3. Dealing

Question 0

What shares are traded on SETS?

Answer 0

The shares traded on SETS include:
• Shares in companies within the FTSE All Share.
• ETFs and exchange-traded commodities (ETCs).
• The most traded AIM and Irish securities.
Example companies include BP, GlaxoSmithKline, HSBC and Marks & Spencer.

Question 1

Define SETS and how does it operates

Answer 1

The Stock Exchange Electronic Trading System (SETS) is a computer system that automatically matches orders to buy and orders to sell equities. It is formally described as an electronic order-driven system.

It operates an electronic order book into which LSE member firms submit their orders to buy and sell equities, and, when there are orders that can be matched, SETS automatically brings them together. The SETS system is available to all LSE member firms, and automatic trading takes place on it between 8.00am and 4.30pm each business day.

Question 2

What order priority is adopted by SETS?

Answer 2

The order priority adopted by SETS is by price, and then time. The best buy and sell prices are always at the top of the two columns of orders and will be executed first. In the case of the buy orders this is the highest-priced order (315p in the above example, where the order to buy 10,000 shares must have been entered into the system before the order to buy 2,000 shares).
In the case of the sell orders this is the lowest-priced order (316p in the above example). Below the best-priced orders, all the other orders are displayed, giving an immediate picture of the depth of liquidity on the order book.

Question 3

What happens during the opening auction call period?

Answer 3

At the start of automatic execution on SETS each day there is an opening auction. Leading up to the auction, the period between 7.50am and 8.00am is known as the opening auction call period. In this period no trading takes place; however, three types of order (limit, iceberg and market orders) can be placed on the order book to take part in the opening auction.

Question 4

When does the auction start on SETS?

Answer 4

The auction itself does not necessarily happen at 8.00am. Instead, it is subject to a random start and will occur at 8.00am plus a random number of seconds between 0 and 30. The auction uses an uncrossing algorithm, through which those orders that overlap on the order book are executed at the single price that maximises the number of shares traded. Simultaneously, the opening price for the security is calculated. During the course of the uncrossing, no further orders can be added and existing orders cannot be deleted or amended.

Question 5

Name and describe the two possible reasons why the opening auction (SETS) may be delayed.

Answer 5

There is a possibility of the opening auction being delayed beyond its scheduled time. The delay can be caused by either market orders not being fully satisfied, or the price arrived at by the uncrossing algorithm being extreme, or a combination of both of these. The resultant delay is termed an extension.
• A market order extension occurs if there are unexecuted market orders on the order book following the auction. This extension is two minutes plus an additional 0–30-second random end period.
• A price monitoring extension occurs if the opening price is more than the price tolerance level of 5% away from the price of the last automated trade which took place on the previous business day. The price tolerance level is a predefined percentage threshold either side of a base price set by the LSE and currently standing at 5% for the opening auction. The price monitoring extension is five minutes long, again plus an additional 0–30-second random end period.

Question 6

What is the maximum amount of time an opening auction could be delayed by?

Answer 6

So, there is the potential for a seven-to-eight minute delay to the opening auction if both the market order and price monitoring extensions are applied.

Question 7

What is the purpose of the Automatic Execution Suspension Period (AESP)

Answer 7

Once the opening auction is complete, automatic execution commences. As orders are entered on to the system, SETS tries to match them. If SETS finds a buyer and seller with agreeable prices and volumes, the trade is automatically executed.

There is a possibility of an interruption to this automatic execution of orders. If the price of a trade is more than the price tolerance level away from the previous trade price, an automatic execution suspension period (AESP) occurs to allow investors time to react to large price changes. The price tolerance level during the continuous trading period varies from 5% to 25%, depending upon the share.
The AESP lasts for five minutes (plus a period of 0–30 seconds) and during this time no trades are executed (although orders can be entered, deleted and amended). Automatic execution then recommences after the uncrossing auction programme is run.
If a SETS security is suspended from trading by the exchange, as with an AESP, no execution takes place, although orders can be entered, deleted or amended.

Question 8

Detail what happens in SETS between 4 and 4:30

Answer 8

After 4.30pm, when automatic execution is completed, the trading day ends with another auction. The auction call period runs from 4.30pm to 4.35pm, and at 4.35pm (plus a period of 0–30 seconds) the auction uncrossing algorithm is run.

