The importance of listed exchange markets requires that we discuss them at some length. In this section, we discuss several types of membership on the exchanges, the major types of orders, and the role and function of exchange market makers—a critical component of a good exchange market.
Fourth Market Third Market
Listed U.S. securities exchanges typically offer four major categories of membership: (1) spe- cialist, (2) commission broker, (3) floor broker, and (4) registered trader. Specialists (or exchange market makers), who constitute about 25 percent of the total membership on exchanges, will be discussed after a description of types of orders.
Commission brokersare employees of a member firm who buy or sell for the customers of the firm. When you place an order to buy or sell stock through a brokerage firm that is a mem- ber of the exchange, in many instances the firm contacts its commission broker on the floor of the exchange. That broker goes to the appropriate post on the floor and buys or sells the stock as instructed.
Floor brokersare independent members of an exchange who act as brokers for other mem- bers. As an example, when commission brokers for Merrill Lynch become too busy to handle all of their orders, they will ask one of the floor brokers to help them. At one time, these people were referred to as $2 brokers because that is what they received for each order. Currently, they receive about $4 per 100-share order.18
Registered traders are allowed to use their memberships to buy and sell for their own accounts. They therefore save commissions on their own trading, and observers believe they have an advantage because they are on the trading floor. The exchanges and others are willing to allow these advantages because these traders provide the market with added liquidity, but regulations limit how they trade and how many registered traders can be in a trading crowd around a spe- cialist’s booth at any time. In recent years, registered traders have become registered competi- tive market makers (RCMMs), who have specific trading obligations set by the exchange.
Their activity is reported as part of the specialist group.19
It is important to understand the different types of orders entered by investors and the specialist as a dealer.
Market Orders The most frequent type of order is a market order, an order to buy or sell a stock at the best current price. An investor who enters a market sell order indicates a willing- ness to sell immediately at the highest bid available at the time the order reaches a specialist on the exchange or an OTC dealer. A market buy order indicates that the investor is willing to pay the lowest offering price available at the time the order reaches the floor of the exchange or an OTC dealer. Market orders provide immediate liquidity for someone willing to accept the pre- vailing market price.
Assume you are interested in General Electric (GE) and you call your broker to find out the current “market” on the stock. The quotation machine indicates that the prevailing market is 45 bid—45.25 ask. This means that the highest current bid on the books of the specialist is 45;
that is, $75 is the most that anyone has offered to pay for GE. The lowest offer is 45.25, that is, the lowest price anyone is willing to accept to sell the stock. If you placed a market buy order for 100 shares, you would buy 100 shares at $45.25 a share (the lowest ask price) for a total cost of $4,525 plus commission. If you submitted a market sell order for 100 shares, you would sell the shares at $45 each and receive $4,500 less commission.
Types of Orders Exchange Membership
DETAILEDANALYSIS OFEXCHANGEMARKETS 125
18These brokers received some unwanted notoriety in 1998: Dean Starkman and Patrick McGeehan, “Floor Brokers on Big Board Charged in Scheme,” The Wall Street Journal, 26 February 1998, C1, C21; and Suzanna McGee, “ ‘$2 Brokers’
Worried about Notoriety from Charges of Illegal Trading Scheme,” The Wall Street Journal, 5 March 1998, C1, C22.
19Prior to the 1980s, there also were odd-lot dealers who bought and sold to individuals with orders for less than round lots (usually 100 shares). Currently, this function is handled by either the specialist or some large brokerage firm.
Limit Orders The individual placing a limit orderspecifies the buy or sell price. You might submit a bid to purchase 100 shares of Coca-Cola stock at $50 a share when the current market is 60 bid–60.25 ask, with the expectation that the stock will decline to $50 in the near future.
You must also indicate how long the limit order will be outstanding. Alternative time specifi- cations are basically boundless. A limit order can be instantaneous (“fill or kill,” meaning fill the order instantly or cancel it). It can also be good for part of a day, a full day, several days, a week, or a month. It can also be open-ended, or good until canceled (GTC).
Rather than wait for a given price on a stock, your broker will give the limit order to the spe- cialist, who will put it in a limit-order book and act as the broker’s representative. When and if the market reaches the limit-order price, the specialist will execute the order and inform your broker. The specialist receives a small part of the commission for rendering this service.
Short Sales Most investors purchase stock (“go long”) expecting to derive their return from an increase in value. If you believe that a stock is overpriced, however, and want to take advan- tage of an expected decline in the price, you can sell the stock short. A short saleis the sale of stock that you do not own with the intent of purchasing it back later at a lower price. Specifi- cally, you would borrow the stock from another investor through your broker, sell it in the mar- ket, and subsequently replace it at (you hope) a price lower than the price at which you sold it.
