GENERAL ORGANIZATION OF SECURITIES MARKETS

GENERAL ORGANIZATION OF SECURITIES MARKETS

·         Primary Market

• Market for first hand securities


• Securities are issued in two ways;


• Private placement


• Issuing securities to less number of institution and individuals (maximum number is specified in the respective act; in case of Nepal, as provisioned by Companies Act, 2006, securities can be issued to less than 50 institutions or individual through private placement)


• Issued on negotiation through letter or telephone or personal contact 


• Public offering


• Basic three types of public offering


• Initial public offering (IPO): Issuing securities to the public for the first time by the company


• Further public offering (FPO): Another public offering after having IPO


• Rights offering: Offering securities to the existing shareholders

·         Secondary Market

• Stock exchanges


• Over-the-Counter (OTC) Markets


• Third and Fourth Markets

Stock Exchanges

·         Centralized trading system

·         Trading through member of stock exchange; (Members: Dealer and Brokers)

• Members: two types of members


• Dealers: who trade on their own account maintaining bid ask spread


• Brokers: who do not trade on their own account


• Open client account


• Collect orders from its clients


• Quote on the floor for transaction


• Report transaction

·         Standard Rules: Listing rules/fees, standard system of trading and clearing and settlement, trading commission, trading hours etc.

·         Information Disclosure System and Supervision Mechanism

·         Advantages:

• Better price discovery


• Better liquidity

·         Examples; NYSE, LISE, TSE, BSE, NEPSE etc.

Over-the-Counter (OTC) Markets

·         Stocks of companies that can not fulfill the listing criteria of stock exchanges are traded

·         Differ with stock exchange with respect to that;

• It doesn't rely on central trading place and market is made up of people in diverse locations


• Instead of brokers/dealers; there are market makers making market in particular stocks


• Members of securities dealers are allowed to trade in the OTC market


• Trading through electronic communication network; Securities Dealers Automated Quotation


• Examples: NASDAQ, JASDAQ, KOSDAQ, OTCEI (OTC Exchange of India) etc.

Informal Market Arrangements

·         Often called third and fourth markets

·         Market for large blocks of securities

·         A kind of OTC market where the stocks both listed and not listed in the stock exchanges are traded

·         Network of brokers/dealers that aggregate quotation information and provides inter-participants order routing tools, but leaves the order execution to the market participants

·         In the fourth market, trading could take place without intervention of the brokers/dealers

·         Concept of such markets developed due to fixed commission nature of stock exchanges and the OTC markets

Dealer and Auction Markets

Dealer Market:

• Market made by dealers who quote prices at which they are willing to buy and sell


• Quote driven market


• Dealers are responsible in setting the price by maintaining bid ask spread

Bid price: Purchase price

Ask/offer: Selling price

• Greater the bid ask spread, greater the profit to dealers


• Greater bid ask spread also means low liquidity


• Price control:


• Dealers change prices as new information is available


• Does not change the prices in case of liquidity imbalance, rather they absorb the imbalance by buying and selling securities


• Benefit from liquidity traders and has always threat of loss from the information traders


• Liquidity traders: traders who trades for reasons unrelated to the price of security


• Information traders: who trade to profit from discrepancies between the market price and the fair price


• Short sale the securities


• All OTC markets are dealer market and some of the exchanges also have dealer market

Auction Market:

• Market in which the orders of traders are matched


• Also called order driven market


• Trading rules usually are as follows


• The first bid or offer at a given prices has priority over any other bid or offer at the same price


• The high bid and low offer have the floor


• A new auction begins whenever all the offers or bid at a given prices exhausted


• Secret transactions are prohibited


• Bid and offer must be made in an audible voice


• Price is established by competitive bidding between brokers acting as an agent for buyers and sellers


• Price is influenced by buy orders and sell orders


• Higher the buy orders, price will go up and vice versa


• Prices of securities rises and falls in response to the new information and liquidity imbalances


