15 The Functioning of Financial Markets
15 The Functioning of Financial Markets
15 The Functioning of Financial Markets
THE FUNCTIONING OF
FINANCIAL MARKETS
by Larry Harris, PhD, CFA
LEARNING OUTCOMES
f Compare long, short, and leveraged positions in terms of risk and poten-
tial return;
INTRODUCTION 1
Have you have ever bought shares, bonds, or invested money in a mutual fund? If
so, you have—whether you realise it or not—been served by financial markets. Many
investors use financial markets to implement their investment decisions, as reflected
by the trillions of financial market transactions each year.
Investors buy and trade securities that are issued by companies and governments
that need to raise capital. Markets in which companies and governments sell their
securities to investors are known as primary markets. Each type of security has its
own primary market. For example, in most countries, there is a primary market for
shares issued by companies or bonds issued by the sovereign (national) government.
Investors also trade securities, such as shares and bonds, as well as contracts, such
as futures and options. These trades take place in secondary markets. When trading
securities and contracts in secondary markets, investors often obtain assistance from
trading services providers, such as brokers and dealers. These specialists perform a
variety of tasks, which were described in the Structure of the Investment Industry
chapter.
offered consist of new shares issued by the company and may also include shares that
the founders and other early investors in the company want to sell. The IPO provides
founders and other early investors with a means of converting their investments into
cash, a process known as monetising.
The selling of new shares by a publicly traded company subsequent to its IPO is
referred to as a secondary, or seasoned, equity offering. Both initial public and sea-
soned offerings occur in the primary market for a particular type of securities—for
instance, the primary market for corporate bonds. Later, if investors buy and sell this
type of securities from and to each other, they do so in the secondary market. Note
that the issuer only receives additional capital when it issues new securities in the
primary market. It will not receive any new capital from the trading of its securities
in the secondary market.
Primary Secondary
Market Market
Issuer Investor Issuer Exchange/ Investor
The issuer receives Broker
no cash (capital) in
Cash secondary market Cash (Buyer) or
(Capital) transactions. Securities (Seller)
Before a public offering, the issuer typically provides detailed information about its
business and inherent risks as well as the proposed uses for the money it hopes to
raise. This information is offered in the form of a prospectus to potential investors.
Most exchanges and their regulators have detailed rules regarding the format and
content of a prospectus.
Companies generally contract with investment banks to help them sell their securities
to the public. Investment banks play an important role in identifying potential investors
and setting the offering price—that is, the price at which the securities are sold. The
role played by investment banks is different, however, depending on whether it is an
underwritten offering or a best efforts offering.
The most common offering type for initial public and seasoned offerings is an under-
written offering. In an underwritten offering, the investment bank acts as an under-
writer. In this role, the investment bank buys the securities from the issuer at a price
that is negotiated with the issuer, thus guaranteeing that the issuer gets the amount
of capital it requires. The securities are then sold at an agreed-on offering price to
investors. The objective of the investment bank is not to become a long-term share-
holder of the issuer but to be an intermediary between the issuer and the investors
for a fee. Finding investors willing to buy the securities is thus an important aspect
of an underwritten offering because it reduces the risk that the investment bank is
unable to resell all the securities it bought from the issuer.
In a process called book building, the investment bank identifies investors who are
willing to buy the securities. These investors are known in the industry as subscribers.
The investment bank tries to build a book of orders from clients or other interested
buyers to whom they can resell the securities.
Primary Security Markets 347
In the book building process, the right offering price is particularly important. If
there are not enough buyers for all the securities that are for sale, the offering is said
to be undersubscribed. If there is more demand than securities for sale, the offering
is said to be oversubscribed. In the case of oversubscription, the securities are often
allocated by the investment bank to preferred clients or on a pro rata basis, by which
all investors get a set proportion of the shares they ordered.
In the case of undersubscription, the investment bank will be left with unsold secu-
rities, which not only commits capital for longer than expected but is also risky. If
after the public offering, the price of the securities falls below the offering price, the
investment bank may face a loss. So, investment banks have a conflict of interest with
respect to the offering price in underwritten offerings. As agents for the issuers, they
should price the issue to raise the most money for the issuer. But as underwriters,
they have strong incentives to choose a lower price because it reduces the risk of
the offering being undersubscribed. Underwriters can also allocate these essentially
“underpriced” securities to benefit their clients, a process that indirectly benefits the
investment bank.
