1st Market, NYSE

Fifteen years ago, distinguishing the NYSE / l ST Market from the OTC/ 2nd Market was getting complicated but not too bad. The NYSE was an exchange that used open outcry like all auction markets did at the time.

But, your industry changes fast. Even though the NYSE is still an auction market and is still an exchange, most of the trading is done electronically. And, electronic trading is what we used to safely associate with the “OTC/ 2nd market," which we will discuss next.

Securities trading on the NYSE, and on NASDAQ, are listed securities. The term should not be associated with securities trading over-the-counter but not on NASDAQ, e.g. the Over-the-Counter Bulletin Board.

Unlike non-NASDAQ OTC securities, issuers who want to list their securities for trading on NYSE must meet and maintain the exchange's rigid listing criteria. If a company lists its security on the NYSE (or NASDAQ), it will be monitored by the exchange, and if they do not meet all obligations under exchange and SEC rules, the security will suddenly not be trading, which is not a distraction any company needs.

Companies also list their debt securities on the NYSE. To meet the requirements, the issue must have a principal value of at least $5 million. If the bond is convertible, it can only be listed if the underlying common stock is subject to real-time last sale reports in the US, and the par value must be $10 million or larger. Even if the issue of debt securities meets those minimum sizes and requirements, the NYSE will only list the issue if it meets one of several criteria that basically require that the issuer have its stock listed on the NYSE, or that an issuer with stock listed on the exchange is either a majority owner or in common control with the other issuer, or that any NYSE-listed issuer has guaranteed the issue. There is also a criterion based on the credit rating of the issue being at least "B", which, as you probably remember or know, is a junk rating.

As the website for NYSE Bonds indicates:

"NYSE Bonds operates the largest centralized corporate bond market in the U.S., providing an opportunity for participants to trade bonds in a fair, open environment. On NYSE Bonds, firm and executable orders entered by members or sponsored participants

There are also specific NYSE requirements for special securities, including Real Estate Investment Trusts (REITs), closed-end investment companies, non-US companies, etc.

Participants

The NYSE now uses both a manual auction and an electronic trading model. That means that even though most trading is done electronically, the exchange also uses the live auction process at the open, at the close, and during any time of extreme volatility or price imbalances between would-be buyers and sellers. The firms in charge of running those manual auctions used to be called "specialists" but are now known as Designated Market Makers or DMMs. The firms are called "DMM Units," while the individuals performing the function of "DMM" are the "DMMs."

As the excellent video at www.nyse.com explains, DMMs are like commercial airline pilots they must be there for the take-off and the landing, and they must step in whenever there is turbulence. During the rest of the flight, they merely participate in the process, watching over things. As of this writing, DMM Units include the following firms: Knight Capital Group, Goldman Sachs, Barclays, and J. Streicher & Co.

Like other market participants, DMMs also trade electronically throughout the day using computerized mathematical formulae designed to determine buying and selling opportunities called trading algorithms. Like the specialists before them, Designated Market Makers are given the responsibility to maintain a fair and orderly market in a security. Their job is to provide liquidity, especially during times of market volatility.

To prevent panic, they step in ready to buy or sell securities for their own account to keep the flow of trading moving. They also must quote at the National Best Bid or Offer (NBBO) a required percentage of the time. The NBBO is what it sounds like the best prices for the security nationwide.

A DMM does not participate in every trade in the security. They are simply the individual overseeing trading in that stock and living up to the DMM's many obligations. When they trade, they can act in either a principal or an agency capacity.

The term "DMM" is used loosely. The firm is the "DMM Unit," while the individual associated with the firm who sits down on the exchange floor is known as the "DMM" or "Designated Market Maker" in a particular exchange-listed security like GM, GE, or IBM.

Other NYSE participants include floor brokers and off-floor supplemental liquidity providers (SLPs). Floor brokers execute trades on the exchange floor on behalf of their clients, who include banks and broker-dealers. They earn a commission for filling orders, so the more orders they can fill, the more money they can make. Floor brokers are physically present on the trading floor and are active participants during opening and closing auctions, as well as throughout the trading day. They also can enter orders electronically, usually through hand-held devices.

