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  • 1. The Global Stock Market Chapter 6
  • 2. Background
    • A variety of different stock markets exist
      • For instance, Germany’s market is over 400 years old while Tanzania’s began in 1998
      • Macedonia has only two companies trading on its stock exchange while India has 5,840
      • The market capitalization of the U.S. is $10 trillion while that of Guatemala is only $2 billion (in U.S. dollars)
    • Many stock markets also trade other financial instruments
    • Consolidations are merging stock markets and technology is pulling national markets together
  • 3. The Global Stock Market
    • Aggregate market capitalization of equity shares in the world grew from $9.6 trillion in 1990 to over $35 trillion in 2000
      • An average rate of 14.8% annually
    • Financial capital is very mobile
      • In 1990 the Tokyo Stock Exchange was 30.5% of the global market but only 12.7% in 1999
      • North America increased its share of the world equity market from 28.0% (1990) to 50.28% (1999)
  • 4. The Global Stock Market
    • Technological advances are automating experienced stock exchange employees out of jobs
    • Stock markets are active in every time zone
  • 5. Brokerage Services
    • Brokers
      • Sales people (earning a commission) employed by dealers
      • Have no money invested in the dealer’s security inventory
      • Help create markets by buying and selling from employer’s inventory
    • Brokerage firms extend credit (margin accounts) to clients
      • Enables client to do more securities trading
  • 6. Brokerage Services
    • Types of stock brokerage services
      • Full-service
        • Take buy and sell orders
        • Extend margin credit to customers
        • Hold clients’ securities in safe keeping
        • Collect cash dividends
        • Provide free investment research
        • Perform ‘hand-holding’ services
          • Pleasant telephone conversations
          • Investment counseling
          • Birthday cards
        • All paid for by clients’ trading commissions
          • Range from $30 - $150 for one common stock transaction
        • Examples
          • Merrill Lynch
          • Goldman Sachs
          • PaineWebber
          • Morgan Stanley Dean Witter
          • Salomon Smith Barney
  • 7. Brokerage Services
      • Discount Brokers
        • Simply take orders
        • Offer little or no investment advice
        • No ‘hand-holding’ services provided
        • Little opportunity for churning
        • Lower commissions
          • Range from $20 to $50
        • Examples
          • Charles Schwab & Company
          • Quick & Reilly
          • Muriel Siebert
          • Jack White & Company
          • Fidelity Investments
          • Vanguard Brokerage Services
  • 8. Brokerage Services
      • Electronic brokers
        • Take buy and sell orders via Internet
        • No ‘hand-holding’ services
        • May provide investment research
          • May or may not be free
        • Low commissions
          • Range from almost free to $35 a trade
        • Examples
          • Discover Brokerage
          • DLJdirect
          • E*Trade
          • Archipelago
          • Bloomberg Tradebook
          • Accutrade
          • Ameritrade
          • Charles Schwab
          • SURETRADE
          • Wall Street Access
  • 9. Transacting
    • When making a trade, the investor must specify
      • Type of order
      • Whether or not margin will be involved
  • 10. Types of Trading Orders
    • Market order—order to buy or sell ASAP at the current market price
      • Simplest, most common order type
      • Executed immediately with virtual certainty
    • Limit order—order to buy or sell with a limit
      • Limit as to the maximum price paid for a buy order
      • Limit as to the minimum price received for a sell order
        • If order cannot be immediately transacted, it is recorded in the market-maker’s limit order book and held for possible future execution
          • Order may never be executed if limit price is not reached
          • May attach a time frame to the limit order
  • 11. Types of Trading Orders
    • Stop orders
      • To buy (sell) are written at prices greater (lower) than the current market price
      • Activated when (if) the market price reaches the stop price
        • Once activated becomes a market order
      • Dangers with stop orders
        • Execution price cannot be known in advance
        • Investor may be whip-sawed in volatile market
      • Variation on stop order
        • Stop limit orders
          • When stop order is activated it becomes a limit order rather than a market order
  • 12. Types of Trading Orders
    • Scale order
      • Requires buying or selling part of the order at each price as market prices change
        • Cumbersome and not all brokers accept them
    • Fill or kill (FOK) order
      • Specifies price at which order must be filled or order is immediately canceled
    • Good till canceled order
      • Remains in effect until canceled
        • Day order—must be filled on the day order is issued
        • Market on close order—can only be executed at the day’s closing price
  • 13. Trading on Margin
    • When opening a new account with a brokerage firm, can have either
      • Cash account
        • Must pay cash for securities
      • Margin account
        • Offers ability to buy securities on credit
        • Money put forth by investor serves as a down payment
        • Amount investors may borrow is controlled by the Federal Reserve Board of Governors
          • For example, the Fed may stipulate a 60% margin, meaning the investor must put forth at least 60% of the purchase price
  • 14. Trading on Margin
    • Federal Reserve’s margin requirements for stocks
      • Varied from 10% (1929) to 100% (1940)
      • In recent years has been 50%
    • Margin requirements are different for different types of securities
  • 15. How Margin Works
    • Example: You wish to purchase 100 shares of XYZ Company for a price of $100 per share. The initial margin requirement is 50%.
