PROBLEMS
4.3 S ECONDARY F INANCIAL M ARKETS
4.2.5 Private Placements and Rule 144A
Rather than a public sale using one of these arrangements, primary offerings can be sold pri- vately. In such an arrangement, referred to as a private placement, the firm designs an issue with the assistance of an investment banker and sells it to a small group of institutions. The firm enjoys lower issuing costs because it does not need to prepare the extensive registration statement required for a public offering. Institutions buying the issue typically benefit because the issuing firm passes some of the cost savings on to the investor as a higher return. In fact, pre-Rule 144A an institution required a higher return because of the absence of any secondary market for these securities, which implied higher liquidity risk.
The private placement market changed dramatically when Rule 144A was introduced by the SEC. This rule allows corporations—including non-U.S. firms—to place securities privately with large, sophisticated institutional investors without extensive registration documents. A major innovation is that these securities can subsequently be traded among these large sophisticated investors (those with assets in excess of $100 million). The SEC introduced this innovation to provide more financing alternatives for U.S. and non-U.S. firms and possibly increase the num- ber, size, and liquidity of private placements, as discussed by Milligan (1990) and Hanks (1990).
Presently, more than 85 percent of high-yield bonds are 144A issues.
4.3.2 Secondary Bond Markets
The secondary market for bonds distinguishes among those issued by the federal government, municipalities, or corporations.
Secondary Markets for U.S. Government and Municipal BondsU.S. government bonds are traded by bond dealers that specialize in either Treasury bonds or agency bonds. Treasury issues are bought or sold through a set of 35 primary dealers, including large banks in New York and Chicago and some large investment banking firms like Goldman Sachs and Morgan Stanley. These institutions and other firms also make markets for government agency issues, but there is no formal set of dealers for agency securities.
The major market makers in the secondary municipal bond market are banks and invest- ment firms. Banks are active in municipal bond trading and underwriting of general obligation issues since they invest heavily in these securities. Also, many large investment firms have municipal bond departments that underwrite and trade these issues.
Secondary Corporate Bond Markets Currently, all corporate bonds are traded over the counter by dealers who buy and sell for their own accounts. The major bond dealers are the large investment banking firms that underwrite the issues: firms such as Goldman Sachs, J.P.
Morgan, Barclay Capital, and Morgan Stanley. Because of the limited trading in corporate bonds compared to the fairly active trading in government bonds, corporate bond dealers do not carry extensive inventories of specific issues. Instead, they hold a limited number of bonds desired by their clients, and when someone wants to do a trade, they work more like brokers than dealers.
Notably, there is a movement toward a widespread transaction-reporting service as with stocks, especially for large, actively traded bond issues. As discussed in Chapter 17, starting in 2005, dealers have been required to report trades within 15 minutes for transactions on 17,000 corporate bonds. Exhibit 4.2 is a daily table from The Wall Street Journalthat provides data for a large set of secondary bond indexes that are similar to various stock indexes.
4.3.3 Financial Futures
In addition to the market for the bonds, a market has developed for futures contracts related to these bonds. These contracts allow the holder to buy or sell a specified amount of a given bond issue at a stipulated price. The two major futures exchanges are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) that merged during 2007. We discuss these futures contracts and the futures market in Chapter 19.
4.3.4 Secondary Equity Markets
Before 2000, the secondary equity markets in the United States and around the world were di- vided into three segments: national stock exchanges, regional stock exchanges, and over-the- counter (OTC) markets for stocks not on an exchange. Because of numerous changes over the past decade, a better classification has been suggested by O’Hara and Ye (2011), as presented in Exhibit 4.3. Following our background discussions on alternative trading systems and call versus continuous markets, we will describe the market types listed in Exhibit 4.3 and discuss how they complement and compete against each other to provide price discovery and liquidity to individual and institutional investors.3
3For a collection of essays by financial industry experts that detail the history of these changes and discuss some ideas related to the future of equity markets, see Knight Capital Group, Inc. (2010).
102 Part 1:The Investment Background
Basic Trading SystemsAlthough stock exchanges are similar because only qualified stocks can be traded by individuals who are members of the exchange, they can differ in theirtrading systems. There are two major trading systems, and an exchange can use one or a combination of them. One is apure auction market (also referred to as anorder-driven market), in which interested buyers and sellers submit bid-and-ask prices (buy and sell orders) for a given stock to a central location where the orders are matched by a broker who does not own the stock but acts as a facilitating agent. Participants also refer to this system as price-driven because shares of stock are sold to the investor with the highest bid price and bought from the seller with the lowest offering price. Advocates of an auction market argue at the extreme for a very centralized market that ideally will include all the buyers and sellers of the stock.
Exhibit 4.2B o n d B e n c h m a r k s
YIELD (%), 52-WEEK RANGE Latest
Tracking Bond Benchmarks
Return on investment and yield spreads over Treasurys and/or yields paid to investors compared with 52-week high and low yields for different types of bonds
Total return
close YTD total return (%) Index
1551.67
1.3
0.6 Broad market Barclays Aggregate 1.6
0.6 0.7 1.8 4.7 4.8 4.9 0.5 0.5 0.5 0.7 0.6 0.7 1.3 1.2 2.1 –1.2
1.2 –0.6 –0.7 –1.1
–0.9 –2.9
–0.8
n.a. n.a.
n.a.
