CHAPTER 3 HOW SECURITIES ARE TRADED 3.

1 HOW FIRMS ISSUE SECURITIES When firms need to raise capital they may choose to sell or float new securities. These new issues of stocks, bonds, or other securities typically are marketed to the public by investment bankers in what is called the primary market. Purchase and sale of already-issued securities among private investors occurs in the seco !ary market. There are two types of primary market issues of common stock. Initial Public Offerings (IP ! are stocks issued by a formerly privately owned company selling that is going public, that is, selling stock to the public for the first time. Seasoned new issues ("# ! are offered by companies that already have floated e$uity. In case of bonds, we also distinguish between two types of primary market issues% a public offering, which is an issue of bonds sold to the general investing public that can then be traded on the secondary market& and a private placement, which is an issue that is sold to one or a few institutional investors and is generally held to maturity. 1. I "estme t #a ki $ a ! U !er%riti $ P&'(ic o))eri $s of both stocks and bonds typically are marketed by investment bankers, who in this role are called underwriters. 'ore than one investment banker usually markets the securities. ( lead firm forms an underwriting syndicate of other investment bankers to share the responsibility for the stock issue. The investment bankers advise the firm regarding the terms on which it should attempt to sell the securities. (( preliminary registration statement must be filed
with the "ecurity and #)change *ommission ("#*! describing the issue and the prospects of the company. This preliminary prospectus is known as a red herring.!

