CHAPTER 25
Equities

David Weisberger

WHAT IS AN EQUITY?

Equity securities, also known as stock or shares, along with bonds are one of the two primary means for corporations to raise additional capital. Unlike bonds, however, stocks do not represent a debt that needs to be repaid. Rather, equity securities represent a defined ownership interest, or a specific claim against earnings of either a corporation or a fund that holds financial assets. There are several types of equity securities, all of which represent a defined interest in the issuing company and are perpetual: There is no predefined date where they mature or cease to exist.

TYPES OF EQUITIES

Equity security types are defined by the nature of the issuing company and the particular rights that are assigned to the individual securities. The following sections describe the primary types of equities: common stock, preferred shares, depository receipts, and investment companies (mutual funds).

Common Stock

The most basic form of equity is called common stock or ordinary shares. Common stock usually has specifically defined voting rights attached to ownership that allow stockholders to cast votes for the company's board of directors as well as for or against changes to the corporate charter.

Some companies issue multiple classes of common stock with different voting rights. For example, Alphabet Inc., the parent company Google, has three share classes:

  1. Class A, ticker GOOG, which has one vote per share
  2. Class B, no ticker, as these shares are privately held by the founders and other insiders, which have 10 votes per share
  3. Class C, ticker GOOGL, which have no voting rights

The rationale in this case for establishing multiple classes of common stock is that the original ownership group, Class B, wanted to retain voting control over the direction of the company.

Preferred Shares

Preferred shares are a form of equities that represent a priority claim on a company's assets over common stockholders, and are typically issued with a fixed dividend but without voting rights. A company must pay all dividends associated with preferred shares before paying any dividends to common stockholders.

Depository Receipts

Depository receipts are securities issued by international banks denominated in a country's local currency, but based on the ordinary shares of a foreign company. For example, American depository receipts (ADRs) are denominated in U.S. dollars. Similarly, global depository receipts (GDRs) are issued and trade in various countries and allow investors in those countries to trade foreign company stocks in their local currencies.

Investment Companies (Mutual Funds)

A mutual fund is an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks and bonds. When purchasing a mutual fund, investors are in essence buying a share of a cross‐section of a diversified pool of financial assets. Investors thus gain access to a professionally managed portfolio, which would be impossible to create with a small amount of investment capital. Each shareholder or unit holder participates proportionally in the income gain or loss of the fund. Mutual fund units, or shares, are issued and can typically be purchased or redeemed as needed at the fund's current net asset value (NAV) per share (calculated by dividing the total value of all the securities in its portfolio by the number of fund shares outstanding).

There are generally two types of mutual funds, open ended and closed ended.

Open‐ended funds issue new shares and repurchase old shares to meet investor demand. These funds thus buy and sell units on a continuous basis, allowing investors to enter and exit at their convenience. The units are bought and sold at the net asset value declared by the fund as of the close of business that day.

Closed‐ended funds issue a fixed number of shares. Thus, unlike open‐ended funds, investors cannot buy and sell shares based on the fund's NAV; instead the investor must purchase shares in the secondary market at current market prices, which may be greater than or less than NAV based on supply and demand.

WHY DO COMPANIES ISSUE EQUITIES?

Corporations issue stock in order to raise capital for ongoing operations, for research and development, or to fund acquisitions. A company has several alternatives when looking to additional raise capital. These include commercial loans, the issuance of corporate bonds, or the sale of equity. Both commercial loans and bonds represent a liability as they both must be repaid. When selling equity the company does not incur a liability, but instead dilutes the ownership interests of the company by increasing the ownership claims to corporate earnings and assets.

Corporations must continually choose between these capital‐raising methodologies when evaluating how to raise capital. There are advantages and disadvantages to the capital‐raising alternatives for the corporation depending on the type of method chosen, including balance sheet impact, ownership structure, financial flexibility, and tax liability. (See Table 25.1.)

Table 25.1: Advantages/Disadvantages of Capital‐Raising Alternatives

Impact On: Common Stock Preferred Stock Bond/Loan
Balance Sheet No impact. Perpetual liability for dividend payment if fixed. Liability for principal and interest.
Ownership Control Dilution of ownership if voting rights attached to common stock. No dilution unless security is convertible to common stock. No dilution unless security is convertible to common stock.
Future Profit Exposure Dilution of owners' claim on future retained earnings. No dilution unless security is convertible to common stock. No dilution unless security is convertible to common stock.
Financial Flexibility Ability to use stock to purchase other companies plus lack of debt means future ability to issue debt is unimpaired. No specific financial flexibility, but there is no liability associated with the initial sale of the securities, only the future dividends. Debt securities need to be repaid.
Tax Some mergers can be accomplished using stock without tax consequences. Interest payments are often deductible.

In order to maximize both short‐ and long‐term earnings for their investors, corporations are constantly evaluating these tradeoffs when they are in need of financing.

EQUITY MARKET PARTICIPANTS

There are several types of participants in the equity market, including various types of investors, speculators, and market makers. Investors in the equity markets include individuals investing for retirement or other future needs, pension funds investing to provide income to retirees, insurance companies interested in growing their assets, and investment companies that provide professional investment management services to their clients. Generally, investors buy equities in order to profit from the combination of long‐term price appreciation and dividends paid by the companies whose stocks are purchased. There are two additional categories of investors that are somewhat different, however. Strategic investors purchase stock to obtain control over a company, often with the goal of merging the existing operations of their own company with those of the company whose stock they purchase. Activist investors are people who believe that the company's stock is undervalued, but that changes in corporate strategy are necessary to unlock that value. In all cases, however, investors purchase equities with the idea of owning the stock for a relatively long period of time.

