In financial terms the word "market" has a meaning that is conceptual: a market is the interaction of offers to buy ("bids") and offers to sell ("asks"). Physical location is a detail, and the market may not have a single location—buyers and sellers may never meet face to face. The critical component is the existence of the offers. A market maker is said to make a market in an item by simply standing ready to buy or sell the item. In the extreme there are as many markets as market makers, but markets can be grouped in various ways. One common grouping is by the item traded. We will focus on the stock markets, as a part of the broader securities markets, using the plural to indicate that there are many trading mechanisms.
Philadelphia was originally the leading financial center of the United States, with New York and Boston as less important locations. In New York, trading was conducted in an area near the site of the wall erected to separate the original Dutch colony from the indigenous inhabitants. Trading in financial instruments was sparse and haphazard, often occurring through personal contact in the area coffee houses. In the late 1700s, however, there was increased trading in the Continental and Colonial war bonds that had been issued to finance the American Revolution. Brokerage services were offered by some merchants as a secondary activity. On May 17, 1792, 24 New York brokers signed an agreement to trade a restricted list of securities among themselves, and to charge a fixed commission of 0.25 percent. This was referred to as the buttonwood agreement because the designated meeting place was in the open near a buttonwood tree. The arrangement worked, and in the next year the association built the Tontine Coffee House and moved trading to one of the rooms inside the building. Trading was conducted as a "call" market. Several times each day the brokers would gather, each in an assigned seat, and the names of the traded securities would be called out one at a time. As the name of a security was read, the brokers would orally exchange offers to buy and sell in an "auction" process, until a price was agreed on.
The buttonwood brokers faced considerable competition from other similar groups and was at times overshadowed. By the 1860s, 11 exchanges had evolved in New York from outdoor trading in the "curb markets"—outdoor markets where trading literally took place at the curbstones, with different stocks being traded at particular lampposts or other similar, agreed upon locations. In 1869 the original buttonwood association merged with the larger Open Board and adopted continuous auction trading, rather than the periodic call system originally used. The much-changed buttonwood association has endured, and still meets near the location of the wall and the buttonwood tree—the location is now on Wall Street. It uses the name adopted in 1863: New York Stock Exchange (NYSE). The NYSE is now the dominant, but not the only, U.S. stock exchange. The remaining New York curb markets went through various associations and combinations, eventually moving trading inside and merging into what is today the American Stock Exchange (AMEX). The exchanges in Philadelphia and Boston continue, and a number of other regional exchanges have come into existence.
Internationally, many exchanges were in existence before the beginning of U.S. markets. Some of the foreign exchanges are large, and compete with U.S. exchanges for international investments. The creation of new exchanges continues, particularly in emerging countries.
In addition to the formal, organized exchanges, stocks also trade in an extensive informal over-thecounter (OTC) securities market. This market does not have a physical location: buyers and sellers interact electronically. In fact, the number of stock issues traded is larger than the number of issues traded on the organized exchanges, although both the volume of trades and the size of the firms traded is generally smaller. For some securities, such as bonds or stock of small firms, these informal markets are the principal trading mechanism.
Securities markets may be classified by role into primary and secondary markets. The primary market is the process by which new securities are issued and marketed. After the distribution period, trading of the issue among investors is referred to as the secondary market.
Capital for growth and new investments is the lifeblood of the firm. Large investors with the means to invest directly are scarce and difficult to attract. By issuing securities, a firm has access to a larger number of investors of varying means. This allows the firm to raise larger amounts of capital at less cost than through seeking direct investment by individuals or from bank loans. Without a primary securities market, new projects are difficult to finance, innovation slows, and economic development stagnates.
The process of selling stock to the general public for the first time is called an initial public offering (IPO). If the firm has previously issued stock to the general public, a new issue is called a seasoned new issue. Given the infrequency of a stock issue for a firm, and the unfamiliarity of the corporate financial officers with the complex process, it is logical for the firm to turn to an investment banker. The investment banker is an expert in public offerings who provides three services to the issuing firm. The first service is advice. The investment banker knows the extensive legal requirements and other arrangements surrounding registration and sale of securities, and guides the firm through the process. The investment banker is familiar with the securities markets, and can help the firm choose the optimal form of security and design its terms. The second service is marketing and distribution. The originating banker also provides price support or stabilization for the issue during the distribution phase, standing ready to buy the security to prevent or reduce price drops due to temporary imbalances. Notice of a public offering in the financial press is in the form of tombstones, so named because of the similarity of appearance. The tombstone describes the security and lists the originating banker and the members of the syndicate.
