Securities

The study of stocks and the stock market must necessarily begin with defining what stocks are. Stocks are equity securities, signifying that the owners of such securities have an equity (ownership) position—a “piece of the action”—in a corporation. The two principal types of stocks are common stock and preferred stock. The first five chapters of this text deal with equity securities.

Bonds are debt securities. The bondholder has loaned money to the enterprise (corporation or government ) and has a debtor—creditor relationship with the issuer of the bonds rather than an ownership interest.

The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, votingtrust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ‘‘security’’; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.

The term ‘‘equity security’’ means any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.

The government securities market is at the core of financial markets in most countries. It deals with tradeable debt instruments issued by the Government for meeting its financing requirements.

The development of the primary segment of this market enables the managers of public debt to raise resources from the market in a cost effective manner with due recognition to associated risks. A vibrant secondary segment of the government securities market helps in the effective operation of monetary policy through application of indirect instruments such as open market operations, for which government securities act as collateral. The government securities market is also regarded as the backbone of fixed income securities markets as it provides the benchmark yield and imparts liquidity to other financial markets. The existence of an efficient government securities market is seen as an essential precursor, in particular, for development of the corporate debt market. Furthermore, the government securities market acts as a channel for integration of various segments of the domestic financial market and helps in establishing inter-linkages between the domestic and external financial markets.

The government securities market has witnessed significant transformation across countries over the years in terms of system of issuance, instruments, investors, and trading and settlement infrastructure. It has grown internationally in tune with the financing requirements of Governments. The fiscal discipline exercised by many countries in recent years has restricted the size of the market. Accordingly, countries have focused on improving trading liquidity of the market through various measures. Many countries in the recent past have pursued a strategy of managing the cost of Government borrowing in the medium to long-term so as to reduce the rollover risk and other market risks in the debt stock, although this may entail higher debt service costs in the short run. Historically, in most countries, the central banks as managers of public debt have played a key role in developing the government securities markets.

Although debt management authorities are increasingly being established outside the central banks in various countries, central banks continue to play a major role in developing the trading and settlement infrastructure of the government securities market.

Government Securities Market

Auction Pricing – Uniform versus Multiple

Pricing in an auction can be on a multiple price basis (also called American auction or discriminatory price auction) or a uniform price basis (also called Dutch auction). In any auction, buyers typically submit bids that specify a quantity and a price (or a yield) at which they wish to purchase the quantity demanded. Once submitted, these bids are ranked from the highest to the lowest price (or from the lowest to the highest yield) and the quantity for sale is awarded to the best bids (i.e., highest prices or lowest yields).

Under the uniform price auction, each successful bidder pays the lowest price accepted by the debt manager, i.e., all the successful bidders will pay the same price, irrespective of their actual bid price. Under the multiple price auction, however, each successful bidder will pay the actual price at which he has bid (even if the cut-off price arrived at the auction may be lower). This results in ‘winner’s curse’, whereby successful bidders pay more than the common market value of the security after auctions. Uniform price auctions lead to a better distribution of auction awards. Under this system, the participants tend to bid more aggressively without fear of ‘winner’s curse’. This is because they will get the securities issued at the price quoted by the lowest accepted bid and not the actual that they have bid, unlike in the case of multiple price auctions. Hence, uniform price auctions are expected to enhance market efficiency. An important disadvantage of the uniform price system, however, is that of indiscriminate or irresponsible bidding which may be out of alignment with the market, as bidders are sure to succeed at the most favourable rate.

Under multiple or discriminatory price auctions, bidders get differential rates in accordance with their need and assessment of price. This is likely to ensure greater commitment to bidding than in the uniform system. The intensity of demand in the market is also clearly reflected in the bidding pattern.

An alternative to these two mechanisms that has been used in Spain since January 1987 is the so-called ‘Spanish auction’. It is a hybrid system combining the features of both the uniform-pricing and the discriminatory-pricing mechanisms. Under the Spanish auction system, winning bids that are above the weighted average winning bid will have to pay the same price, viz., the weighted average winning bid, as in a uniform-price auction. Winning bids that are below the weighted average winning bid will have to pay fully, as in a discriminatory-price auction.

By modelling auction behaviour, some researchers found that uniform price auctions are unfavourable to the issuer in terms of revenues, whether bidders are risk neutral or risk averse (Wilson, 1979). Some other researchers, however, found that discriminatory auctions yield unique equilibrium with greater expected revenues than the uniform auctions if bidders are risk neutral (Back and Zender, 1993 and Wang and Zender, 2002). Wang and Zender also found that uniform price auctions have a more favourable impact on revenue if the bidders are risk averse and the number of bidders are large in relation to the supply. Uniform price auctions are, however, found to permit self-enforcing collusive bidding strategies (Back and Zender, 1993), particularly under perfect information if buyers are allowed to communicate with one another before the auctions take place (Goswami, Noe and Rebello, 1996).

