The Securities Industry

Chapter 3

The Securities Industry

Contents

PageStructure of the Securities Industry . . . . . . . . . . . . . . . . . . . . ... , . . . . . . . . 51

The Development of the Securities Industry in the United States . . . . . . 51Organizations Composing the Securities Industry . . . . . . . . . . . . . . . . . . . 52Industry Users.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57The Regulatory Structure of the Securities Industry . . . . . . . . . . . . . . . . . 59Characteristics of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . 62New Entrants to the Securities Industry. . . . . . . . . . . . . . . . . . . . . . . . . . . 63The Securities Industry and the International Market . . . . . . . . . . . . . . . 64The Effects of Information Technology on the Structure of the

Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

The Functions of the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64The Securities Industry as an Advisor.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 65Acceptance of Risk by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . 67Marketing by the Securities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69Technology and the Functions of the Securities Industry . . . . . . . . . . . . 75

The Effects of Information Technology insecurities Instruments . . . . . . . 75

Appendix 3A: Securities Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76Corporate Capital Structure: Debt and Equity Issues . . . . . . . . . . . . . . . . 76Short-Term Debt–Money Market Securities.. . . . . . . . . . . . . . . . . . . . . . . 83Options and Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

Appendix 3B: Capital Formation and the Functions of theSecurities Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Private Sources of Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Venture Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92Public Offerings of Securities of a Corporation . . . . . . . . . . . . . . . . . . . . . . 93

Tables

Table No. Page2. Contracts Traded-Futures Exchanges: A Comparison of

1983 and 1982 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563A-1. Meet Active Venture Capitalists, 1982 . . . . . . . . . . . . . . . . . . . . . . . . . 93

Figures

Figure No. Page3. Average Daily Share Volume New York Stock Exchange

1963 to 1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544. Volume of Futures Trading, 1958-83 (millions of contracts traded) . . . . . 585. Overview of SIAC Facility Management for NSCC Services . . . . . . . . . . 74

Chapter 3

The Securities Industry

The securities industry in the United States,which developed to help young American busi-ness gain financing from European investors,continues to bring together those who needcapital and those wishing to invest. The indus-try directs its concentrated expertise on finan-cial markets toward its intermediary role offacilitating the development of capital. It pro-vides advice, accepts risk, and offers market-ing services to ensure that an orderly marketfor the issuing and trading of securities* ismaintained.

XFO~ PUW{)=S of this study, securities include debt and equityissues used to develop capital (stocks and bonds, money-marketsecurities, and instruments which have been developed to allowhedging and speculation in securities and commoditymarket s—i. e., options and futures contracts). These instru-ments, as well as investment tools which developed from thepackaging of securities instruments, such as mutual funds andcentral asset accounts, are described in app. 3A.

Since the introduction of the telegraph 140years ago, communications technologies havebeen used by the industry to convey informa-tion on which the operations of securities in-dustry depend. However, while the securitiesindustry has always applied state-of-the-arttechnology to its operations, the level of tech-nology used today and likely to be availabletomorrow is beyond what could have beendreamed of when the telegraph was applied in1844.

In this chapter, the structure, functions, andinstruments of the securities industry are de-scribed. The impact that the application ofcomputer and communications technologieshas had in these areas is reviewedble future effects are discussed.

Structure of the Securities Industry

The structure of the securities industry hasbeen shaped by the demands of users, nationalpolicy objectives regarding the financial serv-ice industry, practical operational concerns,and competitive market forces. In this section,a brief overview of the development of the cur-rent structure of the securities industry anda description of the organizations and compet-itive forces comprising the industry will beprovided. Present and future effects of infor-mation technology on the structure of the in-dustry will be discussed.

The Development of the SecuritiesIndustry in the United States

The securities industry in the United Statesdeveloped to meet the capital demands of thenew Nation. One side effect of the independ-ence won in the Revolutionary War was wardebt. This was funded by the issuance of in-terest-paying bonds, for which a secondary

market shortly developed.1 At the

and possi-

same timethe need to finance development in the newNation was recognized. The burgeoning secu-rities industry provided a vital link to Euro-pean capital markets and also a means oftransferring capital within the United States.The basic role filled by the securities indus-try in the late 1700’s is still a driving forcebehind its operations today: to provide a meansof interaction for those seeking capital andthose wishing to invest.

Two factors which quickly emerged as essen-tial to the operation of the securities industrywere the maintenance of an orderly marketand the availability of trading information.Twenty-four brokers, conducting trading undera buttonwood tree, subscribed to a brokers’agreement that formed the first stock market

IMarketpIace-A Brief History of the New York Stock Ex-change (New York: New York Stock Exchange, Inc., 1982).

51

52 ● Effects of Information Technology on Financial Services Systems—

in New York on May 17, 1792.2 This marketbecame the New York Stock Exchange. Inwhat is now known as the “ButtonwoodAgreement, ” the brokers focused on workingtogether to assure they would be able to tradesecurities smoothly and fairly.

Information on trading and prices has al-ways been essential to trading decisions. Se-curities firms and exchanges clustered (as onWall Street) to facilitate the communicationsneeded for the operation of the market. Anewspaper first published stock prices in 1815.Prior to the introduction of the industry’s firsttechnology-based information system, theelectric stock ticker (in 1867), messengersliterally ran from the trading floor to brokers’offices with information.

Early refinement and expansion of securitiestrading can be related to three communica-tions technologies: the telegraph, the trans-atlantic cable, and the telephone.3 These tech-nologies improved information flows on whichthe markets are dependent. The telegraphlinked exchanges, brokers, and investorsthroughout the country and made decision-making on investments by someone not onWall Street practical for the first time. Thistechnology offered the first hope of a national,noncentralized market. The transatlanticcable, completed in 1866, made an interna-tional market feasible at a time when Ameri-can industry was still very much dependenton financing from European investors. Tele-phones were first used to convey orders frombrokers to the floor of the New York Stock Ex-change in 1878, 2 years after the first suc-cessful test of that technology.

The adoption of these communications tech-nologies and the stock ticker were based onthe recognition that the faster and more ac-curately information flows, the better securi-ties markets function. The introduction of newtechnologies today is largely based on thisassumption.

Organizations Composing theSecurities Industry

Three types of organizations traditionallycompose the securities industry: investmentbanks perform the services surrounding a pub-lic offering of the stocks and bonds of a cor-poration; brokers manage the buying and sell-ing of securities; and exchanges provide avehicle for setting prices and actually conduct-ing transactions.

Investment Banks

The activities of investment banks are cen-tered on the development of capital. The Bank-ing Act of 1933, commonly called “Glass-Stea-gall, ” required that investment banking beseparated from commercial banking becauseof the sometimes incongruent objectives andthe different levels of risk associated withthese kinds of organizations. Investmentbanks fall into two categories: originatingfirms and distribution firms. Originating firmsdeveloped largely as intermediaries betweenEuropean financiers and young American in-dustry, and they remain major players in thedevelopment of securities offerings. Distribu-tion firms come together in syndication, underthe guidance of an originating firm, to guar-antee and sell the securities of an issuer.4

The four leading investment banks in bothdomestic and foreign financing are SalomonBrothers, Inc.; Morgan Stanley Inc.; FirstBoston Inc.; and Goldman Sachs & Co. Mer-rill Lynch, Pierce, Fenner, & Smith Inc. (Mer-rill Lynch) and Paine, Webber, Jackson, &Curtis (Paine Webber) have a significant shareof the domestic market. Three levels of pur-chasers and sellers are reached through invest-ment bank activities: first, the issuers of secu-rities, those corporations and governmentsthat purchase investment bank services; sec-ond, the investors in new issues; and third, theintermediaries who bring these two partiestogether—other investment bankers, distri-

‘New York Stock Exchange 1983 Fact Book (New York: NewYork Stock Exchange, June 1983), p. 66.

‘Marketplace-A Bn”ef History of the New York Stock Ex-change, op. cit.

4Sarnuel L. Hayes III, “The Transformation of InvestmentBanking, ” Harvard Busines 12ew”ew, January-February 1979,pp. 153-170.

—

Ch. 3—The Securities Industry ● 5 3

buting underwriters, and commercial banks.Investment banks assume the risk of a pub-lic offering of investments by guaranteeingtheir purchase—i.e., underwriting them.

The nature of competition within invest-ment banking is changing. Price competitionis cutting fees for underwriting to new lows.In addition, simplification of securities regis-tration requirements could make underwritersunnecessary. Nevertheless, the need to trans-fer risk continues to provide a strong incen-tive for utilizing the services of investmentbanks.

Brokerage Houses

Full-service brokerage houses perform tradesin securities and commodities and provide fi-nancial counseling services supported by in-depth research and analysis of markets andindustries. This segment of the industry isdominated by firms which are subsidiaries ofcompanies that offer a range of financial man-agement services. Six national brokeragehouses lead the industry. They are: MerrillLynch; E. F. Hutton & Co.; Shearson/Ameri-can Express; Prudential Bache; Dean WitterReynolds; and Paine Webber. There are alsomany regional firms, such as Alex Brown &Sons, which play major roles in trading eithernationwide or regionally.

This portion of the industry has been af-fected by the abolition of fixed commissionrates in 1975. While brokerage houses in thepast competed on the reputation of their re-search and the quality of their service, pricecompetition has also become a factor. Dis-counters, who concentrate on the transactionside of the business, have entered the marketand have attracted a significant portion ofboth institutional and individual trading. Inresponse to this market entrance, many full-service brokerage houses are taking steps todistinguish their services and to increase cli-ent loyalty. Increased efforts are being di-rected toward product development and pro-motion.

Exchanges

The fundamental role of all exchanges in thesecurities industry is to provide an orderlymarketplace for trading. Exchanges providea central location and a structure in whichbuyers and sellers can conduct trades. Ex-changes are operated on a membership basis.“Seats,” memberships that carry the right totrade on an exchange, are purchased by firmsor individuals desiring access to its market.Members agree to direct all trades on listedsecurities through the exchange floor. Thisallows the exchanges to manage the marketsbetter–for example, to halt trading on a se-curity, if necessary, with the assurance thatmember firms will not trade off-market.Stocks and bonds, options, and futures con-tracts are usually traded on separate ex-changes. This specialization is a carry-overfrom the separate formation of capital andcommodity markets.

Stock Exchanges.– Stock exchanges are in-dependent players in the securities industryand have two functions: performing transac-tions and accepting risk. Stock exchanges actas a secondary securities market for both debtand equity issues, providing flexibility andchoice for investors. Potential investors in newissues can evaluate the desirability of the in-strument in light of their ability to sell it, andtherefore may recognize a lower opportunitycost. The existence of secondary markets alsoincreases the available investment choicessince securities other than new issues are madeavailable.

There are seven major stock exchanges:New York, American, Boston, Cincinnati, Mid-west, Pacific, and Philadelphia. In 1982, 80.8percent of the total share volume of registeredexchanges was traded on the New York StockExchange (NYSE). The National Associationof Securities Dealers, Inc. (NASD) operates aquotation system and clearing facility for theover-the-counter market. The automated quo-tation system, NASDAQ,5 has been responsi-

5National Association of %curities Dealers Automatic Quota-tion System.

54 • Effects of Information Technology on Financial Services Systems

Figure 3.—Average Daily Share VolumeNew York Stock Exchange 1963 to 1983

85,334 85,000

[ 1 ! !

82500

80,000

7 7 5 0 0

75,00072,50070,000

SOURCE Futures Industry Assoclatlon, Inc

ble for a dramatic increase in trading volumein over-the-counter stocks, an indication of theimportance of information flows to trading.

Options Exchanges.–The goal of optionsexchanges is to provide a continuously com-petitive and orderly market environment forthe purchase and sale of options.6 Each ex-change determines standards regarding whichoptions may be traded on that exchange. Theyselect the underlying securities on which op-tions may be traded based on factors such as

‘American Stock Exchange, Inc., et al., Understanding theRisks and U=s of Listed Options, 1982.

Photo credit. New York Stock Exchange

The trading floor of the New York Stock Exchange: 1984

the number of shares held by the public andtrading volume.

The principal established marketplaces forthe trading of options are: the American StockExchange; the Chicago Board Options Ex-change; the Pacific Stock Exchange; andthe Philadelphia Stock Exchange. These ex-changes compose the Options Price ReportingAuthority (OPRA). Trading information fromall of the options exchanges is coordinated inOPRA’s automated last-sale reporting sys-tem. This system, developed and operated bythe Securities Industry Automation Corp.,provides a consolidated tape of last sale andquote information. The exchanges also formedthe Options Clearing Corp. (OCC), which ac-

Ch. 3—The Securities Industry • 55

;red/t New York Stock Exchange

The trading floor of the New York Stock Exchange: 1930

tually issues the exchange-traded options and futures contracts.7 Futures trading is con-assigns exercises. ducted in price auctions on the trading floor.

Options exchanges aid in industry self-reg-ulation by developing and enforcing rules con-cerning the handling of accounts by brokers,trading hours, and position and exercise limits.Options exchanges and the OCC are regulatedby the Securities and Exchange Commission(SEC).

Futures Exchanges.—The principal respon-sibility of a commodity futures exchange is toensure the existence of competitive marketsfree of price manipulation for the trading of

The exchanges are operated on a membershipbasis, and exchange regulations and policiesare set by their boards of directors and sub-ject to approval of the Commodity FuturesTrading Commission (CFTC). There are manyfutures exchanges in the United States. Thelargest is the Chicago Board of Trade, whichin 1983 handled 44.89 percent of total tradingvolume (see table 2.)

‘Futures Industry Associates, Inc., “Roles Played by EachParticipant, ” Futures Trading Course and Handbook, Wash-ington, D. C., 1983, p. I I-4.

35-505 0 - 84 - 5 : QL 3

56 ● Effects of /formation Technology on Financial Services Systems

Exchange

1. Chicago Board of Trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. Chicago Mercantile Exchange. . . . . . . . . . . . . . . . . . . . . . . .3. Commodity Exchange, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . .4. Coffee, Sugar & Cocoa Exchange5. New York Mercantile Exchange . . . . . . . . . . . . . . . . . . . .6. New York Futures Exchange . . . . . . . . . . . . . . . . . . . . . . . . .7. MidAmerica Commodity Exchange . . . . . . . . . . . . . . . . . . .8. New York Cotton Exchange. . . . . . . . . . . . . . . . . . . . . . . . . .9. Kansas City Board of Trade. . . . . . . . . . . . . . . . . . . . . . . . . .

10. Minneapolis Grain Exchange. . . . . . . . . . . . . . . . . . . . . . . . .11. New Orleans Commodity Exchange . . . . . . . . . . . . . . . . . . .

1983

Contracts

62,811,52337,830,04420,014,5974,876,0693,926,5893,510,2853,166,5371,703,1051,693,042

379,60713,542

139,924,940

Percent

44.8927.0414.303.482.812.512.261.221.210.270.01

100.00

1982

Contracts Percent Rank

48,206,790 42,89 (1)33,574,286 29.87 (2)17,520,712 15.59 (3)3,252,512 2.89 (4)2,649,941 2.36 (5)1,451,442 1.29 (9)2,397,721 2.13 (6)1,479,781 1.32 (8)

1,493,558 1,33 (7)346,264 0.31 (lo)

27,872 0.02 (11)

112.400.879 100.00, .SOURCE: Futures Industry Association.

, ,

Ch. 3—The Securities Industry ● 57— — — — —

The exchanges play a major role in self-reg-ulation of the futures industry. In this rolethey are required to perform four activities:surveillance of market activity to detect andprevent situations conducive to price distor-tion; surveillance of trading practices to detectand prevent trading abuses; investigation ofrule violations and customer complaints; andexamination of members’ books and records.8

The introduction of new investment products,such as stock futures, indicates that activityon futures exchanges may be expected to growover the next several years. The regulatoryand operational role of the exchanges will be-come more complex. Information technologyis being applied to facilitate the operations ofthe exchanges and will play an increasinglyimportant role in their activities.

Industry Users

The demands and characteristics of users ofthe industry are major determinants of indus-try structure. The organizations of the secu-rities industry serve as intermediaries betweentwo sets of users: capital seekers and in-vestors.

Organizations Seeking Capital

While the focus of much of the activity ofsecurities industry is on secondary markets,the underlying demand for capital is the rea-son the industry exists. In 1982, the value ofnew issues of common stock publicly offeredwas $23.4 billion; new, publicly offered debtobligations totaled $45.2 billion. Private place-ments of debt and equity totaled $22.3 billion.As the U.S. economy completes its evolutionto an information economy, it may be expectedthat a great number of both new firms and ex-isting corporations with growing operationswill be seeking capital through both privateand public sources.

Corporations will demand more rapid accessto their capital than ever before because of theeffect of information technology on the over-

8U. S. General Accounting Office, Survey of Investor Protec-tion and the Regulation of Financial Intermediaries, 1983, pp.28-29.

all economy. Business decisions are beingmade more quickly, and delays in financingwill not be tolerated.

Institutional Investors

Institutional investors include special-in-terest funds and companies such as pensionfunds, mutual funds, insurance companies,and private foundations that have a goal ofproducing income for a specific organizationaluse and deal in large blocks of securities. Theydemand prompt, efficient transactions and ex-tensive information.