In a typical underwriting arrangement, the investment bankers purchase the securities from the issuing company and then resell them to the public. The issuing firm sells the securities to the underwriting syndicate for the public offering price less a spread that serves as compensation to the underwriters. This procedure is called a )irm commitme t. The underwriters receive the issue and assume the full risk that the shares cannot in fact be sold to the public at the stipulated offering price. (n alternative to firm commitment is the 'est*e))orts agreement. In this case the investment banker agrees to help the firm sell the issue to the public but does not actually purchase the securities. The banker simply acts as an intermediary
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between the public and the firm and does not bear the risk of not being able to resell the securities at the offering price. The best-efforts procedure is more common for IP s of common stock, for which the appropriate share price is less certain. *orporations engage investment bankers either by e$otiatio or by competiti"e 'i!!i $. ,egotiation is far more common. -esides being compensated by the spread between the purchase price and the public offering price, an investment banker may receive shares of common stock or other securities of the firm. "ee .igure /.+ in the te)tbook for the relationships among the issuing firm, the underwriter and the public. +. S,e() Re$istratio S,e() Re$istratio 0 In +123 the "#* approved 4ule 5+6, which allows firms to register securities and gradually sell them to the public for two years following the initial registration. -ecause the securities are already registered, they can be sold on short notice with little additional paperwork. 'oreover, they can be sold in small amounts without incurring substantial flotation costs. The securities are 7on the shelf,7 ready to be issued, which has given rise to the term shelf registration. 3. Pri"ate P(aceme t Primary offerings can also be sold in a pri"ate p(aceme t rather than a public offering. In this case, the firm (using an investment banker! sells shares directly to a small group of institutional or wealthy investors. Private placements can be far cheaper than public offerings. This is because the 4ule +55 of "#* allows corporations to make these placements without preparing the e)tensive and costly registration statement re$uired of a public offering. Private placements do not trade in secondary markets like stock e)changes& this greatly reduces their li$uidity and presumably reduces the prices that investors will pay for the issue. -. I itia( P&'(ic O))eri $s .IPOs/ Investment bankers manage the issuance of new securities to the public. nce the "#* has commented on the registration statement and a preliminary prospectus has been distributed to interested investors, the investment bankers organi8e roa! s,o%s in which they travel around the country to publici8e the imminent offering. These road shows serve two purposes. .irst, they generate interest among the potential investors and provide information about the offering. "econd, they provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities.
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9arge investors communicate their interesting purchasing shares of the IP to the underwriter& these indications of interests are called a 'ook, and the process of polling potential investors is called 'ook*'&i(!i $. The book provides valuable information to the issuing firm because large institutional investors often will have useful insights about the market demand for the security as well as the prospects of the firm and its competitors. Investment bankers fre$uently revise both their initial estimates of the offering price of a security and the number of shares offered based on the feedback from the investing community. The underwriter needs to offer the security at a bargain price to the investors to induce them to participate in book-building and share their information. Thus IP s commonly are & !erprice! compared to the price at which they could be marketed. "uch underpricing is reflected in price jumps that occur on the date when the shares are first traded in public security markets (see .igure /.3 in the te)tbook which presents average firs-day returns on IP s of stocks across the world.! The results consistently indicate that IP s are marketed to investors at attractive prices. :nderpricing of IP s makes them appealing to all investors, yet big institutional investors are allocated the bulk of a typical new issue. "ome view this as unfair discrimination against small investors. IP s can be very e)pensive, especially for small firms. ;owever the landscape changed in +116 when "pring "treet -rewing *ompany, which produces Wit beer, came out with an I ter et IPO. (nother new entry to the underwriting field is W.4. ;ambrecht < *o., which also conducts IP s on Internet geared towards smaller, retail investors. ;ambrecht conducted a =>utch auction?. In this procedure, which ;ambrecht has called Ope IPO, investors submit a price for a given number of shares. The bids are ranked in order of bid price, and shares are allocated to the highest bidders until the entire issue is absorbed. -y allocating shares based on bids, this procedure minimi8es underpricing. 3.+ HOW SECURITIES ARE TRADED 1. Types o) Markets We can differentiate four types of markets% direct search markets, brokered markets, dealer markets and auction markets. Direct searc, market 0 it is the least organi8ed market. -uyers and sellers must seek each other out directly. (n e)ample of a transaction in such a market is the sale of a used refrigerator where the seller advertises fir buyers in a local newspaper or on *raigslist. "uch markets are characteri8ed by sporadic participation and low-priced and nonstandard goods.
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#rokere! market 0 in markets where trading in a good is active, brokers find it profitable to offer such services to buyers and sellers. ( good e)ample is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to control the searches. (n important brokered investment market is the primary market, where new issues of securities are offered to the public. (nother brokered market is that for large block transactions, in which very large blocks of stock are bought or sold. Dea(er market 0 when trading activity in a particular type of asset increases, dealer markets arise. >ealers speciali8e in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. The spread between dealers@ buy (or bid! prices and sell (or ask! prices are source of profit. >ealer markets save traders on search costs because participants can easily look up the prices at which they can buy from or sell to dealers. A&ctio market 0 the most integrated market is the auction market, in which all traders converge at one price (either physically or electronically! to buy or sell an asset. The ,ew Aork "tock #)change is an e)ample of an auction market. (n advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save bid-ask spread. +. T,e Mec,a ics o) E0c,a $e Tra!i $ When an investor instructs a broker to buy or sell securities, a number of players must act to consummate the trade. The investor places an order with a broker. The brokerage firm for which the broker works and which owns a seat on the e)change contacts its commission broker, who is on the floor of the e)change, to e)ecute the order. F(oor 'rokers are independent members of the e)change who own their own seats and handle work for commission brokers when those brokers have too many orders to handle. The specia(ist is central to the trading process. (ll trading in a given stock takes place at one location on the floor of the e)change called the specialistBs post. (t the specialistBs post is a computer monitor, called the >isplay -ook that presents all the current offers from interested traders to buy or sell shares at various prices as well as the number of shares these $uotes are good for. The specialist manages the trading in the stock. The market making responsibility for each stock is assigned by the ,A"# to one specialist firm. (There is only one specialist firm per
stock but most firms will have responsibility for trading in several stocks. The specialist firm also may act as a dealer in the stock, trading for its own account.!