• Information traders can play to stabilize the price due to liquidity imbalances


• High supply – low price -→ buy and hold and sell when imbalance passes


• Price control mechanism


• Price changes slowly than in dealer market as they are not set by the market makers so can’t change until they are changed by trading


• Price fluctuation limit and circuit breakers


• E.g., NEPSE: 5 percent from previous close and 2 percent from latest trading price (LTP) and circuit breaker in 10 percent


• Basic two types of orders


• Market Order


• to buy or sell at most profitable prices


• Execute quickly


• Limit order


• Customer specifies maximum price to buy or minimum price to sell


• Other types of orders are


• Stop order: Sell stock if price drops to specified price (to protect from rapid loss) or reach to specified price


• Stop limit order: Maximum to buy and minimum to sell


• Fill or kill: Cancel if not executed immediately


• Market if touched order: A sell order entered above the current price


• Not-held order: Market order that gives brokers to delay if they think they can get a better price.


• Specific-time order:


• At-the-opening (ATO)


• On-the-close


• Day order: (expires at the end of the day)


• Good-till-cancelled (GTC)

SECURITIES MARKETS:

SECURITIES MARKETS:

·         Important part of efficient financial system

·         Offer financial intermediation for debt, equity and other securities instruments ensuring greater competition among financing sources and thereby greater efficiency

·         facilitate the sale and resale of transferable securities

·         Addresses the basic three mismatches among the savers and borrowers (Company) in the economy in the following manner

                1.             Size mismatch:

                                Companies always want to raise large amount (large size) of fund while individual savers always have small amount to invest. Securities market reconciles this mismatch by permitting aggregation of a large number of small investors in to the large sums required by the borrowing companies through securities issue.

                2.             Duration mismatch:

                                Borrowers (entrepreneurs) always want permanent capital or capital for the longer term while savers invest for short period and want to have easy exit or liquidity in the investment. Securities market providing the secondary trading mechanism for the issued securities provides easy exit mechanism for the investors.

                3.             Cost/Return mismatch:

                                Borrowers want to raise funds at low cost while investors want to have high return on their investment. The standardized process in the securities market in one hand reduce the cost of raising fund to the borrowing company to a great extent which in turn will increase corporate profit that ultimately distributed to the investors (Shareholders) in the form of dividend or other means. On the other hand when the corporate profit increases the price of securities of that company will increase in the market thus providing price appreciation to the investors in the securities.

·         Includes both money market and capital market

·         Money market: Market for short term securities;

·         Capital markets: Markets for corporate equities and long term debt

·         Categorized into;

·         Primary market: Market for first hand securities

·         Secondary market: Market for existing securities

·         Major securities markets are;

·         Stock Markets

·         Corporate Debt Markets

·         Government Securities Markets

·         Municipal Bond Markets

·         Depository Receipt Markets

·         Mortgage- and Asset-Backed Securities Markets

·         Financial Derivative Markets

FUNCTIONS OF SECURITIES MARKETS

·         There are three basic functions of securities markets;

·         Price discovery

·         Liquidity provision

·         Minimization of trading cost

1.         Price discovery:

·         Price discovery: process of reaching a fair prices for securities

·         Fair price of securities are discovered by the interaction among the buyer and seller of securities

·         Bid and offer price depends on the expectation of future payments and evaluation of the risk involved in the securities

• basis for expectation and evaluation is information


• market should ensure flow of credible information


• Price of same securities differ due to difference in evaluation and expectation of different people

·         Fair offer price: Lowest price at which any well informed traders is willing to sell the securities

·         Fair bid price: Highest price at which any well informed trader is will to buy the securities

·         Ideal market:

• Market in which all trades takes place at a fair price


• Price change immediately to reflect any new information

·         Price formation in auction market are driven by orders where buy and sell orders compete for the best price

·         In dealer market, price of the securities are quoted; so such markets are often called quote driven markets

2.         Liquidity provision

·         Liquidity is the ease of conversion of assets into cash; more specifically it is the ability to convert an asset into cash quickly and without loss

·         Consists of two basic factors

• marketability: conversion to cash


• Fair price: A fair value of securities on the basis of rational analysis of available information

·         The basic source of liquidity is pooling

• There is diversity among people regarding the holding of securities. Some want to convert their security into cash and some want to convert their cash into securities and to a greater extent these two groups can accommodate each other.


