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Market form: exchange-traded and OTC markets
Markets may be of the form over-the-counter (OTC) or of the form exchange-traded (also called formalized). These fit into our growing financial markets illustration as portrayed in Figure 11.
Figure 11: organization of spot financial markets (2)
Most markets in an economy are informal, i.e. OTC or not legislated, and examples are the labour market, the vegetable market, the fish market, and the market for elephants. In the case of the financial markets, however, all the markets start out as informal and some progress to formalized markets. For example, the forward markets are extremely useful markets and some have progressed into futures markets, not because the authorities want them so, but because the participants want them to be well-functioning, liquid and safe markets.
Some of the markets, such as the spot money market and the spot and forward foreign exchange markets never become formalized, and the reasons are straightforward: they work well as they are (i.e. without official intervention) and because they are the domain of intermediaries who themselves are sufficiently regulated.
As an introduction, we present our expanding financial markets illustration (see Figure 12). There are four methods of primary issue: public issue, private placement, auction and tap issue.
Figure 12: organisation of spot financial markets (3)
Public issue (also called public offer or offering) is the process of offering securities to the general public. This is done through the issue of a prospectus or placing document, i.e. an offer for the public to subscribe for the securities at a stipulated price. When shares are offered to the public for the first time it is called an initial public offering (IPO).
A public issue may be either:
• An offer for subscription
• An offer for sale.
In the case of the offer for subscription, the public is invited to subscribe for a specified number of previously unissued (or new) shares. The proceeds accrue to the company.
In the offer for sale, shareholders invite subscribers to purchase a certain number their existing shares. The proceeds do not accrue to the company, but to the existing shareholders.
When a bank or broking firm is appointed to manage the issue of securities for a company, it is called the originator or the bookrunner. The bank or firm is responsible for all aspects of the issue: the legal and financial exchange requirements, appointment of the auditor and lawyer to the issue, etc.
There may also be an underwriter to a public issue, i.e. an undertaking to take up the remaining securities if the offer is not fully subscribed. This undertaking by the underwriter (done for an agreeable fee of course), which is usually an investment / merchant bank, gives comfort to potential investors - if the underwriter is prepared to take up the securities, they must be of good quality and the pricing is fair!
With underwriting there may also be more than one underwriter, termed syndicated underwriting.
Private placement is the placement of securities by the issuer or an originator with a single investor, or with a small group of investors, such as a selected number of "institutions"15. This may also be termed a limited public offer. Some countries use the terminology bookbuilding to describe the activity of the placement of securities with a small group.
A form of private placement is an underwriter taking up all the securities himself at a specific price and then on-selling them to investors at a higher price. The difference between the two prices is called the underwriting spread.
Many issuers make use of the auction method. There are various forms of auction:
• Dutch auction. This is an auction where the seller starts at a high price and continuously lowers the price until a buyer "takes" securities at this price. US companies have repurchased their own shares using this method of auction.
• English auction. This is an auction where a party starts the auction by bidding a price, and then others follow with bids at ever-increasing prices. When the bidding ceases, the last highest price is the price paid. There are variations to this auction method.
• Descending price sealed auction (also called first-price sealed auction). This is the auction type where sealed bids are ranked from highest to lowest price and allocation takes place in descending price order, until all securities are allocated. This means of course that the highest prices bid receive full allocations and bidders lower down the price scale receive partial allocations on a pro rata basis.
The majority of treasury bill issues in the world are done according to the latter method. Many bond markets also operate in this fashion. In many countries this is the preferred method of issue of bonds, and this is executed exclusively with the market makers (usually called primary dealers). The central bank conducts the auction tenders on behalf of National Treasury for specific amounts of government bonds, and the market makers are obliged to tender for a specified minimum amount.
Table 1: Example of descending price sealed auction
An example of the latter method is presented in Table 1 (assumption: LCC 100 million treasury bills offered). The first three tenders (bids) are allocated in full (LCC 80 million), leaving LCC 20 million to be distributed amongst the other bidders on a pro rata basis (percentage of total remaining bids, i.e. 25/105, 50/105 and 30/105).
The tap issue method of issuing securities is where the issuers are open to bids at all times for their securities. They of course reserve the right accept or reject bids according to their view of the markets and need for funds. Most banks issue NCDs according to this method.
Many issuers approach potential investors and offer securities to them at offer prices, i.e. they "tap out" their own securities in this manner. Issuers of securities that make markets in their own securities also "tap out" their securities by being net sellers.