NT_tema_2_English - Module 2. Financial Markets ...

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Unformatted text preview: Module 2. Financial Markets Learning Goals To understand the workings of financial markets To understand the importance of market orders, and how they work. To understand the importance of the law and the regulations To interpret any financial market according to its architecture. To understand the importance of the different trading systems and understand perfectly how they work. To analyze the differences between different forms of trading: Auction markets, Continuous auction markets (driven by orders) and Price ­driven markets. Context You have passed the selection process of the CarlosIII banking organisation and they have hired you to work in the financial markets consultancy department. On your first day of work, the Head of Markets tells you that your first job will be to familiarize yourself with the financial markets: their operation, classification and importance, and an understanding of electronic formats that allow them to operate. Overview 1. Introduction 2. Types of market 3. The competition between markets 4. The Directive on Investment Services Continuous assessment: The group must present an executive report, maximum 2 pages long (Arial 12 single space). In it they will explain the operation of the chosen market. What type of market it is, who can carry out orders etc. The only restriction is that you may not choose any of the Spanish markets. 1 1. Introduction A financial market may be a physical location or otherwise (electronic) where instruments are exchanged. Today the vast majority of markets are electronic. There are a number of reasons for this. Among the most important are: • Price efficiency: many models of modern finance involve price efficiency  ­ in other words, that the prices of instruments incorporate relevant, public information. This efficiency would be more difficult of achieve if the markets opened every day for a few minutes, since company information is produced continually throughout the day. DOES THIS MAKE SENSE TODAY WITH THE FALL IN PRICES? WERE THE MARKETS EFFICIENT? • Ease and equality of access: the fact that the markets are electronic facilitates connection by all operators. • Volume: this aspect is perhaps the most important. The volume that financial markets handle nowadays would be difficult to contemplate without help from the computer networks that take orders to the markets and the computer systems that carry out transactions. The financial markets can be classified according to different criteria. To be specific the two most important: • According to the characteristics of the instruments traded: o Money markets: short ­term instruments with high liquidity and low risk are traded. The vast majority of instruments have a term no longer than a year. o Capital markets: Long ­term instruments with higher risk are traded. (Long ­term debt market and Stock market: Fixed Income and Variable Income) • According to the phase of trading o Primary Markets: Offer newly ­created instruments (auction of bills, share issues, etc.) o Secondary Markets: Instruments traded have already been created In this module we will focus on the organisation of markets  ­ above all secondary markets with securities that are already issued. We must bear in mind that the financial markets are above all companies that have shareholders, and whose aim is to earn money for their shareholders. The structure of BME's revenue and profits shows how the amount of transactions (commission) is key. 2 Given that operators can carry out Spanish share transactions in different markets, it is important for the market to offer sufficiently high quality conditions so that operators carry out their transactions in the Spanish market and not another market. Two good examples of the competition between markets are the platforms: http://www.chi ­x.com/ and http://www.tradeturquoise.com/ One of the characteristics that defines quality are the costs that the investor must face. The type of frictions or costs are • Explicit costs: transaction costs, commissions, taxes • Execution costs: liquidity Explicit costs depend on the country and are taxes, commission, etc. All the costs we must add to the effective volume of the operation. Three points: • There is much competition among brokers • Commission rates are set freely. The law only stipulates a maximum (2.5%) • The commission charged to carry out the transactions is shared between the market, the entity that performed the operation and the broker. The following diagram shows a Reuters screen 3 Explain how market orders work. Example Let us suppose that we buy and later sell 100 shares. The costs of transactions are 0.6%. Ask Bid We buy 11.50 11.48 We sell 11.59 11.55 Calculate the costs incurred carrying out the transactions. 2. Types of market In addition to the two types of market mentioned above, we can classify them according to two additional criteria: those that are electronic and continuous. Not continuous and Not Electronic Here we include markets that open for a short time every day. The main advantage is that all investors have the same information. In contrast, the main drawback is that we only have a little time each day. In Spain, until 1989 all shares on the Spanish Stock Exchange were traded on the floor of the exchange. Since the creation of the electronic trading market the exchange itself took a secondary role. The few companies that continued to be quoted under this system were not taken into account by the vast majority of investors, and much less by analysts. This way of doing business has already disappeared. Now all companies are quoted on the continuous market. Example Suppose we have an instrument that after two rumours rises 19%, and after a press conference the gains are cut back to 8% This would not have happened on the floor of the exchange since all investors would come to the auction with the same information 4 Non ­continuous and Electronic Here we include electronic auction markets such as at the stock market open and close. They open for a short time each day and their key advantage is that they help to to agglutinate information. The drawback is that they take place