• Securities market pool those preference diversity of people in holding securities and make provision of liquidity

·         A situation where there is imbalance in the desire to cash the securities and the desire to exchange cash for securities, i.e. more of the one groups; is called liquidity imbalance

·         If the securities market provide good liquidity, the market price should not fluctuate in response to the temporary liquidity imbalance because we assume that an ideal market always form fair price of securities.

3.         Minimization of trading cost:

Lower the trading cost easier to trade and better the functions of price discovery and provision of liquidity

·         Various ways to reduce trading cost in an organized market

• Restricted access and rules of conduct


• Only authorized traders are allowed


• Rules governing the conduct of the traders


• Standardization


• Standard process of executing transaction, ownership transfer and payment


• Easy to understand the procedure, traders need to agree only on price and quantity


• Board lots/round lots


• Conflict Resolution


• Dispute are costly but obvious


• Agreement for resolving the conflicts minimizes costs.


• Mechanism for resolving conflicts e.g., Arbitrage Committee in NEPSE


• Guaranteed Execution


• Execution of transaction involves risk


• Cancellation may be costly

FINANCIAL SYSTEM

FINANCIAL SYSTEM

• Facilitate resource transfer and mobilizes savings to the productive sectors thereby contributing to the economic development


• Includes;

• Markets


• Institutions


• Instruments

Markets:

• Mechanism designed to facilitate the exchange of  financial assets by bringing buyer and seller together


• Provides channels and pricing mechanism through which flow of savings are allocated to the investment


• Can be classified in to Money and Capital Markets


• Participants are financial institutions, agents, brokers, dealers, borrowers, savers and many others

Institutions:

1.      Regulatory Institutions

• Regularly monitor markets and participants to ensure fairness, transparency and credibility in the market


• Also responsible for executing government policies


• Develop and implement various policies depending on the situation of the market


• Example; In Nepal: Central Bank (Nepal Rastra Bank)- banking regulator; Securities Board of Nepal- securities market regulator; Insurance Board, Company Registrar's Office; Institute of Chartered Accountants of Nepal etc.

2.      Market Intermediaries

·         Intermediate between investors and savers

·         Lend money as well as mobilize savings

·         Liabilities are towards ultimate savers and assets are from investors or borrowers

·         Can be classified in to:

• Banking: Commercial banks, finance companies and other depository institutions- collects deposits


• Non-bank Financial Institutions: Insurance Companies, Investment Companies (Securities Market Intermediaries: Issue Managers, Brokers, Dealers, Market Makers etc.), Mutual Funds, Pension Funds, Employee Provident Funds, Co-operatives, NGOs etc.

3.      Non-intermediaries

·         Perform loan business but their resources are not directly obtained from the savers

·         Created with the efforts of Government to provide assistance to the specific purpose, sectors or regions

·         Philosophy of creation is credit need of certain sectors can not be met by the private institutions

·         Example; Agriculture Development Bank, Nepal Industrial Development Corporation, Rural Development Banks

Instruments:

• Money Market Instruments: (Maturity less than one year)


• Treasury bills: Issued by the government


• Certificate of Deposits: NCDs are also traded in the secondary markets


• Commercial Papers: Issued by high rated companies


• Bankers’ Acceptance: Created to facilitate international trade


• Capital Market Instruments: (Long term maturities; more than one year)


• Government Bonds


• Corporate Securities: Corporate Bonds, Equities (Ordinary Shares, Preference Shares


• Mutual Funds

Others securities instruments: Municipal Bonds, Mortgage-Backed Securities, and Derivatives etc.

