Chapter 1 Part II Capital Markets Operation

PART II
Capital Market Operation
Dr Dakito Alemu
Outline
• Distinguishing primary markets and secondary markets
• Identifying the role investment bankers play in the distribution of newly issued
securities
• Elaborating the functions of investment companies (collective Investment schemes (CIS))
in the capital markets

• Explain functions of the primary markets and how they operate
• Explain underwriting arrangements and the risk associated with underwriting
• Discuss the role of a dealer as a market maker and the costs associated with market
making
• Elaborate the secondary market operations: buy sides and sell sides
• Discuss the career path available in
Dr Dakito Alemu
the capital market.
What Are Capital Markets (‘CM’)?
Goods, services, funds and risks
Capital Markets
Trading Products
Primary Market Secondary Market
• Equity Securities
(e.g., Common Shares)
Corporation Fund Managers / • Debt Securities

Investors
(e.g., Bonds)
New Issue Existing • Foreign Exchange

Securities Securities (e.g., Currencies)
• Derivatives
Fund Managers/ Fund Managers / (e.g., Swaps, Futures, Forwards)
Investors Investors
• A stock exchange is an organized marketplace for the

issuing and trading of securities by members of that
Dr Dakito Alemu exchange.
Forms of securities
• Securities, like equities and bonds, take one of two main forms –
a)registered or
b)bearer
• The form of securities determines how an investor proves ownership of a particular
investment.
• Bearer certificates, as their name suggests, mean that the person that bears (or holds)
them has title to them, like banknotes.
• In comparison, registered certificates require that the holder’s ownership is recorded in a
digital register as the owner (or title-holder) of the investment. The certificate itself is less
important.
• Indeed, with the advent of technology, it is becoming increasingly rare to find share
certificates at all – shares are usually held electronically rather than physically.
• Some securities come in bearer form and, unlike registered securities, the physical
possession of the certificate is the proof of ownership.
• Bearer securities are easier to transfer as there is no register and they can simply be
handed over. Dr Dakito Alemu
Limitations of bearer forms
• However, this does raise some issues including the following:
✓• It is difficult for the authorities to monitor ownership, making them
attractive investments for money launderers.
✓• The issuing organization has difficulty knowing to whom dividends
or interest payments are to be sent.
✓• Physical security of the certificates is of greater importance and can
increase the cost of holding the investment.
• It is important to note that many bearer securities are held in central securities
depositories (CSDs), such as Euroclear and Clear-stream, and are technically
referred to as ‘immobilized’.
Dr Dakito Alemu
Primary vs. Secondary Markets
Capital Markets
Primary Markets Secondary Markets
New Existing
Securities Securities
Cash Cash
Corporation Investor A Investor B
Definition First time offering securities Existing securities are offered
Beneficiary Corporation Investors
1. Issuing Corporation Investors buy and sellamongst

Transaction
2. Investment Bank (Origination) each other via investment
Stakeholders
3. Institutional Investors banks that are broker/dealers
Dr Dakito Alemu
Primary vs. Secondary Markets, Cont’d…
Capital Markets
Primary Markets Secondary Markets
New Existing
Securities Securities
Cash Cash
Corporation Investor A Investor B
Investment Bank, Origination Investment Bank, Sales & Trading

Intermediary
Initial Public Offering (IPO) Existing securities are offered
Products Traded Follow-on Public Offering (FPO)
Selling Frequency One-time event Ongoing trading among investors
Corporation sells shares to Supply and demand sets price

Price
investors at fixed price
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Primary Markets Versus Secondary Market
Origination is to As Sales, Trading, and Research are to
Primary Markets and Corporates… Secondary Markets and the Buy-Side
PRIMARY SECONDARY
MARKETS MARKETS
Dr Dakito Alemu
Who participate in which market?
Dr Dakito Alemu
Who participate in which market?
BUY SIDE SELL SIDE
Institutional Investors /
Primary Fund Managers
Origination
(New Issue) DCM ECM
Market Debt Equity
Capital Capital
Markets Markets
Secondary Sales, Trading

Market & Research
Dr Dakito Alemu
The role of investment Banks and Collective Schemes
(investment companies)
BUY SIDE SELL SIDE
Institutional Investors / Investment Banks
Fund Managers
Primary Origination
(New Issue) DCM ECM
Market Debt Equity
Capital Capital
Markets Markets
Secondary Sales, Trading

Market & Research
Dr Dakito Alemu
Corporate
Actions
Dr Dakito Alemu
Corporate Actions
• Corporate actions are events that are initiated by an issuer of securities, such as a company with shares in
issue or an organization with bonds in issue, that directly impact those securities.
• Common Types of Corporate Actions are:
1)Income Events (eg. dividends and bond coupon payments)
2)Capital Events (eg. bonus issues; stock splits; reverse stock splits)
3)Capital Raising Events (eg. Right Issues, )
4)Share Capital and Changes to Share Ownership (eg. Share Buybacks, M&A)
• Perhaps the most obvious examples are when a company pays a dividend to its shareholders or a coupon to
its bondholders.
• These are referred to as income events.
• Other corporate actions include those that bring about changes to the share capital of a company (capital
events and capital raising events), such as when the company gives away new shares to existing
shareholders for nothing (scrip issues), or offers new shares to existing shareholders at a discounted price
(rights issues). Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Impact of a Rights Issue on the Share Price
• To illustrate the impact on the share price for a company which undertakes a rights
issue, the following are the key variables in the example discussed below:
✓ • Prior to the rights issue the company has one million shares in issue with a nominal value of
￡1.00 each. The nominal value is also referred to as the par value – it is the minimum price
that the issuing company must receive when issuing shares.
✓ • The share premium account (sometimes termed additional paid-in capital) shows a balance of
￡0.5 million. The share premium account is the capital that a company raises upon issuing
shares that is in excess of the nominal value of the shares.
✓ • The company wishes to raise new capital for expansion and undertakes a 1-for-4 rights issue
at a price of ￡1.50 in order to raise ￡375,000.
✓ • The company’s accounts before the rights issue show that net assets are ￡2 million and
retained profits are ￡0.5 million.
✓ • The market price of the shares prior to the rights offering is ￡3.00 per share.
• What is the impact on the accounts and the theoretical market price per share of this
issue?
Dr Dakito Alemu
Solution
• A 1-for-4 rights issue means that for every four shares previously in existence, one new share will be issued.
• In our example, 1 million shares were previously in issue, so 250,000 new shares will be issued at a price of
￡1.50 in order to raise the ￡375,000 cash required.
• In terms of the accounts, the 250,000 new share issue will increase the share capital to 1.25 million shares,
the retained profit (retained earnings) will remain unchanged but the share premium account will need to
be adjusted.
• The reason for this adjustment is that for the ￡375,000 raised, each of the 250,000 new shares can be
issued at the nominal value of ￡1 but the additional ￡125,000 raised in excess of the nominal value of the
shares is allocated to the share premium account as indicated in the simple balance sheet perspective in the
table below.
• The total capitalisation of the company will have increased to ￡2.375 million and can be broken down
according to the upper part of the table which reflects the rights issue from an accounting perspective.
• The impact on the share price can be seen from the calculation of the theoretical market price in the lower
part of the table.
• The price for the shares should have fallen from ￡3.00 per share before the rights issue to ￡2.70 after the
issue to reflect the new capitalisation divided by the greater number of shares now outstanding.
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Nil-Paid Value
• The nil-paid rights is the theoretical value of the right to buy a share in a rights issue. This is
calculated
• by comparing the theoretical ex-rights price to the price of exercising the right.
• As can be seen, it is straightforward to substitute the following values using the minimum number
of shares required to qualify for the rights issue (in this case four shares) from the company
provided above:
• Number of shares held cum-rights = 4
• Cum rights share price = ￡3.00
• Number of rights allocated = 1
• Rights issue price = ￡1.50
• Total shares assuming rights exercised = 5
• Solving = {[4 x ￡3.00] + [1 x ￡1.50]}/5 = ￡13.50/5 = ￡2.70
• Given this example, the price of each nil-paid right should be calculated from the ex-rights share
price – price of the new shares = 270p – 150p = 120p.
• Obviously, it would not be rational to pay more than 120p for the right to purchase a new share for
150p when the ex-rights priceDrof theAlemu
Dakito existing shares in issue is 270p.
Dr Dakito Alemu
Selling Some Rights to Take Up Others (‘Swallowing the Tail’)
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Example
• Amazon’s stock is about to get much, much cheaper!
• Amazon shares are about to get 20 times less expensive.
• The company announced Wednesday its board approved a 20-for-1 stock split, its
first split since 1999.
• If approved by shareholders in May, the split will go into effect 6 June.
• Amazon closed Wednesday at $2,785 per share.
• If the stock split were to happen today, Amazon’s stock would be worth $139 a
share.
• Don’t worry, Amazon stockholders – your stakes will still be worth the same. You will
be holding 20 times more shares when all is said and done.
• ‘This split would give our employees more flexibility in how they manage their equity
in Amazon and make the share price more accessible for people looking to invest in
the company’, Amazon said in a statement.
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
Operations of Primary Markets
Dr Dakito Alemu
Operations of Primary Markets
Dr Dakito Alemu
The Primary Market Map
Cash
Corporates Sell Side Buy Side
CFO / Treasurer Investment Bank Fund Managers /

Origination Institutional Investors
Cash
Bonds/Shares
Lenders /
Investors
Dr Dakito Alemu
The Primary Market - Example
Cash
Corporates Sell Side Buy Side
Investment Bank Fund Managers /

CFO / Treasurer
Origination Institutional Investors
Cash
Bonds/Shares
Lenders /
Investors
Dr Dakito Alemu
Modes of Issuing New Securities
Dr Dakito Alemu
Modes of Issuing New Securities
Issues
Public Issues Rights Issues Private Placements
Qualified Institutional
IPO FPO Preferential Issue
Placement (QIP)
Dr Dakito Alemu
Modes of issuing new securities, Cont’d…
• Initial Public Offering.
• Done by unlisted company.
IPO • Fresh issue of securities/ offers its existing securities for sale/ Combination of both.
• Securities issued for the first time to the public.
• Paves way for listing and trading of the issuer’s securities in the Stock Exchange(s).
•Further Public Offer / Follow-on Offer.

