Chapter 5: Securities Markets

What do securities markets do?

What is the microstructure of securities
markets?
How trades are executed?
Securities Markets Regulation
A comparative study of Nepal with developed
economy

FIM: Securities Markets

 Financial System facilitated lending,

Payments and trade in risk through financial
intermediation and organized securities
markets.
Major security markets are

The market for the government securities

The money markets
The capital markets
The mortgage market
The market for derivatives
FIM: Securities Markets

Functions of Securities Markets

Securities markets facilitate the sale and
resale of transferable securities.
The market in which new securities are sold
is called the primary market; the market in
which existing securities are resold is called
the secondary market. The secondary
markets are created by the brokers and
dealers.

FIM: Securities Markets

 Functions of securities markets include:

Price discovery: Determine a fair price for the
securities
The provision of liquidity: Enable transactions
to be made at this price quickly and easily
Cost minimization: Enable transaction to be
made at as low cost as possible.

FIM: Securities Markets

Price Discovery
Price discovery is the process of arriving
the fair prices for securities.
Security market sets a fair price for the securities.

Fair prices may be offer and bid

Offer price for a security is the lowest price at which
any well informed trader is willing to sell it.
A fair bid price is the highest price any well informed
trader is willing to pay for it.

In an Ideal Market, all traders take place at fair

prices. It is ideal only, however useful for
benchmarking against the performance of the
actual market.
FIM: Securities Markets

Provision of Liquidity
Liquidity is the ability to turn an asset into cash
quickly without loss.
Security market provides liquidity if you can
buy or sell in it quickly without loss.
Example: a) if you want to sell your 100 share
of EBL. b) if you want to purchase 500 shares
of NABIL.
Like financial intermediaries, the basic source
of the liquidity of securities markets is Pooling.
Some people wish to turn their securities into
cash; others wish to turn their cash into
securities.
FIM: Securities Markets

 There is a chance of Liquidity Imbalance,

situation is which the desire to cash an asset
does not balance the desire to exchange cash for
the asset.
In a securities market that provides good
liquidity, the market price should not
fluctuation in response to a liquidity imbalance.
If the market price does fluctuate in response to
a liquidity imbalance, then the market price is
not fair and the market is not ideal.

FIM: Securities Markets

The Minimization of Trading Costs

Trading securities involves all the problems like,
agreeing on the terms of a transaction and the
execution of trade ( the settlement of the
transaction: security against money) that involves
the cost and risk.
Organized markets lower the cost of trading.
Cost Easier Trade Better the market
perform its basic functions

FIM: Securities Markets

Ways of minimizing trading costs

Restricted Access and Rules of
Conduct
Standardization
Conflict Resolution
Guaranteed Execution
FIM: Securities Markets

 Restricted Access and Rules of Conduct:

Restricting access to the market: only authorized
traders are allowed to participate. An authorized
trader must satisfy certain standards: capital
requirements, accounting standards, and the
standard of honesty.
The organized markets also have the sets of rules
governing the conduct of their membersdisciplinary actions to the violating members,
punishments
This all increases the confidence with trading and
reduces the trading costs.
FIM: Securities Markets

10


Standardization:
Transactions
are
standardized for e.g on NEPSE, stocks are
traded in round lot such as 10 or 100 shares.
Settlement is T+3 days, how and when to
transfer the securities and cash .
Standardization makes the trading much easier
and simpler: nature of the transactions and the
other parameters of the transactions are
automatically understood by the traders, only
the traders need to be agreed on the price and
quantity.

FIM: Securities Markets

11

 Conflict Resolution: Disputes among the

trader involves the time and cost. It is
inevitable part of trading, but organized
markets reduce the cost by providing the
institutional frameworks to resolve the
dispute.
Guaranteed Execution: Execution of a
transaction involves a variety of the riskscostly affair. Organized markets guarantee
execution of the transactions agreed to by
traders.
FIM: Securities Markets

12

Dealer Markets and Auction Markets

There are two alternative ways to conduct
trading - the dealer markets and the auction
market
Dealer quotes bid and ask prices for the
securities.
Dealer market is a market made by the
dealers, who quote prices at which they are
willing to buy and sell.
FIM: Securities Markets

13

 The government Securities market is a

Dealer Market.
All OTC markets are Dealer markets.
Auction Market is a market in which
the orders of traders are matched
directly.
You order the broker with the price you
are willing to buy or sell and broker
passes on your order to the trading pit.
FIM: Securities Markets