Supplemental Liquidity Providers (SLPs) provide supplemental liquidity to the market by complying with requirements to buy or sell at times of volatility or price imbalances. They are off-floor electronic participants required to maintain a bid or an offer at the NBBO 10% of the trading day for the security they are assigned and, in return, receive rebates/liquidity fees from the exchange. So, the DMMs and the SLPs are the only participants who are required to trade on the NYSE. But, while the Supplemental Liquidity Providers are required to bid or offer for the security, the Designated Market Maker must do both, maintaining a two-sided quote in the security.

Why all the concern for liquidity? A lack of liquidity can lead to a panic or take a mild panic and turn it into a full-blown crisis. The better the balance of orders and the ease of execution, the better the markets function. The regulators hold this truth to be self-evident. 

As NYSE explains at their website, "Supplemental Liquidity Providers (SLPs) are electronic, high volume members incensed to add liquidity on the NYSE and NYSE MKT. All their trading is proprietary, which means it is done for their own account as opposed to just filling orders for others. All NYSE and NYSE MKT stocks are eligible, but not all have SLPs. Supplemental Liquidity Providers are primarily found in more liquid stocks with greater than 1 million shares of average daily volume."

During the live auctions at the open and close floor brokers are gathered around a group of computers called a trading post. The trading post is just a spot on the floor surrounded by video display terminals and telecommunications equipment.

The DMM is positioned at the trading "post" for a particular security and may be surrounded by one or two floor brokers or maybe a whole crowd if something big is happening with the company's stock. For its long and storied history, the NYSE held live, open-outcry double auctions on their listed securities. These days most trading is done electronically, usually through high-tech devices running sophisticated mathematical models. Still, no matter how hi-tech the trading gets these days, it is interesting that during times of extreme volatility, the NYSE functions more efficiently when everyone moves away from the computers and starts interacting with each other face-to-face and in real-time.

The NYSE also states on their website: Electronic Market Makers and Brokers are active participants who participate electronically in all NYSE and NYSE MKT stocks. They include the same market makers found on other fully electronic exchanges.

Orders

There is still a live-auction process used at the NYSE, but orders are usually routed electronically these days to the NYSE's Display Book, which is an electronic system that automatically fills market orders and holds limit orders showing where investors are willing to buy and sell a security and at what number of units. As the NYSE explains on their website:

"The NYSE OpenBook Real-Time product provides a real-time view -aggregated and refreshed every second - of the New York Stock Exchange's limit-order book for all NYSE-traded issues. NYSE OpenBook Real-Time lets traders see aggregate limit-order volume at every bid and offer price, thus responding to customer demand for depth-of-market data and raising the NYSE market to an even greater level of transparency."

Think of the display book as an electronic system to track open orders and act as an order management and execution medium. Executed transactions are also reported to the Consolidated Tape, which we'll look at.

So, that's the electronic display book. The live-auction process, on the other hand, takes place around the trading pit for a particular issue at the opening and closing of the trading session and also during times of extreme volatility or price imbalances between buyers and sellers. The humans participating in this process are known as the trading crowd.

Records

NYSE rules require members to preserve for at least three years (two years readily accessible) a record of "every order received by such member or member organization, either orally or in writing, which record must include the name and amount of the security, the terms of the order, the time when it was so received and the time at which a report of execution was received." If an order is cancelled, a record of that must be kept including the time of the cancellation.

Before entering any order, a trade ticket must be filled out and must indicate the account for which the order is being executed. Accounts, as we'll see in a later chapter, can be held by an individual, a husband-and-wife, a mother-for-the-benefit-of-her-daughter, etc. How the account is named and/or designated is a very big deal, and the account name or designation cannot be changed unless authorized in writing by the account holder and a principal of the broker-dealer. A record of the essential facts used by the person authorizing the change must also be kept for three years (two years readily accessible). This means if a cash account becomes a margin account, the designation has changed, and records must be kept showing that the customer was aware of the change and authorized it, as did a principal at the firm. Or, if the account holder gets married or divorced and changes her name, this is also a very big deal, like virtually everything else in your industry

The NYSE is an auction market, sometimes referred to as the "first market." The OTC (Over-the-Counter) market, on the other hand, is a negotiated market, and sometimes referred to as the second market.