6.2 Characteristics of bonds and equities

The secondary market in bonds revolves around the gilt-edge market makers. As

we have seen, GEMMS are usually a part of larger rms, often banking groups which

deal in securities of all kinds. Securities trading in the UK underwent a major upheaval

in 1986 with a series of changes which acquired the name of ‘Big Bang’. The main

consequence of Big Bang of relevance here is that it ended the tradition of ‘single

capacity’ trading. In single capacity trading a strict line is drawn between brokers, who

buy and sell securities on behalf of clients, and jobbers, who hold stocks of securities

from which they buy and sell to brokers. After 1986, rms, known as market-makers,

could act in a dual capacity. This meant that they could ‘make a market’, that is they

could hold stocks of securities from which they would buy and sell, like jobbers,

but usually on a much bigger scale. But acting in a dual capacity meant that they

could buy and sell direct to investors, instead of dealing via an intermediary broker.

They could also trade in securities on their own account, for their own prot.

We saw earlier that GEMMs undertake to quote continuous two-way prices. This

means that bond holders know at any moment the price at which they can sell

bonds and the price at which they could buy more. Thus the UK bond market is an

example of what is known technically as a ‘quote-driven’ or ‘dealer’ market. This

contrasts with a ‘matching’ or ‘order-driven’ market, which we shall refer to again

in connection with share trading below. The market has no physical location. Most

GEMMs display the prices at which they are prepared to deal on screens linked to

SEAQ, the Stock Exchange Automated Quotation System. Private investors, without

access to such screens, can obtain prices over the phone. Orders to buy and sell,

likewise, are taken over the phone.

During the 1980s, the Bank of England and the London Stock Exchange developed

a computerised system of trading and settlement for the gilts market, known as the

Central Gilts Ofce, or CGO. This has links to more than 100 nancial rms, including

the GEMMs and IDBs, banks and major holders of government debt. Transactions

through the CGO are settled on the same day. For private clients and rms with-

out direct links to the CGO, settlement normally takes place within three days. The

CGO was originally intended as a facility for wholesale trading, but in 1997 it was

upgraded to handle trades in gilt repo (see section 5.2) and to make it accessible to

a wider range of dealers. Many ‘retail’ brokers who specialise in private client business

now have access to CGO facilities either directly or as ‘sponsored’ members.

One measure of market efciency is the level of transaction cost. Prior to 1986,

gilt transactions involved the payment of a commission on each sale/purchase. In

addition, jobbers quoted one price for a purchase (by the investor) and a lower price

for a sale. The difference, or spread, was another source of income for jobbers. Since

1986 commissions have largely disappeared. Furthermore, spreads have declined

by about a half. It now costs about £600 to trade £1m of gilts. This is much less,

incidentally, than the cost of trading company shares. These relatively low transaction

costs, combined with the short time required for settlement, means that government

bonds are highly liquid assets. This is true even for long-dated bonds.

In the last quarter of 2005 there were about 2,100 trades a day involving GEMMs

and their clients, and about 317 deals per day between GEMMs themselves. The aver-

age size of the deals was about £3.8m for transactions with customers. Deals between

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Chapter 6 • The capital markets

GEMMs, ‘intra-market’ business, were much larger at £18m. The value of total trades,

or ‘turnover’, per day was about £13bn. By far the largest share of government debt

is held by nancial institutions. Over 50 per cent is held by life assurance and pension

funds (see Chapter 4), while banks and building societies hold about 5 per cent (see

Chapter 3), mainly at the very short end of the spectrum. About 10 per cent of the

total is held by private investors and trusts.

The introduction of the euro in January 1999 automatically created a large, unied

market for government bonds denominated in euros. Since these are close substitutes

for sterling bonds, traders in the UK were bound to keep a close watch on develop-

ments in the prices and yields of European bonds, just as they had previously kept

a close watch on the deutschmark bond market. To facilitate comparisons and

calculations, the practice of quoting UK bond prices in fractions of a pound (‘1/32’)

was discontinued. UK bond prices are now quoted in pounds and decimals.

The secondary market for corporate bonds is much smaller than the market

for gilts. The value of bonds outstanding is much smaller, the volume of trading is

lower and so one obvious feature of the market is that it is less liquid. This is one

of the reasons, together with the higher risk associated with private corporations,

why corporate bond yields tend to be higher than gilt yields. Many GEMMs deal in

corporate bonds, especially in the larger issues; however, corporate bond dealing is

not conned to GEMMs but is carried out by market-makers who otherwise deal in

equities. New issues of corporate bonds are usually made by equity market-makers,

i.e. by investment banks.

In recent years, two circumstances have worked against the expansion of the sterling

corporate bond market. The rst was the period of volatile ination and interest rates

in the 1970s and early 1980s. When interest rates were high, rms were reluctant

to issue high coupon bonds which would lock them into paying high interest rates

for years into the future when interest rates might have fallen while high rates of

ination deterred investors from buying xed-interest securities generally. (The same

circumstance encouraged the UK government to introduce index-linked bonds.)

The second is the growth of the eurobond market. Like gilts, sterling corporate

bonds pay interest net of tax and their ownership is registered. For many investors,

there is an advantage in receiving interest without deduction of tax and in holding

bonds anonymously. Eurobonds provide both of these facilities, with the result that

UK corporations now often nd it convenient to issue sterling eurobonds – bonds

denominated in sterling but issued overseas.

The primary market for equities enables rms to issue new shares, normally in

order to raise funds to nance an expansion. Sometimes this will involve a privately

owned rm (a non-plc) seeking a stock exchange listing. This requires that it meets

certain requirements laid down by the relevant exchange. It will have to have an

established trading record, be prepared to publish key nancial information, includ-

ing an annual report, on set dates and hold an annual general meeting to which

all shareholders are invited. When a privately owned rm achieves a listing and

sells shares, its ownership will pass to the holders of the shares. In the UK, the major

market for equities is the London Stock Exchange (LSE). However, because of the

strict criteria which rms have to meet for an LSE listing, it has often been argued

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