants is better pricing and
lower transaction fees
• Dark pools are registered as ATSs
• They do report their transactions on the composite
tape, and it is estimated that they are responsible for
about 25 percent of trading volume
• Broker/Dealer Internalizations
• Internalization is when retail broker/dealers internally
transact an order by buying or selling the stock
against their own account on a consistent basis
• It is considered “dark liquidity” because the brokers
are acting as OTC market makers and are not
required to display quotes prior to execution
• They generally report all trades to the consolidated
tape, so there is post-trade information
• Internalization accounts for about 18 percent of total
trading volume and almost 100 percent of all retail
marketable order flow
• Algorithmic Trading (AT)
• Algorithmic trading is basically creating computer
programs to make trading decisions
• The decisions are sophisticated and complex,
including buying in one market and selling in another
simultaneously for a small profit, or programming that
would trade based on important company news or
macro-economic events, such as Federal Reserve
decisions or domestic or international political news
• Consider anything that will affect stock prices, and
someone can create an algorithm that will act on it in
milliseconds in competition with other investors
• High-Frequency Trading (HFT)
• Following legislation that allowed (required) competitive
commissions and decimalization, the cost of trading experienced
a significant decline—about 80–90 percent
• This made it economically possible for many more individuals to
get into trading, but also for more professionals and even
institutions who used AT to create programs that traded
thousands of times a day for small profits that add up, as noted
earlier
• HFTs are admired because:
• They bring significant liquidity to the market, smaller bid-ask
spreads, and substantially lower transaction costs
• The fact is, it is estimated that about 50 percent
• HFTs are reviled because they bring added volatility to the
market, as their algorithms can cause significant shifts in the
volume of trading and prices
• AT/HFT and the Flash Crash
• The negative side of AT/HFT is concerned with the potential for
major trading problems or an algorithmic glitch or a “fat finger”
event when an operator hits the wrong key and initiates a major
blowout or crash
• On May 6, 2010, the market experienced a “flash crash” when
the major stock and futures indexes were already down over 4
percent for the day; prices suddenly declined a further 5 to 6
percent in a matter of minutes and this was followed by a very
rapid recovery
• In a matter of minutes, an algorithmic trade by an investment
firm in Kansas City caused numerous high-frequency traders to
automatically withdraw from the market
• This reduced the market’s overall liquidity and caused numerous
significant price declines—many of which were subsequently
reversed
• The Current Status
• What has changed:
• Market is more efficient because trading is easier, faster, and
cheaper than it was 20 years ago
• The NYSE has lost a lot of market power, the NASDAQ has
grown in significance, and the numerous new exchanges
have reshaped markets towards electronic trading
• What has not changed:
• The basic orders used to implement trading
• What will change:
• The basic makeup of the secondary equity market—that is,
the numerous mergers
3.5 Alternative Types of Orders
• It is important to understand the different

types of orders available to investors,
regardless of how the market is organized
3.5.1 Market Orders
• An order to buy or sell a stock at the best current

price
• A market sell order
• Indicates a willingness to sell immediately at the highest bid
available at the time the order reaches a registered
exchange, an ECN, or a dark pool
• A market buy order
• Indicates that the investor is willing to pay the lowest offering
price available at the time of the order
• Market orders provide immediate liquidity for an
investor willing to accept the prevailing market
price
3.5.2 Limit Orders
• A limit order specifies

• The buy or sell price
• How long the limit order will be outstanding
• Can be instantaneous (“fill or kill,” meaning fill the
order instantly or cancel it)
• Can be good for part of a day, a full day, several
days, a week, or a month
• Can also be open ended, or good until canceled
(GTC)
3.5.3 Special Orders
• Stop loss order
• A conditional market order whereby the investor
directs the sale of a stock if it drops to a given price
• Because of the possibility of market disruption caused
by a large number of stop loss orders, exchanges
have, on occasion, canceled all such orders on
certain stocks and not allowed brokers to accept
further stop loss orders on those issues
• Stop buy order
• An investor who wants to minimize his or her loss if
the stock begins to increase in value would enter this
conditional buy order at a price above the short-sale
price
3.5.4 Margin Transactions (slide 1 of 5)
• When investors buy stock, they can pay for the stock
with cash or borrow part of the cost, thus leveraging the
transaction
• Leverage is accomplished by buying on margin
• The investor pays for the stock with some cash and borrows the
rest through the broker, thus putting up the stock for collateral
• Federal Reserve Board Regulations T and U determine
the maximum proportion of any transaction that can be
borrowed
• This margin requirement
• Proportion of total transaction value that must be paid in cash
• Has varied over time from 40 percent (allowing loans of 60
percent of the value) to 100 percent (allowing no borrowing)
• After the initial purchase, changes in the market

price of the stock will cause changes in the
investor’s equity, which is equal to the market
value of the collateral stock minus the amount
borrowed
• If the stock price increases, the investor’s equity
as a proportion of the total market value of the
stock increases; that is, the investor’s margin will
exceed the initial margin requirement
• Maintenance margin
• The required proportion of equity to the total value of the stock
after the initial transaction
• Protects the broker if the stock price declines
• Minimum maintenance margin
• Is specified by the Federal Reserve as 25 percent
• If the stock price declines to the point where equity drops below 25
percent of the total value of the position, the account is considered
undermargined and investor will receive a margin call to provide
more equity
• If investor does not respond with the required funds in time, then the
stock will be sold to pay off the loan
• Time allowed to meet a margin call varies between investment
firms and is affected by market conditions
• Under volatile market conditions, the time allowed to respond to
a margin call can be shortened (e.g., to one day)
Assume you bought 200 shares of a $50 stock and

borrowed the maximum amount of money given an initial
margin requirement of 50 percent. If the stock price
increase to $60 per share, what will be your equity position
in the stock?
• Total stock value: $12,000