FPO •Done by already listed company.
•Fresh issue of securities / Offer for sale of securities to public .
Rights Issue • Done by already listed company.

(Pre-emption • Issue of securities to its existing shareholders (as on a Record date).
• Record Date is fixed by the issuer.
right) • The rights offered in a particular ratio to the number of securities held by existing
shareholders as on the record date.
Dr Dakito Alemu
Dr Dakito Alemu
Modes of issuing new securities, Cont’d…
• Done by already listed company.

• Issue of shares to a select group of persons at lower price
Preferential Issue • Issue of shares in bulk to individuals
• The company looks out for strategic investors and
makes a preferential allotment to them
• Qualified Institutional Placement (QIP).

QIP • Done by already listed company.
• Issue of shares to Qualified Institutional Buyers (QIBs).
• Subject to prescribed norms such as minimum pricing and minimum
public shareholding.
Public Company
• Article 2/53
• “Public Company” is a share company, whether listed on a
securities exchange or not, whose shares of stock are traded on:
a) a securities exchange or
b) over-the-counter markets;
• Article 2/57:
• “Publicly Traded Security” means a security traded on a
securities exchangeDr Dakito
or through
Alemu
over-the-counter markets;
Types
of
Offer
Dr Dakito Alemu
Types of Offer
1)Initial Public Offerings (IPOs)
• There are three major ways that a company could use for IPOs and
become listed for the first time – Methods to become listed:
a) Offers for sale,
b) Placings (d/t from private placement) and
c) Introductions
2)Follow-on Offerings
• There are two major ways that a company could use for FPOs –
a) Offers for sale, and
b) Placings and
Dr Dakito Alemu
1) Offers for Sale
• Offers for sale are the most common way of achieving a listing.
• The company seeking to sell the shares approaches an issuing house (usually an investment bank) that
specializes in approaching potential shareholders and preparing the necessary documentation.
• The issuing company sells its shares to the issuing house (usually an investment bank), which then invites
applications from the public at a slightly higher price than the issuing house has paid and on the basis of a
detailed prospectus, known as the offer document.
• For a company applying for a full listing, this provides comprehensive information about the company and
its directors and how the proceeds from the share issue will be applied.
• This document must be prepared by the company’s directors and assessed by their sponsor to satisfy the
regulatory authorities of the company’s suitability to obtain a full listing.
• Offers for sale do not necessarily require the company to create new shares specifically for the share issue.
• Indeed, offers for sale are often used by a company’s founders to release part, or all, of their equity stake in
their company, and have also been the preferred route for government privatization programmes, when
former nationalized companies have been sold to the public.
• In both cases, existing shareholdings are disposed of, rather than new shares created, in order to obtain a
listing.
• An offer for sale can be made on either a fixed- or a tender-price basis
Dr Dakito Alemu
Dr Dakito Alemu
2) Selective Marketing and Placing
• In placing its shares, a company simply markets the issue directly to a broker, an
issuing house or other financial institution, which in turn places the shares with
selected clients.
• Although the least democratic of the three IPO methods, given that the general
public does not initially have access to the issue, a placing is the least expensive, as
the prospectus accompanying the issue is less detailed than that required for the
other two methods (offers for sale and introductions) and no underwriting is
required.
• Placings can be used for IPOs but also for secondary (or follow-on) issues. If the
company is based in a jurisdiction that gives shareholders pre-emptive rights, a
resolution at a shareholders’ meeting will be required to enable the placing to
happen.
• A placing is often referred to as a selective marketing, because the intermediary is
selecting the clients to whom the
Dr Dakito offer is directed.
Alemu
Dr Dakito Alemu
3) Listing by Introductions
• An introduction is not actually an issue at all. It is the third and final way (alongside offers for sale
and placings) that can be used by a company that wishes to become listed in order to gain access to
the secondary market that an exchange will provide.
• Listing by way of introduction is fairly common on many emerging market exchanges.
• An introduction is unusual because most companies use listing as an opportunity to raise extra
funds and some companies are forced to issue more shares to comply with regulations that
typically require a minimum percentage of shares to be held by people other than the founders
and other significant shareholders.
• An introduction is used by a company that does not need to raise extra capital through share
issues, but wishes to gain the extra liquidity in its shares that a listing provides.
• This might be a company that is already listed on another, overseas stock exchange, a new
company formed from two previously listed companies that have merged, or a demutualised
organisation.
• As an introduction does not raise funds, it is not a marketing operation in the same way as an offer
for sale or placing.
Dr Dakito Alemu
Initial Public Offerings (IPOs)
• An IPO is the initial public offering of a company’s shares which, until the IPO, were privately
owned (and controlled) by a small group of investors.
• The owners prior to the IPO are likely to include the founders of the company and/or relatives or
close acquaintances and early-stage investors, such as private equity (PE) or venture capital (VC)
funds.
• By issuing company shares via an IPO, which is also known as ‘going public’, the original owners are
typically giving up a substantial amount of control.
• There are three broad stages to an IPO:
• 1. The decision – the issuing company (in conjunction with its advisers, particularly an investment
bank) makes a decision to raise capital via an IPO. This will involve careful consideration of the pros
and cons of a public offer.
• 2. The preparation of the prospectus – the prospectus is an official document that outlines the
terms of the IPO, and preparing this involves the whole team of advisers, including the investment
bank, reporting accountants and legal advisers.
• 3. The sale of securities – the investment bank will lead-manage the sale and may well establish a
syndicate of co-managers to assist in Alemu
Dr Dakito selling the securities to their clients too.
Example
• The world’s biggest ever IPO occurred in December 2019 – it was the IPO of the Saudi Arabia oil giant Saudi
Aramco.
• Decision –
• The sale of a stake in state-owned Aramco initially targeted selling 5% of the company to a combination of local
and global investors. With an estimated value of the company of $2 trillion, a 5% stake would raise around $100
billion.
• The decision was supported by a group of ‘joint financial advisors’ that consisted of seven international banks
(Citigroup, Credit Suisse, Goldman Sachs, HSBC, JPMorgan, Merrill Lynch/Bank of America and Morgan Stanley)
and two local banks (at the time, these were NCB Capital and Samba; these entities have subsequently merged
to become Saudi National Bank or SNB).
• Prospectus –
• A huge document of over 250 pages, excluding the financial statements and appendices, was produced in
conjunction with a large panel of banks, local and international law firms and two firms of accountants (Ernst
and Young acting as financial due diligence advisor and PwC as independent auditor).
• Sale of securities –
• After scaling back some of the international ambitions, the IPO mainly targeted local and regional investors with
a base number of 3 billion shares, representing 1.5% of the issued share capital.
• A group of 25 banks acted as underwriters, and the shares were sold at SAR 32 each ($8.53), raising around
$25.6 billion for the selling shareholder, the Saudi government.
Dr Dakito Alemu
The IPO Process
As per Article 95, A person shall not enter into or carry out two or more
transactions in the securities of a company which by themselves or in conjunction with any
other transaction:
• stabilize, or are likely to stabilize, the price of securities with the intention of inducing another
person to sell, purchase, or subscribe for, or to refrain from selling, purchasing or subscribing for,
securities issued by the same company
Dr Dakito Alemu
Example 1
• Saudi Aramco is often discussed as one of the world’s biggest
companies.
• As it approached its IPO in December 2019, it was considered by
many to be worth approximately $2 trillion.
• Prior to going public, the oil giant was 100% owned by the Saudi
Arabian state.
• As part of ‘Vision 2030’, the Saudi government is investing heavily and
moving away from its over-reliance on oil.
• So, it sold around 1.7% of Saudi Aramco in an IPO which raised
around $29.4 billion – money that will enable significant government
spending to rebalance the economy in line with its vision for the
future.
Dr Dakito Alemu
Example 2
• The world’s biggest ever IPO occurred in December 2019 – it was the IPO of the Saudi Arabia oil giant Saudi Aramco.
• Decision –
• The sale of a stake in state-owned Aramco initially targeted selling 5% of the company to a combination of local and global
investors. With an estimated value of the company of $2 trillion, a 5% stake would raise around $100 billion.
• The decision was supported by a group of ‘joint financial advisors’ that consisted of seven international banks (Citigroup,
Credit Suisse, Goldman Sachs, HSBC, JPMorgan, Merrill Lynch/Bank of America and Morgan Stanley) and two local banks (at
the time, these were NCB Capital and Samba; these entities have subsequently merged to become Saudi National Bank or
SNB).
• Prospectus –
• A huge document of over 250 pages, excluding the financial statements and appendices, was produced in conjunction with
a large panel of banks, local and international law firms and two firms of accountants (Ernst and Young acting as financial
due diligence advisor and PwC as independent auditor).
• Sale of securities –
• After scaling back some of the international ambitions, the IPO mainly targeted local and regional investors with a base
number of 3 billion shares, representing 1.5% of the issued share capital.
• A group of 25 banks acted as underwriters, and the shares were sold at SAR 32 each ($8.53), raising around $25.6 billion for
the selling shareholder, the Saudi government.
Dr Dakito Alemu
1. Select an underwriter: IPO Process
• The underwriter is the principal player in the IPO
• Criteria for selection:
1. Reputation
2. The quality of research
3. Industry expertise
4. To whom the IB distributes more (institutional or
individual investors)
5. Prior relationship with the investment bank
Dr Dakito Alemu
2. Due Diligence and filling: IPO Process:
• The underwriter drafts the following documents
a) Engagement letter: Includes reimbursement clause, which holds the
issuing company accountable to cover the underwriter’s out-of-pocket
expenses. Also includes the gross spread, also known as the
underwriting discount, which is intended to cover the underwriter’s
fee.
b) Letter of intent: States underwriters commitment to the company and
the company’s agreement to cooperate or provide all information
c) Red Herring document: A preliminary prospectus that has information
on the company’s operations, but doesn’t include share price or
number of shares
Dr Dakito Alemu
2. Due Diligence and filling… IPO Process
• The underwriter prepare a registration statement and file it
with the CMA
– The registration statement discloses all material information
concerning the corporation making a public offering
• Prepare and submit the prospectus
– The prospectus is a legal document describing details of the issuing
corporation and the proposed offering to potential investors
– Contains much of the information in the registration statement
• The preliminary prospectus is sometimes called a “red herring”
Dr Dakito Alemu
3.Pricing: IPO Process
• The road-show is presented to institutional investors
–The road-show allows firms to raise interest in the company
and thus the price
• Road show allows the firm and its underwriters to
gather information from potential purchasers
• The securities are priced based on the value of the
company and expected demand for the securities
Dr Dakito Alemu
4.Stablization: IPO Process
• Underwriters stabilize the price of a stock by purchasing the shares in the
secondary market.
– The shares are typically purchased at the offer price
– where this increased demand from the underwriters prevents the stock's price
from falling
• Stabilization activities can only be carried out for a short period of
time
– During this period of time, the underwriter has the freedom to trade and
influence the price of the issue as prohibitions against price manipulation
are suspended.
• Two common method for stabilisation are:
1) Greenshoe option
2) Circuit Break
Dr Dakito Alemu
Stabilization
• Stabilisation is the process whereby, to prevent a substantial fall in the value of securities when a large
number of new securities are issued, the lead manager of the issue agrees to support the price by buying
back the newly issued securities in the market if the market price falls below a certain predefined level.
• This is done in an attempt to give the market a reasonable chance to adjust to the increased number of
securities that have become available, by stabilising the price at which they are traded.
• By increasing the demand for the securities in the market at the same time as more securities become
available, the price should remain more stable.
• This will mean the issuing company’s securities appear less volatile, and existing investors will be less likely
to begin panic-selling, creating a downward spiral in the security’s price. The securities that are bought back
by the lead manager of the issue will then be sold back into the market over time.
• An alternative way of stabilising the price of shares after an IPO is to use a greenshoe option.
• There are strict rules laid down by regulators regarding stabilisation practices.
• For example, the UK’s FCA requires disclosure to the market that stabilisation is happening, and that the
market price may not be a representative one because of the stabilisation activities.
• Prices can also be stabilised by exchanges using circuit breakers to temporarily suspend trading in periods
of volatility.
Dr Dakito Alemu
Over-allotment Options (Green-shoe)
• An allotment provision used in an IPO that has become almost standard in the case of new
offerings undertaken by US investment banks is the greenshoe.
• It is known as the greenshoe option because the term comes from a company founded in
1919 as Green Shoe Manufacturing Company, now called Stride Rite Corporation, which
was the first company to be permitted to use this practice in an offering.
• More properly known by its legal title as an over-allotment option, the greenshoe provision
gives the underwriters of an IPO the right to sell up to an additional 15% of the original
number of shares at the IPO price in a registered securities offering, if demand for the
securities is in excess of the original amount offered.
• It is used as a tool in providing price stabilisation and a successful execution of the offering
on behalf of the issuer.
• In essence, it is a strategy that underwriters have developed which enables them to smooth
out price fluctuations if demand surges on the one hand, and to help support the IPO if
there are adverse market conditions.
Dr Dakito Alemu
Example
• ABC is a company planning an IPO and using the services of an investment bank.
• The number of shares to be sold is initially agreed to be 100,000.
• The investment bank is also granted an overallotment option (the greenshoe) that
enables it to buy a further 15,000 shares from ABC if demand is sufficient.
• During book-building, the investment bank finds buyers for 115,000 shares rather
than just 100,000.
• Over the days following listing, if the price of the shares holds at the listing price or
higher, the investment bank simply exercises the over-allotment option to cover the
additional 15,000 shares sold.
• In contrast, if ABC shares struggle to stay at the listing price and fall in the immediate
aftermarket, the investment bank can buy back 15,000 shares to help support the
price. If it does this, the overallotment option will not be exercised.
Dr Dakito Alemu
Example
• Saudi Aramco: Greenshoe in the world’s biggest IPO
• As seen, the world’s biggest was the IPO of the Saudi Arabia oil
giant Saudi Aramco in December 2019.
• The IPO consisted of a base number of 3 billion shares,
representing 1.5% of the issued share capital, but the banks were
given the option to sell a further 15% (450 million shares).
• This greenshoe option was exercised, with the IPO overall
proceeds increasing from the initial $25.6 billion to approximately
$29.4 billion.
Dr Dakito Alemu
5.Transition to Market Competition: IPO Process
• Investors shift from relying on prospectus to relying
on the market forces for information regarding their
shares.
• After the required period lapses, underwriters can provide
estimates regarding the earning and valuation of the
issuing company.
• Thus, the underwriter assumes the roles of advisor and
evaluator once the issue has been made
Dr Dakito Alemu
Prospectus
• Article 2/52
–“Prospectus” refers to a document or a publication by,
or on behalf of, a share company containing information
on the
• character,
• nature, and
• purpose of an issue of shares, debentures, or other corporate
securities that extends an invitation to the public to purchase
the securities
•
Dr Dakito Alemu
Information in Offer Document (Prospectus)
About the Company: Management and
Financials
- Business: Company’s business Promoter Section
model, strategies and manufactured - Company's income
products/ process/ services. statement and balance sheet.
- Background and the
- History and Corporate Matters: - Understand company’s past
Material events taken place in experience of the
performance and growth
company’s history and other company’s management
potential.
corporate matters team.
Litigation and Dispute matters

