Chapter Five Securities Makets

FIM: Securities Markets*Chapter 5: Securities MarketsWhat do securities markets do?What is the microstructure of securities markets?How trades are executed?Securities Markets RegulationA comparative study of Nepal with developed economy

FIM: Securities Markets

FIM: Securities Markets*Financial System facilitated lending, Payments and trade in risk through financial intermediation and organized securities markets.Major security markets areThe market for the government securitiesThe money marketsThe capital marketsThe mortgage marketThe market for derivatives


FIM: Securities Markets*Functions of Securities MarketsSecurities markets facilitate the sale and resale of transferable securities.The market in which new securities are sold is called the primary market; the market in which existing securities are resold is called the secondary market. The secondary markets are created by the brokers and dealers.


FIM: Securities Markets*Functions of securities markets include:Price discovery: Determine a fair price for the securitiesThe provision of liquidity: Enable transactions to be made at this price quickly and easilyCost minimization: Enable transaction to be made at as low cost as possible.


FIM: Securities Markets*Price DiscoveryPrice discovery is the process of arriving the fair prices for securities.Security market sets a fair price for the securities.Fair prices may be offer and bidOffer price for a security is the lowest price at which any well informed trader is willing to sell it.A fair bid price is the highest price any well informed trader is willing to pay for it.In an Ideal Market, all traders take place at fair prices. It is ideal only, however useful for benchmarking against the performance of the actual market.


FIM: Securities Markets*Provision of LiquidityLiquidity is the ability to turn an asset into cash quickly without loss.Security market provides liquidity if you can buy or sell in it quickly without loss.Example: a) if you want to sell your 100 share of EBL. b) if you want to purchase 500 shares of NABIL.Like financial intermediaries, the basic source of the liquidity of securities markets is Pooling. Some people wish to turn their securities into cash; others wish to turn their cash into securities.


FIM: Securities Markets*There is a chance of Liquidity Imbalance, situation is which the desire to cash an asset does not balance the desire to exchange cash for the asset.In a securities market that provides good liquidity, the market price should not fluctuation in response to a liquidity imbalance.If the market price does fluctuate in response to a liquidity imbalance, then the market price is not fair and the market is not ideal.


FIM: Securities Markets*The Minimization of Trading CostsTrading securities involves all the problems like, agreeing on the terms of a transaction and the execution of trade ( the settlement of the transaction: security against money) that involves the cost and risk.

Organized markets lower the cost of trading.Cost Easier Trade Better the market perform its basic functions


FIM: Securities Markets*Ways of minimizing trading costs

Restricted Access and Rules of Conduct Standardization Conflict ResolutionGuaranteed Execution


FIM: Securities Markets* Restricted Access and Rules of Conduct: Restricting access to the market: only authorized traders are allowed to participate. An authorized trader must satisfy certain standards: capital requirements, accounting standards, and the standard of honesty.The organized markets also have the sets of rules governing the conduct of their members- disciplinary actions to the violating members, punishmentsThis all increases the confidence with trading and reduces the trading costs.


FIM: Securities Markets* Standardization: Transactions are standardized for e.g on NEPSE, stocks are traded in round lot such as 10 or 100 shares. Settlement is T+3 days, how and when to transfer the securities and cash . Standardization makes the trading much easier and simpler: nature of the transactions and the other parameters of the transactions are automatically understood by the traders, only the traders need to be agreed on the price and quantity.


FIM: Securities Markets* Conflict Resolution: Disputes among the trader involves the time and cost. It is inevitable part of trading, but organized markets reduce the cost by providing the institutional frameworks to resolve the dispute.Guaranteed Execution: Execution of a transaction involves a variety of the risks- costly affair. Organized markets guarantee execution of the transactions agreed to by traders.


FIM: Securities Markets*Dealer Markets and Auction MarketsThere are two alternative ways to conduct trading - the dealer markets and the auction marketDealer quotes bid and ask prices for the securities.Dealer market is a market made by the dealers, who quote prices at which they are willing to buy and sell.


FIM: Securities Markets*The government Securities market is a Dealer Market.All OTC markets are Dealer markets.Auction Market is a market in which the orders of traders are matched directly.You order the broker with the price you are willing to buy or sell and broker passes on your order to the trading pit.