The third service provided by the investment banker is reduction of risk through the process of underwriting. This is perhaps the most important service provided. A public offering is an important event for a firm, and failure of an offering would be disastrous. In underwriting, the investment banker guarantees the success of the issue by simply buying the entire issue from the firm, accepting the risk that the security will not sell at the expected price. There are two reasons the investment banker can accept the risk of underwriting. First, a syndicate, or temporary association of investment bankers, is formed to underwrite, market, and distribute the issue. The originating banker retains a larger portion of the issue and the accompanying risk than other syndicate members, but this is often a small fraction of the total. Second, although the firm has only one issue underway, the investment banker is able to diversify, spreading the risk by participating in many issues. In some cases the investment banker will not accept the risk of the offering by underwriting. Although underwriting appears to be part of the marketing and distribution service, it is separable. In some cases the investment banker will decide that the risk is unacceptable and refuse to underwrite the issue, providing instead a best efforts offering.
In a secondary distribution the stock being sold is not issued by the firm, but is a large amount of previously issued stock held by an investor. The public offering may be accomplished more rapidly and perhaps at better prices than piecemeal selling. There are some variations on the issue process. Since 1982 firms have been permitted to register securities and then sell them gradually over a two-year period. This shelf registration, so called because the securities are "on the shelf awaiting sale, is attractive because it is a ready source of capital. Shelf registration is also thought to have lower flotation costs, because the sale can be timed to take advantage of attractive market conditions, and small sales avoid the possible depression of prices associated with large offers. An altemative to a public offering is private placement. In private placement, the issue is placed with a limited number of investors, usually institutions, instead of being offered to the general public. This altemative is sometimes attractive to the issuing firm because the security and its conditions can be negotiated, the issue can be accomplished in less time, and there are fewer disclosure requirements. Notices of private placements are published in the financial press.
The firm is not directly affected by trading in securities after issue, and only receives proceeds from the original issue of the security. As a result, it is sometimes thought that the secondary markets are somewhat irrelevant, a place where investors gamble without any real economic impact. This view is absolutely wrong. The secondary markets provide the liquidity and price discovery that are necessary for the existence of an effective primary market.
Liquidity refers to the ability to convert an asset to cash quickly at a price reflecting the fair (economically rational) value. Both conditions must be fulfilled, since any asset could be converted to cash quickly if offered at a low enough price. Liquidity in tum depends on three qualities. Depth is the presence of orders to trade at prices closely surrounding the market price. Breadth requires that the size of these orders be sufficient to prevent wide price swings, given trading volume. Resiliency refers to the speed with which mispricing due to temporary supply and demand imbalances call forth new orders. If these qualities are lacking, the resulting poor liquidity increases the risk of the buyer, since asset prices will fluctuate around fair value and the asset may have to be sold at a price below fair value. Under such conditions, investors are hesitant to invest, will demand a higher rate of retum, and often require extensive safeguards. These conditions are often apparent in the venture capital market, in which firms that do not have access to the primary securities markets seek funding. In short, without secondary market liquidity a primary market for securities would not function well. Even the venture capital market is aided by the secondary market, since one factor in investing is the likelihood that the firm will grow enough to accomplish a public offering, so that the stock will become liquid. The possibility of a secondary offering also encourages participation in public offerings by large investors. The liquidity provided by an effective secondary market not only supports, but indeed enables, an effective primary market. It is not surprising that developing countries establish securities markets, since this mobilizes capital and facilitates economic growth.
Price discovery is the valuation of assets. Through trading, an equilibrium price that represents the consensus of the markets is established. This price is the result of information entering the market, and it is also information in itself. It is a signal both to investors and to the firm's management as to the expected future of the firm. The secondary market affects access to the primary through the signals from price discovery. If a firm's securities are given a low value, signaling low expectations, issue of new securities is difficult if not impossible. Even if a primary issue is possible, the cost of capital for the firm will be high, and the capital budget of the firm will be small, slowing growth. In essence, by deciding which firms will receive capital for new projects, the price discovery function of the secondary markets serves as the capital budgeting process of the economy, setting its goals, priorities, and future. Rather than being irrelevant gambling, secondary markets are a vital mechanism in the economy.
