Chapter 4

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 4
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 4
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 4
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?
Bringsbuyers 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
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
◦ Origination
◦ Risk-bearing
◦ Distribution
 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 
Firms sells to a small group
of institutional investors
without extensive registration
Lower issuing costs than
public offering
 Why Secondary Financial
Markets Are Important
Provides liquidity to investors who
acquire securities in the primary
market
Results in lower required returns
than if issuers had to compensate
for lower liquidity
Helps determine market pricing
for new issues
 Secondary Bond Market
Secondarymarket 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
Establishedin 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
Globaltwenty-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 Time EST
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
Directtrading 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
Interestrate 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
Specialistis 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
In1970 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
Listquotes 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