Components of Financial Market System

Numerous approaches exist for classifying the securities markets. At times, the array can be confusing. An examination, however, of four sets of dichotomous terms can help provide a basic understanding of the structure of the U.S. financial markets.

When a corporation decides to raise external capital, those funds can be obtained by making a public offering or a private placement. In a public offering both individual and institutional investors have the opportunity to purchase the securities. The securities are usually made available to the public at large by a managing investment banking firm and its underwriting syndicate. In the public offering the firm does not meet the ultimate purchasers of the securities. The public market is an impersonal market.

In a private placement, also called a direct placement, the securities are offered and sold to a limited number of investors, The firm will usually hammer out, on a face to face basis with the prospective buyers, the details of the offering. In this setting the investment banking firm may act as a finder by bringing together the potential lenders and borrowers: The private placement market is a more personal market than its public counterpart. Both investment banking and private placements are explored in more detail later in this chapter.

Primary markets are those where securities are offered for the first time to potential investors. A new issue of common stock by AT&T is a primary market transaction. This type of transaction increases the total stock of financial assets outstanding in the economy.

As mentioned in our discussion of the development of the financial market system, secondary markets represent transactions in currently outstanding securities. if the first buyer of the AT&T stock subsequently sells it, he does so in the secondary market. All transactions after the initial purchase take place in the secondary market. The sales do not affect the total stock of financial assets that exist in the economy. Both the money market and the capital market, described next, have primary and secondary sides.

The key distinguishing feature between the money and capital markets is the maturity period of the securities traded in them. The money market refers to all institutions and procedures that provide for transactions in short term debt instruments generally issued by borrowers with very high credit ratings. By financial convention, " short term" means maturity periods of one year or less. Notice that equity instruments, either common or preferred, are not traded in the money market. The major instruments issued and traded are U.S, Treasury bills, various federal agency securities, bankers' acceptances, negotiable certificates of deposit, and commercial paper. Keep in mind that the money market is an intangible market. You do not walk into a building on Wall Street that has the words "Money Market" etched in stone over its arches. Rather, the money market is primarily a telephone market where trading does not occur at any specific location. Most agree, however, that New York City is the center of this market.

The capital market refers to all institutions and procedures that provide for transactions in long term financial instruments. Long term, here, means having maturity periods that extend beyond one year. in the broad sense this encompasses term loans and financial leases, corporate equities, and bonds. The funds that comprise the firm's capital structure are raised in the capital market. Important elements of the capital market are the organized security exchanges and the over the counter markets.

Organized security exchanges are tangible entities; they physically occupy space (such as a building or part of a building), and financial instruments are traded on their premises. The over the counter markets include all security markets except the organized exchanges. The money market, then, is an over the counter market.

Because both of these markets are important to financial officers concerned with raising long term capital, some additional discussion is warranted. For practical purposes there are seven major security exchanges in the United States. These are the (1) New York Stock Exchange, (2) American Stock Exchange, (3) Midwest Stock Exchange, (4) Pacific Stock Exchange, (5) Philadelphia Stock Ex change, (6) Boston Stock Exchange, and (7) Cincinnati Stock Exchange. The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are called national exchanges, while the others are loosely described as regionals.

All of these seven active exchanges are registered with the Securities and Exchange Commission (SEQ. Firms whose securities are traded on the registered exchanges must comply with reporting requirements of both the specific exchange and the SEC. About 85 percent of the annual dollar volume of transactions on the registered exchanges takes place on the NYSE. In 1977 the dollar trading volume on the Midwest exchange actually exceeded that of the AMEX, which usually runs second to the NYSE.4 Together, the NYSE, the AMEX, and the Midwest account for over 90 percent of the annual dollar volume transacted on the registered exchanges. in 1982 the NYSE accounted for 81.1 percent of all shares sold on registered exchanges in the United States, with the AMEX accounting for 7.0 percent, and all others 11.9 percent.

