How a Trade is Executed
Securities transactions occur either in the OTC market or in stock exchanges using the open auction method (for example the New York Stock Exchange or NYSE) or electronic trades as it is done on the National Association of Securities Dealers Automated Quotation System – NASDAQ. Increasingly Electronic Communication Networks are matching bids and offers electronically. The primary objective of all these formats is to serve as a market, not necessarily physical to do trade in securities, wherein market participants can match bid and offer prices. According to Bloomberg, current value of all stocks around the world base is $46.8 trillion.
To understand the open auction method better, we will use the NYSE example. To trade in the exchange, companies need to be members on it. They are said to own a seat if they are members. Since the format is that of an auction house, specialists in different stocks form posts. A specialist is someone who handles that stock in one of the member firms. The specialist moderates the auction and matches bids and offers.
When a broker receives an order, usually electronically from a client they go to the post where the stock is being traded. If this broker has a buy order of say 5000 shares and another broker has a sell order for the same share, the brokers negotiate and settle the deal. Otherwise, the broker transacts business with the specialist. The specialist makes money on the spread. Their aim usually revolves around not holding too much inventory at the end of the day, and ensures active flow of the stock. Increasingly this match of bid and offer is happening electronically with the exception of a few high-priced stocks.
Non-exchange traded securities transactions are called over-the-counter or OTC. Bonds, government securities, warrants, ADR’s are some of the instruments traded on the OTC market. This market does not have a physical location. Trades are usually transacted by phone. Brokerage firms that are actively involved in the OTC market, usually specialize in one type of instrument. The OTC market players make their market in the OTC Bulletin Board or OTCBB or Pink Quotes. The OTCBB is an electronic quotation system, based in USA that displays real-time quotes, volume information etc for OTC equity securities not listed on NASDAQ. OTCCB listed companies must comply to the norms of the Securities Commission. Stock exchanges require companies to have a minimum share price and capitalization. This is not a requirement for the OTCCB.
Stock of non-reporting companies (those without current SEC filings) in the OTC market is found in the Pink Sheets or Pink Quotes. OTCBB companies are however found on the OTCBB and the Pink Sheets.
Pink Sheets, is an electronic quotation system that trades in securities that are inactively traded and with a narrow geographic interest. Prior to going electronic, brokers used quotes on pink coloured paper. The Pink Sheets is not a stock exchange. To be quoted in the Pink Sheets, companies do not need to fulfill any requirements (e.g. filing financial statements with the SEC). Since most of these companies are not listed it is difficult to get information on them, making them risky investment options. Traditionally companies on pink sheets aspired to move to become fully listed on the stock exchange. Their volumes are usually low and of narrow scope.
In the traditional market, brokerage firms used to both buy and sell stocks. They made money on the spread, like specialists did on the stock exchange. These traders tend to sell the shares at prices higher than what they bought them. When they get many bids for a share they sell it for higher margins, to compensate for when they get low bids on others.
NASDAQ posts bids and offers are posted electronically. It provides a platform to trade electronically to brokers. Companies can make changes to their quotes through the day. It is an electronic equivalent to the auction house system. There are levels of access to this information.
Level one: merely shows highest bid and lowest offer price.
Level two: shows the bidding and offer prices of each firm. This information is used by retail traders.
Level three: Apart from having information of firm bid and offers, at this level changes can be made to the same for which market is being made. Only persons inside the firm who decide bid and offer prices access this level.
Electronic Communication Networks or ECN on the other hand simply matches offers and bids without market markers. Here earnings are made in turnovers rather than spreads. They levy charges of just few cents. The ECN has an anonymous order book. They receive orders from brokers or brokerages. These orders are matched with bid prices in the order book. Once a match is found the transaction is executed. Earlier inter- network trading did not happen. Now open trading systems are available in which if a corresponding bid match for an offer was not found on a network, these orders were matched on other systems. This open system opened market liquidity and fast closings. Archipelago is one such system. Some large brokerage firms have stakes in ECNs. ECNs allow for greater number of investors to participate in markets, whether they are small or independent. ECN s is working as both stock exchanges and brokers. They are rapidly changing the way markets work.