First-time issuers may accept lower offering prices because they are concerned about
the possibility of the issue being undersubscribed. Many believe that an undersub-
scribed IPO conveys unfavourable information about a company’s prospects at a time
when the company is most vulnerable to public opinion about its future. The issuer
may fear that an undersubscribed IPO will reduce the benefits of going public, such
as the opportunity to raise capital in subsequent offerings and the positive publicity
associated with a successful IPO.
In an IPO, the underwriter usually promises to ensure that the secondary market for
the securities will be liquid. If necessary, the underwriter provides price support for
a limited period of time, typically about a month. During that time, if the price of the
securities falls below a certain threshold, the underwriter will buy securities to stop
or limit the price fall. Providing price support is costly to investment banks, and it is
another factor that motivates them to choose a lower offering price so that the secu-
rity’s price in the secondary market rises immediately following the IPO. However,
price support does not guarantee that the security’s price will not fall. For example,
the price of Facebook’s shares declined substantially in the weeks that followed the
company’s IPO in 2012, despite price support from the underwriters.
Pricing is less challenging in a seasoned offering because the issuer’s securities already
trade in the secondary market. Thus, it is easier to identify an appropriate price for the
offering. The fees charged for a seasoned offering are lower than for an initial public
offering because there is less risk.
A single investment bank may not have the distribution network, capital, or risk appe-
tite to organise a large offering, so large offerings are often organised by a syndicate
that includes several investment banks. The syndicate helps the investment bank that
leads the offering (known as the lead underwriter) to build the book of orders. The
issuer pays the investment banks an underwriting fee for all these services.
In a best efforts offering, the investment bank acts only as a broker and does not
assume the risk associated with buying the securities. If the offering is undersubscribed,
the issuer will sell fewer securities and may not be able to raise as much capital as it
had planned.
Participant Role
Issuer Makes new shares or shares held by the founders and other
early investors available for sale to the public.
Provides detailed information about its business and inherent
risks as well as the proposed uses for the funds.
Investment bank Identifies investors who are willing to buy the securities and
helps sell the securities to the public.
Underwritten offering
Buys the securities from the issuer at a price that is negoti-
ated with the issuer and then resells them to investors at the
offering price. This effectively guarantees that the issuer gets
the amount of capital it expects.
In an initial public offering, it also promises to ensure that
the secondary market for the securities will be liquid and to
provide price support for a limited period of time.
Best effort offering
Only acts as a broker of the offered securities and does not
assume the risk associated with buying the securities.
Syndicate Helps the lead underwriter build the book of orders.
Companies sometimes sell new issues of seasoned securities directly to the public over
time via shelf registrations. In a shelf registration, the company provides the same
detailed information that it would for a regular public offering. However, in contrast
to a seasoned offering in which all the shares are sold in a single transaction, a shelf
registration allows the company to sell the shares directly to investors over a longer
period of time. Shelf registrations provide companies with flexibility on the timing of
raising capital, and they can alleviate the downward pricing pressures often associated
with large secondary offerings.
Investors in private placements are expected to have sufficient knowledge and expe-
rience to recognise the risks that they assume, so most countries require less disclo-
sure for private placements than for public offerings. Thus, private placements allow
quicker access to capital with less regulatory oversight and lower cost of regulatory
compliance than public offerings.
Issuers can raise money in the primary markets at a lower cost when their securities
can be traded in liquid secondary markets. Investors value liquidity because they
may need to sell their securities quickly to raise cash. So investors will pay less for
securities that are difficult or costly to sell (illiquid) than for those that are easy to sell
(liquid). Because securities offered in a private placement do not trade in a secondary
Primary Security Markets 349
market like securities offered in a public offering, investors are willing to pay less
for the former than for the latter. In other words, investors generally require higher
returns for securities issued via private placements than for the same securities issued
via public offerings.
Private
Placement
Qualified
Issuer Investors
Capital
Because rights do not need to be exercised, they are options—one of the types of
derivative instruments presented in the Derivatives chapter. The exercise price of the
rights is typically set below the current market price of the shares so that buying shares
by exercising the rights is immediately profitable—that is, an existing shareholder can
pay the exercise price and get shares that can immediately be sold at a higher market
price for a profit. Accordingly, most rights are exercised.