Besides average revenue to the issuer, the choice of auction procedure may also affect the volatility of prices over time. Auction-to-auction volatility was found to increase significantly after the introduction of uniform pricing for select securities by the U.S. Treasury (Malvey, Archibald and Flynn, 1997). In the case of multiple price auctions, experiences indicate that volatility increases with the duration of assets (Sweden) and market uncertainty (Portugal) (Nyorborg, Rydqvist and Sundaresan, 2002 and Gordy, 1999). Experiments conducted on Spanish auctions show that both uniform and Spanish auctions raise significantly higher revenue than multiple price based auctions as the latter leads to less aggressive bidding than the other two. However, auction-to-auction volatility was higher both in uniform price and Spanish auctions compared to multiple price auctions (Abbink, Brandts and Pezanis-Christou, 2002). Thus, empirical evidence about the superiority of one type of auction over the other seems inconclusive. Cross-country experience shows that although both the methods are used, securities are mostly auctioned using discriminatory auction method.

Buying on Margin and Short Sales

Buying on Margin

• The investor borrows part of the purchase price of the stock from a broker
• Margin: portion of purchase price contributed by the investor

Stock Margin Trading

• Maximum margin is currently 50%; you can borrow up to 50% of the stock value
• Set by the Fed
• Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account
• Margin call: notification from broker you must put up additional funds

U.S. Securities Markets and the Banking System

Apart from government itself, the sector that benefited most from early U.S. securities markets was banking. Banks in the United States, unlike most banks in other countries at the time, were corporations that raised their banking capital by issuing equity securities, which were made all the more attractive to investors by the emergence of active trading markets in the 1790s. Moreover, almost as soon as these markets emerged, securities—both government debt and corporate stock—became useful as collateral for bank loans and objects of bank investment. Early in 1790, for example, the Massachusetts Bank accepted illiquid state securities and old U.S. securities as collateral for bank loans at only 25 percent of par value. When the new 6 percent securities appeared later that year, they could be collateralized at 50 percent of par. A year later, their collateral value had risen to 90 percent of par, and by mid-1792 they were accepted at par value as loan collateral (Davis 1917, vol. 2, p. 65). Colonial and Confederation America had not solved the problem of illiquidity in investment, most of which took the form of real and tangible personal property. The synergies of banks and securities markets released in the Federalist financial revolution led to an outpouring of liquid financial assets and in short order made this long-standing drag on U.S. economic potential disappear.

Increasing Financial Synergies: Banks And Securities-Market Loans

Myers, the historian of the New York money market, long ago drew attention to one aspect of the intimate connection of banks and securities markets that grew up early in U.S. history: The most distinctive feature of the present- day money market in New York is the call loan. The demand loan secured by stocks and bonds is a peculiarly American product, and it is important not only by reason of that fact, but also because it has always been closely linked with other parts of the money market. Upon the supply side it has been intimately connected with the reserves upon which the entire banking structure of the nation rested, so that banks were dependent upon the call loan market for funds in times of crisis. On the demand side, it formed the basis for the investment market, securing the funds with which it operated through the medium of call loans and building up the technique of stock trading around them . . . . Its relation to bank reserves was not assailed until the passage of the Federal Reserve Act in 1913, and its position in the speculative transactions of the Stock Exchange is still untouched (Myers 1931, p. 126).

Myers was not certain when the call-loan innovation developed, although she notes that it was well established under that name in the 1840s. In the 1830s, New York City newspapers published rates for temporary loans on stocks (Myers, chpt. VII). By the 1820s at the latest, New York City banks were holding substantial net balances of out-of-town banks, for purposes of banknote redemption and to provide New York City exchange for their customers, and the City’s banks reported loans on securities collateral to a near-identical amount (Myers, p. 128). It is likely that the practice of out-of-town banks keeping balances in New York City was nearly as old as the banking system. Wright (1996, p. 321) reports that almost as soon as it was organized in 1803, Albany’s New York State Bank deposited $40,000, a substantial chunk of its resources, in two New York City banks to provide for note redemption. It is likely that other country banks of New York State did so, too, and for the same reason—to give their notes greater currency. By the first years of the nineteenth century, New York was emerging as America’s leading port city. Imports arriving there were distributed throughout the country, which meant that out-of-town merchants needed New York exchange to pay for the goods. That is why banknotes were routed to New York City, why outof- town banks found it convenient to keep redemption funds there, and why out-of-town bankers’ balances in the city in excess of what was needed to redeem country bank notes were useful in providing bank customers with drafts payable in New York.