Speculators, on the other hand, include participants that look to profit on short‐term movements in equity prices, either up or down. Examples of speculators include arbitrageurs, day traders, automated quantitative traders, and dedicated short sellers. There are many forms of arbitrage trading that, in its simplest form, buy or sell stocks when simultaneously selling or buying correlated securities. Day traders are professional traders who buy and sell stocks based on a variety of technical indicators, news stories, or other techniques. Automated, quantitative traders include a wide array of trading strategies that range from very high‐frequency strategies to computer models that predict multiday price moves in stocks. Short sellers are professional traders who bet against companies by selling their stock short with the expectation that the price will decline.

One of the more important types of participant in the equity market is the market maker. Those trading firms that almost continuously maintain orders to buy and sell the stocks in which they make markets help to keep the spreads between bids and offers tight, which keeps trading costs lower for all participants.

Unlike long‐term investors, market makers and speculators such as hedge funds and day traders engage in a variety of trading strategies. Day traders buy and sell securities on a short time horizon during the day; market makers use sophisticated computer systems to profit from the bid–offer spread; proprietary trading firms and hedge funds either employ traders or build trading models designed to profit from short‐term price discrepancies between highly correlated individual stocks or baskets of stocks. These short‐term investors are mostly interested in price appreciation or, in the case of short sellers (selling stock that is not owned), betting that the stock prices will fall.

Equities as an asset class are attractive because historically they have outperformed the rate of inflation. As illustrated in the chart in Figure 25.1, equities have provided a higher real rate of return than bonds, bills, gold, or the U.S. dollar over the past 200 years:1

Image described by caption and surrounding text.

Figure 25.1: Total real return indexers

Source: Jeremy Siegel, “Real Returns Favor Holding Stocks,” AAII Journal, August 2014, http://www.aaii.com/journal/article/real‐returns‐favor‐holding‐stocks.touch.

EQUITY MARKETS

The equity market consists of the primary market and secondary market. The primary market involves the initial public offering (IPO) where the stock is first offered to the public and listed on a stock exchange. Firms may wish to issue additional equity at a later date; this is commonly known as a secondary offering, not to be confused with secondary market trading. The secondary market, which normally starts immediately after the IPO, is characterized by the continuous buying and selling of equities during the trading day.

The IPO Process

The IPO process is highly regulated and normally conducted by one or more underwriters and a selling group comprised of broker‐dealers. Underwriters, as the name implies, guarantee some or all of the risk of the IPO and are responsible for leading the IPO process. The underwriter is compensated through the underwriter's spread, which is the difference between what the public pays for the security and the proceeds that the issuing company receives. The underwriting spread is made up of the following components: the management fee for handling the IPO; the selling concession, which is carved out for payment to broker‐dealers that actually sell stock to its customers (whether in the selling group or as an underwriter); and the underwriter's direct compensation for taking on the deal risk.

The underwriter is responsible for the creation of all legal documents that are provided to potential investors. The most important document is the prospectus, which includes audited financial information, descriptions of the company's business and corporate structure, as well as potential risks to the company's business prospects. The Securities and Exchange Commission (SEC) requires that underwriters must disclose all known risks to the company's business model. As a result underwriters conduct extensive due diligence on the company, including documented discussions with company management, auditors, and customers.

Following due diligence, the company's management along with the underwriters and selling group members may conduct a roadshow. Roadshows are presentations that are made by an issuer's senior management, often accompanied by representatives of the lead underwriters, to market the upcoming security to prospective investors. The roadshow is intended to generate interest in the IPO, and gives potential investors an opportunity to ask detailed questions regarding the issue.

Listing Standards

The next step in the process is selecting a listing exchange. The IPO is then conducted pursuant to the guidelines of that particular exchange. While most equity securities post IPO trades on multiple stock exchanges, each company is listed on only one exchange in each country. In the United States, the New York Stock Exchange and the NASDAQ stock exchange are the largest primary markets for corporate stock while the ARCA exchange (Archipelago exchange) and the BATS exchange (Bats Global Markets, Inc.) are the largest primary listing markets for exchange‐traded funds (see Chapter 27 for more). In the United States, the exchanges have regulatory responsibilities, including the supervision of listing standards, which include minimum financial requirements set by each listing exchange and are monitored by the exchanges themselves. The listing standards include:

  • Pre‐tax earnings—income, net of expenses, from continuing operations before income taxes
  • Cash flows—cash received from continuing operations net of cash expenses
  • Market capitalization—over a minimum threshold, calculated by multiplying the shares outstanding on the company's balance sheet by the market or IPO price
  • Revenue—All earned income from continuing operations before expenses
  • Total assets—All investments, cash, production equipment, real estate, intellectual property, or other items of value owned by the company
  • Stockholders equity—The total value of all stock in the company, calculated by subtracting all liabilities from the other assets of the corporations
  • Total number of shareholders
  • Market value of publicly held shares, calculated by multiplying the number of total outstanding shares by the market price of the shares

Once the IPO has been completed the equity shares trade in what is termed the secondary market. The secondary market for equities can include both private and public trading. Privately traded stock, usually referred to as private equity, is restricted to qualified investors and trades far less frequently with limited disclosures and information. The term qualified investor refers to the SEC definitions of an investor's experience and liquid net worth.

Publicly traded equity securities comprise the vast majority of equity trades and come in two varieties: order driven and quote based. Order‐driven markets are by far the most popular. In these markets, client orders are accepted by the stock exchanges and are either posted, matched, or rejected. This is done by aggregating all priced orders into an order book, which is then displayed to the public as a best bid and offer (BBO). These quotes, along with matched trades, are collectively referred to as market data, which is the information behind the ticker commonly seen scrolling across the screens of financial websites and news programs. Today's order‐driven markets are fully automated: Every individual order is required to be entered into an order management system at a broker‐dealer, which in turn sends the order to an exchange.