Existing shareholders who do not want to exercise their rights will be “diluted”—that
is, their proportional ownership will decrease because they will hold the same number
of shares in a company that now has more shares outstanding. By selling their rights
to others who will exercise them, they receive compensation for the decrease in their
proportional ownership. Shareholders generally dislike rights offerings because they
must provide additional capital to avoid dilution or sell their rights and experience
dilution of ownership.
3 TRADING VENUES
So far in this chapter, we have described how primary markets operate; the rest of
the chapter focuses on secondary markets and how they help investors buy and sell
securities. In secondary markets, securities trade among investors, and there is thus
a need for a trading venue—either physical or electronic—where orders can be placed
and trading among investors can occur. Orders are instructions that investors who
want to trade give trading service providers, such as brokers and dealers, who are
discussed in the Structure of the Investment Industry chapter.
This section discusses exchanges and alternative trading venues and then compares
them.
3.1 Exchanges
Securities exchanges, or exchanges, are where traders can meet to arrange their
trades. Historically, brokers and dealers met on an exchange floor to negotiate trades.
Increasingly, exchanges now arrange trades based on orders that brokers and dealers
submit to them electronically. These exchanges essentially act as brokers, blurring the
distinction between exchanges and brokers.
The main distinction between exchanges and brokers is their regulatory operations.
Most exchanges regulate their members’ actions when trading on the exchange and
sometimes also away from the exchange. Brokers generally regulate trading only in
their brokerage systems.
Many exchanges also regulate the issuers that list on the exchange, generally requiring
timely financial reporting and disclosure. Financial analysts use this information to
value the securities traded on the exchange. Without such information, valuing secu-
rities would be difficult and market prices might not reflect the fundamental values
of the securities. Recall from the Structure of the Investment Industry chapter that
a security’s fundamental value is the value that would be placed on it by investors if
they had a complete understanding of the security’s investment characteristics. When
market prices do not reflect fundamental values, well-informed participants can profit
from less-informed participants. To avoid losses, less-informed participants withdraw
from the market, which is detrimental not only to the investment industry but also
to the wider economy.
Exchanges also attempt to ensure that companies are run for the benefit of all share-
holders and not to promote the interests of controlling shareholders who lack significant
economic stakes in the company. For example, some exchanges prohibit companies
from concentrating voting rights in the hands of a few shareholders who do not own
a proportionate share of the company’s equity.
Exchanges derive their regulatory authority from their national or regional govern-
ments or through voluntary agreements by their members and their issuers. In most
countries, regulators created by the national government oversee exchanges. Most
countries also have regulators that impose financial disclosure standards on public
issuers.
Trading Venues 351
Exchanges charge fees for their services. They may charge the buyer, the seller, or
both parties a transaction fee, which is essentially a commission for facilitating trades.
Transaction fees and other transaction costs are further discussed in Section 8.
Many alternative trading venues permit only certain traders or types of traders to
use their trading systems, and each of them has its own rules. Most alternative trad-
ing venues allow institutional traders to trade directly with each other without the
intermediation of dealers or brokers, which makes them lower-cost trading venues.
Some alternative trading venues are known as dark pools because of their lack of
transparency. Dark pools do not display orders from clients to other market partici-
pants. Large institutional investors may transact in dark pools because market prices
often move to their disadvantage when other traders know about their large orders.
Electronic trading systems have greatly decreased the costs of arranging trades. The
lower costs of trading have increased trading volumes, and investors now use many
investment strategies that were previously too expensive to implement.
An important distinction between exchanges and alternative trading venues is the reg-
ulatory authority that exchanges exert over users of their trading systems. Alternative
trading venues only control the conduct of subscribers who use their trading systems.
Another distinction among trading venues is related to trade transparency. A market
is said to be pre-trade transparent if the trading venue publishes real-time data about
352 Chapter 15 ■ The Functioning of Financial Markets
quotes and orders. Quotes are prices at which dealers are prepared to buy and sell
securities and are discussed in Section 6. Markets are said to be post-trade transparent
if the trading venue publishes trade prices and sizes soon after trades occur.