Since the passage of the Employee Retire-ment Income Security Act (ERISA), the im-pact of these investors on the total market hasincreased substantially. Trades in 10,000 -share blocks, a measure of institutional in-volvement, have increased to over 44 percentof total share volume. g The broker must alsobe willing to assume risk by buying from theinstitutional investor because he demands ahigh level of liquidity. At the same time, theimportance of this segment of the market hasled to price competition following the deregula-tion of commission rates in 1975.

The demands of institutional investors havebeen, in large part, responsible for much of theautomation of trading and clearing by the se-curities industry. Exchanges need to attractinstitutional capital to maintain the market-place, yet information technology, combinedwith institutional traders’ level of market ex-pertise, makes off-market trading a viable al-ternative for these traders. The volume oftrading conducted by institutional investorsmakes those investors valuable clients forboth brokers and exchanges.

Pension funds are the most significant insti-tutional investors in capital markets. In 1980,these funds held 13.4 percent of the total mar-ket value of NYSE listed stocks.10 Two factorsthat have contributed to the growing impor-tance of pension funds, both as savings vehi-cles and institutional investors, are the aging

‘Securities Industry Association data.IONew York Stock Exchange 1983 Fact Book, op. cit., P. 52.

58 . Effects of Information Technology on Financial Services Systems

Figure 4.—Volume of Futures Trading, 1958-83 (millions of contracts traded)

1958 ’59’60 ’61 ‘62’63 ’64 ’65 ’66 ’67‘68’69’70 ’71 ’72 ’73 ’74 ‘75’76’77 ’78 ’79 ’80 ’81 ’82 ’83SOURCE New York Stock Exchange data

of the population and ERISA. Since there has for the benefit of shareholders. Shares are soldbeen great interest in individual retirement to investors for the net asset value plus anyplanning, pension funds may be expected to applicable sales charges. The return for the in-be a major player in securities markets. vestor in a mutual fund is similar to that for

any corporate shareholder: the investor prof-A mutual fund is a company whose principal its from the assumed expertise of the company

line of commerce is investment in securities management in investment decisions. Mutual


funds are significant as institutional investorsbecause they usually trade in large volumes.

Funds are classified by investment strategyand fall into three categories: income funds,which strive to provide a current income forinvestors; growth funds, which focus on long-term appreciation; and income and growthfunds, which try to be all things to all people.Generally, funds that seek a higher return forinvestors are more risky. For example, somefunds, such as the Phoenix Fund of MerrillLynch, are composed of securities of failingcompanies that are believed to have the po-tential to rebound. While the risk level ishigher than average, shareholders in this typeof fund have less exposure to risk than if theywere to invest in individual securities, andthey benefit from high yield.

Mutual funds frequently specialize in spe-cific types of securities, such as governmentbonds, or in securities from a particular typeof industry. Money market mutual funds in-vest only in money market securities, whichare by definition short term. For this reason,money market mutual funds are consideredless risky and are more liquid than the tradi-tional mutual funds. Money market fundshave three basic objectives: to preserve share-holder capital; to maintain liquidity; and, inlight of these two objectives, to achieve thehighest possible current income.” Money mar-ket instruments are generally written in highdenominations and are only accessible to manyinvestors because they are able to pool theirinvestment dollars in the funds. The moneymarket benefits from the funds because a largequantity of capital not otherwise available isattracted.

Individual Investors

The typical individual investor in securitiesis an affluent consumer who demands infor-mation and advice geared toward his require-ments. The sales of mutual funds, a proxy in-dicator of the level of individual involvementin the securities market, are rebounding aftera period of decline. This upswing, plus recog-

“U.S. General Accounting Office, op. cit., p. 60.

nized opportunity to market new investmentproducts, has generated renewed interest inindividual investors by the securities industry.

There has been tremendous growth in thenumber of stockholders. NYSE reports that42.36 million Americans own shares of U.S.corporations or stock mutual funds, an in-crease of 10.1 million since 1981. ]2 Of particu-lar significance to the securities industry is thetremendous growth in the number of first-timeinvestors, 7.3 million since 1981. This growthma-y be attributable to several factors, includ-ing the strength of the stock market duringthe early 1980’s, corporate employee stockpurchase plans, and most notably, changingdemographics.

The “aging” baby-boom generation, now ap-proaching peak investment years, may causean increase in the number of people investing.People are waiting longer to get married forthe first time and have families and thereforeare likely to be able to invest at a younger age.While securities firms once targeted their serv-ices towards a small portion of the population,their market has become more diverse in termsof both age and income.

Securities firms have been expanding theirproduct lines and the scope of financial serv-ices they provide to meet the demands of theindividual investor. Movement by firms intoother areas, such as insurance and real estate,is an attempt to draw clients at an earlierstage in their financial lifecycle and to fill allof their financial needs.

The Regulatory Structure of theSecurities Industry

Federal regulations enacted in the 1930’sdisallowed involvement by depository institu-tions in securities activities because of con-cerns about the effects of risk associated withthese transactions on the stability and sound-ness of banks. Such restrictions separated cap-ital creation from the banking activities of cor-porations, such as the extension of operating

‘zJon Friedman and Tom Petruno, “Record 42M of Us AreWall Street Investors, ” USA Today, Dec. 1, 1983, sec. A, p. 1.

60 • Effects of /formation Technology on Financial Services Systems—

credit and transaction accounts. These restric-tions were intended to assure that depositoryinstitutions acted in the best interests ofdepositors.

The regulatory structure of the securities in-dustry recognizes that capital and money mar-kets are essential to the health of all sectorsof the national economy. Legislation concern-ing the securities industry has focused onthree areas: providing for disclosure to in-vestors, promoting self-regulation by the in-dustry, and facilitating the development of anational market for securities. Federal regu-lation that is focused directly on the commodi-ties futures segment of the industry is simi-larly designed and seeks to protect marketsand individual traders.

Securities and commodities trading is over-seen by a two-tier regulatory system: Federaland State government and industry. Federalregulation is focused on the oversight of mar-kets and investor protection. State regulationof securities, commonly called “blue skylaws,” since they were designed to prevent thesale of securities with the investment poten-tial of the blue sky, preceded Federal regula-tion, and the right of States to regulate waspreserved when the first major legislation con-cerning the operation of the securities indus-try, the Securities Act of 1933, was passed.

While Federal regulation focuses on dis-closure without value judgment on the worthof the securities, State laws may actually in-volve licensing. Registration of an issue maybe refused by a State authority, which wouldprohibit sale in that State.13 State laws differ,but efforts to develop uniform laws are beingled by the North American Securities Admin-istrators Association.

Self-regulation is imposed and enforced bythe exchanges and by industry associations.While the industry began formally supervis-ing its own operations with the developmentof the Buttonwood Agreement, the self-regu-latory system was first recognized by Con-gress and subject to Federal Government

13U.S. General Accounting Office, op. cit., p. 22.

supervision with the passage of the SecuritiesExchange Act of 1934.

Federal Regulatory Agencies

Several Federal agencies play roles in theactivities of the securities industry. The SmallBusiness Administration licenses and regu-lates Small Business Investment Corpora-tions, a type of venture capital firm. TheBoard of Governors of the Federal Reserveregulates the extension of credit by brokers,as mandated in the Securities Exchange Actof 1934, and has a major impact on the in-dustry by regulating the activities of banks.However, responsibility for regulating thesecurities industry is held by SEC, and respon-sibility for the futures industry, by CFTC.

SEC was established by the Securities Ex-change Act of 1934. Its regulatory activitiesare based on the belief that disclosure is thepreferable means of assuring the smooth oper-ation of securities markets; it is not invasiveto the operations of industry players, and itretains investor choice. SEC also acts to pre-vent price manipulation of securities and reg-ulates the the practices of exchanges, brokers,and dealers. It acts in conjunction with the in-dustry self-regulatory agencies and overseestheir activities.

While not a regulatory agency, the Securi-ties Investor Protection Corp. (SIPC), a quasi-governmental organization, has brought a uni-form investor protection policy to the securi-ties industry. SIPC operates as a private non-profit membership corporation whose primaryfunction is to provide financial protection forthe clients of failed securities firms. The cor-poration was mandated by the Securities In-vestor Protection Act of 1970 in response toproblems that occurred in the late 1960’sthroughout the brokerage industry as stockprices fluctuated widely and volume on the ex-changes increased dramatically.

The only function of SIPC is to insure ac-counts. It covers shortages in accounts of upto $500,000, including coverage for as muchas $100,000 in cash, for each account. Sinceit began operation in December 1970, it has

Ch. 3—The Securities Industry . 61

paid out more than $133 million in claims. ’4SIPC assesses an annual fee on each of the7,000 brokerage houses in the United States,which are required to be members of the cor-poration, to maintain the $150 million level itis required by law to keep available to satisfyclaims. At times, SIPC has acted as trusteein cases of brokerage house liquidations andas such has distributed payments to custom-ers as accounts were settled.

The corporation relies on SEC and the se-curities industry’s self-regulating organiza-tions for notification that a member firm is indanger of collapse. If SIPC determines thatthe customers of the brokerage house are inneed of its protection, it begins what is termeda “customer protection proceeding, ” which isa liquidation procedure. SEC is the only orga-nization that can sue SIPC to force it to beginliquidation proceedings.

CFTC is responsible for regulating com-modity futures trading on organized ex-changes. It acts to prevent price manipulation,attempts to corner market dissemination offalse or misleading information, and mishan-dling of traders’ margin money and equity.15

It reviews and approves the instrumentstraded on the futures exchanges-i. e., futurescontracts. CFTC oversees the activities of ex-changes and other self-regulatory associations.

Disclosure for the futures industry involvesnot only the characteristics of specific con-tracts, but also the level of risk involved in thistype of investment. All potential investors infutures markets are informed that they mayexperience large losses as well as gains andthat it maybe difficult to liquidate a position.

Industry Self-Regulatory Agencies

Industry associations and exchanges estab-lish and enforce rules concerning the opera-tions of the securities industry, rules that areoften more stringent than Federal regulations.An implicit objective of self-regulatory agen-cies is to maintain the autonomy of the indus-

14 Christine Davies, “Brokerage Failures Bring Agency toLife, ” USA Today, Mar. 9, 1983.


try. To meet this goal, these organizations tryto ensure that the behavior of the industry isabove reproach. They play a major role in over-seeing the markets, market systems, and theindividuals active in the industry. Self-regu-latory agencies also have an educational rolein dealing with both members of the industryand the public.

The two most significant securities indus-try self-regulatory organizations are NASDand NYSE. Their roles may be expected togrow as they continue to carry a great portionof all securities trading. The National FuturesAssociation (NFA) is the self-regulatory orga-nization of the futures industry.

NASD is a self-regulatory agency responsi-ble for regulating the over-the-counter secu-rities market and for promoting high stand-ards of operation throughout the industry. Italso establishes standards of professional com-petence. NASD was empowered through theMaloney Act of 1938 amendments to the Se-curities Exchange Act of 1934. Its central pur-pose—to promote high standards of commer-cial honor and just and equitable principles oftrade throughout the industry—has becomeeven more important to the industry as tech-nology is applied.

NYSE oversees the operation of the ex-change marketplace and administers rules andregulations related to the maintenance of or-derly markets and the standards of profession-al competence. ” NYSE is also a major sourceof information concerning the industry as awhole.

In 1981 NFA was designated a “registeredfutures association” by CFTC, which overseesits activities, with congressional endorsement.It began operating on October 1, 1982. NFAwas formed in recognition of the continuinggrowth of futures trading to bring a uniformsystem of self-regulation to its activities.

NFA works toward four fundamental pur-poses: strengthening industry self-regulationby regulating those segments of the futures


62 ● Effects of Information Technology on Financial Services Systems

industry that were previously outside thescope of self-regulatory organizations; elim-inating duplication in self-regulation, therebycontrolling expenses; eliminating overlap andconflicts in self-regulation of the industry byproviding uniform standards; and aiding ef-fective regulation by removing unnecessaryregulatory constraints.17

Trends in Industry Regulation

Trading volume and the number of types ofsecurities instruments have been increasing.The securities industry is being entered byplayers from other sectors of the financialservices industry and by outside industries.It is likely that more demands will be placedon the oversight functions of the regulatorysystem. However, while the importance of thisrole is increasing, technology will facilitate thisfunction by improving information flows onthe operations of the industry.

While the oversight role may be stream-lined, standards and education will requiremore attention. Changes in industry functionsand the introduction of new products (facili-tated by the application of information tech-nology) will require an expansion of the educa-tional role of the regulatory agencies. Thecontinuing development of technology-basedsystems necessitates coordination of stand-ards to ensure that different markets, both do-mestically and internationally, can interact.

Characteristics of the Securities Industry

Concentration

The securities industry is heavily concen-trated. In 1982, the 25 largest firms, out ofnearly 550 Securities Industry Associationmember firms, controlled nearly 75 percent ofthe total capital of the industry. The 10 largestinvestment banks controlled two-thirds of theprofits for that segment. This high level of con-centration results, in part, from the large num-ber of mergers, reorganizations, and liquida-tions that occurred during the 1970’s. The

l~NatiOn~ FUtUreS Association, A %rtnership Between thePublic and the Industry, Chicago, 1983, p. 11.

consolidation activity was spawned by risingbusiness costs for the industry and the weightof transaction processing, as the volume oftrade had increased throughout the 1960’s.

Throughout the 1970’s several verticalmergers between brokers and investmentbanks occurred-most notably the acquisitionof Reynolds Securities by broker Dean Wit-ter & Co. and the purchase of White Weld byMerrill Lynch. These mergers integrated newissue management with the distribution of se-curities and may be considered an early movetoward consolidation throughout the financialservices industry.

Recent acquisitions and mergers seen in thesecurities industry have frequently involvedplayers from other financial services indus-tries. The product lines of firms are becomingboth horizontally and vertically integratedwith lines previously only offered outside ofthe securities industry.

Movement Toward a NationalSecurities Market

The Securities Acts Amendments of 1975directed SEC and the securities industry tocreate a national market system for bothtransacting and clearance. Movement in thisdirection is having a profound effect on thestructure of the securities industry. Ex-changes have been linked to a degree not pre-viously seen, through development of technol-ogy-based information systems such as theIntermarket Trading System. Clearing sys-tems involving the National Securities Clear-ing Corp. have made same-day settlement apossibility.

The driving force in developing systems thatmake a national market possible is the Securi-ties Industry Automation Corp. (SIAC). Thegreat increase in the volume of trading on themajor exchanges in the late 1960’s made it evi-dent that the securities market needs the ca-pability to deal with extensive volume. SIACwas organized both to operate and to developmore efficient and effective ways of dealingwith the transaction process. SIAC systemssupport order processing, trading, and report-

3333333333. —

Ch. 3—The Securities Industry ● 6 3— — —— ———- — — . ——— . —

ing functions, as well as clearance and settle-ment for stocks, bonds, options, and financialfutures. The corporation is owned by the NewYork and American Stock Exchanges,

One of the major impacts of SIAC on thesecurities industry is that it makes the devel-opment and refinement of technological sys-tems a continual process. This should preventor at least limit the lag between the identifica-tion of a need that could be best addressedwith a technology-based system and the appli-cation of a solution.

New Entrants to the Securities Industry

Entrance by Depository Institutions

An amendment, effective September 9,1983, to Regulation Y of the Federal ReserveBoard has added securities brokerage andrelated margin lending to the list of activitiespermissible for bank holding companies. Thisaction, which extends from previous approvalby the Government for the acquisition of retaildiscount brokers by bank holding companies(notably the BankAmerica Corp. acquisitionof Charles Schwab), may increase the interestamong bank holding companies in entering thesecurities industry. ]8

The motivation of banks for providing dis-count brokerage services may be seen as eithera reaction to market conditions or an attemptto protect market shares. Since many broker-age houses are offering investment opportu-nities that serve functions similiar to depos-itory accounts, often with more flexibility andhigher rates of return, the consumer’s per-ceived need for a bank may be decreased. Onemotivation for providing brokerage servicesmay be to prevent the potential luring awayof other portions of a depositor’s business.

While acquisition of a discount broker pro-vides one method of expansion into securitiesfor depository institutions, economies in op-erations made possible by the application in-formation technology have made other meansof market entrance possible. Twenty-five sav-—-————

‘“Federal Reserve Press Release, Aug. 11, 1983.

ings and loan associations and savings banksown ISFA Holding Co., Ltd., which operatesINVEST, a brokerage service, through awholly owned subsidiary. Thrift institutions,which would not be able to enter the brokeragebusiness independently, can offer transactionand advice investment services to their cus-tomers by subscribing to INVEST.

Special INVEST centers are placed inbranches where they are accessible and evi-dent to customers, yet remain separate anddistinct, by order of SEC and the FederalHome Loan Bank Board, from the other opera-tions of the thrift. Just as the securities indus-try is developing and offering new productsto retain clients, this is also a basic motiva-tion behind INVEST. Thrifts are thus able toexpand the services they can offer their cus-tomers.