3. Types o) Or!ers -roadly speaking there are two types of orders% market orders and orders contingent on price. Market Or!ers 'arket orders are buy or sell orders that are to be e)ecuted immediately at current market prices (buy or sell =at market?!. When a trade is e)ecuted, the specialist@s clerk will fill out an order card that reports the time, price, and $uantity of shares traded, and the transaction will be reported on the e)change@s ticker tape. This simple scenario, however, is subCect to a few potential complications. .irst, the posted price $uotes (bid and ask orders! actually represent commitment to trade up to a specified number of shares. If the market order is for more than this number of shares, the order may be filled at multiple prices. "econd, another trader may beat out investor to the $uote, meaning that her order would then be e)ecuted at a worse price. .inally, the best price $uote may change before her order arrives, again causing e)ecution at a price different from the one at the moment of order. 1imit Or!ers Investors may also place orders, specifying prices at which they are willing to buy or sell a security. ( limit buy order may instruct the broker to buy some number of shares if and when stock may be obtained at or below a stipulated price (e.g. if I-' is selling at D1E bid, D1E.E6 ask, a limit-buy order may instruct the broker to buy the stock when the share price falls below D21!. *orrespondingly, a limit sell order instructs the broker to sell if and when the stock price rises above a specified limit. ( collection of limit orders waiting to be e)ecuted is called a limit order book (see .igure /.5 in the te)tbook which represents a portion of the limit order book for shares in Intel.! Stop or!ers "top orders are similar to limit orders in that the trade is not to be e)ecuted unless the stock hits a price limit. .or stop-loss orders, the stock is to be sold if its price falls below a stipulated level. (s the name suggests, the order lets the stock be sold to stop further losses from accumulating. "imilarly, stopbuy orders specify that the stock should be bought when its price rises above a limit. These trades often accompany short sales, and they are used to limit potential losses from the short position. .igure /.6 in the te)tbook organi8es these types of trades in a convenient matri). rders can also be limited by a time period, e.g. !ay or!ers e)pire at the close of the trading day. If it is not e)ecuted on that day, the order is canceled. Ope or $oo!*ti((*ca ce(e! orders, in contrast, remain in force for up to si) months, until canceled by the customer. (t the other e)treme, )i(( or ki(( or!ers e)pire if the broker cannot fill them immediately. -. Tra!i $ o t,e OTC market
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n the e)changes, all trading takes place through a specialist. Trades on the T* market, however, are negotiated directly through dealers. #ach dealer maintains an inventory of selected securities. >ealers sell from their inventories at ask prices and buy for them at bid prices. (n investor who wishes to buy or sell shares engages a broker who tries to locate the dealer offering the best deal on the security. This is in contrast to e)change trading where all buy or sell orders are negotiated through the specialist, who arranges for the best bids to get the trade. In the T* market brokers must search the offers of dealers directly to find the best trading opportunity. In this sense, ,(">(F is largely a price $uotation system, not a trading system.
;owever, in the wake of the stock market crash of +12G, ,(">(F instituted a Sma(( Or!er E0ec&tio System (" #"!, which is in effect a trading system. :nder " #", market mak ers in a security who post bid or ask prices on the ,asda$ network may be contacted over the network by other traders and are re$uired to trade at the prices they currently $uote. >ealers must accept " #" orders at their posted prices up to some limit , which may be +,EEE shares but usually is smaller, depending on factors such as trading volume in the stock.

-ecause the ,(">(F system does not use a specialist, T* trades do not re$uire a centrali8ed trading floor as do e)change-listed stocks. >ealers can be located anywhere as long as they can communicate effectively with other buyers and sellers. ne disadvantage of the decentrali8ed dealer market is that the investors are vulnerable to tra!i $ t,ro&$,, which refers to the possibility that dealers can trade with the investor at their $uoted bid or ask prices even if other customers have offered to trade at better price, e.g., limit orders =inside the spread?. (This practice harms the investor whose limit order is not filled (is =traded
through?!, as well as the investor whose market buy or sell order is not filled at the best available price.! The "#* reaffirmed its so-called trade-through rule in 3EE6. Its

