Chapter 22 Questionnaire

How does an electronic communications network differ from a crossing network?

Crossing networks do not display public quotes, so there is no price discovery. Orders are simply matched by an algorithm. ECNs, on the other hand, display public quotes and in some cases display some or all of the order book.

Several academic studies suggest that Rule 10b-5-1 has led to above-market returns. These findings have caught the interest of federal prosecutors and the SEC enforcement staff. Explain why

One explanation of the above market returns obtained by Rule 10b-5-1 plans is that insiders allowed to trade through these plans are using their insider information to construct their portfolios. If this is the case, these insiders' actions likely undermine the intent, if not the letter, of insider trading laws.

What is meant by the internalization of a trade?

A broker may route an order to a division of his or her firm for execution. This is referred to as internalization of an order.

What is meant by light pool market and dark pool market?

A crossing network that does not provide full pre-trade transparency, i.e., publicly display relevant ask and bid quotes/volumes, is a dark pool. ECNs that provide both pre-trade transparency about orders and post-trade transparency about executed trades are referred to as light pool markets.

Some stocks are listed on several exchanges around the world. Give three reasons a firm might want its stock to be listed on an exchange in the firm's home country and on exchanges in other countries.

A firm may want to list its stocks on both domestic and foreign exchanges due to: a) a desire to diversify sources of capital. b) a need to increase funding in amounts and currencies not available in domestic markets. c) a feeling that international ownership can help reduce the possibility of a takeover by domestic governments. d) a desire for recognition in those new markets.

What is the motivation for the use of crossing networks by institutional investors?

ATSs developed to allow institutional investors to "cross" trades, matching buyers and sellers directly, typically by computer. Crossing networks (CNs) are batch processes that aggregate orders for execution at specified times. Pre-trade transparency varies with the CN. When there is no public displaying of orders (i.e., no pre-trade transparency) in the CN, we call them dark pools. Dark pools provide institutional investors several benefits: they reduce information leakage contained in an order, avoid front-running of large orders, and lower market-impact costs. With respect to information leakage, the order may be part of a proprietary trading strategy pursued by an intuitional investor, and a displayed order might provide information about such strategies to competitors. There is a concern that other market participants (such as broker-dealers and traders) could front-run the order, with the result that trading costs would be higher than in the absence of a public display of an order. Regardless of the transparency of the network, CNs in general require less information from the trader and so they are useful for both maintaining anonymity and executing certain strategies that would fail if the trader had to specify a limit price for the order.

What is the difference between a block-oriented dark pool and a streaming liquidity pool?

Block-oriented dark pools set a minimum size for each order, such as 5,000 shares. Streaming liquidity pools have no minimum size for any order.

In an alternative trading system, why might only one party to the trade have to pay a transaction fee?

Many Electronic Communications Networks (ECNs) have fee structures that depend on the type of order. Orders either add to or remove liquidity from the ECN's order book. An example of an order that adds liquidity to the ECN's order book is a limit order that is not immediately executable (e.g., for a buy limit order, when the limit price is less than the ask price and for a sell limit order, when the limit price is greater than the bid price). When a market order is immediately executable, then it removes liquidity from the ECN's order book. ECNs typically provide rebates to liquidity providers. If the rebates are sufficiently large, an exchange between a liquidity provider and a liquidity remover may result in only one party to the trade (the liquidity remover) having to pay a transaction fee.

"Unlike national securities exchanges, the danger of alternative trading systems is that they are unregulated." Explain why you agree or disagree with this statement.

Mostly disagree. ATSs are regulated by the SEC. However, they have the discretion to be regulated as a national securities exchange or a broker-dealer. ATSs also consist of ECNs and exchanges that create pools of liquidity resulting from hidden orders where, unlike in other dark pools, the hidden order usually interacts with regular displayed orders. The similarity with respect to pricing that these types of dark pools share is that unlike the other categories of dark pools, which charge a fee on a per share basis, exchange-based pools follow the ECN pricing policy, which provides fees and rebates depending on whether the transacting party is a supplier or a taker of liquidity. Ultimately, one might believe that the ATSs subject to a different regulatory framework than the national securities exchanges are more dangerous than the national securities exchanges, so the sentiment expressed in the quoted statement is not completely wrong.

