Secondary Securities Markets

Investor: Will the stock market go up or down?

Prophet: Yes.

After securities have been issued, they are frequently traded in the secondary markets. Securities can be traded on organized national and local stock exchanges, in the over-the-counter market, and directly between buyers and sellers, often using the services of an electronic network.

A market for financial securities must provide 3 functions:

  1. price discovery
  2. a mechanism for trading, where buyer and seller can agree to a price and settle at a specific time, and a means to enforce those agreements
  3. settlement of the agreements, that allows the buyer to transfer the money to the seller, and the seller to transfer certificates or other evidence of ownership to the buyer

The last 2 steps are commonly called execution, clearing, and settlement. Special market participants facilitate trading:

Many indexes of the various securities markets list aggregated price levels of the underlying securities, enabling investors to see at a glance its current status and past market performance in the past.

Stock Exchanges

In the United States, 2 major national stock exchanges — the New York Stock Exchange (NYSE) and the NASDAQ — list most of the major companies — and many local exchanges, list smaller, local companies or specialize in some other way. The New York Stock Exchange is the largest exchange, followed closely by NASDAQ.

All exchanges have initial listing requirements companies must satisfy before they can be listed on a particular exchange. Since exchanges make money by charging commissions or fees on trades, most requirements are designed to ensure that a minimum of trading will occur in the company's shares. Larger companies have more trading activity, so several requirements are related to ensure a minimum size. The most common requirements are a minimum market value, a minimum income and revenue, a minimum number of shares outstanding, and a minimum number of holders of public stock.

Although most stocks listed on an exchange are listed stocks for that exchange, an exchange can list the securities of any other exchange, if it so chooses. To increase pricing competition, the Securities and Exchange Act of 1934 contains a provision, called unlisted trading privileges (UTP), allowing any exchange to list any securities listed on any other exchange.

Only members of an exchange may list and execute trades at the exchange. When a retail investor wants to trade an exchange-listed stock, he must go to a broker. If the broker is a member of the exchange where the stock is listed, then she can send her client's order to a representative of her firm, who will then execute the trade. However, if her firm is not a member, then she must send the order to another broker or dealer who is a member of the exchange or to their representative at the exchange.

Buy or sell limit orders are entered into the system and crossed with matching orders. If there are no matching orders, then they are queued, first by price, then by date, as a bid or offer price. The list of all bids and offers constitutes the order book, and the current market quote is the best bid and offer.

The Over-the-Counter (OTC) Market

The over-the-counter (OTC) market is, by far, the largest market, since it has few or no listing requirements. Almost every security — including bonds, derivatives, and currencies — are traded in the OTC market. It generally operates by phone or through electronic systems, where individual dealers or brokers list bid and offer prices.

The OTC market has many stocks for less than $1.00 per share, many cost less than 1 penny per share, which is why they are commonly referred to as penny stocks. These cheap stocks are here for a reason: they cannot satisfy the listing requirements for a major exchange. Indeed, virtually any company can list their stock here, even ones with no real business, earnings, or even reports of their financial condition. Thus, this market is the favorite playground for fraudsters, who use social media, such as Twitter, Reddit, and Facebook, to pump up cheap stocks, in which they have already invested, to drive their price higher so that the fraudsters can then sell at a nice profit, called a pump-and-dump scheme. Pump-and-dumps schemes are also common in the markets for cryptocurrencies.

When a broker or dealer wants to buy an OTC stock, he contacts, or sends an electronic order to, the market maker listing that security. For stocks, there are 2 specific OTC markets, the OTC Bulletin Board and the Pink Sheets.

OTC Bulletin Board (OTCBB)

The OTC Bulletin Board (OTCBB) is an electronic inter-dealer quotation system that displays quotes, last-sale prices, and volume information for OTC equity securities, which is any equity security not listed on NASDAQ or a stock exchange. Equity securities include not only domestic and foreign stocks, but also American Depositary Receipts (ADRs), warrants, and Direct Participation Program (DDP) securities. Companies seeking an OTCBB listing must be sponsored by a market-maker firm registered as a broker-dealer and file current financial reports with the SEC or their banking or insurance regulator. The issuers do not have to pay a fee for a listing, nor is there any financial reporting requirements with NASDAQ or the Financial Industry Regulatory Authority (FINRA), which operates the OTCBB. The companies must, however, maintain any required filings with the U.S. Securities and Exchange Commission (SEC) or with its banking or insurance regulator. An SEC report must be filed by the company if any of the following are true:

