Lecture Notes

Financial Products & Modeling

Topic 1
Financial Markets: Functions, Participants, and
Organization

Grigory Vilkov
Frankfurt School of Finance & Management
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Contents
1 Financial Markets: Functions, Participants, and Organization
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.1 Road Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1.2 Plan for the Day . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.1.3 Main Points for Today . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.1.4 Motivating Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.2 Overview of Finance and Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.3 Trading in the Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1.4 Organization of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.5 Regulation of Trading and Securities Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
1.6 Evolution of Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
1.7 OTC Markets: ISDA Master Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
1.8 Trading Gone Awry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
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1.1 Introduction
1.1.1 Road Map
• Financial Markets
? Functions, Participants, and Organization Topic# 1

? Instruments and Their Relevance Topic# 2

• Overview and Asset Pricing in Discrete Time

? Asset Pricing: Model-free Pricing by Replication
Forwards and Futures Topic# 3

? Asset Pricing in Discrete Time: Binomial Tree and its Limit

Options Topic# 4

• Fixed Income Securities

? Introduction to Fixed Income Securities Topic# 5

? Introduction to Swaps: Usage and Pricing Topic# 6

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1.1.2 Plan for the Day

Last Time
• Summer is behind us, so let’s work a bit!

Today
• Main question for the day: Financial Markets
? Trading: what is it and how it works?
? Market organizations: who trades and where?

For Next Time

• Please review the material covered in class.

• Please read the assigned material for the next time.

• Tufano cases: be ready to come forward and present!

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1.1.3 Main Points for Today

1. Trading in the financial markets: idea is simple, but execution...

2. Exchanges, OTC markets, users and service providers: lots of possibilities to

trade if you need to.

3. Financial markets should better be regulated.

4. OTC markets are on the way to being tightly regulated.

• ISDA Master Agreement is the major tool for risk management.
• Central clearing is the other one...

5. Awry trading happens, and needs to be monitored.

• There are lots of things that may go wrong.
• Authorities aim at improving monitoring and responsibility.
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1.1.4 Motivating Problems

Motivating Problem 1.1 (Trading/ risk management process)
You are working as a quant portfolio manager in a fund (RedRock), and you
control the MV portfolio subject to sector, industry risk limits. When you come
your office on November 6, 2017, a risk manager calls and claims that you are
over limit and that you have to sell 50,000 of TSLA right now. Choices?
• You call a trader to sell 50K of TSLA, the trader buys them at a market
price (usd 337.00), but keeps the stocks at her own position.

• You call a trader to sell 50K of TSLA, and she places an order in the trading
system; parts of the order are filled internally, parts are filled by an external
broker, and the remaining volume is filled on NASDAQ.

• You know that risk manager reacted to the downside exposure related to
a particular industry (auto manufacturers), and instead of selling the stock,
you place an order to buy 500 puts on TSLA with strike 300 and maturity
December 19, 2017.
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1. How does the risk profile of your MV portfolio change?

2. How does the risk profile of a fund change?

3. What would you prefer if you know that DB and Morgan Stanley have just
set a new target of usd 310 on TSLA?
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Space for your work.

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1.2 Overview of Finance and Financial Markets

1. Asset Pricing/Capital Markets

I How financial markets determine asset prices?

2. Corporate Finance

I How corporations make financial decisions?

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Financial Markets at Center of (our) Universe

• Financial Markets — where financial assets are traded
- Money markets: Debt securities with maturities up to 1-year
? Treasury bills, commercial paper
? Currencies, . . .

- Capital markets: Other securities

? Stocks
? Government debt (T-notes and T-bonds)
? Corporate debt, . . .

- Derivatives
? Options
? Forward and Futures, . . .
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Functions of Financial Markets

1. Allocating resources
• Transfer resources across time—using the loan market
• Transfer resources across different states of economy—via the market for
risky claims—and thus, improve risk-sharing.

2. Communicating information
• Market prices reflect available information.
Example. What is the best way to value a second-hand (used) gas
turbine?
? Approach 1: Estimate future cashflows; discount appropriately.
? Approach 2: View gas turbine as a real option.
? Approach 3: .........................................................................

What is our focus in this course?

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Implications of Market Efficiency

1. Trust market prices

• Buying and selling assets are zero NPV activities, giving only risk-adjusted
returns.
• Market prices give best estimate of value for projects.
• Firms receive “fair” value for securities they issue.

2. Read into prices

• If markets reflects all available information, we can extract information
from prices.
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3. There are no financial illusions

• Market price reflects value only from an asset’s payoff.
• It is not easy to trick the market.
• Value comes from economic rents such as
- superior information
- superior technology
- access to cheap resources, etc.
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Blank page
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1.3 Trading in the Financial Markets

Trading

1. A trade is a security transaction that creates or alters a portfolio position

based on an investment decision.

2. Trade decisions concern how to execute the investment decision:

• in which markets,
• at what prices,
• at what times,
• through which agents.
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3. Traders compete to generate profits, seeking compatible counterparties in

trade and seeking superior order placement and timing .

4. Trader types include:

• proprietary traders seek profits by trading on their own accounts,
• agency traders trade as commission brokers on behalf of clients,
• arbitrageurs focus on price discrepancies,
• hedgers who seek to control risk,
• dealers, who trade directly with clients,
• brokers who seek trade counterparties for clients;
...split into the two categories:
• buy side traders such as individual investors, mutual funds and pension
funds buy exchange or liquidity services.
• sell side traders such as day traders, market makers and brokers provide
liquidity and markets to buy side traders.
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5. Dealers maintain quotes:

• bid, which is solicitation to purchase,
• offer (ask), which is solicitation to sell,
• and the spread is simply the difference between the best offer and bid,
e.g., check out the the IB screen for SPY options:

? What is the quote for ATM call if current SPY level is 191?
? At what level can you sell? What is the bid-ask spread?