MARKET FAILURE AND NEED FOR GOVERNMENT INTERVENTION

MARKET FAILURE AND NEED FOR GOVERNMENT INTERVENTION

Market failure can be divided into two types;

i)                    Which has impact on efficiency

ii)                  Which has impact on stability

Government intervention is necessary to promote efficiency and maintain stability

1.   Efficiency:

·         A situation in which the sum of all gains from lending, payments and trade in risk are as large as possible

·         Major conditions for efficiency are;

o   Competitive pricing

o   Minimum transaction cost

o   Integration of market services

Competitive pricing

o   First condition for efficiency

o   Pricing that covers the cost of all resources used to produce a good or service but no more

Minimum transaction cost

o   Transaction cost absorbs the resources that could be put to better use

o   One way to attract more business and to increase profit is to find a way arranging transaction cost lower

o   Search for lower cost and for higher profit is driven by competition

Integration of market services

o   Operation of financial system such that similar loans are made on similar terms everywhere

o   Lack of integration may be the cause for inefficiency

Reasons for inefficiency

o   Economies of scale;

High economies of scale                low cost of production               small firms out of financial market

 

Inefficiency in financial system                                  competition minimized

o   Natural monopoly;

Natural monopoly              under little pressure to lower cost                    high cost

 

Market failure                          market inefficiency

Government intervention to promote efficiency:

i)                    Intervention to promote competition

-                Bring policies to prohibit anticompetitive practices such as curtailing (agreement not to compete)

-                Regulate monopoly; e.g. price is regulated

-                Nationalization; Government takeover of a firm or industry

ii)                  Intervention to lower cost and make trade feasible

2.   Stability:

·         Three types of instability observed so far in the financial system; panics, crashes and price level instability

Banking Panics

o   Financial intermediation create liquidity through pooling and nettang

o   For successful adoption of pooling and netting requires

• dIversification and


• confidence

and lack of any one breakdown pooling

o   Breakdown in poodijg leads to bank run and banking panics

Example;

De0ositors’ confidence erodes                  withdrawal of deposits             bank closedown or run           

 

Close down of all banks or banking panics                 chain effect in banking system

Securities market crisis

o   Secondary markets provide liquidity for holders of direct securities

o   A pool of investors holds claims to illiquid underlying assets

o   Secondary markets nets the claim on sells against purchase

o   If everyone wishes to liquidate, pooling becomes weak, which results to the sharp fall of prices that lead to market crash

o   Example; 1929 market crash in USA

Price level instability

o   Two types of price level instability;

• Inflation: continuous rise in price


• Deflation: continuous fall in price

o   Impact on lending

o   Example of hyper inflation: Germany, 1921-23; price doubled every two weeks; inflation at such rate is called hyper inflation.

Reason for financial system subject to instability:

o   Composition Problem:

• Problem that arise out of behavior that is sensible for a single individual but harmful if pursued by all individuals


• Example:


• Banks: withdrawal


• Securities market: tendency to sell


• Price level instability: when single bank increases or decreases lending and creates or destroys money- little effect; if all do so- may lead to price instability

o   Excessive risk taking:

Government intervention to promote stability:

i)                    Regulation:

§  Regulation of excessive risk taking

§  Put limitations on lending and borrowing

ii)                  Creation of institutions:

§  To regularly monitor the activities of specific institutions

§  E.g., Central bank looks after the working of banks and financial institutions; Insurance Board looks after the insurance companies; Securities Regulator monitors the activities in the stock market

iii)                Other types of government intervention:

§  Consumer protection: for example; provision for deposit insurance to protect the credit of depositors

§  Social policy:

• Equal credit opportunity policy


• Community re-investment policy

Failure of government intervention:

o   Intervention often serves special interest

§  Example; legislators may have interest in bringing specific laws

o   Intervention is costly

o   Intervention often does not work

§  Example; mechanism of deposit insurance may not work when there is crises in financial system as a whole