FIM: Securities Markets*The future market is the auction marketDealer markets are Quote-driven and Auction markets are Order-drivenSome markets are Hybrids. For example, NEPSEDealer markets and auction markets have two functions: Price discovery and the Provision of Liquidity.


FIM: Securities Markets*How Dealer Markets WorkIn Dealer market, the responsibility of setting price rests with the dealers. Dealers should change the price with new information and should not change the price with the liquidity imbalance.The important aspects of the dealer market areInformation traders and liquidity tradersThe role of bid and ask spread.


Information Traders and Liquidity TradersInformation traders purchase or sell as per the information available in the markets. They are always motivated by the profit. The gap between market price and the fair price.For example, Mr. Satish is working for the steel industry, steel company currently quoted Rs.2,000. He knows that the price will further reduces to Rs.1,900. So Satish can make a profit from his superior understanding of the Steel industry by selling short.

FIM: Securities Markets*


FIM: Securities Markets*Selling short means borrowing a security and selling it now, and buying back it later when the security prices will decrease.Liquidity traders are those traders who trade for reasons unrelated to the price of a security. Trading in an Ideal market.The problem with dealers is that they cant separate the information traders and liquidity traders.They receive the strong incentive to set fair price .


FIM: Securities Markets*The Role of Bid Ask spread: What will happen with the trading of Mr. Satish if hard Dealers set price of a Steel company; Bid-Rs.1,900 and Ask-Rs.2,100?Generally, greater the uncertainty about the fair price, and the greater the threat from information traders, the greater will be the bid-ask spread. However, greater the bid-ask spread, greater will the dealers profit from trading with liquidity traders. This will compensate the loss from information traders.


FIM: Securities Markets*Therefore, Greater the uncertainty about a fair price, and greater the threat from information traders, the less well will dealer market provide liquidity.


FIM: Securities Markets*How Auction Markets WorkIn an auction market there is no dealer to set the price. Buy and sell orders are brought together and the price is set to clear the market. (Demand and supply determines the price).Price responses to the new information and to liquidity imbalance.Price will rise or fall more gradually as the trading takes place.Information traders play vital role in the auction market by providing liquidity.


FIM: Securities Markets*Differing from the dealer market, in auction market trading informations are made available as quickly as possible. The better the information, the easier it is for information traders to come in and smooth out liquidity imbalance.Types of orders: Auction markets have different ways of bringing orders together.Market OrderLimit Order


FIM: Securities Markets*Market Order: Instruction to buy or sell at the prevailing market price.Limit Order: Instruction to buy or sell if the market price crosses a stated limit.Except these two basic orders there are other orders too:Stop Order: Broker is to trade once the market price reaches a certain level, but then the order becomes market order.Stop limit order: A stop order that becomes a limit order once the price reaches a certain level.


FIM: Securities Markets*Market-if-touched order: A sell order entered at a price above the current price.Fill-or-kill order: The broker is to buy or sell at the specified price or better, but if the order can not be filled immediately, it is automatically cancelled.Percentage order: The percentage of the order to be activated depends on trading volume in the security.


FIM: Securities Markets*Not-held order: Market order that gives floor brokers permission to delay if they think they can get a better price.One-cancels-the-other order: The simultaneous orders, with the remaining one cancelled when the first is executed.Specific-time order: One the must be executed at or by a given time. E.g on the close, at the beginning etc.


FIM: Securities Markets*Types of Auctions:Call Auction and Continuous AuctionSealedbid Auction and Open-bid AuctionCall auction is an auction in which trading takes place only at certain prearranged times-the calls.In contrast to the call auction, in continuous auction the orders are filled as they arrive.Most markets use a combination of call and continuous auctions.


FIM: Securities Markets*For example, there may be a call at the beginning of each trading session-called clearing transaction- to clear orders accumulated since the previous trading session. Then, continuous trading proceeds until the end of the session. The main advantage of call auction is that there is less fluctuation in price as result of liquidity imbalance.


FIM: Securities Markets*The main advantages of continuous auction are; first price is always available; with a call auction price is always uncertain between the calls. The second, it allow the faster execution of the order; traders are executed immediately rather than having to wait for the next call.


