Financial Education

Brokers and dealers play different roles in securities markets.

The broker is an agent of the investor. He represents the order, finding opposite sides of the trade. Brokers also supply market information, provide discretion and secrecy, and sometimes provide other supporting services such as margin, record-keeping, custody, etc.)

Dealers are adversaries of the investor. They benefit from a higher bid/ask spread, where the investor covets a lower one. Since their profits are small on a given trade, they are unwilling to trade against informed investors (those who have specific information that the security is mispriced) or those with a reputation for finding mispriced securities. The informed investors want to maintain their ability to trade, and thus don’t want dealers to know they are behind the order.

Secondary markets are those in which securities that have already been issued trade. Transactions occur between investors, and the proceeds do not affect the issuer. Instead, one investor gives another investor cash in exchange for the securities.

Secondary markets provide liquidity to the investors who initially buy the securities. Investors value liquidity because changes in their circumstances may require them to sell the security in order to use the cash for other purposes. By having a liquid secondary market, investors are willing to pay more (accept a lower return) when buying primary issues. This helps issuers raise money at more favorable rates.

Secondary markets also offer issuers price discovery - new issues can be priced according to the value of other similar securities.

The quoted bid/ask spread is the difference between the lowest ask price for a security and the highest bid price. For small orders, the quoted spread is a good indication of the execution cost for a trade. For large orders, however, it may not fully represent the cost.

The effective spread better captures the cost of a round-trip order by including both price movement (dealers coming in to execute orders at a better price than previously quoted) and market impact (spread widening due to the size of the order itself.)

Effective spread is defined as twice the difference between the actual execution price and the market quote at the time of order entry. For example, an order is entered when the quote is $10.00/$10.20. The order is executed at $10.15. The effective spread is 2(10.15 - 10.10) = $0.10.

The primary market refers to trading in new issues of securities. This could be bond issues by corporations or governments, stock issues by corporations or other types of securities in which the initial trade is being made by transferring funds from investors to the security issuer.

Consider, for example, the initial public offering of a stock. The company sells shares to investors, increasing the total number of shares outstanding. Proceeds from the sale increase the company’s cash position, which enables it to invest in new opportunities.

Part of the responsibility of any investment manager is to seek the best possible execution for clients. Best execution is the trading strategy that maximizes the value of the client’s portfolio, subject to the investor’s objectives and constraints.

Some characteristics of best execution include:

• A tie to the investment decision (obtaining the right price or capitalizing on the information)
• Inability to know what the best execution will be prior to the actual execution, but an ability to measure and analyze the execution afterward
• A component of complex practices and relationships that are undergoing continuous refinement

To help achieve best execution, firms should establish processes around maximizing the asset value of client portfolios, and establish guidelines for measuring and managing execution. The compliance with these procedures should be documented and disclosed to clients.

Firms should also disclose general information about their trading techniques, venues and agents and also any potential conflicts of interest that may result.

Global securities markets are organized into a number of different structures.

Quote Driven (Dealer) Markets

These markets rely on dealers to provide liquidity by establishing firm prices at which securities can be bought or sold. The dealers will buy securities for inventory at a specified offer price and sell securities from inventory (or short) at a specified ask price. The dealers’ benefit for providing liquidity is the difference between the bid and ask prices (the bid-ask spread).

Dealer bid and ask prices are subject to a limit on the number of shares offered (bid or ask size). In effect, the bid and ask are limit orders placed by the dealer. If multiple dealers are placing orders, it is not necessary for the same dealer to have the best bid and the best ask. Consider the following dealer order book:

Dealer C is offering the best bid for shares at $100.05. Any sell orders will go to dealer C. Dealer D is offering the best ask price at $100.15 and will fill any market buy orders. Although Dealer B is willing to accept the smallest spread, he is not offering the best price at either the bid or the ask and will only fill orders that exceed the bid and ask sizes offered by dealers C and D.

The inside quote is the best bid from any dealer and the best ask by any dealer. The spread for the inside quote will be less than or equal to the smallest bid-ask spread for a given dealer.

Order Driven Markets

In order driven markets, transaction prices are established by  public limit orders and there is no intermediation by designated dealers. The lack of dealers could have different types of impact on order prices:

• Competition could be higher because there are more public participants than there would be dealers. This is often true of highly liquid securities.
• Competition could be lower because there are no dealers who are required to fill orders by taking in or drawing down inventory. This can be the case for less liquid securities.

Current trends favor order-driven markets, including:

• Electronic crossing networks that batch orders together and cross them at a specific time. The fulfillment price will be the price at which the most shares can be traded - all buy orders with prices above the trading price are matched with the sell orders below that trading price. When trading on such networks there is no price discovery - the price at execution is not known until there is execution.
• Auction markets in which orders compete for execution. Since the orders are visible there is price discovery. Auction markets can be batch markets or continuous auction markets.
• Automated auctions operate continuously and offer price discovery. Execution is based on a set of rules.

