VIII. INSTITUTIONS AND PROCEDURES IN SECONDARY MARKETS

A. Exchanges and Floor Markets The Securities and Exchange Act of 1934 defined an exchange to be: any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange. An exchange is a physical or virtual meeting place drawing together brokers, dealers and traders to facilitate the buying and selling of securities. Exchanges include the floor-based markets as well as many virtual meeting sites and screen-based systems provided by Electronic Communications Networks (ECNs).

Exchange Functions Exchanges are intended to provide for orderly, liquid and continuous markets for the securities they trade. A continuous market provides for transactions that can be executed at any time for a price that might be expected to differ little from the prior transaction price for the same security. In addition, exchanges traditionally serve as self- regulatory organizations (SROs) for their members, regulating and policing their behavior with respect to a variety of rules and requirements.

NYSE Euronext NYSE Euronext, the major unit of ICE, is the world’s largest exchange, lists over 8,000 issues (excluding European structured products) from 55 countries on six equities exchanges and six derivatives exchanges in six countries. NYSE Euronext was launched on April 4, 2007, the result of a merger between the New York Stock Exchange Group and Euronext, NV.

NYSE Family Tree

U.S. Stock and Options Exchanges NYSE Amex LLC (formerly the American Stock Exchange) BATS Exchange, Inc. BATS Y-Exchange, Inc. NASDAQ OMX BX, Inc. (formerly the Boston Stock Exchange) C2 Options Exchange, Incorporated Chicago Board Options Exchange, Incorporated Chicago Stock Exchange, Inc. EDGA Exchange, Inc. EDGX Exchange, Inc. International Securities Exchange, LLC The Nasdaq Stock Market LLC National Stock Exchange, Inc. New York Stock Exchange LLC NYSE Arca, Inc. NASDAQ OMX PHLX, Inc. (formerly Philadelphia Stock Exchange)

Futures and Partially Exempt Exchanges U.S. Futures Exchanges Board of Trade of the City of Chicago, Inc. CBOE Futures Exchange, LLC Chicago Mercantile Exchange One Chicago, LLC The Island Futures Exchange, LLC NQLX LLC Partially Exempt Exchanges Arizona Stock Exchange SWX Europe Limited (f/k/a Virt-x)

Early Exchanges Precursors to modern stock exchanges might have existed in Egypt as early as the 11 th century, where it is believed that Jewish and Islamic brokers traded a variety of credit-related instruments. 13th century Bruges (Belgium) commodity traders assembled in the van der Beurse family home (and inn), ultimately becoming the “Brugse Beurse.” The Amsterdam Stock Exchange opened in the early 17 th century, trading shares of the Dutch East India Company. The exchange continues to operate as a unit of Euronext, and as the world's longest continuously operated exchange. Several older exchanges began in coffee houses and taverns, where brokers and dealers would meet to trade securities. The first securities exchange to operate in the United States was in Philadelphia. The New York Stock Exchange began operations outdoors after the 1792 signing of the “Buttonwood Agreement.” Exchanges often operated outdoors so that brokers could call out their orders from their office windows to the street where transactions actually took place. The American Stock Exchange, known as the New York Curb Exchange until 1953, did not move indoors until 1921.

Traditional NYSE Structure Until 2006, the NYSE was a hybrid corporation/partnership whose members faced unlimited liability. Only members who owned or leased seats had trading privileges and there were four types of members: – House Broker: Executed orders on behalf of clients submitting orders through brokerage firms. This and other broker roles have been taken over by "Trading Floor Brokers." – Independent Broker: Also called a two-dollar broker, executed orders on behalf of commission brokers when activity was high. This type of distinct membership no longer exists. – Floor Trader: Executed orders on their own trading accounts. The NYSE has created the "Supplemental Liquidity Provider" role, which is intended to enhance market liquidity by allowing for proprietary trading. – Specialist: Responsible for maintaining a continuous, liquid, orderly market for the securities in which he specializes. The specialist has been replaced by the Designated Market Maker (DMM). Now, under its new structure, one can join the 1366 members by purchasing a license that permits the member to trade for one year.

U.S. Options Exchanges; Data from January 1, through July 31, 2011 Cleared Total Avg. Daily % of ExchangeContracts Premiums Contracts Total Contracts ARCA 158,529,881 $36,180,176,001 1,093, % BATS 50,286,898 $12,952,402, , % BOX 49,788,089 $9,882,629, , % C2 10,400,904 $1,457,446,499 71, % CBOE 316,112,979 $60,812,186,839 2,180, % ISE 259,516,879 $45,392,864,394 1,789, % NSDQ 69,144,416 $16,647,189, , % PHLX 367,776,704 $121,172,599,631 2,536, % Total 1,491,204,897 $340,633,377,303 10,284, %

B. Over the Counter Markets and Alternative Trading Systems The over the counter markets have traditionally been defined as the non-exchange markets. An alternative trading system (ATS) might be loosely defined as a securities trading venue that is not registered with the S.E.C. as an exchange.

