Let us have a glance at equity trading’s international arrangements. From a corporate point of view, stocks are after all more interesting in comparison to several other financial options like a foreign government bond, despite there being less money in corporate equity than in foreign government bond. Furthermore, non-equity financial markets might offer more money, but the investment’s subject area is focused on stocks (equities) since easier for retail investors to participate. Also, stocks data comes by comparatively easily. Therefore, it is sensible to explain certain institutional details how stocks and investors connect, i.e., exchange claims for cash and contrariwise.
7.2A Brokers
It is a retail broker with whom majority of individuals put orders for buying or selling stocks. For example, Ameritrade, Merrill Lunch, and Charles Schwab, who are a deep discount, full service and discount broker respectively? The commission of discount brokers might be just $10 for every trade, but they also get rebate payments from concerned market maker. This is known as payment for order flow.
In turn, market maker recovers this payment with execution of your trade at a less conducive price. Even though it might seem that an arrangement like this might have a purpose of deceit, it is evidently suggested that discount brokers still serve as a cheaper option to facilitate investor trades, particularly investor trades that are small, despite taking into consideration the hidden payment involved.
Simply put, they are not actually as cheap as you would be led to believing. Either limits orders, which require execution if price is below or above a limit specified by the investor, or market orders, which require execution at the present price, can be placed.
Different order modifications also exist, such as stop-loss orders, which requires the broker for selling a security if a specific amount is lost, fill-or-kill orders, and good-til-canceled orders. Then, handling execution of trades is the retail brokers’ primary function. It is generally done by routing the orders of investors to a central trading location such as a stock exchange.
Choosing location and agencies engaged in executing the trade is typically done at discretion of the retail broker. Retail broker’s second function is keeping a track of the holdings, facilitating the purchase on margin (by means of which investors may borrow money for purchasing stock. This allows them to buy more securities in comparison to what is affordable for them on the basis of pure cash and facilitating selling securities by shorting. Again this lets investors make speculations on going down of stocks.
Several big institutional investors separate These two functions. They employ their own traders, whereas the brokers are only responsible for taking care of portfolio’s bookkeeping, shorting provisions and margin provisions of the investor. Such brokers with limited functionality are known as prime brokers.
How Does Shorting Stock Work?
You would like to short a stock if you wish to make speculations that the particular stock shall go down. Your broker shall arrange this shorting. It is very important, which is why it requires a more detailed description:
- From getting hold of an investor from whom you can borrow the shares. Ideally, this doesn’t cost anything, but in reality, the brokers have to find investors who are willing to lend. For helping you in facilitation of your short sale, both the lender and broker generally earn some basis points on a yearly basis.
- After borrowing, you sell the shares to someone who is willing to purchase the shares. Ideally, you would earn the interest on the proceeds you would keep. However, in reality, you may be forced by your broker on putting these proceeds into safe bonds with low yields. In case of small retail investors, the brokerage firm might even altogether keep the proceeds.
- When you wish your short to unwind, you need to buy the shares again and then return to the lender.
For instance, if the shares traded for $50 when you borrowed them and they sell now for $30, now you may buy them again for $20 less, which is a profit for you. Effectively, in a perfect world, your role can be considered to be similar to the role of the company. You may issue the shares and then use the proceeds from $50 for funding your investments. However, transaction costs have to be taken into account in reality.
SOLVE THEM!
Q7.10 What primary functions do brokerage firms perform?
Q7.11 What is the difference between a retail broker and a prime broker?
Q7.12 For shorting a stock, is the return rate higher in a real world or an ideal world? Why so?
7.2B Exchanges and Non-Exchanges
Your transaction is routed to central trading location by a retail broker. Exchanges are most prominent of all. Being a central trading location, trading of financial securities is done in an exchange. In the U.S., two stock exchanges that are the most important are NYSE (New York Stock Exchange), also called the Big Board, and NASDAQ or National Association of Securities Dealers Automated Quotation System.
This NYSE exclusively was auction market once, in which the process of auction was managed by a specialist who as designated for every stock. The specialists trade with brokers on floor of exchange. Often, this specialist served as a monopolist. Now, most of the trading on the NYSE are conducted electronically.
In contradiction to the hybrid process involving both electronic and human mainly at the Wall Street, NASDAQ always functions as a completely electronic exchange with no specialists. For the sake of security, the location, or rather the computer system’s location of NASDAQ is kept secret. There is a minimum of one market maker for every NASDAQ stock. A broker or dealer also exists, who has consented on continuously standing by for offering to electronically sell or buy shares, thus forming an immediate and a liquid market for general public.
Furthermore, for offering liquidity, market makers get paid. Additional rebates are received by them when an ask, or a bid posted by them is executed. There are several market makers associated with most stocks on NASDAQ. These market makers are from around 500 trading firms like E*Trade or J.P. Morgan. The advantage of market makers over general public is that they can view limit order book, consisting of currently unexecuted orders for purchasing or selling if there is a change in the price of the stock.
