Organized &OTC Security Markets Concept of Stock Exchange

Organized Security Markets Concept of Stock Exchange

After the new issue or the original issue of securities is complete; securities become second­hand and are traded (i.e. bought and sold) at the floor of the stock exchange-through brokers and other intermediaries.

The literal meaning of stock exchange is an exchange of stock (or shares and other securities) between buyers and sellers.

Under the Securities Contract (Regulation) Act, 1956, the term stock exchange is defined “as an association, organisation or body of individuals- whether incorporated or not-established for the purpose of assisting, regulating and controlling the business in buying, selling and dealing in securities.”

Stock exchange could be very simply defined as follows:

A stock exchange is an organized market, where second-hand securities that have been listed thereon, may be bought and sold, in a safe, quick and convenient manner.

Features of Stock Exchange:

Salient features of stock exchange are the following:

 (i) Stock exchange is a market for second hand securities

(ii) It is basically a market for second-hand listed securities of companies viz., shares, debentures/ bonds and government securities.

(iii) Stock exchange allows dealing only in listed securities. In fact, stock exchange maintains an official list of securities that could be purchased and sold at its floor. Unlisted securities i.e., securities which do not figure in the official list of the stock exchange; could not be dealt in the stock exchange.

(iv) Stock exchange is in organised market for dealing in securities. Activities of a stock exchange are governed by a recognised code of conduct, apart from statutory regulations.

(v) All transactions in securities at the stock market are effected through authorised members only.

Role or Functions of the Stock Exchange

Role of the stock exchange could be highlighted with reference to the following functions performed by it, in the economy of a nation:

(i) Ready Market:

Stock exchange is a convenient meeting place for buyers and sellers of second-hand securities. Investors who have a preference for liquidity (i.e. cash) can sell their securities; and those who wish to invest in securities can buy the same. Since stock exchange ensures liquidity of investment; people are induced to buy securities.

(ii) Safe Market:

Stock exchange is, perhaps, the safest market for having transactions in securities. A stock exchange functions according to a recognised code of conduct and is subject to strict statutory regulations. Since the establishment of SEBI (Securities and Exchange Board of India) in the year 1988, dealings in securities at stock exchanges have become further safer.

In the absence of stock exchange, investing public might be deceived or cheated by shrewd unscrupulous brokers.

(iii) Evaluation of Securities:

Stock exchange determines prices of various securities (in terms of their real worth) through the interplay of demand and supply forces. Prices at which transactions in securities take place are recorded and published, in the form of market quotations.

 (iv) Agency of Capital Formation:

Stock exchange is an agency of capital formation. It draws the savings of the man in the street into productive investment channels. Since stock exchange provides a safe and convenient market for liquidity and investment purposes; people are induced to save and invest in securities.

Through stock exchange, savings of people which otherwise would have gone into destructive channels, are routed into productive channels.

(v) Qualitative Industrial and Commercial Development:

Stock exchange aids in the process of ensuring qualitative industrial and commercial development of the economy. This is so, because, through stock exchange people keep shifting their investment from inefficient companies (which do not pay good dividends) to efficient companies (which promise high returns on investment). This shifting process of investment is specially important for a country where savings are scarce.

(vi) Acting as a Barometer of the Company:

(Barometer is something that shows the changes that are happening in an economic, social or political situation). Stock exchange is sensitive to economic, political and social conditions of the economy; as such conditions affect the prices of securities.

In fact, price trends at stock exchange reflect the economic climate of the country. “Stock exchanges are not merely the chief theatres of business transactions; they are also barometers which indicate the general conditions of the atmosphere of business in a country.”- Alfred Marshall

(vii) Control Over Company Managements:

Stock exchange very directly exercises control over the managements of companies, whose securities are listed with it. In fact, those companies whose securities are listed with a stock exchange have to abide by the rules and regulations of the stock exchange.

(viii) Storehouse of Business Information:

Companies, whose securities are listed with the stock exchange, are required to furnish financial statements, annual reports and other reports to the stock exchange. Many stock exchanges publish directories which provide data on the corporate sector. Such information is highly helpful to the government in economic planning. It is equally useful to managements of many business enterprises.

Over the counter Securities Market:

A security traded in some context other than on a formal exchange such as the NSE,NYSE, TSX, AMEX, etc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network.

In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as "unlisted stock", these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.
Although Nasdaq operates as a dealer network, Nasdaq stocks are generally not classified as OTC because the Nasdaq is considered a stock exchange. As such, OTC stocks are generally unlisted stocks which trade on the Over the Counter Bulletin Board (OTCBB) or on the pink sheets. Be very wary of some OTC stocks, however; the OTCBB stocks are either penny stocks or are offered by companies with bad credit records.

Instruments such as bonds do not trade on a formal exchange and are, therefore, also considered OTC securities. Most debt instruments are traded by investment banks making markets for specific issues. If an investor wants to buy or sell a bond, he or she must call the bank that makes the market in that bond and asks for quotes.
In the OTC market, trading occurs via a network of middlemen, called dealers, who carry inventories of securities to facilitate the buy and sell orders of investors, rather than providing the order matchmaking service seen in specialist exchanges such as the NYSE.

Over the counter market is a decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a physical trading floor? There is no central exchange or meeting place for this market.

Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
In the U.S., over-the-counter trading in stock is carried out by market makers that make markets in OTCBB and Pink Sheets securities using inter-dealer quotation services such as Pink Quote (operated by Pink OTC Markets) and the OTC Bulletin Board (OTCBB). OTC stocks are not usually listed nor traded on any stock exchanges, though exchange listed stocks can be traded OTC on the third market. Although stocks quoted on the OTCBB must comply with U.S. Securities and Exchange Commission (SEC) reporting requirements, other OTC stocks, such as those stocks categorized as Pink Sheets securities, have no reporting requirements, while those stocks categorized as OTCQX have met alternative disclosure guidelines through Pink OTC Markets.