The investor who lent the stock has the proceeds of the sale as collateral. In turn, this investor can invest these funds in short-term, risk-free securities. Although a short sale has no time limit, the lender of the shares can decide to sell the shares, in which case your broker must find another investor willing to lend the shares.20
Three technical points affect short sales. First, a short sale can be made only on an uptick trade, meaning the price of the short sale must be higher than the last trade price. This is because the exchanges do not want traders to force a profit on a short sale by pushing the price down through continually selling short. Therefore, the transaction price for a short sale must be an uptick or, without any change in price, the previous price must have been higher than its previ- ous price (a zero uptick). For an example of a zero uptick, consider the following set of transac- tion prices: 42, 42.25, 42.25. You could sell short at 42.25 even though it is no change from the previous trade at 42.25 because that prior trade was an uptick trade.
The second technical point concerns dividends. The short seller must pay any dividends due to the investor who lent the stock. The purchaser of the short-sale stock receives the dividend from the corporation, so the short seller must pay a similar dividend to the lender.
Finally, short sellers must post the same margin as an investor who had acquired stock. This margin can be in any unrestricted securities owned by the short seller.
Special Orders In addition to these general orders, there are several special types of orders.
A stop loss order is a conditional market order whereby the investor directs the sale of a stock if it drops to a given price. Assume you buy a stock at 50 and expect it to go up. If you are wrong, you want to limit your losses. To protect yourself, you could put in a stop loss order at 45. In this case, if the stock dropped to 45, your stop loss order would become a market sell order, and the stock would be sold at the prevailing market price. The stop loss order does not guarantee that you will get the $45; you can get a little bit more or a little bit less. Because of the possibility of
20For a discussion of negative short-selling results, see William Power, “Short Sellers Set to Catch Tumbling Overhead Stocks,” The Wall Street Journal, 28 December 1993, C1, C2. For a discussion of short-selling events, see Carol J.
Loomis. “Short Sellers and the Seamy Side of Wall Street,” Fortune, 22 July 1996, pp. 66–72; and Gary Weiss, “The Secret World of Short Sellers,” Business Week, 5 August 1996, pp. 62–68. For a discussion of short selling during 2000–2001, see Allison Beard, “Short Selling Goes from Strength to Strength,” Financial Times, 16 March 2001, p. 29.
market disruption caused by a large number of stop loss orders, exchanges have, on occasion, canceled all such orders on certain stocks and not allowed brokers to accept further stop loss orders on those issues.
A related type of stop loss tactic for short sales is a stop buy order. An investor who has sold stock short and wants to minimize any loss if the stock begins to increase in value would enter this conditional buy order at a price above that at which the investor sold the stock short. Assume you sold a stock short at 50, expecting it to decline to 40. To protect yourself from an increase, you could put in a stop buy order to purchase the stock using a market buy order if it reached a price of 55. This conditional buy order would hopefully limit any loss on the short sale to approximately $5 a share.
Margin Transactions On any type of order, an investor can pay for the stock with cash or borrow part of the cost, leveraging the transaction. Leverage is accomplished by buying on mar- gin, which means the investor pays for the stock with some cash and borrows the rest through the broker, putting up the stock for collateral.
As shown in Exhibit 4.8, the dollar amount of margin credit extended by members of the NYSE has increased consistently since 1992 and exploded in late 1999–2000 prior to a decline in late 2000 when the overall market value fell dramatically. Exhibit 4.9 relates this debt to the DETAILEDANALYSIS OFEXCHANGEMARKETS 127
300
250
200
150
100
50
0 Jan
92 Jul 92
Jan 93
Jul 93
Jan 94
Jul 94
Jan 95
Jul 95
Jan 96
Jul 96
Jan 97
Jul 97
Jan 98
Jul 98
Jan 99
Jul 99
Jan 00
Jul 00
Billion $
300
250
200
150
100
50
0
EXHIBIT 4.8 NYSE MEMBER FIRM CUSTOMERS’ MARGIN DEBTS, BILLION $, 1992–2000
Source: Goldman Sachs.
market value of stocks and the increase is still clear but not as sharp. Again, there is a decline at the end of 2000. The interest rate charged on these loans by the investment firms is typically 1.50 percent above the rate charged by the bank making the loan. The bank rate, referred to as the call money rate, is generally about 1 percent below the prime rate. For example, in July, 2002, the prime rate was 4.75 percent, and the call money rate was 3.50 percent.
Federal Reserve Board Regulations T and U determine the maximum proportion of any trans- action that can be borrowed. This margin requirement (the proportion of total transaction value that must be paid in cash) has varied over time from 40 percent (allowing loans of 60 percent of the value) to 100 percent (allowing no borrowing). As of July 2002, the initial margin require- ment specified by the Federal Reserve was 50 percent, although individual investment firms can require higher rates.