If auction matching occurs in the closing auction, then the day’s closing price will be based on the closing auction price. If no execution occurs, the volume weighted average price (VWAP) of the last ten minutes of continuous trading will be used. In the event of no automatic trades in the VWAP period, the last automatically executed trade price will be used.

For the last 25 minutes until 5.00pm, SETS allows participants to delete orders. No execution takes place during this period.

Question 9

Name the types of orders that can be entered into SETS (5)

Answer 9

1. Limit orders
2. Iceberg orders
3. Market orders
4. Execute and eliminate orders
5. Fill or kill orders

Question 10

Explain Fill or kill orders

Answer 10

can only be entered during automatic execution. They normally have a specified price (although they can be entered without one) and either the entire order will be immediately filled at a price at least as good as that specified, or the entire order will be cancelled (ie, if there are not enough orders at the price specified or better).

Question 11

Describe Execute and eliminate orders

Answer 11

can only be entered during automatic execution. As with the at best order, this type will execute as much of the trade as possible and cancel the rest. However, unlike an at best order, this order type has a specified price and will not execute at a price worse than that specified.

Question 12

Define Market Orders

Answer 12

do not specify a price. They are submitted to the order book to deal in a specified number of shares.

Question 13

Describe Iceberg orders

Answer 13

are a particular type of limit order. They enable a market participant with a particularly large order to partially hide the size of their order from the market and reduce the market impact that the large order might otherwise have. The term comes from the fact that just the top part of the order is on view (the peak of the iceberg); the rest is hidden (the bulk of the iceberg is below the water). Once the top part of the order is executed, the system automatically brings the next tranche of the iceberg order on to the order book. This process continues until the whole of the iceberg order has been executed, or the time limit for the order expires.

Question 14

Limit Orders

Answer 14

have a price limit and a time limit, eg, a limit order may state: ‘sell 1,000 shares at 360p by next Tuesday’. SETS will attempt to sell these shares at a price no worse than 360p by next Tuesday. Any time limit up to a maximum of 90 days can be put on these orders. If no time limit is placed on the order, it will expire at the end of the day that it is entered. Limit orders can be partially filled, and it is only limit orders that are displayed on the SETS order book.

Question 15

What is the CCP?

Answer 15

SETS transactions utilise a central counterparty (CCP). The CCP is either the London Clearing House (LCH.Clearnet) or SIX Swiss Exchange’s SIX x-clear. The impact of the CCP is best illustrated by way of a simple example:

Example
A trade is executed on SETS that involves A agreeing to sell some shares to B. One of the CCPs, say LCH. Clearnet, steps in between the two parties and two new obligations replace the initial obligation of A to sell to B. The two obligations are for A to sell to LCH.Clearnet and then for LCH.Clearnet to sell to B. This transfer of obligation is known as novation.
If either of the two parties to this transaction (A or B) were to default, it would no longer affect the other party, as they no longer have a contract with each other. It would only impact LCH.Clearnet.

Question 16

Benefits of CCP for market participants

Answer 16

• Reduced counterparty risk – the risk that the other side of the transaction will default is reduced because it is replaced by one of the CCPs, both of which are well capitalised and have insurance policies in place lessening the risk of default. This reduces the risk of systemic collapse of the financial system.

• Providing total anonymity – both sides of the trade do not discover who the original counterparty was.

• Reduced administration – all trades are settled with one of the two CCPs, rather than a variety of counterparties, improving operational efficiency.

• Facilitating netting of transactions – because all the trades are with a CCP, receipts and payments for transactions in the same share that settle on the same day can be netted against each other.

• Improved prices – because more participants are willing to transact anonymously, it is argued that a CCP results in improvements in price.

The CCP charges a flat fee to both parties for fulfilling its role and also requires margin payments (similar to derivatives margin) to reduce its potential loss, should one party default.

CREST is the settlement system that is used to settle the transactions between the CCP and the member firms.

Question 17

Define Trading Halts

Answer 17

The LSE reserves the right to prohibit any transaction from being dealt on exchange for any reason. This is referred to as a trading halt, and typically arises from the suspension of a security’s listing.

If a security is suspended, permission is required from the exchange before a member firm can effect a transaction in that security. The length of the trading halt is at the discretion of the exchange. Trades that have occurred, but have not yet settled at the time of suspension are settled as normal.

Question 18

SETSqx

Answer 18

The Stock Exchange Electronic Trading Service – quotes and crosses (SETSqx) is the LSE’s trading service for less liquid securities.