Trades conducted through new alternativebrokerage services are executed through theexchanges, usually by way of a clearing bro-ker. The securities industry finds itself in theposition of servicing competitors, a situationthat is quite common throughout the financialservice industry. As capabilities and econ-omies found in information technology con-tinue to grow, more entrants maybe expectedand the wholesale portion of the securities in-dustry will probably grow.

Possible Entrants to the Securities Industry

Players throughout the financial service in-dustry, including the securities industry, havebeen expanding their product lines to fill asmany of their clients’ needs as possible. Rec-ognized economies of scope usually underliethis expansion of distribution systems, bothfor information and for community presence,and in terms of complementing current prod-uct lines. Providers often feel they can retaintheir customer base by entering other lines offinancial services.

The entrance of other financial service play-ers into the securities industry is already oc-curring. Several insurance companies havepurchased regional brokers, and some depos-itories have acquired discount brokers. Shear-


son/American Express and Prudential Bacheare both results of mergers between playersin different sections of the financial servicesindustry. Consolidation within the financialservice industry is likely to continue.

Others, not traditionally thought of as pro-viders of financial services, have also enteredthe securities industry. The most widely citedexample is Sears’ entrance through the acqui-sition of Dean Witter.

Other players who may recognize significanteconomies of scope in entering the securitiesindustry are firms in the communications andcomputer industries. These firms might be inan especially strong position to enter thewholesale side for the securities industry. Bar-riers to entry, such as exchange membership,may be overcome by technology. Computerand communications technologies allow for thecreation of information and transacting sys-tems not dependent on the current industrystructure.

The Securities Industry and theInternational Market

The securities industry has its roots in theneed for the American economy to interact inthe international capital markets. However,prior to the completion of the transatlanticcable in 1866, a real international market couldnot exist because it was impossible to conveyinformation in any meaningful time frame. In-formation technology has made it possible forthe American securities industry to interactin the international market, while economicforces have made it essential.

Information technology has allowed a globalcapital market to develop, resulting in in-

creased opportunities both for investors andcapital seekers. Foreign individuals and insti-tutions made purchases and sales of $79.8 bil-lion of domestic corporate stock in 1982, andtransactions in all securities resulted in a netinflow of $14.3 billion in capital to the UnitedStates. ’g

Communications technologies are so ad-vanced that a market anywhere in the worldcan be selected for trading. This could havesignificant impacts on the stability of the econ-omies of nations. For example, the halting oftrading on an exchange in one country couldsimply result in new trade in another nation.It is not clear what impact large differencesin the valuation of a security by different coun-tries could have on capital markets. Interna-tional issues in the development of capitalmarkets are being considered by various or-ganizations. One such organization is theFederation Internationale des Bourses de Va-leurs, an association of 30 stock exchanges in20 countries.

The Effects of Information Technology onthe Structure of the Securities Industry

The application of information technologyin the securities industry affects its structureby facilitating the flow of information to suchan extent that it removes geographic con-straints on market participants and allows fordevelopment of international capital markets.It may also place additional barriers to entryto the securities industry. Without adequateaccess to telecommunication services, for ex-ample, a securities firm cannot function.

1’New York Stock Exchange 1983 Fact Book, op. cit., p. 63.

The Functions of the Securities Industry

The most significant role of the securitiesindustry is in the development of capital. Theinstitutions and players of the securities in-dustry facilitate the development of capital

structures of organizations and corporations.While it would be possible for organizationsin search of financing and potential investorsto interact directly, the market structure that

Ch. 3—The Securities industry ● 6 5

has developed provides needed services moreefficiently. Since most corporations and orga-nizations do not approach capital markets fre-quently, financing with the aid of the securi-ties industry is usually more cost effectivethan direct attempts because of the expertisesecurities institutions have in analyzing secu-rities markets and in locating potential inves-tors, and because of the ability of the securi-ties industry to accept risk.

The use of information and communicationtechnologies by the industry is nearly univer-sal, and adjustments may be expected in op-erations as the value of technology is realized.However, while information technology maychange the way in which the securities indus-try performs its activities, and may even fa-cilitate attempts by investors to act on theirown behalf, it is expected that the basic func-tions of the securities industry will remain anessential part of the development of capital.In this section, an overview of the functionsof the industry and the emerging effect of theapplication of information technology on theseroles will be described. The significance of theadvisory, risk-accepting, and marketing func-tions of the securities industry to the processof gathering capital will be outlined, and theeffect of information technology on this proc-ess will be summarized. Specific approachesto capital formation are discussed in appen-dix 3B.

The Securities Industry as an Advisor

In its advisory role, the securities industryprovides information and offers guidance toits clients. It is able to advise organizationsseeking capital on the type of financing mostdesirable, whether through private or publicmeans, and, perhaps most significantly, whatthe timing for entering the capital marketshould be. These decisions are based on the ob-jectives of the firm. Factors to be consideredinclude the risk and return associated withvarious issuing organizations and instru-ments. Timing of buy and sell decisions is alsopart of this advice function.

Information Dissemination

Information technology affects informationdissemination by the securities industry inseveral ways. Information is now less costlyto gather, store, and access than it was inlargely manual systems. Therefore, not onlyis it likely that the quantity and quality ofavailable information will increase, but alsothat more information will be sought. Inves-tors and other parties interacting with thesecurities industry may be expected to makebetter and more satisfying decisions becauseof the increased availability of information.

Technology has already had a major impacton information flows throughout the securitiesindustry, and it appears that the resultantchanges may have major impacts on the oper-ation and, in time, the structure of the securi-ties industry. Information technology en-hances the reporting of securities trades. TheConsolidated Quotation System, which wentonline in 1978, collects and disseminates quo-tation information from exchanges across theNation and calculates and appends the na-tional Best Bid and Offer to the quotation in-formation. 20 Communication technologymakes it possible to transmit this informationin real time to system subscribers nationwide.A similar system is in place on the NYSE fordebt issues. The Automated Bond System pro-vides current quotation and trade informationfor more than 80 percent of the exchange-listedbonds.21 This system has improved the qualityof information available on bond trading.

Information technology may increase theindependent role investors assume as infor-mation monitors, particularly the individualinvestors. Although massive quantities of fi-nancial information are currently availablethrough a variety of media, such as news-papers, radio, and television, and through pub-licly available consolidated tapes, individualinvestors may expect to have even more in-

‘“Securities Industry Automation Corp., Annual Report, NewYork, 1982.

21 New York Stock Exchange, Amual Report 1982, New York.

66 . Effects of Information Technology on financial Services Systems

formation at their disposal. While a “more isbetter” philosophy is usually applied to infor-mation, the result can be confusing, deceptive,and frustrating to users. Moreover, informa-tion gathered by intermediaries within thesecurities industry may require translation toa form that can be used by clients.

The adoption of home information systems,particularly interactive cable and personalcomputer systems, may change the way inwhich this information is gathered and used.E. F. Hutton and Dean Witter provide cus-tomers with securities research that can be ac-cessed via home computers.22 It is not clearhow investors will use this information. Thecontinual availability of new information mayresult in more frequent trading; however,home systems may just be, in the aggregate,a new medium. Investors may evaluate nomore information than they did in the past.

Computer and communication technologieshave increased the speed with which informa-tion is available to the mass market. With thesystems now available, investors may becomeless dependent on a broker or dealer for up-dated information. An example of this type ofsystem is Pocket Quote, produced by TelemetAmerica, Inc. The basis of Pocket Quote is an1 l-ounce programmable receiver, which lookslike a calculator and can be used to monitorthe New York and American Stock Exchangesas well as option exchanges. Information, in-cluding price and trade volume, on up to 20securities specified by the user is transmitted,subject to a 15-minute delay. The data arebroadcast in a scrambled form on FM sidebands, using a digital signal. Not only is theinformation readily available to the investor,but the system can be programed to page theuser automatically at any time there is “news”about any investment instrument in which he/she is interested.

The potential for investors to act immedi-ately on information continually updated andtransmitted via such systems may affect thestability of securities markets. The ability of

“Tim Barrington, “Stock Trading by Computer EntersHomes, ” The Wall Street Journal, Oct. 6, 1983.

the market to correct itself in unusual situa-tions may be destroyed. In the long run, thismay be a severe disadvantage for the investor,particularly the small investor, who may findhimself bearing both transaction and lost op-portunity costs because of action taken because of basically meaningless market fluc-tuations.

Counseling

The nature of counseling may be changedby the amount and type of information andsupporting analytical tools available. Researchis expected to become pivotal rather than pas-sive in the investment advisory function.23

Analysis and recommendations presented bysecurities industry intermediaries to clientsconcerning potential investments may be moredetailed and, to complement this process, anal-ysis of the financial needs of the individualmay also improve.

Increased availability of information tech-nology has changed the nature of counselingby placing more sophisticated analytical toolsin the hands of both advisors and investorswho may not have had access to these toolsin the past. This change may affect the wayin which investment decisions are made andthe quality of these decisions.24

The reliance on information technology foranalysis of personal investment needs, objec-tives, and choices may indicate an initial movein the industry to reemphasize individual hu-man judgment and perhaps a reemphasis ofthe client/broker relationship. It is not clearwhat the impact of this change will be; how-ever, a decline in personalized service, basedon the evaluation by the broker of the client’sfinancial objectives, may occur.

While counseling may be displaced in someareas within the securities industry, its impor-tance as a separate and unique service of theindustry has been highlighted in some cases.

“Thomas Moore, “Ball Takes Bache and Runs With It, ” For-tune, Jan. 24, 1983, pp. 97-98.

24 Lee B. Spencer, “The Electric Library, ” remarks to theAmerican Bar Association, Federal Regulation of SecuritiesCommittee, Nov. 19, 1982.


Advice, particularly counseling, has been un-bundled from the total package of services of-fered in a new service supplied by MerrillLynch, called “Pathfinder.” For a set fee, theclient receives what amounts to a financialcheckup. The evaluation provides guidance tothe investor in a somewhat objective frame-work. The success of this product may be anindication of the future role of advice withinthe securities industry.

Acceptance of Risk by theSecurities Industry

The securities industry accepts risk thatmight otherwise be experienced by individualsor organizations seeking investment. It doesthis in two ways: through underwriting andby the extension of credit through margin.Underwriting refers to the assumption of riskby an investment bank or other third partyat the time of a public offering. The extensionof credit by brokerage houses is referred to asmargin.

Underwriting New Issues

Underwriting involves the purchase of se-curities from the issuing company and thesubsequent resale of the instruments to thepublic. This service, which is usually per-formed by investment bankers, is essential tofirms in need of capital that are not in the busi-ness of marketing securities. It allows themto receive the funds they need while transfer-ring the marketing function to an expert whomay be expected to be more effective in reach-ing prospective investors.

The underwriter accepts some of the riskassociated with a public offering. He preventslag time by assuring that the issuing corpora-tion has access to the funds it is attemptingto raise when needed. By buying the public of-fering from the firm in search of financing, theunderwriter makes it easier for the manage-ment of the firm to plan the use of the fundsgenerated. The issuing organization may beless concerned about the flow of cash the saleproduces because it is usually guaranteed afixed price and can use those funds when the

agreement with the investment bank or otherunderwriter is closed.

In most cases, the underwriter also assumesrisk by assuring that the issue will be sold, andhe accepts the risk that market fluctuationsor initial pricing mistakes may influence thesuccess of the issue. Offerings underwrittenon a “best efforts” basis, where the under-writer does not bear the risk of an unsuccessfuloffering, permit those issuers in a startup ordevelopmental stage, whose issues may beconsidered to be more risky, to have access tothe public capital markets.

Underwriters earn money by buying secu-rities at a lower price than they resell them forto investors. The difference in price, or spread,is a major consideration in the selection of aninvestment bank by a firm. A prospective cli-ent for an underwriter may choose an invest-ment bank through two methods: competitivebidding or negotiation. Both systems have ad-vantages, and experts disagree on which pro-vides the best price for the capital seeker. Theadvantage of the negotiated system is that theissuing firm and the underwriter work to-gether to make decisions about the pricing andtiming of the issue.

The company using a competitive biddingsystem invites offers from investment bank-ers. This process is required for many publicutilities and most municipal offerings. Butwhile some experts believe it results in highernet proceeds for the issuing organization (be-cause of the forces of competition), it has dis-advantages. Much of the benefit of the advi-sory function that the issuing company wouldenjoy in a negotiated situation is lost. A higherprice may be received, but this largely dependson the health of the market at the time of theoffering. In a depressed market, investmentbankers are less likely to compete for a pub-lic offering, and therefore the price receivedmay be lower.

It is also typical for investment banks tominimize their risk by forming syndicates.This spreads risk and benefit because of theirpooled sales force and allows a number ofunderwriting firms to participate together in


large public offerings. Changes in industrystructure, particularly consolidation among in-vestment banks, may affect this operation.

The presence of an underwriter provides avaluable service for the prospective investor.Investment bankers are expected to examinethe corporate records with due diligence andare liable to defrauded investors if they failtheir due-diligence obligations and miss anymisstatement or omission of material fact bythe issuer in the prospectus. Therefore, notonly does an underwriter assure that the issuewill be sold in a “firm commitment” offering,but it also provides an oversight function ofthe issuer on behalf of prospective investors.

The underwriter also frequently accepts riskthrough providing a secondary market for se-curities by maintaining a position in the stock.This activity, called “making a market, ” issimilar to the role played by securities special-ists, which is discussed in a later section. Theunderwriter quotes “bid” and “asked” pricesfor the security based on market supply anddemand and intervenes as a buyer or seller,when necessary. The original offering of a debtor equity issue may be expected to be moresuccessful when the potential investors knowthat the existence of a secondary market isguaranteed.

Information technology may affect theunderwriting function by decreasing the timebetween the initial development of a securitiesissue and its sale, lessening the need of capi-tal seekers to be protected against this lag.Pricing decisions and market evaluations maybe more certain if the time frame in which thesecurity is offered is lessened.

Price competition has been increasing in thearea of underwriting. Since the use of syndi-cates is decreasing, there is a greater need forindividual firms to have substantial capital ifthey are to continue functioning as underwrit-ers.25 Information technology may be a con-tributing factor in the advent of bought dealsthat involve the purchase of an entire issue,

usually by a single underwriter who has notlined up buyers in advance. While informationtechnology may allow underwriters to locatebuyers quickly, more risk is involved in thismethod than with a traditional syndicate.

The emphasis on price competition maybea disadvantage for corporations entering cap-ital markets because the benefits of advice onpricing and timing of an issue is sacrificed.While sophisticated analytical tools, which in-formation technology may enhance, may as-sist corporations seeking financing in evalu-ating various possibilities, this type ofanalysis may not be tailored to the needs andobjectives of corporations to the same extentas the information and counseling services pro-vided by an underwriter.

Margin

“Margin” refers to the amount of moneypaid by an investor to acquire a securitythrough credit instead of cash. At the end of1982, the securities industry held nearly $13billion ($12.98 million) in margin debt securedby nearly $39 billion ($38.88 million) worth ofcollateral. 26

The Securities Exchange Act of 1934 em-powers the Federal Reserve Board to regulatethis extension of credit. Brokers are permittedto extend regulated credit on stocks and con-vertible bonds traded on registered exchangesas well as some select over-the-counter stocks.Initial margin requirements, set by the Fed-eral Reserve Board, currently call for a depositequal to 50 percent of the total value for bothstocks and convertible bonds. Stock ex-changes and other self-regulatory agencies ofthe industry have individual requirements forthe opening and maintenance of margin ac-counts. For example, the NYSE requires aninitial deposit of at least $2,000 and the main-tenance of equity of the customer at 25 per-cent of the value of securities carried.

The advent of home equity access accounts,encouraged by advances in information tech-nology, may increase the amount of margin

25A. F. Ehrbar, “Upheaval in Investment Banking, ” Fortune,Aug. 23, 1982, pp. 90-95, Z6New york Stock Exchange 1963 Fact Book, OP. cit., Il. 46.

-..

Ch. 3—The Securities Industry ● 6 9— —

debt and change the nature of collateral. Whilesome accounts restrict this use of credit drawnfrom home equity for the purchase of securi-ties, in many situations this is acceptable.

Margin takes on a different meaning in op-tion and futures contract trading. In futurestrading, margin refers to the amount of moneyor collateral which a client is required to de-posit with his broker to insure the brokeragainst losses on open futures contracts. Op-tion writers must, similarly, deposit cash orsecurities with their brokers so that the bro-kers are covered in case of an assignment.

Margin plays an important role in specula-tion in securities markets. A frequently usedstrategy in the buying and selling of securi-ties is the “short” position. In this case, aninvestor sells securities he does not own, buthas borrowed, to make delivery in the hopesthat the price will decline before it is neces-sary for him to return the security. This activ-ity can be extremely risky. However, it ac-counts for a significant amount of marketactivity. In 1982, 1.5 billion shares, in roundlots, were sold short, an amount that was 9.3percent of all reported securities sales.27

Information technology may decrease thesignificance of margin as a convenience forbrokerage customers because it eases accessto assets and facilitates funds transfers. Cus-tomers may be able to finance securities pur-chases using other assets whose liquidity hasincreased as a result of increased use of infor-mation technology. It is not clear what the neteffect will be; however, the use of electronicfunds transfers may largely eliminate the useof margin by brokerage houses to providefloat.

