How Securities Are Traded - PowerPoint Presentation

Slide1

How Securities Are Traded

P.V.

Viswanath

For a First Course in

INvestmentsSlide2

Learning Goals

2

Understand primary market issue methods

How do investment bankers assist in security issuance?

What are the differences between the various kinds of security markets?

What is margin trading?

What is a short sale?

What is insider trading?Slide3

Types of Markets

3

Target

audience

Public

Offering

Private Placement

Degree

of Familiarity with Security

Initial Public Offering

Seasoned Equity

Offerings

Novelty of the Security

Primary Markets

Secondary

Markets

Why do we make these kinds of distinctions? Each typology says something about the issues involved

.Slide4

Primary vs. Secondary Market Security Sales

4

Primary

New issue is created and sold

Key factor: issuer receives the proceeds from the sale

Public offerings: registered with the SEC and sale is made to the investing public

Private offerings: not registered, and sold to only a limited number of investors, with restrictions on

resale

Secondary

Existing owner sells to another party

Issuing firm doesn’t receive proceeds and is not directly involvedSlide5

Third and Fourth Markets

5

The Third Market refers to trading

by non exchange-member brokers/dealers and institutional investors of exchange-listed stocks. In other words, the third market involves exchange-listed securities that are being traded over-the-counter between brokers/dealers and large institutional investors

.

The Fourth Market refers to

trading

of exchange-listed securities between institutions on a private over-the-counter computer network, rather than over a recognized exchange such as the

NYSE

or

Nasdaq

. Trades between institutions will often be made in large blocks and without a broker, allowing the institutions to avoid brokerage fees.

Source:

Investopedia

.

There is not a big difference in practice between the third and fourth markets.Slide6

Primary vs. Secondary Security SalesSlide7

Investment Banking Arrangements

7

Underwritten vs. “Best Efforts”

Underwritten: banker makes a firm commitment on proceeds to the issuing firm

Best Efforts: banker(s) helps sell but makes no firm commitment

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with investment banker

Competitive bid: issuer structures the offering and secures bidsSlide8

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the PublicSlide9

Shelf Registrations and Private Placements

Shelf Registrations

Introduced in 1982

Governed by SEC

Rule 415

Security is preregistered and then may be offered at any time within the next two years.

any

part or all of the preregistered amount may be offered with 24 hour

notice.

Allows timing of the

issues

Private

placements

Sale

to a limited number of sophisticated investors not requiring the protection of registration

Allowed under SEC Rule 144A

Dominated by institutions

Very active market for debt securities

Not active for stock offerings

→Slide10

Initial Public Offerings

IPO Process

Issuer and Banker put on the “Road Show”

Purpose: Book Building and Pricing

Underpricing

Post

initial sale returns average about 10% or more

Easier to market the issue, but costly to the issuing

firm Slide11

Figure 3.2 Average First Day Returns for European and

Non-European IPOsSlide12

Figure 3.3 Long-term Relative Performance of Initial Public Offerings 1970-2006Slide13

Reasons for Underpricing

13

Institutional investors who take part in the book-building, on the one hand, provide demand information to issuers. On the other hand, they also take the risk of the stock underperforming.

The underpricing is seen as compensation for such risk.

Other theories are based upon the notion that there are informed and uninformed investors, and that uninformed investors would keep out of the market for fear of being subject to the winner’s curse. Underpricing is necessary to draw them into the market.

Inconsistent with both of these stories is the fact that IPOs underperform relative to other securities, as shown in Figure 3.3.Slide14

U.S. Security Markets Overview

Different securities markets in the US

Nasdaq

OTC Bulletin Board

Pink sheets

www.pinksheets.com

Organized Exchanges

New York Stock Exchange

American Stock Exchange

Regionals

Electronic Communication Networks (ECNs

)

These are private trading systems maintained separately from exchanges; these allow investors to enter anonymous orders, which can be valuable.