6. Function of a market is to bring together buyers and sellers for a trade

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Components of a trade

1. Acquisition of trade data: information and quotes.

• Quality information and transparency are crucial to price discovery.
• Transparent markets quickly disseminate high-quality information.
• Opaque markets are those that lack transparency.
? Where do you get up-to-date information?
? What markets would you prefer and why (or when)?
? What is asymmetric information?

2. Routing of the trade order.

• Selecting the broker(s) to handle the trade(s),
• Deciding which market(s) will execute the trade(s) and transmitting the
trade order(s) to the market(s).
? What are the factors affecting your decisions where to route the order?
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3. Execution.
• Buys are matched and executed against sells according to the rules of
the market.
? What’s your role in execution?

4. Confirmation, clearance and settlement.

• Clearance: recording and comparison of the trade records
• Settlement: the actual delivery of the security and/or net cash flow
payment.
• Might include trade allocation.
? ...lots of work, and all parts of it are important!
? Back-office, legal, risk management, ...
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Trade and other market data

1. Markets usually retain ownership of market data to sell to customers.
In fact, in recent years, the single largest source of revenue to the NYSE has
been from the sale of price, volume and quote data.
• Real time streaming quotes are provided via a direct connection to an
exchange, OTC or an electronic communications network (ECN) by means
of direct access software (DAS) through a broker and financial websites.
• Real time quotes are available to traders as quickly as they can be
transmitted; otherwise they are said to be delayed.
? In a trading environment where milliseconds ( 1013 sec) or even microsec-
onds ( 1016 sec) matter, what exactly is real time data?
• In theory, real time data displays exactly as quotes are placed and transac-
tions are executed. However, data cannot be made available to all traders
instantaneously.
• Traders compete to obtain data as quickly as possible and vendors compete
to provide it as quickly as possible.
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Three Seconds Has Become an Eternity in

the Chinese Stock Market
by Eduard Gismatullin
July 2, 2015 — 6:00 PM CEST
Updated on July 3, 2015 — 1:24 AM CEST

For international investors accustomed to speed, trading in Chinas stock market is like flying
blind. Thats because everybody who transacts on the Shanghai Stock Exchange gets price
updates just once every three seconds, or five seconds if they have a lower level of service.

While the gaps have gone largely unnoticed by individual investors who make up more than
80 percent of volume, theyre presenting a problem for overseas traders...

Lack of continuous pricing prevents investors from using strategies that rely on speed and
Investors look through stock information at a trading hall in a
precision, ... onAs
securities firm in Shanghai the
June 19, 2015.country seeks to raise the profile of its equity markets on the global stage

and gain
Photographer: acceptance
Pei Xin/Xinhua via Getty Imagesinto MSCI indexes, UBS Group AG says getting prices in three-second

snapshots
For internationalisinvestorsone of its biggest
accustomed to speed,concerns.
trading in China’s stock market is like flying blind.

That’s because everybody who transacts on the Shanghai Stock Exchange gets price updates just once every
three seconds, or five seconds if they have a lower level of service.

While the gaps have gone largely unnoticed by individual investors who make up more than 80 percent of
volume, they’re presenting a problem for overseas traders -- many of whom just recently gained access to
Chinese shares through the Shanghai-Hong Kong Exchange link.
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2. Real time quotations data is quite expensive... market data types include:

• Level I quote access displays inside quotes or BBO/NBBO and, in some

cases, quote sizes.

• Level II quotes display the same along with other quotes in descending
order for the best bids and ascending for the best offers along with market
symbols for each. Level II provides the order book and is necessary for
most trading strategies.
While most brokers provide only Level I real time quotes for free, as of 2011, ScottradeElite provides NASDAQ Level II and

NASDAQ TotalView Quotes for customers with at least 15 monthly trades while Just2Trade advertises free Level II quotes.

• Level III quotes, offered to Nasdaq members, provide direct access to

enter/revise quotes, allows trading with market makers on Nasdaq stocks.
Users can see the originators of available quotes.
Nasdaqs SuperMontage TotalView provides more detail on the depth of data than Level II, enabling traders to view market

makers’ quotes that are not as good as their best.

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BATS Level II Quotes, MSFT

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3. Other market data

• Bloomberg, which offers real time data and news and access to this data
through its Bloomberg terminals: data, news access, analytical tools, email
and trade processing systems.
• Thomson Reuters, FactSet Research Systems and Dow Jones...
• Less expensive quotations systems, such as eSignal and MetaStock offer
prices and quotes for as little as $100 per month. Many online brokers
(e.g., InteractiveBrokers) provide quotes and executions to traders, and
can be linked to spreadsheet trading platforms.
• For a significant fee, Dow Jones and Reuters can offer electronically
tagged news products that that can be picked up by computer algorithms
to trigger programmed trading decisions.
• Quandl is a new collection of databases with various APIs – very useful
and relatively cheap.
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Orders, liquidity, and depth

Orders: specific trade instructions placed with brokers by traders.
1. Market order: execute at the best price available in the market.

2. Limit order: an upper/lower price limit is placed for a buy/sell order.

3. Stop order: buy once the price is above a given level; or (or stop-loss) sell
once the price has fallen beneath a given level.

