. 20
( 193 .)












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

Tokyo The Tokyo Stock Exchange (TSE) is the largest stock exchange in Japan, account-
ing for about 80% of total trading. There is no specialist system on the TSE. Instead, a saitori
maintains a public limit order book, matches market and limit orders, and is obliged to follow
certain actions to slow down price movements when simple matching of orders would result
in price changes greater than exchange-prescribed minimums. In their clerical role of match-
ing orders, saitoris are somewhat similar to specialists on the NYSE. However, saitoris do not
trade for their own accounts, and therefore they are quite different from either dealers or spe-
cialists in the United States.
Because the saitori performs an essentially clerical role, there are no market making serv-
ices or liquidity provided to the market by dealers or specialists. The limit order book is the
primary provider of liquidity. In this regard, the TSE bears some resemblance to the fourth
market in the United States, in which buyers and sellers trade directly via networks such as In-
stinet or Posit. On the TSE, however, if order imbalances result in price movements across se-
quential trades that are considered too extreme by the exchange, the saitori may temporarily
halt trading and advertise the imbalance in the hope of attracting additional trading interest to
the “weak” side of the market.
The TSE organizes stocks into two categories. The First Section consists of about 1,200 of
the most actively traded stocks. The Second Section is for about 400 of the less actively traded
stocks. Trading in the larger First Section stocks occurs on the floor of the exchange. The re-
maining securities in the First Section and the Second Section trade electronically.

Globalization of Stock Markets
All stock markets have come under increasing pressure in recent years to make international
alliances or mergers. Much of this pressure is due to the impact of electronic trading. To a
growing extent, traders view stock markets as computer networks that link them to other
traders, and there are increasingly fewer limits on the securities around the world that they can
trade. Against this background, it becomes more important for exchanges to provide the
cheapest and most efficient mechanism by which trades can be executed and cleared. This ar-
gues for global alliances that can facilitate the nuts and bolts of cross-border trading and can
benefit from economies of scale. Moreover, in the face of competition from electronic net-
works, established exchanges feel that they eventually need to offer 24-hour global markets.
Finally, companies want to be able to go beyond national borders when they wish to raise
Merger talks and international strategic alliances blossomed in the late 1990s. We have
noted the Euronext merger as well as its alliance with other European exchanges. The Stock-
holm, Copenhagen, and Oslo exchanges formed a “Nordic Country Alliance” in 1999. In the
last few years, Nasdaq has instituted a pilot program to co-list shares on the Stock Exchange
of Hong Kong; has launched Nasdaq Europe, Nasdaq Japan, and Nasdaq Canada markets; and
has entered negotiations on joint ventures with both the London and Frankfurt exchanges. The
NYSE and Tokyo Stock Exchange are exploring the possibility of common listing standards.
The NYSE also is exploring the possibility of an alliance with Euronext, in which the shares
of commonly listed large multinational firms could be traded on both exchanges. In the wake
of the stock market decline of 2001“2002, however, globalization initiatives have faltered.
With less investor interest in markets and a dearth of initial public offerings, both Nasdaq
Europe and Nasdaq Japan have been less successful, and Nasdaq reportedly was considering
pulling out of its Japanese venture.
Meanwhile, many markets are increasing their international focus. For example, Nasdaq
and the NYSE each list over 400 non-U.S. firms, and foreign firms account for about 10% of
trading volume on the NYSE.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

