5. Secondary Markets Flashcards
What are the 3 main purposes of exchanges?
- Central location: facilitates trading by providing a central location for buyers and sellers to meet
- Regulated: both members and traded companies regulated - this gives greater confidence in market
- Transparency: Price discovery mechanisms; both pre and post-trade transparency requirements
What is the major exchange in Europe and its trading system?
- Euronext
- Electronic
What is the major exchange in Japan and its trading system?
- TSE
- Electronic
What is the major exchange in Germany and its trading system?
- Deutsche
Börse - Electronic
What is the major exchange in the UK and its trading system?
- LSE
- Electronic
What are the major exchanges in the US and their trading systems?
- NASDAQ; Electronic
- NYSE; Electronic with some open outcry
What is post-trade transparency?
Obligation to declare price, volume, time etc after a trade is executed
What is pre-trade transparency?
Makes investors aware of prices available for security before
What is pre-trade transparency?
Investors must know prices available for a security before executing a trade
- this can be through market maker quotes or orders set out on order-book platform
What is the overarching purpose of exchanges?
LIQUIDITY - ability to buy and sell at a fair price
Difference between developed and underdeveloped markets?
Developed:
- offer sophisticated formal markets
- high degree of regulation
Underdeveloped:
- lower degree of sophistication
What are the unusual features of China’s market structure (two main types of shares and where they are traded)?
A shares:
- traded on Shanghai and Shenzhen exchanges
- subject to restrictions
H shares:
- mainland Chinese companies listed in Hong Kong
What are the 6 typical conditions for listing on a main market?
- Must be a publicly traded company (Plc in the UK)
- Protection against dilution of ownership
- minimum market value and/or number if share brought to market
- established trading record
- production of a prospectus
- ability to meet ongoing requirements
What are the features of a public traded company to be accepted onto main market?
- shares are freely transferable (from public person to public person, company to company etc.)
- most exchanges will set a minimum free float; this means a minimum number of shares that must be freely available to every investor
- hence shares cannot just be freely transferrable, but also freely available to be transferred
What are the conditions set by exchanges to prevent dilution of ownership?
- pre-emption rights (built into ordinary shares - usually a condition of most exchanges)
- restrictions on shares issued through warrants and convertibles
What are pre-emption rights?
Gives existing shareholders first opportunity to buy any subsequent issues
What is the LSE restriction on shares issued through warrants/convertibles?
No more than 20 % of total issued shares
What is the typical time period to be considered as having an established trading record in Europe?
3 years
What are examples of the ongoing requirements firms must meet to be accepted onto an exchange?
- disclosure requirements around price sensitive info
Through what do firms disclose price sensitive information?
- Primary Information Provider PIP (aka. Regulatory Information Services - RIS)
What is the LSE primary information provider?
RNS (Regulatory News Services)
What are the 4 main alternative trading systems?
- MTF
- OTF
- Dark Pool
- Systematic internalisers (SIs)
What is an MTF?
Crossing network (matching engine) for equities
What is an OTF?
Crossing network (matching engine) for bonds and derivatives (and some structured products)
What is a Dark pool?
For off-exchange transactions
Exchange traded liquidity with OTC confidentiality through hidden orders
What are systematic internalisers?
Where an investment bank facilitates cross trades but as principal for their clients
- eg. an investment firm facilitates a trade between 2 of their clients - IB buys from seller and sells to buyer
What are the features of an MTF?
Operator: Market operator
Regulation: Treated as an exchange
- defined rules for members
- pre/post trade transparency requirements
Users: banks, mutual funds, insurance companies
Benefits: Alternative to exchanges
What are the features of an OTF?
Operator: Investment firms and private organisations
Regulation: Treated as an exchange
- defined rules for clients
- pre/post trade transparency requirements
Users: banks, mutual funds, insurance companies
Benefits: Alternative to exchanges
What are other names for an MTF?
- Electronic Communication Network (ECN)
- Alternative Trading System (ATS)
(used in the US - MTF is a European term)
What are the features of a Dark Pool?