4. Day order: If not executed by the end of the day, this order is canceled.

5. Good till canceled order (GTC)

6. Not held order: broker not obliged to execute while trying to improve a price.

7. Fill or Kill: filled entirely immediately or canceled.

8. Immediate or Cancel: immediately executed to the extent possible.

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Liquidity: asset’s ability to be easily purchased or sold without causing signifi-

cant change in the price of the asset.
1. Black [1971] described liquidity as follows:
• There are always bid and asked prices for the investor who wants to buy
or sell small amounts of stock immediately.
• The bid-ask spread is always small.
• An investor trading a large position can expect to do so over a long period
of time at a price not very different from the current market price.
• An investor can buy or sell a large block of stock immediately, but at a
premium or discount that depends on the size of the block. The larger the
block, the larger the premium or discount.
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2. Kyle [1985] characterized three dimensions of liquidity:

• Width (also known as tightness): the bid-ask spread
• Depth: the markets ability to process and execute a large order without
substantially impacting its price.
• Slippage (also known as market impact, price impact or market resilience),
which indicates the speed with which the price pressure resulting from a
non-informative trade execution is dissipated (price returns to normal).
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Depth: size of an order needed to move the market price by a given amount
Monitor of the Market Depth

? What is the current bid and ask?

? What is the current bid-ask spread?
? What is the market depth for a limit buy order at 106.83?
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1.4 Organization of Financial Markets

Order: from transmitting to settlement

Note: instead of a broker there might be a DTA (direct trading access) platform
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Execution venues
1. Exchanges and Floor Markets
• Floor-based markets
• Virtual meeting sites provided by ECNs
? What is the largest exchange in the world?

2. OTC and ATS (alternative trading system) markets

• ECNs
• Dark Pools and “Crossing Networks”
• Internalization crossing
• Voice-brokered third-party matching

? What is the largest trading venue in the world?

Largest stock exchanges (2013) by value of electronic trading (in billion $)
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Largest derivatives exchanges (2015) by # (mln) of contracts traded

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Exchanges and floor markets

The Securities and Exchange Act of 1934 defined an exchange as any
organization, association, or group of persons, whether incorporated or unincor-
porated, which constitutes, maintains, or provides a market place or facilities
for bringing together purchasers and sellers of securities or for otherwise per-
forming 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.

Main function (in short...)

Provide for orderly, liquid and continuous markets.
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.

What is different from the next page...

Exchanges traditionally serve as self-regulatory organizations for their members, regulating and
policing their behavior with respect to a variety of rules and requirements.
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Over the Counter Markets and Alternative Trading Systems

1. OTC markets have traditionally been defined as the non-exchange markets.

2. ATS—securities trading venue not registered with the SEC as an exchange.

ATS means any organization, association, person, group of persons, or system:
That constitutes, maintains, or provides a market place or facilities for bring-
ing 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

That does not

• 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
• Discipline subscribers other than by exclusion from trading.
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ATS types

1. Electronic Communication Networks (ECNs), which are virtual meeting places

and screen-based systems for trading securities.

2. 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.

3. Internalization Crossing.
Note: Internalization of customer orders is not possible for options markets transactions due
to exchange rules.

4. Voice-Brokered Third-Party Matching.

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Execution structures

1. Quote-driven markets where dealers post quotes and participate on at least

one side of every trade; also called broker-dealer markets, Market Makers
(broker-dealers) trade securities on computer networks called dealer networks.
• Nasdaq (the only dealer-market in the USA with stock exchange status)
• OTC BB (OTC Bulletin Board)
• Pink Sheets (non-reporting companies, i.e., without current SEC filings)

2. Order-driven markets where traders can trade without the intermediation of

dealers (most exchanges).

3. Brokered markets where many blocks are broker-negotiated.

4. Hybrid markets have characteristics of more than one of the above.

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1.5 Regulation of Trading and Securities Markets

Background and Early Regulation
1. The primary purpose of government regulation of competitive markets is to
prevent market failure or collapse.

2. Proponents of regulation argue that financial markets, left unregulated, will

tend towards loss of competition, stability, efficiency and credibility...

3. Senator Edmund Muskie, in his 1970 introduction of what was to become

the Securities Investor Protection Act to the Senate stated:
“The economic function of the securities markets is to channel individual
institutional savings to private industry and thereby contribute to the growth
of capital investment. Without strong capital markets it would be difficult
for our national economy to sustain continued growth... Securities brokers
support the proper functioning of these markets by maintaining a constant
flow of debt and equity instruments. The continued financial wellbeing of
the economy thus depends, in part, on public willingness to entrust assets to
the securities industry.”
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Regulatory Approaches
...around the world can be strikingly different, despite the coordination efforts
of global organizations. Typically, some combination of two basic approaches:
Rules-based approach: authorities set forth specific and detail prescriptive
rules to which securities markets participants must adhere.

• Securities regulatory authorities taking this approach often focus on risk,

where the authority considers whether there is a potential market failure
that needs to be addressed and conducts an analysis to determine how to
address the problem given the constraint of limited resources.
• ...frequently implemented as a preventative mechanism.

Principles-based approach: authorities set forth a small number of reg-

ulatory objectives and principles, granting regulatory authorities and firm
operating and compliance officers more judgment in ensuring that policy
objectives are being fulfilled.
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Objectives of financial regulators (very roughly)

I Market confidence: to maintain confidence in the financial system.

I Financial stability: contributing to the protection and enhancement of

stability of the financial system.

I Consumer protection: securing the appropriate degree of protection for

consumers.

I Reduction of financial crime: reducing the extent to which it is possible

for a regulated business to be used for a purpose connected with financial
crime.
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Structure of supervision
Acts empower organizations, government or non-government, to monitor activi-
ties and enforce actions. There are various setups and combinations in place for
the financial regulatory structure around the globe. Main parts are as follows:

I Supervision of stock exchanges

Exchange acts ensure that trading on the exchanges is conducted in a proper
manner. Most prominent the pricing process, execution and settlement of
trades, direct and efficient trade monitoring.

I Supervision of listed companies

Financial regulators ensures that listed companies and market participants
comply with various regulations under the trading acts. The trading acts
demands that listed companies publish regular financial reports, ad hoc
notifications or directors’ dealings. The objective of monitoring compliance
by listed companies with their disclosure requirements is to ensure that
investors have access to essential and adequate information for making an
informed assessment of listed companies and their securities.
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I Supervision of investment management

Asset management supervision or investment acts ensures the frictionless
operation of those vehicles.

