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.
Markets and participants
Markets can be exchange-traded or OTC.
Trading systems can be order-driven or quote-driven.
Market makers commit to making firm, continuous two-way prices in securities.
Retail Service Providers enable retail brokers to arrive at the most competitive quote for their clients.
Dealing principles
Firms executing deals on behalf of clients must abide by best execution rules.
For retail clients, this is judged by total consideration.
Client orders must be dealt with in the order they are received.
Orders can be aggregated as long as it is unlikely to disadvantage any clients.
Firms must have a clear order allocation policy in place.
Firms should establish Chinese (ethical) walls to prevent conflicts of interest arising, such as front running.
Trading venues
Regulated markets include Recognised Investment Exchanges and Designated Investment Exchanges.
LSE, Aquis and Cboe Europe Equities are examples of regulated markets.
Alternative trading venues include ECNs, crossing networks, MTFs, systematic internalisers, dark pools and OTFs.
Equity dealing
FTSE 350 shares, ETFs, ETCs, liquid AIM shares, and Irish shares are traded via SETS.
The LSE is open between 8am and 4.30pm.
Uncrossing auctions are carried out between 7.50am and 8am to decide the opening price and again at 4.30pm to decide the closing price.
A market extension period delays the opening by 2 minutes + random max 30 seconds, and occurs if there are any unexecuted orders following the opening auction.
A price monitoring extension period is for 5 minutes plus max 30 seconds if the opening price is more than 5% away from the previous closing price.
An Automatic Execution Suspension Period of 5 minutes plus max 30 seconds applies if the price of a security moves by more than a set amount.
Order types include at best, limit, execute and eliminate, fill or kill, and iceberg.
The trade reporting period runs from 7.15am to 5.15pm.
During market hours, trades must be reported within 3 minutes.
Bond dealing
Government bonds are issued via primary dealers who act as market makers and provide liquidity in the secondary markets.
Most corporate bond trading occurs OTC.
Retail investors can buy a variety of gilts and corporate bonds on the LSE’s order book for retail bonds.
Bonds trade on a clean price basis but settle on a dirty price basis.
Bonds go ex-dividend seven business days before the coupon payment date.
The dirty price incorporates accrued interest, which must be added to the clean price for cum-dividend trades and subtracted from the clean price for ex-dividend trades.
TRAX is a trade matching and confirmation system for bond trades.
International markets
The main exchanges in the US are the NYSE and the NASDAQ.
NYSE is a hybrid of electronic order book and open outcry.
NASDAQ is a quote-driven system.
The TSE is the main exchange in Japan.
It uses an electronic continuous order system with price controls to stop the price swinging too wildly.
Xetra is the electronic order book system used for Germany’s main Deutsche Börse.
Euronext is the main exchange for France.
Emerging markets are less developed, but have the potential for rapid economic growth and increase diversification in portfolios due to their low corelation with developed economies.
A client has instructed their broker to buy 1,000 shares in XYZ plc ‘at best’. Which Market Maker would he deal with?
Market Maker Bid Ask
A 231 232
B 230 231
C 229 233
D 229.5 230.5
Market Maker A.
Market Maker B.
Market Maker C.
Market Maker D.
Market Maker D.
The client is buying, so we need to look for the lowest price that the market maker is looking to sell at i.e. the ask price. Market Maker D is willing to sell their shares at the lowest ask price of 230.5p.
Best execution for a retail client means:
the best price.
the fastest execution.
the lowest total consideration.
the cheapest fees.
the lowest total consideration.
For retail clients, best execution is judged by total consideration. In other words, the price and the costs relating to its execution, including all expenses directly related to it, such as execution venue fees, clearing and settlement fees and any fees paid to third parties.
What type of trading generally takes place on an MTF?
Large value, low trading volume.
Low value, high trading volume.
Large value, high trading volume.
Low value, low trading volume.
Low value, high trading volume.
Dark pools are for large trades / low volumes. MTFs are the opposite; low value / high volume.