Operator: Investment firms and private organisations
Regulation: Considered OTC unless volumes are too large a share of trading
Users: funds
Benefits:
- reduces market impact of large orders (as they are not visible to wider market)
- better pricing
- lower execution costs
- confidentiality
What is a DarK Pool treated as if trading volumes are v high?
An MTF
What are the features of systematic internalisers?
Operator: Investment banks
Regulation: Investment bank takes role of central counterparty
Users: Investment banks and their clients
What are the 3 main features of a quote-driven platform?
Market makers:
- prices controlled by price makers (market makers)
Bid/offer spreads:
- market makers quote bid/offer spreads (volume that can be bought/sold has a limit to stop firms forcing market maker to buy/sell too large volumes of shares)
Screen and phone based:
- market makers advertises prices on screen
- interested investors can call up an execute trades
What happens to the prices market makers are bound to beyond the specified limit?
These prices are ‘firm prices’ up until the limit (market maker is bound to sell/buy at these prices)
Beyond this level the prices become indicative and investors can negotiate directly with market maker
What are the 3 main features of an order-driven platform?
- Prices determined by buy and sell orders
- Orders awaiting execution placed on order book
- Electronic trading
What happens in the case of price agreement on an order-driven platform?
Automatic execution of trade
What does the electronic trading in order-driven platforms allow for?
- automatic execution
- automatic matching
- automatic reporting
What are the 5 main participants on exchanges?
- Brokers
- Dealers
- Dual capacity
- Market makers
- Acting as an inter-dealer broker
What does a broker do?
Act as an agent for a client
What does a dealer do?
Act as principal for their own account
What does a dual-capacity participant do?
Able to act as both agent and principal
What can dual-capacity participants be referred to as?
broker-dealer
What do market makers do?
Must provide prices at which it is willing to buy and sell a minimum of its chosen shares throughout the trading day
What does it mean to act as an inter-dealer broker?
- acts as an agent between two firms (central counterparty) in a riskless principal transaction
- provides a facility for trading amongst dealing community
- although it acts as agent it settles the transaction as if it were principal
Does an inter-dealer broker make profit from falls/rises in market?
No - they do not hope to make profits from price rises or falls by taking a position in the market
What is the main motivation to use an IDB?
- provides anonymity
- avoid having impact on market by buying into/getting out of a v large position (eg. by a market maker)
What is the process of executing a trade via IDB?
runs like a mini exchange
- take buy and sell orders from dealers
- when they can match an order they perform a cross trade
What is a cross-trade?
- buy from seller and then sell to buyer
- become a ‘central counterparty’
- this protects identity of each side of trade
How are IDBs regulated?
- must work on riskless principal transactions
- this means that they should act as a broker
- cannot take risk of transaction on themselves
- therefore only buy if they are immediately ready to sell
How do IDBs make money?
Charge fees/commissions
What is stock lending?
temporary transfer of securities with an agreement to return equivalent securities to the lender at pre-agreed time
What does SBLI stand for?
Stock Borrowing and Lending Intermediary
What is algorithmic trading?
High frequency trading developed due to arrival of electronic trading systems
What are 3 main reasons for popularity of algorithmic trading?
- removing emotion of trading
- preservation of discipline
- speed, accuracy, reduced costs
What has been the change in users of algorithmic trading?
- originally used by small, specialist firms
- now frequently used by hedge funds and large investment banks
What are the main concerns/key criticisms of high frequency trading?
Flash crashes: A lot of algorithms running at once - if markets suddenly shift can cause domino effect where many algorithms get triggered
Vulture traders: traders exploit genuine, longer term investors and given their dominance of market turnover, and the impact they can have on pricing
Systemic risks: In event of extreme price movements on one exchange, the arbitrage trades automatically placed by the high frequency traders
can rapidly spread price movements to other exchanges where the
same instruments, or related instruments, are traded
What are two technical issues with algorithmic trading?
Speed and latency - further signal has to travel longer it takes
How do investors get around speed and latency issues?
Co-location: where the trader gets as
close to the exchange as possible to minimise data transmission time
What are the 3 key features of order-book trading?