Marketing by the Securities Industry

For purposes of discussing the securities in-dustry, “marketing” is defined as those activ-ities designed to identify and meet the needsof clients; i.e., both seekers of capital and in-vestors. It is assumed that these clients do notdemand a specific product or type of service,

but rather, that the clients recognize an un-filled need and seek a way to meet it.

At one time the operations of the securitiesindustry were centered on what was possible,given the regulatory framework and its busi-ness concerns. Now, a new awareness of theimportance of basic marketing to retain anddevelop business is evident, resulting in re-search to support activities in product devel-opment and promotion and the targeting ofspecific segments of the population for special-ized products. Given the competition the in-dustry faces in its traditional and new prod-uct lines, especially from new entrants into thefinancial service industry, the marketing func-tion may be expected to continue to grow inimportance for the foreseeable future.

Information technology may affect thosemarketing functions of the securities industrythat comprise product development, sales orbrokerage, and pricing.

Product Development

In recent years, the regulatory restraints onthe financial service industry have decreased,and the securities industry has found competi-tors in what at one time were strictly separatebusinesses. These developments have occurredwhen the securities industry was observing acontinual demographic and psychographicchange among its potential retail clients, agrowing institutional market, and more com-plex financial needs among organizations seek-ing capital.

Shifts in the area of product developmentare seen mainly in the way products are pack-aged, specifically in the variety of mutualfunds and money market mutual funds thathave been developed. It is not yet clear howpatent and copyright laws will affect the de-velopment of information technology-based fi-nancial services products. If financial serviceproducts become patentable, some securitiesindustry experts believe that competitioncould be stifled.28 Many financial service prod-ucts are similar in both character and features,

“New York Stock Exchange 1983 Fact Book, op. cit., p. 48.“’’Merrill Lynch Wins Cash Account Row With Dean Wit-

ter, ” The Wall Street Journal, Dec. 29, 1983, sec. 1, p. 2.


and therefore, there is an inherent possibilityof patent infringement. Differentiating prod-ucts by attribute has not been of great interestto the financial service industry, which hascompeted by geographic market and compara-tive return and cost.

Information technology has created interestin patenting financial service products becausecommunications and computer technologieshave broadened markets. Products that at onetime may have been offered locally now com-pete nationally. Therefore, protection of prod-uct may become as necessary as the position-ing of the product.

The patentability of financial products isnow being tested in cases involving the cen-tral-asset account. In response to perceivedconsumer demand, most major firms in thesecurities industry, including Dean Witter,Paine Webber, Shearson/American Express,and Prudential Bache, have introduced theseaccounts, which are combination margin ac-counts and investment funds. Merrill Lynchled the development of asset managementaccounts with its introduction of the cashmanagement account in 1977, for which it re-ceived patents in August 1982 and March1983, and, with over 1 million accounts, is themarket leader. Following the receipt of its pat-ent, Merrill Lynch notified competitors thatit was imposing an annual licensing fee of $10on all asset management accounts. Initially,this levy was not taken seriously throughoutthe industry; however, without admitting anypatent infringement, Dean Witter resolved itsdispute with Merrill Lynch about the accountsin late December 1983 for $1 million. The firmsagreed to “grant each other a nonexclusive,royalty-free license to use any improvementsor changes either might make relating to cen-tral-asset accounts. ”29

If financial service accounts are routinelypatented, investors may find that their choicesare limited, since the patent may be a barrierto entry into some product lines for some serv-ice providers. Since players within the securi-

29Ibid.

ties industry may be expected to make effortsto distinguish similar products legally, patent-ing may also increase consumer confusionabout product features and attributes.

Brokerage

Brokerage involves bringing together buy-ers and sellers, facilitating trades through themaintenance of a marketplace, and assuringthat the trade is complete. The significance ofthis activity as part of the operations of thesecurities industry cannot be overestimated.Traditionally, all of the costs of supporting aninvestment bank or brokerage house were re-covered through this portion of the business.The services provided to clients, such as re-search support and advice, were bundled intothe commission rate for purchasers of securi-ties and into the spread on new issues for in-vestment banks.

The heart of brokerage with retail clients hasbeen personal selling. The relationship be-tween the investor and the individual brokerhas been fairly constant, and typically, the ac-counts a registered representative developswhile with a particular brokerage house movewith him if he/she switches firms. Firms withinthe industry have expended great effort in at-tempts to retain clients. The development ofnew products unique to particular houses mayencourage a loyalty to the company ratherthan to the broker. It is not yet clear how thismight change the character of the industry.

Most technology-encouraged competition isoccurring within the selling function of retailand institutional brokerage. The end of stand-ardized commissions on the sale of securities(1975) has encouraged the entrance of dis-counters into this market. Discount brokerscomplete trades for investors at prices that aregenerally lower than the commission chargedby full-service brokers. Usually, the serviceprovided by discounters is limited; e.g., thesefirms usually do not support extensive re-search and advice operations. However, theydo fill the needs of a portion of the market.About 15 percent of trading by individual in-vestors is handled by discounters.


Access to information technology for indi-viduals will facilitate direct selling of securi-ties to investors without the interaction of abroker. This type of system is particularlyadaptable for discount brokers whose serviceis basically order-taking. C. D. Anderson &Go., a small discount broker, developed thefirst home brokerage system, and other bro-kerage houses are expected to enter this mar-ket. 30 C. D. Anderson’s system allows clients,who pay a hook-up charge and a usage charge,to enter buy and sell orders at their conven-ience, without dealing with a broker.

Transactions

Congress mandated the development of acomputerized national stock market systemin 1975, believing that by linking all marketcenters, such a market would expose securi-ties to a greater number of buyers and sellers,and an investor would have the chance to ob-tain the best price available. This system wasalso expected to provide competition toNYSE, which dominated the market with 80to 90 percent of the trading volume.

The Cincinnati Stock Exchange was ex-pected by many industry experts to becomethe basis of an automated national stock ex-change. The exchange was supported by Mer-rill Lynch, the largest firm within the securi-ties industry. In July 1983 Merrill Lynchwithdrew a large portion of its business fromthe Cincinnati Stock Exchange and returnedit to the floor of NYSE, noting that not onlyhad the Cincinnati Stock Exchange failed togain the volume anticipated, but that NYSEhad improved.

While NYSE is still largely based on a sys-tem of auction pricing and securities special-ists, the adoption of systems made feasible bythe application of information technology hasallowed it largely to eliminate problems asso-ciated with high volume. In addition, commu-nications systems have been developed thatallow users of NYSE to enjoy many of thebenefits of a national system by providing in-formation on the activities of regional ex-

‘°Carrington, op. cit.

●

35-505 0 - 84 - 6 : QL 3

changes. One such system, the IntermarketTrading System (ITS), may be seen as beingindicative of a trend toward a national mar-ket for securities trading.

ITS allows brokers, specialists, and marketmakers to interact with their counterparts atother markets. The system, maintained bySIAC, currently involves eight stock ex-changes: New York, American, Boston, Phila-delphia, Cincinnati, Midwest, Pacific, and, toa limited extent, NASDAQ.

ITS provides a mechanism through whichthe most favorable exchange setting can bechosen for a transaction. * At NYSE, the bestprice from any member of ITS, as well as theNYSE floor price, is displayed. If it is advis-able for a trader to deal on an exchange otherthan the one at which he is operating, he canenter his order by contacting his counterpartthere. At the end of 1982, 1,039 issues wereeligible for trading on ITS. NYSE reports thatthis represents most of the stocks traded onmore than one exchange.

The Designated Order Turnaround (DOT)system was introduced in 1973 to route smallorders (599 shares or less). It reports elec-tronically between NYSE and member firms.DOT bypasses floor brokers by routing ordersdirectly to the appropriate trading post on thefloor of the exchange and, following execution,back to the member firm on the same elec-tronic circuit. Over 80 percent of the 5.7 mil-lion market orders processed through DOT in1982 were executed and reported back to themember firm within 2 minutes.31 This systemminimizes the cost to member firms of han-dling small transactions while giving small in-vestors the benefit of timely execution of theirtrades. DOT may also provide a better pricethan would normally be received by a smallinvestor. A trade made through DOT ismatched by computer for price with the mostrecent trade of that issue. The investor bene-fits because the price he receives may have

*For Purpows of this discussion, “transacting” is defined asthe physical execution of trades.

“New York Stock Exchange 1983 Fact Book, op. cit.


resulted from price negotiation on a muchlarger order.32

Another technology-dependent system thatfacilitates transacting is the Opening Auto-mated Report Service (OARS). OARS makesefficient and accurate processing of marketorders, that are received at NYSE prior to thestart of daily trading, possible without caus-ing unnecessary delays in the opening of trad-ing, and transmits computer-generated reportsto the originating member firm.33 This systemis especially valuable to specialists on dayswith high trading volume, which have recentlybeen occurring with great regularity.

Future developments in transacting en-hanced by information technology may includethe bypassing of intermediaries in the proc-ess of selling. Some experts believe that theadoption of home information systems maymake it more common for investors to com-plete transactions between themselves pri-vately or to gain direct access to exchangefloors. While it does not appear that the pos-sibility of off-market trading is having a ma-jor impact on the individual investor at thistime, institutional investors have at timesfound it advantageous to trade off-market.

About 500 brokerage houses, pension funds,insurance companies, and other institutionalinvestors are linked through AutEx Systems,a nationwide computer network. The potentialof this system for trading was demonstratedby its use in creating a market in a stock forwhich trading had been closed by NYSE. Jef-feries & Co. is a discount broker specializingin institutional trading. It is not a member ofany major exchange and therefore is able tomake a market in an exchange-listed stockwithout going through the exchange. Follow-ing a request by a client, Jefferies announcedover the AutEx System that it was makinga market in the closed stock. The companytraded a total of about 8 million shares of thestock off-market.34

3’Desmond Smith, “The Wiring of Wall Street, ” The NewYork Times Magazine, Oct. 23, 1983, p. 109.

33New York Stock Exchange, Annual Report 1982, New York,p. 33.

“Smith, op. cit., p. 73.

Given that the primary responsibility of se-curities exchanges is to maintain an orderlymarket, technology, the great facilitator oftheir operations, could also be a major under-mining force for the exchanges. It is basicallymeaningless to stop trading for a security onan exchange if the end result is simply thattrading is moved off of the exchange and con-ducted without the prudent management ofthe specialist. It may be essential for ex-changes to continue trading a given securityin all but the most unusual situations.

Clearance and Settlement of Securities

Clearance and settlement activities consum-mate trades through the exchange of securi-ties and funds.35 As with any marketplace, anaction recognizable to all parties involved isnecessary for finalizing a transaction. Giventhe great number of participants in the secu-rities industry, it is essential that transactionsbe closed as efficiently as possible in a man-ner that is acceptable to all parties involved.

The increasing volume of trade and the con-tinuing development of new securities prod-ucts has made it necessary to refine settlementand clearance. Since ownership is merely con-tractual until the process is finalized, delaysin settlement and clearance could have a se-vere effect on the operation of securities mar-kets. An industrywide effort is under way tomove toward a national settlement and clear-ance procedure through the adoption of stand-ardized proofs of ownership that are not paper-based, such as book entry, and to facilitate ef-fective, marketwide clearance through the useof automated systems that assist in the clos-ing of positions.

Clearance and settlement are recognized asan important portion of the national marketsystem. The formation in 1977 of the NationalSecurities Clearing Corp. (NSCC), for whichSIAC (Securities Industry Automation Corp.)is facilities manager, encouraged movementtoward a national clearing system. NSCC com-bined the clearing corporations of NYSE, the

‘sNational Securities Clearing Corp., Annual Report 1980,New York.

v

American Stock Exchange, and NASD. It hasprovided more efficient clearing at lower costsper trade for listed and over-the-countertrading than was previously possible. SIACfacility management for NSCC services in-tegrates several major processes and entitiesin the settlement process (see fig. 5).

One pivotal change in the settlement proc-ess was the development of Continuous NetSettlement (CNS). CNS represented a changein accounting approach to the provision of con-tinuous net positions against the clearing sys-tem rather than a daily balance order ac-counting.” In addition to improving clearingoperations, savings recognized through the ap-plication of CNS have included manpower andsame-day delivery of securities. An importantlink in this system is the Regional InterfaceOperation, which allows member organiza-tions to trade on any exchange and bring set-tlement to the clearing facility of their choice.

The Options Clearing Corp. (OCC), which isowned by the options exchanges, is the clear-ing entity for options trading. It supports theclearing members and participant exchangesby acting as the issuer of all cleared andsettled options, guaranteeing option contractperformance and fungibility, and effectivelyperforming trade clearance, settlement andassociated clearing functions, and other secu-rities industry services.37 The primary objec-tive of OCC is to provide these services in themost cost-effective manner.

Information technology has been essentialin the refinement of the clearing and settle-ment process. It will affect it further throughsome changes that will be felt in the marketas a whole. If substantial trading is conductedoff-market, general access to the automatedsettlement system may be demanded.

Pricing

Pricing occurs at two points in the securi-ties industry: investment bankers assist in theinitial pricing of new issues, and exchanges

———“Securities Industry Automation Corp., A Decade of Pro-

gress, New York, 1982, p. 8.‘“The Options Clearing Corp., Annual Report 19/?1, Chicago.


provide a framework for price adjustments forsecurities. Price in its most pure form is a func-tion of supply and demand. For securities, thisis generally defined to mean the net presentvalue of anticipated cash flow, in terms ofwhat is received in interest or dividends andresale. Initial pricing decisions on new issuesare particularly sensitive for the securities in-dustry since the risk associated with errorsusually falls totally on the underwriter. If theprice is not in line with value as perceived bythe market, the issue will not be bought.

Pricing for securities in secondary marketsmay be done on a historic basis or by auction.Automated trading systems are based on ahistoric pricing mechanism; that is, the priceof an instrument is determined by its pastbehavior. Prices in the auction system aredetermined by market demand. Proponents ofthis system believe that the auction gives atruer evaluation of the worth of the issue andis therefore beneficial in the aggregate to bothsellers and buyers.

The operation of the secondary market forsecurities provides a method for correctingprices. Securities specialists perform a pricingfunction on exchange floors in fulfilling theirfunction of maintaining an orderly market.The specialist, an independent businessperson,performs this function as an auctioneer, buyer,and seller of securities. He makes a value judg-ment about the opening price of a security atthe beginning of each day when opening trad-ing. Although no trading may occur through-out the day, this establishes a price of record.

The specialist facilitates trades by inter-ested brokers on the floor and stands in as abuyer or seller at times when demand andsupply on the floor do not mesh. By standingin as a buyer or seller, the specialist maintainsan orderly market by assuring that pricechanges occur in small increments. This allowsinvestors to assess the market situation of asecurity in a rational fashion.

NYSE now offers a technology-based sys-tem through which investors can more easilyinteract with the market when they want tosell a security at a set price. The limit order

Figure 5.— Overview of SIAC Facility Management for NSCC Services

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NOTE In addition to acting as faclllty manager for the National Securltles Clearing Corp , SIAC provides clearing serwces for AMEX options. AMEX gold coins and NYFE futures Support sewlcesare also provided for the Options Clearing Corp Paclflc Clearing Corp and Depository Trust Co

SOURCE. Securities Industry Automation Corp

Ch. 3—The Securities Industry w 75— — — — — — — ——. —-—— —.—

system electronically files orders to buy or sellwhen a specific price is reached. These ordersare delivered to the appropriate trading postor member firm on the floor. Orders can belimited to a single day or to their cancellation.

In the context of the securities industry,pricing has referred solely to the investmentinstruments of corporations and organiza-tions. Pricing can also be expanded to the ac-tual services of the industry, whose basic func-tions are being unbundled. Although withinthe securities industry pricing is most clearlyevident in the selling and advising function,it is a factor throughout the entire financialservice industry. The securities industry mayhave an advantage relative to other financialservice providers in this area because of theexpertise it has in analyzing markets and inpricing issues.

Technology and the Functionsof the Securities Industry

Technology is changing not the functions ofthe securities industry, but rather how theyare performed. The number of corporations

seeking financing, the number of potential in-vestors, and the level of trading demandedhave all increased to levels that could not beanticipated when the securities industry wasdeveloping. The one element which has not in-creased is the number of hours in a day, andtechnology makes it possible to overcome thathandicap in processing the level of activitydemanded by the market.

Time and distance are no longer obstaclesto communications for the securities industry.Because of this, securities markets may be-come less location-dependent and, as a result,less physically structured. It will be necessaryfor the industry to make efforts to assure thatthe basic purpose of the markets is retained.

Information technology will generate afaster reaction by the securities industry tochanges in market conditions and consumerdemands because communications and com-puter capabilities may lessen consumer re-sponse time. The market can be expected tooperate at a more rapid pace, and while it maybe possible to monitor change more precisely,this market will require quick and well-devel-oped decisionmaking.