80 Part ONE Elements of Investments

Part of the cost of trading a security is obvious and explicit. Your broker must be paid a com-
mission. Individuals may choose from two kinds of brokers: full-service or discount brokers.
Full-service brokers who provide a variety of services often are referred to as account execu-
tives or financial consultants.
Besides carrying out the basic services of executing orders, holding securities for safe-
keeping, extending margin loans, and facilitating short sales, brokers routinely provide infor-
mation and advice relating to investment alternatives.
Full-service brokers usually depend on a research staff that prepares analyses and forecasts
of general economic as well as industry and company conditions and often makes specific buy
or sell recommendations. Some customers take the ultimate leap of faith and allow a full-
service broker to make buy and sell decisions for them by establishing a discretionary ac-
count. In this account, the broker can buy and sell prespecified securities whenever deemed
fit. (The broker cannot withdraw any funds, though.) This action requires an unusual degree
of trust on the part of the customer, for an unscrupulous broker can “churn” an account, that
is, trade securities excessively with the sole purpose of generating commissions.
Discount brokers, on the other hand, provide “no-frills” services. They buy and sell securi-
ties, hold them for safekeeping, offer margin loans, and facilitate short sales, and that is all. The
only information they provide about the securities they handle is price quotations. Discount
brokerage services have become increasingly available in recent years. Many banks, thrift in-
stitutions, and mutual fund management companies now offer such services to the investing
public as part of a general trend toward the creation of one-stop “financial supermarkets.”
The commission schedule for trades in common stocks for one prominent discount broker
is as follows:

Transaction Method Commission
Online trading $20 or $0.02 per share, whichever is greater
Automated telephone trading $40 or $0.02 per share, whichever is greater
Orders desk (through an associate) $45 $0.03 per share

Notice that there is a minimum charge regardless of trade size and cost as a fraction of the
value of traded shares falls as trade size increases. Note also that these prices (and most ad-
vertised prices) are for the cheapest market orders. Limit orders are more expensive.
In addition to the explicit part of trading costs”the broker™s commission”there is an im-
plicit part”the dealer™s bid“ask spread. Sometimes the broker is a dealer in the security be-
bid“ask spread
ing traded and charges no commission but instead collects the fee entirely in the form of the
The difference
bid“ask spread.
between a dealer™s
Another implicit cost of trading that some observers would distinguish is the price conces-
bid and asked price.
sion an investor may be forced to make for trading in any quantity that exceeds the quantity
the dealer is willing to trade at the posted bid or asked price.
One continuing trend is toward online trading either through the Internet or through soft-
ware that connects a customer directly to a brokerage firm. In 1994, there were no online
brokerage accounts; only five years later, there were around 7 million such accounts at
“e brokers” such as Ameritrade, Charles Schwab, Fidelity, and E*Trade, and roughly one in
five trades was initiated over the Internet.
While there is little conceptual difference between placing your order using a phone call
versus through a computer link, online brokerage firms can process trades more cheaply since
they do not have to pay as many brokers. The average commission for an online trade is now
less than $20, compared to perhaps $100“$300 at full-service brokers.
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

SEC Prepares for a New World of Stock Trading
costless processing of the basic investor transactions,
What should our securities markets look like to serve to-
brokerages would aid investors in placing more sophisti-
day™s investor best? Congress addressed this very ques-
cated orders. More importantly, brokers would provide in-
tion a generation ago, when markets were threatened
vestment advice. Although today™s investor has access to
with fragmentation from an increasing number of
more and more information, this does not mean that he
competing dealers and exchanges. This led the SEC to
has more understanding of the forces that rule the mar-
establish the national market system, which enabled
ket or the principles of constructing the best portfolio.
investors to obtain the best quotes on stocks from any
As the spread between the best bid and offer price
of the major exchanges.
has collapsed, some traditional concerns of regulators
Today it is the proliferation of electronic exchanges
are less pressing than they once were. Whether to allow
and after-hours trading venues that threatens to frag-
dealers to step in front of customers to buy or sell, or al-
ment the market. But the solution is simple, and would
low brokerages to cross their orders internally at the best
take the intermarket trading system devised by the SEC
price, regardless of other orders at the price on the book,
a quarter century ago to its next logical step. The high-
have traditionally been burning regulatory issues. But
est bid and the lowest offer for every stock, no matter
with spreads so small and getting smaller, these issues
where they originate, should be displayed on a screen
are of virtually no consequence to the average investor
that would be available to all investors, 24 hours a day,
as long as the integrity of the order flow information is
seven days a week.
If the SEC mandated this centralization of order
None of this means that the SEC can disappear once
flow, competition would significantly enhance investor
it establishes the central order-flow system. A regulatory
choice and the quality of the trading environment.
authority is needed to monitor the functioning of the
Would brokerage houses or even exchanges exist,
new systems and ensure that participants live up to their
as we now know them? I believe so, but electronic
promises. The rise of technology threatens many estab-
communication networks would provide the crucial
lished power centers and has prompted some to call for
links between buyers and sellers. ECNs would compete
more controls and a go-slow approach. By making clear
by providing far more sophisticated services to the in-
that the commission™s role is to encourage competition
vestor than are currently available”not only the enter-
to best serve investors, not to impose or dictate the ulti-
ing and execution of standard limit and market orders,
mate structure of the markets, the SEC is poised to take
but the execution of contingent orders, buys and sells
stock trading into the new millennium.
dependent on the levels of other stocks, bonds, com-
modities, even indexes.
SOURCE: Abridged from Jeremy J. Siegel, “The SEC Prepares for a
The services of brokerage houses would still be
New World of Stock Trading,” The Wall Street Journal, September 27,
in much demand, but their transformation from 1999. Reprinted by permission of Dow Jones & Company, Inc. via
commission-based to flat-fee or asset-based pricing Copyright Clearance Center, Inc. © 1999 Dow Jones & Company, Inc.
would be accelerated. Although ECNs will offer almost All Rights Reserved Worldwide.