"Federal securities law define what illegal insider trading is." Explain whether you agree or disagree with this statement.

Mostly disagree. Federal law never explicitly defines an insider trade. In general terms, the SEC describes illegal insider trading activity as the trading in a security that is "in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security." This is not a legal definition because the laws dealing with insider trading are shaped by judicial opinions. That is, although Congress gave the SEC responsibility and the enforcement powers (both criminal and civil) to protect investors and maintain the integrity of the market, what constitutes insider trading has been developed on a case-by-case basis under the antifraud provisions of the federal securities laws (principally Section 10(b) of the Securities Exchange Act of 1934).Specifically, the federal securities laws covering insider trading set forth in Section 10(b) of the Securities Exchange Act of 1934 makes it illegal for someone:to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.For this reason, one might argue that federal law specifies what an insider trade is.

Explain why the NYSE is described as a "hybrid market."

Prior to 2006, the NYSE was a pure continuous-order market. Such a market is also called a "continuous market" or "continuous auction market." In this type of order-driven market, prices are determined continuously throughout the trading day as buyers and sellers submit orders. The other type of market structure is the order-driven market, characterized by a periodic call auction, or an auction market, in which orders are batched or grouped together for simultaneous execution at preannounced times. Today, the NYSE uses both types of market structures, continuous auction and call auction. More specifically, the NYSE is a continuous auction market during the trading day and a call auction market when opening and closing the market (as well as when restarting trading if a stock has stopped trading). Hence the NYSE can be described as a hybrid market.

What is Rule 144A

Rule 144A allows qualified institutional buyers to transact privately-placed securities. Private placements are securities which are unregistered with the SEC.

a. What is a euro-equity issue and a euro-equity tranche? b. What is the most important innovation that euro equities have achieved?

See below: a) The term euro equity applies to a stock issue offered simultaneously in several countries by an international syndicate. U.S. corporations engage in equity offerings that, in addition to the primary U.S. component, include a portion of the issuance reserved for sale in the Euromarkets. This portion of a newly issued stock is referred to as a euro- equity tranche. b) The most important innovation of euro equities has been an efficient international system for selling and distributing equity offerings to various markets in different countries at the same time.

a. What is meant by payment for order flow? b. What are the requirements for a broker to receive a payment for order flow? c. What is the disadvantage to an investor of requesting a broker to direct an order to a particular venue?

See below: a) To induce brokers to route an order to their venue, regional exchanges, third market makers, and many Nasdaq market makers will pay brokers a fee based on the number of shares directed. This practice is referred to as payment for order flow. b) The broker cannot obtain payment for order flow without the approval and knowledge of the customer. When an account is opened, the brokerage firm must inform the customer by written notification whether they receive payment for order flow. This notification must also be provided annually. Moreover, on a trade confirmation the customer must be told whether the broker received a payment for order flow. If the customer desires, more information about the payment for a trade can be obtained by requesting the information from a broker. c) A customer has the right to direct the broker to use a particular venue to execute an order, but there may be a cost associated with doing so. In particular, the broker has the right to charge customers an additional fee for using a particular exchange.

a. What are the alternatives available to a broker when executing a trade? b. What factors must be considered by a broker when determining where to execute a trade?

See below:a) Assuming that the customer does not specify a venue, the broker's decision as to which venue to direct the order to is as follows. For a stock that is listed on an exchange, the broker has three choices: i. direct the order to the exchange where the stock is listed. ii. direct the order to a regional exchange. iii. direct the order to a firm that stands ready to execute the order at publicly quoted prices. If instead of an exchange-listed stock, the order involves an unlisted stock traded on the Nasdaq, the broker may send the order to a market maker on the Nasdaq.There are two other choices available to a broker for routing an order (regardless of whether that order involves listed issues or not):i. internalization.ii. an ECN.b) In making a decision about the venue, the broker has an obligation to find the "best execution" that is reasonably available for customer orders. In doing so, the broker considers all customer orders and makes an evaluation of which venue gives the most favorable terms. When evaluating the alternative venues to obtain the best execution for customer orders, the broker will look for:i. a better price than quoted in the market when the order is placed (referred to as "price improvement").ii. the likelihood that the order will be executed.iii. the speed of execution. The speed of execution is important when a market order is placed because in a fast-moving market, any delays in the execution of an order can result in an inferior price than at the time the order was received. Although the SEC does not set forth any rules that require the execution of an order be completed within a specific period of time after the order is placed, a brokerage firm that advertises about the speed at which it can execute an order would be expected to execute accordingly.