The Effects of Information Technology onSecurities Instruments

Securities instruments are designed to satis-fy both the goals of investors and the need ofcorporations and organizations to gather cap-ital to finance industrial research and devel-opment and resulting expansion or diversifica-tion. Securities instruments are of interest indiscussions of the effect of information tech-nology on the financial service industry forseveral reasons. First, the direct impact oftechnology on the securities industry, from thepoint of view of the consumer, may be moststrongly felt in the way in which the character-istics of investment instruments are changed.Second, the intrinsic characteristics of secu-rities instruments may affect the way in which

they evolve in a technology-intensive environ-ment. As information technology changes theway in which the securities industry operates,the relative importance of various investmentinstruments may be affected by informationtechnology.

Third, interest in instruments that are nowon the market may be predictive of which in-vestment products may best meet future de-mands of consumers in terms of liquidity, levelof risk, and return. This type of activity hasalready been seen in the financial service mar-ket in the development of money market mu-tual funds, which were patterned after the idea


of mutual funds and met the consumer de-mand for more liquidity.

The development and trading of securitiesinstruments is largely dependent on the appli-cation of information technology. Such tech-nology has also had a major impact on thecalculation and payment of return and therecording of ownership. The rate of growthseen in options and many types of futures con-tracts would not have been possible withoutcommunications and computer technologies.As securities markets become more technolo-gy-based, it must be expected that investmentinstruments will also.

However, it is unlikely that technology willbe the sole cause of the development of anynew securities product, although it maychange the characteristics of some investmentproducts or expand their application to suchan extent that they are different in functionand operations. As a result of these changes,both investors and their advisors will have toexamine their methods of evaluating potentialinvestments. The characteristics of invest-ment instruments may be expected to changein four ways because of the application of in-formation technology: liquidity of instru-ments, the packaging of securities products,the way in which potential investments areanalyzed, and the importance of speculativemarkets.

The liquidity of an investment instrumentis determined both by the contractual term ofthe instrument and the speed with which theinvestor can trade or redeem the instrument.New communications technologies, notably in-teractive cable and the adoption of personalcomputers with networking capabilities, havebeen applied to allow investors greater accessto securities markets. For example, systemsavailable to individual investors provide up-dated information continually on price and sig-nificant activities involving securities in whichthe investor is interested. Easier access to thisinformation changes the way investments areanalyzed by making it easier for the investorto make decisions on his portfolio in a shorttime frame.

Securities products are being packaged,often with products from other financial serv-ice industries, to fill a wider range of investors’financial needs. This trend is likely to continueas the number of investment options increasesand the demands of users become increasinglymore complex. Much of the new product devel-opment that will be seen in securities marketsmay result from the increasing role of specu-lative markets. The ability of investors to usespeculative markets is increased by the appli-cation of information technology.

Appendix 3A: Securities InstrumentsThis appendix describes, the characteristics of

debt and equity instruments as well as options andfuture contracts. The relationship of informationtechnology to these products and the future effectsof this technology are outlined.

Corporate Capital Structure:Debt and Equity Issues

The capital structure of a firm is determined bythe mix of securities it issues. Capital is developedthrough internal sources—i.e., retained earnings—and through the issuance of debt and equity. Acorporation tries to maximize its market value

through this structure. There can be as manyunique capital structures as there are corporations.The financing plan chosen reflects the operatingand growth objectives of the organization.

While the basic purpose of all debt and equityissues of a firm is the same, to gather capital, theyrepresent different costs and concessions for theissuing organization. The return offered and riskinvolved for the investor also differs substantially.When debt is issued through bonds, the investorbecomes a creditor to the organization; the firmassumes a noncontingent obligation to pay the in-vestor a definite sum of money. Equity issuesgrant ownership in the corporation in return forinvestment. Such shares of stock represent owner-


ship rights proportional to the value of the shareof the firm purchased at the time of investment.

Financing through debt is developed boththrough money markets and capital markets.Money markets are basically wholesale marketswhose major function is liquidity management.They are centered on short-term instrumentsthrough which organizations can manage suchoperating factors as cash flow. Capital marketsare centered on long-term securities, includingboth debt issues and stock, and represent thedevelopment of financing for long-term projectsand goals for the organization, such as equip-ment purchases, research and development, andexpansion.

Long-Term Debt—Corporate Bonds

When money is borrowed on a long-term basis,the contract representing this debt takes the formof a bond. A corporate bond is a fixed, noncon-tingent, long-term obligation to pay a definite sumof money and interest on that amount. The for-tunes of the corporation affect the resale poten-tial of the security but cause the bondholder nei-ther benefit nor loss in terms of return, assumingthat the corporation does not default on the issue.

The market value of the instrument is the pres-ent value of the payments stream to the investor,using market interest rates. The bondholder is acreditor to the corporation and as such has a claimon the assets prior to any by the owners. Corporatebonds have a fixed return, known as a coupon rate,and a specific maturity. The financial benefit theinvestor realizes from the bond depends on mar-ket conditions at purchase and investment oppor-tunities at the time of maturity. A bond issue maybe distinguished in several ways, most notably:how the contract is guaranteed in case of bank-ruptcy, call provisions, registration, the way inwhich interest is paid, and the way in which thebond issue is retired.

SECURED AND UNSECURED BONDS

Bonds may be classified as secured, or mort-gage, bonds or unsecured bonds, called deben-tures. Mortgage bonds are backed by specific cor-porate assets and were historically most popularamong regulated industries, such as railroads andutilities. A closed-end provision in a mortgage con-tract requires that the corporation secure no ad-ditional bonds on the lien. The majority of con-tracts, however, include an open-end provisionthat allows for the issuance of additional bonds

against the property. From the investor’s point ofview, the value of the mortgage lies more in thepotential resale value of the pledged property inthe case of corporate failure than in the exclusivityinvolved.

Debentures are guaranteed by the general creditof the corporation. They have become the mostpopular form of bond issue across the economy andare particularly useful for industries in whichmany assets may be intangible, such as in publish-ing, or have a limited lifecycle, as is the case inmany high-technology industries. Most issues ofdebentures include a negative pledge clause thatprovides that the firm will issue no new debt hav-ing priority over the bonds covered by the agree-ment. This helps ensure that the risk to the in-vestor does not increase over the life of the bond.Debentures are usually subordinate to bank loansand short-term debts.

BEARER BONDS ANDFULLY REGISTERED BONDS

Registration of bonds affects the extent to whichthe investor is protected in case of loss or theft,the way in which interest is paid, and the ease withwhich ownership can be traced and transferred.The ownership of a fully registered bond is re-corded in the register of the issuing organizationor agent. Company records comprise proof of own-ership, and interest is paid directly to the holderof record. If the bond is traded, the issuer or agentmust be notified so that ownership rights may betransferred.

For a bearer bond, the certificate issued at thetime the debt instrument is developed is the onlyproof of ownership. Ownership rights are enjoyedby whoever has possession of that certificate atthe moment. Many investors find that the easewith which the bonds may be transferred and thelack of traceability outweighs the risk of losing thepaper. This type of bond is an extremely flexible,cashlike instrument.

Whether a debt instrument is a registered bondor a bearer bond affects its value and appropriate-ness as an investment for particular investors.Since July 1, 1983, the Federal Government hasrequired all new bonds to be registered to makeit easier for the Internal Revenue Service to de-termine to whom interest is paid and to trace anychanges in ownership. However, there is still a sig-nificant secondary market in bearer bonds. ’ As the

“’The High Price of Financial Privacy, ” Ilusiness W’eek. Aug. 1, 1983,p. 97.


bearer bond is eliminated from the market, someincrease in demand for different instruments thatsafeguard the privacy of the investor to a similardegree may be expected.

A significant difference between bearer and reg-istered bonds from the point of view of both issu-ers and investors is the way in which interest ispaid. The holder of a bearer bond initiates the pay-ment of interest by depositing the appropriate cou-pon at the financial institution of his choice. Fed-eral Reserve collection mechanisms are used by theinstitution to obtain credit for the interest due.Usually, the depositor is paid the interest by thefinancial institution prior to the completion of thisprocess; in most cases, immediate use is granted.The payment system for bond coupons is extreme-ly paper-based. The physical coupon “follows” thecollection process.

Greguras and Carlile suggest that as new tech-nologies make it possible to record essential infor-mation in the physical coupon in a format that canbe used by electronic systems, this type of systemwill allow financial institutions quicker access totheir funds and, as a result, benefit the investor.’Information contained in the coupon could betransformed to electronic form at the point atwhich the coupon enters the redemption process.

The electronic system proposed would result inlittle, if any, change in the action required by theinvestor. Presentation of coupons would remainthe same; from the investor’s viewpoint the cou-pon is already truncated since it is never returnedto the holder. Cost-saving benefits result for theissuer of the bond, the paying agent, and the fi-nancial institution used by the bondholder. Gre-guras and Carlile point out that computer sort ca-pability could replace the current labor-intensivesystem used by issuer and holder.3 The electronicsystem would be faster and would facilitate the de-velopment of computerized bookkeeping and set-tlement systems. It is not clear how the end of newissues of bearer bonds will affect the possibilityof automating the interest payment process, al-though the potential application of this type ofsystem will naturally decline.

The payment of interest on registered bonds iseasier because the paying agent knows the holderand initiates the payment process. Greguras andCarlile note that there is a great potential to useautomated clearing houses (ACHS) for these trans-actions, Following the issuance of a payment or-

‘Fred M. Greguras and Larry L. Carlile, “The Use of Electronic f3ank-ing for Bond Coupon Payments, 1980.

‘Ibid.

der specifying which accounts should be paid bythe bond issuer or paying agent bank, the ACHcould take responsibility for routing these interestpayments, which would be credited to an accountspecified by the bondholder. Savings would resultfrom the elimination of check-processing costs.

RETIREMENT OF BONDS

Bonds may be retired by payment at finalmaturity; by conversion to common stock if theinstruments are convertible; by refunding, throughenacting a call provision; or through periodic re-payment, if the bond is a sinking fund or serialbond issue.

Many bonds contain a provision allowing thecorporation to “call” or repurchase the debt in-struments at any time. This gives corporationsflexibility if market conditions change before thebond matures. The call price is usually above theface value of the bond, but generally this premiumdecreases as the maturity date is approached. Acorporation may move to call a bond because ofa drop in market interest rates or to be free of re-strictive protective covenants that may have beennecessary to gain financing initially. The initialdebt contract specifies whether the call provisionis immediate, that is, can be invoked at any timefollowing issue, or deferred, in which case the in-vestor is assured that no call will take place fora definite period of time, usually 5 to 10 years.

Call provisions become a disadvantage to inves-tors when the stable return anticipated when thedebt instrument was selected for investment islost. The investor may find it necessary to selectan alternative investment. If interest rates havedropped since the original investment, the investormust not only bear additional transaction costsbut also, in some cases, select between less attrac-tive investment alternatives.

For tax purposes, the income gained by the in-vestor from the call premium is treated as a capi-tal gain. For the corporation it is deducted as anexpense from ordinary income. Many experts be-lieve that the net tax advantages received by theinvestors and the corporation make call provisionsattractive to both parties.4

Refunding involves the replacement of one bondissue, prior to maturity, with a new issue of bonds.A corporation may wish to refund an issue to es-cape restrictive protective covenants, but the mostcommon reason is to take advantage of a drop in

‘James C. Van Home, Financial Management and Policy (EnglewoodCliffs, N. J.: Prentice-Half, Inc., 1983), p, 555.


market interest rates. Market conditions must beextremely favorable for the issuing corporation tojustify the expenses involved in refunding, whichinclude the cost of calling the old bonds, issuingthe new bonds, and, possibly, expenses resultingfrom the payment of interest on the old bonds dur-ing any overlap period.

The repayment of a total issue of bonds at ma-turity could present a severe cash strain for theissuer. Therefore, two methods have been devel-oped through which debt issues are retired in amore controlled and gradual manner: the issuanceof serial bonds and sinking fund provisions. Serialbonds give an investor a choice of maturity dates.The entire package of bonds is issued by the cor-poration at the same time, but the bonds matureindividually in successive years.

Most bond issues carry a provision requiringthat the corporation retire a given number ofbonds per year through a sinking fund managedby a trustee. The bond issuer makes payments intothe fund, with which the trustee finances the re-tirement, by calling or purchasing bonds selected(usually) by lottery. While calling before the an-ticipated maturity date may be undesirable for theinvestor, most investors value the assurance of or-derly retirement of debt and liquidity provided bya sinking fund provision. For bondholders whoseinstruments are not called, the sinking fund mayrepresent a reduction in risk, as the total amountof debt the organization holds is continuallyreduced.

PAYMENT OF INTEREST

The return of most debt investments is embod-ied in a periodic interest payment referred to asthe coupon. It is designed to compensate the in-vestor for the time-value of money, the lost oppor-tunity cost, and the risk assumed. Usually, thisis a semiannual payment. The market value of thebond is determined by the present value of thisstream of payments. Bonds with less traditionalpayment schedules have developed in response tomarket pressures. These include income bonds,zero- and low-coupon bonds, indexed bonds, andfloating-rate bonds.

While most bonds are strictly debts of the cor-poration, for which interest must be paid regard-less of the corporation’s financial situation, inter-est is only paid on income bonds when the earningsof the corporation permit. The corporation benefitsfrom the tax advantages of debt, since any interestpaid is deductible because it is part of a contrac-tual agreement, Also, unlike preferred stock, which

is discussed later, the decision to pay interestbelongs to management rather than the board ofdirectors. If not paid, interest accumulates and issenior to preferred and common stock dividendsand subordinated debt.

Income bonds are unpopular with investors be-cause the income stream from their investment isunpredictable. Some experts also believe that thepast association of this instrument with corpora-tions, particularly railroads, trying to avoidbankruptcy has made them unattractive to in-vestors. As a result, income bonds are used pri-marily in reorganizations, which of course mayperpetuate their negative image.’

Return paid on a zero-coupon bond is embodiedentirely in price appreciation to maturity. No pe-riodic interest payment is made, This bond offerstwo advantages to the investor: the bond cannotbe called, so the holder experiences no reinvest-ment risk, and an exact return is assured if the in-strument is held to maturity. For tax purposes,the investor must declare the interest accrued ina given year as interest income, despite the factthat this money is not available for his use. Thecorporation also deducts the interest expense forthe year accrued, although no actual payment ismade. While the corporation enjoys the advantageof no cash outlay until the maturity date of thebond, the no-call provision is a disadvantage ifmarket interest rates fall during the lifetime of thebond,

Two types of bonds, floating-rate and indexed,have become more popular in response to the con-cerns of both issuers and investors that long-termdebt instruments have generally been locked intoa rate of interest that reflected market conditionsat the time of issue, but that may not be desirableif market conditions change. For example, floating-rate bonds, which include instruments for whichthe interest rate is set in relation to 90-day Treas-ury bills, may be attractive to an investor whobelieves that interest rates are likely to rise dur-ing the lifetime of the bonds, and to an issuer whofeels rates will fall. To both parties the uncertaintyabout the return that will be received and the costof the borrowed funds may be disadvantages.

The return on indexed bonds is tied to the rateof inflation and therefore is considered fixed in realterms. These bonds become popular in times ofhigh inflation. In theory, any index can be selectedas a basis for setting the rate paid on this type of

61 bid., p. 551,


bond; however, in the United States the ConsumerPrice Index is generally used.

Information technology may be expected to in-crease the number and complexity of differenttypes of interest-paying plans for bonds. Indexedand floating rates can be designed to respond morequickly to changes in the base line on which inter-est is determined. This may result in some confu-sion for bondholders, as change may occur at sucha rapid rate that the logic behind it may not beperceived. More complex interest-paying arrange-ments will require special attention to the dis-closure of these bond characteristics for investors,a role likely to be the responsibility of brokers andissuers of bonds.

RATING OF BONDS

Two highly respected rating services for bondsare Moody’s Investors Service and Standard andPoor’s. Their ratings result from an analysis of thefinancial and business propects of the issuer andare used by individuals and financial institutionsas a tool for assessing risk.

Moody’s Investors Service offers nine possibleratings, ranging from a low of C, which representsextremely poor prospects for the issuer, to a highof Aaa, which represents an extremely low amountof risk and predicts that it is unlikely that any neg-ative change will affect the issue. Generally, orga-nizations with poor ratings must pay a higher rateof interest to borrow funds to compensate lendersfor risk.

It is rare for the rating of an issue to change.Any reevaluation by Moody’s or Standard andPoor’s indicates a very substantial change in thecondition of the issuing firm and attracts a greatdeal of attention from investors.

Those bonds that Moody’s rates “Baa,” thefourth highest rating, or above are consideredinvestment-grade bonds. Some financial institu-tions, including some commercial banks and manypension funds, are not allowed to invest in anyissues that do not make this grade. Some expertsbelieve that rating services have caused certaintypes of organizations, particularly municipal gov-ernments, to pay higher than warranted interestrates because of unfavorable and perhaps some-what subjective ratings.6 However, investmentcounselors and investors still rely heavily on therating services.

Information technology may be expected tocreate more competition in rating bonds as thecapacities of new online computers and interactivecable are explored. As technologies become moresophisticated and interactive systems become lesscostly, it has become possible to personalize ratingservices to the objectives of the individual investorin real time.