• Less amount borrowed: ($5,000)
• Equity amount: $7,000
• Equity position (%): $7,000/$12,000 = 58%
What would be your percentage return if the price reaches

$60 in the earlier example? If the maintenance margin is
25%, what is the margin call price?
• Return on your margin account:

• Stock return: ($60 − $50)/$50 = 20%
• Your return: ($12,000 − $5,000)/$5,000 = 40%
• Margin call price (P):

• Equity position: 200P − $5,000
• Percentage margin : (200P − $5,000)/200P
• At margin call: (200P − $5,000)/200P = 25%
Solving for P, P = $33.33
3.5.5 Short Sales
• The sale of stock not owed with the intent of purchasing it back later at a
lower price
• Stock is borrowed from another investor through the broker and sold in
the market
• Subsequently stock is replaced by buying shares of the stock at a price
lower than the price at which it was sold (covering the short position)
• If the lender of the shares decided to sell the shares, then the broker
must find another investor willing to lend the shares
• Technical points affecting short sales:
• Dividends
• The short seller must pay any dividends due to the investor who lent the
stock
• Margin
• Short sellers must post the same margin as an investor who had acquired
stock
• Margin can be in cash or any unrestricted securities owned by the short
seller
Margin Transactions
You believe that a stock is overpriced and decide to sell
1,000 shares short at $80. You have posted 50% margin as
required. If the stock price drops to $70 per share, what will
be the percentage margin on your account?
• The Value of Your Equity

• Sales of the stock: $8,000
• Money deposited: +$4,000
• The Value of the stock owed: −1000P
• Percentage Margin
($8,000 + $4,000 − 1000P)/1000P
= ($8,000 + $4,000 − 1000 × $70)/1000 × $70 = 71%
3.5.6 Exchange Merger Mania (slide 1 of
3)
• Why Merger Mania?
• Trend toward portfolios that are diversified
both between countries (globally) and among
asset classes
• The economics of high-technology trading
• Combination of high cost and required scale leads
to the need for mergers within a country and
across countries and asset classes so that the
exchange can afford the equipment and the staff to
attain the scale required to have a desirable and
profitable operation
3.5.6 Exchange Merger Mania (slide 2 of 3)
• Some Past Mergers

• 1990s
• Following the creation of a number of ECNs, there were mergers of these
entities into something like Archipelago (a registered stock exchange), which
then acquired PCX Holdings, an electronic trader of options
• 2006
• The NYSE acquired Archipelago Holdings Co., a public company, and
became a publicly traded entity, the NYSE Group, Inc
• Chicago Mercantile Exchange (CME) Holding went public in 2006, and
subsequently the Chicago Board of Trade (CBOT) also went public
• 2007
• NYSE Group, Inc merged with Euronext NV (the product of several mergers
of European exchanges including Lisbon and Oporto, Amsterdam, Brussels,
and the Paris stock exchanges and Liffe, a derivatives exchange)
• NASDAQ acquired the Instinet Group, an ECN, and became a public
company that acquired the Philadelphia Stock Exchange and OMX, an ECN
that became a registered exchange
• In late 2007 CME & the CBOT merged to create the largest derivatives
exchange, and were subsequently joined by the New York Mercantile
Exchange in 2008
• London Stock Exchange acquired Borsa Italiana
3.5.6 Exchange Merger Mania (slide 3 of 3)
• Present and Future

• The financial market landscape has become a
few large holding companies that own global
exchanges for stocks, bonds, and derivatives
• Continuing mergers within the major
developed markets, but also in smaller, less
developed sectors such as the Far East
• Beyond mergers within these countries,
someone will want to dominate regions such
as Europe or Asia through mergers

Organization and Functioning of Securities Markets

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Organization and Functioning of Securities Markets

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CHAPTER 3

• A market is the means through which

• Characteristics of a good market:

• Prior to 2001, common stocks in the United

• Principal distinction is between

• The primary market is where new issues

• U.S. government bond issues segments:

• New municipal bond issues are sold by:

• The Underwriting Function

• Corporate bond issues are typically sold

• Seasoned equity issues

• Introduction of Rule 415

• Secondary markets permit trading in

• Provides liquidity to the individuals who

• Secondary Markets for U.S.

• Different secondary equity markets

• New York Stock Exchange (NYSE)

• Global Stock Exchanges

• The Global 24-Hour Market

• The NASDAQ Market

• Listing Requirements for NASDAQ

• It is important to understand the different

• An order to buy or sell a stock at the best current

• A limit order specifies

• After the initial purchase, changes in the market

Assume you bought 200 shares of a $50 stock and

• Total stock value: $12,000

What would be your percentage return if the price reaches

• Return on your margin account:

• Margin call price (P):

• The Value of Your Equity

• Some Past Mergers

• Present and Future

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