      • Purchase price is $100 x 100 shares = $10,000
        • You put forth 50%, or $5,000
        • Borrow the remaining $5,000 from your broker
          • Broker charges you the brokers’ call rate for a margin loan
  • 16. How Margin Works
    • Assume that the market value of the stock rises to $150 a share
      • Your total profit will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions
        • Your return is 100%: Profit of $5,000  Investment of $5,000
          • If you had not used margin, you could have only afforded 50 shares, and your profit would only have been $2,500
            • Your return would have been 50%: Profit of $2,500  Investment of $5,000
  • 17. How Margin Works
    • Assume that the market value of the stock falls to $50 a share
      • Current market value of the investment is now only $5,000 (which exactly equals the amount that was borrowed from the broker)
      • Your total loss will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions
        • Your return is -100%: Loss of $5,000  Investment of $5,000
          • If you had not used margin, you could have only afforded 50 shares, and your loss would only have been $2,500
            • Your return would have been -50%: Loss of $2,500  Investment of $5,000
  • 18. Maintenance Margin
    • If a margined portfolio decreases sufficiently in value, investor will receive a margin call
      • Investor must put up more margin money ASAP
      • Otherwise, broker liquidates enough of the investor’s securities to bring account up to the required minimum margin
        • Easy for broker to do because investor with a margined account must keep securities at the broker’s office as collateral for their loan
    • The NYSE has a maintenance margin requirement of 25%
      • Investor’s equity cannot fall below 25% of the account’s market value
      • Or, investor’s loan amount cannot exceed 75% of the account’s market value
  • 19. Maintenance Margin
    • Continuing the example, if you had purchased $10,000 of stock with a 50% margin, you would face a margin call when
      • Market value of stock dropped below $6,666.67
        • Because your loan of $5,000 cannot exceed 75% of the market value of portfolio
          • 75% × X = $5,000
          • X = $6,666.67
    • Some brokers set a higher maintenance margin than the 25% minimum
  • 20. Investment Banks Make Primary Markets
    • Initial public offerings (IPOs) occur when corporations and governments issue new securities into the primary market
    • Sometimes corporations and governments with existing securities raise additional capital by issuing a new issue of seasoned securities
    • Investment bankers find buyers for both IPOs and seasoned new issues
  • 21. Investment Banks
    • A few thousand investment banking firms exist in the U.S., including
      • Merrill Lynch & Co.
      • Morgan Stanley Dean Witter
      • Lehman Brothers
      • Credit Suisse First Boston
      • Goldman, Sachs & Co.
      • Salomon Smith Barney
      • Bear Stearns Cos.
      • Paine Webber
  • 22. Investment Bankers’ Functions
    • Each public offering has four steps
      • Consulting with the issuer
      • Carrying out administrative duties
      • Underwriting the issue
      • Distributing the securities to investors
  • 23. Consulting
    • The investment bank that serves as the IPO’s originator must analyze the client’s needs and suggest a financing plan
      • What type of security should be issued?
      • How much financing is needed?
      • When should the new securities be issued?
