The Secondary Markets
There are several stock exchanges in the United States. Two of these, the New York Stock Exchange
(NYSE, or the Big Board) and the American Stock Exchange (Amex), are national in scope and are located in New York City. The others, such as the Boston or Pacific stock exchanges, are to a considerable extent regional exchanges, which tend to list firms located in a particular geographic area. There also are several exchanges for the trading of options and futures contracts, which we will discuss later in the options and futures chapters.
An exchange provides a facility for its members to trade securities, and only members of the exchange may trade there. Therefore, memberships or seats on the exchange are valuable assets. The majority of seats are commission broker seats, most of which are owned by the large full-service brokerage firms. The seat entitles the firm to place one of its brokers on the floor of the exchange where he or she can execute trades. The exchange member charges investors for executing trades on their behalf. The commissions that members can earn through this activity determine the market value of a seat. A seat on the NYSE has sold over the years
for as little as $4,000 (in 1878) and as much as $2,650,000 (in 1999). See Table 3.1 for a history of seat prices since 1875.
The NYSE is by far the largest single exchange. The shares of nearly 3,000 firms trade there, and more than 3,000 stock issues (common plus preferred stock) are listed. Daily trading volume on the NYSE averaged 1.04 billion shares in 2000. The NYSE accounts for about 85–90% of the trading that takes place on U.S. stock exchanges.
The American Stock Exchange also is national in scope, but it focuses on listing smaller and younger firms than the NYSE.3 The national exchanges are willing to list a stock (i.e., allow trading in that stock on the exchange) only if the firm meets certain criteria of size and stability. Regional exchanges provide a market for the trading of shares of local firms that do not meet the more stringent listing requirements of the national exchanges.
Table 3.2 gives some of the initial listing requirements for the NYSE. These requirements ensure that a firm is of significant trading interest before the NYSE will allocate facilities for it to be traded on the floor of the exchange. If a listed company suffers a decline and fails to meet the criteria in Table 3.2, it may be delisted.
Regional exchanges also sponsor trading of some firms that are traded on national exchanges. This dual listing enables local brokerage firms to trade in shares of large firms without purchasing a membership on the NYSE.
The NYSE recently has lost market share to the regional exchanges and, more dramatically, to the over-the-counter market. Today, approximately 75% of the trades in stocks listed on the NYSE are actually executed on the NYSE. In contrast, more than 80% of the trades in NYSElisted shares were executed on the exchange in the early 1980s. The loss is attributed to lower commissions charged on other exchanges, although, as we will see below, the NYSE believes that a more comprehensive treatment of trading costs would show that it is the most costeffective trading arena. In any case, many of these non-NYSE trades were for relatively small
transactions. The NYSE is still by far the preferred exchange for large traders, and its market share of exchange-listed companies—when measured in share volume rather than number of trades—has been stable since 1990, between 82% and 84%.
The over-the-counter Nasdaq market (described in detail shortly) has posed a bigger competitive challenge to the NYSE. Its share of trading volume in NYSE-listed firms increased from 2.5% in 1983 to about 8% in 2000. Moreover, many large firms that would be eligible to list their shares on the NYSE now choose instead to list on Nasdaq. Some of the well-known firms currently trading on Nasdaq are Microsoft, Intel, Apple Computer, and Sun Microsystems. Total trading volume in over-the-counter stocks on the computerized Nasdaq system has increased rapidly, rising from about 50 million shares per day in 1984 to 1.8 billion shares per day in 2000.
Share volume on Nasdaq actually surpasses that on the NYSE. Table 3.3 shows the trading activity in securities listed on the national exchanges in 2000. Other new sources of competition to the NYSE have come from abroad. For example, the London Stock Exchange is preferred by some traders because it offers greater anonymity. In addition, new restrictions introduced by the NYSE to limit price volatility in the wake of the market crash of 1987 are viewed by some traders as another reason to trade abroad. These socalled
circuit breakers are discussed below.
The Over-the-Counter Market
Roughly 35,000 issues are traded on the over-the-counter (OTC) market, which allows any security to be traded there, but the OTC market is not a formal exchange. There are no membership requirements for trading or listing requirements for securities (although there are requirements to be listed on Nasdaq, the computer-linked network for trading securities of larger OTC firms). Thousands of brokers register with the SEC as dealers in OTC securities. Security dealers quote prices at which they are willing to buy or sell securities. A broker then executes a trade by contacting the dealer listing an attractive quote.
Before 1971, all OTC quotations of stock were recorded manually and published daily. The so-called pink sheets were the means by which dealers communicated their interest in trading at various prices. This was a cumbersome and inefficient technique, and published quotes were a day out of date. In 1971, the National Association of Securities Dealers Automatic Quotation System, or NASDAQ, was developed to offer via a computer-linked system immediate information on bid and ask prices for stocks offered by various dealers.