Risk Factors
- Litigations in which the issuer
- Risks associated with
company, subsidiary(ies), group
the business, industry
company(ies), promoter(s) are
etc.
involved.
Information in Offer Document (Prospectus)
Capital Structure
- Capital formation of the Objects of the Issue
company, - Basic purpose of the company for going
- Existing shareholders and public and / or raising funds.
their percentage - Informs how the funds will be utilized.
shareholdings etc.
Basis for Issue Price Managements discussions and

- Helps understand the basis for pricing Analysis of financial conditions
and results of operations
- Comparison with other listed entities in
the same / similar segment. -
Functions of Primary/New Issue Market
Dr Dakito Alemu
Functions of Primary/New Issue Market
• Investigations, analysis and processing of new project

Origination proposals
• Agreement whereby the underwriter promises to subscribe to a

Underwriting specified number of unsold securities
• Selling of new securities to the ultimate investors

Distribution • Performed by brokers and agents
Dr Dakito Alemu
1) Primary markets function: Origination
• There are two aspects of origination function
1. Study of the Project: A careful study of the technical, economic and financial
viability of the project is done.
2. Advisory Services: to improve the quality of new issue and ensure its success.
• The advisory services include the following:
– Type of issue, Magnitude of the issue, Time of floating the issue ,Price of the
issue, Methods of issue, Technique of selling the issue
Dr Dakito Alemu
2)Primary markets function: Underwriting
• When a company wants to go public, the first thing it
does is hire an investment bank.
–A company could theoretically sell its shares on its own,
but realistically, an investment bank is required.
–You can think of underwriters (investment banks) as
middlemen between companies and the investing public
–The company and the investment bank will meet and
negotiate the deal
Dr Dakito Alemu
Underwriter
• Article 2/75
• “Underwriter” means any person who has purchased
from an issuer
–with a view to, or offers or sells on behalf of the issuer in
connection with,
–the distribution of any security, or participates or has a
participation in the direct or indirect underwriting of any such
undertaking;
•
Dr Dakito Alemu
Primary markets function: Types of Underwriting
Firm All -or-none

Best Efforts
commitment Commitment
• The underwriter buys the • Underwriters do their best to • The entire issue must be sold
entire issue sell all the securities at the offering price
• Assume full financial • The underwriter sells as much • Otherwise, the deal is voided
responsibility for any unsold of the issue as possible, and the underwriter will not
shares • But, can return any unsold receive any compensation
• exposes the underwriter to shares to the issuer without • Investors’ funds are held in
substantial risk financial responsibility escrow until all of the
securities are sold
Dr Dakito Alemu
3) Primary markets function: Distribution
• Various methods are used to distribute the new
issue.
–Public issues through prospectus
– Offer for sale.. is a mechanism enabling existing shareholders of a listed company to sell or dilute their holdings through an exchange-based bidding platform
–Placement or Private placement