14

 The future market is the auction market

Dealer markets are Quote-driven and
Auction markets are Order-driven
Some markets are Hybrids. For
example, NEPSE
Dealer markets and auction markets
have two functions: Price discovery
and the Provision of Liquidity.
FIM: Securities Markets

15

How Dealer Markets Work

In Dealer market, the responsibility of
setting price rests with the dealers.
Dealers should change the price with new
information and should not change the price
with the liquidity imbalance.
The important aspects of the dealer market
are
Information traders and liquidity traders
The role of bid and ask spread.
FIM: Securities Markets

16

Information Traders and Liquidity

Traders
Information traders purchase or sell as per the
information available in the markets. They are always
motivated by the profit. The gap between market price and
the fair price.
For example, Mr. Satish is working for the steel
industry, steel company currently quoted Rs.2,000. He
knows that the price will further reduces to Rs.1,900.
So Satish can make a profit from his superior
understanding of the Steel industry by selling short.

FIM: Securities Markets

17

 Selling short means borrowing a security

and selling it now, and buying back it later
when the security prices will decrease.
Liquidity traders are those traders who
trade for reasons unrelated to the price of a
security. Trading in an Ideal market.
The problem with dealers is that they cant
separate the information traders and
liquidity traders.
They receive the strong incentive to set fair
price .
FIM: Securities Markets

18

 The Role of Bid Ask spread:

What will happen with the trading of Mr. Satish
if hard Dealers set price of a Steel company;
Bid-Rs.1,900 and Ask-Rs.2,100?
Generally, greater the uncertainty about the fair
price, and the greater the threat from
information traders, the greater will be the bidask spread.
However, greater the bid-ask spread, greater
will the dealers profit from trading with
liquidity traders. This will compensate the loss
from information traders.

FIM: Securities Markets

19

 Therefore,
Greater
the
uncertainty about a fair price,
and greater the threat from
information traders, the less
well will dealer market provide
liquidity.

FIM: Securities Markets

20

How Auction Markets Work

In an auction market there is no dealer to set the
price. Buy and sell orders are brought together and
the price is set to clear the market. (Demand and
supply determines the price).
Price responses to the new information and to
liquidity imbalance.
Price will rise or fall more gradually as the trading
takes place.
Information traders play vital role in the auction
market by providing liquidity.
FIM: Securities Markets

21

 Differing from the dealer market, in

auction market trading informations are
made available as quickly as possible. The
better the information, the easier it is for
information traders to come in and smooth
out liquidity imbalance.
Types of orders: Auction markets have
different ways of bringing orders together.
Market Order
Limit Order

FIM: Securities Markets

22

 Market Order: Instruction to buy or sell at

the prevailing market price.
Limit Order: Instruction to buy or sell if
the market price crosses a stated limit.
Except these two basic orders there are
other orders too:
Stop Order: Broker is to trade once the market
price reaches a certain level, but then the order
becomes market order.
Stop limit order: A stop order that becomes a
limit order once the price reaches a certain
level.
FIM: Securities Markets

23

 Market-if-touched order: A sell order

entered at a price above the current price.
Fill-or-kill order: The broker is to buy or
sell at the specified price or better, but if the
order can not be filled immediately, it is
automatically cancelled.
Percentage order: The percentage of the
order to be activated depends on trading
volume in the security.

FIM: Securities Markets

24

 Not-held order: Market order that gives

floor brokers permission to delay if they
think they can get a better price.
One-cancels-the-other
order:
The
simultaneous orders, with the remaining one
cancelled when the first is executed.
Specific-time order: One the must be
executed at or by a given time. E.g on the
close, at the beginning etc.

FIM: Securities Markets

25

 Types of Auctions:
Call Auction and Continuous Auction
Sealedbid Auction and Open-bid Auction

Call auction is an auction in which trading

takes place only at certain prearranged
times-the calls.
In contrast to the call auction, in
continuous auction the orders are filled as
they arrive.
Most markets use a combination of call and
continuous auctions.
FIM: Securities Markets

26

 For example, there may be a call at the

beginning of each trading session-called
clearing transaction- to clear orders
accumulated since the previous trading
session. Then, continuous trading proceeds
until the end of the session.
The main advantage of call auction is that
there is less fluctuation in price as result of
liquidity imbalance.

FIM: Securities Markets

27

 The main advantages of continuous

auction are; first price is always
available; with a call auction price is
always uncertain between the calls.
The second, it allow the faster
execution of the order; traders are
executed immediately rather than
having to wait for the next call.

FIM: Securities Markets

28

 Open-Bid
Auction:

Versus

Sealed

Bid

In an open-bid auction, offers to trade are

announced to all market participants. For
example, Open-outcry trading in the NEPSE.
In a sealed bid auction, offers to trade are
known only to the bidder and perhaps to the
auctioneer. For example, Auction for Nepal
Rastra Banks T-Bill.