Another way of classifying securities markets is by the trading arrangements and rules. An organized exchange is characterized by a definite physical location and a restricted list of securities and traders. The OTC market, on the other hand, is simply a net of brokers and dealers who maintain contact and trade through various means of communication. A broker trades for the client as an agent without entering the trade as a principal, and is compensated by a commission. A dealer trades with the client as a principal. The dealer trades from inventory and receives no commission, compensation comes from trading gains and losses and the spread between the bid and ask prices. The distinction is by form of participation only. A given individual may function as both a dealer and a broker, but is not allowed perform both functions in the same transaction.
The NYSE and the AMEX are examples of an organized exchange. In terms of numbers of companies, the NYSE is small, listing (in 1995) just over 3,000 stock issues of about 2,600 companies. These are large firms that meet the listing requirements, however, and in terms of value traded the NYSE is huge, accounting for about 85 percent of the value traded on U.S. exchanges. The AMEX is national in scope but has less stringent listing requirements, and the firms tend to be smaller than on the NYSE. Within the United States there are also regional stock exchanges that list firms that do not meet the listing requirements of the national exchanges.
Both the NYSE and the AMEX provide continuous trading in an auction process. Each stock trades at a designated trading post on the trading floor. Only members, who are said to hold a seat on the exchange (the term arises from the original buttonwood association practice of call trading from assigned seats) are allowed to trade. The public has access to trading through commission brokers who represent brokerage houses, executing trades for the firm's clients. The commission brokers may be assisted by independent two-dollar brokers, the name arising from the amount once charged for this assistance. Two-dollar brokers may also be floor traders, trading for their own account, but they may not fill both roles in the same stock in the same day, to avoid conflict of interest . An exchange member called a specialist will be present at the designated trading spot. The specialist makes a market in the stock by providing firm bid and ask offers. Normally, there is only one specialist for a given issue, although there have been exceptions. The specialist also handles the several types of away-from-the-market or limit orders left by brokers, which specify trading at a price other than the immediate market price. To fill this role, the specialist maintains the order book. The order book, now a computer, is simply a listing of clients' away-from-the-market orders left with the specialist by floor brokers. The specialist will execute these orders if and when the order flow permits. The execution of the orders preserves price priority, i.e., execution of highest bid or lowest offer to sell. The system does not necessarily preserve time priority, or execution in the order received, since order size is taken into account.
The specialist has the responsibility to maintain an orderly market, i.e., to avoid wide fluctuations in trading price. In order to do this, the specialist must stand ready to buy and sell on the firm's own account, and is subject to various trading rules to avoid conflict of interest. The possibility of large market movements makes market maintenance very risky, and the sharp market decline of 1987 caused large losses to specialists. Specialists must meet requirements to assure that they will have sufficient capital to maintain an orderly market. Despite the risks and limitations, being a specialist is rewarding. One source of specialist income is the commission on handling away-from-the-market orders. Prices were historically quoted in "eighths," or $0.125 increments (the increment is sometimes called the "tick"). In 1997, trading in 16ths was permitted, and it is likely that decimalization (penny tick) will follow.
It must be noted that the specialist does not control or set the price. The trading edge comes only from superior information of probable price movements. Indeed, many trades do not involve the specialist but are instead the product of the simultaneous crowd trading. The crowd is the group of traders and brokers present at the trading post. New offers are announced publicly, and may be accepted or responded to by a member of the crowd independently of the specialist and the book. This may occur at a price inside the specialist's bid ask spread, although price priority must be maintained.
Block trades are transactions of more than 10,000 shares, and account for about half of all transactions on the NYSE. Specialists are prohibited from soliciting orders in the stock in which they make a market. In order to maintain an orderly market in the face of such an order, the specialist would be forced to absorb much of the order into inventory. Understandably, specialists are reluctant to assume the risk of so large an inventory. As a result, block trades are not sent directly to the trading floor. Instead, a brokerage firm called a block house will undertake to find matching orders in what is sometimes called the upstairs market. The block and matched orders are then taken to the specialist and crossed, or executed, on the floor of the exchange.