few times a day. Brusco and Tapia show the learning process at auctions in the Spanish market. It is important to be clear about the concept of auctions.1 Continuous and Non ­Electronic These are markets with trading floors that open all day. They generally have a parallel electronic market. Some examples are the NYSE2 or the German derivatives market. As the video shows these systems are increasingly insignificant. Continuous and Electronic Here we include almost every share, bond and derivatives market in the world. Continuous markets The reason for markets being continuous is obvious (the drawback of trading floors (opening/closing times)). But it is not so obvious why continuous markets do not all work in the same way. In addition to electronic and non ­electronic, we can distinguish between: • Price ­driven markets: markets with market makers. • Orders ­driven Markets: markets that allow for placement of orders. The basic difference between these two types of market is that in Price ­driven markets only the market makers can place limit orders. The rest can only place market orders. On the other hand, in Orders ­driven Markets: any investor can place limit orders in addition to market orders. Continuous markets Examples of limit orders: Buy 100 Ferrovial shares at 77 €. Sell 5000 Indra shares at 19.50 € Examples of market orders: Buy 2000 Inditex shares at best offer (<46€). 1 Conceptosubasta.pdf 2 http://www.youtube.com/watch?v=TPUDPhpCecA 5 Sell 300 Gas Natural shares at best bid (>38€). At this point, we need to consider which trading system is better. Theory, experiments and data analysis have given a partial response to this question. In practice, markets prefer hybrid markets that try to take advantage of both systems (the New York Stock Exchange is a market of this type). Type of Advantage Drawback Example Market Price ­driven Hybrid Markets Market Maker: constant Possible collusion liquidity for all securities With both Currencies, MTS Spain, SENAF NYSE, NASDAQ,… no of SIBE, MEFF More suppliers and There is Orders ­driven demanders: more guarantee competition. execution. 3. Competition between markets In recent years, we have witnessed a clear increase in the competition between financial markets. This has been the result of market liberalization, business globalisation and the development of Information Technology The competitors have different names, but they are parallel markets where operations of any value can be executed while there is supply and demand for the securities. The different names are Alternative Trading Systems (ATS), Electronic Communication Networks (ECN) or MTF (MultiTrading Facilities) The competitors are a clear alternative to the traditional markets. The following tables summarise the traditional situation and the current situation. Traditional Situation The broker has to send orders to the market. New Situation. 6 The ECN or the broker decides what to do with the order: (i) hold it internally, (ii) place it on the market, (iii) send it to some trading platform. Remember this situation arises because of competition to capture order traffic. What result should competition have? We can distinguish between positive and negative consequences. Positive • Lower costs (commission) • Greater liquidity for each share: more markets, more supply and demand available • New services (after hours trading) Negative • Fragmentation: less liquidity in each market • Less information (the legislation ensures that this does not happen) • Less control on the part of the CNMV? Given this situation most markets decided to increase in size, integrating with markets from other countries and incorporating different markets in a single country. Examples: • In 1998: The DB platform and Swiss Stock Exchange created Eurex • In 2002, Euronext = Paris + Brussels + Amsterdam • In 2002, Euronext acquires LIFFE • In 2003, Euronext merges with the Portugal Stock Exchange • In 2006, Nasdaq tries to buy the London Stock Exchange and Deutsche Borse (DB) launches takeover bid for Euronext. Both failed. • The New York Stock Exchange launches a better takeover bid for Euronext and they finally merge in 2007. • In 2007 NASDAQ acquires OMX (which in turn is the result of a previous merger of the 7 Northern European markets. OMX: Scandinavian and Baltic Stock Exchanges) 4. The Investment Services Directive 7 The Investment Services Directive is one of the most important regulatory effort in the financial markets.3 The creation of the Eurozone has (among others) 2 results: (i) The elimination of exchange rate risk, (ii) Launching a of process of harmonisation The key aims are: • To set up a new regulatory framework that promotes an integrated, efficient and transparent infrastructure • To increase investor protection. • To extend the aim of the previous directive in terms of financial services covered (analysis, brokerage houses, etc.) and instruments • To strengthen cooperation between regulatory bodies The measures adopted are: • To allow a single Investment Services passport • To guarantee investor protection throughout Europe. • To allow the Internalisation of Orders and the creation of Alternative Trading Systems (ATS) such as ECNs Investor protection is one of the key aims of the MiFID. To this end the Directive establishes two types of measures: • INTERRELATION MEASURES: requirements that affect to the way entities deal with clients and with the markets o Classification of Clients o Classification of Products o Suitability and Appropriateness Test o Information to clients o Better Execution and management of orders o Records and data storage • ORGANISATIONAL MEASURES: requirements that affect the internal organisation of entities o Externalisation Policies o Safeguard instruments o Business Continuity Policies o Regulations Compliance Policies o Policies of Conflict of Interest o Incentives 3http://europa.eu/legislation_summaries/internal_market/single_market_services/financial_servi ces_general_framework/l24036e_en.htm 8 ...
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This note was uploaded on 02/03/2011 for the course ECON 101 taught by Professor Flora during the Spring '11 term at Universidad Carlos III de Madrid.

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