Chapter 9 (9 marks) – Dealing Flashcards
Whilst chapter 8 dealt with regulation and primary issuance, this chapter focusses on how securities are traded in the secondary market.
What is as pre and post trade transparency?
Where Exchanges are required to display prices along with trades that are waiting to be executed and those that have already been executed.
A lot of OTC products settle bilaterally; What does this mean and what is the risk associated with this?
A lot of OTC products settle bilaterally; i.e. directly between the two parties involved.
This presents a risk that one side doesn’t pay up.
This is not an issue with products that are exchange traded
Markets can be order-driven or quote-driven.
What does this mean, and does this apply to exchange traded or OTC markets?
Applies to both Exchange traded & OTC
Order Driven =
Quote-driven =
Quote-driven markets use market makers to provide ‘buy and sell quotes’ to the rest of the market. The most well-known quote-driven equity market is the NASDAQ.
Hybrid systems =
Some order-driven systems, such as LSE SETS and NYSE, also use market makers to provide liquidity throughout the day in case there are low volumes of orders. These are known as hybrid systems.
When executing trades, members of the exchange can be acting in one of 2 ways: as a principal or as an agent.
Tell me the difference
principal =
it means they are buying and selling securities for their own account. I.e. they will be holding the shares and profiting as the market rises (hopefully not losing as the market falls). Firms acting in this capacity are dealers or market makers.
Agent =
Brokers. They are not taking a position in the underlying securities but just acting as an intermediary between their client and the buyer / seller. They will charge a fee for arranging the deal.
Some firms can act in a dual capacity and are known as broker/dealers.
What are market makers?
What are retail service providers?
What are interdealer brokers?
Market Maker = They provide liquidity to the rest of the market.
They are vetted and approved by the exchange to make a market in specific securities are obliged to provide two-way processes continuously throughout the day. There will be a minimum number of market makers for each stock.
RSPs =
are market makers that provide quotes to retail investors, usually via an online broker.
The client places the trade with the broker who uses the RSP system to collect quotes from various market makers.
These are firm commitments to buy or sell, and once a quote has been received you usually have between 15 and 30 seconds to accept or reject it.
If accepted, the deal will then be executed with the relevant RSP.
Interdealer brokers =
Interdealer brokers act as an agent between dealers and market makers, but settle as a principal.
A benefit of this is:
Let’s say a market maker sells shares in HSBC to a member firm.
If they don’t own these shares, they will need to buy them in the market, but they may not want the market to know what they are doing (especially if they have a large amount to buy).
If they use an IDB their anonymity will be preserved, as the party selling them the HSBC shares will only see the name of the IDB and not the party that they traded with.
IDBs, however, cannot take principal positions i.e. trade on their own account.
Rather than use full names of each security issuer, every security will have its own unique identifier code.
LSE use EPIC codes, e.g. LLOY is the code for Lloyds Banking Group
NYSE use stock tickers, e.g. XOM for ExxonMobil
Reuters use RIC codes. These are made up of the stock ticker and a code denoting the exchange, such as LLOY.L (London) and XOM.N (New York)
Bloomberg use something similar to the RIC codes but use two letters as the market identifier e.g. LLOY.LN, XOM.US
Different market price quotes
Bid price – the price the dealer is willing to pay for securities.
Offer or ask price – the price the dealer is willing to sell securities at.
Shares are quoted in pence per share.
Bonds are quoted per £100 nominal.
For a market to function properly there has to be a few ‘rules of behaviour’. Some of the key principles are:
9.2.1: Price transparency
9.2.2: Dealing rules
9.2.3: Transaction reporting
9.2.4: Client reporting
9.2.2: Dealing rules
there are several regulatory requirements in place that relate to dealing to protect investors.
Best execution
Timely execution
Aggregation and allocation
Conflicts of interest
What is front running?
Front running, also known as dealing ahead, refers to an unethical and often illegal practice in financial markets where a broker, trader, or other intermediary executes orders on their own account based on advance knowledge of pending client transactions.
This is prohibited under dealing rules as it is a Conflicts of interest
9.3 trading venues -
Nowadays there are several trading venues where you can go to trade shares and other securities
For example,
9.3.1: Regulated markets (LSE, NYSE or Tokyo Stock Exchange (TSE))
9.3.4: Systematic Internalisers (SI)
9.3.3: Dark pools
9.3.2: Alternative trading systems (such as MTF’s)
9.3.5: Organised Trading Facilities (OTF)
9.3.2: Alternative trading systems
Multilateral Trading Facility (MTF) = small traded sizes. large volume
9.3.3: Dark pools = large trade size, low volume
9.4.1: What is the Stock Exchange Electronic Trading System (SETS)
This is how those that trade on the LSE make their trades
LSE member firms need to input orders via SETS, where buy orders are automatically matched against sell orders on a strictly price then time basis.