National Market

System

An initiative to tie all exchanges together so that quotes on one market can be availed of by an investor in another market. It also refers to centralized reporting of trades on all exchanges. However, the NMS only requires that the inside quote be made available, which is often only for a small number of shares. Hence information the depth of the market is still not available to traders in other markets.Slide15

NASDAQ

NASDAQ is the largest organized stock market for OTC trading; it is also an information system for individuals, brokers and dealers

It is a dealer market, i.e. it is a market without centralized order flow. That is, orders are not directed automatically to the best offer in the order book. Securities traded are: stocks, bonds and some derivatives.

There are two

Nasdaq

markets

:

National Market, covering over 3000 companies that have a national or international shareholder base, meet stringent financial requirements and agree to specific corporate governance standards

Nasdaq

SmallCap

Market for lower cap firms and looser listing requirements.

There are several levels of subscribers to

Nasdaq

quotation system

Level 1: inside quotes

Level 2: receives all quotes but they can’t enter quotes

Level 3: dealers can see and post quotes

SuperMontage

is a centralized

limit order book for

Nasdaq

securities that allows automatic trade execution. Slide16

Table 3.1 Partial Requirements for Listing on NASDAQ MarketsSlide17

Organized Exchanges

Auction markets are markets with centralized order flow

Dealership function: can be competitive or assigned by the exchange (Specialists

)

Securities: stock, futures contracts, options, and to a

lesser

extent bonds

Examples:

NYSE

, ASE, Regionals, CBOE,

CMESlide18

Players in Organized Exchanges

Members of the exchange:

Purchase a seat on the exchange,

obtain

the right to trade and a say in the governance of the exchange

.

Commission broker:

Employee of a member firm, processes orders for the firm, earns a commission

.

Floor broker:

Independent broker who works for various member firms as needed

.

Floor trader:

Independent trader who buys and sells securities for his/her own account. Often called speculator or arbitrageur

.

Specialist:

Exchange appointed firm in charge of running the market for a given stock(s).

Acts as both a broker and a dealer charged with matching buy and sell orders from customers and/or filling customer's orders by adding to or selling their own inventory of stock.

When an

investor places a market order with his broker, the broker electronically submits the order to the floor of the NYSE. The commission broker takes the order; he may send it to a floor broker or to the specialist.Slide19

Electronic Trading on the NYSE

SuperDot

Electronic order routing system allows brokers to electronically send orders directly to specialist.

Useful for program trading

0

DirectPlus

Fully automated trade execution system

Execution time < ½ second

Electronic order placement is growing,

but large

orders still require human intervention.Slide20

Electronic Computer Networks (ECNs)

ECNs allow institutional investors to post quotes and trade directly with each other. (4

th

Market)

Public limit order book

Automatic execution

Advantages include

Lower transactions costs (usually < 1¢ per share)

Speed even on large trade sizes

Anonymity

ECNsSlide21

Market Consolidation Trends

NYSE:

Merged with Archipelago ECN in 2006

Merged with Euronext in 2007

Acquired the ASE in 2008

Entering Indian and Japanese stock markets

NASDAQ

Acquired Instinet/Island in 2005

Acquired Boston Stock Exchange in 2007

Jointly acquired Swedish exchange

OMX

Euronext

Formed from merger of Paris, Brussels, Lisbon and Amsterdam exchanges

Acquired the

Liffe

in London

Merged with NYSE in 2007

CME acquired CBOT in

2007Slide22

Types of Markets: Nature of Trading

22

Direct

Search

Markets

Example: Craig’s List.

Brokered Markets

Example: Real estate market

Dealer

Markets

Quote-Driven

Markets

Auction

Markets

Order-Driven

Markets

Dealer and Auction markets are the most common kind of securities markets.Slide23

Auction Markets

23

An auction market is a market where buyers and sellers directly interact. The NYSE is an example of such a market.

The NYSE specialist is charged with

maintaining a

“continuous

, orderly market

.”

He has four roles:

Auctioneer: to ensure that bids and offers are posted accurately and in a timely manner.

Agent: to accept limit orders from investors and ensure that the order is appropriately filled.

Catalyst: to make sure that price changes are not huge. If there is a demand-supply imbalance, the specialist may bring in other active traders.