Organized exchanges exist throughout the world, and compete with each other and with U.S. exchanges for international capital flows. Trading arrangements on these exchanges may differ from those used on domestic exchanges. The Tokyo Stock Exchange, for instance, is a pure agency market, in which the price is set by orders without exchange influence. Rather than using specialists, the order book is maintained by officials who may not trade in the stocks assigned to them. Trading on the Paris Bourse and the German and Austrian exchanges are call markets. In call markets orders are accumulated over time and crossed or executed at intervals, as in the original NYSE buttonwood trading. Investors considering international investment on foreign exchanges must be careful to understand the differing exchange arrangements. Another difference is that U.S. stock exchanges are private, while other exchanges such as the Paris Bourse are public exchanges under the authority of the government. Another arrangement is the bankers bourse used in Germany, where banks are the major securities traders. These arrangements will undergo rapid change with the introduction of the euro.
The OTC markets are sometimes defined as any securities trade that does not take place on an organized exchange. The name originates from the time when stock trading was a sideline for merchants and bankers, and securities were literally sold over a counter. Stocks trading OTC tend to be smaller and younger firms, although there are exceptions. The quality of the securities varies widely. As indicated by the plural, the OTC is properly viewed as a group of submarkets sharing certain characteristics. One characteristic is that this market has no central meeting place. It is instead an informal network of brokers trading for clients and dealers who make a market in the securities. There may multiple market makers for a given security, typically between 2 and 20. Brokers and dealers communicate and trade with each other by various means. The price of a trade is set by negotiation, rather than by the auction process of the NYSE. A broker receiving an order will contact the market makers and receive bid and ask quotations, and may choose the best offer or attempt to negotiate a better offer. There is no specialist or specific mechanism to maintain an orderly market, and price fluctuations depend on the breadth, depth, and resiliency of the market for the particular security. Trades executed OTC for stocks not listed on an exchange are referred to as the second market. Stocks listed on an exchange may also be traded OTC, and such trades are sometimes referred to as the third market.
One OTC subgroup consists of stocks listed on the Nasdaq exchange. This system provides electronic display of dealer bids and asks, allowing the broker to obtain the best price. Listing on Nasdaq is restricted to about 3,500 of the more widely traded stocks that also meet other listing requirements. As with NYSE listings on the exchanges, Nasdaq stocks are a minority in numbers but a majority in value and trading among OTC stocks. A step down from Nasdaq stocks are the pink-sheet stocks. The pink sheets were printed bid and ask quotations that were distributed daily; the name derives from the color of the paper used. This system has been supplanted by computerized quotation systems. Unlike Nasdaq quotes, these quotes are more in the nature of workout quotes or estimates, rather than firm quotes at which a trade can be executed. Although some large firms are included in this group, most are smaller firms. Trading in pinksheet stocks tends to be relatively thin, or lacking in order depth and breadth, so that it is often difficult to move more than small amounts of stock without price concessions. Recently the fourth market has seen increased volume. This market consists of trading directly between institutions, without involving brokers.
Among the first applications of computers was a search for the trends in stock prices postulated by the Dow theory. Various tests detected only very weak trends that were incapable of supporting investment strategies. Although the tests do not definitively disprove the existence of trends, the empirical observations led to the conclusion that stock prices are best described as a random walk, i.e., that changes in stock prices are random variables. The efficient markets hypothesis (EMH) arose as an explanation of this empirical observation. The EMH suggests that information is fully reflected in stock prices. If information is fully reflected, price changes will be the result of the arrival of new information. The arrival of new information will be random, since anything known would already be reflected in the price. This random arrival of information will result in random price fluctuations: informationally efficient markets will result in a random walk in stock prices. Two important possible misconceptions must be mentioned. The first misconception is that the random walk and the efficient markets hypotheses suggest that stock prices are random. Quite the opposite, the EMH suggests that information is fully and accurately reflected in prices, so that prices will be close estimates of true intrinsic value. The random walk refers to price changes, not to the prices themselves. The second misconception is that the hypotheses imply that nothing can be known about the price changes. This is wrong. Although a random walk implies that price changes cannot be exactly predicted, it is still possible to describe the probability distribution of price changes.
