. 19
( 193 .)


The specialist™s published quotes are valid only for a given number of shares. If a buy or sell order is placed for more
shares than the quotation size, the specialist has the right to revise the quote.
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

worse than those of public traders, the specialist will not participate in any trades and will lose
the ability to profit from the bid“ask spread. An equally important reason that specialists can-
not use large bid“ask spreads to protect their interests is that they are obligated to provide
price continuity to the market. To illustrate the principle of price continuity, suppose the high-
est limit buy order for a stock is $30, while the lowest limit sell order is $32. When a market
buy order comes in, it is matched to the best limit sell at $32. A market sell order would be
matched to the best limit buy at $30. As market buys and sells come to the floor randomly, the
stock price would fluctuate between $30 and $32. The exchange authorities would consider
this excessive volatility, and the specialist would be expected to step in with bid and/or ask
prices between these values to reduce the bid“ask spread to an acceptable level, typically less
than $.15 for large firms. When a firm is newly listed on an exchange, specialist firms vigor-
ously compete to be awarded the rights by the exchange to maintain the market in those
shares. Since specialists are evaluated on their past performance in maintaining price continu-
ity, they have considerable incentive to maintain tight spreads.
Specialists earn income both from commissions for acting as brokers for orders and from
the spreads at which they buy and sell securities. Some believe specialists™ access to their
“books” of limit orders gives them unique knowledge about the probable direction of price
movement over short periods of time. However, these days, interested floor traders also have
access to the Display Books of outstanding limit orders.
For example, suppose the specialist sees that a stock now selling for $45 has limit buy or-
ders for over 100,000 shares at prices ranging from $44.50 to $44.75. This latent buying de-
mand provides a cushion of support, in that it is unlikely that enough sell pressure will come
in during the next few hours to cause the price to drop below $44.50. If there are very few
limit sell orders above $45, in contrast, some transient buying demand could raise the price
The specialist in such circumstances realizes that a position in the stock offers little down-
side risk and substantial upside potential. Such access to the trading intentions of other mar-
ket participants seems to allow a specialist and agile floor traders to earn profits on personal
transactions and for selected clients. One can easily overestimate such advantages, however,
because ever more of the large orders are negotiated “upstairs,” that is, as fourth-market deals.

Block Sales
Institutional investors frequently trade blocks of tens of thousands of shares of stock. Table 3.6 transactions
shows that block transactions of over 10,000 shares now account for about half of all trad-
Large transactions in
ing. The larger block transactions are often too large for specialists to handle, as they do not which at least 10,000
wish to hold such large blocks of stock in their inventory. For example, the largest block trans- shares of stock are
action in the first half of 2001 was for 34 million shares of USX-Marathon stock. bought or sold.

Average Number of Block
TA B L E 3.6 Year Shares (millions) % Reported Volume Transactions per Day
Block transactions on
1965 48 3.1% 9
the New York Stock
Exchange 1970 451 15.4 68
1975 779 16.6 136
1980 3,311 29.2 528
1985 14,222 51.7 2,139
1990 19,682 49.6 3,333
1995 49,737 57.0 7,793
2000 135,772 51.7 21,941

Source: Data from the New York Stock Exchange Fact Book, 2001.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

76 Part ONE Elements of Investments

“Block houses” have evolved to aid in the placement of larger block trades. Block houses
are brokerage firms that specialize in matching block buyers and sellers. Once a buyer and a
seller have been matched, the block is sent to the exchange floor where specialists execute the
trade. If a buyer cannot be found, the block house might purchase all or part of a block sale for
its own account. The block house then can resell the shares to the public.

The SuperDot System
SuperDot enables exchange members to send orders directly to the specialist™s Display Book
over computer lines. The largest market order that can be handled is 30,099 shares. In 2000,
SuperDot processed an average of 1.5 million orders per day; the average time to execute mar-
ket orders submitted through SuperDot was 15 seconds.
SuperDot is especially useful to program traders. A program trade is a coordinated pur-
program trade
chase or sale of an entire portfolio of stocks. Many trading strategies (such as index arbitrage,
Coordinated sale or
a topic we will study in Chapter 16) require that an entire portfolio of stocks be purchased or
purchase of a
sold simultaneously in a coordinated program. SuperDot is the tool that enables many trading
portfolio of stocks.
orders to be sent out at once and executed almost simultaneously.
The vast majority of all orders are submitted through SuperDot. However, these tend to be
smaller orders and account for only a bit more than half of total share volume.

Since June 1995, an order executed on the exchange must be settled within three working
days. This requirement is often called T 3, for trade date plus three days. The purchaser
must deliver the cash, and the seller must deliver the stock to the broker, who in turn delivers
it to the buyer™s broker. Frequently, a firm™s clients keep their securities in street name, which
means the broker holds the shares registered in the firm™s own name on behalf of the client.
This convention can speed security transfer. T 3 settlement has made such arrangements
more important: It can be quite difficult for a seller of a security to complete delivery to the
purchaser within the three-day period if the stock is kept in a safe deposit box.
Settlement is simplified further by the existence of a clearinghouse. The trades of all ex-
change members are recorded each day, with members™ transactions netted out, so that each
member need transfer or receive only the net number of shares sold or bought that day. An ex-
change member then settles with the clearinghouse instead of individually with every firm
with which it made trades.

