Chapter 3The Trading Industry

Terminology

Agency vs. proprietary traders (trading)• Brokers are agency traders

Long vs. short positions• Short covering

Buy vs. sell side• Liquidity demanders vs. liquidity providers

People and institutions who use market services are on the buy-side.

Those who provide market services are on the sell-side.

These sides have nothing to do with whether you

are a buyer or seller of a specific security.

Buy-side players - Investors Individuals Corporate pension fund

sponsors Charitable trusts Legal trusts Endowments

=> Stocks and bonds

Investment managers

Corporate investment funds

Governmental funds

Buy-side players – Borrowers and Hedgers Homeowners Students Corporations

=> Mortgages, Bonds, Notes

Farmers Manufacturers Miners Shippers Financial Institutions

=> Forwards, Futures, Swaps, and Options

Sell-side players Dealers trade for their own accounts.

• Day traders• Market makers• Floor traders

Brokers trade for other people’s accounts. • Retail and institutional• Full-service and discount

Broker-dealers do both.• Specialists• Wire houses

Sell-side trade facilitators Exchanges provide systems that help

traders arrange their trades.

Clearing houses help settle trades and guarantee that traders will perform.

Depositories and custodians hold securities.

A typical set of relationships A sponsor owns funds. An investment manager makes portfolio

decisions. A broker implements trades. A dealer supplies liquidity. A clearing house guarantees trades. A depository holds the security. Consultants advise everyone.

Primary vs. secondary security sales Primary

• New issue• Key factor: issuer receives the proceeds from

the sale. Secondary

• Existing owner sells to another party.• Issuing firm doesn’t receive proceeds and is

not directly involved.

Primary markets: Public offerings

Public offerings: registered with the SEC and sale is made to the investing public.• Shelf registration (Rule 415, since 1982)

Initial Public Offerings (IPOs)• Evidence of underpricing• Performance

US primary listing market New York Stock Exchange (N) American Stock Exchange (A) NASDAQ (Q) Over-the-Counter (OTC)

• Nasdaq small cap (S)• OTCBB (U)• Pink Sheets

Primary markets: Private placements

Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration.

Dominated by institutions. Very active market for debt securities. Not active for stock offerings.

Organization of secondary markets

Organized exchanges OTC market Third market Fourth market

Organized Exchanges Auction 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, AMEX, Regionals,

CBOE.

NYSE The NYSE is a hybrid market. It has:

• floor traders (like a futures pit)• an electronic limit order book (like Euronext)• a designated dealer (the specialist) to maintain

liquidity and otherwise coordinate trading.

This mix is the outcome of political, technological and economic forces over the last 200 years.

NYSE NYSE’s MarkeTrac: http://marketrac.nyse.com/mt/

NYSE The NYSE was first a floor market (loosely

resembling the futures pits). Many of the trading rules reflect the “floor”

aspect of the market. The NYSE next evolved strong central

dealers (late 1800’s). The specialist, in the sense of a trader who

specializes in a particular stock.

NYSE Beginning in the 1980’s, electronic order

entry has come to play an increasing role. The exchange has always permitted limit orders, but the book has become more important over time.

The basic reading for this material is the NYSE Floor Official Manual, abbreviated FOM.

What does the NYSE do? Trading and trading services. The NYSE charges (directly and indirectly)

for trades that occur and for software supplied to its members.

Listing To be listed on the NYSE, a corporation

must meet/maintain certain financial standards and pay listing fees.

http://www.nasdaq.com/about/appa.pdf

US regional exchanges

Pacific Exchange / Archipelago (P) Chicago (formerly Midwestern)

Stock Exchange (M) Boston Stock Exchange (B) Philadelphia Stock Exchange (X) Cincinnati Stock Exchange (C)

Third markets

Trading of listed securities away from the exchange.

Institutional market: to facilitate trades of larger blocks of securities.

Involves services of dealers and brokers

Fourth Market

Trading in exchange-listed stocks within Alternative Trading Systems (ATS), such as ECNs (Instinet, Island, Archipelago)

Institutions trading directly with institutions

No middleman involved in the transaction

Major international stock markets Europe

• London Stock Exchange (LSE)• EuroNext (Paris/Netherlands/Belgium)• Deutsche Borse (DB)• Milan Stock Exchange• Swiss Stock Exchange

Stockholm/Copenhagen/Helsinki/Oslo (OM)

Toronto Stock Exchange (TSX)

Asia

• Tokyo Stock Exchange (TSE)• Taiwan Stock Exchange• Korean Stock Exchange (KSE)• Australian Stock Exchange (ASX)• Hong Kong Stock Exchange

International market structures London Stock Exchange

• Dealer market similar to NASDAQ• Stock Exchange Automated Quotation • Greater Anonymity

Tokyo Stock Exchange• No market making service• Sartori provides bookkeeping service• Feature a floor and electronic trading

KSE

http://www.kse.or.kr/

The regulators

Securities and Exchange Commission (SEC)• Securities markets, equity options markets,

and cash-settled equity index options markets

Commodity Futures Trading Commission (CFTC)• Commodity spot, forward, and futures markets