BOND TRUSTEES

As will be discussed later, the interests of theshareholders of a corporation are represented bythe board of directors. Bondholders have a specialrepresentative—the trustee—who is not part ofcorporate management and who is expected to actin bondholders’ best interests. Paid by the issu-ing corporation, the trustee is usually a commer-cial bank. The responsibilities of the trustee forbond issues over $1 million are specified in theTrust Indenture Act of 1939 and involve protect-ing the rights of the bondholders by ensuring boththat the initial contract is legal and, following theissue, that the corporation fulfills its contractualresponsibilities to the bondholders. This act, whichis administered by the Securities and ExchangeCommission (SEC), requires that the trustee actstrictly in the best interests of the bondholders.

It is the responsibility of the trustee to act toprotect the interests of the bondholders if the com-pany is in default—that is, fails to meet the provi-sions of the bond contract. This responsibility hasbeen brought to the forefront by the recent defaulton Washington Public Power Supply System(WPPSS) bonds. A problem the bond trustee ap-pears to be encountering is reaching and purvey-ing information to the 78,000 holders of the bonds.

in spite of the press received by the WPPSS de-fault and the efforts by the trustees to reach andinform bondholders, it appears that, prior to thefirst missed coupon payment on the WPPPS bonds,many bondholders did not know or did not under-stand that there was a problem.7 Communicationtechnology may facilitate attempts by the trusteesto reach bondholders in the future by improvinginformation flows and corporate recordkeeping.

THE EFFECT OF INFORMATIONTECHNOLOGY ON LONG-TERM

DEBT INSTRUMENTS

Long-term debt is likely to remain a significant

‘Brealily and Myers, p. 468.

part of corporate capital structure. Information

‘Lynn Asinof, “WPPSS Begins to Cause Pain for Investors, ” TheWall Street Journal, Dec. 28, 1983, p. 15.

—

Ch. 3—The Securities Industry— .—.——. . —

technology may change the approach of organiza-tions searching for finance and investors seekingdebt instruments as the following impacts of themain advantages of automated systems are felt:increased speed of handling information, moreprecise and less expensive analysis, and improvedcommunication systems.

Equity

A firm may also decide to gather capital throughissuing equity, or ownership rights, in the form ofcorporate stock. The investor receives with theshares of stock he owns rights proportional to thetotal amount of stock issued by the corporation.Equity capital strengthens the balance sheet andenhances the future borrowing power of the com-pany. Decisions to issue debt or equity are usu-ally based on what will maximize the market valueof the corporation.

From the point of view of potential investors,the purchase of equity may give the opportunityto share in the growth of the company. As some,if not all, of the return received may be in the formof capital gains, the investor may find a tax advan-tage in equity investments. Equity shareholdersmay also receive an income stream in the form ofdividends as a form of return on their ownership,In some cases, this return may be greater thanwhat would be realized from a debt investment.While tax laws have been subject to change, attimes there have been tax advantages from incomein the form of dividends rather than interest.

A firm may sell equity in two forms: commonstock or preferred stock. The choice will dependon the financial structure and objectives of the cor-poration and on industry and market conditions.The equity profile of a corporation may be ex-tremely complex. Both common and preferredstocks may be issued, and several varieties of pre-ferred stock may be active simultaneously.

COMMON AND PREFERRED STOCK

Common stock is generally more significantthan other types of securities in the capital struc-ture of a firm. The holders of common stock haveresidual rights to the income of the firm, whichthey usually receive in the form of dividends. Atthe same time, the liability of individual share-holders is usually legally limited, particularly forthe debts of the corporation. Additional rights ofholders of common stock include a claim on com-pany assets in the case of bankruptcy, followingthe claims of creditors and holders of preferred

● 8 1

stock; the right to maintain their share of owner-ship through purchase of new shares issued by thecorporation; the right to information on the oper-ation of the firm, to the extent that it is competi-tively feasible; and the right to transfer ownershipto another investor.

The most significant benefit for the owner ofcommon stock is the right to maintain control ofthe corporation through the election of the boardof directors, who in turn appoint the officers of thefirm and represent the interests of the holders ofequity in the firm. The management of the corpora-tion is expected to act in accordance with thegoals of the owners and to be accountable to themthrough the board.

Preferred stock is considered a safer investmentbecause holders of these shares have a claim onthe assets of the company before holders of com-mon stock, although after the holders of debt, inthe case of bankruptcy. Owning such stock alsocarries a prior claim to income in the form ofdividends. However, the preferred stockholderusually enjoys only limited voting rights, so thathe has less impact on the operation of the corpora-tion than do common stockholders.

DIVIDENDS

Depending on the corporation’s profits, corpora-tion earnings may be used to pay dividends tostockholders at the behest of the board of direc-tors. Dividends are only declared when the pay-ment will not impair the operation of the firm orlegally compromise its contractual relationships.tionships.

Two significant dimensions of the dividend pol-icy of a corporation are dividend stability and long-run dividend payout ratio. a A dividend may bestable in terms of real dollars paid out or in theratio of dividends to earnings. While the lattermay appear more rational, it is rarely used. Con-sideration of the return expected by stockholdershas led most corporations to pay a stable dollardividend when possible, indicating the importanceof income as a motivation for investing in equityissues.

Decisions on long-run dividend payout ratiosmay be based on the objectives of the owners andmanagement of the firm. The reinvestment of asignificant portion of earnings may result in highergrowth for the corporation as a whole and maybeattractive to investors desiring long-term income

‘Lawrence D. Schall and Charles W. Haley, Introduction to Finan-cial Afanagement (New York: McGraw-Hill, Inc., 1980), p. 366,


in the form of capital gains. In this case, earningsare used as a form of internal financing, and anydividend paid is from earnings left over afterfinancing objectives are met. If the shareholdersof the corporation are interested in more immedi-ate income, a fixed payout may be used. In thiscase, the amount of money available for internalfinancing would differ from year to year as itwould be, in a sense, the residual part of earnings.

THE EFFECT OF INFORMATIONTECHNOLOGY ON EQUITY

Information technology may be expected to af-fect equity instruments directly in three areas: thepayment of dividends, the recording and proof ofownership, and the transfer of ownership. Thetransfer of ownership of stock will be examined asa function of the securities industry in a latersection.

The improved ability of shareholders to moni-tor and analyze the activities of corporations moredirectly through the use of new technologies mayalso have some impact on individual firms. Themagnitude of this impact will largely depend onthe characteristics of the ownership of the corpora-tions involved. An increased awareness by theshareholders of the environment and operation ofthe firm may be a benefit; however, managementsand boards of directors may find an increased de-mand for information dissemination and respon-siveness.

Detailed records are maintained on who the cor-poration’s shareholders of record are to assure thatthey receive their ownership rights. While tradi-tionally this operation was solely paper-based andinvolved the issuance of certificates that servedas proof of ownership, there is some indication thatthe application of information technology is facil-itating a movement toward a book entry system.This type of arrangement is expected to benefitthe issuers of equity by lowering operating costs,including those of printing and postage, and tobenefit the holders of equity by making it easierto transfer ownership of these securities.

Book entry may require some adjustment byshareholders because the mechanics of proof ofownership will differ. The success of this type ofprogram will depend largely on how apparent andimportant the benefits involved are to the in-vestor, particularly when trading.

The mechanics of developing a dividend policymay be aided by the application of informationtechnology; however, the value of improvementsin communications and computer capabilities is

likely to be most directly felt in the actual payingof dividends. Operation costs for this activity maybe expected to decline as recordkeeping and sort-ing activities can be automated. It may also bepossible to use electronic funds transfer for thepayment of dividends. While initial costs for thistype of system may be high, the resulting efficien-cies and the decrease in postage costs may be ofgreat benefit.

Convertible Securities

Preferred stock or bonds that can be convertedto common stock at the option of the holder arecalled convertible securities. Such securities offera middle ground to investors who demand lowerrisk than common stock carries yet want to par-ticipate in the growth of a corporation.

Convertible bonds offer both interest paymentsand conversion opportunity. This instrument is at-tractive for the issuing corporation because gen-erally a lower-than-market rate of interest may beoffered, owing to the conversion option. A corpora-tion may view a convertible bond as both a short-run debt and long-run equity issue without thecost of two separate issues. Convertibles are con-sidered deferred common stock financing. Theseinstruments were also traditionally attractive tonew or speculative corporations unable to gatherequity capital on other terms or to corporationswith low-grade credit ratings.

Compared to the issuance of common stock, theissuance of convertible bonds creates less dilutionof earning per share at the time the bonds are firstoffered and at the time of conversion. At the timethe bonds are issued, no stock is involved; at con-version, the size of the conversion generally addsfewer shares than a new issue of common stockwould. Usually, it is expected that the financialcondition of the issuing firm will be improved inboth yield and stability at the time of conversion,as indicated by the fact that the conversion priceis higher than the market price of the commonstock at the time the bond is issued.

The stock package stipulated in the conversionplan may be more favorable to the organizationthan one designed later when changing marketconditions could be taken into account. The expec-tations of investors for the common stock provi-sion may be less stringent at the time the bondsare issued because of both the benefits to be re-ceived before conversion and the anticipation ofparticipating in corporate growth at the time ofconversion.

The tax provisions of typical convertible bondsmay be beneficial for investors. The conversion ofthe bond to common stock is considered a tax-freetransaction by the Internal Revenue Service. Theyear-plus-one holding period for long-term capitalgains on any subsequent sale of the common stockis counted from the time the bond, not the stock,is issued.

One variation on convertibles that often resultsfrom failed takeover bids is the exchangeablebond, which can be converted to the stock stipu-lated in the bond contract of a corporation. Thisstipulated stock may be issued by someone otherthan the issuer of the bond. The exchangeablebond requires the investor to evaluate the creditpotential of the issuing corporation and the long-range growth and earning potential of the firmwhose common stock is involved. Tax provisionsmust also be a major concern for such an investor. g

The Internal Revenue Service considers this con-version to be the equivalent of two cash trans-actions because the securities of two different cor-porations are involved. Since the bond would notbe redeemed by a rational investor unless the stocksells for more than the original cost of the bond,a taxable gain is realized.

Recently, the interest in this bond instrumentby both corporations and investors has grown.While in the past institutional investors domi-nated this compromise market, individuals arebecoming more active. Information technologymay be expected to affect convertible instrumentsto the extent that it makes more sophisticatedanalysis cost effective for investors and financialintermediaries, and therefore the complex natureof the instrument may be less of a disincentive topotential issuers and investors. Growth in thisarea may be expected, however, to be related pri-marily to the fiscal needs of corporations involvedand to the demands of consumers.

Short-Term Debt–Money Market Securities

The essential characteristic of money marketsecurities is their liquidity. This derives from theirshort maturity, by definition less than 1 year, andthe generally high quality of the issuing organiza-tion. ’” There are several types of money market

—“’Investing in Convertible Bonds,” Business U’eek, June 20, 1983,

p. 191.‘“Roland 1. Robinson and Dwayne Wrightsman, Financial ,$fm-kets;

The Accumulation and Allocation of Wealth [New York: McGraw-Hill,Inc. 1974), p. 14’7.

Ch. 3— The Securities Industry ● 83

securities and, as the market demands, it is likelythat additional instruments will be developed.These short-term debt instruments include Treas-ury bills, certificates of deposit, commercial paper,bankers’ acceptances, and repurchase agreements.They are important to corporations in money man-agement as both financing tools and investmenttools.

A Treasury bill is a short-term debt of the U.S.Government. The bills are sold on an auction basisat a discount from face value. Since the U.S. Gov-ernment is continually borrowing to pay off debts,Treasury bills are issued on a very frequent basis.Biddings are closed by the U.S. Treasury weeklyfor 91- and 182-day debt issues and monthly for9- and 12-month bills. Short maturities and thebacking of the U.S. Government make them de-sirable investments.

Although the market is quite short-term, an ac-tive secondary market has developed. Therefore,bills can be traded before the maturity date, add-ing to their liquidity. Treasury bills are a desirableshort-term investment tool for corporate investorsbecause of the high level of liquidity and low levelof risk they carry.

Commercial paper is a short-term debt issued byfinance companies and some other corporations.Interest rates for commercial paper are generallyhigher than for Treasury bills because of the riskfactors involved in private firms. Many companiesuse commercial paper to supplement bank loans.In general, it is a less expensive method of financ-ing for prime quality obligatory than loans (be-cause banks are not used as intermediaries) andmay fill a need at a time when the issuance of long-term debt is not appropriate. The issuance of com-mercial paper lacks the supportive, interactivenature of a relationship between a corporation anda commercial bank.

Commercial paper may be sold directly by theissuing corporation or through a dealer. Sincedealers screen the instruments to a certain extent,commercial paper placed by a dealer may be lessrisky for an investor, although commercial paperdirectly placed by some major corporations is ofvery high quality. The investor holds an unsecuredshort-term promissory note as evidence of thedebt, and the instrument is tradable in moneymarkets.

Commercial paper is designed to avoid a require-ment of registration with the SEC. Because of pastproblems in commercial paper markets- specifical-ly, those generated by the bankruptcy of PennCentral-investors have caused the market to


become quite conservative. Commercial paper ofcompanies that do not have a very high financialreputation is rarely marketable.

Banker-s’ acceptances, which originated at aboutthe same time as international trading, continueto play a significant role in importing and export-ing. A banker’s acceptance is issued by a corpora-tion and guaranteed by a commercial bank. Theacceptance is a liability of the bank and is tradedin money markets based on the reputation andcredit standing of the bank. The instruments areof value in international trade, owing to the time-lags that can occur because of the physical aspectsof transporting goods and because of the uncer-tainty with which many traders approach foreignmarkets.

Certificates of deposit are negotiable securitiesissued by commercial banks. They have fixed ma-turities and pay interest to maturity. Yields on cer-tificates of deposit are higher than for Treasurybills and are paid at the time the certificatematures, The risk associated is dependent on thequality of the issuing bank. Certificates can betraded in a secondary market before maturity; thismarket is particularly active for the certificates ofdeposit issued by major commercial banks.

Repurchase agreements stipulate that the short-term securities sold will be repurchased by theseller. They are frequently issued by bond dealersto finance inventories. U.S. Government securitiesare the usual basis for the agreement throughwhich an investor “purchases” the securities whileagreeing to resell them at a specified time andprice. The term of repurchase agreements may befor several months or for overnight, and thereforehas the potential to offer a great deal of flexibility.

Major questions involving repurchase agree-ments center on the level of risk involved and howthe transaction should be classified. Historically,repurchase agreements were considered extremelysafe transactions, although they are not federallyinsured, because they involve Government secu-rities and are handled by recognized players in thefinancial service industry. However, recent col-lapses of dealers caused some investors to experi-ence high losses.

The qualification of repurchase agreements asa sale or debt has created some controversythroughout the financial service industry. The In-ternal Revenue Service has held that it is a col-lateralized debt, and therefore the investor wouldbe liable for interest income received. Dealers inGovernment securities sales disagree and considerthe instrument to be a purchase/sale agreement.

Congressional action is expected to confirm thisstance. 11

The short-term debt market has been greatly af-fected by the use of information technology. Thenature of some short-term debt includes a definiteend-date for the instruments. Improvements insorting and transacting brought about by comput-er capabilities may extend the effective lifecycleof the instrument since it can be marketed morequickly. The availability of better data and the im-proved ability to analyze information about thedebt instrument and about the issuing organiza-tion may affect the market for short-term debt in-struments. The potential of short-term debt in-struments as investment tools may be expectedto improve to the extent that the application oftechnology will refine this evaluative process.

Information technology may also improve thepackaging of short-term debt instruments by al-lowing securities industry marketers to match bet-ter the characteristics of various instruments tothe demands of investors. The proliferation ofmoney market mutual funds and demand accountsmay be a result of this opportunity.

Options and Futures Contracts

The capital market investor’s investment goalsmay not be completely met by debt and equityissues. The desire of investors to increase their li-quidity or return or to limit risk has led to the de-velopment of instruments that comprise what maybe considered a second-tier securities market.These securities are based on the fortunes and fluc-tuations of capital markets, but are not essentialto the capital structure of individual firms.

Off-shoot investment products include optionson stocks and bonds and futures contracts on com-modities, currencies, and market indices. These in-struments are all based on the market behavior ofunderlying products or securities. The interest ofthe investor is focused on the price fluctuationsof the product, usually in a relatively short timeframe, rather than on the intrinsic operations ofthe firm. Interest in options and futures contractsinvestment has led to the development of an in-dustry structure specializing in these products, in-cluding exchanges and clearing corporations. Thedevelopment of this structure has increased inter-est in the products and has led to further growthin option and future contracts trading.

“’’The Repo Market Is Still in Shock, ” Business Week, Apr. 4, 1983,p. 74.


Options

Options provide a method of participating in asecurities market without ownership of actual debtor equity instruments. An option is a tradable in-strument that grants an investor the right to buy(a call option) or the right to sell (a put option) aspecific security at a given price for a limitedamount of time. It is a legal contract in which twofactors are explicitly stated: the expiration dateand the exercise price. The value of an option isdirectly related to the market price of the under-lying security. The exercise price of an option in-dicates the change anticipated in the market. Theexercise price of a call option (at which the investorcan buy the underlying security) is, at the time theoption is issued, generally higher than the marketprice of the security. Conversely, the exercise priceof a put option, which entitles the holder to sellthe security, is generally lower than the marketprice. Options may be written and sold for realestate, debt instruments, and foreign currencies;they have recently become most significant inequity markets.