Secondary markets are organised either as call markets or as continuous trading mar-
kets. In a call market, participants can arrange trades only when the market is called,
which is usually once a day. In contrast, in a continuous trading market, participants
can arrange and execute trades any time the market is open. Most markets, including
alternative trading venues, are continuous.
Buyers can easily find sellers and vice versa in call markets because all traders interested
in trading (or orders representing their interests) are present at the same time and
place. Trading venues that are call markets have the potential to be very liquid when
they are called, but they are completely illiquid between calls. In contrast, traders can
arrange and execute their trades at any time in continuous trading markets.
There are three main types of market structures for trading: quote-driven, order-
driven, and brokered markets.
Because rules match buyers and sellers, trades are often arranged among complete
strangers. Order-driven markets thus must have settlement systems to ensure that
buyers and sellers settle their security trades and perform on their contract trades.
Otherwise, dishonest traders would not settle their obligations if a change in market
conditions made settlement unprofitable.
Brokers who are organising markets in unique assets try to know everyone who might
now or in the future be willing to trade such assets. These brokers spend most of their
time on the telephone and in meetings building their client networks.
POSITIONS 5
A position refers to the quantity of an asset or security that a person or institution
owns or owes. An investment portfolio usually consists of many positions.
Investors are said to have long positions when they own assets or securities. Examples
of long positions include ownership of shares, bonds, currencies, commodities, or real
assets. Long positions increase in value when prices rise. In contrast, positions that
increase in value when prices fall are called short positions. To take short positions,
investors must sell assets or securities that they do not own, a process that involves
borrowing the assets or securities, selling them, and repurchasing them later to return
them to their owner. Section 5.1 describes this short-selling process more thoroughly,
and Section 5.2 discusses leveraged positions.
354 Chapter 15 ■ The Functioning of Financial Markets
The potential gains in a long position generally are unlimited. For example, the share
prices of successful companies can increase many times over. But the potential losses in
a long position are limited to 100%—a complete loss of the initial investment—unless
the position is financed by borrowings (debt). We will discuss leveraged positions in
the next section.
The potential gains and losses in a short position are mirror images of the potential
losses and gains in a long position. In other words, the potential gains in a short
position are limited to 100%, but the potential losses are unlimited. The unlimited
potential losses make short positions potentially highly risky.
Although security lenders may believe that they still own the securities they lend, this
is not the case during the period of the loan. Instead, security lenders own promises
made by the short sellers to return the securities. These promises are recorded in
security lending agreements. These agreements specify that the short sellers will pay
the security lenders all dividends or interest that they otherwise would have received
had they not loaned their securities. These payments are called payments in lieu of
dividends or of interest.
Security lending is subject to the risk that one of the parties to the contract will fail
to honour their obligation, a risk called counterparty risk. To limit counterparty risk,
security lenders require that short sellers leave the proceeds of the short sale on deposit
with them as collateral for the loan. Collateral refers to assets that a borrower pledges
to the lender. Security lenders run the risk that short sellers will fail to return the
securities if their price rises. Thus, short sellers must provide additional collateral to
secure the loan following an increase in the price of the securities. In contrast, short
sellers run the risk that security lenders will fail to return the collateral if the price of
the securities falls, so security lenders must return some of the collateral following a
decrease in the price of the securities.
Buying securities on margin increases the potential gains or losses for a given amount
of equity in a position because the buyer can buy more securities using borrowed
money. The use of leverage allows buyers to earn greater profits when prices rise.
But, equally, a buyer who has leveraged a position suffers greater losses when prices
fall. Buying securities on margin thus increases the risk of investing in the securities.
Investors usually borrow the money from their brokers. The borrowed money is called
a margin loan, hence the reference to buying on margin. The maximum amount an
investor can borrow is often set by the government, the trading venue, or another
trading services provider, such as a clearing house. In practice, though, a broker may
only be prepared to lend an investor less than that maximum amount, particularly if
the broker wants to limit its exposure to a certain investor. The loan does not have a
set repayment schedule and must be repaid on demand. As with any loan, the borrower
must pay interest on the borrowed money.
The leverage ratio is the ratio of a position’s value to the value of the equity in it. It is a
useful measure because it indicates the effect of the return on the equity investment,
as illustrated in Example 1.
EXAMPLE 1
But if Toyota’s share price falls by 10%, the return on the equity investment
will be –25%. That is, a loss of 25%, or 2.5 times the loss on a debt-free position.