    • The originator will also manage
      • The underwriting syndicate
        • Ranges from 5 to 200 investment banking firms that share the financing and underwriting risk
      • The selling group
        • Investment banks and brokerage firms that sell the securities to investors
  • 24. Administration
    • Deals with legal issues associated with an IPO
    • Helps obtain necessary government permissions
    • Has the prospectus printed
    • Makes public announcements
  • 25. Underwriting
    • An underwriter guarantees the issuer will receive a pre-specified amount of cash for the new securities
      • Days or weeks from the time the underwriter buys the securities from the issuer till they sell the securities to the investors are very risky to underwriter
        • Market conditions may fluctuate and underwriter may lose money on the securities because they have to sell them at a lower price
    • It is important to set the ‘right’ price for an IPO
      • If price is too high, underwriters may not be able to sell securities
      • If price is too low, issuer may find it costly to issue securities
  • 26. Distribution
    • Investment banker may sell securities to a wide group of investors
      • Or may act as intermediary between issuer and buyer in a private placement
    • The difference between the investment banker’s cost and the sale price is known as the spread
      • Ranges from 5 – 16% for stocks
      • About 4% for bonds
  • 27. Electronic Investment Bankers
    • There are several investment banking firms offering internet services
      • DLJdirect
      • Freidman, Billings, Ramsey Group
      • E*Offering
      • OpenIPO
      • E-InvestmentBank
      • Wit Capital
    • Vary in size and sophistication
  • 28. Full Disclosure
    • In U.S. the SEC requires most primary issues be accompanied by a prospectus
      • 10 to 20 page document that fully discloses, among other items
        • Purpose for which the proceeds of the issue will be spent
        • Offering price to the public
        • Offering price for special groups, in any
        • Underwriter’s fees
        • Net proceeds to the issuer
        • Information on the issuer’s products, history and location
        • Names and remuneration of officers
        • Detailed statement of capitalization
        • Detailed financial statements
        • Details about any pending litigation
  • 29. Full Disclosure
    • Approval of a prospectus by the SEC does not mean the investment is a good value, but that all the necessary information required by the SEC has been disclosed
    • Full disclosure allows investors to estimate value of new securities
  • 30. Secondary Market
    • Once securities are issued in the primary market, they can begin trading in the secondary market
    • Types of secondary markets
      • Organized exchange run by dealers (NYSE)
      • Electronic market in which dealers compete with one another (Nasdaq)
      • Electronic communication networks
  • 31. NYSE
    • New York Stock Exchange ( ) lists approximately
      • 3000 common and preferred stocks issued by American corporations
      • 300 foreign stocks
      • 250 American Depository Receipts (ADRs)
      • Also trades bonds
  • 32. NYSE
    • Each stock traded on the NYSE is assigned a specialist who must
      • Continuously post bid and ask prices for the stocks in which they make a market
      • Stand at assigned posts on the trading floor
      • Act as market-makers (dealer)
        • Always ready to buy at their bid price and sell at their ask (or offer) price
          • Invest their own capital (risky) but may earn a return
      • Execute orders for others (broker)
      • Earn the bid-ask spread on every transaction
  • 33. Decimalization
    • A tick represents the minimum amount by which a price can change
      • Prior to 1997 the tick was 1/8 but then became 1/16
        • However the tick size is now 1 ¢ since the exchanges instituted decimalization
          • Expected to reduce the bid-ask spread and trading costs
  • 34. NYSE Listing Requirements
    • To be listed on the NYSE must have
      • A minimum taxable annual income of $2.5 million
      • A minimum net tangible assets of $18 million
      • A minimum of 1.1 million shares of publicly held stock with a minimum market value of $18 million
      • A minimum number of 2,000 investors owning round-lots (100 shares)
      • One specialist
  • 35. NYSE Operations
    • Approximately 460 specialists with about 8 stocks assigned to each specialist’s trading post
    • About 1,500 trading booths with telephones surround the perimeter of the trading floor
      • Allows for order transmission and confirmation between brokers’ offices and exchange floor
    • NYSE has 1,366 members who must own a seat on the exchange
