. 17
( 193 .)


share of exchange-listed companies”when measured in share volume rather than number of
trades”has been stable since 1990, between 82% and 84%.
The over-the-counter Nasdaq market (described in detail shortly) has posed a bigger compet-
itive challenge to the NYSE. Its share of trading volume in NYSE-listed firms increased from
2.5% in 1983 to about 8% in 2000. Moreover, many large firms that would be eligible to list their
shares on the NYSE now choose instead to list on Nasdaq. Some of the well-known firms
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

Dollar Volume
TA B L E 3.3 Trading Volume of Trading
Trading in national Market (billions of shares) ($ billion)
stock markets, 2000
New York 262.5 $11,060.0
American 13.3 945.4
Nasdaq 442.8 19,798.8

Source: International Federation of Stock Exchanges.

currently trading on Nasdaq are Microsoft, Intel, Apple Computer, and Sun Microsystems. Total
trading volume in over-the-counter stocks on the computerized Nasdaq system has increased
rapidly, rising from about 50 million shares per day in 1984 to 1.8 billion shares per day in 2000.
Share volume on Nasdaq actually surpasses that on the NYSE. Table 3.3 shows the trading ac-
tivity in securities listed on the national exchanges in 2000.
Other new sources of competition to the NYSE have come from abroad. For example, the
London Stock Exchange is preferred by some traders because it offers greater anonymity. In
addition, new restrictions introduced by the NYSE to limit price volatility in the wake of the
market crash of 1987 are viewed by some traders as another reason to trade abroad. These so-
called circuit breakers are discussed below.

The Over-the-Counter Market
Roughly 35,000 issues are traded on the over-the-counter (OTC) market, which allows any over-the-counter
security to be traded there, but the OTC market is not a formal exchange. There are no mem- (OTC) market
bership requirements for trading or listing requirements for securities (although there are re- An informal network
quirements to be listed on Nasdaq, the computer-linked network for trading securities of larger of brokers and dealers
OTC firms). Thousands of brokers register with the SEC as dealers in OTC securities. Secu- who negotiate sales of
rity dealers quote prices at which they are willing to buy or sell securities. A broker then exe-
cutes a trade by contacting the dealer listing an attractive quote.
Before 1971, all OTC quotations of stock were recorded manually and published daily. The
so-called pink sheets were the means by which dealers communicated their interest in trading
at various prices. This was a cumbersome and inefficient technique, and published quotes
were a day out of date. In 1971, the National Association of Securities Dealers Automatic
Quotation System, or NASDAQ, was developed to offer via a computer-linked system imme- Nasdaq
diate information on bid and ask prices for stocks offered by various dealers. The bid price is stock market
the price at which a dealer is willing to purchase a security; the ask price is the one at which The computer-linked
the dealer will sell a security. Hence, the ask price is always higher than the bid price, and the price quotation
difference, the bid“ask spread, makes up the dealer™s profit. The system allows a broker who system for the OTC
receives a buy or sell order from an investor to examine all current quotes, call the dealer with
the best quote, and execute a trade. The system, now called the Nasdaq Stock Market, is di-
bid price
vided into two sectors, the Nasdaq National Market System (comprising almost 4,000 com-
panies), and the Nasdaq SmallCap Market (comprising over 1,000 smaller companies). The The price at which a
National Market System securities must meet more stringent listing requirements and trade in dealer is willing to
purchase a security.
a more liquid market. Some of the more important initial listing requirements for each of these
markets are presented in Table 3.4. For even smaller firms, Nasdaq maintains an electronic
ask price
“OTC Bulletin Board,” which is not part of the Nasdaq market, but is simply a means for bro-
kers and dealers to get and post current price quotes over a computer network. Finally, the The price at which a
smallest stocks continue to be listed on the pink sheets distributed through the National Asso- dealer will sell a
ciation of Securities Dealers.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

68 Part ONE Elements of Investments

Nasdaq National Nasdaq SmallCap
TA B L E 3.4 Market Market
Partial requirements
Shareholders™ equity $15 million $5 million
for initial listing on
Nasdaq markets Shares in public hands 1.1 million 1 million
Market value of publicly traded shares $8 million $5 million
Minimum price of stock $5 $4
Pretax income $1 million $750,000
Shareholders 400 300

Source: The Nasdaq Stock Market.