MECHANICS OF ORDER‐DRIVEN MARKETS

Consider the following sequence of orders sent to a stock exchange in stock “XYZ”:

  1. Client A—buy order at 100.50 for 200 shares
  2. Client B—sell order at 100.52 for 500 shares
  3. Client C—buy order at 100.49 for 800 shares
  4. Client D—sell order at 100.53 for 500 shares

    At this point, the exchange will be displaying a BBO of 100.50 bid and 100.52 offered and the order book will have additional liquidity available at the lower bid of 100.49 and higher offer of 100.53. Typically, this is represented in trading screens with the BBO expressed as: XYZ 100.50 100.52 200 × 500 (verify how volume is displayed. i.e., should it state 20x50) (Common convention for equity tickers is to list the bid price followed by the offer price and then the bid size “x” offer size in smaller print.)

    The full order book, often called a montage, would look like this:

    Shares Bid Offer Shares
    100.53 500
    100.52 500
    200 100.50
    800 100.49

    If, at this point, a buyer willing to pay 100.52 enters an order of 500 shares or less, the exchange will match that order with the par 100.52 best offer and a trade will occur. To illustrate, consider the following sequence of orders:

  5. Client initiates buy order for 200 shares at 100.52.

    The exchange would report a trade of 200 shares at 100.52 and the BBO would change to: XYZ 100.50 100.52 200 × 300. The order book would also change to look like this:

    Shares Bid Offer Shares
    100.53 500
    100.52 300
    200 100.50
    800 100.49
  6. Client initiates buy order for 500 shares at 100.51.

    No trade would occur, but the BBO would change to: XYZ 100.51 100.52 500 × 200.

    Shares Bid Offer Shares
    100.53 500
    100.52 200
    500 100.51
    200 100.50
    800 100.49
  7. Client initiates sell order for 1000 shares at 100.50.

The market would report two individual trades: 500 shares at 100.51 and 200 shares at 100.50 and the BBO would change to: XYZ 100.49 100.52 800×300.

Shares Bid Offer Shares
100.53 500
100.52 200
100.51 300
800 100.49

Quote‐driven markets are also often referred to as dealer markets, since they are characterized by competing quotes displayed by market makers. Market makers post quotations based on both the orders that they have received as well as their own trading interest. Unlike the order‐based markets described earlier, market makers generally display quotes for a standard amount of shares rather than for individual order amounts. In the largest U.S. market of this type (OTC markets2), this is referred to as a tier size and represents the minimum size required for market makers to trade in any particular stock. In most dealer markets, market makers are required to register with the market in order to post quotes. Broker‐dealers accept an affirmative obligation to both bid and offer for stocks in which they make markets. This is in direct contrast to order‐driven markets where any broker‐dealer that connects to the market can place an order. This exclusivity is provided to market makers in exchange for meeting this two‐sided markets obligation as described previously.

Most of the exchanges worldwide, including those in the United States, operate on an order‐driven basis. It is important to know that the primary exchange for equity securities also conducts both opening and closing auctions. In the opening and closing auctions, either the exchange system or a designated market maker aggregates all buy and sell orders to set the price. The price is set in order to maximize the number of shares that can trade while fulfilling the most orders possible.

The closing auction on the primary exchange is a very important price point, as it is used for pricing the closing value of all stock indexes and derivative products such as stock options. When investors look at historical price data for equities, it is typically the closing auction price.

HISTORY OF EQUITY TRADING

There have been a number of milestone events that have greatly influenced the equity markets. This section discusses some of the organizational, historical, technological, and regulatory changes that had a major impact.

Timeline of Milestone Events:

  • 1602—Amsterdam Stock Exchange established (Dutch East India Company)
  • 1711–1720—South Sea bubble
  • 1792—Buttonwood Agreement forms the New York Stock Exchange and fixes commissions
  • 1801—Rules created the subscription room of the London Stock Exchange
  • 1867—Tickertape invented
  • 1929—Crash of '29
  • 1933/4—The Securities Exchange Acts passed to create the National Market System in the United States
  • 1971—NASDAQ debuts with electronic display of stock quotes
  • 1975—“Mayday” deregulation of equity commissions
  • 1977—CATS OS debuts in Toronto
  • 1982—CME introduces S&P 500 futures
  • 1987—Crash of '87
  • 1996–98—NASDAQ scandal leads to order handling rules and Reg ATS
  • 2001—Decimalization
  • 2007—Reg NMS

The Buttonwood Agreement Leads to the Formation of the NYSE

During the industrial revolution, stock markets became an important means for emerging corporations to raise capital. In 1792, in lower Manhattan, the leading stock brokers in New York City formed a members‐only association by what is known as the “Buttonwood Agreement.” That agreement, under which all the signatories agreed to trade directly with each other and to fix a floor on commission rates, established the precursor to the New York Stock Exchange, which was formalized years later. While the NYSE was not the first stock exchange in the United States (Philadelphia has that distinction), it soon became the most important. After the invention of the telegraph enabled faster communication between investors and New York City, stock trading grew rapidly and the NYSE became the dominant exchange.

The Tickertape

The invention of the tickertape in 1867 further sped the development and expansion of stock trading. By the 1880s, there were over a thousand tickertape machines installed in offices in New York City alone. The development of this technology facilitated the establishment of brokerage offices throughout the country.

