Fundamentals of Financial Instruments. Sunil K. Parameswaran

AND OVER-THE-COUNTER (OTC) MARKETS

      A securities exchange is an organized trading system where traders interact to buy and sell securities. Thus, a securities exchange is a secondary market for securities. Public traders cannot directly trade on these exchanges but are required to route their orders through a securities broker who is a member of the exchange. Historically, trading took place on a trading floor, where member brokers would congregate and seek to match buy and sell requests received from their clients. These days most exchanges are electronic markets. Traders do not get to interact face-to-face but are required to key in their orders into a computer terminal which conveys the orders to a central processing system. The procedure for matching and executing orders is coded into the software.

There are two types of orders that can be placed by an investor. In the case of market orders, investors merely specify the quantity they seek, with the understanding that they will accept whatever price is offered. However, investors who are very particular about the price they pay or receive will place what are known as limit orders. The limit orders require not only the specification of the quantity sought, but also a limit price. The limit price is a ceiling in the case of buyers, that is, it represents the maximum amount that the investor is willing to pay. In the case of sell orders, the limit price is a floor, which represents the lowest price at which the investor is willing to sell. To ensure that traders are given access to the best available prices, all limit buy orders are ranked in descending order of price, while limit sell orders are ranked in ascending order of price. This is known as the price priority rule. Thus, potential buyers are given access to the lowest price on the sell side while potential sellers are given access to the highest price on the buy side. If two or more limit buy or sell orders were to have the same limit price, then the order that came in first would be ranked higher. This is known as the time priority rule.

      The newer exchanges like EUREX in Frankfurt are fully automated electronic systems. Some of the older exchanges have changed with the times and have abandoned their trading rings or floors and have embraced electronic trading platforms. However, some of the other older exchanges continue to operate with a hybrid model. The New York Stock Exchange and the CME Group continue to run floor-based and screen-based trading platforms in parallel.

      An over-the-counter or OTC network is an informal network of securities brokers and dealers who are linked by phone and fax connections. Most deals on such markets tend to be institutional in nature and are of sizeable volumes. The foreign exchange market globally is an OTC market, and most of the trading in bonds also takes place on such markets.

BROKERS AND DEALERS

      A broker is an intermediary who arranges trades for clients by helping them to locate suitable counterparties. The broker's compensation is in the form of a commission paid by the client. Brokers do not finance the transaction, in the sense that they do not carry an inventory of the asset(s) being sought. They are merely facilitators of the trade, who receive a processing fee for the services rendered. Brokers are very common in real estate markets. For instance, if we were to contemplate the purchase of a house, we would approach a realtor, who will have a list of properties whose owners have evinced interest in selling. Realtors do not own an inventory of houses they have financed.

      A dealer, on the other hand, is a market intermediary who carries an inventory of the asset in which he is making a market. Thus, unlike a broker, a dealer has funds locked up in the asset. Effectively, a dealer takes over the trading problem of the client. If the client is seeking to sell, the dealer will buy the asset from them in anticipation of the latter's ability to resell it subsequently at a higher price. Similarly, when a client wishes to buy the asset, the dealer will sell the asset from their inventory in the hope of being able to replenish their stock subsequently at a lower price. Thus, in order to ensure profits from trading activities, a dealer has to be a master of the art of trading. In developed countries, dealers will usually specialize in narrow segments of the securities market. That is, some will handle Treasury bonds, while others may choose to specialize in municipal debt securities. This is because, considering the volumes of transactions, skill is of the essence, and even small errors could lead to huge losses, given the magnitude of the deals.

      How do dealers make money? Obviously, the price they quote for acquiring an asset will be less than the price at which they hope to sell to another party. The price at which a dealer is willing to buy from a client is called the bid and the price at which the dealer is willing to sell to a client is called the ask. The difference between the bid and the ask is called the bid–ask spread, or quite simply the spread. Dealers seek to make money by rapidly rotating their inventories. A purchase at the bid followed by a subsequent sale at the ask will result in a profit equal to the spread. Such a transaction is termed as a round-trip transaction. Dealers doing many round-trip transactions can survive on a lower spread. However, if transactions are few and far between, then the spreads will be high. In other words, if the volumes are high, then margins can be low. However, if the volumes are low, then the margins need to be high.

      Many dealers don the mantle of both brokers and dealers. Thus, in certain transactions they will act as trade facilitators who provide services in anticipation of a commission, while in other cases they will position themselves on one side of the trade, by either buying or selling securities. Such dealers are called dual traders. A transaction where the dealer functions merely as a broker is referred to as an agency trade. However, a trade where the dealer is one of the parties to the transaction is termed as a proprietary trade.

      Dealers who undertake to provide continuous two-way price quotes are referred to as market makers. Their role is to create a liquid secondary market. On the New York Stock Exchange (NYSE) there is only one market maker for a security. However, one dealer may make a market in multiple securities. This monopolist market maker is referred to as a specialist, and is also known as an assigned dealer because that role has been assigned by the exchange. When a company seeks to list its securities on the exchange, a number of potential market makers will express their desire to act as the specialist for the stock being introduced. They will be interviewed by representatives of the company as well as the exchange, and finally one of them will be selected as the specialist for that particular stock. There are also interdealer brokers who act as intermediaries for trades between market makers.

THE NEED FOR BROKERS AND DEALERS

      Why do we require market intermediaries such as brokers and dealers? The reason is that when investors seek to buy or sell assets in the secondary market, they have to locate a suitable counterparty. Thus, a potential buyer needs to locate a seller and vice versa. Second, not only should a counterparty be available, there should be compatibility in terms of price expectations of the two parties, and the quantity that each of them is seeking to transact. Every trader seeks to trade at a price that is good from their own standpoint. Buyers will therefore be on the lookout for sellers who are willing to offer securities at prices which are less than or equal to what they are willing to pay. Similarly, sellers will seek to locate buyers who are willing to offer a price which is greater than or equal to the price at which they are willing to sell. As we have explained earlier, limit orders are arranged in descending order of the limit price on the buy side and in ascending order of the limit price on the sell side. Thus, buyers are guaranteed access to the lowest prices quoted by sellers while sellers are guaranteed access to the highest prices quoted by buyers. In addition, it is important that the quantity on offer matches the quantity being demanded. Often a large buy or sell order may require more than one trader to take the opposite position before execution.

On an organized exchange it is necessary to go through a broker or a dealer for certain reasons. First, access to the exchange is provided to only registered brokers and dealers. For exchanges that are totally automated, only brokers and dealers will have terminals through which orders can be routed to the central processing system of the exchange. Thus, it is essential for a public trader to go through a licensed market intermediary. Of course, big institutional investors may be provided with order routing systems so that they can seamlessly send orders to the exchange via the intermediary. Similarly, Internet brokers facilitate the access of electronic exchanges