–Rights issues
–Book-building method or Tender method
Dr Dakito Alemu
Admission Criteria for Listing
• From a regulatory perspective, listing securities, such as a company’s shares, is typically a
two-stage process that aims to make sure potential investors have relevant and reliable
information about the securities and their issuer, and that there are likely to be sufficient
securities available to make them relatively easy to buy and sell.
• The first stage usually involves the filing of a prospectus with the regulator that contains
information about the securities’ issuer, its history, financial situation and its operations.
• This will be coordinated by a sponsor (generally an investment bank) and supported by
reporting accountants vetting the numbers and legal advisers ensuring the sponsor has
discharged its legal responsibilities.
• The prospectus is filed and made available to interested investors (the public).
• The second stage is an application to the stock exchange to have the securities listed.
• The exchange will want to see that there is a minimum number of shares held by persons
other than the issuing company’s directors and other dominant investors (a sufficient
‘free float’), and that there are investment banks willing to buy and sell the securities
once listed. Dr Dakito Alemu
Forms of Stock Exchange Market
• It is common in developed markets around the world to have more than one market for company securities:
a major or main market for securities issued by the bigger, well-established companies, and a junior
market for securities issued by smaller, less well-known companies.
• Examples include the UK and Hong Kong. In the UK, the LSE has established two markets for company
securities: the Main Market and AIM (which originally stood for ‘Alternative Investment Market’).
• The Main Market is the more senior market for securities that have been admitted to the Financial
Conduct Authority’s (FCA’s) Official List.
• Entry rules are stringent, ensuring that only companies of a high quality can be involved.
• AIM was created with less stringent admission requirements to provide a market for smaller, less well
established companies.
• In Hong Kong, the senior and junior markets are referred to as the Main Board and the Growth Enterprise
Market.
• The latter captures the logic of providing a facility for trading smaller companies’ shares, where entry
requirements are less stringent.
• It is a fact that small companies can, if they are successful, grow very quickly and provide extremely
attractive returns to their early-stage investors.
Dr Dakito Alemu
The UK’s Junior Market: AIM
• In contrast to the Official List, to which access is via application to the FCA with the FCA’s Listing Rules being complied with, AIM
companies’ application and regulations are set by the LSE.
• AIM companies are usually smaller than their fully listed counterparts, and the rules governing their listing are much less stringent.
• For example, there is no restriction on market value, percentage of shares in public hands or trading history.
• Among the more important rules for the AIM is the requirement that AIM companies need to have a nominated adviser.
• The nominated adviser is often referred to as the ‘nomad’ and is typically a firm of stockbrokers or accountants or an investment
bank.
• Each nomad needs to be approved by the LSE for assessing the appropriateness of the applicant for AIM, and for guiding and
advising AIM companies on their responsibilities under the rules of the market that have been laid down by the LSE.
• The main requirements for a company’s shares to be admitted to the AIM are twofold:
• 1. That there is no restriction on the transferability of the shares.
• 2. That the AIM company appoints two experts to assist it:
– a. the nominated adviser – as seen, the nomad can be thought of as an exchange expert, advising the company on all aspects of AIM Listing Rules and compliance
– b. the broker – AIM companies’ shares are usually less liquid than those of fully listed companies; it is the broker’s job to ensure that there is a market in the
company’s shares, to facilitate trading in those shares and to provide ongoing information about the company to interested parties.
• As with the Official List, the LSE imposes similar continuing obligations on AIM companies.
• There are also certain other aspects in relation to AIM companies and their broker and nominated adviser:
– • The broker and adviser can be the same firm; they are often firms of stockbrokers or accountants.
– • If a company ceases, at any time, to have a broker or adviser, then the firm’s shares are suspended from trading.
– • If the company is without a broker or adviser for a period of one month it is removed from AIM.
Dr Dakito Alemu
Follow-on Public Offerings (FPO)
Dr Dakito Alemu
Follow-on Offerings
• An already listed company looking to raise more capital can choose to go through a follow-on offering.
• A follow-on offering is alternatively referred to as a secondary offer. Issuing more shares in a follow-on
offering will only be considered if the equity markets are sufficiently robust. Where prices are falling in a
bear market, there is unlikely to be sufficient demand for the shares at the price the issuing company
wants.
• Like an IPO, a follow-on offering will be structured with a base number of shares that the company is
planning to issue. Again, the issuing company may also retain a greenshoe option to increase the number
of shares that it issues, if significant levels of demand would otherwise remain unsatisfied.
• A secondary offering will inevitably be quicker, easier and cheaper than an IPO, simply because the
company has been through the stages before in its IPO.
• The broad stages of a follow-on offer are the same as an IPO:
• 1. The decision.
• 2. The preparation of the prospectus – this should be relatively easy, since the issuing company has
prepared a prospectus before, when it first became a listed entity.
• 3. The sale of securities – as in an IPO, the appointed investment bank will lead-manage the sale and may
well establish a syndicate of co-managers to assist in selling the securities to its clients.
Dr Dakito Alemu
Private Placements
Dr Dakito Alemu
Private placements
• Private transactions are those offerings of securities which are made, not to the general public, but
to a subset of so-called sophisticated investors, when the same rigorous kinds of disclosures that
have to be made in an initial public offering (IPO) prospectus can be avoided.
• In the US, the Securities and Exchange Commission (SEC) has special provisions for what are
termed private placements.
• A private placement (or non-public offering) is a funding round of securities which are sold without
an IPO, and without the formality of an approved prospectus, usually to a small number of chosen
private investors.
• Although these placements are subject to the Securities Act of 1933, the securities offered do not
have to be registered with the SEC if the issuance of the securities conforms to an exemption from
registrations as set forth in the Rules known as Regulation D. Private placements and purchasers
are often institutional investors such as banks, insurance companies and pension funds.
• Private placements are commonly used by growing businesses in their early stages, such as many
technology businesses that require substantial amounts of cash as they develop their business
model and scale in advance of an IPO.
• The various rounds of equity funding are often given alphabetic characters – eg, equity funding
stage A or B – as illustrated in the following example.
Dr Dakito Alemu
Dr Dakito Alemu
Sell Side: Primary Markets
Dr Dakito Alemu
1) Sell-Side : Investment Banking- Origination, Primary Markets
Investment Banking Capital Markets
Industry Group Product Group Sales & Trading Research
Financial Mergers & Government Equity

Real Estate Origination Equities Debt
Institutions Acquisitions Bonds
Telecom, Debt Equity Money

Oil & Gas Commodities
Media & Tech Capital Capital Market
Markets Markets
Consumer & Foreign
Healthcare (DCM) (ECM) ABS/MBS
Retail Exchange
Corporates
Derivatives
Bonds
Investment Banking Division (IBD) CM – Primary Markets CM – Secondary Markets
Dr Dakito Alemu
Sell-Side Investment Banking
Investment
Banking
Industry Product
Group Group
Financial Media & Mergers &

Origination
Institutions Telecom Acquisitions
Metals &
Oil & Gas Mining DCM ECM
Dr Dakito Alemu
Buy Side: Primary Markets
Dr Dakito Alemu
2) Buy-Side Overview: Primary Markets
Investor Money Manage Grow
Goal
Dr Dakito Alemu
2.1) Primary Market Buy-Side: Traditional (Examples)
Buy Public Retirees & Policy Current & Family
Traditional
Side investors Pensioners Holders Prospective Members
Students
Investors
Function
Asset Pension Insurance Endowment Family
Managers Funds Companies Funds Offices
Structure
Day in the Life
Personality Fit
Buy Side
Firms
Dr Dakito Alemu
Mutual Fund
• Article 2/44:
• “Mutual Fund” means
➢a company or partnership that issues equity interests or units,
➢the purpose or effect of which is the pooling of investor funds with the
aim of spreading investment risks and enabling investors in the mutual
fund to receive profits or gains from the
➢acquisition,
➢holding,
➢management or
➢disposal of investments
Dr Dakito Alemu
Primary Market Buy-Side Activities: Traditional
Conduct external Call broker and Rebalance
research booking trade portfolio positions
Buy
Traditional
Side
Function
Investment Trade Portfolio
Structure
Analysis Execution Management
Day in the Life
Personality Fit
Portfolio Trader Back

M anager Office
Dr Dakito Alemu
Primary Market Buy-Side Day in the Life: Traditional
Buy
Traditional
Side
Function
Structure
Day in the Life

Gather and analyze data Monitor current Execute trades and
to inform your views active positions rebalance positions
Personality Fit
Dr Dakito Alemu
2.2) Primary Market Buy-Side: Non Traditional (Examples)
Buy Non-
Side Traditional Accredited investors only
Investors
Function
Hedge Distressed Venture Private Family
Funds Funds Capital Equity Offices
Structure
Day in the Life
Personality Fit
Buy Side
Firms
Dr Dakito Alemu
Primary Market Buy-Side: Non Traditional
Compared with the traditional funds, non-

traditional funds:
1)Use more leverage
2)Actively managed
3)Unregulated or are less regulated
4)Have limited investor base (only accredited investors)
Dr Dakito Alemu
Primary Market Buy-Side: Non Traditional
Buy Non - Traditional Non-Traditional

Side Traditional
Market Facing Market Facing Deal-Oriented / Non-Market Facing
PF
Pension HF
Hedge PE
Private VC
Venture
Function Fund Fund Equity Capital
Structure
Day in the Life
Personality Fit
Not seeking Take material interest in
Low risk, conservative ownership companies, and focus on
investment strategy influence achieving returns through
management influence
Dr Dakito Alemu
Primary Market Buy-Side Day in the Life : Non Traditional
Buy Non-
Side Traditional
Get caught up on headline news that may impact your portfolio
Function
Structure
Day in the Life

Gather and analyze data Monitor current Execute trades and
to inform your views active positions rebalance positions
Personality Fit
Take calls from sell-side brokers to discuss markets
Discuss and debate investment ideas with colleagues
Dr Dakito Alemu
Secondary Markets Operation
Dr Dakito Alemu
Secondary Markets Operation
Dr Dakito Alemu
Secondary markets operations: Roles of brokers and dealers
Roles of brokers
• Brokers and dealers are necessary to the smooth functioning of a secondary market.
• Investors need someone
– to receive and keep track of their orders for buying or selling
– to find other parties wishing to sell or buy
– to negotiate for good prices
– to serve as a focal point for trading, and
– to execute the orders
• The broker performs all these functions.
• A broker is an entity that acts on behalf of an investor who wishes to execute
orders.
Dr Dakito Alemu
Secondary markets operations: Roles of brokers and dealers
Roles of Dealers (Market Makers)
• Buy a financial asset for its own account or sell from its own account
• Dealers are the suppliers of immediacy—for enhancing the ability to trade promptly
• There are two roles that dealers play:
– providing reliable price information to market participants (price stabilization)
– providing the services of an auctioneer in bringing order and fairness to a market
• Dealer hold inventories of securities and make their living by selling these securities for a
slightly higher price than they paid from them
– Spread between
• Bid price: The price that the broker pays for securities they buy for their inventory and
• Ask price: The price they receive when they sell the securities
Dr Dakito Alemu
Investment Banks Sell-Side: Sales, Trading, and Research
Sell Sales, Trading& SALES TRADING RESEARCH

Side Research
Function
SALES, TRADING, AND RESEARCH
Structure
PROVIDE VALUE BY:
Day in the Life 1) Providing market liquidity
2) Granting access to live market insights from
Personality Fit real-time trading data
3) Publishing deep data analysis and insights
on a regular basis
Dr Dakito Alemu
Dr Dakito Alemu

SALES TRADING RESEARCH
Sell Sales, Trading&
Side Research
Function
Client-facing Market-facing Support Sales and

Structure Trading
• ‘Cover’ clients, • Market maker – will ‘Cover’ whole industries
effectively owning the always • have a bid/offer
Day in the Life for all securities and companies, more so
relationship with buy-
than products
side investors
Personality Fit • Provide value to the • Provide value to clients
• Provide value to clients
Bank by developing a by publishing deep
by relaying live market
deep and narrow analysis and
information from Traders
expertise in one
(e.g., market color) commentary
market
01 02 03
SALES
Side Research
Call buy-side Communicate Relay quote(s)

client market color from Trader(s)
Function
Sales| AM Agenda
Structure
Morning call with Sales/Trading/Research

Day in the Life
Start calling clients
Personality Fit Respond to price quote requests from clients on Bloomberg
Connect clients to resources at the firm
Take clients out to dinner and drinks to build relationship
Marketcolor” is the collaborative effort to better understand the market, to see color in the marketplace.
Dr Dakito Alemu
01 03
TRADER
02
Side Research
Make Respond to Work with Sales