Margin

When a buyer of stock purchases equity on margin, they are borrowing the money to complete their purchase from the brokerage firm they are using. The buyer is only required to deposit funds in their account sufficient to cover the margin requirement. Today, due to a rule called Regulation T, which was adopted by the U.S. Federal Reserve in 1974, the margin requirement for most equities is 50%. Thus, if a person was to purchase 100 shares of stock XYZ at $50, they would only need to deposit $2,500, and would therefore be borrowing $2,500 to enable the purchase of $5,000 of this stock. If the price of the stock were to decline substantially, the margin requirement would force the investor to either deposit more money to maintain the position or sell enough of the position to make up for the decline in value.

During the late 1800s and early 1900s, there were no regulations governing the use of margin. Speculators in those days could purchase stocks on extremely low margins, in some cases as low as 2%. While not the primary cause of volatility in markets, excessive margin debt did contribute to magnifying financial shocks and severe dislocations, experienced often in those days. Prior to the Great Depression, there were so‐called financial “panics” in 1873, 1884, 1890, 1893, 1896, 1901, 1907, and, after the end of World War I, the depression of 1920–21. Financial panics were all marked by dramatic declines in the value of the stock market and other speculative assets that led directly to significant losses to investors and corporations as well as to spikes in unemployment.

The Crash of 1929 Leads to Change

Despite these financial panics, there were very few changes in the equity markets in this era. After the depression ended in 1922, the decade of the “Roaring Twenties” ensued with a strong economy and significant gains in the stock market that accelerated as the decade progressed. It was estimated that, in the year before the onset of the Great Depression, the average stock purchase was made with as little as 10% margin. This meant that as the market was approaching its highs in 1929, 90% of stock purchases were made by borrowed money. As a result, once the stock market crash began, widespread forced selling ensued, causing many investors to suffer a complete loss of their investment.

Founding Legislation of Equity Markets

Starting in the depths of the Great Depression, new legislation began shaping the modern equity markets. The 1933 Securities Act established the first federal regulations on the issuance and trading of equity securities, and in 1934, the Exchange Act established the Securities and Exchange Commission, creating the regulatory framework for stock exchanges and brokers. This legislation was followed by amendments in 1938 that created the National Association of Securities Dealers (the precursor organization to FINRA), the self‐regulatory organization (SRO) that is primarily responsible for the oversight of client‐facing broker‐dealers. In 1940, the Investment Company Act established the regulatory environment for mutual funds. The establishment of this regulatory framework produced a lengthy period of growth in the equity markets. By the end of the 1960s, trading volumes had grown too large to be accommodated by the back‐office processes of that day, which handled the settlement of trades. In order to settle an equity trade, the buyer must deliver the agreed‐upon funds to the seller's account and the seller must transfer the securities purchased to the account of the buyer. At that time, the process was manual, where equity securities were represented by physical stock certificates and were tracked by related documents such as “floor reports,” “contract sheets,” and “transfer statements.” The paperwork associated with physically renaming the owner of stock certificates was cumbersome and labor intensive. The entire system became so unwieldy that there were an ever‐increasing number of failed trades, substantial theft, and, ultimately, over 200 brokerage houses were driven out of business.

Subsequently, a new phase of rulemaking began, which culminated in the 1975 amendments that established the National Market System we have today. Among other things, these amendments authorized the creation of the Securities Information Processor (SIP), which was created to be the central, consolidated live stream and aggregator of every exchange's best quotes (bids and offers) as well as reported trades. The data comes from all the exchanges and is processed and fed back out as one stream of data. This is often referred to as the consolidated tape, and it is considered the official vehicle for disseminating price information in the U.S. equity market.

Market Data under the National Market System

At the time that the National Market System (NMS) was established, there were three primary listing markets: the New York Stock Exchange, the American Stock Exchange, and the NASDAQ market. The rules creating the NMS mandated that all stock quotes and trades be aggregated. They established the Consolidated Tape Association Plan/Consolidated Quotation Plan (CTA/CQ Plans) for the two exchanges and the OTC UTP plan for the NASDAQ market (NASDAQ did not become a registered exchange until 2006). These plans governed the collection, processing, and distribution of quotation and transaction information for all NMS securities and were broken out into three tapes (tapes A, B, and C representing the NYSE, AMEX, and NASDAQ, respectively). The data is collected from all market centers where NMS securities are traded, including securities exchanges, ATSs, and other broker‐dealers. All of this data must be provided to a centralized Securities Information Processor (SIP) for each tape data consolidation and dissemination. The current SIPs are run by the New York Stock Exchange for tapes A and B and NASDAQ for tape C, and that data is made available to all market data vendors, broker‐dealers, and technology platforms that want such access.

Commissions and “May Day”

In addition to the creation of the National Market System, 1975 was also the year that the SEC mandated the deregulation of fixed commissions. This occurred on May 1 of that year and was dubbed “May Day” by the financial industry. Starting on that date, the original agreements that bound members of the New York Stock Exchange to fix commissions were declared void, and the law mandated that all commission agreements be negotiated. Initially, the law was seen to have limited impact, since brokerage firms operated as a somewhat closed community. While the established brokerage firms made minor modifications to commission rates, offering some small discounts to large clients and even raising fees to small clients, newer firms were more innovative. Over the next decades, “discount” brokerage firms changed the industry by driving down commission costs to the levels seen today.

NASDAQ

Another major innovation in the equity markets was the debut of NASDAQ in 1971, the first all‐electronic market. NASDAQ was a dealer market and, as such, did not have a trading floor. Thus only market makers were allowed to post quotes via the NASDAQ display system for public dissemination. Although NASDAQ market makers displayed their quotes electronically, up until the late 1990s most actual trades were still consummated via telephone. As a result, bulge bracket firms with extensive client lists and large trading desks dominated the trading of NASDAQ stocks for the first 25+ years of its history.