FIM: Securities Markets

29

Execution of Trade
Execution of trade means changing the
hands of securities and money. It is costly
and involves risk.
The Risk of Trade Execution:
Suppose there are two brokers X and Y at
NEPSE, X agrees to sell 1000 shares of LBL (
order of A ) at Rs.500. To execute this
transaction, X need to transfer ownership of
shares to Y, and Y needs to transfer the cash to
X. The hundreds of transactions happens in
each day. It involves the paperwork.
FIM: Securities Markets

30

 If this all work had to do by X and Y,

they wouldnt be able to do much
trading.
In reality, once X and Y agree on the
terms, execution is handed over to
others in the back office. Process
T+3 in NEPSE.
This delay between agreement on a trade
and its execution makes a transaction in the
securities markets a forward transaction.
FIM: Securities Markets

31

 It involves following risks.

Principal risk
Liquidity risk
Operational risk
Systemic risk
Replacement risk

Principal risk is the risk of default by a

counterparty after you have fulfilled your
part of a deal. This risk can be eliminated
by making delivery and payments
simultaneously. Delivery against payments (DAP).
FIM: Securities Markets

32

 Replacement Risk is the risk that a counterparty

will fail to execute an agreed-upon transaction,
leaving you to find other deal.
Liquidity Risk is the risk that other transactions
will be compromised because an agreed upon
transaction is delayed.
Operational Risk the risk that execution will be
delay due to failure of the trading system.

Systemic Risk is the risk that the failure of

one trade or trader will cause the failure of
others in a domino effect.
FIM: Securities Markets

33

Clearing and Settlement

Trade execution involves two steps
Clearing and
Settlement

Both take time

Clearing is the process of comparing and
matching trades
Settlement is the fulfillment of obligations
conformed during clearing
FIM: Securities Markets

34

 A brief conversation in trading ;You and B

You: EBL?
B: 1200 to 1200 10/20 ( bid and ask price)
You: I sell 100! (You sell 100 round lots of
100 shares each.)
This conversation should be implemented.
First, Conform the trade ( Clearing) Types and quantity of security
Transaction date and price
Identification of buyers and sellers

FIM: Securities Markets

35

 After clearing the trade, the Second

is the arrangement of settling the
trade.
This is delivering the securities to
B; B verifies the securities and you
receive payments in the acceptance
form.

FIM: Securities Markets

36

The Advantages of Netting

Netting is a financial technique used to
reduce the costs involved in the settlement
of trade.
General bilateral netting arrangement: e.g.
trading EBL shares with B over a period of
time, and just settle net position at the end
of the period.
Multi-issue netting- netting trade is all
securities with B.
FIM: Securities Markets

37

 Multilateral multi-issue netting: All

securities and all other traders in the market.
At the end you would just make a receive a
single transfer of money and a single
transfer of each securities you made.
Longer the netting period, the more
transaction will offset one another, and
fewer will be the deliveries that actually
need to be made.
On the other hand, longer the netting period,
the greater the exposure to replacement risk.
FIM: Securities Markets

38

Need for regulating security markets

1. Information efficiency
2. The need for consumer protection
1. Information Efficiency
Information efficiency refers to the condition in
which the prices a market generates accurately
reflect available information.
Definitions of information efficiency
A market displays weak informational efficiency if
current prices reflect all information contained in
the record of past prices.

 A market displays semi strong informational

efficiency if current prices reflect all generally
available information.
A market displays strong informational
efficiency if current prices reflect all
information, even if that information is not
generally available.
Efficient securities markets reduce the cost of
lending and trade in risk.
They result in more lending and more trade in
risk and consequently for the economy as a
whole.

 Finding the fair price is not only beneficial to

the buyers and sellers but also others that do
not directly involved in the securities markets.
For example, many people who do not
involved in the oil futures, such as
manufacturers of the automobiles, will be
affected by the future price of the oil.
Therefore, it is reasonable to regulate the
security market

2. The need for consumer protection

Due to asymmetries of information, the small

investor is less well informed than market
professional and is therefore in danger of
being cheated.
Government regulation is required to ensure
fair deal for small investor-consumer
protection.
First requirement of a fair deal is that
securities trade at a fair price.