ATS Types Electronic Communication Networks (ECNs), which are virtual meeting places and screen-based systems for trading securities. Dark Pools and "Crossing Networks," where quotations for share blocks are matched anonymously. Participants in crossing markets enjoy reduced transactions costs and anonymity but often must wait for counterparty orders to accumulate before transactions can be executed. Internalization Crossing Voice-Brokered Third-Party Matching.

Sample ATS List Host NameCountryInstrumentsFeatures AlphaCanadaEquitiesContinuous trading market ArcaEdge U.S.EquitiesNYSE ATS Chi-X Europe U.K.European SharesMultilateral Trading Facility Citi Match U.S.EquitiesInternal Crossing Network Crossfinder GlobalEquitiesBills itself as the world's largest dark pool; Internal crossing network

ATS Definition Alternative trading system means any organization, association, person, group of persons, or system: 1. That constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 under the Securities Exchange Act of 1934; and 2. That does not: i. Set rules governing the conduct of subscribers other than the conduct of such subscribers' trading on such organization, association, person, group of persons, or system; or ii. Discipline subscribers other than by exclusion from trading. What the ATS does not do is what distinguishes it from an exchange.

Equity Trading Centers Volume 2009 NYSE14.7% NYSE Arca13.2% Nasdaq19.4% NASDAQ OMX BX 3.3% Broker-Dealer (Internalization)17.5% Direct Edge 9.8% BATS 9.5% Dark Pools 7.9% Other Exchanges 3.7% Other ECNs 1.0%

Electronic versus Open Outcry Bakos et al. [2000], opened a series of accounts at various full-service, discount and electronic securities brokers. Their commissions for 100-share lots averaged $7.50 for electronic brokers and $47 for full-service voice brokers. They found that full-service brokers were more likely to route orders to the principle exchanges than electronic brokers and that such orders were more likely to be improved. However, for smaller orders, these price improvement advantages are more than offset by the higher brokerage commissions. Hence, specialists and market makers on exchanges were able to provide better order executions while brokers using electronic markets charged smaller commissions. It appeared that smaller investors fared better with discount electronic brokers while larger transactions resulted in better after-commission executions on the principle exchanges.

D. Crossing Networks and Upstairs Markets Slippage, associated with large transactions, occurs when an order forces prices against the trader. Crossing networks are alternative trading systems that match buyers and sellers with agreed-upon quantities. Crossing networks do not publicly display quotations, thereby enabling participants anonymity. Trades are priced by reference to prices obtained from other market. The crossing network then matches buy and sell orders at prices obtained from more traditional markets such as the NYSE. This crossing procedure enables institutional traders to execute without exposing orders to competitors. The crossing network, by having prices determined elsewhere, also prevents the price impact or pressure typically associated with auctions of large blocks of shares. Because crossing networks do not reveal prices or client identities, and that they represent non-displayed liquidity, they are sometimes referred to as dark pools of liquidity. MidPoint Match and Nasdaq Crossing provide traders with opportunities to match orders anonymously at known benchmark (e.g., the mid-point of the spread) or closing or other prices several times a day. The Securities and Exchange Commission [1998] defines crossing networks as ‘‘systems that allow participants to enter unpriced orders to buy and sell securities. Orders are crossed at a specified time at a price derived from another market.’’

Internalization Internalization occurs when brokers execute their own client buy orders against their own client sell orders, representing both sides of a trade and without routing them to central markets. Internalization allows brokers to easily execute transactions at a lower cost. However, internalization – may inhibit the broker’s ability to properly represent the client as the client’s agent – results in fewer transactions being executed in the central market, which increases market fragmentation and reduces transparency and potential price competition. – can lead to reduced liquidity and increased price volatility in the central market. – can lead to violations of price and time priority. – the transaction might be more susceptible to manipulation or may not be executed at the best possible prices. Internalization of customer orders is not possible for options markets transactions due to exchange rules.