Nasdaq has three levels of subscribers. The highest, level 3 subscribers, are for firms deal-
ing, or “making markets,” in OTC securities. These market makers maintain inventories of a
security and constantly stand ready to buy or sell these shares from or to the public at the
quoted bid and ask prices. They earn profits from the spread between the bid and ask prices.
Level 3 subscribers may enter the bid and ask prices at which they are willing to buy or sell
stocks into the computer network and may update these quotes as desired.
Level 2 subscribers receive all bid and ask quotes, but they cannot enter their own quotes.
These subscribers tend to be brokerage firms that execute trades for clients but do not actively
deal in the stocks on their own account. Brokers attempting to buy or sell shares call the mar-
ket maker (a level 3 subscriber) with the best quote in order to execute a trade. Notice that
Nasdaq is a price quotation, rather than a trading, system. While bid and ask prices can be ob-
tained from the Nasdaq computer network, the actual trade still requires direct negotiation (of-
ten over the phone) between the broker and the dealer in the security.
Level 1 subscribers receive only the inside quotes (i.e., the highest bid and lowest ask
prices on each stock). Level 1 subscribers are investors who are not actively buying and sell-
ing securities but want information on current prices.

The Third and Fourth Markets
The third market refers to trading of exchange-listed securities on the over-the-counter mar-
third market
ket. In the past, members of an exchange were required to execute all their trades of exchange-
Trading of exchange-
listed securities on the exchange and to charge commissions according to a fixed schedule.
listed securities on the
This procedure was disadvantageous to large traders when it prevented them from realizing
OTC market.
economies of scale on large trades. Because of this restriction, brokerage firms that were not
members of the NYSE and so not bound by its rules, established trading in the OTC market of
large NYSE-listed stocks. These trades could be accomplished at lower commissions than
would have been charged on the NYSE, and the third market grew dramatically until 1972,
when the NYSE allowed negotiated commissions on orders exceeding $300,000. On May 1,
1975, frequently referred to as “May Day,” commissions on all NYSE orders became nego-
tiable, and they have been ever since.

2. Look again at Table 3.1, which gives the history of seat prices on the NYSE. Inter-
pret the data for 1975 in light of the changes instituted on May Day.
The fourth market refers to direct trading between investors in exchange-listed securities
without the benefit of a broker. The direct trading among investors that characterizes the
fourth market has exploded in recent years due to the advent of electronic communication
networks, or ECNs. ECNs are an alternative to either formal stock exchanges like the NYSE
or dealer markets like Nasdaq for trading securities. These ECNs allow members to post buy
or sell orders and to have those orders matched up or “crossed” with orders of other traders in
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

3 How Securities Are Traded

TA B L E 3.5 Attain
Registered Electronic B-Trade Services
The BRASS Utility
Networks (ECNs)
Instinet Corporation
The Island ECN
Market XT

Source: Nasdaq in Black & White, Nasdaq, 2001.

the system. Both sides of the trade benefit because direct crossing eliminates the bid“ask fourth market
spread that otherwise would be incurred. Early versions of ECNs were available exclusively Direct trading in
to large institutional traders. In addition to cost savings, systems such as Instinet and Posit al- exchange-listed
lowed these large traders greater anonymity than they could otherwise achieve. This was im- securities between
one investor and
portant to the traders since they did not want to publicly signal their desire to buy or sell large
another without the
quantities of shares for fear of moving prices in advance of their trades. Posit also enabled
benefit of a broker.
trading in portfolios as well as individual stocks.
ECNs have captured about 30% of the trading volume in Nasdaq-listed stocks. They must
be certified by the SEC and registered with the National Association of Security Dealers to
participate in the Nasdaq market. Table 3.5 is a list of registered ECNs at the start of 2001.
networks (ECNs)
While small investors today typically do not access an ECN directly, they can send orders
Computer networks
through their brokers, including online brokers, who can then have the order executed on the
that allow direct
ECN. Eventually, individuals will likely have direct access to most ECNs through the Inter-
trading without the
net. In fact, several financial firms (Goldman, Sachs; Merrill Lynch; Salomon Smith Barney; need for market
Morgan Stanley; and Bernard Madoff) have combined to build an electronic trading network makers.
called Primex, which is open to NASD broker/dealers, who in turn have the ability to offer
public access to the market. Other ECNs, such as Instinet, which have traditionally served in-
stitutional investors, are considering opening up their services to retail brokerages.
The advent of ECNs is putting increasing pressure on the NYSE to respond. In particular,
big brokerage firms such as Goldman, Sachs and Merrill Lynch are calling for the NYSE to
beef up its capabilities to automate orders without human intervention. Moreover, as they push
the NYSE to change, these firms are hedging their bets by investing in ECNs on their own.
The NYSE also has announced its intention to go public. In its current organization as a
member-owned cooperative, it needs the approval of members to institute major changes.
However, many of these members are precisely the floor brokers who will be most hurt by
electronic trading. This has made it difficult for the NYSE to respond flexibly to the challenge
of electronic trading. By converting to a publicly held for-profit corporate organization, it
hopes to be able to compete more vigorously in the marketplace of stock markets.