On the exchanges, all trading occurs through a specialist. On the over-the-counter (OTC) mar-
ket, however, trades are negotiated directly through dealers who maintain an inventory of se-
lected securities. Dealers sell from their inventories at ask prices and buy for them at bid prices.
An investor who wishes to purchase or sell shares engages a broker who tries to locate the
dealer offering the best deal on the security. This is in contrast to exchange trading, where all
buy or sell orders are negotiated through the specialist, who arranges for the best bids to get
the trade. In the OTC market, brokers must search the offers of dealers directly to find the best
trading opportunity. In this sense, Nasdaq is a price quotation system, not a trading system.
While bid and ask prices can be obtained from the Nasdaq computer network, the actual trade
still requires direct negotiation (often over the phone) between the broker and the dealer in the
However, in the wake of the stock market crash of 1987, Nasdaq instituted a Small Order
Execution System (SOES), which is in effect a trading system. Under SOES, market makers
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

in a security who post bid or ask prices on the Nasdaq network may be contacted over the net-
work by other traders and are required to trade at the prices they currently quote. Dealers must
accept SOES orders at their posted prices up to a limit which may be 1,000 shares, but usually
is smaller, depending on factors such as trading volume in the stock.
Because the Nasdaq system does not use a specialist, OTC trades do not require a central-
ized trading floor as do exchange-listed stocks. Dealers can be located anywhere they can
communicate effectively with other buyers and sellers.
One disadvantage of the decentralized dealer market is that the investing public is vulner-
able to trading through, which refers to the possibility that dealers can trade with the public at
their quoted bid or asked prices even if other customers have offered to trade at better prices.
A dealer who posts $20 bid and $20.15 asked prices for a stock may continue to fill market
buy orders at the ask price and fill market sell orders at the bid price”even if there are limit
orders by public customers “inside the spread,” for example, limit orders to buy at $20.05 or
limit orders to sell at $20.10. This practice harms the investor whose limit order is not filled
(is “traded through”) as well as the investor whose market buy or sell order is not filled at the
best available price.
Trading through on Nasdaq sometimes results from imperfect coordination among dealers.
A limit order placed with one broker may not be seen by brokers for other traders because
computer systems are not linked and only the broker™s own bid and asked prices are posted on
the Nasdaq system. In contrast, trading through is strictly forbidden on the NYSE or Amex,
where “price priority” requires that the specialist fill the best-priced order first. Moreover,
because all traders in an exchange market must trade through the specialist, the exchange pro-
vides true price discovery, meaning that market prices reflect the prices at which all partici-
pants at that moment are willing to trade. This is the advantage of a centralized auction
In October 1994, the Justice Department announced an investigation of the Nasdaq Stock
Market regarding possible collusion among market makers to maintain spreads at artificially
high levels. In 1996, the Justice Department settled with the Nasdaq dealers. The dealers
agreed to refrain from pressuring any other market maker to maintain wide spreads and from
refusing to deal with other traders who try to undercut an existing spread.
Also in 1996, the SEC settled with the National Association of Securities Dealers (NASD)
as well as with the Nasdaq stock market. The settlement called for NASD to take steps to pro-
hibit market makers from colluding on spreads. In addition, the SEC mandated the following
three rules on Nasdaq dealers:
1. Publicly display all limit orders. Limit orders from all investors that exceed 100 shares
must now be displayed. Therefore, the quoted bid or ask price for a stock must now be
the best price quoted by any investor, not simply the best dealer quote. This shrinks the
effective spread on the stock.
2. Make best dealer quotes public. Nasdaq dealers must now disclose whether they have
posted better quotes in private trading systems or ECNs such as Instinet than they are
quoting in the Nasdaq market.
3. Reveal the size of best customer limit orders. For example, if a dealer quotes an offer to
buy 1,000 shares of stock at a quoted bid price and a customer places a limit buy order
for 500 shares at the same price, the dealer must advertise the bid price as good for

Market Structure in Other Countries
The structure of security markets varies considerably from one country to another. A full
cross-country comparison is far beyond the scope of this text. Therefore, we will instead
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

78 Part ONE Elements of Investments

briefly review three of the biggest non-U.S. stock markets: the London, Euronext, and Tokyo
exchanges. Figure 3.7 shows the volume of trading in major world markets.

London Until 1997, trading arrangements in London were similar to those on Nasdaq.
Competing dealers who wished to make a market in a stock would enter bid and ask prices
into the Stock Exchange Automated Quotations (SEAQ) system. As in the U.S., London se-
curity firms acted as both dealers and as brokerage firms, that is, both making a market in se-
curities and executing trades for their clients.
In 1997, the London Stock Exchange introduced an electronic trading system dubbed
SETS (Stock Exchange Electronic Trading Service). This is an electronic clearing system sim-
ilar to ECNs in which buy and sell orders are submitted via computer networks and any buy
and sell orders that can be crossed are executed automatically.
Most trading in London equities is now conducted using SETS, particularly for shares in
larger firms. However, SEAQ continues to operate and may be more likely to be used for the
“upstairs market” in large block transactions or other less liquid transactions.

Euronext Euronext was formed in 2000 by a merger of the Paris, Amsterdam, and Brus-
sels exchanges. Euronext, like most European exchanges, uses an electronic trading system.
Its system, called NSC (for Nouveau Système de Cotation, or New Quotation System), has
fully automated order routing and execution. In fact, investors can enter their orders directly
without contacting their brokers. An order submitted to the system is executed immediately if
it can be crossed against an order in the public limit order book; if it cannot be executed, it is
entered into the limit order book.
Euronext is in the process of establishing cross-trading agreements with several other Eu-
ropean exchanges such as Helsinki or Luxembourg. In 2001, it also purchased LIFFE, the
London International Financial Futures and Options Exchange.

F I G U R E 3.7 22,500
Dollar volume of
equity trading in major
Annual trading volume ($ billion)

world markets, 2000
Source: International
Federation of Stock
Exchanges, www.fibv.com.

The Paris and Amsterdam
exchanges have (together
with the Brussels exchange)
merged to form the Euronext
exchange. Although the
exchanges have been
integrated, trading continues
to be conducted in each of
these cities.


New York


. 19
( 193 .)