E. Quotation, Inter-market and Clearing Systems Consolidated Tape (CTA): High-speed electronic system maintained by SIAC for reporting transaction prices and volumes for securities on all U.S. exchanges and markets. Consolidated Quotations System (CQS): Provides traders with price quotes through SIAC from the various exchanges and FINRA and calculates the NBBO. The CQS does not time delay as the Consolidated Tape can during periods of heavy volume. Intermarket Trading System (ITS): Displays quotes in different markets and links markets for trade executions to facilitate investors’ access to the best quotes. This system might be considered to be the centerpiece of the National Market System. Securities Investors Protection Corporation (SIPC): analogous to FDIC in that it insures investors' account for up to $500,000 in securities and $100,000 in cash, but only when the investor’s brokerage firm fails. Thus, this coverage is very limited.

Clearing and Settlement The general clearing process involves two primary tasks: trade comparison (matching of trades) and settlement (delivery of securities or book entry). – Clearing refers to activities resulting in the settlement of claims of financial institutions against other financial institutions. – The operations department of a financial institution, often referred to as the institution’s back office, is responsible for handling or overseeing the clearing and settlement processes. – A clearing firm is authorized by a clearing house to manage trade comparisons and other back office operations. – Leading clearing firms include Pershing, LLC, JPMorgan Clearing Corp. and National Financial Services, LLC. – A clearing house clears transactions for a market such as the NYSE. A clearing house facilitates the trade settlement between two clearing firms and seeks to ensure that the clearing firms honor their trade settlement obligations. The clearing house will typically guarantee the obligations of its member firms. – The clearing house steps into a transaction to be settled by its members and assumes the settlement obligations of both counterparties to the transaction, in effect becoming the counterparty to both sides of every transaction, a process known as novation. Thus, the clearinghouse, acting as a central counterparty, acts as the counterparty for each party to every transaction, and assumes all credit risk.

Clearing In the United States, the National Securities Clearing Corporation (NSCC, a division of the Depository Trust and Clearing Corporation) is the major clearing agent for equity markets. Its primary facility for clearing is the Securities Industry Automated Corporation (SIAC).

Clearing Process Confirmation is the first step of the clearing process. – Buyers and sellers record trade details. – Brokers and dealers receive confirmations that the trade has been executed and pass on details to clients. – The typical confirmation document received by the client reports the stock's name and CUSIP number (the security’s 9-character alpha-numeric identifier issued by the Committee on Uniform Security Identification Procedures), the number of units traded, the security price, the broker commission and other fees, along with trade and settlement dates. Trade comparison is the second step in the clearing process. – Comparison matches counterparties in transactions. – Trades are compared and are said to be cleared when the counterparties’ records are identical. – Out-trades in futures markets or DK’s (Don’t Knows) in other markets, which are trade reports with discrepancies. Netting is the simplification process used by clearing firms, which is the process of adding all of an institution’s purchases of each security, adding the sales of each security, deducting sells from buys to determine the net change in holdings of that security for the institution and computing the net cash flows associated with all transactions. The NSCC uses an automated system through the Securities Industry Automation Corporation (SIAC) to “net down” or reduce the number of trading obligations that require financial settlement. At the end of the netting process, the NSCC delivers to each brokerage firm settlement instructions.

Settlement Details Trade settlement occurs when buyers receive securities and sellers receive payment. The Depository Trust & Clearing Corporation (DTCC), holds stock certificates of member firms, registering them in member names. – As of year-end 2006, the DTCC was holding over 5.5 million stock certificates worth over $36 trillion and had processed over 8.5 billion transactions during the year. – The DTCC settled more than $1.48 quadrillion in securities transactions in 2009, including equities, fixed income instruments, mutual funds, insurance products, etc. Equity securities are held in street name, meaning that securities are held in the names of brokers, who, in turn, maintain their own records of ownership in client accounts. Settlement of a trade is completed when the DTCC transfers the ownership of the shares from the selling firm to the buying firm in its automated book-entry recordkeeping system and transfers money between firms with net credits and net debits. Federal law requires that settlement occur within three days after the transaction. The DTCC provides clearing services at low cost, averaging approximately $ per share. In the 1960s, clearing involved the physical transfer of paper securities and checks. The Depository Trust Corporation (DTC) was set up in 1973 to mechanize the clearing business for the major stock exchanges.

H. Markets around the World ExchangeUSD bill. Year end NYSE Euronext (US)13,394 2NASDAQ OMX (US) 3,889 3Tokyo Stock Exchange Group 3,828 4London Stock Exchange Group 3,613 5NYSE Euronext (Europe) 2,930 6Shanghai Stock Exchange 2,716 7Hong Kong Exchanges 2,711 8TMX Group (Toronto) 2,170 9Bombay SE 1,632 10National Stock Exchange India 1,597 Table 6: Major Exchanges of the World