The LSE has a set routine each day. (LOOK AT 9.4)
Do things always go to plan?
(these are a favourite question in the J12 exam)
Occasionally there may be delays to the market opening. (these are known as extensions)
Market order extension =
If there are unexecuted orders on the order book following the opening auction, e.g. if there were more sellers than buyers, then the opening of the market is delayed by 2 minutes followed by a random period of 30 seconds maximum.
Price monitoring extension =
This applies if the result of the indicative opening auction price is greater than a 5% move from the previous closing price.
In this case, the opening is delayed by 5 minutes flowed by a random period of 30 seconds maximum.
Once the market is open, there may also be times of high volatility where it is necessary to suspend the trading of stocks.
This happens if the price has moved by a set tolerance away from the last auction price (static limit) or the previous trade price (dynamic limit). The tolerance depends on the limit type and the stock being traded, typically ranging from 1% to 10%. If this occurs an Automatic Execution Suspension Period (AESP) is triggered which results in trading being suspended for 5 minutes followed by a random period of 30 seconds maximum.
Once the market is open, there may also be times of high volatility where it is necessary to suspend the trading of stocks.
This happens if the price has moved by a set tolerance away from the last auction price (static limit) or the previous trade price (dynamic limit).
The tolerance depends on the limit type and the stock being traded, typically ranging from 1% to 10%. If this occurs an Automatic Execution Suspension Period (AESP) is triggered which results in trading being suspended for 5 minutes followed by a random period of 30 seconds maximum.
on the LSE, Trading may be halted in a stock completely. This occurs when a listing has been suspended.
How long can a stock be suspended for?
The length of the suspension is at the discretion of the LSE. Any trades that have already been executed will settle as normal, but no new trades can take place during this time.
9.4.2: Order types
(Another favourite topic in the exam is order types. )
Tell me what each of the following orders are:
At best or at market
Limit
Execute & eliminate
Fill or Kill
Stop-loss
Stop limit
Iceberg
These are all applicable to orders made on SETS
At best or at market = buy or sell at current price
Limit = buy or sell specific quantity of shares at specific price. min price for sell order or max price for buy order. Can be held on Sets for 90days.
Execute & eliminate = buy or sell specific quantity of shares. Order is executed immediately in part or in full at or better than a specific price. Remainder of order is deleted
Fill or Kill = specific quantity of shares. All or nothing, either it executes in full immeditaly or it is rejected
Stop loss = buy or sell at the current price after a specific price is reached. Once reached it becomes a best order for immediate execution
Stop limit = Buy or sell at a specific price after that specfic price is reached. Once the specific price is met , it becomes a limit order
Iceberg = buy or sell at a specific price. Large limit orders where only a set portion is visible to the public whilst the rest remains invisible (like an iceburg) . Once first part is executed the second part is brought into the order book until the whole order is executed or the time limit expires
Here’s a breakdown of Limit, Execute & Eliminate (E&E), and Fill or Kill (FOK) orders, with examples to illustrate each:
- Limit Order
A Limit Order is an instruction to buy or sell a specific quantity of shares at a specific price or better. The order can remain active for up to 90 days (depending on the exchange rules), but it is not guaranteed to execute.
Buy Limit: The maximum price you are willing to pay to buy.
Sell Limit: The minimum price you are willing to accept to sell.
Example:
Scenario: Stock XYZ is trading at $50.
Buy Limit Order: You place a limit order to buy 100 shares at $48.
This order will execute only if the price drops to $48 or lower.
Sell Limit Order: You place a limit order to sell 100 shares at $52.
This order will execute only if the price rises to $52 or higher.
If the stock never reaches your specified price, the order will remain pending or expire after 90 days.
- Execute & Eliminate (E&E)
Also known as Immediate or Cancel (IOC), an E&E Order attempts to execute immediately at or better than the specified price. Any portion of the order that cannot be filled immediately is canceled.
Example:
Scenario: Stock ABC is trading at $30.
Order: You place an E&E buy order for 200 shares at $29.
The system immediately checks the market for shares available at $29 or lower.
Suppose only 120 shares are available at $29; these 120 shares are purchased, and the remaining 80 shares are canceled.
