PROBLEMS
4.4 C LASSIFICATION OF U.S. S ECONDARY E QUITY M ARKETS
determine a new equilibrium price that reflects the supply and demand due to the new informa- tion. If the buy orders were three or four times as numerous as the sell orders, the new price based on the call market might be $44. For an analysis of price movements surrounding trading halts, see Hopewell and Schwartz (1978) and Fabozzi and Ma (1988). Several studies have shown that using the call-market mechanism contributes to a more orderly market and less volatility at openings and following trading halts.
In a continuous market, trades occur at any time the market is open wherein stocks are priced either by auction or by dealers. In a dealer market, dealers make a market in the stock, which means that they are willing to buy or sell for their own account at a specified bid- and-ask price. In an auction market, enough buyers and sellers are trading to allow the market to be continuous; that is, when one investor comes to buy stock, there is another investor avail- able and willing to sell stock. A compromise between a pure dealer market and a pure auction market is a combination structure wherein the market trading system is basically an auction market, but there exists an intermediary who is willing to act as a dealer if the pure auction mar- ket does not have enough activity. These intermediaries who act as both brokers and dealers provide temporary liquidity to ensure the market will be liquid and continuous.
Notably, many continuous auction market exchanges also employ a call-market mechanism on specific occasions at the open and during trading suspensions. The NYSE is such a market.
was originally called the Outdoor Curb Market. In 1910, it established formal trading rules and changed its name to the New York Curb Market Association. The members moved inside a building in 1921 and continued to trade mainly in unlisted stocks (stocks not listed on one of the registered exchanges) until 1946, when its volume in listed stocks finally outnumbered that in unlisted stocks. The current name was adopted in 1953.
The AMEX became a major stock options exchange in January 1975 and subsequently added options on interest rates and stock indexes. In addition, a number of exchange-traded funds (ETFs) that have grown in popularity (as discussed in Chapter 3) are listed on the AMEX.
The AMEX and the NASDAQ merged in 1998, but in 2005 NASDAQ sold the AMEX back to its members (see Horowitz and Kelly, 2005). The AMEX was acquired by the NYSE in 2007 and is currently referred to as the NYSE AMEX.
Global Stock ExchangesThe equity-market environment outside the United States is similar in that each country typically will have one relatively large exchange that dominates the mar- ket. Examples include the Tokyo Stock Exchange, the London Stock Exchange, the Frankfurt Stock Exchange, and the Paris Bourse.
Notably, even in emerging economies, stock exchanges have been created because of the li- quidity that secondary equity markets provide. Three points about these international ex- changes: first, there has been a trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors.
This trend toward consolidation will be discussed in a subsequent section. Second, many of the larger companies in these countries that can qualify for listing on a U.S. exchange become dual-listed. About 20 percent of the stocks listed on the NYSE are non-U.S. firms. Third, the existence of these strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world continuously, as discussed in the following section. There is intense competition between the various ex- changes, as discussed by Ewing and Ascarelli (2000) and Cherney and Beal (2000).
The Global 24-Hour MarketThe markets in New York, London, and Tokyo, because of their relative size and importance, can be envisioned to represent the major segments of a world- wide 24-hour stock market wherein investment firms “pass the book”around the world. This means the major active market in securities moves around the globe as trading hours for these three markets (and other exchanges) begin and end.
As an example, consider the individual trading hours for each of the three exchanges, trans- lated into a 24-hour eastern standard time (EST) clock:
L o c a l T i m e
( 2 4 - h o u r n o t a t i o n s ) 2 4 - h o u r E S T
New York Stock Exchange (NYSE) 0930–1600 0930–1600
Tokyo Stock Exchange (TSE) 0900–1100 2300–0100
1300–1500 0300–0500
London Stock Exchange (LSE) 0815–1615 0215–1015
Imagine trading starting in New York at 0930 and going until 1600 in the afternoon, being picked up by Tokyo late in the evening and going until 0500 in the morning, and continuing in London (with some overlap) until it begins in New York again (with some overlap) at 0930.
Given this scenario, the U.S. trader asks,“What happened in Tokyo and whatishappening in London?” The trader in Tokyo is concerned with what happened in New York, and subse- quently the London traders are aware of what happened in New York and want to know what is happening in Tokyo. The point is, the markets operate almost continuously and are related in their response to economic events. Therefore, investors are not dealing with three or more separate and distinct exchanges, but with one interrelated world market because of the availability of sophisticated telecommunications. Paraphrasing a statement by O’Hara and
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Ye (2011), it is a single virtual market with multiple points of entry. Participants in this global market are the stocks of companies that have global markets for their products like General Electric, Coca Cola, Johnson & Johnson, McDonald’s, and similar international firms.