Options are “wasting assets”; that is, after thespecified expiration date, they have no value.Therefore, the timing of market changes, as wellas direction, must be correctly evaluated by theinvestor to assure that the potential value of theinvestment is realized. The writer of an option, ex-cept for warrants, which are discussed below, isnot controlled by the organization named in theunderlying security. More shares of stock may berepresented collectively through outstanding op-tions than have been issued by the corporation.While option writing and buying may be part ofa complex investment portfolio that includes debtand equity instruments of an institution, the oper-ations of option markets are, in a practical senseat least, totally separate from the capital structureof a corporation.

While options have been traded among individu-als for many years, the market has grown andbecome more sophisticated since the organizationof regulated exchanges in the mid-1970’s. Thetrading of options entails a relatively new marketstructure; therefore, the influence of informationtechnology on this structure is quite visible. Forexample, options use book entry rather than cer-tificates as proof of ownership.

PARTICIPATING IN THE OPTIONS MARKET

Participants in options markets attempt to prof-it from their knowledge of the potential declinesand rises of a corporation but have no direct stakein its operations. In the basic options market,players may be involved in four activities: buyingcall options, buying put options, writing call op-tions, or writing put options.

An option buyer hopes to profit from or protecthimself from a change in the price of the under-lying security. The holder of a call option has theright to buy a security at a specified price. Thisinvestor may do three things with this right: ex-ercise it by buying the underlying securities, sellit to another investor, or let it expire. He has nolegal obligation to make any transaction of theunderlying security. Further action on his part in-volving the contract is self-motivated and will re-sult only from his evaluation of the market.

The writer, on the other hand, is obligated to buyor sell the underlying security under the conditionsspecified in the contract. His continued involve-ment with the instrument is not voluntary and,while in some cases may not be required, is legallyenforceable. Both writers and buyers of optionscan liquidate their positions by purchasing off-setting options before the expiration or exerciseof the option.

The motivation of an investor to buy a call op-tion may be related to two separate strategies. Hemay hope to participate in the benefits of a risein stock prices with a limited current investmentand therefore may buy call options to achieveleverage or establish a future price at which heplans to purchase the security. He may also bemotivated to purchase call options to limit risk,either as part of a conservative overall investmentstrategy or to hedge a short stock position.

For the individual investor, leverage may bemeasured through the percentage of total assetsnecessary to invest for a given rate of return. Itis assumed that the financial assets of an in-dividual are finite and that each investment deci-sion is evaluated by its opportunity cost. Achiev-ing leverage could be the motivation for buyingcall options for an investor who expected the priceof an issue to rise. The cost of buying a call optionfor a given number of shares of stock representsa much smaller investment than does the purchase


of the shares. A higher percentage of return on in-vestment may result in the case of a rise in theprice of the stock to the holder of a call option.However, it must be recognized that with a highlyleveraged investment, a larger share of the invest-ment may be lost. Since options are wasting as-sets, the investor must be correct in his evalua-tion of the timing as well as the likelihood of a priceincrease in order to profit from his purchase of op-tions. If the option expires without being exer-cised, the investor’s loss would be equal to his in-vestment. Absolute return or loss will usually belower for the option investor than if he held theequivalent number of shares of stock.

Options are also bought by investors who wouldlike to invest in the underlying security and ex-pect its price to rise but who do not have the cashto make the investment. The call option estab-lishes a guaranteed maximum price for the secu-rity. This strategy is particularly useful if the in-vestor anticipates receiving a flow of cash beforethe expiration of the option. If the price of thestock falls below the exercise price, the investormay purchase the security at the market price andconsider the option a sunk cost.

While investment in options increases the lever-age and establishes the price of future stock forthe investor, the lower dollar investment requiredto buy call options rather than stock limits abso-lute risk, since the investor exposes less of hisassets to the market. A common, conservative in-vestment strategy is to purchase call options andinvest the difference between the options and theprice of the underlying security in a low-risk in-strument, such as Treasury bills. Any loss in-curred through the options investment would beat least partially off-set by the interest earned onthe investment of the remainder.

Decreasing risk may also motivate an investorto purchase call options if he maintains an ex-tremely risky position in equity markets by sell-ing short, that is, selling securities he does not ownin anticipation of a price decline. This investortheoretically exposes himself to unlimited loss ifthe price of the stock increases because he wouldbe forced to pay market prices to deliver the secu-rities. By buying call options, the investor whotakes a short position establishes his maximumpurchase price for the securities he is selling andtherefore insures himself against limitless loss. Ofcourse, if the market behaves in the manner antic-ipated by the short seller, the price of the optionis lost profit.

While the buyer of call options generally acts inanticipation of increases in the price of the under-lying security, the buyer of put options attemptsto profit from or limit risk if the price declines. Theoption grants the holder the right to sell at an es-tablished price, and therefore it can be used forleverage and for limiting risk. As with call options,the investor must have correctly analyzed the di-rection of the price change and the timing of thechange in order to profit.

The conservative investor can use put optionsas a hedge against a substantial decline in the priceof a stock he holds. This strategy may be particu-larly attractive as protection for an individual whohas a significant portion of his assets invested ina single security. However, it must be recognizedthat the insurance provided only lasts through thelife of the option and that the cost of the optioncuts into the investor’s potential profits.

The writer of an option exposes himself to fargreater risk than the buyer does. A writer of calloptions may be required to sell the underlyingsecurity to a holder at the exercise price at anytime during the life of the option. Conversely, thewriter of a put option may be required to buy theunderlying security from the holder at any timeduring the contract.

The writer of call options is motivated by thepossibility of gaining a return through premiumincome, Calls may be covered, wherein the writerowns the specified underlying security, or uncov-ered, wherein the writer would be required to pur-chase the security at market cost if he is assignedan exercise. Leverage for an investment portfoliomay be the most significant motivating factor forthe writer of covered calls. Return from the under-lying security may be realized both through divid-ends or interest paid and through income receivedfrom premiums. While the covered call writer mayhope to maintain his position in the underlyingsecurity, option writing may greatly increase hisincome-producing potential.

The writer of uncovered calls is the player atmost risk in the options market. His potential lossmay equal the market price of the stock less thesum of the exercise price and premium received forthe option and, in theory, is limitless. The un-covered call writer must be extremely sensitive toany factors in the economy at large or for the cor-poration that may cause a significant price in-crease.

A writer of put options is obligated to buy thespecified underlying security at the exercise price

Ch. 3—The Securities Industry . 87

at any time until the option expires, The put writermust have sufficient liquid assets to buy the secu-rity and, as an exercise is only likely when the ex-ercise price is higher than the market price, hemust anticipate paying more than the value of thesecurity. The option writer who trades through anexchange is required to deposit cash or securities,referred to as margin, with a brokerage firm. Putsmay, alternatively, be secured with cash equal tothe option exercise price. No additional margin re-quirements will be required in this case, and in-terest may be earned by the writer on the cash de-posited.

Investors are usually motivated to write putsby a desire to earn income from premiums, theprice paid by the buyer of an option to the writerof that option. The opportunity to purchase thespecified securities may also be a motivating fac-tor in some cases. In a stable or rising market, itis possible to earn premium income with relativelylow risk; however, demand for put options may beexpected to be fairly low in this circumstance.Some put writers hope to acquire the stock at anet cost which, considering premium income, isless than the current value of the stock.

The four possible ways of participating in theoptions market may be combined by an investorto form a strategy he believes is most likely tomeet his investment goals of producing income orlimiting risk. The options tactics chosen are influ-enced by the investor’s expectations about howthe price of the underlying security is likely tochange in direction and magnitude.

Spreads and straddles are the two most commonmultiple-options investment strategies. Spreadsare used to limit risk in option transactions andinvolve writing and buying the same type of op-tion, calls or puts, for the same specified security.The options generally have different expirationdates or exercise prices. If the investor wereassigned an exercise for the option he wrote, thespread benefits would disappear, and his risk posi-tion would be drastically changed. The writer ofspreads generally anticipates little change in theprice of the underlying security. A stable marketprovides his best opportunity for profit.

The investor who anticipates a great change inthe price of an underlying security but is unsureof the direction or magnitude may maintain astraddle position. The straddler either writes orbuys both a call and a put option for the same secu-rity. Both the call and the put should have thesame exercise prices and expiration dates. Buyingstraddles has limited risk because maximum loss

equals the premium price and, theoretically, un-limited profit potential. However, the price changemust be significant in order for the investor toprofit, and the investor must be correct in hisevaluation of the timing of the change. Straddlewriters are generally motivated by their belief thatthere will be little, if any, change in the price ofthe security and, therefore, that if an exercise wereassigned, profit from premium income would in-sure a net profit after costs of satisfying the exer-cise conditions. Risk for straddle writers is limit-less, as a substantial loss can be incurred on bothpositions if the market price for the security fluc-tuates more than expected.

PRICING OF OPTIONS

The premium (i.e., price) of an option is subjectto change and is influenced by characteristics ofthe option, the underlying security, and generaleconomic conditions. Factors influencing the pre-mium include the expiration date of the actual in-strument, the price and volatility of the underlyingsecurity, supply and demand effects on the optionmarket for the specific security, and, on the wholeas well, interest rates. The premium for an optionis comprised of intrinsic value and time value. Anoption has intrinsic value any time the differencebetween the exercise price of the option and themarket price of the security works to the advan-tage of the holder. Anytime this is not the case,the option has no intrinsic value, and the premiumis based only on time value.

Time value represents an evaluation by an in-vestor of the potential of the option to increase invalue owing to a change in the price of the under-lying security prior to expiration of the option.Time value may generally be expected to declineas the expiration date approaches and as the pos-sibility of fluctuation in the security price de-creases. It is also influenced by the amount of dif-ference between the exercise price and the marketprice of the underlying security. A large differencemay result in a decrease in time value because thepossibility of profitably exercising or selling of theoption is more remote. Increasing interest ratesgenerally result in increases in time value.

Warrants

A warrant is unique because it is issued by thecorporation that issues the underlying securityand, as such, is part of the capital structure of thefirm. A warrant is a type of call option that grantsthe holder the right to purchase company stock

35-505 0 - 84 - 7 : QL 3


at a stated price, usually somewhat above marketat the time of issue. The value of the warrant itselfat any time is dependent on the current price ofthe stock of the issuing corporation. Warrants areoften offered with debt issues by corporations tomake the debt issues more attractive to potentialinvestors. They offer a participation right of sortsif the corporation grows. The investor benefitsfrom the fixed return of the debt investment aswell as the opportunity to purchase stock at anestablished price.

As with all options, an exercise price is specifiedfor the warrant. It may have a specific expirationdate or be perpetual. The contract also specifieswhether it can be traded, as with other option in-struments, or be exercised only by the holder.

Unlike other options, warrants directly affectthe capital structure of a corporation. A call or putoption is exercised through a capital market andwith no net change in the number of shares out-standing for the corporation. However, when awarrant is exercised, the corporation issues newshares of stock; therefore, the earnings of the com-pany, from the point of view of the shareholders,are diluted. This situation complicates valuationboth of the stock of the corporation and of thewarrant.

THE EFFECT OF INFORMATIONTECHNOLOGY ON OPTIONS

Information technology is likely to continue tofacilitate the development and trading of options.Because option markets have only recently be-come highly structured and have been heavily de-pendent on technology from their inception, thecontinuing application of communications andcomputer technologies in these markets is notlikely to lead to major revisions in ways of doingbusiness to the same extent as they have in debtand equity markets. Options may serve as a test-ing ground of sorts for new technologies, and tech-nology use in this area may presage future applica-tions throughout the securities industry.

The use of personal computers and sophisticatedcommunications technologies may spur the devel-opment and marketing of option contracts by in-dividuals and may lessen the role of brokers inbringing writers and buyers together. Informationtechnology should also facilitate the monitoringof option markets by investors, brokers, corpora-tions issuing securities on which options are writ-ten, and market observers and regulators. Thismay become increasingly important as the use ofoptions as an investment instrument grows.

Futures

Futures, or future contracts, are legally bindingagreements that call for the purchase or sale of realor hypothetical items at a stated price at sometime in the future. Future contracts can be devel-oped for anything and are traded on establishedexchanges for physical commodities such as porkbellies and coffee, for financial instruments, andfor hypothetical stock portfolios.

Even though future markets at one time werefocused only on commodities; they have expandedgreatly. In the past, communities needed to be self-sufficient in their production of foodstuffs andother necessary goods because transportation be-tween regions was not efficient. As lack of trans-portation became less of a barrier to trade, com-modities markets developed that allowed forspecialization in production and made a widerassortment of goods available. Centralized com-modity markets made more extensive trading pos-sible, and future markets grew from them to ad-dress price-change risks.

Commodity futures markets developed becauseof the need in both agricultural and industrialsocieties to minimize the potential impact of un-known and hard-to-predict forces that influencethe price and availability of resources and prod-ucts. For example, through the use of futures con-tracts, food processors are able to set definite max-imum prices for the commodities they will need forproduction throughout the entire year. Most cropsare only harvestable for a very short period of timein any year, and it is desirable for farmers to beable to sell all of the harvest at that time to avoidthe need for expensive storage. While the demandfor some food products, such as turkey and pump-kins, may be seasonal, food processors face a year-round demand for products made from commodi-ties only available for a very short time. Theseprocessors need to have the commodity availableat a predictable price when it is needed. By pro-viding a reliable means to conduct future buyingand selling, futures markets have served to equal-ize the marketing of most seasonal farm crops. 12

The development of futures markets centeredaround the desire to transfer risk. The play of themarket attracts a large quantity of risk capitalthrough which changes in commodity price levelscan be absorbed with only a minimum direct im-pact on producers and processors of commodities.

‘2 Future Industry Association, “Development of Commodity Ex-changes, ” Futures Trading Course and Handbook, Washington, D. C.:1983, p. 1-4.


This allows the producers and processors to oper-ate at lower cost than would be possible if they hadto bear the entire risk of market fluctuations. Inturn, this lowers prices to the public. ”

Commodity futures markets help effect stabilityin consumer prices. Because food processors canbound their costs, consumers are assured thatproducts will be available when needed at a rela-tively predictable price and therefore approach themarket in rational manner. This price stability isboth of importance to the general economy of theNation and of social interest, since allocationsthrough Government programs, such as foodstamps, can be set with some certainty as to whatmarket conditions will be for the recipients.

THE OPERATIONS OF FUTURES

The taking of a position in future contracts fora product on which one depends in one’s primaryeconomic activity is called hedging. For example,General Foods might be expected to hold a posi-tion in coffee futures contracts to guarantee themaximum price it would need to pay for beans forfuture production. In the discussion of futures,hedging is not a speculative strategy but ratherrefers only to the activities of players who face riskbecause of possible fluctuations in price and avail-ability of an actual commodity.

STOCK FUTURES

Options, which were discussed in an earlier sec-tion, allow for the transfer of risk associated witha particular debt or equity issue. Broad changesin the stock market prices pose a blanket risk tohighly diversified investors, and stock futures mayoffer inherent price change protection to these in-vestors. Stock futures are contracts that call forthe buying or selling of a mythical basket ofstocks, usually a grouping which is used in an in-dex of market behavior. Due to practical limita-tions, these futures are settled through cash ratherthan the actual purchase or sale of the underlyingsecurities.

The availability of stock futures through whichan investor can hedge against swings that affectthe entire stock market may add a great deal ofstability to that market and is expected to be ofgreat significance to institutional investors, whohold a growing proportion of all shares. Investorsmay be more judicious in their response to mar-ket changes because their risk may be minimizedby the holding of offsetting positions in stock

“Ibid.

futures, and therefore the stock market may be-come less volatile.

If the stock market becomes less volatile, itmust be expected that funds currently held inmutual funds or the savings instruments of depos-itory institutions because of the desire of the in-vestor for stability will be transferred to direct par-ticipation in capital markets. More money may beavailable for corporate capital formation; how-ever, this may be at the expense of the bankingstructure.

Questions that must be addressed are: what hap-pens to the risk that is transferred away from thestock market? and what effect will this transferhave on the market? The result may be that theassumers of risk, in this case players in stockfutures, may be expected to be advised better andmore able to accept this position.

One cannot blindly accept that risk was bad forthe stock market when, in fact, it was the market’sreason for being. It is essential that some meansof projecting what the impact of the possible endof the need for a risk-accepting role by stock ex-changes will mean to the process of capital forma-tion be available. It is also necessary to determinewhat, if any, effect the activities of markets instock futures will have on the inherent soundnessof capital markets. Stock futures may cushion thestock market from changes in the general econ-omy; however, it is not clear what impact a cata-strophic event in the futures market might haveon the entire capital formation process.

THE EFFECT OF INFORMATIONTECHNOLOGY ON FUTURES

Futures markets provide a glimpse of what thepossible impacts of information technology on thesecurities industry as a whole may be. The poten-tial of information technology was available asmany of the operations of this segment of the in-dustry were developed.