SETSqx is a hybrid system, combining some of the order-driven features of SETS with the potential for two-way quotes from market makers. Functionally it is similar to the SETS order book, with buy and sell orders displayed in a central order book. However, it is supplemented by one or more market makers also displaying two-way prices. Furthermore, unlike SETS, execution on the central order book is only at periodic auctions (uncrossings) that occur four times per day – at 8.00am, 11.00am, 3.00pm and 4.35pm. Like SETS, these auctions can be subject to price monitoring extensions.

The order types that are accepted into the SETSqx central order book are anonymous limit orders and named orders, which detail the firm, as well as the order. Any member firm has the option to phone the counterparty behind a named order and fill the order before the next uncrossing if the two parties agree.

The minimum number of market makers for securities traded on SETSqx is zero, but if there are one or more market makers they must provide continuous liquidity throughout the trading day. They must quote prices to buy or sell at least one times the normal market size (NMS).

Question 19

Normal market size (NMS)

Answer 19

Normal market size (NMS) is the minimum number of shares, determined by the LSE, for which a market maker is obliged to quote firm bid and offer prices. NMS for each security is calculated quarterly and is based on 2.5% of the security’s average daily turnover in the preceding year. Most market makers will also be prepared to quote firm prices for sizes greater than the NMS, usually up to a maximum of 200,000 shares.

Question 20

IOB

Answer 20

The international order book (IOB) is an order-driven trading service primarily for depositary receipts of international securities. It operates in the same way as the SETS order book with one additional feature – the facility for inputting orders that are not anonymous. Such orders are commonly referred to as named orders and are placed by LSE member firms dealing in a principal capacity and wanting to display their willingness to deal on the order book. The acronym that identifies the firm appears next to their order on the IOB.

Both GDRs and ADRs are traded on the IOB, mostly from companies in developing countries in Central and Eastern Europe and Asia. Orders are required to be for at least one share, with no restriction on the maximum order size. The IOB is accessible to all LSE member firms.

Question 21

What are the two main differences between trading on the NYSE and the LSE?

Answer 21

The two main differences between trading on the NYSE and the LSE are:

• the NYSE continues to retain some open outcry trading on the trading floor; and

• the NYSE still employs designated market makers, sometimes known as ‘specialists’, who act as an official market maker for a given security, whereas the LSE has a more heterogeneous structure, which includes specific market makers in certain securities but no ‘specialists’ as the term is
traditionally understood.

Question 22

Define Designated Market Makers or Specialists

Answer 22

A market maker is a financial intermediary, often an investment bank or specialist dealer, that quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the bid- offer spread, or turn. The market maker often maintains an inventory of positions and stands ready to buy or sell the securities for which it makes a market, on demand from other market participants. The market makers provide a required amount of liquidity to the security’s market, and take the other side of trades when there are short-term buy- and sell-side imbalances in customer orders. This helps prevent excess volatility, and in return the specialist is granted various informational and trade execution advantages.

Question 23

What distinguishes these specialists?

Answer 23

As with a lot of financial terminology, some imprecision has entered the discussion of the role of market makers but, in fairness, with the advent of sophisticated high-frequency trading platforms, where taking a position into inventory could mean holding it for a nanosecond, it becomes harder to separate out the different kinds of liquidity providers in contemporary capital markets. One of the key differentiators which distinguishes the designated market maker role is that the specialist is expected to hold inventory in the stocks which they represent. In other words, they act not only as agent and facilitator of liquidity but also as a principal, and hold stocks in their own accounts. In cases where there is a demand-supply imbalance of a particular security, the specialist must make adjustments by purchasing and selling out of their own inventory to equalise the market. For example, a specialist is required to buy shares for their own inventory in the event of a large sell-off.

Question 24

What are the 3 main duties of the specialists on the NYSE floor?

Answer 24

These specialists working on the NYSE floor have been described as fulfilling three main roles to ensure a fair and orderly market:

• The NYSE is an auction market where bids and asks are continuously published to all investors. It is the job of the specialist to ensure that all bids and asks are reported in an accurate and timely manner, that all marketable trades are executed and that order is maintained on the floor.

• Along with posting the daily bid and ask prices, the specialist must also set the opening price for the stock every morning. This price can greatly differ from the previous day’s closing price, based on after-hours news and events. The role of the specialist is to find the correct market price based on supply and demand.