The NASDAQ Market5This market system was historically known as the over-the-counter (OTC) market, which included stocks not formally listed on the two major exchanges (NYSE and AMEX). This description has changed since it was recognized that this is an equity market similar to the major exchanges with several minor differences. The first difference is that it is a dealer market, in contrast to a broker/dealer (specialists) market as is the NYSE. Second, trad- ing by dealers on NASDAQ takes place via computer communication rather than on a trading floor as in the other exchanges. Notably, as will be discussed, this is no longer a difference since the NYSE has adopted electronic trading which is growing rapidly. What the NASDAQ also has in common with the other exchanges is a set of requirements for a stock to be traded on the NASDAQ National Market System (NMS). Also while NASDAQ dealers do not have to pay for a seat (membership) on the exchange, they are required to be members of the National Association of Security Dealers (NASD) and abide by its rules.
The NASDAQ market is the largest U.S. secondary market in terms of the number of issues traded. As noted earlier, there are about 3,000 issues traded on the NYSE. In contrast, more than 2,800 issues are actively traded on the NASDAQ NMS and almost 700 on the NASDAQ Small-Cap Market (SCM). The NASDAQ market is also the most diverse secondary market component in terms of quality because it has multiple minimum requirements. Stocks that trade on the NASDAQ market (NMS and SCM) range from those of small, unprofitable com- panies to large, extremely profitable firms such as Microsoft, Intel, and Apple.
In early 2011, an estimated 650 issues of NASDAQ were either foreign stocks or American Depository Receipts (ADRs). About 300 of these issues trade on both NASDAQ and a foreign exchange such as Toronto. NASDAQ has developed a link with the Singapore Stock Exchange that allows 24-hour trading from NASDAQ in New York to Singapore to a NASDAQ/London link and back to New York.
Although the NASDAQ market has the greatest number of issues, the NYSE has a larger total value of trading. In 2010 the approximate value of average daily equity trading on the NYSE was about $58 billion and on NASDAQ was about $35 billion.
Operation of the NASDAQ MarketAs noted, stocks can be traded on the NASDAQ market as long as there are dealers willing to make a market by buying or selling for their own account.6 Listing Requirements for NASDAQQuotes and trading volume for the NASDAQ market are re- ported in two lists: a National Market System (NMS) list and a regular NASDAQ list. There are alter- native standards for initial listing and continued listing on the NASDAQ NMS. A company must meet all of the requirements under at least one of the three listing standards for initial listing and then meet at least one continued listing standard to maintain its listing on the NMS. The standards for the NMS listing are significant but not quite as onerous as for the NYSE. For stocks on this system, reports include up-to-the-minute volume and last-sale information for the competing market makers as well as end-of-the-day information on total volume and high, low, and closing prices.
A Sample Trade Assume you are considering the purchase of 100 shares of Intel. Although Intel is large enough and profitable enough to be listed on the NYSE, the company has never applied for listing because it enjoys a very active market on NASDAQ. (It is one of the volume leaders, with daily volume typically above 25 million shares and often in excess of 50 million
5NASDAQ is an acronym for National Association of Securities Dealers Automated Quotations. The system is discussed in detail in a later section. To be traded on the NMS, a firm must have a certain size and trading activity and at least four market makers. A specification of requirements for various components of the NASDAQ system is contained in Exhibit 4.7.
6Dealerandmarket makerare synonymous.
shares.) When you contact your broker, she will consult the NASDAQ quotation machine to determine the current dealer quotations for INTC, the trading symbol for Intel.7 The quote machine will show that about 35 dealers are making a market in INTC. An example of differ- ing quotations might be as follows:
D e a l e r B i d A s k
1 30.60 30.75
2 30.55 30.65
3 30.50 30.65
4 30.55 30.70
Assuming these are the best markets available from the total group, your broker would call either Dealer 2 or Dealer 3 because they have the lowest offering prices. After verifying the quote, your broker would give one of these dealers an order to buy 100 shares of INTC at
$30.65 a share. Because your firm was not a market maker in the stock, the firm would act as a broker and charge you $3,065 plus a commission for the trade. If your firm had been a market maker in INTC, with an asking price of $30.65 the firm would have sold the stock to you at $30.65 net (without commission). If you had been interested in selling 100 shares of Intel instead of buying, the broker would have contacted Dealer 1, who had the highest bid ($30.60).