The bid price is the price at which a dealer is willing to purchase a security; the ask price is the one at which
the dealer will sell a security. Hence, the ask price is always higher than the bid price, and the difference, the bid–ask spread, makes up the dealer’s profit. The system allows a broker who receives a buy or sell order from an investor to examine all current quotes, call the dealer with the best quote, and execute a trade. The system, now called the Nasdaq Stock Market, is divided into two sectors, the Nasdaq National Market System (comprising almost 4,000 companies), and the Nasdaq SmallCap Market (comprising over 1,000 smaller companies). The National Market System securities must meet more stringent listing requirements and trade in a more liquid market. Some of the more important initial listing requirements for each of these markets are presented in Table 3.4. For even smaller firms, Nasdaq maintains an electronic “OTC Bulletin Board,” which is not part of the Nasdaq market, but is simply a means for brokers and dealers to get and post current price quotes over a computer network. Finally, the smallest stocks continue to be listed on the pink sheets distributed through the National Association of Securities Dealers.
Nasdaq has three levels of subscribers. The highest, level 3 subscribers, are for firms dealing, or “making markets,” in OTC securities. These market makers maintain inventories of a security and constantly stand ready to buy or sell these shares from or to the public at the quoted bid and ask prices. They earn profits from the spread between the bid and ask prices. Level 3 subscribers may enter the bid and ask prices at which they are willing to buy or sell stocks into the computer network and may update these quotes as desired.
Level 2 subscribers receive all bid and ask quotes, but they cannot enter their own quotes. These subscribers tend to be brokerage firms that execute trades for clients but do not actively deal in the stocks on their own account. Brokers attempting to buy or sell shares call the market maker (a level 3 subscriber) with the best quote in order to execute a trade. Notice that Nasdaq is a price quotation, rather than a trading, system. While bid and ask prices can be obtained from the Nasdaq computer network, the actual trade still requires direct negotiation (often over the phone) between the broker and the dealer in the security.
Level 1 subscribers receive only the inside quotes (i.e., the highest bid and lowest ask prices on each stock). Level 1 subscribers are investors who are not actively buying and selling securities but want information on current prices.
The Third and Fourth Markets
The third market refers to trading of exchange-listed securities on the over-the-counter market. In the past, members of an exchange were required to execute all their trades of exchangelisted securities on the exchange and to charge commissions according to a fixed schedule. This procedure was disadvantageous to large traders when it prevented them from realizing economies of scale on large trades. Because of this restriction, brokerage firms that were not members of the NYSE and so not bound by its rules, established trading in the OTC market of large NYSE-listed stocks. These trades could be accomplished at lower commissions than
would have been charged on the NYSE, and the third market grew dramatically until 1972, when the NYSE allowed negotiated commissions on orders exceeding $300,000. On May 1, 1975, frequently referred to as “May Day,” commissions on all NYSE orders became negotiable, and they have been ever since.
The fourth market refers to direct trading between investors in exchange-listed securities without the benefit of a broker. The direct trading among investors that characterizes the fourth market has exploded in recent years due to the advent of electronic communication networks, or ECNs. ECNs are an alternative to either formal stock exchanges like the NYSE or dealer markets like Nasdaq for trading securities. These ECNs allow members to post buy or sell orders and to have those orders matched up or “crossed” with orders of other traders in the system. Both sides of the trade benefit because direct crossing eliminates the bid–ask spread that otherwise would be incurred. Early versions of ECNs were available exclusively to large institutional traders. In addition to cost savings, systems such as Instinet and Posit allowed these large traders greater anonymity than they could otherwise achieve. This was important to the traders since they did not want to publicly signal their desire to buy or sell large quantities of shares for fear of moving prices in advance of their trades. Posit also enabled trading in portfolios as well as individual stocks.
ECNs have captured about 30% of the trading volume in Nasdaq-listed stocks. They must be certified by the SEC and registered with the National Association of Security Dealers to participate in the Nasdaq market. Table 3.5 is a list of registered ECNs at the start of 2001. While small investors today typically do not access an ECN directly, they can send orders through their brokers, including online brokers, who can then have the order executed on the ECN. Eventually, individuals will likely have direct access to most ECNs through the Internet.
In fact, several financial firms (Goldman, Sachs; Merrill Lynch; Salomon Smith Barney; Morgan Stanley; and Bernard Madoff) have combined to build an electronic trading network called Primex, which is open to NASD broker/dealers, who in turn have the ability to offer public access to the market. Other ECNs, such as Instinet, which have traditionally served institutional investors, are considering opening up their services to retail brokerages.
The advent of ECNs is putting increasing pressure on the NYSE to respond. In particular, big brokerage firms such as Goldman, Sachs and Merrill Lynch are calling for the NYSE to beef up its capabilities to automate orders without human intervention. Moreover, as they push the NYSE to change, these firms are hedging their bets by investing in ECNs on their own.
The NYSE also has announced its intention to go public. In its current organization as a member-owned cooperative, it needs the approval of members to institute major changes. However, many of these members are precisely the floor brokers who will be most hurt by electronic trading. This has made it difficult for the NYSE to respond flexibly to the challenge of electronic trading. By converting to a publicly held for-profit corporate organization, it hopes to be able to compete more vigorously in the marketplace of stock markets.
Read More:Where Securities Are Traded?