Market efficiency is closely related to both liquidity and price discovery. An efficient market is one in which price discovery is rapid and accurate, and the requirements for efficiency include the breadth, depth, and resiliency required for support of liquidity. Aside from the importance of efficiency for the capital budgeting role of the secondary markets, the question of market efficiency is important to investor strategy. If information is fully reflected in stock prices, that information cannot be used to generate excess returns, i.e., returns greater than could be expected without using the information. Definition of excess returns requires a definition of normal profits as a standard for comparison. A large number of tests of market efficiency have used the capital asset pricing model (CAPM) to establish a level of expected return on a risk adjusted basis. In this approach, risk is defined as the beta or systematic, nondiversifiable variation. More recently, the CAPM has been found to be inadequate in several ways. Some researchers have instead used a multifactor approach based on the arbitrage pricing theory. Unfortunately, the factors are not defined by the theory, and there is no theoretically supported and generally accepted set of factors. While there is no entirely satisfactory theory to specify expected returns, this does not make testing impossible, merely less precise. The effect of information can be detected by testing not for "excess" but for "unusual" returns, where unusual returns are returns that differ from observed historical returns relative to market returns.
The question of which information is reflected is treated by defining three levels of market efficiency based on the information set reflected. The lowest level of efficiency is called the weak form. This form of the EMH holds that investors cannot use historical market trading data (such as prices and volume) to increase returns over what would otherwise be expected. The next level of efficiency is the semi-strong form. This form applies to all publicly available data, such as annual reports, published brokerage reports, or newspaper articles, and all weak-form information. The highest level of efficiency is the strong form, which holds that all information, both public and private, is fully reflected in stock prices.
Studies of the weak form of the EMH include the original trend studies and numerous tests of trading rules. The majority of evidence to date supports weakform efficiency. This would seem to rule out technical analysis as an investment approach. Proponents of the technical approach argue, however, that the tests are inadequate and that application of mechanical rules without human judgment would, of course, be useless. Tests of the strong form have indicated that this extreme form is violated by exclusive information such as the specialist's knowledge of the order book. Finally, tests of the semi-strong form have provided mixed results, revealing the presence of anomalies that indicate that at least some forms of public information are not fully reflected. The tests have several shortcomings. One problem is that they tend to use computer-accessible data that deal with the markets we would expect to be efficient. Another shortcoming is the time frame, with the majority of studies using daily or longer data.
The question of efficiency is best thought of as one of degree, rather than kind. Efficiency is not so much a matter of all stocks being correctly priced at all times, but of most stocks being close to intrinsic value most of the time. Markets are relatively efficient if mispricing is small, infrequent, and short-lived. Further, the question of efficiency depends on the market, the investor, and the time frame. The NYSE is relatively efficient, as is the AMEX. When we move to the OTC, we must consider the subgroup. For widely traded Nasdaq stocks, the markets are likely quite efficient. But the bond market is often described as less efficient, and market efficiency for low-volume pink-sheet stocks can be expected to be below Nasdaq efficiency. This would indicate an indexing (i.e., purchase of a portfolio of stocks mirroring a market index) approach on the NYSE, but fundamental analysis might be more appropriate for pink-sheet investors. Investor expertise and position in the information chain must also be considered. The market seems much more efficient for part-time amateur investors in the countryside than for full-time investment professionals on Wall Street. Finally, investors who are slow to act on information, or face trading delays, will find that information has already caused price adjustment. For these investors, the market is relatively efficient. Rather than present market efficiency as an absolute quality, the idea of "grossly efficient" or "approximately efficient" markets seems to predominate.
Given the importance of securities markets to the economy, and the spectacular profits that can be gained from abuse, regulation of securities markets is surprisingly recent and somewhat informal. There was little market regulation until 1911, when individual states began to enact blue sky laws regulating securities. The name comes from a court ruling that noted that some investment schemes promised little more than a patch of blue sky. These state laws were insufficient, inadequately enforced, and easily circumvented. Pools, or small groups of investors, cooperating in manipulation of stock prices and other unethical practices were not unusual. Financial information was difficult to obtain. Although organized exchanges required the disclosure of some financial information for traded stocks, this information was not always reliable. Federal regulation did not appear until after the market fluctuations of 1929. The major regulatory framework was constructed by the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 act required that firms issuing new stock register and disclosure financial information about the issue, and included antifraud provisions. The 1934 act extended the disclosure requirements to publicly traded securities, and established the Securities and Exchange Commission (SEC) to administer and revise the securities regulations. The OTC market was not brought into the regulatory structure until the Maloney Act of 1938. The Securities Investor Protection Act of 1970 established the Securities Investor Protection Corporation (SIPC) to protect against failure of brokerage firms, similar to protections against bank failure. It is important to note that the SIPC does not protect against investment losses, only against losses due to failure of brokerage firms.
