How Securities are Traded in the Financial Markets

Investment Policy

1. 3.
How Securities are Traded

2. Intro
Markets are organized to
➢provide liquidity (trading without delay at relatively low
cost),
➢transparency (availability of timely and accurate market
and trade information), and
➢trade settlement
Below are the list of main execution systems:
➢Brokered markets, in which traders rely on a broker to find
the other side of a desired trade.
➢Quote-driven (or dealer) markets, in which members of
the public trade with dealers rather than directly with one
another.
➢Order-driven markets, in which members of the public
trade with one another without the intermediation of
dealers.

3. Types of Markets/Execution
Systems
Brokered markets
Brokers actively search to match buyers and sellers in
brokered markets.
Broker's role is to find liquidity. This is valuable in
typically illiquid markets where traders usually do not
make public offers to trade
➢items traded are unique and
➢dealers will not hold inventories and will not normally
trade
E.g., a market for large blocks of stocks and bonds
(although these securities may trade in very liquid
markets for small sizes), the real estate market.

4. Quote-Driven or Dealer markets
Searching buyer/seller can take time and prices may change.
Quote-driven markets offer liquidity.
Dealers (market makers) buy and sell from their own
inventory.
A dealer’s compensation is the difference between the price
at which a security is purchased by investors (ask) and that
at which it is sold by investors (bid). This is called the bid-ask
spread.
Over the Counter (OTC) Market - dealers tend to specialize in
a narrow range of issues, as market makers.
Types of Markets
(Continued)

5. The Over the Counter (OTC) Market
Dealer market without centralized order flow (no
physical location)
NASDAQ (a.k.a. the “unlisted” market) - largest
organized stock market for OTC trading (since
1971)
Can have more than one dealer (market maker)
per stock.
Securities: stocks, corporate and municipal bonds
(most secondary bond transactions), and
derivatives (e.g., swaps and spot currencies).
Gross market value of OTC derivatives was over
$15 trillion in 2020.

6. Order-driven markets
➢Transaction prices are established by public limit
orders
➢Usually no intermediation by designated dealers
(market makers)
➢Lists of limit orders are called a limit order book
(LOB)
➢Orders submitted by traders are arranged based
on a rules-based, order-matching system run by
an exchange, a broker, or an alternative trading
system (ATS), also known as electronic
communication networks (ECNs).
Electronic trading systems have largely displaced
floor-based trading systems in all instruments for
which order-driven markets are viable.
Types of Markets (Continued)

7. Order-driven markets are now organized by most
exchanges and electronic communication networks
(ECNs).
Types
➢Electronic Crossing Networks
➢Auctions (markets in which the orders of multiple
buyers compete for execution)
➢Automated Auctions (Electronic Limit-Order
Markets) such as ECNs (Electronic Communication
Networks): NYSE Arca Exchange in the United
States and the Paris Bourse in France for equities
➢Hybrid markets are combinations of the previously
described market types.
Types of Markets
(Continued)

8. Island ECN Limit
Order Book
sell 190 market
Top limit order filled
2 shares remain here
Top of Island ECN at 11:57:28 ET on
January 28, 2002
Source: Larry Harris, “Trading and
Exchanges”

9. Island ECN Limit
Order Book
sell 350 market
Top 3 limit orders filled
Price drops to $19.73
Top of Island ECN at 11:57:28 ET on
January 28, 2002
Source: Larry Harris, “Trading and
Exchanges”

10. Auction markets
For example, the world’s largest exchange (New
York Stock Exchange or NYSE – now a hybrid
market)
High transaction volume ensures that trades are
executed swiftly
Auction ensures price discovery (prices are
determined by supply and demand) and, thus,
avoids the insecurity of attaining less than best
prices
Types of Markets
(Continued)

11. Organized Exchanges (“Listed” Markets)
Auction markets with centralized order flow
(physical location)
A specialist or registered trader per stock (assigned
by the exchange)
Examples:
➢National – The Toronto Stock Exchange (TSE), NYSE
(hybrid), AMEX;
➢Regional – Boston, Pacific
Securities: stocks, futures, and bonds. Corporate
bonds are traded both on the exchanges and OTC, but
Canada, Provincial and Municipal bonds are traded
only over the OTC (same as U.S. federal and
municipal government bonds)

12. The New York Stock Exchange (NYSE)
NYSE is an auction market, but it is also a quote-
driven market (by NYSE dealers, a.k.a.
specialists), and a brokered market (brokers may
arrange large block trades here).
Automated trading - members post buy/sell
orders that are matched with orders posted by
other traders in the automated trading system.
NYSE specialists act as both brokers and dealers in
the stocks assigned to them
➢Maintain the limit order book
➢Provide liquidity to keep a fair and orderly
market

13. Types of Orders
⚫Instructions to the brokers on how to complete the order.
⚫Market – removes liquidity, immediate execution at the
best current price (cost: pay the bid/ask spread).
Drawback is price uncertainty.
Limit order – trade at the limit price or better, offers
liquidity. Drawback is execution uncertainty and ex post
regret (prices move toward and through their limit prices).
➢limit buy - buy when price falls to target (trade at or
below the limit price)
➢limit sell - sell when price rises to target (trade at or
above the limit price)
➢Adverse selection risk is the most important cause of ex
post regret.
➢standing limit orders are options to trade

14. Types of Orders
⚫Stop order – stops an order from executing until price
reaches a stop price. Purpose: risk management.
➢turns into a market order once the stop is reached.
➢want to buy (sell) only after price rises (falls) to the
stop price
➢stop loss (= order to sell) - sell when price falls to
target
➢stop buy - buy when price rises to target
⚫Question on Types of Orders:
➢Why do Bid/Ask spreads tend to widen in volatile
markets?