Changing Dealer Inventory Let’s consider the price quotations by a NASDAQ dealer who wants to change his inventory on a given stock. For example, assume Dealer 4, with a current quote of 30.55 bid–30.70 ask, decides to increase his holdings of INTC. The NASDAQ quotes indicate that the highest bid is currently 30.60. Increasing the bid to 30.60 would bring some of the business currently going to dealer 1. Taking a more aggressive action, Dealer 4 might raise the bid to 30.63 and buy all the stock offered, because he has the highest bid. In this ex- ample, the dealer raises the bid price but does not change the ask price, which was above those of Dealers 2 and 3. This dealer will buy stock but probably will not sell any. A dealer who had excess stock would keep the bid below the market (lower than 30.60) and reduce the ask price to 30.65 or less. Dealers constantly change their bid-and-ask prices, depending on their current inventories or changes in the outlook based on new information for the stock.
Other NASDAQ Market Segments Now that we are familiar with the NASDAQ system and its operation, we can easily describe the other segments of this market since the major differences relate to the size and liquidity of the stocks involved.
• The NASDAQ Small-Cap Market (SCM)has initial listing requirements that consider the same factors as the NMS but are generally about one-half to one-third of the values re- quired for the NMS. As of early 2011, there were about 700 stocks listed in the NASDAQ small-cap segment. As noted earlier, the NASDAQ NMS contained about 3,000 issues as of early 2011. Therefore, the total NASDAQ market includes approximately 3,700 issues (3,000 NMS and about 700 issues on the SCM).
• The NASDAQ OTC Electronic Bulletin Board (OTCBB) reports“indications”for small stocks sponsored by NASD dealers. Indications are approximate values—if an investor wants to buy or sell the stock it would be necessary to contact a dealer in the stock for a tradeable quote. As of early 2011, there were about 3,400 stocks included on the OTCBB.
• The National Quotation Bureau (NQB) Pink Sheets report order indications for the smallest publicly traded stocks in the United States. Pre-1970, these pink sheets (actually
7Trading symbols are one-to four-letter codes used to designate stocks. Whenever a trade is reported on a stock ticker, the trading symbol appears with the figures. Many symbols are obvious, such as GM (General Motors), F (Ford Motors), GE (General Electric), GS (Goldman Sachs), HD (Home Depot), AMGN (Amgen), and DELL (Dell).
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printed on pink sheets of paper) were the primary daily source of OTC stock quotes. With the creation of the NASDAQ electronic quotation system, the sheets were superseded.
Currently, the NQB publishes a weekly edition on paper and distributes a daily edition electronically with quotes that need to be confirmed.
4.4.2 Regional Stock Exchanges
Regional exchanges typically have the same operating procedures as national exchanges in the same countries, but their listing requirements are less stringent than for national exchanges.
Regional stock exchanges exist for two main reasons: First, they provide trading facilities for local companies not large enough to qualify for listing on a national exchange.
Second, regional exchanges can list firms that also list on one of the national exchanges to give local brokers access to these securities. As an example, Walmart and General Motors are listed on both the NYSE and several regional exchanges. This dual listing allows a firm that is not a member of the NYSE to buy and sell shares of the dual-listed stock without going through the NYSE. In addition, regional exchanges can trade some stocks on the NASDAQ market under unlisted trading privileges (UTP) granted by the SEC. The majority of trading on regional exchanges is due to dual-listed and UTP stocks.
The regional exchanges in the United States as of 2010 are shown in Exhibit 4.3. The Chi- cago, Philadelphia, and Boston exchanges accounted for about 90 percent of the volume on all U.S. regional exchanges. A discussion at the end of the chapter will consider regional exchange mergers.
4.4.3 The Third Market
Historically, the third category was the third market. The term third market involves dealers and brokers who trade shares that are listed on an exchange away from the exchange. Al- though most transactions in listed stocks have historically taken place on an exchange, this has been changing, as will be discussed in the following section. The point is, an investment firm that is not a member of one of the major exchanges can make a market in a listed stock away from the exchange. Most third market trading is in well-known stocks such as General Electric, Coca-Cola, and Johnson & Johnson. As will be discussed, the success or failure of the third market depends on whether the alternative market in these stocks is as good as the exchange market and whether the relative cost of the transaction compares favorably with the cost on the exchange. This market was critical during the relatively few periods when trading is not available on the NYSE either because trading is suspended or the exchange is closed.