Moreover, these e-brokers are beginning to provide some of the same services offered by
full-service brokers such as online company research and, to a lesser extent, the opportunity
to participate in IPOs. The traditional full-service brokerage firms have responded to this
competitive challenge by introducing online trading for their own customers. Some of these
firms are charging by the trade; others charge for such trading through fee-based accounts, in
which the customer pays a percentage of assets in the account for the right to trade online.
An ongoing controversy between the NYSE and its competitors is the extent to which bet-
ter execution on the NYSE offsets the generally lower explicit costs of trading in other mar-
kets. Execution refers to the size of the effective bid“ask spread and the amount of price
impact in a market. The NYSE believes that many investors focus too intently on the costs
they can see, despite the fact that quality of execution can be a far more important determinant
of total costs. Many NYSE trades are executed at a price inside the quoted spread. This can
happen because floor brokers at the specialist™s post can bid above or sell below the special-
ist™s quote. In this way, two public orders can cross without incurring the specialist™s spread.
In contrast, in a dealer market, all trades go through the dealer, and all trades, therefore, are
subject to a bid“ask spread. The client never sees the spread as an explicit cost, however. The
Bodie’Kane’Marcus: I. Elements of Investments 3. How Securities Are © The McGraw’Hill
Essentials of Investments, Traded Companies, 2003
Fifth Edition

82 Part ONE Elements of Investments

price at which the trade is executed incorporates the dealer™s spread, but this part of the price
is never reported to the investor. Similarly, regional markets are disadvantaged in terms of ex-
ecution because their lower trading volume means that fewer brokers congregate at a special-
ist™s post, resulting in a lower probability of two public orders crossing.
A controversial practice related to the bid“ask spread and the quality of trade execution is
“paying for order flow.” This entails paying a broker a rebate for directing the trade to a par-
ticular dealer rather than to the NYSE. By bringing the trade to a dealer instead of to the ex-
change, however, the broker eliminates the possibility that the trade could have been executed
without incurring a spread. In fact, the opportunity to profit from the bid“ask spread is the ma-
jor reason that the dealer is willing to pay the broker for the order flow. Moreover, a broker
that is paid for order flow might direct a trade to a dealer that does not even offer the most
competitive price. (Indeed, the fact that dealers can afford to pay for order flow suggests that
they are able to lay off the trade at better prices elsewhere and, possibly, that the broker also
could have found a better price with some additional effort.) Many of the online brokerage
firms rely heavily on payment for order flow, since their explicit commissions are so minimal.
They typically do not actually execute orders, instead sending an order either to a market
maker or to a stock exchange for listed stocks.
Such practices raise serious ethical questions, because the broker™s primary obligation is to
obtain the best deal for the client. Payment for order flow might be justified if the rebate is
passed along to the client either directly or through lower commissions, but it is not clear that
such rebates are passed through.


. 20
( 193 .)