This provides them with a reasonable idea about the price at which several of the selling or buying activity shall occur. Being older exchange, NYSE is a biggest exchange to trade most ‘blue chip’ stocks. (The term ‘blue chip’ comes from poker, wherein the blue chips were of the highest denomination. Now, it means serious and well-established).
NYSE listed nearly 3000 companies worth nearly $25 trillion in 2006. Usually, NASDAQ trades high-technology and smaller firms. It also lists nearly the same number of firms and also has comparatively more trading activity in comparison to NYSE. Certain stocks are traded both on NYSE and NASDAQ.
Trading whenever investor wishes to execute is known as continuous trading. It depends on standby intermediaries (market makers or specialists) being present. When everyone else is unavailable, these intermediaries can absorb shares. There is a risk involved, which is why intermediaries must get a good return rate for doing so.
For avoiding such a cost, exchanges have been organized by a few countries into auction systems that are discontinuous. These systems match the sell and buy orders twice a day. There is a disadvantage: it is not possible to immediately execute orders. Instead, delaying is must until there is an accumulation of a range of sell orders and buy orders. The fact that the expense of an intermediary is eliminated serves as the advantage. Therefore, usually, auctions have slower execution but also offer lower trading costs.
Change and innovation are omnipresent, also in the U.S. For instance, ECNs (electronic communication networks) have made huge changes in trading business by replacing exchanges, particularly for big institutional trades. (The same stock traded by exchanges is traded by them, thus allowing them to compete with exchange as far as execution speed and cost are concerned.)
The specialist is eliminated by an ECN, which allows investors in posting orders that are price-contingent themselves. ECNs can specialize in faster execution, higher broker kickbacks or lower costs of execution. Instinet and Archipelago are the biggest ECNs. Archipelago merged with NYSE and Instinet was purchased by NASDAQ in 2005. (Keeping track of trading arrangements is difficult. For instance, NYSE, in 2006, even had mergence with ArcaEx, which also an electronic trading system. It also merged with a Paris-based stock exchange named Euro next, which is pan-European. Currently, it is known as NYSE Euronext.)
Crossing systems like POSTIT of ITG is another method of buying and trading stocks that is even more intriguing. ITG mainly focuses on matching of huge institutional trades like an auction. The order simply may not be executed if a match is not found. On the other hand, in case a there is a match, execution is way cheaper in comparison to exchange as a market maker, or specialist is eliminated.
More interesting trading places have come up in recent times. For instance, like original Napster, peer-to-peer networking is used by Liquidnet for real time matching of sellers and buyers. Worldwide, electronic limit order books and ECNs are the major trading system nowadays for equities. With United States exchange floors being the only holdouts. Computer programs and similar exchanges are even used for trading currencies, futures, bonds and derivatives.
Other different financial markets exist as well. Financial exchanges exist for handling insurance contracts, commodities, stock options, and on and on. The OTC (over-the-counter) markets are a huge segment. OTC means calling around to certain well-known traders until you get hold of someone wanting to sell or buy at price of your liking. Most transactions of bonds remain over-the-counter, even though fast institutional change is taking place.
In terms of dollar amounts, a lot more trading of bonds is handled by OTC markets as compared to bond exchanges. However, for retail investors, the transaction prices for OTC are extremely high. If you don’t have much knowledge of the market and call, you might be quoted an unreasonably high price. The National Association of Securities Dealers (NASD) also runs a semi-OTC market for smaller firm stocks listed on pink sheets. It is on the local national exchanges where foreign securities are traded.
Costs for retail investors of U.S are usually very high, which is why direct participation is not worth while.
Solve Them!
Q7.13 What is the difference between electronic exchange and crossing system?
Q7.14 What is a market maker and specialist? What advantages are offered by them, as far as trading is concerned?
Q7.15 Explain a few trading on main stock exchanges alternatives.
7.2C Investment Vehicles and Companies
A lot of investment vehicles active in the financial markets of the United States are regulated by the SEC. Under 1940’s Investment Company Act, there exist three kinds of asset companies: closed-end funds, open-end funds, and UITs.
Open-end is synonymous with mutual fund in the U.S. In other places; other classes might be included in mutual funds. The meaning of open end is that shares can be created by the fund at will. The fund shares can also be redeemed by investor at each trading day’s end in return of net asset value or the NAV, which should be posted every day. With this, investors have hardly any reasons for selling shares to others, which is why mutual fund doesn’t trade on exchanges. A lot of bite is provided top the law of one price by redemption right. The worth of fund shares is always almost exactly the worth of the underlying holdings.
If the share price of an open-end fund falls way below its holding’s value, fund shares could be bought and redeemed by an arbitrageur, thus earning him free money. (There is a discrepancy because of certain unusual complications with tax: the capital losses and gains of the fund are passed to the investors at each year’s end, although they mayn’t be what were experienced by every investor. In the U.S financial market, interestingly enough, the number of mutual funds are more in comparison to stocks.