- Fully automatic trading
- Trading halts
- Transparency of member orders
What processes are fully automated in order-book trading?
- execution
- matching
- reporting
- entire process from processing to settlement
What are trading halts?
The exchange can prohibit any transaction for any reason
- members must gain permission to trade in suspended activity
Who decides the length of a trading halt?
It is at the discretion of the exchange
How are member orders transparent in order-book trading?
- members (only) can view order book
What is the priority of orders in order book trading?
- price
- time
(best price order executed first - if number of orders at same price then time consideration
What are the limits for order size in orderbook trading?
No max/min order size
What is the phases of a trading day for an order book?
- Opening auction call period
- Matching
- Continuous order book trading (bulk of day)
- Closing auction call period
- Matching
- House-keeping period
What is the opening auction call period?
- Member firms enter orders
- no automatic execution
What is the matching phase?
Algorithm is triggered to try set opening price for day
- anything that can be filled at opening price will be filled
- orders cannot be placed while matching process is in place
What is matching also known as?
The uncrossing period
What is the continuous order book trading phase?
- can enter various types of orders - anything that can be filled will be automatically executed
What is the closing auction call period and its purpose?
No matching - only ability to enter further orders before the e.o.d
Purpose: to create extra liquidity towards end of day
- this is followed by another matching process which is concluded by setting closing price of the day
What is the housekeeping period?
period where member firms may delete, but not add new orders
- no automatic execution
What is the only phase of orderbook trading where automatic execution takes place?
Continuous orderbook trading phase
Which order’s default is to be deleted at the e.o.d?
Limit order
To who is auction activity visible to?
All auction members
What is the purpose of the random start to auctions?
- To prevent manipulation
The price assessed by the uncrossing algorithm becomes the opening price for the security
Can orders be changed during the matching (uncrossing) period?
No - During the course of the uncrossing (matching), addition, amendment or deletion of orders is not permitted
What happens if the price of a trade is
significantly different from the last automated trade (anything from 5%-25%)?
- Automatic execution can be suspended
- Trading would restart with an intra-day auction
What is a limit order?
An order with a specified volume and limit price
- price guarantee
- does not have execution guarantee
What happens if a limit order is only partially executed?
Remainder of order is added to order book to hopefully sell later
What are the two options for entering limit orders?
- anonymous
- iceberg
What is an iceberg order?
Allows an order to be partially hidden from the market view
- used for large orders where you don’t want whole order to be made visible (avoids market impact)
What must the participant specify when entering an iceberg order?
- Total order size
- Visible ‘peak’ size
What is the peak size?
- Maximum volume that will be shown to the market at any time
What is the process of an iceberg order?
- Matching orders will execute against the visible peak
- The system
automatically brings in the next tranche onto the order book as a new order - This will continue until the order has been exhausted or until
deleted
What is a market order?
- specifies volume only
- no limit on price; want it filled at best price market has to offer
- will always be executed, but not necessarily always getting best price
- no price guarantee but greater certainty of execution
What happens each time a new tranche of an iceberg order is revealed?
New time stamp
is given to the order
What is an execute and eliminate order?
- type of limit order
- volume and price specified
- if partially filled remainder is then cancelled
What is a fill or kill order?
Like a limit order (volume + limit order)
- cannot be partially filled
- aka. all or nothing
When might a fill or kill order stay on the book for the whole day?
if it requires immediate execution
What are the 3 stages in the trade cycle?
- trade execution
- clearing
- settlement
What is ‘novation’?
- legal term
- Breaks original deal into to; making clearing house (central counterparty) the buyer to the seller and the seller to the buyer
Who takes on risk of one party defaulting on a trade in exchanges?
The clearing house
What are the 5 main benefits of CCP service?
- Reduced counterparty risk
- Providing total anonymity
- Reduced administration
- Facilitates netting
- Improved pricing (due to anonymity)
What are the main costs involved in trading?
- Broker’s commission
- Account fees
- exchange fees
- regulatory fees
- clearing fees
- taxes
What is broker’s commission?
- based on set percentage of the value of the securities being purchased/sold
What qualifies a discount broker?
