Download Fabozzi_CM4_Chapter13(equitymarkets)

CHAPTER
13
Common Stock Market: I
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall.
1
Learning Objectives
• Where stocks are traded
• Categorization of markets in terms of
exchange-listed stocks (national and
regional exchanges), Nasdaq-listed overthe-counter stocks, and non-Nasdaq overthe- counter stocks
• Four types of markets where stocks are
traded: first, second, third and fourth
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Learning Objectives (continued)
• Structure of the NYSE and Nasdaq
• Alternative trading systems, ECN’s and
crossing networks
• Alternatives available to a broker for trade
execution
• Role and regulation of dealers in exchange
and OTC markets in the USA
• Reasons why issuers raise equity funds
outside their domestic stock market
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Overview of Trading
Locations in the U.S.
• There are two basic types of trading in the
secondary market for equities
• Organized exchanges (also called central
auction specialist systems) which are
specific geographic locations called
trading floors, where buyers/sellers meet
• The trading mechanism is the auction
system
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Overview of Trading
Locations in the U.S. (continued)
• over-the-counter (OTC) trading (also
called multiple market maker systems),
which results from geographically
dispersed traders or market makers
electronically linked to one another
• The trading mechanism is a negotiated
system whereby buyers negotiate with
sellers
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Overview of Trading
Locations in the U.S. (continued)
• Electronic communications networks
(ECN's) are independently owned and
operated and have recently developed as
a platform for trading common stocks
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Overview of Trading
Locations in the U.S. (continued)
• Major national stock exchanges
• New York Stock Exchange (NYSE)
(about 2000 listed companies) Big Board
• American Stock Exchange (AMEX)
(about 700 listed companies) Curb
• The major OTC market is Nasdaq (more
listed companies than NYSE but less
market capitalization)
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Overview of Trading
Locations in the U.S. (continued)
• Practical categorization of traded
stocks
• Exchange listed stocks
• Nasdaq listed OTC stocks
• Non-Nasdaq OTC stocks
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Overview of Trading
Locations in the U.S. (continued)
• Four major types of markets on which
stocks are traded
• First Market: trading which occurs on
organized, physical exchanges
• Second Market: trading in the OTC
market of stocks not listed on an
exchange
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Overview of Trading
Locations in the U.S. (continued)
• Four major types of markets on which
stocks are traded
• Third Market: trading of listed stocks in
the OTC market
• Fourth Market: institutional transactions
which occur without an intermediary or
exchange
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Stock Exchanges
• listed stocks are those that are traded on
exchanges
• The right to trade securities or make
markets on an exchange floor is granted
to individuals or firms called a member,
who buys a seat on the exchange
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Stock Exchanges (continued)
• stocks that are listed on regional
exchanges are
– stocks that could not qualify for a national
exchange
– dual listed stocks, which are listed on
both regional and national exchanges
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Stock Exchanges (continued)
• New York Stock Exchange
• NYSE is a hybrid market and uses both
continuous auction and call auction
market structure
• The majority of members are designated
commission brokers, and they execute
trades on behalf of clients via the
specialist structure
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Stock Exchanges (continued)
• Commission broker, an employee of one
of the nearly 500 securities houses
• Independent floor brokers execute
orders for other exchange members who
have more orders than they can handle
alone
• Registered traders individual members
who buy and sell for their own account
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Stock Exchanges (continued)
• A NYSE specialist is a market maker for
each stock and is required to buy and sell
those shares from other members and
maintain an orderly market for that stock
• Specialists maintain the limit order book
which contains the prearranged quantities
and prices which the specialist receives
from brokers
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Stock Exchanges (continued)
• Specialists have four major functions at
the exchange
• As a dealer, they buy and sell for their own
inventory and provide liquidity if there are no
investors on the other side of a new transaction
• They serve as agents for other exchange
members, executing orders on their behalf
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Stock Exchanges (continued)
• Specialists have four major functions at
the exchange
• Given their presence in the exchange, specialists
help to act as catalysts (brokers) by bringing
buyers and sellers together
• Finally, they serve as auctioneers, quoting
current bid and ask prices that are determined by
market conditions
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Stock Exchanges (continued)
• Specialists must always give precedence to
public orders over trading for their own
account
• . When acting as an agent, they execute
customer orders
• When acting as a principal, they assume
responsibility of maintaining a fair and
orderly market
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Stock Exchanges (continued)
• Commissions have become negotiable
• Because of the ability to negotiate
commissions the discount brokers have
become a in increasingly popular method
for executing orders in the market
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The OTC Market
• The OTC Market
• The OTC market trades unlisted stocks
• Dealers make markets in stocks and trade
with each other and with retail customers
• Bid-ask spreads are the main source of
dealer profits
• The National Association of Securities
Dealers (NASD) regulates the market
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The OTC Market (continued)
• NASDAQ Stock Market
• The Nasdaq (National Association of
Securities Dealers Automated Quotations
founded in 1971) is an ECN (electronic