M arkets clients via Sales to pitch trades
Function
Structure
Trading| AM Agenda
Day in the Life

Morning call with Sales/Trading/Research
Personality Fit See where markets open, while taking in overnight

information and analyzing the day’s news to develop views
Respond to price quote requests from Sales team
Dr Dakito Alemu
RESEARCH
01 02 03
Side Research
Research Report Project
Function
Research| AM Agenda
Structure
Day in the Life

Get caught up on all overnight news and headlines
Personality Fit
Listen in on the morning call with Sales/Trading/Research
Listen to earnings calls, ask questions, write call notes, update
financial models
Prepare marketing material for client presentations
Dr Dakito Alemu
Full Circle Transaction
01 02 03
TRADING
Trader,
HG Credit
• Analyzes markets movements

• Communicates with Sales team to
PENSION FUND SALES move positions and balance risk
• Sends RUNZ to clients and internally
Portfolio Manager, Salesperson,
Fixed Income Government Bonds
RESEARCH
• Calls/Receives call • Gets market insights from Corporate Debt
from Salesperson to traders and works together
get market color, as to make mutually beneficial
well as talk about any trades with buy-side • Researching, reporting, and projecting
transactions the Fund • Call client base to relay – on companies and industries
may want to execute market color and intel from • Sends RUNZ to clients and internally
traders
Dr Dakito Alemu
Methods of Trading:
Types of Secondary Market trading methods
Dr Dakito Alemu
Methods of Trading (Trading systems)
• Trading systems provided by exchanges around the world can be
classified on the basis of the type of trading they offer. Broadly,
systems are either quote-driven or order-driven:
a) Quote-driven systems – market makers agree to buy and sell at least a set
minimum number of shares at quoted prices. The buying price is the bid and the
selling price is the offer. The prime example of a quote-driven equity trading
system is Nasdaq in the US.
b) Order-driven systems – the investors (or agents acting on their behalf) indicate
how many securities they want to buy or sell, and at what price. The system then
simply brings together the buyers and sellers. Order-driven systems are very
common in the equity markets – the NYSE, the TSE and trading in the shares of
the largest companies on the LSE are all examples of order-driven equity
markets.
Dr Dakito Alemu
Dr Dakito Alemu
Dr Dakito Alemu
1) Quote-Driven Market
• A quote-driven market is a type of secondary market trading structure where
investors trade with dealers.
• Nearly all bonds, currencies, and spot commodities are traded in quote-driven
markets.
• Such markets are also commonly known as price-driven markets or dealer
markets.
• In a quote-driven market, trades are all executed electronically through dealers.
• The dealers act as market makers (essentially the middleman) by posting bid and ask prices for
traders and keeping an inventory of securities. As a result:
❑ The ask price is the lowest price that a dealer is willing to sell the underlying security to buyers; and
❑ The bid price is the highest price that a dealer is willing to buy the underlying security from sellers.
Bid / Ask Spread = Ask Price − Bid Price

Dr Dakito Alemu
• In a quote-driven market, the dealers are the sole provider of liquidity and generate
profit from the bid-ask spread.
• A quote-driven market is more liquid than other forms of secondary market
trading structures due to the presence of market makers (dealers).
• However, it is not as transparent compared to an order-driven market in that the
market orders and prices that traders are willing to buy or sell at are not available to
the counterparty.
Examples of quotes-driven market
• Examples of quotes-driven market include:
–Nasdaq Stock Market,
–London Stock Exchange, and
–eSpeed government bond trading system.
• In these markets trades are conducted through
inhouse digital communication systems, telephone
or even though instant messaging.
Dr Dakito Alemu
Quote Driven Market Trade Execution
• Quote driven markets operate using market makers
• The quote-driven market is commonly used for trading over-the-counter (OTC)
securities, such as bonds and some types of derivatives
Market Maker A
Bid ‐ 495p
Ask ‐ 499p
Broker obtains
Client instructs Market Maker B
prices from
broker to buy 1000 Bid ‐ 494p
competing market
ABC shares at best Ask ‐ 498p
• A market price
maker’s makers
Market Maker C
comprises of bid and Broker executes

with market maker
offering best price
Bid ‐
Ask ‐
494p
499p
offer prices Market Maker D

Bid ‐ 495p
Ask ‐ 499p
Dr Dakito Alemu
2) Order-driven market
• Trades are executed when a buyer and a seller are brought together by
a broker and the trade takes place directly between the buyer and
seller.
• An order-driven market displays all the bids and offers for a security in the
open marketplace or exchange.
• In an order-driven market, trades are executed using trade rules.
• Both buyers’ and sellers’ orders are all displayed on an order book,
and trades are only executed when the bid and ask prices are
matched.
• In an order-driven market, dealers are not involved; instead,
traders buy and sell to each other directly.
Dr Dakito Alemu
• Pure auction market (also known as Broker Market ) exists by fees collected to connect buyers and sellers.
Dr Dakito Alemu
Order driven (Order Book)
• The advantage of an order driven market is that it provides transparency
of all the orders
Buy Price Buy Volume Sell Price Sell Volume

$50.00 1000 $50.10 500
$49.90 800 $50.20 700
$49.80 600 $50.30 900
$49.70 400 $50.40 1000
Dr Dakito Alemu
Dr Dakito Alemu
Types of Orders
Dr Dakito Alemu
Types of Orders, Cont’d…
Dr Dakito Alemu
Member firms of an exchange (Participants)
Dr Dakito Alemu
Member firms of an exchange (Participants)
• Member firms of an exchange can act in two different capacities or roles – as a principal and as an agent.
• This does not preclude an individual firm from acting in both capacities; at times it may be acting as an
agent and at others it may be acting as a principal.
• When a firm is acting as a principal it is essentially buying shares for its own account, in the hope of the
shares increasing in value before it sells them, or, in the case of a short transaction, selling borrowed shares
at a higher price at the time of borrowing than the price it has to pay when it wishes to replace or cover.
• Market makers also hope to, on average, profit from buying at the bid and selling at the offer.
• Firms acting in this way can also be described as performing their function as dealers and, in more
specialised cases, as outlined below, as market makers.
• When a firm is acting as an agent, it is essentially arranging and making deals on behalf of other third
parties, and it makes money, when acting in this capacity, by charging a commission on the deal.
• This agency role is commonly described as acting as a broker. For instance, when acting as an agent or
broker a firm will receive orders to buy and sell equities on behalf of its clients and find matches for the
trades that its clients want to make.
• In return for these services, brokers charge commission.
• If a firm decides to focus only on acting as a principal it is known simply as a dealer, and some exchange
member firms may choose simply to buy and sell equities for their own account. Most exchange members,
however, are broker-dealers.
• This means they have the dual capacity to either arrange deals (acting as a broker), or to buy and sell shares
for themselves (acting as a dealer).
Dr Dakito Alemu
Securities Exchanges
• Stock exchanges offer membership to investment banks and firms of stockbrokers.
• Becoming a member of an exchange enables these banks and stockbrokers to be involved in secondary market trades
• As a consequence of the ongoing activities of the major participants in the secondary market – institutional investors, banks, and
speculators – these exchanges provide liquidity to existing and potential investors, enabling existing investors to sell their securities
and allowing potential investors to become actual investors by purchasing securities.
• Brokers arrange deals for their clients, as well as potentially giving advice to their clients, as to which securities they should buy, sell
or retain
• The broker never actually buys or sells securities – the broker is simply an agent that facilitates the transaction(s) between two
parties. Firms of stockbrokers tend to act as brokers on the stock exchanges.
• Dealers, in contrast to brokers, actually buy or sell securities.
• If a client wants to sell shares, a dealer may buy those shares from the client; if another client wants to buy shares, a dealer may sell
those shares to the client.
• Acting as a dealer is often described as dealing as principal, because the dealer is taking a principal position by either buying or
selling the securities.
• It is the investment banks that tend to act as dealers on the stock exchanges.
• Firms, such as investment banks, that are involved in both acting as agent (broking) and as principal (dealing), are often described
as broker-dealers
• However, over recent decades, the equity markets in the developed world have seen a proliferation of venues beyond the single
national exchange.
• A number of developed markets now have a multitude of regulated exchanges, plus a variety of so-called alternative trading
systems (ATSs), including firms (such as investment banks) that internalise their customers’ trades by executing them against other
customers’ trades or the firm’s own inventory.
Dr Dakito Alemu
Example 1
• The US is the largest developed market in the world and its equity trading
venues include the following:
– • 23 registered ‘national securities exchanges’ including the two
dominant exchanges, Nasdaq and the NYSE.
– • More than 40 alternative trading systems, including specialised
platforms, such as Tradeweb (for fixed income) and those operated by
investment banks, such as Goldman Sachs, Morgan Stanley, UBS and
Bank of America Merrill Lynch.
• The same variety of venues for trading equities exists in developed
markets elsewhere in the world although, sometimes, the
terminology differs a little, such as that introduced in the EU.
Dr Dakito Alemu
Example 2
• In Europe, the terminology used was originally introduced by the Markets in
Financial Instruments Directive (MiFID).
• It distinguished three venues for trading equities:
– 1. Regulated markets – these are basically stock exchanges.
– 2. Multilateral trading facilities (MTFs) – these are systems other than regulated markets that are
operated and/or managed by a market operator which bring together multiple third-party buying and
selling interests in financial instruments (such as shares) in a way that results in a contract.
– 3. Systematic internalisers (SIs) – these are investment firms (such as investment banks) which, on an
organised, frequent, systematic and substantial basis, deal on their own account when executing client
orders outside other markets.
• A second Markets in Financial Instruments Directive (MiFID II) was
subsequently introduced in early 2018 that added a fourth type of venue – the
organised trading facility (OTF).
• This venue type is for instruments other than equities, such as bonds or
derivatives, where multiple third-party buying and selling interests are able to
interact in a way that results in a contract.
Dr Dakito Alemu
Inter-dealer broker (IDB)
• An inter-dealer broker (IDB) is an exchange member firm that has registered with the
exchange to act as an agent between dealers (such as market makers).
• When one dealer trades with another, it often prefers its identity to remain a secret.
This is the key benefit of using an IDB.
• The IDB is acting as agent for the dealer but settles any transactions as if it were
principal in order to preserve the anonymity of the dealer.
• An IDB is not allowed to take principal positions, and it has to be a separate firm, not
a division of another broker-dealer.
• The term ’systematic internaliser’ was introduced by the EU Markets in Financial Instruments
Directive (MiFID).
• It is an investment firm (such as an investment bank) which, on an organised, frequent, systematic
and substantial basis, deals on its own account when executing client orders instead of placing the
orders elsewhere.
Dr Dakito Alemu
Algorithmic Trading
• As exchanges have become increasingly computer-driven, and other electronic venues, such as MTFs, have
become part of the financial services infrastructure, a new form of trading has evolved.
• Variously known as algorithmic trading, automated trading, black-box trading, quant trading or simply algo-
trading, it relies on computer systems to buy shares automatically when predefined market conditions are
met.
• Algorithmic trading is, in essence, automated trading by computers which are programmed to take certain
actions in response to varying market data.
• Market-predicting algorithms are created in order to find potential trades and then execute them. These
algorithms are continually evolving through artificial intelligence and the sophisticated uses of statistics.
• The key reasons that are advanced for the popularity of algorithmic trading are as follows:
– • Removing the emotion of trading – since entry and exit rules are predefined and incorporated in the algorithm, there is no
opportunity for the trader to divert from the plan or to overtrade.
– • Preservation of discipline – since trades are automated, the strategy will be consistently maintained, regardless of market volatility.
– • Speed, accuracy and reduced costs – automated algorithmic trading will be executed quicker than other forms of order.
• One major sub-category of algorithmic trading is high frequency trading (HFT) which involves the use of
powerful computers that are programmed to transmit orders based on algorithms.
• These algorithms will respond extremely rapidly to market movements and, because the computers are
usually located physically closely to those of the exchange, the orders will arrive ahead of other
conventional orders.
Dr Dakito Alemu
Types of
Securities
Transactions
Dr Dakito Alemu
Types of Securities Transactions
•An investor can make a number of basic