 Causes of securities not trading at fair price:

Asymmetries of information's- better informed traders
might sell securities for more than they are worth or buy
them for less.
Manipulation of the market- Squeeze or corner- the
creation of an artificial liquidity imbalance designed to
raise the market price of an assets

A fair markets price is only requirement for a fair deal

- Small investors do not trade in the market
themselves: they delegate the task to professions.
Churning- Unjustified trading of a customers
account by a broker to generate commissions for the
broker.

Market Solution
Self regulation: enforcement of standards and rules
by a community of market participants.
Brokers should think about the long term profit rather
than short term.
They sometimes provide investor with explicit or
implicit guarantees to enhance their confidence in the
market.
In addition, if investors feel so disadvantage in in
securities markets a variety of institutions have grown
as an alternative where investors can delegate their
investors such as life insurance companies, pension
funds and mutual funds.

Security market regulating laws in US

Securities Act of 1933

Securities Exchange Act of 1934
Glass-Steagall Act of 1933
Investment Advisors Act of 1940
Securities investor protection corporation Act
of 1970
Commodity Exchange Act of 1936
Commodity Future Trading Commission 1974.

Security Markets in Nepal

Nepalese Security market started with the
floatation of shares by Biratnagar Jute Mills
& Nepal Bank Ltd in 1937.
1964: First issuance of the Government
Bonds
The study of security market of Nepal can be
organized into two parts.
a) Organizational Aspect
b) Regulation Aspect

Organizational Aspect
Primary market: In primary market, the fresh issues
are made. In Nepal, there are 9 issue managers
(Investment banks) are performing the primary
transaction
Secondary market: The sole secondary market,
market where the already issued securities are traded,
is Nepal Stock Exchange (NEPSE).
In NEPSE, corporate securities and bond securities
are traded.
Corporate securities include Ordinary Shares,
debentures and preference shares.
Government Bonds and NMC Mutual Fund are also
popular trading securities in NEPSE

 At present, there are 49 brokers, 9 issue

manager and 2 dealers working in the securities
market in Nepal.
Besides this, in the money market consists of
the T-Bills, Certificates of deposits, Letters of
Credit, Reverse Repo.

Regulation Aspects
Securities Board of Nepal (SEBON) is an apex
regulator of securities market in Nepal. It has
been regulating the market under the securities
exchange act of 2006.

Major securities laws in Nepal

Act: Securities Act 2063
Regulations:
Securities Board Regulation, 2064
Stock Exchange Operation Regulation, 2064
Securities Businessperson (Stock Broker, Dealer & Market
Maker) Regulation, 2064
Securities Businessperson (Merchant Banker) Regulation, 2064
Securities Registration and Issue Regulation, 2065
SEBON Procurement Regulation, 2066
Mutual Fund Regulation, 2067
Central Depository Service Regulation, 2067 (2010)
Credit Rating Regulation, 2068

Guidelines and Bylaws

Mutual Fund Guidelines-2069

Compliance Guidelines for Securities Broker, 2058
Securities Issue Guidelines, 2065
Bonus Share Guidelines, 2067
Portfolio Management Guidelines, 2067 (2010)
Government Securities Bylaws of SEBON, 2062
Government Securities Transaction Bylaws of NEPSE,
2062
Securities Allotment Guidelines, 2068
CDS Byelaws, 2068
FIM: Securities Markets

50

Comparison: Listed Companies

Country

Numbers

Nepal

176

India

4,921

Sri Lanka

234

Indonesia

396

Malaysia

977

Tanzania

Uganda

6
FIM: Securities Markets

51

Market capitalization/DGP

FIM: Securities Markets

52

Turnover / Market capitalization

FIM: Securities Markets

53

Top Ten Companies/Market

Capitalization

FIM: Securities Markets

54

Nepal India Comparison

Legal Framework

India
SEBI Act 1992 set up SEBI as an independent regulator
Powers under Companies Act delegated to SEBI

Nepal
SEBON empowered under the Securities Act of 2007
Companies Act for issuance and listing of shares

FIM: Securities Markets

55

Market Infrastructure
India
Two main exchanges; BSE and NSE
Two depositories
Online screen based trading with 99% trading in demat form
Clearing Corporations offering guaranteed clearing and settlement of
trades

Nepal
One exchange-NEPSE - govt owned
Manual clearing & settlement system
Central depository system being introduced by NEPSE

FIM: Securities Markets

56

Level of Intermediation
India
Large number of brokers
Approx 1000 each at BSE and NSE

Merchant Bankers
Depository Participants
Mutual Funds
Debenture Trustees
Credit Rating Agencies

Nepal
Few brokers
Merchant bankers
Limited role

No depository participants
One mutual funds/ portfolio managers
No Credit Rating Agencies
No Debenture Trustees
FIM: Securities Markets

57