The business of an exchange, including securities transactions, is conducted by its members. Members are said to occupy "seats." There are 1366 seats on the NYSE, a number that has remained constant since 1953. Major stock brokerage firms own seats on the exchanges. An officer of the firm is designated to be the member of the exchange, and this membership permits the brokerage house to use the facilities of the exchange to effect securities trades. During 1982 the prices of seats that were exchanged for cash ranged from a low of $190,000 to a high of $340,000. The highest price paid in recent times was $515,000 in 1969. Stock exchange benefits Both corporations and investors enjoy several benefits provided by the existence of organized security exchanges. These include:

1. Providing a continuous market. This may be the most important function of an organized security exchange. A continuous market provides a series of continuous security prices. Price changes from trade to trade, then, tend to be smaller than they would be in the absence of organized markets. The reasons are that there is a relatively large sales volume in each security, trading orders are quickly executed, and the range between the price asked for a security and the offered price tends to be narrow. The result is that price volatility is reduced. This enhances the liquidity of security investments and thereby makes them more attractive to potential investors. While it is difficult to prove, it seems logical to offer that this market feature probably reduces the cost of capital to corporations.

2. Establishing and publicizing fair security prices. An organized exchange permits security prices to be freely set by competitive forces. They are not set by negotiations off the floor of the exchange, where one party might have a bargaining advantage over the other. A bidding process is followed that flows from the supply and demand underlying each security. This means the specific price of a security is determined in the manner of an auction. Additionally, the security prices determined at each exchange are widely publicized. just read the pages of most newspapers and the information is available to you. By contrast, the prices and resulting yields on the private placements of securities are more difficult to obtain.

Helping business raise new capital. Because a continuous secondary market exists where prices are competitively determined, it is easier for firms to successfully float new security offerings. This continuous pricing mechanism also facilitates the determination of the offering price of a new issue. This means that comparative values are easily observed.

Listing requirements To directly receive the benefits provided by an organized exchange, the firm must seek to have its securities listed on the exchange. An application for listing must be filed and a fee paid. The requirements for listing vary from exchange to exchange; those of the NYSE are the most stringent. The general criteria for listing fall into these categories: (1) profitability, (2) size, (3) market value, and (4) public ownership. To give you the flavor of an actual set of listing requirements, those set forth by the INYSE are displayed in Table 17 6.

Many publicly held firms do not meet the listing requirements of major stock ex changes. Others may want to avoid the (1) reporting requirements and (2) fees required to maintain listing. As an alternative their securities may trade in the over the counter markets. On the basis of sheer numbers (not dollar volume), more stocks are traded over the counter than on organized exchanges. As far as secondary trading in corporate bonds is concerned, the over the counter markets are "where the action is." In a typical year, upwards of 90 percent of corporate bond business takes place over the counter.

Most over the counter transactions take place through a loose network of security traders who are known as broker dealers and brokers. Brokers do, not pur chase securities for their own account, whereas dealers do, Broker dealers stand ready to buy and sell specific securities at selected prices. They are said to "make a market" in those securities. Their profit is the spread or difference between the price they will pay for a security (bid price) and the price at which they will sell the security (asked price).

Price quotes The availability of prices is not as continuous in the over the counter market as it is on an organized exchange. Since February 8, 1971, however, when a computerized network called NASDAQ came into existence, the availability of prices in this market has improved substantially. NASDAQ stands for National Association of Security Dealers Automated Quotation System. It is a telecommunications system that serves to provide a national information linkup among' the brokers and dealers operating in the over the counter markets, Subscribing traders have in their offices a cathode ray terminal that allows them to obtain representative bid and ask prices for thousands of securities traded over the counter. NASDAQ is a quotation system, not a transactions system. The final trade is still consummated by direct negotiation between traders.

NASDAQ price quotes for many stocks are published daily in ' the Wall Street journal. This same financial newspaper also publishes prices on hundreds of other stocks traded over the counter. Local papers supply prices on such stocks of regional interest. Finally, the National Quotation Bureau publishes daily "pink sheets," which contain prices on about 8000 securities; these sheets are available in the offices of most security dealers.