I Supervision of banks and financial services providers

Banking acts lays down rules for banks which they have to observe when they
are being established and when they are carrying on their business. These
rules are designed to prevent unwelcome developments that might disrupt
the smooth functioning of the banking system. Thus ensuring a strong and
efficient banking system.
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Major authorities around the world

I United States
U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA)
Commodity Futures Trading Commission (CFTC)
Federal Reserve System (”Fed”)
Federal Deposit Insurance Corporation (FDIC)
Office of the Comptroller of the Currency (OCC), National Credit Union Administration
(NCUA), Office of Thrift Supervision (OTS), Consumer Financial Protection Bureau (CFPB)

I United Kingdom
Financial Conduct Authority (FCA)
Prudential Regulation Authority (PRA)

I Japan: Financial Services Agency (FSA)

I Germany: Federal Financial Supervisory Authority (BaFin)

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1.6 Evolution of Regulation

just for general information!
1. In 1285, broker licensure was instituted after the finding that English brokers
provided less satisfactory service than their Italian counterparts.

2. The Brokers Act of 1696 required stock brokers to be licensed and limited
the number of these licenses to 100.

3. The 1720 Bubble Act passed in Britain provided for the issuance of security
prospectuses and prohibited certain types of trading fraud, but was ultimately
repealed in 1825.

4. The Companies Act of 1844 provided once again for company issuances
of prospectuses, and the Companies Act of 1867 along with subsequent
legislation provided for specific details in those prospectuses.
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5. This 19th century British legislation, based largely on full disclosure of

material information, served as an important conceptual foundation to 1930s
U.S. securities legislation.
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Early U.S. Securities Legislation

Securities legislation activity in the U.S. was very slow to start...

1. Massachusetts enacted one of the earliest securities regulations in 1852,

requiring railroad companies to certify that responsible parties had subscribed
to their stock.

2. The Constitution of the State of California signed in 1879 prohibited the sale
of stock on margin. Why would they do that, I wonder?

3. At the Federal level, Congress passed and then quickly repealed the Anti-Gold
Futures Act of 1864, restricting trading in gold and exchange contracts.

4. Congress attempted to regulate agricultural futures trading with the Future

Trading Act of 1921, but this Act was found by the U.S. Supreme Court to
be unconstitutional.
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5. In the early 1900s, several states passed limited legislation to regulate

securities markets. These earlier laws sought to prevent issuance of securities
that were considered to be unfair or did not promise a “fair return”.
Securities were potentially subject to merit tests.
What is your opinion on “fairness” of a security and/or its return?
• For example, in response to numerous incidents of brokers having sold
worthless securities of sham companies, Kansas enacted a securities law in
1911 requiring registration of brokers and securities.
• These worthless securities were said to be backed by “nothing but the blue
skies of Kansas.”
• This state legislation was considered to be the first of the state Blue Sky
Laws intended to regulate securities markets.

Prior to the 1930’s, most regulation of U.S. securities markets were provided
by these so-called Blue Sky Laws.
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U.S. Securities Market Legislation: The Foundation

1. Beginning in the 1930s, a series of regulatory acts were proposed to prevent

or mitigate market failures such as the Great Crash of 1929.

2. Such sweeping legislation was made possible, in part due to overwhelming

Democratic majorities having been elected to both houses of Congress and
the election of President Roosevelt in 1932.

3. 25 days after his inauguration in 1933, President Roosevelt asked Congress

for a new law that would “put the burden of telling the whole truth on
the seller” of securities, and, referring to the caveat emptor rule 1 generally
preferred in business circles, added: “Let the seller also beware.”

4. Business leaders were in poor position to effectively protest this imposition

of regulation at the height of the Great Depression.
1 Under the principle of caveat emptor, the buyer could not recover damages from the seller for defects on the property that rendered
the property unfit for ordinary purposes. The only exception was if the seller actively concealed latent defects or otherwise made material
misrepresentations amounting to fraud.
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The Securities Act of 1933

1. The Securities Act of 1933 is sometimes called the Truth in Securities Law

2. Deals primarily with new issues of securities.

• The Act requires that issuers and underwriters provide financial and other
significant information concerning securities offered for public sale.
• The Act prohibits deceit, misrepresentations, and other fraud in the sale
of securities.
• Unlike most of the ”Blue Skies Laws” that focused on the merits of secu-
rities, the Securities Act focused on making reliable information available
to prospective investors in securities.
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3. Its major provisions are as follows:

• All primary issues must be registered with an appropriate government
agency (later to be the Securities Exchange Commission or S.E.C.).
• The registration will include proper statements and documentation.
• A prospectus must accompany each new issue. This prospectus must
contain a complete and accurate accounting of the firm’s condition, risks
and prospects and state how the proceeds of the new issue will be used.
• Small and private issues are exempt from the registration provisions.
In addition, a more recently (1982) instituted S.E.C. Rule 415 (shelf
registration) allows up two years for securities to actually be issued after
completing the S.E.C. registration process.
• Firms, officers of firms and underwriters are prohibited from making false
statements regarding their new issues, and may be criminally liable for
doing so.
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The Securities Exchange Act of 1934

1. The Securities Exchange Act of 1934 was primarily intended to improve

information availability and to prevent price manipulation.