• In addition to the notion that a market maker acts as a facilitator, the role of the specialist has been seen as one of encouraging enough market interest in the particular stocks for which they are designated market makers. This is carried out by specialists seeking out recently active investors in cases where the bids and asks cannot be matched. This aspect of the specialist’s job helps to induce trades that may not have arisen within the context of a more passive and automated notion of the role of the market maker.

Question 25

How do LSE Market Makers differ?

Answer 25

On the LSE there are no equivalents of designated market makers as just described. There are market makers but their role is less formally defined, and even that more loosely defined role is becoming more indistinct, as the changes in the underlying technology more closely resemble an electronic order matching system.

At present on the LSE, there are official market makers for many securities (but not for shares in the largest and most heavily traded companies, which are traded on SETS). These market makers are LSE member firms that take on the obligation of always making a two-way price in each of the stocks in which they make markets. Their prices are displayed on the system and it is they who generally deal with brokers buying or selling stock on behalf of clients.

Question 26

Liquidity Rebates

Answer 26

Exchanges are having to fight much harder to retain their role within a decentralised market system where investors have many off-exchange choices as to where to conduct business. There is also a lot of competition among exchanges as transnational trading and settlement has meant that the actual place or geographical location of an exchange becomes fairly meaningless in a virtual world of electronic trading.

One area of competition among exchanges is to encourage market makers to use their platforms over others by providing liquidity rebates for each share that is sold to or purchased from each posted bid or offer. In this respect, the Archipelago Exchange (ARCA) facility, which is becoming a very significant division of the NYSE/Euronext platform, and hosts the trading of most ETFs, has been one of the most aggressive in providing liquidity rebates as a way of promoting business.

Question 27

Name the 3 main participants in the Government Bond Markets

Answer 27

In addition to the government itself, there are three major groups of participants that facilitate deals in the government bond markets:

• Primary dealers – such as GEMMs in the UK.
• Broker-dealers.
• Inter-dealer brokers.

These three participants will be illustrated using the UK government bond market as an example.

Question 28

What is the issuing agency for Gilts?

Answer 28

The DMO is the issuing agency for the UK government. It is an executive agency of the Treasury, making new issues of UK government securities (gilt-edged securities or gilts). Once issued, the secondary market for dealing in gilts is overseen by two bodies, the DMO and the LSE.

The DMO is the body that enables certain LSE member firms to act as primary dealers, known as GEMMs. It then leaves it to the LSE to prescribe rules that apply when dealing takes place.

Question 29

Define Gilt-Edged Market Makers (GEMMs)

Answer 29

The GEMM, once vetted by the DMO and registered as a GEMM with the LSE, becomes a primary dealer and is required to provide two-way quotes to customers (clients known directly to them) and other member firms of the LSE throughout the normal trading day. There is no requirement to use a particular system for making those quotes available to clients, and GEMMs are free to choose how to disseminate their prices.

Question 30

What obligations are the GEMMs subject to?

Answer 30

The obligations of a GEMM can be summarised as follows:

• To make effective two-way prices to customers on demand, up to a size agreed with the DMO, thereby providing liquidity for customers wishing to trade.

• To participate actively in the DMO’s gilt issuance programme, broadly by bidding competitively in all auctions and achieving allocations commensurate with their secondary market share – effectively informally agreeing to underwrite gilt auctions.

• To provide information to the DMO on closing prices, market conditions and the GEMM’s positions and turnover.

Question 31

What benefits are the GEMMs privy too?

Answer 31

The privileges of GEMM status include:

• executive rights to competitive telephone bidding at gilt auctions and other DMO operations, either for the GEMM’s own account or on behalf of clients;

• an exclusive facility to trade as a counterparty of the DMO in any of its secondary market operations;

• exclusive access to gilt IDB screens.

Question 32

A firm can register as a GEMM to provide quotes in which?

Answer 32

A firm can register as a GEMM to provide quotes in either:

• all gilt-edged securities; or
• gilt-edged securities excluding index-linked gilts; or
• index-linked gilts only.

There are exceptions to the requirement to customers, including the members of the LSE. The obligation does not include quoting to other GEMMs, fixed-interest market makers or gilt IDBs.

Question 33

Broker-Dealers

Answer 33

These are non-GEMM LSE member firms that are able to buy or sell gilts as principal (dealer) or as agent (broker). When acting as a broker, the broker-dealer will be bound by the LSE’s best execution rule, ie, to get the best available price at the time.