types of securities transactions.
•Each type is available to those who meet the requirements
established by government agencies as well as by brokerage firms.
1) Long Purchase
2) Margin Trading
3) Short Selling
Dr Dakito Alemu
1) Long purchase
– Long purchase: transaction in which investors buy securities,
usually in the hope they will increase in value and can be sold at
a later date for profit.
– Objective is to “buy low and sell high”
– It is the most common type of transaction
– Return comes from any dividends or interest received during the
ownership period, plus the difference (capital gain or loss)
between the purchase and selling prices.
• Reduced by transaction costs
Dr Dakito Alemu
2) Margin Trading
• Margin trading: Investors use funds borrowed from
brokerage firms to make securities purchases.
– Margin requirement: the minimum amount of equity that must be in the
margin investor’s own funds.
– In the US margin requirement for stocks has been 50% for some time; set
by the Federal Reserve Board.
• Essentials of Margin trading
• The idea of margin trading is to employ financial leverage.
– Financial leverage: the use of debt financing to magnify investment
returns
• Margin loan: official vehicle through which the borrowed funds are made
Dr Dakito Alemu
available in a margin transaction.
3) Short Selling
– Essentials of Short Selling
• Short selling: practice of selling borrowed securities
• Investor borrows securities from a broker
• Broker lends securities owned by other investors
• Investor must make a deposit with the broker equal to the
initial margin requirement applied to short-sale proceeds;
broker retains proceeds from the short sale.
• Objective: “Sell high and buy low”
• Investors make money when stock prices go down
Dr Dakito Alemu
Securities Lending
• Article 2/68:
–“Securities Lending” means the temporary exchange of
securities which requires
• collateral generally in cash or other securities of at least an
equivalent value,
• with an obligation to redeliver a like quantity of the same securities
on a future date and is in the nature of
–a securities loan,
–a repurchase agreement and
–a sell-buy back agreement
Dr Dakito Alemu
Stock Borrowing and Lending
• Stock lending is the temporary transfer of securities, by a lender to a borrower, with agreement by the
borrower to return equivalent securities to the lender at a pre-agreed time.
• It is commonly seen in the more developed markets where liquidity is greatest and regulations easily allow
for shorting.
• There are two main motivations for stock lending: securities-driven, and cash-driven.
• In securities-driven transactions, borrowing firms seek specific securities (equities or bonds), perhaps to
facilitate their trading operations.
• In the cash-driven trades, the lender is able to increase the returns on an underlying portfolio, by receiving a
fee for making its investments available to the borrower.
• Such transactions may boost overall income returns, enhancing, for example, returns on a pension fund.
• The terms of the securities loan will be governed by a securities lending agreement, which requires that the
borrower provide the lender with collateral, in the form of cash, government securities, or a letter of credit
of value equal to or greater than the loaned securities.
• As payment for the loan, the parties negotiate a fee, quoted as an annualised percentage of the value of the
loaned securities.
• If the agreed form of collateral is cash, then the fee may be quoted as a rebate, meaning that the lender will
earn all of the interest that accrues on the cash collateral, and will rebate an agreed rate of interest to the
borrower.
Dr Dakito Alemu
The Mechanics of a Short Sale
Transaction
Short Sale transaction Amount
Step 1. Short sale initiated
100 shares of borrowed stock are sold at Br50/share:
Proceeds from sale to investor Br5,000
Step 2. Short sale covered
Later, 100 shares of the stock are purchased at
Br30/share and returned to broker from whom stock
was borrowed:
Cost to investor - Br3,000
Net profit Br2,000