Principal: s/he may also do this by trading on his/her own behalf. In this role, s/he

Must at times trade against the market

Can

petition exchange to halt

trading

Incur inventory costs/risks of holding stock

Monitor and limit the bid/ask spread

http://www.investopedia.com/ask/answers/128.asp#axzz26I4Ifo00Slide24

Dealer Markets

24

A dealer market is one where dealers stand ready to buy and sell. All transactions are routed through them. The NASDAQ is an example of a dealer market

.

The most important player in the NASDAQ is the broker-dealer.

They are large investment companies that buy and sell securities through an electronic network. These market makers maintain inventories and buy

and sell stocks

from their inventories to individual customers and other dealers

.

Each

market maker on the

Nasdaq

is required to give a two-sided quote, meaning they must state a firm bid price and a firm ask price that they are willing to honor

.

A market-maker on the NASDAQ does not have the same legal obligation as a NYSE specialist to ensure smooth trading. However, this is effectively his/her function.

The difference between the NASDAQ and the NYSE has reduced quite a bit in recent years, especially after the automation of both exchanges.

http://www.investopedia.com/ask/answers/128.asp#axzz26I4Ifo00Slide25

Types of Orders

25

Market

Orders

Price-Contingent Orders

http://webpage.pace.edu/pviswanath/notes/investments/securities_trading.html Slide26

Trading Costs

26

Broker

Commissions

Bid-Ask Spread (Implicit cost)

Liquidity Cost

Quality of Execution (if there’s a wait, then a worse price may be

obtained;

ie

. the Effective

Bid-Ask

Spread may be greater than the quoted bid-ask spread)

Margin CostSlide27

The Bid-Ask Spread

27

The bid price is the price that a trader is willing to pay for a security; the ask price is the price at which he is willing to sell a security. The difference is called the bid-ask spread.

A market order is one that can be executed at the market price, while a limit order either specifies a specific bid price (buy order) or a specific ask price (sell order). Hence as long as there is any limit buy (sell) order, a market sell (buy) order is sure of being executed. Hence a market order takes advantage of liquidity, while a limit order offers liquidity.

The

bid-ask spread is the price that impatient traders pay for immediacy. The spread is the compensation that dealers and limit order traders receive for offering immediacy.

Traders

consider the spread when deciding whether to submit limit orders or market orders. When the spread is wide, immediacy is expensive, market order executions are costly, and limit order submission strategies are attractive.

The

spread is also the most important factor that dealers consider when deciding whether or not to offer liquidity in a market. If the spread is too narrow, dealing may not be profitable

.Slide28

Components of the Bid-Ask Spread

28

Transaction cost spread component – that part of the bid/ask spread that compensates dealers for their normal costs of doing business. These include financing costs for their inventories, wages for staff, exchange membership dues, expenditures for telecommunications, research, trading system development, clearing and settlement, accounting, office space, utilities, etc.

The adverse selection spread component is the part of the bid/ask spread that compensates dealers for the losses they suffer when trading with well-informed traders. This component allows dealers to earn from uninformed traders what they lose to informed traders

.Slide29

A model of the bid-ask spread

29

The dealer first uses all information currently available to her to estimate the asset value. This estimate V

0

is the basis for her bid and ask quotes.

Using this basis, she estimates the asset value, assuming that the next trader is a buyer (V

0B

) or a seller (V

0S

).

For example, if

the next trader is a buyer, then the chances are

(e.g. if

the buyer is

informed),

that the true value V

0

is

higher. Taking the probability of an informed buyer, the dealer comes up with V

0B

.

And similarly for

V0S .She obtains her ask price by adding half of the transaction cost spread component to her value estimate for a buyer. She likewise obtains her bid price by subtracting half of the transaction cost spread

component from her value estimate for a seller.Slide30

A model of the bid-ask spread

30Slide31

Model of the Bid-Ask Spread

31

When the next trader arrives, the dealer learns whether she wants to buy or sell. If the dealer learns nothing more about the trader or about values, other than that the new trader is a buyer or a seller, then the dealer’s new unconditional value estimate will be the appropriate previous conditional value estimate. The bid and the ask will both rise by half of the adverse selection component

.Slide32

Bid-Ask Spread in Order Driven Markets

32

The bid-ask spread will be non-zero even in pure order driven markets, even if there are no considerations of information asymmetry.

