Chapter Three

How Securities
are Traded
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 Chapter Overview
• Broad introduction to the many venues and
procedures available for trading securities in
the U.S. and international markets
• Trading securities
• Mechanics of trade execution
• Essentials of some specific types of transactions
• E.g., buying on margin and short-selling

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 How Firms Issue Securities
• Firms requiring new capital can raise funds by
borrowing money or selling shares in the firm
• Primary market is the market in which new issues of
securities are offered to the public
• Secondary market involves already existing securities
being bought and sold on the exchanges or in the OTC
market
• Shares of publicly listed firms trade continually in
markets such as the NYSE or NASDAQ, but the shares
of private corporations are held by small numbers of
managers and investors
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 How Firms Issue Securities
Privately Held Firms

• Owned by a relatively small number of

shareholders
• Fewer obligations to release information to
the public
• Jumpstart Our Business Startups (JOBS) of
2012 allows up to 2,000 shareholders
• Raise funds through private placement

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 How Firms Issue Securities
Publicly Traded Companies

• Initial public offering, or IPO

• A firm’s first issue of shares to the public
• Seasoned equity offering
• The sale of additional shares in firms that already
are publicly traded
• Public offerings of both stocks and bonds
typically are marketed by underwriters
• Advises the firm regarding the terms on which it
should attempt to sell the securities
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Relationships Among a Firm Issuing Securities,
the Underwriters, and the Public

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 How Firms Issue Securities
Shelf Registration

• Shelf registration
• Rule 415 was introduced in 1982
• Allows firms to register securities and gradually sell
them to the public for three years following the initial
registration
• Shares can be sold on short notice and in small
amounts without incurring high floatation costs

• These securities are referred to as “on the shelf”

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 How Firms Issue Securities
Initial Public Offerings

• Initial public offerings

• Road shows to publicize new offering
• Bookbuilding to determine demand
• Degree of investor interest provides valuable pricing
information
• Shares of IPOs are allocated across investors in part
based on the strength of each investor’s expressed
interest

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 How Firms Issue Securities
Initial Public Offerings (Continued)

• Underwriter bears price risk

• IPOs are commonly underpriced compared
to the price they could be marketed
• Example: Dropbox
• Some IPOs are overpriced
• Example: Facebook
• Others cannot be fully sold

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 Types of Markets
• Direct search market
• Least organized
• Buyers and sellers seek each other out directly
• Brokered markets
• Brokers offer search services to buyers and sellers
• Dealer markets
• Traders specializing in particular assets buy and sell
assets for their own accounts
• Auction markets
• All traders in an asset meet (physically or
electronically) at one place to buy and sell
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 Bid and Ask Prices

Bid Price Ask Price

• Bids are offers to buy • Ask prices are sell offers
• In dealer markets, the bid • In dealer markets, the ask
price is the price at which price is the price at which
the dealer is willing to buy the dealer is willing to sell
• Investors “sell to the bid” • Investors must pay the ask
price to buy the security

Bid-asked spread is the difference between a dealer’s bid and ask price

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 Types of Orders

• Market orders
• Buy or sell orders that are to be executed
immediately
• Trader receives current market price
• Price-contingent orders
• Traders specify buying or selling price
• Limit buy (sell) order instructs the broker to buy
(sell) shares if and when those shares are at or
below (above) a specified price
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Price-Contingent Order:
Example

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 Trading Mechanisms
• Dealer markets
• Over-the-counter (OTC) market is an informal network of
brokers and dealers where securities can be traded (not a
formal exchange)
• Electronic communication networks (ECNs)
• Computer-operated trading network
• Register with the SEC as broker-dealers
• Specialist/DMM markets
• Designated market maker (DMM) accepts the obligation
to commit its own capital to provide quotes and help
maintain a “fair and orderly market”
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 The Rise of Electronic Trading
(1 of 2)

• 1975: Elimination of fixed commissions on the

NYSE
• 1994: New order-handling rules on NASDAQ,
leading to narrower bid-ask spreads
• 1997: Reduction of minimum tick size from
one-eighth to one-sixteenth
• 2000s: In the US, the share of electronic
trading rose from 16% to 80% in 2000s

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 The Rise of Electronic Trading
(2 of 2)

• 2000: Emergence of NASDAQ Stock Market

• 2001: Decimalization allowed the tick size to
fall to 1 cent
• 2005: SEC adopted Regulation NMS
• 2006: NYSE acquired electronic Archipelago
Exchange and renamed it NYSE Arca
• 2007: NMS fully implemented

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The Effective Spread Fell Dramatically
as the Minimum Tick Size Fell