15. Buying on margin
Borrow part of the cost of the security from
broker (Margined stock is left with the broker)
Margin arrangements differ across securities
For stocks margin requirement (cash
collateral): 30% of the total value of the
trade is equity (borrow 70%)
Margin Trading

16. Cannot borrow more than 70% (Set by securities
commissions)

Minimum margin - minimum level the equity
margin can be (called “maintenance” in USA)
Margin call – broker calls for more equity funds
We assume that no interest is earned on margin
accounts and that stocks do not pay dividends
during the margin trading period
Buying Stocks on Margins to ck of v alu e
lo an-s to ck of v alu e
s to ck of v alu e
acco u n t ineq u ity
Margin ==

17. X Corp. share costs: $70
Initial Margin 60%
Minimum Margin 30%
Shares Purchased 1,000
Initial Position
Stock $70,000 (= 1,000x$70)
Borrowed ($28,000) (40%)
Equity $42,000 (60%)
Margin Trading – Initial Conditions

18. Margin Trading - Minimum Margin
Stock price falls to $60 per share
New Position
Stock $60,000 (changes with stock price)
Borrowed ($28,000)
New Equity $32,000 (changes with stock price)
New Margin%33.53Margin
$60,000
$32,000
stock of value
accountin equity
===

19. Margin Trading - Margin Call
How far can the stock price fall before a margin
call?
Recall: the minimum margin is 30%
Therefore, P = $40
Note: 1,000xP – Amount Borrowed = Equity%30
000,1
000,28$000,1
stock of value
loanstock of value
=

−
=
−
P
P

20. Short Sales
Purpose:
to profit from a decline in the price of a stock or
security
Mechanics:
borrow stock through a dealer and instantaneously:
sell it and deposit proceeds and margin in an
account as a collateral
close out the position at a later day: buy the stock
and return it to the owner

21. Short Sale - Initial Conditions
Z Corp. share costs: $100
Initial Margin 45%
Minimum Margin 30%
Short 100 Shares
Initial Position
Sale Proceeds $10,000 (= $100x100)
Margin $4,500 (= 45%x$10,000)
Collateral in account $14,500
Stock Owed (liability) $10,000

22. Short Sale - Minimum Margin
Stock Price Rises to $110
New Position
Sale Proceeds $10,000
Initial Margin $4,500
Collateral in account $14,500 (unchanged)
Stock Owed (liability) ($11,000)(changes w/ stock price)
Net Equity $3,500 (= $14,500-11,000)
(changes w/ stock price)
New Margin%82.31Margin
$11,000
$3,500
liability
equitynet
===

23. Short Sale - Margin Call
How much can the stock price rise before a
margin call?
Recall: the minimum margin is 30%
Therefore, P = $111.54%30
100
100500,14$
liability
liabilitycollateral
liability
equitynet
=

−
=
−
=
P
P

24. Costs of Trading
Explicit
Commission: fee paid to broker for making the
transaction
◼Discount broker (only facilitates trading)
◼Full-service broker (also advice)
Implicit
Spread: cost of trading with a dealer
◼Bid: price dealer will buy from you
◼Ask: price dealer will sell to you
◼Spread: ask – bid
Price Impact (“walking” down LOB)

25. Example: Norbert’s Gambit
US-listed ETFs is a tax-efficient way to invest in US
equity within your RRSP
Currency = USD
Discount brokerages charge ~1.5% to convert CAD to
USD
Is there a better way? Yes, Nortbert’s Gambit using two
versions of Horizon’s US Dollar Currency ETF, DLR and
DLR.U (both trade on the TSX; DLR in CAD and DLR.U in
USD).
Buying USD on2024-12-29 to buy USD
Venue Bid, CAD/USDAsk, CAD/USDCCU.A/RBC.A vs O.A DLR XR
CCU 1.4203 1.4603 1.28%
OANDA 1.4411 1.4418
DLR 14.7700 14.7800
DLR.U 10.2500 10.2600 1.4420
RBC 1.3968 1.4738 2.22%

26. Example: Norbert’s Gambit
How much will you save?
Assume you use CAD 5000 to buy USD. Assume a
commission of $9.95 on each leg.
Strategy
CAD
investment
# DLR
bought
USD proceedsEFF XR
NG USD
savings
NG USD
savings, %
NG $5,000.00337.62$3,450.671.44899
CCU $5,000.00 $3,423.951.46030$26.72 0.77%
RBC $5,000.00 $3,392.591.4738$58.08 1.68%
Wise$5,000.00 $3,458.661.44646-$7.99 -0.23%