      • Almost all members are either specialists or floor brokers
  • 36. Floor Brokers
    • Buy and sell securities for the clients of brokerage houses or for their own accounts
    • Order process
      • Broker receives order via phone from the brokerage
      • Walks to trading floor and executes transaction at the specialist’s post
      • Phones brokerage and provides confirmation
  • 37. Specialists
    • Accepts obligation to make a fair and orderly market by
      • Selling shares out of their own inventory if there are more buy orders than sell orders (or by raising the price of the security they control)
      • Buying shares for their own inventory if there are more sell orders than buy orders (or by lowering the price of the stock)
    • Keeps a limit order book (LOB) for each stock in which they make a market
  • 38. Limit Order Book
    • Today is kept on a computer
    • Records buy and sell orders from potential traders
      • Outlines the supply and demand curves that determine market price of security
        • Helps specialists earn trading profits
    2 Gabelli 3/8 3 McGovern 1/4 4 Jacoby 1 Sullivan 1/8 3 Dalton 9 Mirandi 4 Wentz 0/8 BID: $42 and ?/8
  • 39. NYSE
    • NYSE has lagged behind other organizations in terms of technology
    • Uses Super Designated Order Turnaround (SuperDOT) system
      • Routes small market orders and limit orders directly from member firms to specialists
        • Bypasses floor brokers
        • Specialists usually let PCs execute SuperDOT transactions automatically
  • 40. Block Trades
    • A single transaction involving 10,000 or more shares
    • Increased steadily throughout the 1960s-1980s but leveled off in the 1990s
    • Specialists are not involved in block trades that occur outside the NYSE by block positioners
      • Special brokers/dealers that line up multiple buyers for a large block
      • Some large investment banks have a block positioning department
        • Have the capital to carry a large block for a few days and the connections to distribute it
        • The upstairs market
      • Economies of scale lead to small commissions per share
  • 41. Nasdaq Market
    • Electronic, over-the-counter (OTC) market
    • Lists over 15% of the world’s stock market capitalization
      • Over 6,400 common and preferred stocks
      • About 320 foreign stocks
      • About 140 ADRs
  • 42. Nasdaq Market
    • National Association of Securities Dealers Automated Quotations (Nasdaq) is the communications network that services the OTC market
      • About 61,000 computer terminals are connected to Nasdaq’s mainframe via phone lines
        • Can obtain current bid and ask prices for all Nasdaq stocks
          • Updated continuously by about 540 competing Nasdaq market-makers (dealers)
      • Investor’s broker can access the system to find the best bid/ask price for a security
        • Broker then calls dealer to execute transaction as trades cannot be executed via Nasdaq computer
  • 43. Nasdaq Market
    • Centralizes a geographically dispersed market into a mainframe computer
    • When a broker or dealer inquires about a security’s price, bid-ask quotes are instantly provided even if the dealers are many miles apart
    • Designed to handle up to 20,000 stocks
      • Currently lists about 6,500 actively traded stocks
    • In 1999 Nasdaq merged with AMEX
    • Nasdaq plans to cross-list stocks with various international exchanges
      • Positioning itself to more effectively compete with NYSE
  • 44. CQS, ITS and Law of One Price
    • SEC requires that the Consolidated Quotation System (CQS) report current transactions for NYSE, OTC, AMEX, regional U.S. stock exchanges and the third market
      • Helps investors find the best prices
      • CQS cannot perform executions
        • SEC urged NYSE to create the Intermarket Trading System (ITS)
          • Electronic trading network linking various U.S. markets
        • Nasdaq supplemented ITS with an electronic communications network called Primex
          • Gives faster access to NYSE-listed stocks
        • Combining CQS with ITS and Primex allows arbitrageurs to enforce the law of one price
  • 45. Non-Nasdaq National Quotation Bureau (NQB)
    • To be included in Nasdaq’s national daily list, a stock must have
      • At least two market makers
      • A minimum of 1,500 stockholders
      • Significant investor interest
    • A stock not meeting these requirements are listed with the National Quotation Bureau (NQB)
      • NQB lists 3,600 stocks, some of which are not actively traded
        • Includes
          • Domestic U.S. micro-cap stocks
          • Shares in foreign corporations that cannot be listed on an organized exchange
          • ADRS and GDRs for stocks that do not meet the accounting standards for listing on an organized exchange