2. Whereas the Securities Act of 1933 dealt mainly with primary issues, the
Securities Exchange Act of 1934 dealt mainly with secondary markets:
• Established the S.E.C. as the primary federal securities regulatory authority
• Provided for annual and other periodic reporting by public companies
• Limited insider trading activity
• Provided rules for proxy solicitation
• Required registration of exchanges
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• Provided for credit regulation:

I Regulations T (for brokerage firms) and U (for non-broker lenders)
permit the Board of Governors of the Federal Reserve to set margin
requirements.
I Since 1974, investors have been required to post 50% margin (deposit
or collateral) when purchasing stock on margin.
FINRA Rule 2520 permits pattern day traders 25% initial margin re-
quirements (subject to a $25,000 account equity balance).
• Subjected institutions to the Net Capital Rule, imposing limits on broker-
dealer debt-to-net capital ratios.
Certain exceptions were made in 2004 to five of the largest institutions, all of which were
bankrupted, merged or otherwise suffered significant financial distress in the financial
market crisis of 2008.

• Prohibited securities price manipulation

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Additional Major Depression-Era Legislation

1. The Banking Acts of 1933 (Glass Steagall) was motivated by the failure of
thousands of banks. Glass Steagall sought to restore faith in the banking
system and prevent a similar crisis. There were 3 main features:
• FDIC was created to provide federal insurance on bank deposits (subject
to a current $250,000 ceiling).
• It imposed restrictions on the activities of commercial banks (Chinese
Wall). It prevented commercial banks from underwriting securities, to
trade with the public (excepting certain U.S. government and municipal
bonds and real estate loans) and owning risky securities. Much of this
provision was relaxed by court decisions, regulators and the Gramm-Leach-
Bliley Act of 1999.
• The Act placed regulations on bank interest rates (Reg Q), though most
of these provisions were relaxed in the 1980s.
 Page 53 of Topic 1

2. The Commodity Exchange Act of 1936 provided for regulation of commodities

and futures trading markets by the Department of Agriculture and required
all futures and commodity options to be traded on organized exchanges.

3. The Maloney Act of 1938 provided for the self-regulation of the Over the
Counter markets, leading to the establishment of the National Association
of Securities Dealers (N.A.S.D., which merged into FINRA approximately 70
years later).

4. The Trust Indenture Act of 1939 provided that issuers of bonds must
clearly specify purchaser rights in a trust indenture, provide bond trustees
with periodic financial reports, and that the trustee not impair its right or
willingness to sue the issuing corporation.

5. The Investment Companies Act of 1940 extended the Securities Act and the
Securities and Exchange Act to investment companies such as mutual funds.
This Act provided that investment companies must:
• avoid fraudulent practices
 Page 54 of Topic 1

• fully disclose financial statements

• distribute prospectuses
• publish statements outlining goals, which will not be changed without
appropriate process
• limit issuance of debt
• follow uniform accounting procedures
• operate the fund to benefit its owners, not managers.

6. The Investment Advisers Act of 1940 requires advisors and certain investment
institutions who provide clients with paid investment advice to register with
the S.E.C.
 Page 55 of Topic 1

Deregulation

I Wendy Gramm (wife of Senator Gramm), as Chair of the CFTC, in 1989 and
1993 exempted a number of swaps and derivatives from regulation.

I These exemptions were broadened by the Gramm-Leach-Bliley Act.

I The Federal Reserve Board reinterpreted the Glass-Steagall Act several times
during the 1980s and 90s so as to ultimately permit bank holding companies
to earn up 25% of their revenues from investment banking activities.

I The Financial Modernization Act of 1999, also known as the Gramm-

Leach-Bliley Act contributed to the consolidation of the financial services
industries, allowing for the formation of “mega-banks.”

I The Commodity Futures Modernization Act of 2000 exempted most OTC

non-agricultural derivatives and transactions between sophisticated parties
from regulation under the Commodity Exchange Act (CEA) or as securities
under other federal securities laws.
 Page 56 of Topic 1

What do you think the result of deregulation was?

 Page 57 of Topic 1

Sarbanes-Oxley (SOX)
1. The Sarbanes-Oxley Act of 2002 (SOX) was enacted after a wave of corporate
scandals (Enron, WorldCom, etc.) in the late 1990’s and early 2000’s.

2. SOX, also known as the Corporate and Criminal Fraud Accountability Act
was passed to provide for accounting reform, improved financial reporting,
reduced conflicts of interest and increased penalties for securities fraud.
• Creation of a five-member Public Company Accounting Oversight Board
(PCAOB) to oversee public auditing firm practices.
• Restricting public accounting firms from providing non-auditing services
contemporaneously with auditing services to prevent certain conflicts of
interest.
• Prohibitions of share trading by officers and directors during certain
“blackout” periods.
• Requirement that firms to disclose material off-balance sheet transactions
and relationships.
 Page 58 of Topic 1

Financial crisis and post-SOX regulation

...it started in the summer 2007..

I Increasing reports of troubled mortgages and weakening of the securitized

assets and portfolios that contained them...

I March 2008: Bear Stearns

I September 2008: Freddie Mac and Fannie Mae placed under U.S. government
conservatorship,

I Lehman Brothers filed for Chapter 11 bankruptcy protection

I The U.S. entered its worst recession since the Great Depression
 Page 59 of Topic 1

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

1. The most significant piece of securities legislation passed since the 1930s...

2. Responding to the Financial Crisis of 2007-09, Congress passed major reform

intended to:
• promote the financial stability of the United States by improving account-
ability and transparency in the financial system
• to end “too big to fail”
• to protect the American taxpayer by ending bailouts
• to protect consumers from abusive financial services practices.

3. This 848 page act was intended to promote financial stability and consumer
protection, and extended well beyond securities trading. Among the important
reforms affecting traders are:
• Providing new rules for transparency, independence and accountability for
credit rating agencies
 Page 60 of Topic 1

• Providing for the Volcker Rule, regulating and limiting banks, their affiliates
and non-bank financial institutions supervised by the Fed with respect to
proprietary trading, investment in and sponsorship of hedge funds and
private equity funds.
• Authorizing the Federal Reserve Board or FSOC to supervise activities of
clearing agents
• Providing for regulatory authority over swaps between the SEC (security-
based swaps) and the CFTS (all other swaps).
Rather than mandate that all swap contracts be traded on exchanges, Dodd-Frank
provided for the creation of a swap execution facility (SEF), specifically designed to
provide for trade transparency, encourage competitive execution, and ensure a complete
record and audit trail of trades, all designed to enhance swaps markets.