Modern futures markets need both man and ma-chine to operate. Human decisionmaking has beenand will continue to be the one irreplaceable andessential characteristic of any successful market.However, the volume of trading demanded by cur-rent market conditions requires a level of opera-tions not feasible for mortals in a free society atan acceptable cost. It would be impossible to op-erate futures markets with the precision and at thevolume demanded by the market without the ap-plication of information technology; for example,for performing simple tasks, such as sorting faster,that would be impossible for a human work force.


Computer and communications technology didgenerate a futures market; however, if these tech-nologies were not available, the market could nothave grown to its current size and importance. Itsabsence would have effectively foreclosed the pos-sibility of responding to the demands of the econ-omy for the level and quality of operations nowseen.

Mutual Funds

The importance of mutual funds as institutionalinvestors is discussed earlier in this report; how-ever, these funds also have a role in the securitiesindustry in the role of investment instruments.

Mutual funds offer investors a way of partici-pating in securities markets without directly pur-chasing capital or money market securities. An in-vestor may be attracted to a mutual fund as a sortof proxy method of participating in the securitiesmarket. The individual benefits from the expertiseof the fund management, and risk is generallylower than that through direct participation, al-though actual risk differs significantly, based onthe investment strategy of the fund. Mutual fundsallow investors greater liquidity than capital mar-kets; shares are redeemable at any time at currentasset value less applicable redemption fees.

Mutual funds have traditionally been especiallyimportant for the small investor because they canfrequently be entered with a smaller amount of in-vestment capital than can the securities market,as the money invested is pooled with that fromother participants. The investor may also takeadvantage of the possible benefits of a diversifiedportfolio that he might not have been able to sup-port by directly participating in capital or moneymarkets. For the investor interested in an entireindustry rather than a specific company, certainfunds allow such a focusing of investments.

Mutual funds that are made up of corporatebonds and stocks are significant to the formationof capital because they attract investment moneyto the market that would not otherwise have beenavailable. While some mutual funds centered oncapital markets have charged high transaction fees(called a load), their availability has increased bothconsumer options and competition for investmentdollars throughout the financial service industry.The application of information technology to thedevelopment and marketing of mutual funds shouldincrease the number and variety of funds availableto consumers.

Money market mutual funds are one of the moreliquid instruments available to investors. Theliquidity of this type of investment is demon-strated by the fact that, in many cases, sharehold-ers may access their funds by writing drafts, asquickly as a bank checking account by requestingwire transfers, or in some cases, by using an auto-mated teller machine (ATM).

Such funds invest in short-term money marketsecurities and, because of the nature of the under-lying securities, are extremely liquid and relativelyrisk-free. Money market mutual funds are a valu-able cash management instrument for businessesand an extremely valuable tool for individual in-vestors, both the “small” and the more affluent.

Money market mutual funds give investors ac-cess to money market securities on terms thatthey could not likely match themselves. Econ-omies found in issuing and servicing large-denom-ination money market securities result in higheryields than those offered on similar securities ofsmaller denomination. 14 The holder of shares in amoney market mutual fund benefits from thishigher rate of return.

Money market mutual funds have enjoyed ma-jor market success. While information technologyis not directly responsible for this, many industryexperts believe that it would not have been possi-ble, from an operational or business point of view,to introduce this type of fund without the supportof communication and computer technologies. In-formation technology makes it possible to retainthe highly liquid character of the funds by simpli-fying access for the investor. The level of tradingin short-term securities required by the fundswould be difficult to complete physically withoutthe assistance of information technology.

The number and variety of capital and moneymarket mutual funds will probably continue togrow. While this growth will provide more optionsfor investors, it may also have an impact on theway in which securities markets operate. Althoughinformation on the investments of the fund is in-cluded in prospectuses and periodic reports toshareholders, it is not clear that the individuals in-vesting in the fund take an active interest in whatinstruments their money is invested in. While thepool effectively lowers risk, the responsiveness ofindividual shareholders is markedly lower than

“William Jackson, ‘ Money Market Mutual Funds, ” CongressionalResearch Service Issue Brief No. 81057, Jan. 20, 1983.

Ch. 3— The Securities Industry ● 91

would be expected in normal market circum-stances. The institutional investor behaves dif-ferently, for better or worse, because he makesdecisions differently, and this may have an impacton securities markets.

Central Asset Accounts

The central asset account is considered by manyto be the single most important investment prod-uct of the next decade. ’5 In developing the market-leading Cash Management Account, Merrill Lynchrecognized that the financial needs of a single cus-tomer are interrelated and form well-defined typesof systems. The central asset account attemptsto meet an investor’s full range of financial needswith three basic components: the securities marginaccount, the money market fund account, and azero-balance bank loan account that can be ac-cessed by check or card. A central asset accountprovides a full range of financial services to itsuser. The accounts offer a centralized method ofcontrolling assets and, as free credit balances inthe zero-balance account are “swept” into a moneymarket fund, both liquidity and return are maxi-mized for the investor.

Nearly all major securities firms offer a centralasset account. While they have the same basiccomponents, their features often differ. Among the

i ~T& Fin8nCia] .~crt,ices Industr\’ of 7’omorrour, a N?pOrt prepared h)’the Committee to I?xamine the Future Structure of the Securities In-dustry, National Association of Securities Dealers, November 1982,p. 20

“Herbert M Allison, Jr., “The Perspective of a Diversified Finan-cial Services Company, ’ panel presentation at the Eighth Annual Con-ference of the Federal Home I.oan Bank of San Francisco, Strategic[~lannjng for ~conomjc and Technological Change in the Financial Serl’-ices Industr~,, San Francisco, Calif,, Dec. 9-10, 19/32, p, 157.

features that distinguish accounts are: how fre-quently “sweeps” of free credit balances occur,whether a charge or debit card is issued for access,the offering of excess insurance coverage; whetherthe account is accessible through an ATM net-work, and the availability of a bank overdraft lineof credit.17 The accounts have been targetedtoward the upscale market, an estimated 10 to 12percent of the population. A substantial minimumopening deposit of securities or cash, usually of be-tween $15,000 and $20,000, is required and an an-nual fee is charged.

Merrill Lynch first offered the Cash Manage-ment Account in 1977 and as market leader nowhas nearly 1 million accounts, The market growththat central asset accounts experienced may havebeen attributable in part to market conditions,especially high interest rates. As conditions havechanged, the growth of these accounts has de-clined.l8 The significance of the account in the longrun is difficult to judge, although it seems likelythat it will continue to serve the needs of a seg-ment of the market. One important feature of acentral asset account is that it allows brokers tofill more of their customers’ financial needs formore of their personal financial lifecycle. 19 Thismakes the account a valuable tool for financialservice offerers, as it may help to attract and re-tain customers.

“Joseph Diamond, “Central Asset Accounts Developed by the Secu-rities Industries, ” Financial Services Institute Handbook, vol. 1, p. 358;prepared for distribution at the Practicing Law Institute Financial Serv-ices Institute Program, Feb. 14-15, 1983.

“Alice Arvan, “Asset Accounts Reach Out for Broader Markets, ”.4merican Banker, May 20, 1983, p. 9.

‘William L. White, “The Outlook for Money Market Mutual Funds, ”a report to the Investment Company Institute, Sept. 30, 1982, p. 62,

Appendix 3B: Capital Formation and theof the Securities Industry

The securities industry performs its functions firm, its size, management

Functions

style, and financial his-of advising, underwriting; and marketing to gather tory, as well as the-amount of capital needed andcapital by bringing investors and organizations in market conditions, all contribute to the decisionneed of capital together in two ways: through pri- on whether to attempt to finance through privatevate sources and through public offerings. Finan- or public offerings. An overview of the role thecial advisors may assist the firm in determining securities industry plays in both private and pub-which path to follow. The characteristics of the lic financing is provided below,

92 ● Effects of /formation Technology on Financial Services Systems

Private Sources of Funds

Seeking capital through private sources may of-fer salient advantages for many corporations. Reg-ulatory requirements associated with public issuesare avoided. This may save time and, more impor-tantly, the avoidance of disclosure requirementsmay be an advantage for many firms, particularlythose in highly competitive industries. However,because the firm is only likely to approach a limitednumber of investors and because the assurancesassociated with a regulated public offering maynot be found in private financing, the firm mayfind it necessary to pay a higher rate of interestor return on money obtained and may find that thecreditor or holder of equity has a greater interestin the operations of the firm than investors in pub-lic issues.

Private Placements

A corporation may sell an entire issue of securi-ties directly to a single investor or small group ofinvestors. Such an action is referred to as a pri-vate or direct placement and may involve eitherdebt or equity issues, although more commonly,debt instruments are involved. Private placementoffers several advantages over a public offering forthe issuing firm. It is generally quicker and cheaper,as registration of the issue with the SEC is notneeded, and the firm deals either directly with thepotential investor through a placement agent. Theissue may also be more directly tailored both tothe needs of the borrower and the investor in theterms outlined and in the timing of the issue.

A potential disadvantage of this type of offer-ing may be mitigated by the application of infor-mation technology; that is, the location of suitablepotential investors in a time frame that allows thecapital seeker to plan the use of the funds withsome precision. Communications technologies maystreamline brokerage private offerings.

Privileged Subscription Basis

An offering of stock only to existing stockhold-ers is termed a privileged subscription, or rights,offering. In many cases equity holders are granteda preemptive right in the articles of incorporationof the company that requires the firm to give cur-rent shareholders the opportunity to maintaintheir “position,” that is, percent share of totalownership, any time a new issue is made. In thissituation each shareholder is issued one right foreach share of stock owned. The number of rights

needed to purchase new shares are specified in theoffering; however, the shareholder is assured thathe will be able to purchase new shares in propor-tion to his current stake.

A privileged subscription may provide basicmarketing advantages to the issuing corporationand therefore to the shareholders, even those whoopt not to purchase additional shares. The tar-geted market for the offering is known to have aninterest. Assumed knowledge of the corporationand the costs associated with the offering are usu-ally lower than they would be for an offering tothe general public. Often, flotation costs are halfthose of a public issue. From the point of view ofthe investor, margin requirements for a purchasethrough a rights offering are generally lower thanin other circumstances.

The corporation may identify two major dis-advantages with a rights offering. First, to attractinvestors, the price per share may have to be lowerthan would be assigned in a public issue. As alower total amount of capital may be raised by theissue, earnings per share may be diluted. Second,the increased number of actual shareholders result-ing from a public offering may be desirable for thecorporation. The greater the number of stockhold-ers, the more likely that management will retaincontrol of the operations of the company.

Venture Capital

Venture capital is money invested in new orsmall businesses by corporations or individualsthat are not directly involved in the managementof the business, although they may provide advice.The investor is usually granted a large enoughshare of equity in the venture to exercise signifi-cant control of the corporation and, in cases wherethe venture is successful, to receive a significantreturn. The equity is frequently issued in the formof letter stock, a private placement that cannot beresold until the issue is registered with the SEC,which may be years later.

Although it may be an extremely risky invest-ment, individuals who are venture capitalists areattracted for several reasons. Not only is the rateof return significantly higher, but as it is in theform of capital gains rather than dividends, it istaxed at a lower rate. Organizations that provideventure capital are part of many corporate fami-lies, not only because of their primary goal of fi-nancial returns but also because of other tangiblebusiness benefits the venture capital relationshipcan provide. Several investment banks have formed

Table 3A-l.— Most Active Venture Capitalists, 1982. —. .

1982 totalinvestment

Rank Name of firm (in millions)

1. The Hillman Co. ., .. ., . . . . . . . . 101.52. Allstate Insurance Co.

Venture Capital Division ... . 64.23. First Chicago Investment Corp. 48.54. General Electric Venture Capital

Corp. (G. E. Corp.) . . . . . . ... 41.65. Brentwood Associates ., . . . . . . 356. E, M. Warburg Pincus & Co, . . . 33.97. TA Associates (Tucker Anthony

& R. L. Day) . . . . . . . . . . . ... . . 32.38. Security Pacific Capital Corp. . . 32.259. Citicorp Venture Capital Ltd. . 30.5

10. BT Capital Corp.(Bankers Trust N.Y.). . . . . . . 26

S O-URCE Venture June 1983

1981rank

1

92

271012

483

45

venture capital units in the hope of handling even-tual public issues if the company experienceshoped-for growth. The desire to attract and retaincustomers is an incentive also for commercialbanks and insurance companies.

Some major corporations, particularly in the en-ergy and electronics fields, have formed venturecapital units because of interest in financial returnand the hope of gaining access to new ideas andtechnology that may be beneficial to the corpora-tion. The need of established industrial giants tomaintain the pace of technological innovation mayencourage further entry into the venture capitalmarket.

For a small or new corporation, venture capital-ists may provide a valuable source of financing.Intermediaries in the securities industry provideassistance to this capital seeker. They help locatea potential investor whose objectives are in linewith those of the organization in need of financ-ing and assure that the financial arrangement de-veloped is in the best interests of the firm in boththe long and short runs.

Venture capital has become more plentiful in thepast several years. Industry experts attribute thisto changes in Federal Government policies that re-duced capital gains tax in 1978 and 1981 and re-laxed pension trust fund investment rules in 1979. ’Information technology may have an impact onventure capital financing because it may facilitateanalysis of possible deals, New communication ca-pabilities may also make it easier for prospective

] (J S. (;eneral Accounting office, (;otw-nment-IndustrJ, Cooperation(’an Enhance The \renture (’apitaI Process, Report to Senator I,loydBentsen, Joint k;conomic (’ornmittee, Aug 1 !.2, 1982, p. 4.

Ch 3— The Securities Industry ● 9 3

venture capitalists and the seekers of financing tolocate one another.

An important source of venture capital for smallbusinesses are Small Business Investment Cor-porations (SBICs). These firms are licensed andregulated by the Small Business Administrationunder a program established by the Small Busi-ness Investment Act of 1958 to contribute to thedevelopment of small businesses. SBICs are pri-vately owned and operated investment firms, butare eligible to receive some Federal funding. Cap-ital is developed in the form of equity or long-termloans.

These firms are an important part of the capitalformation process for small businesses that mightbe at a disadvantage in competing for venture cap-ital. Information technology may be expected tofacilitate the development of financing betweenSBICs and businesses by making it easier for bothto identify potential investment arrangements.

Public Offerings of Securitiesof a Corporation

The decision by the management of a privatelyheld corporation to “go public” is based on theirobjectives and strategies for the future of thatbusiness. The desire to acquire capital, to in-crease the liquidity of the original owners, and tostrengthen the balance sheet of the corporationmust be weighed against the expense involved insuch a move, the increased vulnerability of the cor-poration to general market conditions, and the ne-cessity that management take on additional re-sponsibility for the actions of the corporation and,possibly, relinquish control of it.

There is no strict formula through which the de-cision to go public can be made. Going public mayinvolve a significant change in the structure andoperation of a firm, and this change must be as-sessed in terms of the objectives of the owners andmanagement of the company, The decision cannotbe assessed individually; it must be considered inlight of other alternatives such as private fundingor additional investment by the owners, In eval-uating the option of going public, several mattersmust be considered; these include business, ac-counting, legal, and regulatory considerations.

Careful attention must be paid to the planningof an offering to assure that the normal operationof the firm is not disrupted and that maximumvalue is derived from the offering, Major factorsto be considered by the corporation include tim-ing of the issue, both in terms of the operations

94 ● Effects of /formation Technology on Financial Services Symtems— . — .—— — — —

of the company and of investment markets; theability of the firm to attract an underwriter, ifneeded; and the ability and desire of the corpora-tion to adhere to disclosure requirements. Infor-mation technology may ease these problems byaiding in the analysis of decision factors and pos-sibly by shortening the issue process and there-fore the disruption of business.

Federal laws governing public offerings by cor-porations or organizations require the disclosureof information on which investment decisions canbe based. A prospectus is information provided topotential investors in a new securities issue thatdescribes the current condition and history of theissuing firm. It attempts to provide informationon which a decision to invest can be made but doesnot contain any type of objective judgment on theadvisability of investing in the described issue.

Information technology may affect public offer-ings by corporations in several ways. First, theessential requirement of Federal securities laws isthe provision of information to potential investors.It is quite likely that the application of informa-tion technology for disseminating information willradically change the physical activity of going pub-lic. Paper was the logical medium through whichinformation could be transmitted in the 1930’s,when many of the currently applicable securities

laws were enacted.2 It was cheaper and more reli-able than the communications technologies of theday, notably telephone and radio, and was easierto use.

Paper was never intended to be a sacred mediumfor conveying information about securities offer-ings. Its use was specified because it was the mostpractical choice. The vast improvement in qualityand cost of information technology has turned thetable on the comparative effectiveness of paperand communications media. Recognition of thischange is causing a reexamination of the processof filing new offerings with the SEC.

The SEC is trying to make the volumes of in-formation it receives easier to manage and use byapplying information technology to its informationgathering and dissemination process. Some ex-perts advocate the eventual movement towardpaperless filing and information dissemination.Potentially, a system based on information tech-nology could result in faster dissemination of in-formation and more efficient review and storageprocesses.

Lee B. Spencer, Jr., “The Electric Library, ” Remarks to the AmericanBar Association, Federal Regulation of Securities Committee, Nov. 19,1982.

The Securities Industry

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