The National Market System
The Securities Act Amendments of 1975 directed the Securities and Exchange Commission to
implement a national competitive securities market. Such a market would entail centralized
reporting of transactions and a centralized quotation system, with the aim of enhanced com-
petition among market makers.
In 1975, Consolidated Tape began reporting trades on the NYSE, Amex, and major regional
exchanges, as well as trades of Nasdaq-listed stocks. In 1977, the Consolidated Quotations
Service began providing online bid and ask quotes for NYSE securities also traded on various
other exchanges. This has enhanced competition by allowing market participants, including
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

70 Part ONE Elements of Investments

brokers or dealers who are at different locations, to interact and for orders to be directed to the
market in which the best price can be obtained.
In 1978, the Intermarket Trading System (ITS) was implemented. ITS currently links nine
exchanges by computer (NYSE, Amex, Boston, Cincinnati, Pacific, Philadelphia, Chicago,
Nasdaq, and the Chicago Board Options Exchange). Nearly 5,000 issues are eligible for trad-
ing on the ITS; these account for most of the securities that are traded on more than one ex-
change. The system allows brokers and market makers to display and view quotes for all
markets and to execute cross-market trades when the Consolidated Quotation System shows
better prices in other markets. For example, suppose a specialist firm on the Boston Exchange
is currently offering to buy a security for $20, but a broker in Boston who is attempting to sell
shares for a client observes a superior bid price on the NYSE, say $20.12. The broker should
route the order to the specialist™s post on the NYSE, where it can be executed at the higher
price. The transaction is then reported on the Consolidated Tape. Moreover, a specialist who
observes a better price on another exchange is also expected either to match that price or route
the trade to that market.
While the ITS does much to unify markets, it has some important shortcomings. First, it
does not provide for automatic execution in the market with the best price. The trade must be
directed there by a market participant, who might find it inconvenient (or unprofitable) to do
so. Moreover, some feel that the ITS is too slow to integrate prices off the NYSE.
A logical extension of the ITS as a means to integrate securities markets would be the es-
tablishment of a central limit order book. Such an electronic “book” would contain all orders
conditional on both prices and dates. All markets would be linked and all traders could com-
pete for all orders.
While market integration seems like a desirable goal, the recent growth of ECNs has led to
some concern that markets are in fact becoming more fragmented. This is because participants
in one ECN do not necessarily know what prices are being quoted on other networks. ECNs
do display their best-priced offers on the Nasdaq system, but other limit orders are not avail-
able. Only stock exchanges may participate in the Intermarket Trading System, which means
that ECNs are excluded. Moreover, during the after-hours trading enabled by ECNs, trades
take place on these private networks while other larger markets are closed, and current prices
for securities are harder to access. In the wake of growing concern about market fragmenta-
tion, some big Wall Street brokerage houses have called for an electronically driven central
limit order book. But full market integration has proven to be elusive.

Bond Trading
The New York Stock Exchange also operates a bond exchange where U.S. government, cor-
porate, municipal, and foreign bonds may be traded. The centerpiece of the NYSE bond mar-
ket is the Automated Bond System (ABS), which is an automated trading system that allows
trading firms to obtain market information, to enter and execute trades over a computer net-
work, and to receive immediate confirmations of trade execution.
However, the vast majority of bond trading occurs in the OTC market among bond dealers,


. 17
( 193 .)