It is interesting to note that the disclosure requirements of the organized exchanges had an important impact on the field of public accounting, and that the 1933 and 1934 acts added the requirement that financial statements be audited by an independent accountant. The auditor's opinion and the acceptance of registration of a securities issue by the SEC are similar in that neither is an endorsement of investment value. Instead, both simply indicate that all required information is included and presented according to accepted standards. Judgment of investment value is left to the informed investor. Registration of a new issue is automatic unless the SEC specifically rejects the statement within 20 days. The 1934 act granted the SEC approval of commission rate changes and power to change and formulate trading rules. It left the SEC out of some areas, granting control over minimum margin to the Federal Reserve Board and discipline of exchange members to the exchanges. The resulting structure is one that relies heavily on self-regulation by the exchanges, and by the National Association of Securities Dealers for the OTC market. Several professional organizations, such as the Institute of Chartered Financial Analysts, also set forth ethical codes governing those holding the designation.
Insider trading is an important issue that has not been satisfactorily resolved. Insider trading is trading on private information about a firm that has not been released to the general public. As a form of control, the SEC requires that insiders such as corporate officers and directors of publicly held firms report all transactions in the firm's stock. While some cases of insider trading are clear, such as buying by a corporate officer based on knowledge of unannounced increased earnings, there is no exact definition of insider trading. Present interpretations involve not only the nature of the information, but how and by whom it was obtained. Accidental acquisition of confidential information does not confer a fiduciary obligation, and the information can be used. Simply holding inside information does not preclude trading if the information is part of an overall mosaic of reasoning behind the trade, but was not by itself the primary reason for the trade.
Since the days of buttonwood trading, the securities markets have been constantly changing. The introduction of the telegraph in the 1840s and the 1850s opened up trading on exchanges countrywide, and local newspapers began to list Wall Street price quotations. The 1870s saw the introduction of stock tickers and the telephone. In 1883 a two-page leaflet called the Customer's Afternoon Letter started publication; in July 1889 the leaflet was expanded and the name changed to the Wall Street Journal. The assets traded also changed, from mining and railroad stocks to industrial issues. After the market crash of 1929, trading practices changed remarkably, although trading did not recover to its previous level until the 1960s.
Recent changes have been perhaps even more rapid. As trading volume expanded during the 1960s Wall Street experienced a back office crisis. A number of firms failed because they were unable to keep up with the paperwork. Trading by institutions began to increase, and these institutions began to work outside the usual market procedures to avoid fixed commissions. In 1975, Congress passed the Securities Act Amendments. The amendments obligated the SEC to block anticompetitive exchange rules, precluded fixed commissions, and mandated the development of a National Market System (NMS). Although various steps have been taken that have resulted in closer integration of the markets, the controversy over how to achieve the NMS continues. The role of the specialist has been challenged by those who point to the OTC and to foreign markets such as the Tokyo exchange as proof that the specialist is an anachronism.
Regulation is only one source of pressure for change, however, and competition and technological innovation may be a bigger factor. Quotes from, and rapid execution on, all of the U.S. exchanges are available online. This has led to the phenomenon of "day traders," individuals who trade online on a very short-term basis, often changing position in a stock within minutes. While for various reasons these arrangements are still of relatively low trading volume, that volume is increasing rapidly. The presence of the alternatives itself is a powerful force. Although computer trading moves through the existing market system, it is likely that trading will become more direct, and the impact on the market structure is uncertain. Computerization and electronic communication makes trading on foreign exchanges not only feasible but easy, and, for some purposes, preferable. While on a year-to-year basis change may seem slow, it is likely that the next decade will see major changes in trading mechanisms and practices.
[ David E. Upton ]
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