This example shows that by buying shares on margin with a leverage ratio of
2.5, the investor magnifies the return, both positive and negative, on her equity
investment by 2.5. These calculations do not count interest on the margin loan
and commission payments, both of which lower realised returns.
356 Chapter 15 ■ The Functioning of Financial Markets
Some investors, including hedge funds and investment banks, get into trouble when
they use leverage. In an attempt to obtain greater profits by borrowing to increase
their positions, they often underestimate the risks to which they are exposed. If prices
move against their positions, their losses can put them into financial distress or, in
extreme cases, bankruptcy.
6 ORDERS
When investors want to trade a security, they issue an order that will be directed to
a chosen trading venue. All orders specify what security to trade, whether to buy or
sell, and how much should be bought or sold. In addition, most orders have other
instructions attached to them, including order execution, exposure, and time-in-force
instructions, discussed in Sections 6.1, 6.2, and 6.3, respectively.
In quote-driven markets, the prices at which dealers are willing to buy from investors
or other dealers are called bid prices, and the prices at which they are willing to sell
are called ask prices (or offer prices). The ask prices are invariably higher than the
bid prices.
Dealers may also indicate the quantities that they will trade at their bid and ask prices.
These quantities are called bid sizes for bids and ask sizes for offers. Depending on
the trading venue, these quotation sizes may or may not be exposed to other traders
or dealers in that market.
Dealers are said to quote a market when they expose their bids and offers. They often
quote both bid and ask prices, in which case they quote a two-sided market. The high-
est bid in the market is the best bid and the lowest ask in the market is the best ask.
The difference between the best bid and the best offer is the market bid–ask spread.
The market bid–ask spread is generally smaller than dealers’ bid–ask spreads (it can
never be more) because dealers often quote better prices on one side of the market
than on the other. Accordingly, the bids and asks that are the best bid and best ask in
the market often come from different dealers.
■■ A market order instructs the broker or trading venue to obtain the best price
immediately available when filling the order.
■■ A limit order also instructs the broker or trading venue to obtain the best price
immediately available when filling the order, but it also specifies a limit price—
that is, a ceiling price for a buy order and floor price for a sell order. A trade
cannot be arranged at a price higher than the specified limit price when buying
or a price lower than the specified limit price when selling.
Orders 357
Market orders generally execute immediately if other traders are willing to take the
other side of the trade. The main drawback with market orders is that a market buy
order may fill at a high price and a market sell order may fill at a low price. The filling
of orders at disadvantageous prices is particularly likely when the order is placed in
a market for a thinly traded security or when the order is large relative to normal
trading activity in the market.
Buyers and sellers who are concerned about the possibility of trading at unacceptable
prices add limit prices to their orders. The main problem with limit orders is that
they may not execute. Limit orders do not execute if the limit price on a buy order is
too low or if the limit price on a sell order is too high. For example, if an investment
manager submits a limit order to buy at €20 and nobody is willing to sell at or below
€20, the order will not be filled.
Whether traders use market orders or limit orders when trying to arrange trades
depends on whether their main concerns are about price, trading quickly, or failing
to trade. On average, limit orders trade at better prices than market orders when they
trade, but they often do not trade.
A stop order is an order for which a trader has specified a stop price—that is, a price
that triggers the conversion of a stop order into a market order. For a sell order, the
trader’s order may not be filled until a trade occurs at or below the stop price. After
that trade, the order becomes a market order. If the market price subsequently rises
above the sell order’s stop price before the order trades, the order remains valid. For
a buy order, the trader’s order becomes a market order only after a trade occurs at
or above the stop price.
Traders who want to protect their long positions often use stop orders that trigger
market sell orders if prices are falling with the hope of stopping losses on positions
that they have established. These stop orders are often called stop-loss orders.
Some order execution instructions specify conditions on size. For example, all-or-
nothing orders can trade only if their entire sizes can be traded. Traders can likewise
specify minimum fill sizes.
Note that there is nothing wrong or unethical about hiding an order. Traders with large
orders use hidden orders when they are afraid that other investors might trade against
them if they knew that a large order was in the market. In particular, large buyers fear
that they will scare sellers away if their orders are seen. Sellers generally do not want
to be the first to trade with large buyers because large buyers often push prices up.