• Requiring companies selling credit and mortgage-backed products to retain

at least 5% of the instruments credit risk unless the underlying loans meet
certain standards that reduce risk
 Page 61 of Topic 1

I Some new developments: Commodity business (2014) – what is coming?

 Page 62 of Topic 1

I ...in 2016 [September 23, 2016 – 6:00 PM CEST Updated on September 23, 2016 – 11:12 PM CEST]:

Goldman Sachs Group Inc.’s and Morgan Stanley’s sometimes lucrative

romance with metals, coal and oil could become prohibitively expensive
under a proposed rule released Friday [September 23, 2016] by the Federal
Reserve.
The long-awaited regulation would require banks to put up much more capital
to support investments in physical commodities, restrict involvement with
power plants and limit the amount of trading banks can do.
Meanwhile, banks that were once big players in physical commodities have
shied away. Morgan Stanley sold off its oil business last year and backed away
from industrial metals trading, and JPMorgan shed a big part of its physical
commodities business in 2014. While Goldman Sachs dumped a coal-mining
operation in 2015, Chief Executive Officer Lloyd Blankfein has maintained
that commodities trading is a “core” part of his firm’s business.
 Page 63 of Topic 1

1.7 OTC Markets: ISDA Master Agreement

I ISDA: International Swaps and Derivatives Association

OTC markets: remember, how big they are?

I at the end of 2017 the notional amount outstanding in global OTC derivatives
markets was usd 532 trillion, as compared to

I the gross market value of OTC derivatives valued at usd 11 trillion.

? What is the market cap of the US equity market (about 21 trillion)?
 Page 64 of Topic 1

OTC vs exchange-traded derivatives: what’s the main difference?

I exchange-traded derivatives: trading is publicly facilitated by a recognized

investment exchange (CME, etc), transactions are highly standardized

I OTC derivatives: transactions are typically carried out on a bilateral basis

between two counterparties!! transactions are highly customized

Hence, each counterparty has to carry out its own risk management due
diligence on the other counterparty with which it is trading with:
• investigations into the counterparty’s credit ratings,
• its creditworthiness,
• its operating structure,
• its firm capitalization,
• ...
 Page 65 of Topic 1

Risk management techniques in OTC derivatives transactions

1. Setting credit limits for counterparties.

2. Financial guarantees.

3. Collateralization.
The number of active collateral agreements (with exposure or collateral balances) supporting
non-cleared OTC derivatives transactions was 136,936 at end-2014.

4. Margin.
According to ISDA’s latest ’Margin Survey’, the amount of collateral in the global non-cleared
OTC derivatives market was usd 5 trillion as at 31 December 2014.

5. Legal protection through bilateral documentation.

6. NEW: Centralized clearing

 Page 66 of Topic 1

ISDA Master Agreement: what is it?

...the most commonly used master service agreement for OTC derivative trans-
actions internationally.

I Forms a framework that consists of (i) a master agreement, (ii) a schedule,

(iii) confirmations, (iv) definition booklets, and (v) a credit support annex.
ISDA master agreement is published by ISDA (web link). See sample docs!

I Master agreement is combined with a Schedule to set out the basic trading
terms between the parties; each subsequent trade is then recorded in a
Confirmation which references the Master Agreement and Schedule.

I Single agreement
All transactions are entered into in reliance on the fact that this Master Agreement and all
Confirmations form a single agreement between the parties ... and the parties would not
otherwise enter into any Transactions.

This single agreement concept is integral to the structure and forms

part of the netting based protection offered by the master agreement. All
 Page 67 of Topic 1

transactions are the one contract reinforces the ability to close out those
transactions and get a single net amount payable if a default occurs.

I Events of default and termination events

These are events which can lead to termination of transactions before their intended maturity.

NEW YORK–The International Swaps and Derivatives Association ruled Friday that sellers of credit default swaps tied to Argentine
sovereign debt must pay buyers, judging the nation’s failure to pay bondholders Wednesday a credit event.

There are $20.7 billion of Argentine sovereign CDS outstanding, according to the latest figures from the Depository Trust &
Clearing Corp., but at most $1.04 billion stands to change hands as a result of the ruling, the data show. Information on who
has bought and sold the derivatives isn’t public. The swaps are contracts that oblige the seller to pay the buyer under certain
predetermined circumstances.

ISDA said in a statement Friday that it would hold an auction to determine the size of the payout, though it didn’t say when.
 Page 68 of Topic 1

Argentina defaulted Wednesday for the second time in 13 years after last-ditch talks with creditors failed before the country was
scheduled to pay interest on its bonds.

The ISDA didn’t immediately detail the reasoning backing up the panel’s unanimous decision, but Argentina’s bond documents

say that the country can only be considered to have satisfied its obligations once bondholders get the money they are owed. While

Argentina had deposited money with an intermediary, that money had not reached holders, thanks to a U.S. court ruling.

ISDA has five Determinations Committees, each having jurisdiction over a specific region of
the world (the Americas, Asia excluding Japan, Australia/New Zealand, EMEA and Japan).
The committees make official, binding determinations regarding the existence of ”credit
events”, which may trigger obligations under a CDS.

I Close out and netting

...contains the provisions which enable a party to terminate transactions early if an Event
of Default or Termination Event occurs and set out the procedure to calculate and net the
termination values of transactions to produce a single amount payable between the parties.

