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Thursday, September 13, 2007

A stock exchange, share market or bourse

A stock exchange, share market or bourse is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities traded on a stock exchange include: shares issued by companies, unit trusts and other pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it has to be listed there. Usually there is a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors which, as in all free markets, affect the price of stocks (see stock valuation).
There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that bonds are traded. Increasingly, stock exchanges are part of a global market for securities.

The "upstairs market"

Recent research by Kumar Venkataraman, finance professor at SMU's Cox School of Business, and Hendrik Bessembinder offers insight and evidence into new possibilities and difficult issues facing stock exchanges. In “Does an electronic stock exchange need an upstairs market?” from the July, 2003 issue of Journal of Financial Economics, the authors find that a large proportion of institutional trading in electronic exchanges is executed away from the centralized book in the informal 'upstairs market', thus presenting new challenges.
Despite the efficiencies of computerized markets, virtually every stock market is accompanied by a parallel "upstairs" market, where larger traders employ the services of brokerage firms to locate counterparties and negotiate trade terms. Upstairs markets are based on relationships. Rather than submitting an electronic order to effortlessly attract counterparties, the upstairs brokers seek out counterparties (from traders known to them who might be interested). They then negotiate transactions that might otherwise be executed at an inordinate cost or delay. An electronic trading system lowers the fixed costs of trading for relatively liquid stocks in block sizes not likely to overwhelm the current market. However, it does not allow for the informal exchange of information (?) that is important for certain types of large trades and for illiquid stocks.

In electronic markets, traders don’t get a sense of who they’re trading with, how much more the other party is trading, etc., and that information can be very important to some traders. Large (institutional) traders therefore seek other trading venues such as the 'upstairs market' to lower the risk of exposing their order positions, to ensure symmetric transfer of information, and to retain some of the give and take of the old open outcry market. Approximately 70% of block-size trade transactions are executed in the upstairs market in Paris.
The Paris Bourse provides an excellent illustration of the use of upstairs intermediation markets, because its electronic limit order market closely resembles the downstairs (electronic) markets envisioned by theorists. The best evidence from the Paris Bourse is that:
Upstairs brokers lower the risk of adverse selection by "certifying" block orders as uninformed (i.e., as not having access to nonpublic information).
Upstairs brokers are able to tap into pools of hidden or unexpressed liquidity (they frequently 'go looking' for buyers or sellers not currently in the market).
Traders strategically choose across the upstairs and downstairs markets to minimize expected execution costs (including slippage, etc.).
Trades are more likely to be routed upstairs if they are large or are in stocks with low overall trading activity.
The second result is the most novel and arguably the most important. The upstairs broker completes transactions by searching for institutional investors who may be interested in the stock, but who have not as yet formally expressed their trading intentions. It is documented that executions costs of transactions completed by the upstairs broker average only 35% of what they would have paid if completed against limit orders in the centralized electronic exchange, suggesting that trading relationship and the informal exchange of information between upstairs brokers and institutional traders helps lower execution costs. One major challenge facing electronic markets is the lack of a comparable mechanism of certification of traders and information exchange.
The Euronext market allows large transactions in some stocks to be executed outside the quotes. Such outside-the-quote transactions are not permitted in United States markets. For eligible stocks in Paris, market participants agree to outside-the-quote execution mainly for more difficult trades and at times when downstairs liquidity is lacking. These likely represent trades that probably could not have been otherwise completed, suggesting that market quality can be enhanced by allowing participants more flexibility to execute blocks at prices outside the quotes. These findings are particularly relevant to U.S. markets because quoted spreads and depths have decreased substantially in the wake of decimalization.
The upstairs market in the Paris Bourse completes two-thirds of block trading volume, compared with 20% on the New York Stock Exchange (NYSE). A likely explanation is that the NYSE floor allows large traders to execute customized strategies through a floor broker, while avoiding the risks of order exposure. If orders submitted to electronic markets do not allow block initiators to limit order exposure and trade strategically, then order flow is likely to migrate to alternative trading venues such as the upstairs market. If you’re a liquidity trader, you don’t want the system to be anonymous. If you’re an informed trader you like anonymity because you can hide in the order flow.

To compete with broker-intermediated markets, the next generation of electronic trading systems needs to include features that better meet the needs of large traders, particularly the lack of anonymity. To allow large investors to manage order exposure in an electronic exchange, a wider range of order types that include state contingent exposure and execution algorithms need to be made available. The NYSE’s recently introduced “Conversion and Parity” (CAP) orders which are intended to be “smart” orders for large lots of stocks that are executed gradually through the day, contingent on market conditions, are a step in this direction.

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