Let's look into the institutional arrangements for equity trading. After all, from our corporate perspective, stocks are more interesting than many other financial instruments, such as foreign government bonds, even if there is more money in foreign government bonds than in corporate equity. After all, it is the equity holders who finance most of the risks of corporate projects, Moreover, although there is more money in non equity financial markets, the subject area of investments often focuses on equities (stocks), too, because retail investors find it easier to buy stocks, and historical data for stocks is relatively easy to opine by, So it makes sense to describe a few institutional details as to how investors and stocks "connect"—exchange cash for claims, and vice versa

Brokers

Most individuals place their orders to buy or sell stocks with a retail broker, such as. Ameritrade (a "deep-discount" broker), Charles Schwab (a "discount" broker), or Men-in Lynch (a "full. service" broker). Discount brokers may charge only about $10 commission per trade, but they often receive "rebate" payments bad( from the market maker to which they route your order. This is called "payment for order flow." The market maker in turn recoups this payment to the broker by executing your trade at a price that is less favorable. Although the purpose of such an arrangement seems deceptive, the evidence suggests that discount brokers are still often cheaper in facilitating investor trades—especially small investor trades—even after taking this hidden payment into account. They just are not as (relatively) cheap as they want to make you believe.

Investors can place either market orders, which ask for execution at the current price, or limit orders, which ask for execution if the price is above or below a limit that the investor can specify (There are also many other modifications of orders, e.g., stop-foss orders [which instruct a broker to sell a security if it has lost a certain amount of money], good-rif-canceled orders, and fin-or-kill orders.) The first function of retail brokers then is to handle the execution of trades. They usually do so by ['Outing investors' orders to a centralized trading location (e.g., a particular stock exchange), the choice of which is typically at the retail broker's discretion, as is the particular individual (e.g., floor broker) engaged to execute the trade. The second function of retail brokers is to keep track of investors' holdings, to facilitate purchasing on margin (whereby investors can borrow money to purchase stock, allowing them to purchase more securities than they could afford on a pure cash basis), and to facilitate selling securities 'short," which

allows investors to speculate that a stock will go down.

Many large institutional investors separate the two functions; The investor employs its own traders, while the broker takes care only of the bookkeeping of the investor's portfolio, margin provisions, and shorting provisions. Such limited brokers are called prime brokers.

How Shorting Stocks Works

If you want to speculate that a stock will go down, you would want to short it. This shorting would be arranged by your broker. Shorting is important enough to deserve an extended explanation:

· You find an investor in the market who is willing to lend you the shares. In a perfect market, this does not cost a penny. In the real world, the broker has to find a willing lender, Both the broker and lender usually earn a few basis points per year for doing you the favor of facilitating your short sale.

· After you have borrowed the shares, you sell them into the market to someone else who wanted to buy the shares. In a perfect market, you would keep the proceeds and earn interest on them. In the real world, your broker may force you to put these proceeds into low-yield safe bonds. If you are a small retail investor, your brokerage firm may even keep the interest proceeds altogether.

· When you want to "unwind" your short, you repurchase the shares and return them to your lender.

For example, if you borrowed the shares when they were trading for $50 (and sold them into the market), and the shares now sell for $30, you can repurchase them for $20 less than what you sold them for into the market. This $20 is your profit. In an ideal world, you can think of your role effectively as the same as that of the company—you can issue shares and use the $50 proceeds to fund your investments (e.g., to earn interest). In the real world, you have to take transaction costs into account. (Shorting has become so common that there are now exchange-traded futures on stocks that make this even easier.)

Exchanges and Non-Exchanges

A retail broker would route your transaction to a centralized trading location. The most prominent are exchanges. An exchange is a centralized trading location where financial securities are traded. The two most important stock exchanges in the United States are the New York Stock Exchange (NYSE, also nicknamed the Big Board) and NASDAQ (originally an acronym for "National Association of Securities Dealers Automated Quotation System"). The NYSE used to be exclusively an auction market, in which one designated specialist (assigned for each stock) managed the auction process by trading with individual brokers on the floor of the exchange. This specialist was often a monopolist However, even the NYSE now conducts much of its trading electronically In contrast to the NYSE's hybrid human-electronic process primarily in one physical Location on Wall Street, NASDAQ has always been a purely electronic exchange without specialists_ (For security reasons, its location—well, the location of its many computer systems—is secret.) For each NASDAQ stock, there is at least one market maker, a broker-dealer who has agreed to stand by continuously to offer to buy or sell shares, electronically of course, thereby creating a liquid and immediate market for the general public_ Moreover, market makers are paid for providing liquidity: They receive additional rebates from the exchange when they post a bid (short for bid price) or an ask (short for ask price) that is executed. Most NASDAQ stocks have multiple market makers, drawn from a pool of about SOO trading firms (such as .1.P Morgan or ETracle), which compete to offer the best price. Market makers have one advantage over the general public: They can see the limit order book, which contains as-yet-unexecuted orders from investors to purchase or sell if the stock price changes—giving them a good idea at which price a lot of buying or selling activity will occur. The NYSE is the older exchange, and for historical reasons, is the biggest exchange for trading most "blue chip" stocks. ("Slue chip" now means 'well-established and serious," Ironically, the term itself