I Multi-branch issues
...addresses issues that arise in connection with counterparties that enter into transactions
through more than one office or branch and more than one jurisdiction.
 Page 69 of Topic 1

Milesstones

I 1987: ISDA published two standard “Master Swap Agreements” and a set
of definitions, which aimed to document, simplify, and standardize “swap”
agreements between two counterparties
(i) Interest Rate and Currency Exchange Agreement (THE 1987 ISDA Master Agreement),
(ii) Interest Rate Swap Agreement, and (iii) the interest rate and currency definitions.

I 1990s: two ISDA Master Agreements: (i) Local Currency Single Jurisdiction
and (ii) Multicurrency Cross Border : THE 1992 Master Agreement, (iii)
a revised version of the Swaps Code, known as the 1991 ISDA Definitions,
(iv) commodities derivatives definitions, and (v) the Annex with collateral
documentation, (vi) 1999 Credit Derivatives Definitions with basic definitions
for credit default swaps, total return swaps, credit linked notes and other credit
derivative transactions.. equity and plenty other derivatives definitions...

I 2000s: 2002 ISDA Master Agreement responds to market difficulties in

the late 1990s,‘ 2003 Credit Derivatives Definitions, replaced by 2014 ISDA
Credit Derivatives Definitions (went live 22/09/2014).
 Page 70 of Topic 1

New in the OTC derivatives regulation

I Dodd-Frank Wall Street Reform and Consumer Protection Act 2010

I European Market and Infrastructure Regulation (the EMIR)

require centralized clearing of OTC derivatives by centralized counterparties!
? Swap Execution Facility (SEF): regulated platform for swap trading
that provides pre-trade information (bids and offers) and an execution
mechanism for swap transactions among eligible participants
? Certain swaps (equity swaps and credit-default swaps) are now mandatory
to trade on SEFs as of 15/02/2014
? If a swap is executed on a SEF, the SEF must provide written confirmation
of the terms to each counterparty!
? Bloomberg is the first who has received approval from CFTC to operate a
multi-asset SEF and SDR (Swap Data Repository), CME, Reuters, etc...
Does it kill ISDA or make it stronger?
 Page 71 of Topic 1

1.8 Trading Gone Awry

Lots of things may go wrong when one has access to BIG money
I Illegal Insider Trading

I Front Running and Late Trading

I Bluffing, Spoofing and Market Manipulation

I Payment for Order Flow

I Fat Fingers, Hot Potatoes and Technical Glitches

I Rogue Trading and Rogue Traders

I Trading and Ponzi Schemes

 Page 72 of Topic 1

Illegal Insider Trading

Traditionally defined as the execution of transactions on the basis of material

non-public information.

I Possession of material nonpublic information;

I Trading while in possession of that non-public information;

I Violation of a relationship of trust and confidence

The Insider Trading Sanctions Act of 1984 authorized penalties for illegal insider
trading equal to 3x the illegally obtained profits plus forfeiture of the profits.
 Page 73 of Topic 1

Monitoring Inside Trading Activity (how would you do it?)

• Successful insider trading prosecutions usually require cooperation from code-
fendants or damaging information concerning other illegal behavior (such as
tax evasion).

• Surveillance techniques have improved significantly. The SEC, all of the

major markets and companies themselves are purchasing software systems to
monitor for illicit activity.

• The SEC uses more resources to monitor insider activity: formation of special
surveillance teams, wire tapping and payments of bounty to informants.

• The SEC currently contends with ≈700,000 tips per year from informants.

• Markets such as the NYSE, Nasdaq and CBOE are making greater use of
technology to monitor trading activity for suspicious activity. FINRA has
been using an intelligent surveillance application known as the Securities
Observation, News Analysis and Regulation (SONAR) system to detect
suspicious patterns. Regardless, insider trading enforcement remains difficult.
 Page 74 of Topic 1

Front Running and Late Trading

• Front Running occurs when a broker uses his knowledge of a large pending
order to buy (sell) the relevant security in front of the pending buy (sell)
order so as to benefit from the market reaction to the large order.

In one front-running scandal, the U.S. Attorney’s Office and the SEC accused brokers
from Merrill Lynch of allowing certain clients to listen to conversations involving other
clients through broadcasts on Merrill Lynch internal speaker systems. In this “Squawk Box
Scandal,” some clients were privy in advance to other clients trades.

• A similar, often legal, but frequently unethical practice is tailgating, a form

of parasitic trading where the broker places an order immediately after the
clients order.

• Another type of ethically questionable parasitic order is penny-jumping,

where the broker places a buy (sell) order one uptick above (downtick below)
below the clients buy (sell) limit order.
 Page 75 of Topic 1

Bluffing, Spoofing and Market Manipulation

• Bluffing is the act of fooling other traders into making unwise trades by
convincing them that the bluffer has superior material information about
security values.
? There are a number of ways that traders bluff, both legal and illegal. A
trader can bluff the market by placing a bid or offer at a price or in a
quantity that exaggerates his or her own true position, interest or lack of
interest in a security. For example, a bluffer might place a particularly
attractive offer for a small quantity of shares, intending then to sell a much
larger quantity of shares after a positive price response to the initial offer.
? As long as such orders are executed, they are usually perfectly legal.

• Spoofing is the act of placing a quote that is intended to be canceled prior

to its execution. Spoofing might be considered a form of bluffing where the
trader places a trade that she has no intent to execute.
 Page 76 of Topic 1

Mystery Trader Armed With Algorithms

Rewrites Flash Crash Story
by Silla Brush and Tom Schoenberg
4:52 AM CEST April 22, 2015

Navinder Singh Sarao was as anonymous as they come – little more than a day trader by
the standards of the Street. But 5 years ago [May 6, 2010, the day of the flash crash],
U.S. authorities now say, Sarao helped send the DJ30 on the wild, 1,000-point ride...he was
responsible for a stunning one out of five sell orders during the frenzy...