4egulation ,'" re$uires that investors@ orders be filled at the best price that can be e)ecuted immediately, even if the price is available in a different market. 2. Tra!i $ Mec,a isms -roadly speaking, there are thee trading systems in the :"(% +! the over-thecounter dealer markets, 3! electronic communication networks, and /! formal e)changes. 1. Dea(er Markets 4oughly /6,EEE issues are traded on the o"er*t,e*co& ter ( T*! market and any security may be traded there, but the T* market is not a formal e)change. There are no membership re$uirements for trading, nor are there listing re$uirements for securities (although there are re$uirements to be listed on ,asda$, the computer-linked network for trading securities of larger T* firms!. Thousands
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of brokers register with "#* as dealers in T* securities. "ecurity !ea(ers $uote prices at which they are willing to buy or sell securities. ( 'roker then e)ecutes a trade by contacting the dealer listing an attractive $uote. (In +1G+, the ,ational
(ssociation of "ecurities >ealers (utomatic Fuotation "ystem, or ,(">(F was developed to link brokers and dealers in a computer network where price $uotes could be displayed and revised. (s originally organi8ed, ,(">(F was more of a price-$uotation system than a trading system.!

+. T,e E(ectro ic Comm& icatio 3et%orks The direct trading among investors through computer networks has e)ploded in recent years due to the advent of the e(ectro ic comm& icatio et%ork4 or EC3. The #*, is an alternative to either formal stock e)change like the ,A"# or dealer markets like ,(">(F for trading securities. These networks allow participants to post buy or sell orders (market and limit orders! and to have those orders matched up or 7crossed7 with orders of other traders in the system. #*,s offer several attractions. >irect crossing of trades without using a brokerdealer system eliminates the bid-ask spread that otherwise would be incurred. Instead, trades are automatically crossed at a modest cost, typically less that a penny per share. #*,s are attractive as well because of the speed with which a trade can be e)ecuted. In addition to cost savings, systems such as I sti et and Posit offer large traders considerable anonymity in their trades.
#*,s have already captured about /EI of the trading volume in ,asda$-listed stocks. The advent of #*,s is putting increasing pressure on the ,A"# to respond. In particular, big brokerage firms such as Joldman "achs and 'errill 9ynch are calling for the ,A"# to beef up its capabilities to automate orders without human intervention. 'oreover, as they push the ,A"# to change, these firms are hedging their bets by investing in #*,s on their own.

3. Specia(ist Markets In format e)changes such as the ,ew Aork "tock #)change trading in each security is managed by a specia(ist assigned the responsibility for that security. -rokers who wish to buy or sell shares on behalf of their clients must direct the trade to the specialist@s post on the floor of the e)change. #ach security is assigned to one specialist, but each specialist firm 0currently there are fewer than +E on ,A"# - makes a market in many securities. This task may re$uire the specialist to act as either a broker or dealer. The specialistBs role as a broker is simply to e)ecute the orders of other brokers. "pecialists may also buy or sell shares of stock for their own portfolios. When no other trader can be found to take the other side of a trade, specialists will do so, even if it means they must buy for or sell from their own accounts. "pecialist firms earn income both from commissions for managing orders (as implicit brokers! and from the spreads at which they buy and sell securities (as implicit dealer!.
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The specia(ist is re$uired to use the highest outstanding offered purchase price and lowest outstanding offered selling price when matching trades. Therefore, the specialist system results in an auction market, meaning that all buy and all sell orders come to one location, and the best orders 7win7 the trades. In this role, the specialist acts merely as a facilitator. The more interesting function of the specialist is to maintain a =)air a ! or!er(y market? by acting as a dealer in the stock. (The specialist is re$uired by the e)change to maintain an orderly market by buying and selling shares from inventory!. "pecialists maintain their own portfolios of stock and $uote bid and ask prices at which they are obligated to meet at least a limited amount of market orders. If market buy orders come in, specialists must sell shares from their own accounts at the ask price& if sell orders come in, they must stand willing to buy at the listed bid price. "pecialists strive to maintain a narrow bid-ask spreads for at least two reasons. .irst, one source of the specialistBs income is derived from fre$uent trading at the bid and ask prices, with the spread as a trading profit. ( too-large spread would make the specialistBs $uotes uncompetitive with the limit orders placed by other traders. If the specialistBs bid and ask $uotes are consistently worse than those of public traders, it will not participate in any trades and will lose the ability to profit from the bid-ask spread. (n e$ually important reason for narrow specialist spreads is that they are obligated to provide price co ti &ity to the market. (In this role, in cases of e)cessive volatility, the specialist would be e)pected to step
in with the bid andKor ask prices to reduce the bid-ask spread to an acceptable level, typically below DE.E6 for large firms!.