When an OTCBB company fails to file its reports on time, the NASD will add a fifth letter "E" to its 4-letter stock symbol. The company then has 30 days to file with the SEC or 60 days to file with its banking or insurance regulator. If it's still delinquent after the grace period, the company will be removed from the OTCBB. A watch list of delinquent companies and their securities is maintained at

The OTCBB began as a pilot program in June 1990, then, after SEC approval, became permanent in April 1997. The Penny Stock Reform Act of 1990 mandated that the SEC establish an electronic system that met the requirements of Section 17B of the Exchange Act. Since December 1993, firms have been required to report trades in all domestic OTC equity securities through the Automated Confirmation Transaction Service (ACT) within 90 seconds of the transaction. In May, 1997, DPPs became eligible for listing on the system, and in April, 1998, all ADRs and foreign securities that are registered with the SEC also became eligible for listing.

The OTCBB transmits real-time quote, price, and volume information in domestic securities, foreign securities and ADRs; and displays indications of interest and prior-day trading activity in DPPs. Only qualified market makers can display quotes on the OTCBB. However, quotes and information can be obtained from the OTCBB website.

The OTCBB is organized as the OTC Link ATS (Alternative Trading System), divided into 3 marketplaces based on the amount and quality of information available on the stocks:

  1. OTCQB - includes securities of companies current in their reporting to the SEC or a U.S. bank, thrift or insurance regulator;
  2. OTCQX - includes securities of companies either current in their reporting to the SEC or a U.S. bank, thrift or insurance regulator, or, for companies not required to report to the SEC, meeting and remaining current in their reporting obligations to OTC Link under its proprietary Alternative Reporting Standard, while also meeting other eligibility requirements, including audited financial statements and partnering with a 3rd-party securities attorney or investment bank that reviews disclosures and acts as a professional advisor; and
  3. OTC Pink - includes other equity securities. There are no government financial standards or reporting requirements to be listed in OTC Pink. However, OTC Pink companies must make available basic information provided to broker-dealers who quote the security, which is required under Exchange Act Rule 15c2-11 to initiate a quote for an OTC Pink security. Companies can also provide more information by using the Alternative Reporting Standard available on OTC Pink.

OTC Link, a member of FINRA registered as a broker-dealer and as an Alternative Trading System, displays quotes, last-sale prices, and volume information for exchange-listed securities, OTC equity securities, foreign equity securities, and certain corporate debt securities. OTC Link subscribers can also negotiate trades with OTC Link broker-dealers.

Some OTC stocks may be listed on more than 1 of the OTCBB submarkets.

OTC Pink Securities (formerly known as Pink Sheets)

In the early 1900's, new and outstanding stocks were advertised in financial newspapers or in the financial sections of large newspapers by investors, dealers, and brokers. The National Quotation Bureau started, in 1904, to consolidate and print this information for dealers and brokers. Through various incarnations, this has become the pink sheets of today, when, despite the name, most of the information is distributed electronically at the OTC Pink website.

OTC Pink lists mostly stocks that do not qualify for a listing on an exchange. These thinly traded stocks — often called penny stocks, but also includes shell companies and distressed or bankrupted firms — are issues from mostly small companies. The name is based on the color of the paper of the traditional sheets that were printed daily by Pink Sheets, LLC. Nowadays, listings are displayed on the Electronics Quotation System. The listings include the stock, the market makers dealing in the stock, their phone numbers, and may include a quote for the stock. However, these quotes are static quotes that the market maker is not obliged to uphold because they are only updated once per day. To buy a stock listed in the pink sheets, the customer's broker would call 1 or more of the market makers listed for that security, and ask for a firm quote.

National Market System (NMS)

Because stocks are listed on multiple exchanges and in the OTC markets for different prices, the SEC wanted to promote competition among the different trading centers by consolidating the quotes in 1 place — the National Market System, (NMS), which was the result of Regulation NMS. The SEC has been trying to implement this strategy since 1975, but because of technical problems and industry opposition, it has taken some time. The NMS would allow individual investors to see the same quotes as big institutional investors.

The Regulation NMS lowered the cost of trading by:

Consolidated Tape — Network A and Network B

The National Market System began with the Securities Act Amendments of 1975 that gave the SEC authority to effect some institutional changes so that quotes from different markets could be consolidated. One result was the consolidated tape, which began operating in June, 1975, and is composed of Network A and B.