Another attraction was that New York banks were able to pay interest to bankers on balances held with them. Here the presence of the nation’s most active securities market was critically important. The securities market, as Myers noted, became a source of demand for loans to carry investments in stocks and bonds, which served as liquid collateral for loans from the city’s banks. If a city bank needed to, it could call in securities market loans, and the borrower could either arrange a new loan or dispose of securities on the market to meet the call. Since New York City banks could lend out-of-town bankers’ balances on liquid securities collateral, they could afford to pay interest on them, which made keeping balances in New York City banks attractive to out-of-town banks. Such balances became still more attractive when some states (and in 1863, the United States, for National Banks) enacted reserve requirements and allowed banks to count New York City balances as reserves. With the development of securities trading, which was funded with growing amounts of bankers’ balances, the U.S. banking system in a sense returned a favor. When banks were first becoming established, the securities market funded them by providing capital.7 Then, as banks concentrated their reserves in money centers, particularly in New York City, money-center banks found that short-term loans and call loans on securities collateral were a good use of those funds because of the liquidity the securities market imparted to the collateral. These synergies of American banks and securities markets were well established by the 1840s but were being established throughout the previous four decades.

Decimal Pricing Has Contributed to Lower Trading Costs and a More Challenging Trading Environment

With encouragement from Congress, in 2000 the Securities and Exchange Commission (SEC) ordered U.S. stock and option markets to begin quoting prices in decimal increments rather than fractions of a dollar.  As U.S. markets implemented decimal pricing in early 2001. They also reduced the minimum price increment, or tick size, at which prices could be quoted. The minimum tick on the stock markets generally fell from 1/16 of a dollar to a penny and on the option markets from 1/8 and 1/16 of a dollar to 10 cents and 5 cents, respectively. The United States had been one of the last countries to use fractions on its markets, and decimal pricing was expected to simplify securities pricing for investors, help lower investors’ trading costs and align U.S. pricing standards with those of other markets.

Many market participants and others who have observed the markets believe that decimal pricing has benefited small retail investors seeking to buy or sell a few hundred shares of stock. But concerns have been raised that the smaller tick size has made trading more challenging and costly for large institutional investors, including mutual funds and pension plans, that trade large blocks of shares. In addition, concerns exist over whether trading in 1-cent ticks has negatively affected the financial livelihood of market intermediaries, such as the broker-dealers that trade on floor-based and electronic markets

Background

The study of the development of securities markets was long neglected, beyond histories of individual stock exchanges or studies of particular events that caught the public’s attention. The state of financial history as a whole was very similar until the 1960s, when it began to attract attention in academic circles, with the pioneering work of Rondo Cameron and his associates. However, that was almost exclusively focused on banking. As banks were regarded as the central elements in a financial system it was perfectly accept able to confine the study of such systems to that of banking alone. Hence the focus on comparisons between Germany’s universal banks, Britain’s branch banks, and US unitary banks, and these formed the basis of the conclusions drawn about the superiority or inferiority of entire financial systems. To many observers, whether from the left or the right of the political spectrum, securities markets were considered little more than centers of gambling, where speculators bet on the rise and fall of prìces, and were exposed to the fraudulent practices of unscrupulous intermediaries.

As Raines recently noted popular imagery, stock markets represent the most exciting aspect of capitalism . . . where soaring bull markets bring sudden wealth only to subsequently wipe it out during spectacular crashes with the bursting of speculative bubbles’ Even to most economists securities markets were not worthy of serious study, being more symbols of popular capitalism than the substance of complex and sophisticated financial systems. What mattered was the process of capital formation, which involved consideration of the collection, mobilization, and use of savings for productive purposes rather than financial market activity that produced no obvious or measurable gain for society.

The federal regulatory structure of the U.S securities markets was established by the Securities Exchange Act of 1934 (the Exchange Act). Congress also created SEC as an independent agency to oversee the securities markets and their participants. Under the Exchange Act, the U.S. securities markets are subject to a combination of industry self- regulation (with SEC oversight) and direct SEC regulation. This regulatory scheme was intended to give SROs responsibility for administering their ordinary affairs including most of the daily oversight of the securities markets and broker-dealers. The Exchange Act provides for different types of SROs, including national securities exchanges and national securities associations. Entities operating as national securities exchanges or associations are required to register as such with SEC. As of March 31, 2002, nine securities exchanges  were registered with SEC as national securities exchanges.  As of the same date, NASD was the only registered national securities association; NASD Regulation (NASDR) is its regulatory arm. Although it is the SRO, NASD delegates to NASDR, its wholly owned subsidiary, SRO responsibilities for surveilling trading on Nasdaq and the over-the-counter market and for enforcing compliance by its members (and persons associated with its members) with applicable laws and rules. Nasdaq also surveils trading on its market and refers potential violations to NASDR and SEC for investigation. While NASD is currently the parent company of Nasdaq, NASD is in the process of selling Nasdaq.

Recognizing the inherent conflicts of interest that exist when SROs are both market operators and regulators, the Exchange Act states that to be registered as a national securities exchange or association, SEC must determine that the exchange’s or association’s rules do not impose any burden on competition and do not permit any unfair discrimination. SROs are also responsible for enforcing members’ compliance with their rules and with federal securities laws by conducting surveillance of trading in their markets and examining the operations of member broker-dealers.

References – Fundamentals of the Securities Industry –  By William A. Rini