As far as closed-end fund is concerned, there is a singly huge major offering of the fund shares. These shares can’t be redeemed by investors for their underlying value. Advantage associated with such a fund is it can invest itself in less liquid assets. That is because it cannot be obligated to sell its handling according to the will of its investors.
A lot of closed-end funds are traded on exchange, which allows an investor to resell shares in case they require cash. The disadvantage lies in the fact that there is much less bite associated with the law of one price. Averagely, closed-end funds are traded way below their underlying holdings’ value, about in line with the usually high fees charged by the managers of these funds.
Managers of both closed-end and mutual funds are allowed to actively trade their holdings, and a lot of them even do so. Even though some funds imitate the common indexes of stock market, a lot more try guessing the market. Most of funds are categorized depending on the motivation of general trading (for example, market timing, growth, value, income, or capital appreciation).
A UIT (unit investment trust) is kind of closed end when it comes to its creation (generally through a singly huge major offering) and kind of open as far as its policies for redemption are concerned (generally redemption requests from investors are accepted.) Furthermore, it is forbidden by SEC rules ton actively trade UITs (that shall change soon) and there must be a certain date for termination with UITs (even if it’s in future of 50 years.)
Buying and selling UITs is easier for retail investors as they can be listed on stock exchange. Certain early ETFs (exchange-traded funds were structured as UITs; however, some additional legal contortions were required that helped them in creating more shares on demand. Nowadays, ETFs are generally structured like open-end funds.
SEC also regulates certain other investment vehicles under other rules. The most major may be some kinds of ADR (American Depositary Receipt.) Being an investment vehicle that is passive, an ADR generally owns only on foreign security’s stock, which is held usually in escrow at the Bank of New York. An ADR makes trading foreign securities simpler for retail investors of U.S with no big transaction costs incurred. A great bite is given to the law of one price since ADRs can be redeemed.
There are even structured funds so they don’t have to be registered with SEC. Thus, they cannot advertise openly for investors and limited to less than a hundred investors. It includes venture capital funds, hedge funds and private equity funds. Several offshore funds are made for helping foreign investors in holding stocks with no imposing of SEC regulation and also without getting into vicinity of U.S. IRS.
7.2D Appearance and Disappearance of Securities
Inflows
Most of the equities traded publicly come out on public exchanges, usually NASDAQ, through IPOs (initial public offerings.) It is an even in which the companies that are privately traded first sell shares to institutional investors and ordinary retail. It is usually the underwriters who execute IPOs. There are accustomed with the regulatory process and complex legal and have access to client investor base for buying the shares that are newly issued. Typically, shares are sold in IPOs at a specific price: for nearly 10% below the likely price at which it is likely that they will trade on after-market open trading’s first day. (A lot of shares of IPO are assigned to the favorite customers of the brokerage firm as they can serve as a great profit source.
Generally, nearly one-third of company is sold in IP and the worth of typical shares offered by IPO is in the range from $20 million to $100 million, though some are a lot bigger. Nearly two-third of such companies do not amount to a lot or die in a year or two. The remaining one-third thereafter soon offers more shares in SEOs (seasoned equity offerings.) Nowadays, the increase in number of shares in the companies that are publicly traded, particularly the larger companies, comes from employee stock option plans rather than seasoned equity offerings. Eventually, these turn out to be unrestricted shares that are publicly traded.
Since legal regulations faced by IPOs are complex, there has recently been an increase in the prominence of reverse mergers’ alternative. With reverse merger, privately-owned large company wanting to go public is merged with small company that is already traded publicly. The big company’s owners get shares that are newly issued in combined entity. Obviously, whenever a company that is publicly traded purchases assets like a privately held company, it effectively means that the capital is being deployed into public markets from private sector.
In 1933/34, the SEC (Securities and Exchange Commission) was stablished by Congress through Securities Exchange Acts. Further, through 1940’s Investment Advisers Act, it regulated investment advisors. Apart from the regulation of IPO process, what a publicly traded company must do is also prescribed by them.
For example, companies that are traded publicly must report financials regularly to SEC along with other information. Furthermore, insider trading is prohibited on specific information that is unreleased. However, general insiders trading are legal. Only civil fines can be pursued by the SEC. Pursuing criminal sanctions is in the hands of the states, which they usually do in a simultaneous manner. Other regulations that have to be followed by publicly traded companies are derived from state laws and federal laws.
Links of Previous Main Topic:-
- Introduction of corporate finance
- The time value of money and net present value
- Stock and bond valuation annuities and perpetuities
- A first encounter with capital budgeting rules
- Risk and return risk aversion in a perfect market
- Cash bonds and stocks 1970 to 2007
Links of Next Financial Accounting Topics:-