Dr Dakito Alemu
Advantages and Disadvantages of Short Selling
• Short Selling
– Advantages
• Chance to profit when stock price declines
– Disadvantages
• Limited return opportunities: stock price cannot go below Br0.00
• Unlimited risks: stock price can go up an unlimited amount
• If stock price goes up, short seller still needs to buy shares to pay
back the “borrowed” shares to the broker
• Short sellers never earn dividend income and must pay to the lender
any dividends paid out during the short-sale transaction
Dr Dakito Alemu
Long versus Short Potential
Payoffs Maximum Loss Maximum Gain
Long -100% Infinity
Short -Infinity 100%
Dr Dakito Alemu
Prime Broker Services; Central Counterparty
(CCP) & Costs of Trading
Dr Dakito Alemu
Prime Broker Services
• Prime brokerage is the term given to a collection of services provided by investment banks to their hedge
fund clients. The typical services that are provided by a prime broker include the following:
1) Securities lending and borrowing – eg, to cover short positions in a hedge fund’s long/short strategy.
2) Leveraged trade execution – undertaking trades on the fund’s behalf that are partly financed by borrowed funds, essentially providing
margin for conducting trades.
3) Cash management – maximising the return that is generated from cash held by the fund.
4) Core settlement – taking the necessary steps to make sure that any securities purchased become the property of the fund, and that the
appropriate cash is received for any sales made of the fund’s securities in a timely manner.
5) Custody – keeping safe the securities held by the fund and processing any corporate actions promptly and in accordance with its targets.
6) Rehypothecation – in addition to holding collateral and having a charge over the fund’s portfolio, the prime broker might also require a
right to re-charge, dispose of, or otherwise use the customer’s assets which are subject to the security, including disposing of them to a
third-party. This is commonly described as a ‘right of rehypothecation’. When assets have been rehypothecated, they become the property
of the prime broker as and when the prime broker uses them in this way, for instance, by depositing rehypothecated securities with a third-
party financier to obtain cheaper funding or by lending the securities to another client.
7) Access to OTC markets – either serving as the counterparty, or finding a third party to take the other side to non-exchange instruments
such as swaps and structured products.
• In addition to these transaction-related services, the prime broker would also be expected to offer all the other typical
services of an investment bank, such as providing research, invitations to roadshows/deal presentations, arranging
meetings with strategists, analysts and company management, and any other services generally provided to their
institutional clients. Dr Dakito Alemu
The Central Counterparty (CCP)
• Most stock exchanges utilise a central counterparty (CCP); the impact of a CCP is best
illustrated by way of an example (see next slide)
• The use of a central counterparty provides certain benefits to market participants,
particularly:
✓ Reduced counterparty risk – the risk that the other side of the transaction will default is reduced because it is
replaced by the CCP, which is invariably well-capitalised and has an insurance policy in place lessening the risk of
default. This reduces the risk of systemic collapse of the financial system.
✓ Providing total anonymity – both sides of the trade do not discover who the original counterparty was.
✓ Reduced administration – all trades are settled with the CCP, rather than a variety of counterparties, improving
operational efficiency.
✓ Facilitating netting of transactions – because all the trades are with a single CCP, receipts and payments for
transactions in the same share that settle on the same day can be netted against each other.
✓ Improved prices – because more participants are willing to transact anonymously; it is argued that a CCP results in
improvements in price.
• The CCP typically charges a flat fee to both parties for fulfilling its role and also
requires margin payments (similar to derivatives margin) to reduce its potential loss,
should one party default.Dr Dakito Alemu
Example
• A trade is executed on an exchange’s order book that involves A
agreeing to sell shares to B.
• The CCP steps in between the two parties and two new obligations
replace the initial obligation of A to sell to B.
• The two obligations are for A to sell to the CCP and then for the CCP to
sell to B.
• This transfer of obligation is known as ‘novation’.
• If either of the two parties to this transaction (A or B) were to default, it
would no longer affect the other party, as they no longer have a
contract with each other.
• It would only impact the CCP.
Dr Dakito Alemu
Costs of Trading
• Whenever a trade is undertaken in a security, be it a share or a bond, there will be costs.
• There are what might be described as tacit fees in the difference between the bid and offer prices: if an
investor buys shares and pays the offer price, that investor would only be able to sell the shares at the lower
bid price.
• There is also the dealing cost in the form of commission that needs to be paid to the broker arranging the
transaction, but in particular environments there may be additional costs as outlined below:
• • Broker’s commission – commission is typically based on a set percentage of the value of the securities
being purchased or sold. The precise percentage varies by broker and market, but it is generally at least 0.5%
of the value of the securities traded. It will invariably be higher when the broker is providing the client with
research and advice, with these so-called full service brokers likely to charge a higher percentage of perhaps
1.5%.
• • Account fees – brokers also tend to charge account fees to their ongoing customers, although a number of
brokers will waive these fees where the client undertakes more than a minimum number of trades during a
particular period, such as a quarter or a year. These fees typically are charged to cover the various
administrative costs of maintaining the account, such as providing account statements and custody charges.
• • Exchange fees, regulatory fees, clearing fees, taxes/duties – there are typically minor charges that are
either subsumed within the brokers’ commissions, or added separately to cover the charges the stock
exchange makes per transaction, charges to contribute to the clearing system, and, in many jurisdictions,
some form of tax such as the UK’s Dr stamp duty or stamp duty reserve tax.
Dakito Alemu
Clearing and Settlement
Dr Dakito Alemu
Introduction to Settlement Systems
• Settlement occurs after a deal has been executed.
• While the change in economic ownership is immediate, the transfer of securities from the
seller and the payment from the buyer takes some time.
• The process consists of several key stages, collectively described as clearing and settlement:
1) Pre-settlement and clearing – as soon as a trade has been executed, a number of procedures and checks must be
conducted before settlement can be completed. These include matching the trade instructions supplied by each
counterparty to ensure that the details they have supplied for the trade correspond. It also involves conducting checks to
ensure that the seller has sufficient securities to deliver and that the buyer has sufficient funds to cover the purchase
cost.
2) Settlement – the process through which legal title (ie, ownership) of a security is transferred from seller to buyer in
exchange for the equivalent value in cash. Usually, these two transfers should occur simultaneously.
3) Post-settlement – this entails the management of failed transactions and the subsequent accounting of trades.
• When a trade has been executed, a key step in the management of risk in the post-
execution, pre-settlement stage is for the two sides to the trade to compare trade details,
and to eliminate any mismatches prior to the exchange of cash and securities. This is
broadly called the ‘trade confirmation’
Dr Dakito Alemu step.
Matching of the buyer’s and seller’s trade data
• The matching of the buyer’s and seller’s trade data is typically conducted at two levels:
1) Trading counterparties compare trade details – this may take place bilaterally, via matching
facilities extended by the securities settlement system (at the central securities depository
(CSD) for example), or via a third-party central matching facility that will compare trade details
electronically and issue a report on matching status (ie, whether matched or unmatched).
Trades conducted via an electronic order book will effectively be auto-matched – matching
engine software is integrated into the electronic order management technology that will
provide automated matching of buyers’ and sellers’ orders in the order book. For centrally
cleared transactions, matched instructions may be forwarded to the central counterparty
(CCP) for clearing (see below).
2) Custodians acting on behalf of the buyer and seller will compare settlement instructions in
order to identify potential mismatches prior to the settlement date.
• Clearing (or clearance) is the process through which the obligations held by the buyer and
seller to a trade are defined and legally formalised. In simple terms, this procedure
establishes what each of the counterparties expects to receive when the trade is settled. It
also defines the obligations each must fulfil, in terms of delivering securities or funds, for
the trade to settle successfully.
Dr Dakito Alemu
Clearing process
• Specifically, the clearing process includes:
1) Recording key trade information so that counterparties can agree on its terms
2) Formalising the legal obligation between counterparties
3) Matching and confirming trade details
4) Agreeing procedures for settling the transaction
5) Calculating settlement obligations and sending out settlement instructions to the
brokers, custodians and the CSD, and
6) Managing margin and making margin calls; this relates to collateral paid to the clearing
agent by counterparties to guarantee their positions against default up to settlement.
• Trades may be cleared bilaterally between the trading counterparties or via a
CCP that interposes itself between buyer and seller.
• When trades are cleared bilaterally, each trading party bears a direct credit risk
against each counterparty that it trades with.
Dr Dakito Alemu
Clearing process…..
• CCP services are available in a range of markets in order to mitigate this risk.
• For example, LCH, a multiasset class clearing house with divisions in both the UK (LCH ltd),
and France (LCH SA), provides CCP services for equities called EquityClear that can be used
for shares traded on both the LSE and the Euronext European markets.
• Similar CCP services are provided by the LCH Group in other markets such as SwapClear for
OTC interest rate swaps, and CDSClear for credit default swaps (CDSs).
• In the US, two major subsidiaries of the Depository Trust and Clearing Corporation (DTCC)
provide clearing services.
a) The National Securities Clearing Corporation (NSCC) provides these services for US equities trades and
b) the Fixed Income Clearing Corporation (FICC) for US fixed income transactions.
• Eurex Clearing AG, which is part of Deutsche Borse Group, is another significant CCP
service provider, that deals with German equities and derivatives.
• The CME Group in the US also provides clearing services for certain OTC trades such as
interest rate swaps and foreign exchange transactions.
Dr Dakito Alemu
Basic elements to the settlement of trades
• There are two further basic elements to the settlement of trades that can differ
across different instruments and/or markets:
• Timing of settlement –
– the length of time it takes for a trade to settle is based on the trade date plus a set number of
business days after the trade is executed.
– This is sometimes called the processing cycle.
– Settlement length is usually expressed as T (trade date) + the number of days, for example, T+2
means transaction date plus two business days.
– Settlement timing differs across different countries/exchanges and can differ within the same
country/exchange by type of security.
• Structure of the settlement system –
– the Bank for International Settlements (BIS) has identified three common structural
approaches/models for linking delivery and payment in a securities settlement system that are
all typically described as achieving delivery versus payment (DvP).
– These are described in detail in the following section.
Dr Dakito Alemu
Dr Dakito Alemu
Settlement Models
• Delivery versus payment (DvP) incorporates two aspects – only making delivery (transferring ownership)
when the payment is certain, and paying over the cash when the transfer of ownership is certain.
• The reason for this is that, after agreeing a deal, the two parties concerned, for example, the buyer of shares
and the seller of those shares, both face risks.
• The seller faces the risk that the buyer may not pay for the shares and the buyer faces the risk that the seller
may not pass over ownership of the shares.
• A system that guarantees DvP will remove those risks by only transferring ownership of the shares when the
payment is certain, and only making the payment when the transfer of ownership is certain.
• The BIS identifies the following three models for DvP settlement systems:
1) Model 1 – systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross)
basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final
transfer of funds from the buyer to the seller (payment).
2) Model 2 – systems that settle securities transfer instructions on a gross basis, with final transfer of securities
from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net
basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle.
3) Model 3 – systems that settle transfer instructions for both securities and funds on a net basis, with
final transfers of both securities and funds occurring at the end of the processing cycle.
Dr Dakito Alemu
BIS Model 1: Gross, Simultaneous Settlements of Securities and Funds Transfers
• The essential characteristic of model 1 systems is the simultaneous settlement of individual securities
transfer instructions and associated funds transfer instructions.
• The system typically maintains both securities and funds accounts for participants and makes all transfers
by book entry.
• An against-payment transfer instruction is settled by simultaneously debiting the seller’s securities account,
crediting the buyer’s securities account, debiting the buyer’s funds account and crediting the seller’s funds
account.
• Debiting the seller’s securities account…………….XXX
• Crediting the buyer’s securities account………………..XXX
• Debiting the buyer’s funds account …………………$XXX
• Crediting the seller’s funds account……………………….$XXX
• All transfers are final (irrevocable and unconditional) transfers at the time the debits and credits are posted
to the securities and funds accounts.
• Overdrafts (negative balances) on securities accounts are prohibited. Funds account overdrafts are allowed
in most model 1 systems, and an instruction to transfer securities against payment would not be executed
either if the seller had an insufficient securities balance or if the buyer had an insufficient funds balance or
overdraft facility.
• Model 1 systems may require participants to maintain substantial money balances to ensure the
completion of settlements, especially if participants are unable to adjust their money (or securities)
balances during the processing Dr cycle, orAlemu
Dakito if the volume and value of transfers are relatively large.
Example of Exchanges that use BIS Model 1
• The majority of transactions in UK equities are settled via an electronic settlement
facility called CREST.
• CREST is a computer system that settles transactions in shares, gilts and corporate bonds, primarily on
behalf of the London Stock Exchange (LSE). It is owned and operated by a company that is part of
• the Euroclear group of companies, called Euroclear UK & Ireland ltd.
• The financial instruments settled by CREST are dematerialised:
– instead of using paper share certificates, the underlying company uses an electronic entry in its
register of shareholders.
• This allows transactions in shares to be settled electronically.
• CREST clears the trade by matching the settlement details provided by the buyer and the seller.
• The transaction is then settled when CREST updates the register of the relevant company, to transfer the
shares to the buyer, and at the same time instructs the buyer’s bank to transfer the appropriate amount of
money to the seller’s bank account.
• In summary, to complete the settlement of a trade, CREST simultaneously:
• • updates the register of shareholders – CREST maintains the so-called ‘operator register’ for UK companies’
dematerialised shareholdings
• • issues a payment obligation – CREST sends an instruction to the buyer’s payment bank to pay for the
shares
• • issues a receipt notification – CREST notifies
Dr Dakito Alemu the seller’s payment bank to expect payment.
Example of Exchanges that use BIS Model 1…..
• If a trading system provides a CCP to the trades (such as LCH ltd), it is the CCP that assumes responsibility for settling
the transaction with each counterparty.
• The buyer and seller remain anonymous to each other.
• For frequently traded, listed company share trades, CREST gives the option to LSE member firms to settle with LCH ltd’s
EquityClear on a gross basis or on a net basis.
• To illustrate this, if a firm has 20 orders executed in the same security through the Stock Exchange Electronic Trading
Service (SETS), it could choose to either settle 20 trades with LCH ltd (settling on a gross basis), or choose to have all 20
trades netted so that the firm just settles a single transaction with LCH ltd (settling on a net basis).
• The settlement period (the time between the trade and the transfer of money and registration) for UK equities (and
most other developed equities markets) is on a T+2 basis, where ‘T’ is the trade date and ‘2’ is the number of business
days after the trade date that the cash changes hands and the shares’ registered title changes.
• In other words, if a trade is executed on a Tuesday, the cash and registered title will change two business days later, on
the Thursday.
• So, if the trade is executed on a Thursday, settlement will occur on the following Monday. In May 2024, The US and
Canada will move to a T+1 settlement period for equities and some other securities.
• This is a step toward an eventual T+0 or instantaneous settlement.
• This move is in response to expanded technology, and an effort to reduce credit risk, market risk and liquidity risks
associated with unsettled trades.
• The shift will, however, require a significant lift for many market participants, who will need to ensure processing takes
place in half the time, requiring much of theAlemu
Dr Dakito process to take place on the trade date.
BIS Model 2: Gross Settlements of Securities Transfers Followed by Net Settlement of Funds Transfers
• The essential characteristic of the model 2 system is that securities transfers are settled on a trade-
fortrade (gross) basis throughout the processing cycle, while funds transfers are settled on a net
basis at the end of the processing cycle.
• The system maintains securities accounts for participants, but funds accounts are generally held
by another entity, either a commercial bank or the central bank.
• Securities are transferred by book entry, that is, by debiting the seller’s securities account and
crediting the buyer’s securities account..
• Debiting the seller’s securities account…………….XXX
• Crediting the buyer’s securities account………………..XXX
• These transfers are final at the instant the entries are made on the system’s books.
• The corresponding funds transfers are irrevocable but not final.
• During the processing cycle the system calculates running balances of funds debits and credits.
• The running balances are settled at the end of the processing cycle when the net debit positions
and net credit positions are posted on the books of the commercial bank or central bank that
maintains the funds accounts
• Debiting the buyer’s funds account …………………$XXX
• Crediting the seller’s
Dr Dakito funds account……………………….$XXX
Alemu
BIS Model 2: Gross Settlements of Securities Transfers Followed by Net Settlement of Funds Transfers……………..
• Settlement of funds transfers may occur once a day or several times a day.
• Thus, final transfer of securities (delivery) precedes final transfer of funds (payment).
• Like model 1 systems, model 2 systems typically prohibit participants from overdrawing securities accounts but funds
overdrafts are tacitly allowed since the running balances are permitted to be net debit balances.
• A securities transfer instruction is rejected if, and only if, sufficient securities are not available in the seller’s account.
• Without additional safeguards, model 2 systems would expose sellers of securities to the risk that they do not get the
funds to which they are entitled.
• However, by allowing participants to settle funds transfer instructions on a net basis, the frequency of failed
transactions is reduced, limiting the potential for fails to exacerbate such risks to participants.
• Nonetheless, failed transactions would occur in the case of insufficient securities balances.
• Thus, queuing arrangements need to be developed, although they generally do not need to be as complex as in a
model 1 system.
• Still, the system must decide whether to depart from first-in, first-out processing of securities transfer instructions and
adopt more complex procedures that maximise the number or value of transfers completed.
• Operators of model 2 systems have recognised the dangers inherent in allowing delivery prior to payment, and these
systems are designed to provide strong assurances that sellers will receive payment for securities delivered.
• In most cases, an assured payment system is utilised, that is, a system in which the seller delivers securities in
exchange for an irrevocable commitment from the buyer’s bank to make payment to the seller’s bank at the end of the
processing cycle.
• Model 2 is the settlement system that predominates globally, particularly in the US. Furthermore, since it is probably
the easiest model in which to realise liquidity efficiencies, it is particularly popular in the emerging markets of Latin
America, Africa and the Middle East.
Dr Dakito Alemu
BIS Model 3: Simultaneous Net Settlement of Securities and Funds Transfers
• The essential characteristic of model 3 systems is the simultaneous net settlement of both securities and funds transfer
instructions.
• Settlement may occur once a day or at several times during the day.
• The system maintains securities accounts for participants.
• Funds accounts may be maintained by a separate entity, either a commercial bank or a central bank.
• Securities are transferred by book entry, that is, by debiting the seller’s securities account and crediting the buyer’s securities
account.
• During a processing cycle, running balances of debits and credits to funds and securities accounts are calculated, and in some
systems this information may be made available to participants.
• However, book-entry transfers of securities do not occur until the end of the processing cycle.
• The obligation of the seller’s bank in the event of failure of the buyer’s bank is a matter of negotiation between the seller’s
bank and the seller.
• In some cases, the seller’s bank may guarantee that the seller will receive payment even if the buyer’s bank fails.
• If a participant has insufficient balances, it may be notified and given an opportunity to obtain the necessary funds or
securities.
• If, and only if, all participants in net debit positions have sufficient balances of funds and securities, final transfers of the net
securities balances and net funds balances are executed.
• Model 3 systems can achieve, and most do achieve, DvP and, therefore, eliminate the risk of the seller not receiving their
money.
• The exceptions involve systems that in certain circumstances allow provisional securities transfers to become final prior to the
settlement of funds transfers.
• DvP model 3 has the advantage of reducing both the funds and securities liquidity requirements within the settlement
systems, but can potentially create large liquidity exposures if a participant fails to settle its net funds debit position, in which
Dr Dakito Alemu
case some or all of the defaulting participant’s transfers may have to be unwound.
Continuous Linked Settlement (CLS)
• As international trade and investment has increased, so has the foreign exchange (FX)
market.
• The average daily volume in the global FX market, and related markets, has grown
enormously and was reported to be approximately US$7.5 trillion in 2022 by the BIS (the
most recent of the BIS triennial surveys published at the time of writing).
• Continuous linked settlement (CLS) is a process by which most of the world’s largest banks
manage FX settlement among themselves (and their customers and other third parties).
• The process is managed by CLS Group Holdings and regulated by the Federal Reserve Board
of New York.
• CLS settles transactions on a payment versus payment (PvP) basis.
• The two parties to an FX transaction will buy and sell the respective currencies exchanged
and the payments made will occur simultaneously.
• Unless such simultaneity in payments is ensured, there is a possibility of settlement risk
which is also often referred to as Herstatt risk.
• Before the establishment of CLS, FX transactions were settled by each side of a trade
making separate payments.
Dr Dakito Alemu
Distributed Ledger Technology (DLT) Block-Chain
• Distributed ledger technology (DLT) is, in simple terms, the replacement of one, centralised ledger of transactions with
a decentralised network of computers all holding copies of exactly the same ledger.
• The computers are often referred to as ‘nodes’ and any changes to the ledger must to be done by consensus.
• Consensus is typically achieved using a ‘consensus algorithm’ – a process used to achieve agreement.
• The distributed ledger could be open to any participant, and described as ‘public’, or it could be restricted to a selected
group of participants and ‘private’.
• Blockchain is an example of DLT and is commonly associated with the cryptocurrency Bitcoin.
• Bitcoin is a public system that uses blockchain DLT and a consensus algorithm based on proof of work.
• Among the advantages of DLT are that it should:
➢ • Produce a trustworthy and reliable record, since consensus is required for any changes.
➢ • Prevent a single point of failure (in one of the nodes) from creating a wider problem because of all the remaining nodes hold
copies of the valid ledger.
➢ • Be very difficult to hack, because of the use of multiple nodes.
➢ • Remove the costs and delays caused by the need to maintain and update a single, central database.
• The above advantages make it clear that DLT could be adopted to settle trades and may be able to speed up settlement
and reduce settlement costs.
• Original versions of DLT had an ever-expanding blockchain so verifying transactions took an increasing amount of time.
• However, other types of consensus Dralgorithms have since been introduced which speed up the process.
Dakito Alemu
Activity
• Briefly define each of the following terms and give