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 U.S. Markets:
NASDAQ
• NASDAQ
• Lists about 3,000 firms
• NASDAQ’s Market Center consolidates NASDAQ’s
previous electronic markets into one integrated
system
• Three levels of subscribers

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 U.S. Markets:
NYSE
• Largest U.S. stock exchange, as measure by
market value of listed stocks
• Automatic electronic trading runs side-by-side
with broker/specialist system
• 1976 (and later) – DOT and SuperDot
• 2000 - Direct+
• 2006 – NYSE Hybrid
• Allowed NYSE to qualify as a fast market for the
purposes of Regulation NMS, but still offered
advantages of human interaction for complex trades
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 U.S. Markets:
ECNs
• Electronic communication networks (ECNs)
are computer-operated trading network for
trading securities
• Some registered as formal stock exchanges, while
others are considered part of the OTC market
• Compete in terms of the speed they can offer
• Latency refers to the time it takes to accept,
process, and deliver a trading order
• Example: CBOE Global Markets advertises average
latency times of around 100 microseconds

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 New Trading Strategies
(1 of 2)

• Algorithmic trading is the use of computer

programs to make trading decisions
• High-frequency trading is a subset of
algorithmic trading that relies on computer
programs to make extremely rapid decisions
• Dark pools are private trading systems in
which participants can buy or sell large blocks
of securities without showing their hand

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 New Trading Strategies
(2 of 2)

• Bond trading
• Vast majority of bond trading takes place in the
OTC market among bond dealers
• Market for many bond issues is “thin” and is
subject to liquidity risk
• One impediment to heavy electronic trading is
lack of standardization in the bond market
• A single company may have dozens of outstanding
bond issues, differing by coupon, maturity and seniority

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 Globalization of Stock Markets
• Pressure in recent years to make international
alliances or merges
• Much of the pressure is due to the impact of
electronic trading
• Wave of mergers has lead to a few giant
security exchanges
• ICE, NASDAQ, the LSE, Deutsche Boerse, the CME
Group, TSE, and HKEX

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Biggest Stock Markets in the World

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 Trading Costs
• Explicit cost - brokerage commissions
• Full-service versus discount brokers
• Execute orders, hold securities for safe-keeping, extend
margin loans, facilitate short sales, and provide
information and advice about investment alternatives
• Implicit costs
• Dealer’s bid-ask spread
• Price concession an investor may be forced to make for
trading in quantities greater than those associated with
the posted bid or ask price

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 Buying on Margin
(1 of 2)

• Investors have easy access to a source of debt

financing called broker’s call loans
• Buying on margin means the investor borrows
part of the purchase price of the stock
• Margin in the account is the portion of the
purchase price contributed by the investor;
remainder is borrowed from the broker
• Board of Governors of the Federal Reserve
System limits the use of margin loans
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 Buying on Margin
(2 of 2)

• Current initial margin requirement is 50%

• Maintenance margin
• Minimum equity that must be kept in the margin
account

• Margin call is made if value of securities falls

below maintenance level

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 Short Sales
• Short sales allows investors to profit from a
decline in a security’s price
• Mechanics
1. Investor borrows stock from a broker and sells it
2. Must then purchase a share of the same stock in
order to replace the one that was borrowed
• Referred to as covering the short position
• Proceeds from a short sale must be kept on
account with the broker, per exchange rules
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Short Sale Mechanics

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 Regulation of Securities Markets
(1 of 2)

• Major governing legislation

• Securities Act of 1933
• Securities Exchange Act of 1934
• Securities Investor Protection Act of 1970
• Blue sky laws

• Self-Regulation
• Financial Industry Regulatory Authority (FINRA)
• CFA Institute
• Standards of professional conduct
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 Regulation of Securities Markets
(2 of 2)

• Sarbanes-Oxley Act
• 2000-2002 scandals centered on three broad practices
• Allocations of shares in IPOs
• Tainted securities research and recommendations
• Misleading financial statements and accounting practices
• Key provisions
• Public Company Accounting Oversight Board
• Independent financial experts to serve on audit committees of a
firm’s board of directors
• CEOs and CFOs personally certify firms’ financial reports
• Auditors may no longer provide several other services to clients
• Boards must have independent directors
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 Insider Trading
• Regulations prohibit trading on inside information
• SEC requires officers, directors, and major
stockholders to report all transactions in their
firm’s stock
• Insiders do exploit their knowledge
• Well-publicized convictions of principals in insider
trading schemes
• Considerable evidence of “leakage”
• Documented abnormal returns on trades by insiders
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