After the initial purchase, changes in the market price of the stock will cause changes in the investor’s equity, which is equal to the market value of the collateral stock minus the amount bor- rowed. Obviously, if the stock price increases, the investor’s equity as a proportion of the total market value of the stock increases; that is, the investor’s margin will exceed the initial margin requirement.
Assume you acquired 200 shares of a $50 stock for a total cost of $10,000. A 50 percent ini- tial margin requirement allowed you to borrow $5,000, making your initial equity $5,000. If the stock price increases by 20 percent to $60 a share, the total market value of your position is
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
Dec 92 Mar 93 Jun 93 Sep 93 Dec 93 Mar 94 Jun 94 Sep 94 Dec 94 Mar 95 Jun 95 Sep 95 Dec 95 Mar 96 Jun 96 Sep 96 Dec 96 Mar 97 Jun 97 Sep 97 Dec 97 Mar 98 Jun 98 Sep 98 Dec 98 Mar 99 Jun 99 Sep 99 Dec 99 Mar 00 Jun 00 Sep 00 Dec 00
Percent of Capitalization
EXHIBIT 4.9 NYSE MARGIN DEBT AS A PERCENT OF U.S. MARKET CAPITALIZATION (1993–2000)
Source: Goldman Sachs.
$12,000 and your equity is now $7,000 or 58 percent ($7,000/$12,000). In contrast, if the stock price declines by 20 percent to $40 a share, the total market value would be $8,000 and your investor’s equity would be $3,000 or 37.5 percent ($3,000/$8,000).
This example demonstrates that buying on margin provides all the advantages and the disad- vantages of leverage. Lower margin requirements allow you to borrow more, increasing the per- centage of gain or loss on your investment when the stock price increases or decreases. The lever- age factor equals 1/percent margin. Thus, as in the example, if the margin is 50 percent, the leverage factor is 2, that is, 1/.50. Therefore, when the rate of return on the stock is plus or minus 10 percent, the return on your equity is plus or minus 20 percent. If the margin declines to 33 per- cent, you can borrow more (67 percent) and the leverage factor is 3(1/.33). When you acquire stock or other investments on margin, you are increasing the financial risk of the investment beyond the risk inherent in the security itself. You should increase your required rate of return accordingly.21
The following example shows how borrowing by using margin affects the distribution of your returns before commissions and interest on the loan. When the stock increased by 20 percent, your return on the investment was as follows:
1. The market value of the stock is $12,000, which leaves you with $7,000 after you pay off the loan.
2. The return on your $5,000 investment is:
In contrast, if the stock declined by 20 percent to $40 a share, your return would be as follows:
1. The market value of the stock is $8,000, which leaves you with $3,000 after you pay off the loan.
2. The return on your $5,000 investment is:
You should also recognize that this symmetrical increase in gains and losses is only true prior to commissions and interest. Obviously, if we assume a 6 percent interest on the borrowed funds (which would be $5,000 × .06 = $300) and a $100 commission on the transaction, the results would indicate a lower increase and a larger negative return as follows:
20 12 000 5 000 300 100
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DETAILEDANALYSIS OFEXCHANGEMARKETS 129
21For a discussion of the investment environment in early 2000, see Greg Ip, “Margin Debt Set a Record in January, Sparking Fresh Fears Over Speculation,” The Wall Street Journal, 15 February 2000, C1, C2.
In addition to the initial margin requirement, another important concept is the maintenance margin, which is the required proportion of your equity to the total value of the stock; the mainte- nance margin protects the broker if the stock price declines. At present, the minimum maintenance margin specified by the Federal Reserve is 25 percent, but, again, individual brokerage firms can dictate higher margins for their customers. If the stock price declines to the point where your equity drops below 25 percent of the total value of the position, the account is considered undermargined and you will receive a margin callto provide more equity. If you do not respond with the required funds in time, the stock will be sold to pay off the loan. The time allowed to meet a margin call varies between investment firms and is affected by market conditions. Under volatile market con- ditions, the time allowed to respond to a margin call can be shortened drastically.
Given a maintenance margin of 25 percent, when you buy on margin you must consider how far the stock price can fall before you receive a margin call. The computation for our example is as follows: If the price of the stock is P and you own 200 shares, the value of the position is 200P and the equity in the account is 200P – $5,000. The percentage margin is (200P – 5,000)/200P.
To determine the price, P, that is equal to 25 percent (0.25), we use the equation:
Therefore, when the stock price declines to $33.33 (from the original cost of $50), the equity value is exactly 25 percent; so if the stock goes below $33.33, the investor will receive a margin call.
To continue the previous example, if the stock declines to $30 a share, its total market value would be $6,000 and your equity value would be $1,000, which is only about 17 percent of the total value ($1,000/$6,000). You would receive a margin call for approximately $667, which would give you equity of $1,667, or 25 percent of the total value of the account ($1,667/$6,667).