came from poker, where the highest-denomination chips were blue.) In 2006, the NYSE

listed just under 3,000 companies worth about 25 trillion. (This is about twice the

annual U.S. GDP) NASDAQ tends to trade smaller and high-technology firms, lists about

as many firms, and has more trading activity than the NYSE Some stocks are traded on

both exchanges.

Continuous trading—trading at any moment an investor wants to execute—relies on the presence of the standby intermediaries ( specialists or market makers), who are willing to absorb shares when no one else is available. This is risky business, and thus any intermediary must earn a good rate of return to be willing to do so. To avoid this cost, some countries have organized their exchanges into non continuous auction systems, which match buy and sell orders a couple of times each day. The disadvantage is that you cannot execute orders immediately but have to delay until a whole range of buy and sell orders have accumulated. The advantage is that this eliminates the risk that an (expensive) intermediary would otherwise have to beat: Thus, auctions generally offer lower trading costs but slower execution.

Even in the United States, innovation and change are everywhere. For example, electronic communication networks (ECNs) have recently made big inroads into the trading business, replacing exchanges, especially for large institutional trades. (They can trade the same stocks that exchanges are trading, and thus they compete with exchanges in terms of cost and speed of execution.) An ECN outs out the specialist, allowing investors to post price-contingent orders themselves, ECNs may specialize in lower execution costs, higher broker kickbacks, or faster execution. The biggest ECNs are Archipelago and Instinct. In 2005, the NYSE merged with Archipelago, and NASDAQ purchased Instinet. (It is hard to keep track of the most recent trading arrangements. For example, in 2006, the NYSE also merged with ArcaEx, yet another electronic trading system, and merged with Euronext, a pan-European stock exchange based in Paris. As of this writing, it is now officially called NYSE Euronext—and the Deutsche Weise is

in the process of acquiring it in turn. In addition, the NYSE converted from a mutual company owned by its traders into a publicly traded for-profit company itself.)

An even more interesting method to buy and trade stocks is that of crossing system, such as ITC's POSIT. ITG focuses primarily on matching large institutional trades with one another in an auction-like manner. if no match on the other side is found, the order may simply not be executed, But if a match is made, by cutting ow the specialist or market maker, the execution is a lot cheaper than it would have been on an exchange.

Recently, even more novel trading places have sprung up. For example, Liquid net uses peer-to-peer networking—like the original Napster—to match buyers and sellers in real time. ECNs and electronic limit order books are now the dominant trading systems for equities worldwide, with only the U.S. exchange floors as holdouts. Similar exchanges and computer programs are also used to trade futures, derivatives, currencies, and even some bonds.

There are many other financial markets, too. There are financial exchanges handling stock options, commodities, insurance contracts, and so on. A huge segment is the over-the-counter (OTC) markets. Over-the-counter means "call around, usually to a set of traders well known to trade in the asset, until you find someone willing to buy or sell at a price you like." Though undergoing rapid institutional change, most bond transactions are still over-the-counter, Although OTC markets handle significantly more bond trading in terms of transaction dollar amounts than bond exchanges, OTC transaction costs are prohibitively high for retail investors. If you call without knowing the market in great detail, the person on the other end of the line will be happy to quote you a shamelessly high price, hoping that you do not know any better- The NASD (National Association of Securities Dealers) also operates a semi-OTC market for the

stocks of smaller firms, which are listed on the so-called pink sheets. Foreign securities trade on their local national exchanges, but the costs for U.S. retail investors are again often too high to make direct participation worthwhile.

Flow Securities Appear and Disappear

Inflows

Most publicly traded equities appear on public exchanges, almost always NASDAQ, through initial public offerings (IPOs). This is an event in which a privately traded company first sells shares to ordinary retail and institutional investors. IPOs are usually executed by underwriters (investment bankers such as Goldman Sachs or Merrill Lynch), which are familiar with the complex legal and regulatory process and have easy access to an investor client base to buy the newly issued shares, Shares in IPOs are typically sold at a fixed price—and for about 10% below the price at which they are likely to trade on the first day of after-market open trading, (Many IPO shares are allocated to the brokerage firm's favorite customers, and they can be an important source of profit.)