Network A lists the best prices for NYSE-listed stocks from the NYSE, local exchanges, and the OTC market. Network B lists the best prices for the local exchanges, and the OTC market, and also stocks listed only on local exchanges and the OTC market.

The Consolidated Quotation System (CQS) electronically disseminates these quotes across the networks.

Intermarket Trading System (ITS)

The Intermarket Trading System (ITS) was a network linking the NYSE, NASDAQ, and other local exchanges. This system, began in 1978, allowed market makers and brokers to transmit quotes to other exchanges for better prices for the approximately 4,500 stocks listed on multiple exchanges. Thus, if a customer for a broker who is a member of the Philadelphia Stock Exchange, sees a better price on the NYSE, the broker can route the customer's order to the NYSE, then the trade is reported on the Consolidated Quotation System.

One of the problems with the ITS is that the orders are not routed automatically to the best price, but must be sent there by a market participant. For instance, if an NYSE specialist receives an order for a stock, but sees a better price on the ITS system, then he must either send the order to that exchange, or match the price. The ITS system is also considered too slow for the NYSE. However, a major drawback is that it does not include quotes from ECNs, which are transacting increasing numbers of shares because of their low cost.

The ITS has become obsolete as trading systems have become more automated and linked to other trading platforms electronically, facilitating the search for the best price.

The solution for the future is to have an electronic network that links all the markets, aggregating all orders into 1 central limit order book, where the best inside prices can be quoted. This not only gives the best prices to the customers, but will also force the exchanges to become more efficient, since the lowest cost networks will generally have the best prices. Eventually, there will be no market makers or specialists — buyers will simply buy directly from sellers, electronically, for the lowest transaction cost possible.

Alternative Trading Systems (ATSs)

Alternative Trading Systems (ATSs) are private, SEC-regulated electronic trading systems matching buy and sell orders of securities. An ATS, known in Europe as a Multilateral Trading Facility (MTF), is not a national securities exchange, but it may become a national securities exchange by applying to the SEC. All Alternative Trading Systems require the approval of the U.S. Securities and Exchange Commission (SEC) to protect investors and ensure the fairness of transactions. Regulation ATS requires an ATS to register as a broker-dealer and file an initial operation report with the Commission on Form ATS before starting operations. Changes of operation or ceasing operation must also be reported to the Commission as an amendment to Form ATS.

The main advantages of an ATS is that there are fewer regulations on trading on an ATS compared to a public exchange. Brokers do not have to pay an exchange fee, and they even profit if they own the ATS. Large institutional traders also like ATSs because they can make large trades anonymously and the trades do not have to be reported until later. Most small retail orders are traded in an ATS, which helps brokers to offer reduced or no commissions on trades, especially if they are being paid for order flow by the market makers on the ATS.

All current ATSs are dark pools, trading systems that allow trading without publicly displaying order prices or sizes to other dark pool participants. ATS trades do not appear on national exchange order books. (As a contrast, the major stock exchanges are sometimes referred to as lit markets, because all their transactions are displayed.) However, trades of listed stock will still be reported to the consolidated tape after they occur, at the best price available, usually at or within the current national best bid and best offer of all trading venues.

Institutional investors making large trades, sometimes consisting of thousands of shares, may do so in the OTC market or through an ATS, because large trades in these smaller venues do not affect prices as much if the transaction used a major exchange, because the size of the order is not displayed. Most large institutional investors, including mutual fund operators, trade in the OTC market or in an ATS. Brokers also route many orders from retail customers to market makers trading in the OTC market or ATS, especially to market makers paying for order flow, which is what allows brokers to offer commission-free trading for retail customers.

Electronic Communication Networks (ECNs)

Electronic Communication Networks (ECNs) are electronic ATS networks that can connect buyers directly with sellers for listed securities — no brokers or market makers are involved. Often called the fourth market or network, ECNs can eliminate the spread that dealers charge, if a crossing match can be found for the buy or sell orders that were entered. The ECN earns its money from fees for the transactions, rather than from commissions or a spread. Most ECNs are also connected to NASDAQ through the Intermarket Trading System. Participants, mostly institutional investors, post bids or offers on the ECN. The ECN will try to match the order with another participant on the ECN, or, if that fails, it will send the order to NASDAQ. Most large traders also like ECNs because of their anonymity — the rest of the market does not know who is buying or selling large blocks of securities.

ECNs must be registered by the SEC, and by the FINRA if it wants to connect to the NASDAQ market.