What are the differences between a sponsored GDR and an unsponsored GDR?

Sponsored GDRs are those which are initiated by the corporation itself in order to take advantage of offshore funding, while unsponsored GDRs are those which are created by multiple institutions which pool shares.

There is a widespread use of Rule 10b-5-1 trading plans by officers and directors of public companies who regularly possess material nonpublic information but who want to buy or sell stock of their corporation at a time when they are not in possession of material nonpublic information. Usually, a 10b-5-1 trading plan is a contract between the insider and a broker. Why are these plans used by corporate insiders, such as officers and directors?

The SEC adopted Rule 10b-5 for the purpose of implementing Section 10(b) (see question 22.14 for more details). This rule defines when a trade is done on the basis of material nonpublic information. The SEC has two rules that make up Rule 10b-5: Rule 10b-5-1 and Rule 10b-5-2. Rule 10b-5-1 applies to a person who trades on the basis of material nonpublic information if that person at the time of the trade knows that the information in his or her possession is in fact material nonpublic information. Conditions under which permissible trading by an insider are described. For example, a person who is an insider is allowed to trade if that information is not a factor in the decision to trade. An example would be an executive who has an established investment plan that specifies the automatic purchase of the corporation's stock at designated time intervals. In other words, corporate insiders such as officers and directors must use 10b-5-1 trading plans if they want to trade their own firm's stock.

"Stocks traded on the Nasdaq are nonlisted stocks." Explain why you agree or disagree with this statement.

This is not entirely correct. Most of the volume of trades of Nasdaq stocks is generated by those stocks which are subject to listing requirements. Although the Nasdaq owns and operates the OTC Bulletin Board, those firms are generally not associated with the Nasdaq system. Listing requirements for Nasdaq NNM and small-cap issues are not as stringent as those of the NYSE, but there are listing requirements, nonetheless.

a. What is meant by a circuit-breaker rule? b. What was the motivation for the adoption of circuit breakers?

a) A circuit breaker is a temporary halting of trading during a severe market decline. The key to instituting circuit breakers is coordination and infrequency. b) Circuit breakers have been adopted to address market volatility. The idea is that large price movements in a short time frame are not likely to be driven by fundamental changes in the value of security, but by investor fear. Temporary trading halts are thought to dampen volatility by giving investors time to emotionally recover.

a. What is the purpose of the alternative uptick rule? b. What are the risks with naked short selling?

a) Beginning in 1934, federal securities laws imposed restrictions on short sales by allowing short selling of a stock only at a price that exceeded the last trade price or if the last price exceeded the previous price. These are uptick rules. An uptick rule is a restriction on short selling in which short selling is only allowed when market prices appear to be increasing. The specific operationalization of "appear to be increasing" defines the particular rule. The alternative uptick rule simply sets a circuit for every stock of 10% below the previous trading day's closing price for that stock. Once the circuit breaker is triggered, short selling can only occur if the security's current price is above the current national best bid. The old uptick rule, abolished completely in 2007, consisted of Rule 10a-1 of the Securities Exchange Act of 1934, which said that, subject to certain exceptions, an exchange-listed security may only be sold short if either of the following conditions is met: i. the price at which a stock is shorted is above the immediately preceding reported price (referred to as a "plus tick"). ii. the price at which a stock is shorted is higher than the last different reported price (referred to as a "zero-plus tick").Two reasons why the "alternative uptick rule" was adopted include: a desire to reduce the number of failed trades and the success of circuit breaker rules in other contexts.b) Although the mechanism for selling short involves borrowing the shorted security to cover the sales, there are short sales where no borrowing occurs or no arrangement is made for borrowing in time for the settlement of the shorted security to the buyer. This is referred to as naked short selling. Risks of naked short selling include:i. the short seller might not be able to deliver the shorted security at the required settlement date.ii. naked short sales might push the security below its fundamental value (this is not mentioned in the text, but is commonly cited in the media as a potential risk from naked short sales)