Similarly, for a sell order, any shares that cannot find a buyer at or above the limit price are canceled.
- Fill or Kill (FOK)
A Fill or Kill Order is an all-or-nothing order that must be executed in full immediately, at or better than the specified price. If it cannot be executed in full, it is canceled outright. No partial fills are allowed.
Example:
Scenario: Stock DEF is trading at $40.
Order: You place a FOK buy order for 500 shares at $39.
The system checks the market for 500 shares available at $39 or lower.
If exactly 500 shares (or more) are available at $39 or lower, the order executes fully.
If fewer than 500 shares are available, the order is canceled entirely.
Sell Order Example: You place a FOK sell order to sell 1,000 shares of Stock GHI at $42.
If the system cannot find buyers for all 1,000 shares at $42 or higher, the order is canceled without executing any part of it.
9.4.3: Other LSE dealing systems
For securities that are not traded on SETS there are other dealing systems that we need to be aware of.
SETSqx – the qx stands for quotes and crosses. This is a hybrid system that includes quotes from market makers and is for less liquid securities.
The International Order Book – order-driven service for ADRs and GDRs. Minimum order size of 50 shares. It works in the same way as SETS.
SEAQ - Stock Exchange Automated Quotation System. A quote-driven system some fixed income securities.
9.4.4: Trade reporting
We have already talked about the need for pre and post trade transparency so that as investors we have full information about the depth and liquidity of the market.
For any trades that are executed on the LSE then this information is provided and displayed automatically, but what if we execute trades away from the order book, for example via a systematic internaliser or a dark pool?
These trades must be manually reported in to the exchange, and there are strict requirements regarding what exactly needs to be reported and when.
Where a trade must be manually reported to an exchange, for example trades that are made outside of the book order such as systematic internaliser or a dark pool, there are strict requirements to when it must be reported by.
What are these requirements?
THIS IS A POPULAR EXAM QUESTION
The trade reporting period runs between 7.15am and 5.15pm. It is the responsibility of the more senior party to the trade to report it i.e. market maker followed by broker-dealer followed by non-member.
Where both parties are the same seniority, it is the selling member that must report the trade to the exchange.
-Off order book trades during the trading reporting period (7.15am and 5.15pm) must be reported within 3 mins of the order
-If trade is executed between 7.45am-8:00am = reported by the later of 8am or 3 mins
-If trade is executed within 5.12pm - 5.15pm (last 3 minutes) it must be reported on 5.15pm
-If a trade is executed outside of reproting period, it must be reported by 7.45am the following day
9.5.1: Government Bond trading
The backbone of government bond trading is the primary dealers. They play a key role in the issuance of government bonds, as we saw in chapter 8. They also help ensure a smooth-running, liquid secondary market by making firm, continuous, two-way prices in the government bonds for which they are registered to quote.
Trading in government bonds is significant, and the primary dealers are instrumental in providing the necessary liquidity to the market.
This system of primary dealers is used by many countries including the UK, USA, Canada, Germany, France, Italy and Spain. In the UK they are the GEMMs.
They can register themselves to provide quotes in all gilts (including index-linked gilts), just conventional gilts or just index-linked gilts. The GEMMs are not restricted in how they provide these quotes; they are free to use whichever system they prefer.
Secondary market trading of gilts in the UK takes place either through a GEMM or an LSE broker dealer. They can both trade as either principal or agent.
9.5.2: Corporate bonds
Corporate bonds do not enjoy the same levels of liquidity as government bonds. There are no dedicated market makers in the same way as for the government bond market.
Trading is either done between dealers or between a dealer and customer with little in the way of pre-trade price transparency as per the equity markets. LOOK AT EXAMPLE
9.5.3: Retail bonds
So far, we have been talking about trading systems for large scale bond trades, but what about retail investors who are looking to trade in smaller volumes. How can they trade bonds?
The LSE’s Order book for Retail Bonds (ORB) provides continuous two-way prices in a range of UK gilts, supranationals, and corporate bonds for retail investors. This enables retail investors to not only monitor the prices of various bonds but also to get a reliable valuation of their bond portfolios.
Because it is overseen by the LSE, retail investors can be confident that the market conforms to all the relevant regulatory requirements.
9.5.4: Calculating tge Accrued interest FOR BONDS (popular exam question!)
This is needed to calculate the bonds dirty price
9.5.5: TRAX
What is TRAX a real-time matching and main reporting system for OTC bond trades within the EU. It aims to reduce the errors that had been previously associated with paper-based confirmations.