FIM: Securities Markets*Open-Bid Versus Sealed Bid Auction:In an open-bid auction, offers to trade are announced to all market participants. For example, Open-outcry trading in the NEPSE.In a sealed bid auction, offers to trade are known only to the bidder and perhaps to the auctioneer. For example, Auction for Nepal Rastra Banks T-Bill.


FIM: Securities Markets*Execution of TradeExecution of trade means changing the hands of securities and money. It is costly and involves risk.The Risk of Trade Execution: Suppose there are two brokers X and Y at NEPSE, X agrees to sell 1000 shares of LBL ( order of A ) at Rs.500. To execute this transaction, X need to transfer ownership of shares to Y, and Y needs to transfer the cash to X. The hundreds of transactions happens in each day. It involves the paperwork.


FIM: Securities Markets*If this all work had to do by X and Y, they wouldnt be able to do much trading.In reality, once X and Y agree on the terms, execution is handed over to others in the back office. Process T+3 in NEPSE.This delay between agreement on a trade and its execution makes a transaction in the securities markets a forward transaction.


FIM: Securities Markets*It involves following risks.Principal riskLiquidity riskOperational riskSystemic riskReplacement riskPrincipal risk is the risk of default by a counterparty after you have fulfilled your part of a deal. This risk can be eliminated by making delivery and payments simultaneously. Delivery against payments (DAP).


FIM: Securities Markets*Replacement Risk is the risk that a counterparty will fail to execute an agreed-upon transaction, leaving you to find other deal.Liquidity Risk is the risk that other transactions will be compromised because an agreed upon transaction is delayed.Operational Risk the risk that execution will be delay due to failure of the trading system.Systemic Risk is the risk that the failure of one trade or trader will cause the failure of others in a domino effect.


FIM: Securities Markets*Clearing and SettlementTrade execution involves two stepsClearing and SettlementBoth take time Clearing is the process of comparing and matching tradesSettlement is the fulfillment of obligations conformed during clearing


FIM: Securities Markets*A brief conversation in trading;You and BYou: EBL?B: 1200 to 1200 10/20 ( bid and ask price)You: I sell 100! (You sell 100 round lots of 100 shares each.)This conversation should be implemented. First, Conform the trade ( Clearing)-Types and quantity of securityTransaction date and priceIdentification of buyers and sellers


FIM: Securities Markets*After clearing the trade, the Second is the arrangement of settling the trade. This is delivering the securities to B; B verifies the securities and you receive payments in the acceptance form.


FIM: Securities Markets*The Advantages of NettingNetting is a financial technique used to reduce the costs involved in the settlement of trade. General bilateral netting arrangement: e.g. trading EBL shares with B over a period of time, and just settle net position at the end of the period.Multi-issue nettingnetting trade is all securities with B.


FIM: Securities Markets*Multilateral multi-issue netting: All securities and all other traders in the market. At the end you would just make a receive a single transfer of money and a single transfer of each securities you made.Longer the netting period, the more transaction will offset one another, and fewer will be the deliveries that actually need to be made.On the other hand, longer the netting period, the greater the exposure to replacement risk.


Need for regulating security marketsInformation efficiencyThe need for consumer protection1. Information EfficiencyInformation efficiency refers to the condition in which the prices a market generates accurately reflect available information.Definitions of information efficiencyA market displays weak informational efficiency if current prices reflect all information contained in the record of past prices.

A market displays semi strong informational efficiency if current prices reflect all generally available information.A market displays strong informational efficiency if current prices reflect all information, even if that information is not generally available.Efficient securities markets reduce the cost of lending and trade in risk.They result in more lending and more trade in risk and consequently for the economy as a whole.

Finding the fair price is not only beneficial to the buyers and sellers but also others that do not directly involved in the securities markets.For example, many people who do not involved in the oil futures, such as manufacturers of the automobiles, will be affected by the future price of the oil.Therefore, it is reasonable to regulate the security market

2. The need for consumer protectionDue to asymmetries of information, the small investor is less well informed than market professional and is therefore in danger of being cheated.Government regulation is required to ensure fair deal for small investor-consumer protection.First requirement of a fair deal is that securities trade at a fair price.

Causes of securities not trading at fair price:Asymmetries of information's- better informed traders might sell securities for more than they are worth or buy them for less.Manipulation of the market- Squeeze or corner- the creation of an artificial liquidity imbalance designed to raise the market price of an assetsA fair markets price is only requirement for a fair deal - Small investors do not trade in the market themselves: they delegate the task to professions.Churning- Unjustified trading of a customers account by a broker to generate commissions for the broker.