The decade of the 1970s saw a lingering recession that depressed investor interest in the evolving equity markets. In 1982, the bear market reached a generational bottom and the market proceeded to start an extended bull run. It was in this year that the stock index futures contract on the Standard and Poor's (S&P) 500 stock index was introduced.

Stock Index Futures and the Crash of 1987

Creation of the S&P 500 stock futures was an extremely important development in the history of the modern stock market. The index itself was (and still is) created by S&P to represent the most liquid and largest public companies in the United States. The futures contract is traded on the Chicago Mercantile Exchange (CME) and is cash settled, whereby, upon the expiration of a contract, the buyers and sellers exchange the cash difference between the purchase (or sale) price and the actual price of the index.3 The ability to trade one single futures contract to gain upside or downside exposure to equity price movements was revolutionary. The S&P futures quickly became one of the more liquid vehicles for trading equity market risk and was heavily used by a wide array of investors and speculators. Its popularity led to the creation of several new trading businesses, including index arbitrage and a variety of derivative products.

One of the most innovative derivative products using the S&P 500 futures during the 1980s was called portfolio insurance. This product was sold to a variety of large institutional investors and asset managers to protect their clients against substantial losses in the case of a large downturn in the market. Financial models were designed to signal to portfolio insurers when they should sell futures contracts to hedge their risk. It was generally considered that the S&P 500 futures contracts were so liquid that firms selling insurance would always be able to sell sufficient futures contracts in order to hedge. This assumption was proved incorrect in the fall of 1987. The stock market had been on a virtually uninterrupted 5‐year bull run, but stresses were beginning to show and in the third week of October the market dropped by roughly 9%. This left portfolio insurers with a substantial amount of futures to sell the following Monday. On Monday, October 19, the market crashed.

Following the crash of 1987, there were several new regulations implemented, including market‐wide circuit breakers that were designed to pause trading during times of severe price moves, as well as special reporting to document the amount of program trading. Program trading was defined as any computer trading program that traded more than 15 stocks simultaneously with a market value exceeding $1 million, and included all index arbitrage and computerized trading for the accounts of brokerage firms. Specific rules were put in place to prohibit most program trading during times of severe market stress.

In addition to these measures, there was a major effort to reduce the settlement period for equity trades to three days from the previous five days, meaning the brokerage firm must now receive payment no later than three business days after the trade was executed. Conversely, when securities are sold, they must be delivered to the brokerage firm no later than three business days after the sale. The crash of 1987 helped to galvanize this effort since the SEC was concerned about the risks of unsettled trades during periods of extreme market movements. In the SEC's words:

Unsettled trades pose risks to our financial markets, especially when market prices plunge and trading volumes soar. The longer the period from trade execution to settlement, the greater the risk that securities firms and investors hit by sizable losses would be unable to pay for their transactions.4

The NASDAQ Scandal and the Order Handling Rules Lead to Modern Markets

As the 1990s unfolded, technological changes were accelerating in many businesses, and the stock market was no exception. Retail stock trading was revolutionized by the introduction and rapid growth of online brokers. Regional stock exchanges started to experiment with new technologies such as an all‐electronic market (Cincinnati stock exchange) to compete with the NYSE. The NYSE, while continuing to require its specialists to be directly involved in all trades, facilitated the development and use of handheld computers by floor brokers, which allowed firms an electronic method of communicating with the floor. NASDAQ market makers transitioned away from exclusive reliance on the telephone for trading, using new software systems such as Tools of the Trade to update their quotes as well as to trade with other market makers. Those market makers began using a newly developed inter‐dealer electronic market terminal developed by Instinet. Technological advances further accelerated after a NASDAQ market trading scandal in 1996.

In that year, there were multiple allegations made against the largest NASDAQ market makers. They were accused of colluding to keep bid–offer spreads artificially wide, of using the Instinet terminal to trade without passing on the benefit to their clients, and of putting their firm's profits ahead of their “best execution” duties. This resulted in a settlement with the SEC and a series of new regulations referred to as the order handling rules. These rules included regulations that forced brokers to display most limit orders they received from clients, gave client orders priority over the brokers' proprietary orders, and forced market makers to make public their best quotes. These new rules led directly to the NASDAQ market implementing a new system called SuperMontage, and resulted in the transition of the NASDAQ market from a dealer quote–based market to an order‐driven market. With the SuperMontage system in place, for the first time both orders and quotes were fully executable electronically by a central matching engine. During this same time period, in order to promote innovation, the SEC also passed Regulation ATS, which facilitated the development of new electronic markets.

The cumulative impact of these regulations was both to promote more electronic order‐based systems at the large brokerage firms and to spur the proliferation of alternative trading systems (ATSs) and electronic communication networks (ECNs). (ECNs are a particular type of ATS that display their bids and offers to their subscribers.) In the 1990s, the market became extremely fragmented as many ECNs emerged to compete with the New York Stock Exchange and the NASDAQ market. They included Instinet, the Island ECN, Brut and Strike (multiple broker–owned), REDI, Archipelago, and the Attain ECN.

Over the following years, however, these ECNs combined with each other and ultimately were either purchased by exchanges or became exchanges themselves. Brut and Strike combined, Instinet and Island merged, and both of these new entities were purchased by NASDAQ. REDI and Archipelago combined and, after becoming a publicly traded company, was purchased by the NYSE to form the largest exchange operator at the time. The Attain ECN was purchased by a consortium of brokers and became Direct Edge, and the BATS ECN, which was formed in the following decade, eventually became the BATS Exchange. Those two entities merged, forming the BATS Exchange Group, which is the exchange group with the largest equity volume traded at the current time.