Large buyers are also concerned that other buyers will be able to trade before them
by buying first to profit from any increase in price necessary to fill their large orders.
This increases the costs of filling large orders by taking buying opportunities away
from the large traders. Large sellers likewise fear that buyers will shy away from their
exposed orders and that other sellers will trade before them.
358 Chapter 15 ■ The Functioning of Financial Markets
■■ day orders, which can be executed only on the day they are submitted and are
cancelled at the end of that day;
Brokers and trading venues, especially those that arrange trades among strangers, gen-
erally need intermediaries to help traders clear and settle orders that have been filled.
7.1 Clearing
The most important clearing activity is confirmation, which is performed by clearing
houses. Before a trade can be settled, the buyer and seller must confirm that they
traded and the exact terms of their trade. Confirmation generally takes place on the
day of the trade and is necessary only for manually arranged trades. For electronic
trades, confirmation is done automatically.
To ensure that their members settle their trades, clearing houses require that mem-
bers have adequate capital and post margins. Margins are cash or securities that are
pledged as collateral. Clearing houses also limit the aggregate net quantities (that is,
buy minus sell) that their members can settle. In addition, they monitor their members
to ensure that these members do not arrange trades that they cannot settle.
This system generally ensures that traders settle their trades. The brokers and dealers
guarantee settlement of the trades they arrange for their individual and institutional
clients. The clearing members guarantee settlement of the trades that their clearing
clients present to them, and clearing houses guarantee settlement of all trades presented
to them by their clearing members. If a clearing member fails to settle a trade, the
clearing house settles the trade using its own capital or capital pledged by the other
members of the clearing house.
The ability to settle trades reliably is important because it allows strangers to confi-
dently contract with each other without worrying about counterparty risk. A secure
clearing system thus greatly increases liquidity because it vastly expands the number
of counterparties with whom a trader can confidently arrange a trade.
Clearing and Settlement 359
7.2 Settlement
Following confirmation, settlement may occur in real time (instantaneously) or it
may take up to three trading days. The settlement cycle refers to the timing of the
procedures used to settle trades and differs across markets. For example, in most
countries, stocks and bonds settle three trading days after negotiating a trade. The
seller must deliver the security to the clearing house and the buyer must deliver cash.
The settlement agent then makes the exchange in a process called delivery versus
payment. This process eliminates the losses that would occur if one party settles and
the other does not.
Many markets have reduced the length of their settlement cycles to reduce what is often
referred to as settlement risk, a form of counterparty risk in which one of the parties
fails to honour their obligation between the time a trade is negotiated and the time
the trade is settled—for instance, as a result of bankruptcy. The fewer unsettled trades
outstanding, the less damage occurs when a trader fails to settle. Also, the shorter the
settlement period, the fewer extreme price changes can occur before final settlement.
Once a trade is settled, the settlement agent reports the trade to the issuing company’s
transfer agent, which maintains a registry of who owns the company’s securities.
Most transfer agents are banks or trust companies, but sometimes companies keep
their own records and act as their own transfer agents. Companies need to maintain
databases about their security holders so they know who is entitled to any interest
and dividend payments, who can vote in corporate elections, and to whom various
corporate communications should be sent.
Exhibit 2 shows the life of a trade from order to settlement/closure. An order for a
trade is placed by one party. For the trade to execute and settle, another party has to
be willing to take the other side of the trade. Throughout the life of a trade, various
people within the firm receiving the order will be involved. These include people taking
the order, executing the order, and accounting for the order/trade.
360 Chapter 15 ■ The Functioning of Financial Markets
Order Placed
No Yes
Market
Order?
No Yes
Order
Remains
Open?
No
Order Closed Order Settled
* This assumes the order is one for which the trade is approved. For example, the order’s magnitude
is within approved limits for the trader. Generally, market orders will be executed. The exceptions
occur when there are liquidity issues.
Peter Robinson, an asset manager for Aus Ltd., wants to buy 1 million shares
in a company that is listed on a stock exchange in the Middle East.
The order is filled and financial settlement takes place. A record of the
transaction is then sent to James Armistead, who works for Big Bank Financial
Services, a custodian bank. It provides safekeeping of assets, such as the shares
purchased by Aus Ltd. Big Bank Financial Services keeps a record of the security
and the price paid, and this record is available—usually online—so that Aus
Ltd. Can prove it owns the shares and can include them in its accounts.