ANECDOTE Trading Volume in the Tech Bubble

During the tech bubble of 1999 and 2000, 1POs appreciated by 6S% on their opening day on average. Getting an IPO share allocation was like getting free money. Of course, ordinary investors rarely received any such share allocations—only the underwriter's favorite clients did. This later sparked a number of lawsuits, one of which revealed that Credit Suisse First Boston (CSFB) allocated shares of IPOs to more than 100 customers who, in return for IPO allocations, funneled between 33% and 65% of their IPO profits back to CSFB in the form of excessive trading of other stocks (like Compaq and Disney] at inflated trading commissions.

How important was this "kickback" activity? In the aggregate, in 1999 and 2000, underwriters left about $66 billion on the table for their first. day IPO buyers. If investors rebated 20% back to underwriters in the form of extra commissions., this would amount to $13 billion in excessive underwriter profits. At an average commission of 10 cents per share, this would require 130 billion shares to be traded, or an average of 250 million shares per trading day. This figure suggests that kickback portfolio churning may have accounted for as much as 10% of all shares traded!

Usually, about a third of the company is sold in the IPO, and the typical IPO offers shares worth between $20 million and $100 million, although some are much larger (e..g...„ privatizations, like British Telecom). About two-thirds of all such IPO companies never amount to much or even die within a couple of years, but the remaining third soon thereafter offer more shares in seasoned equity offerings (SEOs). These days, however much expansion in the number of shares m publicly traded companies--especially for large companies—comes not from seasoned equity offerings but from employee stock option plans, which eventually become unrestricted publicly traded shares.

The SEC is also in charge of regulating some behavior of publicly traded companies. This includes how they conduct their IPO It also describes how they have to behave thereafter. For example, publicly traded companies must regularly report their financials and some other information. Moreover, Congress has banned insider trading on unreleased spectac information, although more general informed trading by insiders is legal (and seems to be done fairly commonly and profitably). The SEC can only pursue civil fines. If there is fraud involved, then it is up to the states to pursue criminal sanctions, which they often do simultaneously (Publicly traded firms also have to follow a hodgepodge of other federal and state laws.)

Because Epps face unusually complex legal regulations and liability, the alternative of reverse mergers has recently become prominent. A larger privately-owned company simply merges with a small company (possibly just a shell) that is already publicly traded. The owners of the big company receive newly issued shares in the combined entity: And, of course, the newly issued shares in effect move private-sector assets into the public markets, where it appears as more market capitalization.

Outflows

Capital flows out of the financial markets in a number of ways. The most important venues are capital distributions such as dividends and share repurchases. Many companies pay some of their earnings in dividends to investors, Dividends, of course, do not fall like manna from heaven. Fox- example, a firm worth $100,000 may pay $1,000, and would therefore be worth $99,000 after the dividend distribution, If you own a share of $100, you would own (roughly) $99 in sick and $1 in dividends after the payment—still $100 in total, no better or worse. (If you have to pay some taxes on dividend receipts, you might come out for the worse.) Alternatively, firms may reduce their outstanding shares by paying out earnings in share repurchases. For example,

the firm may dedicate the $1,000 to share repurchases, and you could ask the firm to use $100 thereof to repurchase your share_ But even if you hold onto your share, you have not lost anything. Previously, you owned $100/$100,000 = 0.1% of a $100,000 company, for a net of $100. Nov, you will own $100/$99,000 P6 1.0101% of a $99,000 company—multiply this to find that your share is still worth $100. In either case, the value of outstanding public equity in the firm has shrunk from $100,000 to $99,000.

We will discuss dividends and share repurchases in Chapter 19.

Finns can also exit the public financial markets entirely by delisting. Delisting usually occur either when a firm is purchased by another firm or when it runs into financial difficulties so bad that they fail to meet minimum listing requirements, Often, such financial difficulties lead to bankruptcy or liquidation. Some firms even voluntarily liquidate, determining that they can pay their shareholders more if they sell their assets and return the money to them. This is rare because managers usually like to keep their jobs—even if continuation of the company is not in the interest of shareholders. More commonly, firms make bad investments and fall in value to the point where they are delisted from the exchange and/or go into bankruptcy. Fortunately, investors enjoy limited liability, which means that they can at most lose their investments and do not have to pay further for any sins of management.

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