This fragmentation of the market into competing electronic order books also spurred the development of the smart order router (SOR). The SOR is a trading technology that scans every market to see which has both the best available price and sufficient quantity to satisfy the order, and then sends orders to those markets. SORs are used by traders seeking liquidity as a more expedient alternative to sending one order at a time to each market seen onscreen. SORs helped traders achieve a best execution standard at a time when conventional trading systems failed to show available liquidity from all ATSs and markets.

Decimalization

The next major change to the equity market in the United States was that of decimalization, where equity prices are quoted using a decimal format rather than fractions. The decision radically impacted the market, making it easier for investors to interpret and react to changing price quotes. This led to significantly tighter spreads. For example, prior to decimalization the minimum quoted spread was 1/16 of a dollar, called a teeny, representing .0625 cents per share. After, the minimum quoted spread was .01 cent. The average quoted spread for stocks fell by almost the same amount, thus dramatically lowering the cost of trading. The lower trading costs resulted in a significant increase in trade volume, particularly in NASDAQ securities. By 2001, NASDAQ securities traded only on fully electronic order‐driven markets. The rise of SOR technology facilitated this volume increase by helping to link the electronic markets together.

Smart Order Routing

Smart order routers were built mainly to handle marketable orders, defined as buy orders at or above the best offer and sell orders at or below the best bid. To illustrate the benefit of SOR technology, the following table contains a modified version of the earlier BBO example that was in the order‐driven market example. Consider the situation where stock XYZ is traded in four different markets. In this example, the stock's order book can be shown by what traders refer to as a montage that depicts the orders on the order book displayed as follows:

Market Shares Bid Offer Shares Market
100.55  500 NASDAQ
100.54 1000 NASDAQ
100.53  500 ARCA
100.53  500 NASDAQ
100.52  500 Instinet
100.52  500 Island
Island  200 100.50
Instinet  800 100.49
NASDAQ  500 100.49
ARCA 2500 100.48
NASDAQ  500 100.48

In this scenario, the actual NBBO is XYZ 100.50 100.52 200 × 500 but, depending on the technology used by the trader, they might not have had this full visibility into the market. For example, if a trader was using the NASDAQ proprietary workstation of the time, they would have only seen a best bid of 500 shares at 100.49 and a best offer of 500 shares of 100.53. If that trader had received an order to buy 2000 shares up to 100.55, then the most likely event would have been the trader buying 500 shares at 100.53, 1000 shares at 100.54, and 500 shares at 100.55, all on the NASDAQ system, for an average price of 100.54. If, however, the trader used an SOR that was connected to the Island ECN, the Instinet ECN, the ARCA ECN, as well as to NASDAQ's SuperMontage system, the results would have been much better. Since the SOR was capable of accessing all of the orders on all of the markets, instead of being limited to NASDAQ alone, the SOR would have bought 500 shares from Island at 100.52, 500 shares from Instinet at 100.52, 500 shares from ARCA at 100.53, and 500 shares from NASDAQ at 100.53, for an average price of 100.525. In this example, the SOR would have saved 1.5 cents per share on the 2000‐share order.

In addition to SORs, brokers have developed algorithmic trading programs designed to trade large orders. Those algorithms were designed to trade larger orders by splitting them up into smaller pieces and then trading them either by using SORs or through direct connections to systems such as the New York Stock Exchange's DOT system. Most early algorithms either used schedules based on patterns such as historical volume, or were programmed to participate at a particular percentage of the actual volume traded. These algorithms also spurred the growth of internal crossing systems, which allow brokers to match client trades.

Prior to the development of algorithms, one of the primary functions of large broker‐dealers was to match large institutional buy and sell orders. Sales traders, handling institutional orders throughout the trading day, either worked to find a natural match to the order from another client, or worked in conjunction with NYSE or NASDAQ traders to execute the order. As the use of algorithms became more widespread and broker crossing systems were developed to facilitate matching institutional orders it became harder for sales traders to compete with computers in matching buyers and sellers. Many of these systems evolved into alternative trading systems (ATSs) and expanded beyond crossing orders and actually attracted other sources of order flow. In addition to the broker‐operated systems, several other ATSs were developed, including several designed to match large orders. Due to the fact that these trading venues did not display any orders, they became known as dark pools. Dark pools have become an important tool for institutional investors by facilitating the matching of natural buyers and sellers while displaying less information to the market.

Even after decimalization the New York Stock Exchange (NYSE) still operated on a floor‐based trading model. They required all trades, even those that could match electronically, to be approved by the specialists on the floor. Despite publishing bids and offers electronically, it was not always possible to execute trades against those quotes. This model helped the NYSE maintain over 80% market share, by traded volume, in the securities where they were the primary listing exchange. Competitors such as regional stock exchanges, NASDAQ, and the ECNs in operation at that time complained that the NYSE's membership rules and large market share enabled them to ignore other quotes and discourage real competition. By the middle of last decade, these complaints helped lead to a sweeping set of regulatory changes to the U.S. equity markets: Regulation NMS.

Regulation NMS

Regulation NMS introduced several important changes; the most important from a structural point was the Order Protection Rule, which essentially forced all exchanges to honor the fully executable quotes on other exchanges. It did so by introducing the concept of a protected quote, which meant that no exchange could execute a trade at a price inferior to that being displayed at an exchange whose quote was electronically executable. The rule also introduced a prohibition on knowingly locking a market, which prohibited exchanges from accepting and displaying bids or offers at a price that could be satisfied by routing to a different exchange. The impact of these rules was that the NYSE was now forced to make their quotes electronically executable, which in turn led to significantly increased trading volumes overall, but decreased market share for the NYSE.