3.3 U.S. SECURITIES MAR5ETS 1. 3ASDA6 In +1G+, the ,ational (ssociation of "ecurity >ealers (utomated Fuotation system, or 3as!a7, was developed to offer immediate information via a computer-linked system on bid and ask prices for stocks offered by various dealers. That system now called ,(">(F "tock market lists about /,3EE firms and offers three listing options. The !S"!# $lobal Select %arket lists over +,EEE of the largest, most actively traded firms, the !S"!# $lobal %arket is for the ne)t tier of firms, and !S"!# &apital %arket is the third tier of listed firms. "ome of the re$uirements for initial listing are presented in Table /.+ in the te)tbook. (s noted, the ,asda$ market was originally set up more as a price-$uotation system than a trading system. ;owever, in 3EE3 ,(">(F introduced "uper'ontage, which is an integrated order display and trade e)ecution system.
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"uper'ontage allows market makers to enter multiple $uotes and orders at different prices. It can aggregate limit orders at all price levels and make available total trading interest at the best price as well as the ne)t-best four prices. -y aggregating orders from participating market makers at all price points, "uper'ontage can serve as a central limit order book for all ,(">(F-listed securities. (,(">(F has steadily developed even-more-sophisticated electroic trading
platforms, which today handle the great maCority of its trades. The currect version, called the ,(">(F 'arket *enter, consolidates all of ,asda$@s previous electronic markets into one integrated system.!

+. T,e 3e% 8ork Stock E0c,a $e There are several e)changes in the :nited "tates. Two of these, the ,A"# and (me), are national in scope and are located in ,ew Aork *ity. The 3e% 8ork Stock E0c,a $e (,A"#! is by far the largest stock e)change. The shares of about 3,2EE firms are traded there, with a combined market capitali8ation in early 3E+E of nearly D+3 trillion. >aily trading volume on the ,A"# averaged 6 billion shares in 3EE1. The ,A"# accounts for about 26-1EI of the trading that takes place on :.". stock e)changes. (n investor who wishes to trade shares on the ,A"# places an order with a brokerage firm, which either sends the order to the floor of the e)change via computer network, or contacts its broker on the floor of the e)change to =work? the order. -rokers must purchase the right to trade on the floor of the ,A"#. riginally, the ,A"# was organi8ed as a non-for-profit company owned by its members or =set holders?. .or e)ample, in 3EE6there were +,/HH seat-holding members of the ,A"#. The seat entitles the firm to place a broker on the floor of the e)change where he or she can e)ecute trades. The e)change@s member firms could charge investors for e)ecuting trades on their behalf, which made the seat a valuable asset. The commissions that members can earn by trading on behalf of clients determined the market value of the seat, which were bought and sold like any other asset. 'ore recently however, many e)changes have decided to switch from a mutual form of organi8ation, in which seat holders are Coint owners, to publicly traded corporations owned by shareholders. In 3EEH, the ,A"# merged with the (rchipelago #)change to form a publicly held company called the ,A"# Jroup, and in 3EEG, the ,A"# Jroup merged with #urone)t to form ,A"# #urone)t. (s a publicly traded corporation, its share price rather than the price of a seat on the e)change is the best indicator of its financial health. (Table /.3 in the te)tbook gives
some of the initial re$uirements for the ,A"#. These re$uirements ensure that a firm is of significant trading interest before the ,A"# will allocate facilities for it to be traded on the floor of the e)change.!