  • 46. Third U.S. Market
    • Third market—subset of OTC market where exchange-listed stocks are traded
      • Competes with organized exchanges
        • Offers cost savings in the form of better bid-ask prices
      • Nasdaq and regional stock exchanges are the core of the third market
        • For instance, in 1999 Chicago Stock Exchange (CHX) traded over 90% of the NYSE-listed stocks
          • Majority of CHX’s trading volume is from dual listings
          • CHX pays for order flow
            • Specialists take a penny or so (per share) from their bid-ask spread and give it to brokers to encourage brokers to execute their orders on the CHX rather than NYSE
  • 47. Fourth U.S. Market
    • Fourth market—a network of market-makers, block traders and institutions
      • Bypass normal dealer services and negotiate directly with each other
      • Instinet (short for Institutional Network) has operated in the fourth market since 1970
        • Has computer terminals in over 5,000 subscribers’ offices
          • Millions of shares are traded in secrecy daily via Instinet
          • Commissions range from 2 ¢ to 8¢ a share
  • 48. Order Crossing Networks
    • An electronic communication network that tries to match buy and sell orders
      • The price may be
        • The last reported price from an organized exchange
        • Midway between the current bid-ask prices on an organized exchange
    • Traders may pay a fixed annual fee to use alternative market systems
      • Variable trading costs are zero
    • Rapid executions are possible if the other half of the transaction is already present in network
    • Offers anonymity
    • Sometimes the network is not operating when it is needed
    • Or the other half of the transaction is unavailable
  • 49. Order Crossing Networks
    • Instinet operates the Crossing Network and competes with Investment Technology Group’s (ITG) Portfolio System for Institutiional Trading (POSIT)
    • Bloomberg runs Tradebook—a continuous matching system mainly for Nasdaq stocks
      • In 1999 Bloomberg & ITG created SuperECN
        • Offers a crossing network with a larger order flow
    • Other crossing networks include
      • Investor’s Liquidity Network by Fidelity Investors
      • E-Crossnet is for European stocks
  • 50. Electronic Order Working Systems
    • Electronic order working systems
      • Screen telecommunication networks, capture current market information and use it to make ongoing transactions
      • Needs the following information
        • Securities that are to be traded
        • Limit order prices
        • Quantities available at different prices
        • Binding time limits
        • Markets where the securities are traded
        • Any additional information
  • 51. Electronic Order Working Systems
    • Various EOWS include
      • QuantEX by Investment Technology Group
      • Order Management System by Instinet
      • Lattice Trading System by Credit Suisse First Boston
      • REDIBook
      • Archipelago Exchange
  • 52. Electronic Stock Exchanges
    • Arizona Stock Exchange (AZX)
      • Formed in 1990 in Phoenix
      • Periodic call market
        • Automated auction process that attempts to equate the supply and demand for a broad list of common stocks at a few specified times each trading day
          • Client submits order as if it were a limit order
          • The limit order book is open to all participants, but anonymity of participants is maintained
      • Each time an auction occurs, the AZX computer calculates supply and demand curves for each security being auctioned
        • The intersection of the curve determines the security’s market clearing price
          • All sell (buy) orders below (above) the market clearing price are matched
      • On a daily basis, about two dozen institutional investors used the AZX system, trading several hundred thousand shares
  • 53. Electronic Stock Exchanges
    • European Association of Securities Dealers Automated Quotations (EASDAQ)
      • Based in Brussels
      • Nasdaq acquired EASDAQ in 2001
      • Lists and trades about 50 technology stocks
    • Primex
      • Patterned after NYSE
      • Takes a customer’s buy or sell order to the NYSE and other competing exchanges in search of best available price
      • Allows users to haggle for the best prices
  • 54. Electronic Stock Exchanges
    • Tradepoint
      • Conducts auctions for U.K. equities
      • Operates with a transparent order book
    • Jiway
      • Stockbrokers can transact with each other in over 6,000 European and American stocks
      • Auctions off the right to be the designated market-maker for each stock in its system to member firms
      • Provides custody services, etc .