In addition to increased trading volumes, the transformation of the NYSE to a fully electronic model and the impact of Reg NMS accelerated the trend toward algorithmic trading. The ability to access all markets electronically made it possible to computerize all types of trading strategies with speed and precision. By the time Reg NMS was fully implemented and all quotes were accessible electronically, all large broker‐dealers had fully developed suites of algorithmic trading tools. Virtually every institutional investor's trading desks had linkages to those systems and the percentage of trading handled by computers rapidly increased.

MODERN MARKET STRUCTURE—ORDER TYPES

One of the unique features of the equity market is the ability of traders to enter a variety of order types when attempting to buy or sell stock. At the most basic level, orders are characterized by features such as price considerations, the discretion the broker‐dealer or market center maintains when holding the order, when the order is eligible to be traded, as well as special trading restrictions that vary by market.

The most basic types of orders are market and limit orders. Market orders are orders to buy or sell stock without regard to price. These orders tend to always get executed since they are the most aggressive. Limit orders, however, are orders with a specific price limit beyond which the order cannot be executed. For a buy limit order, the price specified is the highest price that the order will pay, and for a sell limit order, the price specified is the lowest price that the seller is willing to accept. When evaluating limit orders, participants categorize them as marketable or nonmarketable, depending on how the price relates to the national best bid and offer (NBBO).

The concept of discretion is relevant to both brokers and to individual market centers. From the perspective of a broker‐dealer, it is important to know whether the order is considered held or not held. Held orders essentially means that the broker‐dealer has no discretion over how to work the order, meaning that such orders must either be executed immediately or posted onto an exchange for public display. Not held orders, however, can be handled by the broker on a best‐efforts basis, but brokers in either case are always responsible for proving that they are meeting the obligation of best execution for their clients.

In the U.S. equity market, stocks can trade in the pre‐market, during market hours, or after the markets have closed during extended hours. All stocks in the National Market System have an official opening price determined by an opening auction and an official closing price determined by a closing auction. Orders, therefore, can be placed with a restriction to be executed exclusively in the official opening auction called on open, in the official closing auction called on close, during market hours, called day, or during the pre‐market and during extended hours. Orders can also be sent to a market for immediate execution or cancellation, called immediate or cancel (IOC).

MODERN MARKET STRUCTURE—COMPLEXITY

Today's U.S. equity market is quite complex. There are 12 exchanges and over 40 alternative trading systems in operation. Most of these exchanges and alternative trading systems are located in one of three data centers in northern New Jersey. The ICE group runs the NYSE, NYSE market, and Archipelago in Mahwah, New Jersey, while the NASDAQ OMX group runs the NASDAQ, Boston, and Philadelphia stock exchanges in Carteret, New Jersey. The BATS Group runs the BATS and Direct Edge exchanges in Secaucus, New Jersey, which also houses the National Stock Exchange. Trading firms, meanwhile, have built their own infrastructure in all three data centers in order to be closer to the exchange matching engines. This practice, called co‐location, is the modern equivalent of the booths located on the floor of the old New York Stock Exchange. Historically the large brokerage firms strategically placed their trading booths in close proximity to the specialist posts on the floor to quickly garner information being disseminated. Modern co‐location is no different; the co‐location of market making, algorithm, and smart order routing technology provides faster access to both the exchange matching engines and the market data that exchanges provide via their direct feeds.

MODERN MARKET STRUCTURE—MARKET DATA

Each exchange provides their own market data via direct feeds to facilitate trading in their market. They also provide market data to the consolidated tape delivered via the SIP as part of their regulatory requirements established by the CQA/CTA/UTP plans described earlier. The direct feeds differ from the data provided by the consolidated tape in two important ways. First, the exchanges provide data on all the levels in their order books via the direct feeds, but only provide the top‐of‐book data to the SIP. The Regulation NMS order protection rule only applies to the highest bid and lowest offer per individual exchange, which are often referred to as the top‐of‐book quotes. Second, there is only one instance of each of the three SIPs, which means in many cases, even if the SIP software was infinitely fast, that there would be a major speed advantage to the direct feeds. To understand this, consider the configuration of the major exchanges (shown in Figure 25.2) and how a co‐located server in the Secaucus data center would receive data from the BATS and Direct Edge exchanges directly versus from the SIP for Tape A located in Mahwah. A co‐located server in Secaucus trading in IBM, for example, would receive data from BATS and Direct Edge in a few microseconds due to their location. If the same server was receiving data from the Tape A SIP, the data would need to traverse the distance from Secaucus to Mahwah and back. The distance involved, due to the speed of light, would take roughly 400 microseconds. While such a delay does not sound too extensive, in today's market, it is sufficient to provide a competitive disadvantage to algorithms and SORs that do not subscribe to direct market data feeds.

A process diagram of example of data being transmitted across servers.

Figure 25.2: Example of data being transmitted across servers

HIGH‐FREQUENCY TRADING

The development of automated order‐driven exchanges and the proliferation of electronic algorithmic trading led directly to the emergence of disruptive competitors to the incumbent banks and institutional brokers. These new trading firms, called high‐frequency traders (HFTs), developed sophisticated technology that utilized high‐speed networking, quantitative models, and modern server technology to make trading decisions orders of magnitude faster than the human traders that used to dominate the markets. Twenty‐five years ago, the leading equity trading firms by volume were all well‐known, established firms that employed hundreds of traders. Today, most of the largest market makers, by volume, on the NASDAQ and BATS exchanges are HFT firms as well as all of the designated market makers on the New York Stock Exchange. Most observers believe that roughly 50% of the equity market volume in the United States is traded by HFT firms. These firms employ servers that are located inside of the data centers where the stock exchange systems are housed. They utilize direct data feeds provided by the stock exchanges in combination with technology designed to minimize the latency between receipt of market data messages and the sending and modification of orders sent to the exchanges.

