Financial Markets and Institutions (2-downloads)

National Association of Securities Dealers Automated Quotation System

(NASDAQ). This system, introduced in 1971, provides current bid and ask prices

on about 3,000 actively traded securities. Dealers “make a market” in these stocks by

buying for inventory when investors want to sell and selling from inventory when

investors want to buy. These dealers provide small stocks with the liquidity that is

essential to their acceptance in the market. Total volume on the NASDAQ is usu-

ally slightly lower than on the NYSE; however, NASDAQ volume has been growing

and occasionally exceeds NYSE volume.

Not all publicly traded stocks list on one of the organized exchanges or on 

NASDAQ. Securities that trade very infrequently or trade primarily in one region of the

country are usually handled by the regional offices of various brokerage houses. These

offices often maintain small inventories of regionally popular securities. Dealers that

make a market for stocks that trade in low volume are very important to the success

of the over-the-counter market. Without these dealers standing ready to buy or sell

shares, investors would be reluctant to buy shares of stock in regional or unknown firms,

and it would be very difficult for start-up firms to raise needed capital. Recall from

Chapter 4 that the more liquid an asset is, the greater the quantity demanded. By

providing liquidity intervention, dealers increase demand for thinly traded securities.

Organized vs. Over-the-Counter Trading

There is a significant difference between

how organized and OTC exchanges operate. Organized exchanges are characterized

as auction markets that use floor traders who specialize in particular stocks. These

specialists oversee and facilitate trading in a group of stocks. Floor traders, repre-

senting various brokerage firms with buy and sell orders, meet at the trading post

on the exchange and learn about current bid and ask prices. These quotes are called

out loud. In about 90% of trades, the specialist matches buyers with sellers. In the

other 10%, the specialists may intervene by taking ownership of the stock them-

selves or by selling stock from inventory. It is the specialist’s duty to maintain an

orderly market in the stock even if that means buying stock in a declining market.

About one of four orders on the New York Stock Exchange is filled by floor traders

personally approaching the specialist on the exchange. The other three-quarters of

trades are executed by the SuperDOT system (Super Designated Order Turnaround

system). The SuperDOT is an electronic order routing system that transmits orders

directly to the specialist who trades in a stock. This allows for much faster commu-

nication of trades than is possible using floor traders. SuperDOT is for trades under

100,000 shares and gives priority to trades of under 2,100 shares. About 95% of orders

to buy or sell on the NYSE are executed using this system.

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Part 5 Financial Markets

Whereas organized exchanges have specialists who facilitate trading, over-the-

counter markets have market makers. Rather than trading stocks in an auction for-

mat, they trade on an electronic network where bid and ask prices are set by the

market makers. There are usually multiple market makers for any particular stock.

They each enter their bid and ask quotes. Once this is done, they are obligated to buy

or sell at least 1,000 securities at that price. Once a trade has been executed, they

may enter a new bid and ask quote. Market makers are important to the economy

in that they assure there is continuous liquidity for every stock, even those with lit-

tle transaction volume. Market makers are compensated by the spread between the