an example.
–Market order
–Limit order
–Short sale
–Stop loss order
Dr Dakito Alemu
Summarizing Security Market’s Operation
Dr Dakito Alemu
Career Paths
Sell-Side Buy-Side
➢ Investment banking ➢ Portfolio management
➢ Equity research ➢ Wealth management
➢ Sales & Trading ➢ Private equity
➢ Commercial & Corporate Banking ➢ Venture capital
➢ Hedge funds
Dr Dakito Alemu
Career Paths… Skill Required
Sell-Side Buy-Side
➢ Industry research ➢ Industry research
➢ Financial modelling ➢ Financial modelling
➢ Excel skills ➢ Excel skills
➢ Research report generation ➢ Research report generation
➢ Client relationship management ➢ Raising capital
➢ Winning new business ➢ Achieving targeted rates of risk-adjusted

return
➢ Selling and closing deals
Dr Dakito Alemu
Dr Dakito Alemu

Chapter 1 Part II Capital Markets Operation

Uploaded by

Copyright:

Available Formats

Chapter 1 Part II Capital Markets Operation

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 1 Part II Capital Markets Operation

Uploaded by

Copyright:

Available Formats

PART II

Capital Market Operation

in the capital markets

Corporation Fund Managers / • Debt Securities

New Issue Existing • Foreign Exchange

• A stock exchange is an organized marketplace for the

Primary Markets Secondary Markets

Corporation Investor A Investor B

Definition First time offering securities Existing securities are offered

Beneficiary Corporation Investors

1. Issuing Corporation Investors buy and sellamongst

Primary Markets Secondary Markets

Corporation Investor A Investor B

Investment Bank, Origination Investment Bank, Sales & Trading

Selling Frequency One-time event Ongoing trading among investors

Corporation sells shares to Supply and demand sets price

Secondary Sales, Trading

Secondary Sales, Trading

Corporates Sell Side Buy Side

CFO / Treasurer Investment Bank Fund Managers /

Corporates Sell Side Buy Side

Investment Bank Fund Managers /

Public Issues Rights Issues Private Placements

•Further Public Offer / Follow-on Offer.

Rights Issue • Done by already listed company.

• Done by already listed company.

• Qualified Institutional Placement (QIP).

Litigation and Dispute matters

Basis for Issue Price Managements discussions and

• Investigations, analysis and processing of new project

• Agreement whereby the underwriter promises to subscribe to a

• Selling of new securities to the ultimate investors

• The advisory services include the following:

Firm All -or-none

–Placement or Private placement

Investment Banking Capital Markets

Industry Group Product Group Sales & Trading Research

Financial Mergers & Government Equity

Telecom, Debt Equity Money

Investment Banking Division (IBD) CM – Primary Markets CM – Secondary Markets

Financial Media & Mergers &

Investor Money Manage Grow

Day in the Life

Day in the Life

Portfolio Trader Back

Day in the Life

Day in the Life

Compared with the traditional funds, non-

Buy Non - Traditional Non-Traditional

Day in the Life

Day in the Life

Take calls from sell-side brokers to discuss markets

Discuss and debate investment ideas with colleagues

Sell Sales, Trading& SALES TRADING RESEARCH

Investment Banks Sell-Side: Sales, Trading, and Research

Client-facing Market-facing Support Sales and

Call buy-side Communicate Relay quote(s)

Morning call with Sales/Trading/Research

Personality Fit Respond to price quote requests from clients on Bloomberg

Connect clients to resources at the firm