Market SolutionSelf regulation: enforcement of standards and rules by a community of market participants. Brokers should think about the long term profit rather than short term.They sometimes provide investor with explicit or implicit guarantees to enhance their confidence in the market.In addition, if investors feel so disadvantage in in securities markets a variety of institutions have grown as an alternative where investors can delegate their investors such as life insurance companies, pension funds and mutual funds.

Security market regulating laws in USSecurities Act of 1933Securities Exchange Act of 1934Glass-Steagall Act of 1933Investment Advisors Act of 1940Securities investor protection corporation Act of 1970Commodity Exchange Act of 1936Commodity Future Trading Commission 1974.

Security Markets in NepalNepalese Security market started with the floatation of shares by Biratnagar Jute Mills & Nepal Bank Ltd in 1937.1964: First issuance of the Government BondsThe study of security market of Nepal can be organized into two parts. Organizational Aspect Regulation Aspect

Organizational AspectPrimary market: In primary market, the fresh issues are made. In Nepal, there are 9 issue managers (Investment banks) are performing the primary transactionSecondary market: The sole secondary market, market where the already issued securities are traded, is Nepal Stock Exchange (NEPSE).In NEPSE, corporate securities and bond securities are traded.Corporate securities include Ordinary Shares, debentures and preference shares.Government Bonds and NMC Mutual Fund are also popular trading securities in NEPSE

At present, there are 49 brokers, 9 issue manager and 2 dealers working in the securities market in Nepal.Besides this, in the money market consists of the T-Bills, Certificates of deposits, Letters of Credit, Reverse Repo.Regulation AspectsSecurities Board of Nepal (SEBON) is an apex regulator of securities market in Nepal. It has been regulating the market under the securities exchange act of 2006.

Major securities laws in NepalAct: Securities Act 2063Regulations:Securities Board Regulation, 2064Stock Exchange Operation Regulation, 2064Securities Businessperson (Stock Broker, Dealer & Market Maker) Regulation, 2064Securities Businessperson (Merchant Banker) Regulation, 2064Securities Registration and Issue Regulation, 2065SEBON Procurement Regulation, 2066Mutual Fund Regulation, 2067Central Depository Service Regulation, 2067 (2010)Credit Rating Regulation, 2068

Guidelines and BylawsMutual Fund Guidelines-2069Compliance Guidelines for Securities Broker, 2058Securities Issue Guidelines, 2065Bonus Share Guidelines, 2067Portfolio Management Guidelines, 2067 (2010)Government Securities Bylaws of SEBON, 2062Government Securities Transaction Bylaws of NEPSE, 2062Securities Allotment Guidelines, 2068CDS Byelaws, 2068 FIM: Securities Markets*


Comparison: Listed CompaniesFIM: Securities Markets*

CountryNumbersNepal176India4,921Sri Lanka234Indonesia396Malaysia977Tanzania7Uganda6


Market capitalization/DGPFIM: Securities Markets*


Turnover / Market capitalizationFIM: Securities Markets*


Top Ten Companies/Market CapitalizationFIM: Securities Markets*


Nepal India ComparisonLegal Framework

India SEBI Act 1992 set up SEBI as an independent regulatorPowers under Companies Act delegated to SEBI NepalSEBON empowered under the Securities Act of 2007Companies Act for issuance and listing of shares FIM: Securities Markets*


Market InfrastructureIndia Two main exchanges; BSE and NSETwo depositoriesOnline screen based trading with 99% trading in demat formClearing Corporations offering guaranteed clearing and settlement of trades NepalOne exchange-NEPSE - govt ownedManual clearing & settlement systemCentral depository system being introduced by NEPSEFIM: Securities Markets*


Level of IntermediationIndiaLarge number of brokersApprox 1000 each at BSE and NSE Merchant BankersDepository ParticipantsMutual Funds Debenture TrusteesCredit Rating Agencies NepalFew brokersMerchant bankersLimited roleNo depository participantsOne mutual funds/ portfolio managersNo Credit Rating AgenciesNo Debenture Trustees

FIM: Securities Markets*


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Chapter Five Securities Makets