Financial Markets Operations Management (20 page)

It is difficult to judge when the first stock exchange was formed. In fact there is little consensus on this point; however, it is true to say that stock exchanges have been around for many centuries. Some say they originated in ancient Rome; others will disagree. What is true, however, is that stock exchanges provide services for certain market participants (e.g. market makers, brokers and traders) that enable securities such as equities and bonds
to be issued and subsequently traded. Traditionally, the stock exchange would have been a physical building and the trading would have taken place on the floor of the stock exchange. Furthermore, trading would not have been allowed anywhere other than the floor of the stock exchange.

Companies that wish to issue shares and raise debt through bond issues will have the securities listed on the stock exchange. Again, traditionally a security would have been listed on one particular stock exchange, more often than not in the country of the issuer. Once the securities had been issued in the so-called primary markets, then subsequent trading, known as secondary market trading, would also take place on the exchange. In today's world, there is sometimes no compulsion to have to trade listed securities on the exchange. Instead, buyers and sellers can come together away from the exchange; we refer to this as being “off exchange” (otherwise known as “over-the-counter” or OTC).

In recent times, many of the traditional stock exchanges have moved away from being a physical location to becoming computer or telephone-based. Indeed, more recently established exchanges have tended to dispense with a floor and have gone straight into trading using computers, telephones, etc.

Whilst there is no reason why any trading in today's environment should be on the floor of an exchange, there are still a few exchanges where trading continues to take place on the floor. One example where floor trading still takes place is the New York Stock Exchange. Here, specialist brokers execute trades on behalf of buyers and sellers through a process of
open outcry
. Floor trading takes place alongside computerised trading, which was introduced in the early 1970s. The exchanges system was known as the
Designated order turnaround
system (DOT).

Derivatives exchanges can either be part of a stock exchange (e.g. Singapore Exchange) or a separate entity in their own right (e.g. Shanghai Futures Exchange). A selection of derivatives exchanges is listed in
Table 4.23
.

Unlike securities, which are issued by the organisation that raises equity and/or debt capital, derivative products that are traded on an exchange are created by the exchange. The derivative products have nothing to do with the underlying asset (e.g. equities, bonds, commodities), although they are priced according to the price movements of the underlying assets.

These derivative products are standardised by the exchange in terms of the criteria (referred to as contract specifications) shown in
Table 4.24
.

MTFs provide similar trading services, rules and market surveillance to the regulated markets. However, MTFs do not have a listing process and cannot change the regulatory status of a security.

Under new European rules (MiFID II), investment firms will have to be authorised as an MTF if they wish to operate internal matching or crossing systems in order to execute client orders.

MTFs are also obliged to make prices on existing orders available on market data feeds (pre-trade transparency) and publish trades in real time (post-trade transparency). Furthermore, there must be a consistent application of pricing and charges to all Facility members, a system rulebook and the means by which to apply for membership of the Facility.

In 2011, two pan-European MTFs, BATS Europe and Chi-X Europe, merged to form BATS Chi-X Europe. The merged entity became a Recognised Investment Exchange in 2013. According to its press release dated 4 December 2013, BATS Chi-X Europe had 23% overall market share in Europe.
²¹

An ATS is the US equivalent of an MTF in Europe. They are similar in concept to MTFs, in that they provide a marketplace for buyers and sellers to trade in securities. There are, however, some differences between an ATS and an MTF, for example:

• They do not perform self-regulation;
  
• They do not necessarily provide public information on prices;
  
• They do not set rules governing the conduct of ATS subscribers.
  

In the USA, ATSs are regulated as broker/dealers and are regulated differently than traditional stock exchanges.

According to a paper prepared by the SEC's Division of Economic and Risk Analysis (DERA),
²²
there are 35 broker/dealers operating 44 ATSs, and trading on the systems comprises 10–15% of US equity trading volume. Lists of current ATS operators (including ECNs – see below) can be found on the SEC website at
www.sec.gov/foia/docs/atslist.htm
.

An ECN is a type of ATS that enables traders and institutional investors to deal directly amongst themselves without the need to go through an exchange/OTC market maker.

ECNs include Instinet (Institutional Network), which was established in 1969 and enables US institutions to trade directly with each other. The system was opened to broker/dealers and NASDAQ market makers in 1983.

In the OTC derivatives market, transactions in financial instruments such as interest rate swaps are tailored by the counterparties themselves rather than a derivatives exchange. Whilst this leads to innovation and bespoke products, there is a high degree of opacity due to the fact that there is no centralisation of the products; in other words, the only counterparties who know about the product, and the transaction, will be the buyer and the seller. This can lead to a variety of risks, including, for example, counterparty risk. In recent years, the global regulators have been concerned with this risk (and other types of risk as well) and have taken steps to introduce what is known as
centralised clearing
into the system. We will come across central counterparties (CCPs) in Chapter 5: Clearing Houses and CCPs.

A second major reform is the formation of new platforms for trading OTC derivatives electronically. In the USA, these new platforms are known as
swap execution facilities
(SEFs), and an SEF is defined as “… a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system, through any means of interstate commerce”.
²³

In Europe, the EU has proposed a similar approach by means of the establishment of
organised trading facilities
(OTFs) defined as “… any system or facility, which is not a regulated market or MTF, operated by an investment firm or a market operator, in which multiple third-party buying and selling interests in financial instruments are able to interact in the system”.
²⁴

Whilst there are some key differences in these definitions, the overall objective is to move OTC derivative instruments and trading onto an exchange-type environment (i.e. an SEF or an OTF) with increased transparency and regulatory oversight. Differences include:

• OTFs are designed to trade equities, commodities and other derivatives rather than just swaps (as under SEFs).
  
• The OTF model includes the ability to use execution models that include voice brokerage as well as electronic trading.
  

The Eurobond market is a variation on the OTC theme. Whilst many Eurobond issues are listed in Luxembourg and London, none are domiciled in any country. This means that as there are no domestic exchanges on which to trade, trading takes place “off exchange”. The Eurobond industry is regulated by the International Capital Market Association as a Self-Regulated Organisation and its Rule Book covers the trading and settlements of this product type.