3.4Secondary Markets forEquity

As Chapter 1 discussed, the advantage of publicly traded securities is that they can be

sold later in public secondary markets. This section discusses the types of secondary

equity markets that exist and how each type operates.

Types of Secondary Markets for Equity

Secondary equity marketscan be organized either as an exchangeor as an over-the-

counter(OTC) market. An exchange is a physical location where buyers and sellers

come together to buy and sell securities. The New York Stock Exchange (NYSE) is

probably the best example, though there are many more, both in the United States and

abroad. Anover-the-counter(OTC) market, in contrast, allows buyers and sellers to

transact without meeting at one physical place. For example, OTC transactions, such

as the debt-based Euromarkets described in the last chapter, often take place over com-

puter networks. The National Association of Security Dealers Automated Quotation

System (Nasdaq) market in the United States is a noteworthy example of a computer-

linked OTC equity market.

Grinblatt172Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw172Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

74Part IFinancial Markets and Financial Instruments

Two alternatives to the traditional exchange-based and OTC-based markets,

known as the third market and the fourth market, include elements of both OTC and

exchange markets. Thethird marketis composed of exchange-listed stocks that can

be bought and sold over the counter by a broker. The fourth marketconsists of large

investors who trade exchange-listed stocks among themselves, bypassing the

exchange. Generally the trades take place through an electronic communication net-

work, or ECN. Although it is difficult to obtain data on transaction costs in alterna-

tive markets, an estimate of the cost of trading on the exchange floor is $0.05 to

$0.10 per share.⁹In contrast, costs of trading in the off-exchange markets can be as

low as $0.01 per share.

In all markets, trading is done by brokers, dealers, or both. Abrokerfacilitates a

trade between a buyer and a seller by bringing the two parties together. Brokers profit

by charging a brokerage commission for this service. Alternatively, dealersbuy and sell

securities directly; that is, they maintain an inventory in the security and stand willing

to take the opposite side of a buy or sell. Dealers make their money on the bid-ask

spread, buying at the bid price and selling at the ask.

Exchanges

Numerous exchanges in the United States trade everything from stocks and bonds to

options and futures contracts. The major stock exchanges are the NYSE and the Amer-

ican Stock Exchange (AMEX). Nasdaq acquired the American Stock Exchange in

November 1998, but the AMEX still functions as a separate entity. There are also a

number of regional exchanges such as the Midwest Exchange in Chicago, the Pacific

Exchange in San Francisco, and the Boston and Philadelphia exchanges, which often

trade stocks that are also listed on the major exchanges. By far the most important

exchange in terms of capitalization and trading volume is the NYSE, where, in terms

of capitalization, 80 to 90 percent of all U.S. equities trade.

Like all exchanges, the NYSE has certain listing requirements. One requirement,

which can change over time, specifies the minimum size of the firm to ensure that the

firm is large enough to be of interest to many investors. As of the late 1990s, the NYSE

required the firm to have at least $20.0 million in assets, a pretax income of $2.5 million,

a market value of publicly held shares of $40.0 million, and 2,000 shareholders. The

AMEX, Nasdaq, and the regional exchanges have less stringent minimums: For exam-

ple, Nasdaq requires that a firm have a market value of publicly held shares exceed-

ing $8 million, 400 shareholders, and assets of $6 million.

Once a firm has applied for and been accepted to list on the NYSE, it is assigned

a specialistto “make a market” in the security. The specialist acts as both broker and

dealer. As a broker, the specialist brings together a buyer and a seller, either physically

in front of the specialist’s booth or electronically by matching buy and sell orders. The

specialist also functions as a dealer, ready to buy and sell from his or her own inven-

tory. In this role, the specialist is supposed to make a “fair and orderly market” in the

security, which means ensuring that prices do not move up or down precipitously.

Specialists take both market orders and limit orders. Amarket orderis an order

to buy or sell at whatever the prevailing market price may be. For small-sized orders,

this usually means purchasing at the specialist’s quoted ask price and selling at the

specialist’s quoted bid price. Alimit orderis an offer to buy or sell at a prespecified

share price.

⁹See Story (1988).

Grinblatt174Titman: Financial	I. Financial Markets and	3. Equity Financing	© The McGraw174Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 3

Equity Financing

75

Dealer Markets for Equity

Despite the enormous capitalization of the NYSE, only about 2,800 of more than 12,000

U.S. public firms are traded there. The majority of firms not listed on the NYSE trade

over the counter through a network of dealers. Dealer networks can be telephone- or

computer-based, although there has been a clear movement toward more computer-

based trading. Computers make it easier to gather price quotes and to see what the

prices were in recent transactions. In any dealer network, a customer who wants to buy

or sell a security calls a broker. The broker in turn contacts dealers to get price quotes,

selecting the dealer with the best quote to make the trade.

The most sophisticated dealer network is Nasdaq, which originated in the early

1970s to automate the old over-the-counter system, in which dealers would record

quotes and trades manually. Nasdaq links brokers and dealers by a computer system

that allows them to see all the quotes on a particular stock. The typical firm listed on

Nasdaq has approximately 10 dealers or market makers who are active in trading the

stock. Each market maker is required to give a bid-ask quote and a “depth”_that is,

how many shares the market maker is willing to buy at the bid price and sell at the

ask price. Nasdaq regulations insist that the quote and depth be good for at least one

trade. Of course, there is no requirement that the quote be competitive and, indeed,

there is some evidence suggesting that most stocks have just a few active market

makers.¹⁰

Electronic Communication Networks (ECNs)

ECNs have become increasingly popular places to trade stocks, particularly after the

exchanges and dealer markets are closed for the day and before they open. Many are

open to individuals as well as institutions. The most popular ECNs are Instinet (owned

by Reuters), Island, and Archipelago.