communication network) which links
thousands of geographically dispersed
market-making participants and memberdealers across the country
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The OTC Market (continued)
• NASDAQ Stock Market
• The Nasdaq is divided into two tiers
• Nasdaq National Market System (NNM)
– approximately 3600 stocks traded on the
NNM
• Small Capitalization Market
– approximately 800+ stocks traded on the
Small Cap Market
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The OTC Market (continued)
• NNM dealers must
• Continuously post firm two-sided (bid
and ask) quotes for the issues that they
maintain in inventory
• Report trades on a timely basis
• Be subject to immediate execution against
their posted quotes
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The OTC Market (continued)
• NNM dealers must
• Integrate the limit orders of customers
into their quoted prices
• Give precedence to customer limit orders
and not place a quote on any system
different from their Nasdaq quote
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The OTC Market (continued)
• Other OTC Markets
• OTC Bulletin Board, owned and
operated by the NASD, is where a
majority of trades occur outside of the
Nasdaq
• Pink Sheet, a subscription service
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The Third Market
• Third market is the trading of listed
exchange stocks in the OTC market, by
dealers (not members of an exchange)
• Dealers that make markets in the third
market operate under the regulatory
jurisdiction of the NASD
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The Fourth Market:
Alternative Trading Systems
• Fourth market is the direct trading of
stocks between two customers without the
use of a broker
• This is direct trading of securities among
institutions, thereby avoiding brokerage
and dealer costs
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The Fourth Market:
Alternative Trading Systems
(continued)
• Electronic Communications Networks
• ECN’s are privately owned broker and
dealers that operate as market participants
within the Nasdaq system
– Limit order book open for continuous
trading to subscribers who may enter and
access orders displayed on the ECN
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The Fourth Market:
Alternative Trading Systems
(continued)
• The largest ECN’s
• Instinet, NYSE Euronext, Archipelago
and Nasdaq Brut
• Crossing networks are batch processes
that aggregate orders for execution at
specified times
– Provide anonymity and reduced cost, and are
designed to minimize trading costs
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Execution of an Order
• Brokers have a choice as to which market
to execute stock transactions
• Payment for order flow monetary
inducement to route orders to regional
exchanges and third market makers
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Execution of an Order
(continued)
• Alternatively the broker may
– Route the order to an ECN that
automatically matches buy and sell orders
at specified prices
– Route the order to another division of the
firm to be fulfilled from the firm’s
inventory (a process called
internalization)
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Other Types of Common
Stock Trading
• Offshore Trading
– Broker/dealers may trade exchange listed
or Nasdaq equities offshore via foreign
exchanges or trading desks
– Such transactions must be reported to the
U.S. marketplace the next day.
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Other Types of Common
Stock Trading (continued)
• Rule 144A Securities
– Allows trading of nonfungible
unregistered securities among qualified
institutional buyers (QIB) by creating a
“safe harbor” from SEC registration
requirements
– QIBs are institutions with $100 million
invested in securities
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Other Types of Common
Stock Trading (continued)
• American Depository Receipts
– (ADRs) are negotiable certificates in
registered form, issued in the United
States by a U.S. bank, which certify that a
specified number of foreign shares have
been deposited with an overseas branch of
the bank that acts as a custodian in the
country of origin.
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The Role and Regulation of Dealers
in Exchange and OTC Markets
• Background of Regulatory Issues
– To address the problems associated with
fragmentation in the 60’s and 70’s, the
Securities Act of 1975 was enacted
• Intermarket Trading System (ITS)
– electronic system that displays quotes
posted on all the exchanges where a stock
is listed and provides the intermarket
execution
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The Role and Regulation of Dealers
in Exchange and OTC Markets
(continued)
• Background of Regulatory Issues
• Consolidated Quotation System is a
display system providing data on trades of
listed stocks in different market centers
• NASDAQ Pricing Controversy
• SEC Cost Study
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The Role and Regulation of Dealers
in Exchange and OTC Markets
(continued)
• Decimalization
– In 2001, the NYSE, AMEX and
NASDAQ all used actual decimal or
"penny" quotes rather than the older
conventions such as sixteenths or eighths
• Regulation FD (Full Disclosure)
– In 2000, corporations were restricted from
providing disclosure to only select groups
of market participants
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Trading Stocks Outside the
Country Where Domiciled
• Global Depositary Receipts
– When shares are issued in other markets,
banks issue documents which represent
those securities
• American Depositary Receipts
– This is the domestic form of GDR’s
– Sponsored ADR’s
– Non-sponsored ADR’s
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Trading Stocks Outside the
Country Where Domiciled
(continued)
– Sponsored ADR’s
• A foreign corporation seeks to have its stock
traded in the United States and only one
depository bank issues the ADRs.
– Non-sponsored ADR’s
• One or more banks or brokerages can
assemble a large block of the shares of a
foreign corporation and issue ADRs without
the participation of the foreign corporations
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Summary
• Common stock represents ownership or
equity on a corporation
• Secondary trading occurs either on the
NYSE, the AMEX, five regional
exchanges and the OTC
• Listing of international shares (GDR’s,
ADR’s) reduces financing costs and
broadens ownership
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