  • 55. Electronic Stock Exchanges
    • European Alliance
      • Informal alliance of eight stock exchanges, including
        • London Stock Exchange
        • Amsterdam Stock Exchange
        • Brussels Stock Exchange
    • Reg ATS Exchanges
      • SEC rule that allows alternative trading systems in the U.S. to register as stock exchanges
      • Exchanges must
        • report their prices via the Consolidated Quotation System
        • Operate as a self-regulating organization
        • Participate in the intermarket trading system
  • 56. The Twenty-First Century
    • In 1999 NYSE and Nasdaq announced that they are interested in reorganizing as for-profit corporations
      • Would allow them to raise outside capital in order to obtain better technology
    • In 2000 Merrill Lynch started an electronic brokerage subsidiary—the last full-service brokerage in U.S. to do so
    • In 2000 several companies submitted a joint proposal to SEC to establish a central limit order book
      • Would reduce market fragmentation and increase transparency within U.S.
  • 57. The Twenty-First Century
    • Electronic technology will continue to accelerate change
      • Trading volume will increase as transaction costs fall
      • There will be pressure on stock exchanges and ECNs to consolidate
    • A global market will eventually emerge
  • 58. Liquidity
    • Perfectly liquid assets are highly marketable
      • Do not suffer from a decline in price if they are liquidated quickly
        • For example, the U.S. dollar is perfectly liquid whereas most real estate is not because
          • To quickly sell a house, seller must offer a price discount
          • Real estate brokers commonly have commissions of 6% of the property value
  • 59. Liquidity Continuum
    • Assets categorized from most liquid to least liquid
      • U.S. dollar bills
      • U.S. Treasury bonds
      • NYSE-listed stocks and large Nasdaq stocks (such as Microsoft)
      • Nasdaq stocks
      • Corporate bonds
      • Most municipal bonds
      • Most real estate
      • Art objects and collectibles
    Investors pay a liquidity premium for the convenience of owning liquid assets.
  • 60. Liquidity in Securities Markets
    • A liquid securities market possesses the following qualities
      • Depth—buy-sell orders exists both above and below the price at which the security is transacting
        • A market lacking depth is shallow
      • Breadth—when a large amount of buy-sell orders as described above exist
        • Markets lacking breadth are called thin markets
      • Resiliency—if new orders occur in response to price changes due to temporary order imbalances
  • 61. Transaction Costs
    • Direct transaction costs
      • Brokers’ commissions
      • Income taxes
      • Transfer fees
      • Custodial fees
      • Outlays for research information
    • Indirect transaction costs
      • Bid-ask spread—determined by the cost of market-making expenses such as
        • Interest expense for financing inventory of securities
        • Risk premium for investing capital
        • Administrative costs
  • 62. Transaction Costs
    • Indirect transaction costs
      • Market impact
        • Buying (selling) tends to bid up (down) the price of a security
          • Large transactions tend to move prices more than smaller transactions
      • Opportunity cost (implicit)
        • Decay of information value of a trade incurred when market moves against a trader waiting to trade
          • Tends to increase with time between decision to trade and the actual execution of the trade
  • 63. Transaction Costs
    • Total transactions costs can range from less than 1% of the value to much of the investor’s return (in countries with high capital gains taxes)
      • The cost of transaction varies inversely with the market’s liquidity
        • Large cap stocks are usually more actively traded than small cap
          • Thus, small cap stocks generally have a higher transaction cost
        • Large industrialized nations generally have lower transaction costs because
          • The stock markets are more active
          • More political stability
          • More efficient legal systems
  • 64. The Bottom Line
    • Small and large stock markets provide varying degrees of liquidity
    • Institutional investors may use block positioners to execute large trades
    • Full-service brokers charge high commissions
    • Discount brokers, electronic brokers or ECNs offer less costly services
    • Most trades are market orders, however other order types exist
  • 65. The Bottom Line
    • Investors may buy on margin—effectively borrowing money from their brokerage
      • Margin trading enhances gains and losses
    • Investment bankers assist their clients in raising money in the primary market
      • Organizing distribution syndicates
      • Underwriting the issue
      • Distributing the securities
  • 66. The Bottom Line
    • NYSE is the largest stock market in the world
      • Continuous auction market
      • Specialists
    • NASDAQ is a large electronic market
    • ECNs involve several different categories of market technology
    • Technology is
      • Increasing the array of brokerage services
      • Increasing the competition between brokerage
      • Reducing transaction costs
      • Speeding executions
      • Creating new types of stock exchanges
      • Altering the IPO process
      • Integrating the world’s stock markets into a global one