*Constrained indexes limit individual issuer concentrations to 2% the High yield 100 are the 100 largest bonds
**EMBI Global Index Sources: Dow Jones Indexes; Merrill Lynch; Barclays Capital; J.P. Morgan
In U.S. dollar terms Euro-zone bonds
–2.2 –2.9
Yankee Barclays 0.7
6.2
5.3
U.S. Corporate Barclays Capital
High Yield Constrained Merrill Lynch
U.S. Agency Barclays
Mortgage-Backed Barclays
Muni Master Merrill Lynch
Global Government J.P. Morgan Canada
EMU France Germany Japan Netherlands U.K.
Emerging Markets**
7-12 year 12-22 year 22-plus year
Ginnie Mae (GNMA) Fannie Mae (FNMA) Freddie Mae (FHLMC) 10-20 years 20-plus years
Intermediate
Latest Low 0 9 18 27 36 45 High
Long term Double-A-rated Triple-B-rated
Triple-C-rated High Yield 100
Global High Yield Constrained Europe High Yield Constrained 1986.39
2009.24 2310.62 422.72 473.11 273.44 271.71 1971.50 242.06 191.04 1427.54 1316.30 2178.55 1643.06 1621.78 954.60 1476.76 398.51 272.38 282.41 250.80
3.080 2.350 3.480
4.580 4.030 6.200 3.760 5.080 9.411 13.065 8.207 9.552 10.180 2.140 1.950 4.970 4.090 4.140 4.090 4.160 3.612 3.856 5.316 5.938 3.800 2.860 3.630 4.420 3.670 3.410 1.450 3.510 4.130 6.766 3.470
2.750 5.320 2.600 4.030 6.772 9.441 5.918 6.913 7.111 1.090 0.900 3.490 2.500 2.410 2.430 2.640 2.411 2.354 3.463 4.599 2.570 2.080 2.740 3.110 2.370 2.050 0.990 2.130 3.230 5.314 4.000 3.360 5.910 3.250 4.530 6.855 9.826 6.223 7.021 7.659 1.600 1.390 4.580 3.820 3.710 3.820 3.880 3.360 3.569 4.843 5.766 3.260 2.810 3.300 4.380 3.630 3.350 1.430 3.460 3.880 428.05
611.08 263.99 515.73 386.08 244.23 415.75 617.34 1912.71
Source:Reprinted with permission ofThe Wall Street Journal, April 14, 2011, C7. All Rights Reserved Worldwide.
The other major trading system is adealer market(also referred to as aquote-drivenmarket) where individual dealers provide liquidity for investors by buying and selling the shares of stock for themselves. Ideally, with this system there will be numerous dealers who will compete against each other to provide the highest bid prices when you are selling and the lowest asking price when you are buying stock. Clearly, this is a very decentralized system that derives its benefit from the competition among the dealers who are connected by technology to provide the best price for the buyer and seller. When we discuss the various equity markets, we will indicate the trading system used.
Call versus Continuous MarketsBeyond the different trading systems for equities (brokers vs. dealers), the operation of exchanges can differ in terms of when and how the stocks are traded.
In call markets, the intent is to gather all the bids and asks for a stock at a point in time and attempt to arrive at a single price where the quantity demanded is as close as possible to the quantity supplied. Call markets are generally used during the early stages of development of an exchange when there are few stocks listed or a small number of active investors-traders.
For an exchange that is strictly a call market with a few listed stocks and traders, a designated market maker would call the roll of stocks and ask for interest in one stock at a time. After determining the available buy and sell orders, exchange officials specify a single price that will satisfymostof the orders, and all orders are transacted at this price.
Notably, call markets also are used at the opening for stocks on a large exchange if there is an overnight buildup of buy and/or sell orders, in which case the opening price can differ from the prior day’s closing price. Also, a call market process is used if trading is suspended during the day because of some significant new information. In either case, the specialist or market maker would attempt to derive a new equilibrium price using a call-market approach that would reflect the imbalance and take care of most of the orders. For example, assume a stock has been trading at about $42 per share and some significant, new, positive information was released overnight or during the day. If it happened overnight it would affect the opening price; if it happened during the day, trading would be temporarily suspended and a call-market process would be used to
Exhibit 4.3T r a d i n g V e n u e s f o r U . S . E q u i t i e s
Exchanges ECNS ATS
Nasdaq BATS ITG POSIT CITIMATCH
New York Stock Exchange DIRECTEDGE BIDS CS CROSSFINDER
Archipelago TRADEBOOK LEVEL LX
National Stock Exchange LAVA LIQUIDNET MLXN
American Stock Exchange TRACK MATCHPOINT SIGMA X
Chicago Stock Exchange INSTINET MORGAN STANLEY POOL
Philadelphia Stock Exchange MILLENNIUM UBS PIN
Boston Stock Exchange PIPELINE BNY CONVERGEX
International Securities Exchange PULSE FIDELITY CROSS STREAM
Chicago Board Options Exchange ESPEED AQUA LAVA ATS
Note:This table gives trading venues executing equity trades during the period January to June 2008. ECNS refers to electronic communication networks, which are electronic limit order books without designated market makers. ATS refers to alternative trading systems, which are typically crossing networks in which buy and sell orders are matched and executed at a single price. These crossing networks are referred to as dark pools if the orders are never revealed to the market.
Source:Maureen O’Hara and Mao Ye,“Is Market Fragmentation Harming Market Quality?”Journal of Financial Economics, 100, no. 2 (February, 2011), p. 463.
104 Part 1:The Investment Background
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.