Trading costs/commissions are likely to be higher for limit traders than for market traders because they are more demanding of the exchange’s and the broker’s resources. Suppose commissions for limit orders are

l

per round trip and

m

for market orders.

Then since limit traders make the bid-ask spread and market traders pay it, and considering that any trader can either put in a limit or market order and so, in equilibrium, would be indifferent between the two, it must be the case that the net costs for the two types of trades are equal.

Hence l-s =

s+m

, or s = (l-m)/2

That is, the

bid-ask spread (i.e. the difference between the highest limit buy price and the lowest limit sell price – the price at which limit traders are willing to sell) will be non-zero.Slide33

Bid-Ask Spread

33

As we discussed above, limit orders are not guaranteed to execute.

Also, they provide liquidity and can be picked off by better informed traders, as discussed above.

Hence the bid-ask spread

spread

will be greater,

the greater the spread between limit order commissions and market order commissions,

the greater the cost of canceling and resubmitting limit orders

the more volatile underlying true asset values are (the greater the volatility of true values, the greater the value of the timing option granted by limit traders)

the greater the information asymmetry.Slide34

Fragmentation and Internalization

34

The setup:

A

stock you like is offered on your screen for $20.25. You don't want to pay that, so you give your discount broker an order to buy 500 shares at $20.125. Your bid pops up on the screen: It's now the highest in the market, and you figure it's only a matter of time before you get your stock.

Free Riding:

Then

you see 500 shares trade at $20.125. Then another block at that price. And another. Still you don't get any stock.

Other

dealers simply use that investor's bid or offer as a reference price at which they will execute their own customers' orders.

Stepping ahead:

Then

your own broker buys 200 shares from another investor by paying $20.1875, a smidgen above your bid.

The stock rallies, and your broker unloads the shares he just bought. Frustrated, you cancel your first order and enter another with no preset limit. Five seconds later, your broker confirms you bought 500 shares at $20.375. You paid $125 more than you expected, but at least you paid just $10 in commission

.

How Any Market Revamping Might Remove, Add

Wrinkles, WSJ, Feb

. 29, 2000Slide35

Fragmentation and Internalization

35

Internalization: The practice of executing orders internally using the public best bid or offer as the benchmark is called "internalization" and is how all

Nasdaq

dealers have traditionally treated their own customers' orders.

Paying

for order flow:

A huge share of

Nasdaq's

volume comes from customers of online brokers, who direct orders in particular stocks exclusively to wholesaler dealers such as Knight/

Trimark

Group Inc. and Charles Schwab Corp.'s capital-markets unit. Wholesalers usually pay for other brokers' order flow because of the opportunity to trade profitably.

The ability for brokers to sell order flow allows them to offer lower commissions.

Some of these problems are because there are several markets. Bids/offers in one market need not be referenced in other markets. A bid to buy on one market can be used as a basis for a dealer to sell that stock at that same price in another market. If those two markets were combined, then the first bid would have to be executed first!

Fragmentation is a

discentive

to compete

. Investors willing to post the best bids or offers aren't necessarily those whose orders get executed

.

Potential Solution for some of these problems: Central Order Book

Question: Which of the problems above won’t be solved by centralization?Slide36

Buying on Margin

36

http://webpage.pace.edu/pviswanath/notes/investments/shortsal.html#buyingmarginSlide37

Short Sales

37

http://webpage.pace.edu/pviswanath/notes/investments/shortsal.html#shortSlide38

Regulation

38

Securities

Act of 1933

Securities Exchange Act of 1934 – establishes the SEC

Commodity Futures Trading Commission

Securities Investor Protection Act of 1970

FINRA (Financial Industry Regulatory Authority) – non-governmental self-regulation body

Sarbanes-Oxley Act

Insider Trading regulations – recent investigations of the SECSlide39

Recent Issues in exchange listings

39

http://dealbook.nytimes.com/2011/09/08/canada-extends-trading-ban-on-sino-forest/

(A Chinese company that acquired listing on the TSE through a reverse-merger with a defunct listed company)

http://dealbook.nytimes.com/2012/02/02/losing-the-goose-that-laid-the-golden-egg/

(Trading of unlisted private companies on private exchanges.)