The America Stock E0c,a $e ((me)! is also national in scope, but it focuses
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on listing smaller and younger firms than does the ,A"#. The national e)changes are willing to list a stock (i.e. allow trading in that stock on the e)change! only if the firm meets certain criteria of si8e and stability. Re$io a( e0c,a $es provide a market for trading shares of local firms that do not meet the listing re$uirements of the national e)changes. 4egional e)changes also sponsor trading of some firms that are listed on the ,A"#. This arrangement enables local brokerage firms to trade in shares of large firm witout obtaining a floor licence on the ,A"#. #(ock Sa(es Institutional investors fre$uently trade tens of thousand of shares of stock. 9arger block transactions (technically, transactions of over +E,EEE shares, but often much larger! are often too large for specialists to handle, as they do not wish to hold such large blocks of stocks in their inventory. In response to this problem, 7block houses7 have evolved to aid in the placement of larger block trades. -lock houses are brokerage firms that speciali8e in matching block buyers and sellers. nce a buyer or seller has been matched, the block is sent to the e)change floor, where the specialists e)ecute the trade. If a buyer cannot be identified, the block house might purchase all or part of a block sale for its own account. The block house then can resell the shares to the public. E(ectro ic Tra!i $ o t,e 38SE The ,A"# dramatically stepped up its commitment to electronic trading in the last decade. Its "uper>ot is an electronic order-routing system that enables brokerage firms to send market and limit orders directly to the specialist over computer lines. "uper>ot is especially useful to program traders. ( program trade is a coordinated purchase or sale of an entire portfolio of stocks. While "uper>ot simply transmits orders to the specialist@s post electronically, the ,A"# also has instituted a fully automated trade-e)ecution system called >irectPlus. It matches orders against the inside bid or ask price with e)ecution time of a small fraction of a second. #o ! Tra!i $ In 3EEH, the ,A"# obtained regulatory approval to e)pand its bond-trading system to include the debt issues of any ,A"#-listed firm. In conCunction with these new listings, the ,A"# has e)panded its electronic bond-trading platform, which is now called ,A"# -onds and is the largest centrali8ed bond maket of any :.". e)change. ,evertheless, the vast maCority of bind trading occurs in the T* market among bond dealers, even for bonds that are actually listed on the ,A"#. .or bonds, the o"er*t,e*co& ter .OTC/ market is a loosely organi8ed network of dealers linked
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together by a computer $uotation system. In practice, however, the corporate bond market often is $uite =thin,? in that there are few investors interested in trading a particular bond at any particular time. The bond market is therefore subCect to a type of 7li'uidity risk7, because it can be difficult to sell one@s holdings $uickly if the need arises. 3.- MAR5ET STRUCTURE I3 OTHER COU3TRIES The structure of security markets varies considerably from one country to another. The biggest non-:.". stock markers are the 9ondon, #urone)t and Tokyo e)changes (see .igure /.H in the te)tbook for the market capitali8ation of maCor world stock e)changes.! T,e 1o !o Stock E0c,a $e (9"#! uses an electronic trading system dubbed "#T" for trading in large, li$uid securities. It is an electronic clearing system similar to #*,s in which buy and sell orders are submitted via computer networks and any buy and sell orders that can be crossed are e)ecuted automatically. ;owever, less-li$uid shares are traded in a more traditional dealer market called the "#(F ("tock #)change (utomated Fuotation! system, where market makers enter bid and ask prices at which they are willing to transact. E&ro e0t was formed established in 3EEE by a merge of the Paris, (msterdam and -russels e)changes (,> IT"#9. '#4J#> WIT; the ,A"# Jroup in 3EEG. #urone)t uses an electronic trading system called ,"* (,ouveau "ysteme de *otation, or ,ew Fuotation "ystem!. It has fully automated order routing and e)ecution. In fact, investors can enter their orders without contacting their brokers. #urone)t has established cross-trading agreements with several other #uropean e)changes such as ;elsinki or 9u)emburg. Tokyo Stock E0c,a $e .TSE/ is among the largest in the world measured by the market capitali8ation of its roughly 3,5EE listed firms. In +111 it closed its trading floor and switched to all-electronic trading. It switched from a membership form of organi8ation to a corporate form in 3EE+. The two maCor stock inde)es for the T"# are the ,ikkei 336 inde), which is a price-weighted average, and T PIL inde), which is value-weighted inde). 9(o'a(i:atio a ! Co so(i!atio o) Stock Markets (ll stock markets have come under increasing pressure in recent years to make international alliances or mergers. 'uch of this pressure is due to the impact of electronic trading. In the face of competition from electronic networks, established e)changes feel that they eventually need to offer 35-hour global markets and platforms that allow trading of different security types, for e)ample, both stocks and derivatives. These pressures have resulted in a broad
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trend toward market consolidation. In the :."., the ,A"# merged with (rchipelago #*, in 3EEH, and in 3EE2 ac$uired the (merican "tock #)change. ,(">(F ac$uired Instinet (which operated another maCor #*,, I,#T! in 3EE6, and the -oston "tock #)change in 3EEG. In #urope, #urone)t was established in 3EEE, and shortly thereafter purchased 9iffe, the derivatives e)change based in 9ondon. The 9"# merged in 3EEG with -orsa Italiana, which operates the 'illan e)change. (There has also been a wave of intercontinental
consolidations. .or e)ample, the ,A"# Jroup and #urone)t merged in 3EEG. ,(">(F ac$uired a foothold in #urope in 3EE, when it Coined forces with -orse >ubai to ac$uire the "wedish e)change 'L.!