When seeking a quote from a GEMM, the broker-dealer must identify at the outset if the deal is a small one, defined as less than £1 million nominal.

Question 34

Gilt Inter-Dealer Brokers (IDBs)

Answer 34

Gilt IDBs arrange deals between gilt-edged market makers anonymously. They are not allowed to take principal positions, and the identity of the market makers using the service remains anonymous at all times. The IDB will act as agent, but settle the transaction as if it were the principal. The IDB is only allowed to act as a broker between GEMMs, and has to be a separate company and not a division of a broker-dealer.

Question 35

Government Issues in the US

Answer 35

The Federal Reserve is the co-ordinator of the issuance of US government securities. As with the UK, it conducts auctions on a regular basis and appoints primary dealers, which include the major investment banks as conduits in the auction process to place bids and to buy the issue on behalf of their clients or for their own account.

The US government securities are typically issued in one of three forms – bills, notes and bonds – that differ in the length of time between issue and maturity:

• T-bills are issued for terms less than a year.
• T-notes are issued for terms of two, three, five, seven and 10 years.
• T-bonds are issued for terms of 30 years.

T-bills are issued in regular auctions with maturity dates of 28 days (or four weeks, about a month), 91 days (or 13 weeks, about three months), 182 days (or 26 weeks, about six months), and 364 days (or 52 weeks, about one year). T-bills are sold by single price auctions held weekly.

During periods when Treasury cash balances are particularly low, the Treasury may sell cash management bills (or CMBs). These are sold at a discount and by auction just like weekly Treasury bills. They differ in that they are irregular in amount, term (often less than 21 days), and day of the week for auction, issuance, and maturity. When CMBs mature on the same day as a regular weekly bill, usually Thursday, they are said to be on-cycle.

T-notes, and T-bonds pay interest every six months until they mature. T-bonds have the longest maturity of 30 years. Both T-notes and T-bonds are issued by auction.

For T-notes, two-year notes, three-year notes, five-year notes, and seven-year notes are auctioned every month. Ten-year notes are auctioned at original issue in February, May, August, and November, and in reopenings in January, March, April, June, July, September, October, and December. In a reopening, additional amounts of a previously issued security are auctioned. Reopened securities have the same maturity date and interest rate as the original securities.
For T-bonds, original issue auctions take place in February, May, August, and November, and reopening auctions in the other eight months.

Question 36

Government Issues in Japan

Answer 36

Japanese Government Bonds (JGBs) are issued by the Bank of Japan (BoJ) and, as the name implies, they are the bonds issued by the government, which is responsible for interest and principal payments. Interest is paid every six months, and principal payments are secured at maturity.

JGBs are available with various maturity periods. Coupon-bearing bonds, which feature semi-annual interest payment and principal payment at maturity, have maturities of two, five, five (for retail investors), ten, ten (inflation-indexed), ten (for retail investors), 15 (floating rate), 20, 30 and 40 years.

The Japanese government also offers a separate strips programme.

Question 37

Government Issues in Germany

Answer 37

German government securities offer original maturities ranging from three months to 30 years. In the money market segment, the Federal Government issues Treasury discount paper (Bubills) with maturities of six and 12 months. The offering of capital market products begins with Federal Treasury notes (Schaetze) with a maturity of two years, followed by five-year Federal notes (Bobls) (Bundesobligationen) and Federal bonds (Bunds) with maturities of ten and 30 years.

The German Federal Government usually places single issues by auction. Only credit institutions domiciled in an EU member state can be members of the auction group and participate directly in these auctions. The Bund uses a multiple price auction procedure. In other words, bids for Bunds, Bobls and Schaetze accepted by the government are allocated at the price quoted in the respective bid and are not settled at a uniform price. Bids priced above the lowest accepted price are allotted in full, while bids priced below the lowest accepted price receive no allotment. Non-competitive bids are allotted at the weighted average price of the accepted price bids. The government reserves the right to re-allot the bids at the lowest accepted price as well as the non-competitive bids, eg, to allot them only at a certain percentage rate. The same procedure is applied on a yield basis for Bubills.

To remain a member of the auction group, a credit institution must subscribe to at least 0.05% of the total issuance allotted at the auctions in a calendar year, weighted according to maturity. Members who do not reach the required minimum allotment drop out of the auction group bund issues. There are no other requirements placed on the members of the auction group.