Transaction Costs 361
Settles Order
and Keeps Record
Custodian
Bank
TRANSACTION COSTS 8
Trading is expensive. The costs associated with trading are called transaction costs
and include two components: explicit costs and implicit costs.
Most market participants employ brokers to trade on their behalf. They pay their
brokers commissions for arranging their trades. The commissions are usually a fixed
percentage of the principal value of the transaction or a fixed price per share, bond,
or contract.
The commissions compensate brokers for the resources they use to fill orders. Brokers
must maintain order routing systems, market data systems, accounting systems,
exchange memberships, office space, and personnel to manage the trading process.
These are all fixed costs. Brokers also pay variable costs, such as exchange, regulatory,
and clearing fees, on behalf of their clients. Traders who do not trade through brokers
pay the fixed and variable costs of trading themselves.
■■ bid–ask spreads
362 Chapter 15 ■ The Functioning of Financial Markets
■■ price impact
■■ opportunity costs
Market participants use various techniques to reduce their transaction costs. They
employ skilful brokers, use electronic algorithms to manage their trading, or as men-
tioned before, use hidden orders or dark pools so other market participants cannot
see their orders and exploit them.
Summary 363
Most brokers and large institutional traders conduct transaction cost analyses of their
trades to measure the costs of their trading and to determine which trading strate-
gies work best for them. In particular, these studies help large institutional investors
better understand how their order submission strategies affect the trade-off between
transaction costs and opportunity costs.
The following are the three types of efficiency that ultimately contribute to efficient
financial markets:
SUMMARY
Financial markets that function efficiently benefit all investors by keeping transaction
costs low and allowing investors to trade financial instruments easily.
Some important points to remember about financial markets include the following:
■■ Issuers sell their securities and raise capital in primary markets. The securities
then trade in secondary markets among investors.
364 Chapter 15 ■ The Functioning of Financial Markets
■■ Other ways to issue securities in the primary markets are through private
placements or rights offerings. In a private placement, companies sell securities
directly to a small group of investors, usually with the assistance of an invest-
ment bank. In a rights offering, companies give existing shareholders the right
to buy shares in proportion to their holdings at a price that is typically set below
the current market price of the shares, thus making the exercise of the rights
immediately profitable.
■■ Liquid secondary markets reduce the costs of raising capital because investors
value the ability to sell their securities quickly to raise cash.
■■ Exchanges are the most common type of trading venue, but alternative trad-
ing venues, which have their own rules, have gained in popularity. The two
main distinctions between exchanges and alternative trading venues are that
exchanges typically have regulatory authority and more trade transparency than
alternative trading venues.
■■ When investors borrow some of the purchase price to buy securities, they are
said to buy securities on margin and leverage their positions. Leveraged posi-
tions expose investors to more risk and higher potential gains and losses than
otherwise identical debt-free positions.
■■ Orders are instructions to trade. They always specify what security to trade,
whether to buy or sell, and how much should be bought or sold. They usually
provide several other instructions as well, such as execution instructions about
Summary 365
how to fill an order; exposure instructions about whether, how, and by whom an
order should be seen; and time-in-force instructions about when an order can
be filled.
■■ Market orders are instructions to obtain the best price immediately available
when filling the order. They generally execute immediately but can be filled at
disadvantageous prices. A limit order specifies a limit price—a ceiling price for
a buy order and a floor price for a sell order. They generally execute at better
prices, but they may not execute if the limit price on a buy order is too low or if
the limit price on a sell order is too high.
■■ Stop orders specify stop prices; the order is filled when a trade occurs at or
above the stop price for a buy order and at or below the stop price for a sell
order. Traders often use stop orders to stop losses on their long positions.
■■ Intermediaries help traders clear and settle orders that have been filled. The
most important clearing activity is confirmation, which is performed by clearing
houses. Settlement follows confirmation; at settlement, the seller must deliver
the security to the clearing house and the buyer must deliver cash.
■■ The costs associated with trading are called transaction costs and include two
components: explicit costs and implicit costs. Brokerage commissions are the
lowest explicit trading cost. Implicit trading costs result from bid–ask spreads,
price impact, and opportunity costs. Traders usually choose order submission
strategies that minimise transaction costs.