3.2 TRADI39 COSTS Part of the cost of trading a security is obvious and e)plicit. Aour broker must be paid a commission. Individuals may choose from two kinds of brokers% fullservice or discount brokers. F&((*ser"ice 'rokers, who provide a variety of services, often are referred to as account e)ecutives or financial consultants. -esides carrying out the basic services of e)ecuting orders, holding securities for safekeeping, e)tending margin loans, and facilitating short sales, brokers routinely provide information and advice, relating to investment alternatives. Disco& t 'rokers, on the other hand, provide 7no-frills7 services. They buy and sell securities, hold them for safekeeping, offer margin loans, and facilitate short sales, and that is all. The only information they provide about the securities they handle consists of price $uotations. >iscount brokerage services have become increasingly available in recent years. In addition to the e)plicit part of trading costs - the brokerBs commission - there is an implicit part - the dealerBs 'i!*ask sprea!. "ometimes the broker is also a dealer in the security being traded and charges no commission but instead collects the fee entirely in the form of the bid-ask spread. (nother implicit cost of trading that some observers would distinguish is the price co cessio an investor may be forced to make for trading in $uantities greater that those associated with the posted bid or ask price. ne continuing trend is toward o (i e trading either through the Internet or through software that connects a customer directly to a brokerage firm. While there is a little conceptual difference between placing your order using a phone call vs. through a computer link, online brokerage firm can process trades more cheaply since they do not have to pay as many brokers. (n ongoing controversy between the ,A"# and its competitors is the e)tent to which better e)ecution on the ,A"# offsets the generally lower e)plicit costs of trading in other markets. E0ec&tio refers to the si8e of the effective bid-ask
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spread and the amount of price@s impact in a market. The ,A"# believes that many investors focus too intently on the costs they can see despite the fact that $uality of e)ecution can be a far more important to their total trading costs. 'any ,A"# trades are e)ecuted at a price inside the $uoted spread. In contrast, in a dealer market such as ,(">(F all trades go through the dealer, and all trades, therefore, are subCect to a bid-ask spread. The client never sees the spread as an e)plicit cost, however. (The price at which the trade is e)ecuted incorporates the dealer@s
spread but this part of the trading cost is never reported to the investors!. ( controversial practice related to the bid-ask spread and the $uality of trade e)ecution is ;payi $ )or or!er )(o%.7 This entails paying a broker a rebate for directing the trade to a particular dealer rather than to the ,A"#. -y bringing the trade to a dealer instead of to the e)change, however, the broker eliminates the possibility that the trade could have been e)ecuted without incurring a spread. 'oreover, a broker that is paid for order flow might direct the trade to a dealer that does not even offer the most competitive price. 'any of the online brokerage firms rely heavily on payment for order flow, since their e)plicit commissions are so minimal. They typically do not actually e)ecute orders, instead sending an order either to a market maker or to a stock e)change for some listed stocks.