This market has also grown because of the quality and cost factors mentioned. Third market dealers typically displayed their quotes on the NASDAQ InterMarketsystem. For articles that discuss the impact of third market trading and the practice of purchasing order flow, see Bat- talio (1997); Battalio, Greene, and Jennings (1997); and Easley, Kiefer, and O’Hara (1996).
4.4.4 The Significant Transition of the U.S. Equity Markets8
The prior discussion of the U.S. equity market is correct and relevant but it does not reflect the rapid and very dramatic changes that have transpired over the past 17 years to financial institutions that have existed for almost 220 years (recall that the Buttonwood Agreement for the NYSE was signed in 1792). Prior to the significant transition that started in 1994, there were some initial changes introduced by the SEC to bring about a national competitive securi- ties market. The SEC mandated a consolidated tape in the mid-1970s that reportedcentralized transactions from the national and regional exchanges and NASDAQ. This was followed by consolidated quotations and then the introduction of the Intermarket Trading System (ITS)
8This section benefitted from the very informative essay by Daniel Mathisson entitled“Man versus Machine: The Regulatory Changes that Led to the Modern Market,”in Knight Capital Group. (2010).
that linked the national and regional exchanges and the CBOE. The ITS“allowed”trades to go to the best quotes, but unfortunately it was not required or automatic. The transition story is best described by the time line of events and legislation that started in 1994.
The Initial Setting The equity markets in the early 1990s were best described as relatively busy, but also controlled, with the NYSE and its members dominating the listed stock market and being very prosperous—a“seat”(membership) on the NYSE consistently sold for over $2 million in the early 2000s and had a peak price of $3.25 million in 2005. The NYSE had virtu- ally only one competitor—the NASDAQ market that was concentrated in the over-the-counter (OTC) market that was basically an electronic dealer market.
The Transition BeginsThe U.S. equity market began to change in 1994 with the publication of a study by Christie and Schultz (1994) that documented the strong tendency for market quotes to be concentrated in quarters (0,14;12;34) even though price quotes could be in eighths (18;38;58;78). It was documented by Christie and Schultz that the dealers apparently were colluding to maintain wide bid-ask spreads to ensure high profits. The reaction by the Justice Depart- ment and the SEC to these empirical findings was fairly fast and dramatic.
In 1996 there were convictions for“anticompetitive behavior,”and in early 1997 new order- handling rules were specified that designated computerized trading platforms such as Instinet as electronic communications networks (ECNs) and required that ECNs make their quotes available to the public markets. As a result, previously private quotes were made available to the total market including several small electronic trading markets that were just beginning.
This legislation allowed these ECNs to compete with the major exchanges and gain significant market share. It also encouraged the creation of additional ECNs. As a result, significant com- petition developed among the ECNs on the basis of speed, price, and reliability. This prolifer- ation of ECNs led to a battle for trading volume wherein ECNs began paying for order flow that involved rebates of commissions for limit orders. These rebate fees were revenue for tra- ders and led to a significant increase in trading volume.
The Move to Decimal Pricing The next big change followed shortly in June 1997 when the first change in pricing increments occurred. Specifically, prices went from being quoted in one-eighths (that had been used since the 1800s) to one-sixteenths. While this change clearly was significant and caused a decline in spreads, there were still potential problems with a spread of six cents that led to civil violations by traders and even specialists on the NYSE.9
In 2000 the SEC eliminated this problem by ordering the markets to go to decimal pricing (pennies) by April 2001. In response to this mandate, all the markets went to one cent incre- ments in early 2001. The immediate impact was significantly smaller spreads—from six cents to possibly a penny—which caused many NASDAQ traders to leave the business. In response to the decimalization, the NYSE created a new trading order entitled “Direct+” that allowed member firms to electronically trade up to 1,099 shares every 30 seconds without allowing an order to get in front of the order submitted. This innovation, combined with the DOT system that was an electronic order routing system that allowed market and limit orders to go directly to the NYSE trading posts, transformed how large orders were executed. Specifically, rather than “block trades” of 10,000 shares or more, this combination of DIRECT+ and DOT made it possible to do large trades by the use of multiple small orders that could be executed without the information impounded in large trades. Almost immediately (mid-2001) firms developed computer programs (algorithms) to divide the large orders into small orders—these programs were really the initiation of algorithmic trading. A follow-on to the creation of numerous
9A detailed discussion of this is contained in the Mathisson essay in Knight Capital Group, (2010), pp. 58–60.
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