Brokered Markets

The broker is an agent of the buy side trader who collects a commission in exchange for skillful execution of the trade. Particularly when a trade involves blocks of illiquid securities, a broker may be useful for finding a natural counterparty. In some cases the broker may put its own capital at risk and take the other side of the order, hoping to find various parties willing to accept parts of the order at a later time. Brokers may also be useful in providing a reputational screen - offering the trade only to parties that will not try to trade in front of it.

Hybrid Markets

Many markets operate as a combination of the types listed above. For example, the New York Stock Exchange batches orders for market-on-open and market-on-close execution using a batch auction process. During the day, trading is accommodated using a continuous auction process. This consists of both order-driven quotes that do not reach a dealer and dealer-driven quotes offered by the specialists.

Investors have the option to invest borrowed money, leveraging the return on their transactions. Brokers provide margin funds for this purpose.

In a margin transaction, the investor posts a portion of the cash needed to buy a security and borrows the rest. The stock or security purchased serves as collateral on the loan.

The Federal Reserve Board determines the margin requirement, or maximum portion of any transaction that can be made using margin. A lower margin requirement permits higher borrowing levels. Currently the margin requirement is 50%, meaning investors can borrow up to half the funds for a transaction.

Using margins exaggerates the return on an investment. For example, buying 100 shares of stock for $100 per share at 50% margin, the investor uses only $5,000 cash. The investor’s cash is also called the “equity” in the transaction.

If the stock rises to $110, the shares are worth $11,000 but the investor would still only owe $5,000 (plus some interest.) The equity has increased to $6,000 - which is a 20% gain even though the stock itself rose only 10%.

Of course, the same phenomenon works in reverse. If the stock falls 10% to $90, there is only $4,000 of equity and the investor loses 20% when the stock has lost just 10%.

In order to function well, a securities market must have the following attributes:

• Information - timely, accurate information regarding volume, prices, bids and offers
• Liquidity - the ability to buy or sell quickly at a known price (near the most recent price). Continuity in prices means that the prices flow rather than gap. This requires depth - a large number of participants willing to buy and sell at prices above and below the current price.
• Low transaction costs, including the cost of reaching the market, brokerage costs, and transfer costs.
• Rapid adjustment of prices to reflect new information, which means the current price reflects all available information.

Algorithmic trading systems use electronic trading methods driven by quantitative rules and user-specified benchmarks and constraints. The objective of an algorithmic trading system is to exploit patterns of market trading volume to control execution costs and risks by breaking large trades into smaller, more manageable pieces.

The main types of trading algorithms are logical participation strategies and implementation shortfall strategies.

In a logical participation strategy, one of a number of simple rules is used to determine the proper size of each trade.

• VWAP strategy - uses an estimated VWAP  to break up the order based on a predicted volume profile to match or improve upon the daily VWAP.
• Time weighted VWAP assumes a flat volume profile throughout the day and trades in proportion to time passed. This strategy is useful for illiquid securities.
• Percentage of volume - trades are placed in proportion to the total volume throughout the day until completed.

Implementation shortfall strategies solve for an “optimal” trading strategy, which should minimize the trading costs when measured as implementation shortfall. Such strategies are often front-loaded to take advantage of the higher volume that usually occurs early in the trading day. It can be a useful strategy for portfolio trades or for managing transitions between managers.

The two most common types of orders that can be placed when buying a security are market orders and limit orders.

Market orders are executed promptly at the best available price, which in the case of a buy order is the lowest price a prospective seller is willing to accept. If the buyer wants more shares than the lowest asking party is offering, the remaining shares would be sold to the next-lowest ask price and so on until all shares requested were purchased.

For example, a buyer places a market order for 10,000 shares of stock X. The lowest ask price is offering 5,000 shares at $100 and these are filled. The next lowest ask price is for 3,000 shares at $100.25 and these are filled. The third-lowest ask price is for 5,000 shares at $100.50 and 2,000 of these are filled to complete the order. The effective purchase price is ((5,000 X 100) + (3,000 X 100.25) + (2,000 X 100.50))/10,000 = $100.175

Market orders emphasize prompt execution, and in return result in accepting some uncertainty as to the actual execution price.

Limit orders are instructions to accept only those prices that are better than a designated limit, including a time (end of day, good-til-canceled, etc) at which the order will expire.

For example, the buyer above may specify that the order has a $100.25 limit price. In that case, 5,000 shares would be executed at $100 and 3,000 at $100.25. The others would remain on order until a prospective seller was willing to accept $100.25 or less. The average price at execution would be ((5,000 X 100) + (3,000 X 100.25))/8,000 = $100.09375. If the remaining 2000 shares were executed at $100.25 the effective price would be ((5,000 X 100) + (5,000 X 100.25))/10,000 = 100.125.

Limit orders emphasize price at the expense of uncertainty as to whether the order will be filled in entirety.