When little/no advice is being offered
What are account fees?
Charge imposed by brokers to ongoing customers (when they are providing an account to customer)
What are stock indices?
- simple way pf summarising market movements
- benchmarks to track or outperform
What is the difference between passive and active investors?
Passive: try to perform equally with indices
Active: try to outperform indices
What is typically done when using indices as a benchmark?
the benchmark will be free-float adjusted (looks at what is investable)
What do returns show us?
- tell us the return on a particular market
- summarise market movements
What are the 3 main types of returns and their features?
- Price return: only the price of the share/components of the index considered (does price go up/down?)
- Total return index: Calculates performance of a group of stocks assuming that dividends are reinvested into the index constituents (look at price return + income generated through assets - coupons for bonds, dividend for shares)
- Net total return: Same as above after deduction of witholding tax
What are the 2 main types of weightings used for indices?
- Price weighting
- Market-value weighting
What is price weighted?
- Assumes equal number of shares in each constituent stock (ie. equal number of shares in each company is present in the index)
What are the features of price-weighted indices?
- highest share price has greatest influence
- needs adjusting for splits, consolidation etc.
What are 2 examples of price-weighted indices?
- DJIA
- Nikkei 225
What is market-value weighted?
Assumes proportionate value investment in each constituent stock in an index
What are the features of market-value weighted indices?
- Highest market cap has greatest influence
What are 4 examples of market-value weighted indices?
- S&P
- Nasdaq
-FTSE
-MSCI
(however assume for exam that every index aside from DJIA and Nikkei 225 use market-value weighting)
What is the Dow Jones Divisor
- adjustment to ensure things such as splits, consolidations,
spin-offs etc. do not change the numerical value of price-weighted indices
How is Dow Jones Divisor used?
Total price of component stocks in an index is divided by the DJD to get the correct value for the index
What do broad vs narrow mean in terms of indices?
Broad index: represents 98-99% of market cap
Narrow index: less market cap covered y index
Which 4 indexes may be tested for composition in the exam?
- Dow Jones Industrial Index - US; 30
- Nikkei Stock - Japan; 225
- DAX - Germany; 30
- CAC - France; 40
What are the three main types of indices you can have?
- National - Represents the performance of a stock market of a given nation and reflects investor sentiment on the state of the economy
- International - Indices representing multiple economies, e.g. MSCI World, STOXX
- Sector - indices that track specific sectors
Who are the gov debt issuance agencies in UK, US, Japan, and the Eurozone?
UK: DMO
US; Federal Reserve
Japan: Ministry of Finance
Eurozone: Federal governments
What are the primary dealers of a gov. bond?
Dealers who participate in the primary auctions to provide liquidity in the secondary markets
What are the primary dealers of gov. bonds referred to as in the UK?
GEMMs - market makers of bonds
- quote driven market
- guarantee liquidity to investors and DMO
Who are the other participants on government bond markets?
Same as those found in equity markets:
- dealer/brokers
- SBLIs (stock borrowing and lending intemediaries)
- IDB
- custodian banks
How is the dealing of corporate bonds different from gov. bonds?
Typically decentralised
- no primary dealers
- no guaranteed liquidity
What are the 2 ways dealing of corporate bonds is carried out?
direct: telephone contact
indirect: via inter-dealer systems (eg. broker)
What are the 3 electronic trading platform types used for trading corporate bonds?
B2B
B2C
OTC request for quote systems - investors request quotes from a number of dealers simultaneously and pick the best deal
What are some examples of B2B platforms?
BrokerTec, eSpeed and MTS cash
What are some examples of B2C platforms?
MTS BondVision and TradeWeb
Where are exchange traded bonds traded?
Order book for retail bonds - ORB
- for both corp and gov bonds
- to attract retail investors minimum nominal value is quite low
What are the quotation methods for bonds?
Government: Price is quoted (£X per NV)
Corporate: Yield (X%)
Why do corporate bonds tend to quote yields instead of price?
Market for corp bonds v fractured so cant tell if a cheaper bond is acc a better deal - therefore yield is a better indicator
- quicker way to compare