An over-the-counter contract is a bilateral contract in which two parties agree on how a particular trade or agreement is to be settled in the future. It is usually from an investment bank to its clients directly.

An over-the-counter (OTC) securities market is a secondary market through which buyers and sellers of securities (or their agents or brokers) consummate transactions. Secondary markets (securities markets where previously issued securities are re-traded) are mainly organized in two ways. One is to form an organized exchange, where buyers and sellers of securities (mostly represented by their agents or brokers) meet at a central place to conduct transactions. The New York Stock Exchange (NYSE), the American Stock Exchange (located in New York) and the Chicago Board of Trade for Commodities are examples of major organized exchanges in the United States. An over-the-counter securities market provides an alternative way of organizing a secondary market—in this, dealers with inventories of securities at different geographical locations are in contact with each other through a computer network. In other words, these dealers of securities are ready to buy or sell securities over the counter to anyone who contacts them and accepts their quoted price. One may thus describe an over-the-counter securities market as an electronic market. The National Association of Securities Dealers Automated Quotations System (now generally referred to simply as "the Nasdaq") is an example of an over-the-counter securities market in the United States.


THE EVOLUTION OF THE OVER-THE-COUNTER MARKETS 

The NASDAQ over-the-counter market was established in 1971. Before the NASDAQ was instituted, trading in OTC securities used to be a rather haphazard operation—individual broker/dealer firms bought and sold securities for their own accounts. In doing so, they acted as dealers, not brokers. For larger OTC stocks, a dozen or so firms quoted bid and asked prices for securities—account executives relied on these quoted prices in buying and selling securities for customers. However, for many small over-the-counter securities, only a couple of firms made a market—that is, quoted bid and asked prices. Thus, one could never be sure if one got the best price. Moreover, record keeping was done on "pink sheets" that recorded bids and offers, not actual trades. The computer system replaced the telephone communications mechanism in 1971 and provided a far better method of uncovering the best price.

EFFICIENCY OF THE OTC MARKETS

Since over-the-counter securities dealers are in computer contact with each other, they know the prices set by one another. As a result, an OTC market is very competitive and is not significantly different from a securities market that utilizes an organized exchange. Nevertheless, it is fair to say that the stocks of many large and well known corporations are traded on the NYSE, often called the Big Board. This provides the NYSE with high visibility—it is considered the real marketplace. The trading in shares of approximately 2,000 corporations takes place on the floor of the exchange; transactions are recorded on an electronic ticker tape flashed on the floor itself as well as in brokerage offices throughout the country. As a consequence of the emphasis on Big Board stocks, the common stocks listed on over-the-counter markets are often called secondary issues.

OTC MARKETS FOR DIFFERENT SECURITIES

There are over-the-counter securities markets for a variety of financial securities or instruments. The most widely followed is the over-the-counter market in common stocks. While many large corporations have their stock traded at the New York Stock Exchange, not all common stocks traded in the NASDAQ market are small. For example, IBM Corp., AT&T, or General Motors Corp. stocks (that are also part of the 30 common stocks included in the widely followed Dow Jones Industrial Average index) are traded on the Big Board. However, many widely known common stocks, such as Intel Corp. or MCI Communications Corp., are traded in the over-the-counter stock market. Both the NYSE and the NASDAQ market have a large number of small common stocks.
The financial market in U.S. government bonds is also set up as an over-the-counter market. It is important to note that the U.S. government bond market has a larger trading volume than the NYSE. The OTC market in government bonds was established by approximately 40 dealers in Treasury bonds who were ready to buy and sell Treasury securities.

Over-the-counter securities markets exist in other financial instruments, in addition to common stocks and government bonds. Markets for several money-market financial instruments are also established as over-the-counter markets. For example, negotiable certificates of deposit, banker's acceptances, and federal funds are all traded in over-the-counter securities markets. There are OTC markets in non-money market instruments as well. These include trading in a foreign exchange.

DERIVATIVES AND THE OTC MARKETS.

The relatively newly issued financial instrument known as a derivative is also traded in the OTC securities markets. Peter Abken (in Economic Review) discusses the implications of derivative securities trading in the over-the-counter markets. He points out that, aside from their complexity, the largely unregulated character of the OTC derivatives markets sets them apart from the financial markets for other securities, due to their extremely rapid growth and fast pace of innovation. In recent years, over-the-counter derivatives have become a mainstay of financial risk management and are expected to continue growing in importance, according to Abken. The current structure of the OTC markets is being closely examined, and a set of recommendations has been made. The central policy question in derivatives regulation debated by Abken is whether further federal regulation is appropriate, or whether the existing structure can oversee these markets. 

BID-ASK PRICES AND THE DEALER'S SPREAD

The bid price is the amount that a securities dealer must pay to obtain a security, while the ask price is the amount that a securities dealer receives after selling it. Frederic S. Mishkin commented in The Economics of Money, Banking, and Financial Markets that "you might want to think of the bid price as the 'wholesale price' and the asked price as the 'retail' price."

The ask price for securities is higher than the bid price. The difference between the two prices provides the dealer with his profit margin, compensating the dealer for his work. This compensation amount is known as the dealer's spread. Since securities can rise or fall in price during the period that the dealer owns them, thus impacting a dealer's ability to secure an acceptable asking price, this business can be a tricky one.