A market extension order:
occurs when a stock has moved by more than 5% from the previous night’s close.
is five minutes plus a random max 30 seconds.
occurs when the indicative opening auction price is more than 5% away from the previous closing price.
occurs if there are unexecuted orders on the order book following the opening auction.
occurs if there are unexecuted orders on the order book following the opening auction.
A, B and D are all to do with price monitoring extension orders.
Market extension orders are for 2 minutes plus max 30 seconds if there have been more buyers than sellers or vice versa in the opening auction.
NOTE: DO NOT CONFUSE WITH THE FOLLOWING
Off order book trades during trading hours must be reported within 3 minutes.
Off order book trades executed between 7.15am and 8am must be reported by the later of 8am or within 3 minutes.
Off order book trades executed within the last 3 minutes of the trade reporting period must be submitted by 5.15pm.
A trade occurs off-order book outside the trade reporting period. This trade must be reported…
within 3 minutes.
by 7.45am in the next trade reporting period.
by 8am in the next trade reporting period.
by 5.15pm.
by 7.45am in the next trade reporting period.
Off order book trades during trading hours must be reported within 3 minutes.
Off order book trades executed between 7.15am and 8am must be reported by the later of 8am or within 3 minutes.
Off order book trades executed within the last 3 minutes of the trade reporting period must be submitted by 5.15pm.
Off order book trades executed outside of the trade reporting period must be reported by 7.45am in the next trade reporting period.
can stay on the order book for up to 90 calendar days.
A limit order is one where the dealer will trade at a specified price or better. It can be executed in full or partially, and will only expire at the end of the day if no time limit has been placed on the order. A limit order does not have to be executed immediately; it can remain displayed on the SETS system for up to 90 calendar days.
A bond is trading at a clean price of £97.283 per £100 nominal. It has a coupon of 4% and pays interest every 1 April and 1 October. What is the accrued interest for £10,000 nominal if the bond is traded on 17th June?
£85.25.
£86.81.
£86.96.
£87.43.
£85.25.
Settlement date = T+1 = 18 June
The last coupon was paid on the 1 April, and the next coupon of £4 ÷ 2 = £2 will be paid on the 1 October.
The accrued days is the number of days from 1 April to 18 June = 29+31+18 = 78
The total number of days in the period is from 1 April to 1 October = 29+31+30+31+31+30+1 = 183
Accrued interest= 4/2×78/183=0.8525 per £100 nominal
Accrued interest = 0.8525 x 100 for £10,000 nominal = £85.25
A bond is traded 3 business days before the coupon payment date. Who will receive the coupon?
The buyer and they can keep it.
The seller and they can keep it.
The buyer but they have to give it to the seller.
The seller but they have to give it to the buyer.
The seller and they can keep it.
The bond is trading ex-dividend. This means that the seller’s name will be on the register on the record date, therefore the seller will receive the full coupon. They will not need to pay any back to the buyer, as the accrued interest will have already been subtracted from the clean price.
A fill or kill buy order for 2,000 shares has been placed at a price of 165p. The best quote in the market is a bid of 165 for 1,000 shares and an offer of 167p for 2,000 shares. What trading action if any will be carried out?
1,000 shares will be bought at 165p, with the balance remaining on the order book.
1,000 shares will be bought at 165p, with the balance being cancelled.
2,000 shares will be bought at 167p.
No purchase will be undertaken.
No purchase will be undertaken.
With a fill or kill order, if the entire order cannot be filled immediately at a price that is no worse than that which has been stipulated then the whole order is automatically deleted.
The main reason for a firm to establish a Chinese wall is to:
ensure where client orders are aggregated, they are allocated fairly.
prevent front running of client orders.
ensure all trades are executed in a timely fashion.
ensure that the firm provides best execution for their clients.
prevent front running of client orders.
Chinese (ethical) walls are used by firms to prevent conflicts of interest such as front running of customer orders. They stop different functions within a firm communicating which could create a conflict of interest