Now that we have discussed the overall structure of the exchange markets and the orders that are used to buy and sell stocks, we can discuss the role and function of the market makers on the exchange. These people and the role they play differ among exchanges. For example, on U.S.
exchanges these people are called specialists; on the TSE they are a combination of the Saitori and regular members. Most exchanges do not have a single market maker but have competing dealers such as the Nasdaq Stock Market. On exchanges that have central market makers, these individuals are critical to the smooth and efficient functioning of these markets.
As noted, a major requirement for a good market is liquidity, which depends on how the mar- ket makers do their job. Our initial discussion centers on the specialist’s role in U.S. markets, fol- lowed by a consideration of comparable roles on exchanges in other countries.
U.S. Markets The specialist is a member of the exchange who applies to the exchange to be assigned stocks to handle.22The typical specialist will handle about 15 stocks. The minimum capital requirement for specialists was raised in 1998 to $1 million or the value of 15,000 shares of each stock assigned, whichever is greater.
Exchange Market Makers
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22Each stock is assigned to one specialist. Most specialists are part of a specialist firm where partners join together to spread the work load and the risk of the stock assigned to the firm. As of mid-2002, a total of 460 individual specialists were in 10 specialist firms—seven that traded equities and three that only traded Exchange Traded Funds (ETFs).
Functions of the Specialist Specialists have two major functions. First, they serve as bro- kers to match buy and sell orders and to handle special limit orders placed with member brokers.
As noted earlier, an individual broker who receives a limit order (or stop loss or stop buy order) leaves it with the specialist, who executes it when the specified price occurs.
The second major function of a specialist is to act as a dealer to maintain a fair and orderly market by providing liquidity when the normal flow of orders is not adequate. As a dealer, the specialist must buy and sell for his or her own account (like an OTC dealer) when public supply or demand is insufficient to provide a continuous, liquid market.
Consider the following example. If a stock is currently selling for about $40 per share, the current bid and ask in an auction market (without the intervention of the specialist) might be a 40 bid–41 ask. Under such conditions, random market buy and sell orders might cause the stock price to fluctuate between 40 and 41 constantly—a movement of 2.5 percent between trades.
Most investors would probably consider such a price pattern too volatile; the market would not be considered continuous. Under such conditions, the specialist is expected to provide “bridge liquidity” by entering alternative bids and asks or both to narrow the spread and improve the stock’s price continuity. In this example, the specialist could enter a bid of 40.40 or 40.50 or an ask of 40.60 or 40.70 to narrow the spread to about $0.20.
Specialists can enter either side of the market, depending on several factors, including the trend of the market. Notably, they are expected to buy or sell against the market when prices are clearly moving in one direction. Specifically, they are required to buy stock for their own inven- tories when there is a clear excess of sell orders and the market is definitely declining. Alterna- tively, they must sell stock from their inventories or sell it short to accommodate an excess of buy orders when the market is rising. Specialists are not expected to prevent prices from rising or declining, but only to ensure that prices change in an orderly fashion (that is, to maintain price continuity). Evidence that they have fulfilled this requirement is that during recent years NYSE stocks traded unchanged from, or within 10 cents of, the price of the previous trade about 97 per- cent of the time.
Assuming that there is not a clear trend in the market, a factor affecting specialists’ decisions on how to narrow the spread is their current inventory position in the stock. For example, if they have large inventories of a given stock, all other factors being equal, they would probably enter on the ask (sell) side to reduce these heavy inventories. In contrast, specialists who have little or no inventory of shares because they had been selling from their inventories, or selling short, would tend toward the bid (buy) side of the market to rebuild their inventories or close out their short positions.
Finally, the position of the limit order book will influence how they narrow the spread.
Numerous limit buy orders (bids) close to the current market and few limit sell orders (asks) might indicate a tendency toward higher prices because demand is apparently heavy and supply is limited. Under such conditions, a specialist who is not bound by one of the other factors would probably opt to accumulate stock in anticipation of a price increase. The specialists on the NYSE have historically participated as dealers in about 15 percent of the trades, but this percent has been increasing in recent years—from about 18 percent in 1996 to 27 percent in 2000.23 Specialist Income The specialist derives income from the broker and the dealer functions.
The actual breakdown between the two sources depends on the specific stock. In an actively traded stock such as IBM, a specialist has little need to act as a dealer because the substantial public interest in the stock creates a tight market (that is, a small bid-ask spread). In such a case, DETAILEDANALYSIS OFEXCHANGEMARKETS 131
23For a discussion of this trend and its effect on specialists’ income, see Greg Ip, “Big Board Specialists: A Profitable Anachronism, The Wall Street Journal, 12 March 2001, A10.