The emergence of high‐frequency technology has been transformational for the equity market. Virtually all firms have embraced aspects of the technology, including co‐located servers and the use of direct data feeds. This has led directly to lower trading costs for investors, due to tighter bid–offer spreads and significantly more volume traded.

Strategies of HFT Firms

Market Making

HFT firms dominate the business of providing liquidity to aggressive buyers and sellers as market makers. These firms place buy and sell orders on multiple exchanges in a wide range of securities at the same time. In order to manage their risk and to avoid mispricing orders, these firms need to employ state‐of‐the‐art technology to react to changes in the market.

Proprietary Trading

Since the invention of the tickertape in 1867, there have been proprietary traders that scanned the tape for clues on the future direction of stock prices. This type of proprietary trading was chronicled in the classic book, Reminiscences of a Stock Operator, a fictionalized account of Jesse Livermore, a famous investor whose insights are still widely quoted. For example, in Jack Schwager's Market Wizards,5 Reminiscences was quoted as a major source of stock trading learning material for experienced and new traders by many of the traders whom Schwager interviewed. One of the more fascinating things about that book was how similar the concepts the author expressed are to today's quantitative proprietary trading. In the book the author described trading in the following way6:

Observation, experience, memory and mathematics, these are what the successful trader must depend on. He must not only observe accurately but remember at all times what he has observed. He cannot bet on the unreasonable or on the unexpected, however strong his personal convictions may be about man's unreasonableness or however certain he may feel that the unexpected happens very frequently. He must bet always on probabilities, that is, try to anticipate them. Years of practice at the game, of constant study, of always remembering, enable the trader to act on the instant when the unexpected happens as well as when the expected comes to pass.

A man can have great mathematical ability and an unusual power of accurate observation and yet fail in speculation unless he also possesses the experience and the memory. And then, like the physician who keeps up with the advances of science, the wise trader never ceases to study general conditions, to keep track of developments everywhere that are likely to affect or influence the course of the various markets. After years at the game it becomes a habit to keep posted. He acts almost automatically. He acquires the invaluable professional attitude and that enables him to beat the game at times! This difference between the professional and the amateur or occasional trader cannot be overemphasized. I find, for instance, that memory and mathematics help me very much. Wall Street makes its money on a mathematical basis. I mean, it makes its money by dealing with facts and figures.

Similarly, modern proprietary HFT firms utilize computer models to buy and sell stocks based on quantitative signals. There is a wide range of such strategies, including trading based on technical price signals that are the modern equivalent to the mathematics described earlier. Obviously, modern computers can calculate these indicators in fractions of a second in sharp contrast to manual calculations of the past, which took days.

Another type of proprietary trading strategy is called statistical arbitrage. This strategy attempts to determine when securities get mispriced by the market. This is accomplished by comparing a stock price with the prices of other stocks or groups of stocks, and buying the underperforming and selling the outperforming stocks. Such strategies have been augmented by algorithms that scan digital news and social media to assure that the price divergence is truly an aberration and not created by a fundamental change. In addition, these strategies attempt to uncover whether the price divergences are created by detectable large orders. In this case, the strategy may be to trade aggressively in the same direction as those orders in order to profit from the likely continued movement. Such order‐detection algorithms are usually very short term and have become less profitable as the sophistication of institutional algorithms has increased.

Index and ETF Arbitrage

As explained earlier, algorithms that can scan multiple markets across baskets of securities are used to implement arbitrage strategies. These strategies attempt to profit by either buying or selling stock index futures or buying or selling either the correlated ETFs or the underlying baskets of stocks that make up the index. Arbitrage strategies typically involve large trading volumes and minuscule margins, minimizing the mispricing of both indexed futures and ETFs. This assures that those instruments are rarely mispriced and provides a distinct benefit to consumers of these products.

The evolution of equity trading technology has continued to improve the quality of the market over time. Whether it was the introduction of the telegraph, the tickertape, screen‐based trading, automated order‐driven markets, or even high‐frequency trading, all these innovations have helped increase trading volumes and the efficiency of the equity markets. While it is true that some of these technologies caused disruption and, in some cases, forced long‐tenured participants out of the business, for the most part, firms have adapted. Today, the vast majority of brokers have adopted co‐located servers processing direct data feeds in their suite of electronic trading products. In essence, most firms have adopted some aspects of HFT in their infrastructure, in the same way as all surviving firms adopted the telegraph, the ticker tape, market data terminals, and so on.

There are two key roles that the equity market plays in the economy. First, it provides a means for companies to raise capital in order to grow their business without the liability of taking on debt. Second, the equity market provides a method for various types of investors to earn a rate of return commensurate with the growth of the companies they invest in. Over the past 200‐plus years, the U.S. stock market has undergone dramatic changes, but for the most part has done a good job of performing both of those roles, and yet the market has evolved. Advances in regulation have formalized the process of offering and trading stocks as well as establishing rules that govern the types of investment vehicles that can be provided to the public. The establishment of the SEC and the creation of the National Market System created a more stable environment for the equity market to develop and subsequent rules culminating with Regulation NMS have established a dynamic and competitive marketplace. Technological innovations starting with the telegraph, the tickertape, electronic market data, and now including exchange systems capable of microsecond‐level timestamps have led to the lowest bid–offer spreads and trading costs in history. At the same time, financial innovations such as stock futures and ETFs have improved the ability for investors to manage risk and for traders to execute their strategies. All of this progress has been good news to most investors in the market as well as to the companies that rely upon equity issuance for capital.

NOTES

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