3.< #U8I39 O3 MAR9I3 When purchasing securities, investors have easy access to a source of debt financing called broker(s call loan. The act of taking advantage of broker@s call loan is called '&yi $ o mar$i . Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker. The mar$i in the account is the portion of the purchase price contributed by the investor& the remainder is borrowed from the broker. The broker, in turn, borrows money from banks at the call money rate to finance these purchases, and charges its clients that rate plus a service charge for the loan. (ll securities purchased on margin must be maintained with the brokerage firm in street name, for the securities are collateral for the loan. The -oard of Jovernors of the .ed "ystem limits the e)tent to which stock purchases may be financed using margin loans. The current initial margin re$uirement is 6EI, meaning that at least 6EI of the purchase price must be paid for in cash, with the rest borrowed. The initial perce ta$e mar$i is defined as the ratio of the net worth, or 7e$uity value7 of the account to the market value of the securities% Percentage margin M #$uity in account K 'arket value of stock If the stock value were to fall below the loan from the broker (see #)ample /.+ in the te)tbook!, owners@ e$uity would become negative, meaning that the value of the stock is no longer sufficient collateral to cover the loan from the broker. To
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guard against this possibility, the broker sets a mai te a ce mar$i . If the percentage margin falls below the maintenance level, the broker will issue a margin call, which re$uires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell the securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level. Why do investors buy securities on marginN They do so when they wish to invest an amount greater than their own money allows. Thus, they can achieve greater upside potential, but they also e)pose themselves to greater downside risk (see #)ample /.3 in the te)tbook!. 3.= SHORT SA1ES A s,ort sa(e allows investors to profit from a decline in a securityBs price. (n investor borrows a share of stock from a broker and sells it. 9ater, the short-seller must purchase a share of the same stock in the market in order lo replace the share that was borrowed. This is called co"eri $ t,e s,ort positio . Table /.6 in the te)tbook compares stock purchases to short sales. The short-seller anticipates the stock price will fall, so that the share can be purchased later at a lower price than it initially sold for& if so, the short-seller will reap a profit. "hortsellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale. (In practice, the shares loaned out for a short sell are
typically provided by the short-seller@s brokerage firm, which holds a wide variety of securities of its other investors in street name, i.e. the broker holds the shares registered in its own name on behalf of the client.!

#)change rules permit short sales only when the last recorded change in the stock price is positive. This rule apparently is meant to prevent waves of spec&(atio against the stock. In other words, the votes of 7no confidence7 in the stock that short sales represent may be entered only after a price increase. .inally, e)change rules re$uire that proceeds from a short sale must be kept on account with the broker. The short-seller cannot invest these funds to generate income, although large or institutional investors typically will receive some income from the proceeds of a short sale being held with the broker. "hort-sellers are also re$uired to post mar$i (cash or collateral! with the broker to cover losses should the stock price rise during the short sale. ("top-buy orders often
accompany short sales as they provide protection to the short-seller if the stock price moves up!.

The initial perce ta$e mar$i is the ratio of the e$uity in the account to the current value of the shares that have been borrowed and must been returned% Percentage margin M #$uity in account K Oalue of stock owed
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,otice that when buying on margin, you borrow a given number of dollars from your broker, so the amount of the loan is independent of the share price. In case of short sale you borrow a given number of shares, which must be returned. Therefore, when the price of the shares changes, the value of the loan also changes. 9ike investors who purchase stock on margin, a short-seller must be concerned about receiving a margin call.
"ort-selling periodically comes under attack, particularly during times of financial stress when share prices fall. The last few years have been no e)ception to this rule. .or e)ample, following the 3EE2 financial crisis, the "#* voted to restrict short sales in stocks that decline by at least +EI on a given day. Those stocks may now be shorted on that day and the ne)t only at a price greater than the highest bid price across national stock markets. 3.> RE9U1ATIO3 OF SECURITIES MAR5ETS .optio a(/

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