On May 6, 2010, CME sent Sarao a message. All orders to CMEs electronic exchange
were to be entered in good faith for the purpose of executing bona fide transactions That
same day, Sarao and his firm used layering and spoofing algorithms to trade thousands of
Photographer: Jin Lee/Bloomberg
futures S&P 500 E-mini. The orders amounted to $200 mio worth of bets that the market
From a modest stucco house in suburban west London, where jetliners roar overhead on their approach to
would fall, i.e., between 20 percent and 29 percent of all sell orders at the time. The orders
Heathrow Airport, a small-time trader was about to play a hand in one of the most harrowing moments in Wall
were then replaced or modified 19,000 times before being canceled in the afternoon. The
Street history.

imbalance
Navinder Singhon thewasexchange
Sarao due
as anonymous to come
as they Saraos orders
-- little contributed
more than a day trader byto
the market conditions
standards of the that saw
Street.
the derivatives contract plunge and later also the stock market, according to the CFTC.
But on that spring day five years ago, U.S. authorities now say, Sarao helped send the Dow Jones Industrial
Average on the wild, 1,000-point ride that the world came to know as the flash crash. By regulators’ account, he
was responsible for a stunning one out of five sell orders during the frenzy. On Tuesday, he was arrested by
Scotland Yard and charged in the U.S. with 22 criminal counts, including fraud and market manipulation.
 Page 77 of Topic 1

Sarao, 37, extradited from the U.K. two days ago, pleaded guilty to spoofing and wire fraud
Wednesday in Chicago federal court and agreed to forfeit $12.9 million in ill-earned gains
from his trades. He was accused of making $40 million spoofing CME Group Inc.’s stock
futures market over five years, including on May 6, 2010, when a trading frenzy briefly wiped
almost $1 trillion from the value of American equities.
 Page 78 of Topic 1

• Corners involve the purchase a sufficient level of a given security to obtain

market power over its price. The purpose is to manipulate the market.
? The Hunt brothers (Nelson and Lamar), two of the then wealthiest men
in the world, attempted to corner silver markets in the early 1980s.
? Although they succeeded in bidding up the price of silver almost ten-fold,
the bottom fell out of the market before they could unload.
? They nearly went bankrupt.
? What is the market short/long squeeze?

No bidder was permitted to bid for or obtain 35% or more of a given Treasury issue. In
1991, Salomon Brothers routinely bidded on more than 35% of issues, illegally bidding on
as much as 105% of certain new issues. To conceal their actions, many bids were parked
under names of clients. Such overbidding enabled Salomon to corner the market and fix
prices for new two-year treasuries.
 Page 79 of Topic 1

• A Pool is a common fund comprising participants combining their resources

to obtain a large position in a security in order to manipulate its price. Pools
are typically used to facilitate cornering of a market, and were a common
activity prior to the 1929 stock market crash.

• Wash sales are sham transactions intended to create the appearance of sales
where, in effect, no sales actually take place. The SEC defines a wash sale
as a transaction that involves no change in beneficial ownership.

• Predatory algo trading strategies are designed to exploit other institutional

algo orders.

? Suppose the predatory trader detects an institutional algo order to buy a

large number of shares

? These shares are offered at 50.00, and the predatory trader suspects that
the institution has pegged its order to the NBBO and is willing to pay as
much as 50.25 per share.
 Page 80 of Topic 1

? The predatory algo can seek to lock in a profit by artificially increasing

the share price. Upon detection of this institutional order, the predatory
trader places a small bid of 50.01, then continues placing small bids at
successively higher figures as the institutional algo trader increases its bid
with the NBBO.
? Ultimately, the predatory places a short sell order at 50.25, knowing that
it created much of the apparent demand running the price up to 50.25.
? When the price falls, the predatory algo covers its short position.
 Page 81 of Topic 1

Payment for Order Flow

• Many exchanges and markets will provide rebates on orders that create
liquidity, which essentially represents payment for order flow.

• Such payments and rebating for order flow might lead to market abuses,
reduce price competition for securities and reduce security price transparency.
Some observers argue that the customer may lose the opportunity to obtain
an unannounced better price from a broker on the national exchange floor.

• The SEC adopted Exchange Act Rule 11Ac1-6 (now SEC Rule 606), requiring
broker-dealers to make available quarterly reports that present a general
overview of their routing practices.
 Page 82 of Topic 1

Fat Fingers, Hot Potatoes and Technical Glitches

I A trader at Bear Stearns caused a 100-point drop in the Dow after inad-
vertently entering a $4 billion sell instead of his intended $4 million buy
order.

I Morgan Stanley made a similar mistake with a 2004 order for $10.8 billion
rather than the intended $10.8 million.

I Washington Post Co. dropped by 99% in less than one second on June 16,
2010 on NYSE Arca and Progress Energy Inc. increased by 90% in less than
one second on September 27, 2010 on NASDAQ.

I Nikkei 225 futures contracts dropped by 1.1% on June 1, 2010 as a result of

an unintentional algo-order placed on the Osaka Stock Exchange.

I Each of these occurrences illustrates the need (and failures) for effective
trade filters, even in the absence of automatic algo executions.
 Page 83 of Topic 1

On May 6, 2010, the ”Flash Crash, often been blamed on High Frequency
Trading caused the DJIA to drop almost 1,000 points in less than 30 minutes.
? Trades were executed at absurd prices, ranging from less than one cent to
over $100,000.
? Exchanges ultimately canceled over 20,000 executions.
? An SEC report noted that the crash was preceded by a rapid algo-initiated
short, reportedly by mutual fund group Waddell & Reed (not an HFT), of
a $4.1 billion block of E-Mini S&P 500 futures contracts on CME.
? However, HFT firms apparently were counterparties to these shorts, and
immediately covered themselves by further shorting (turning the contracts
into hot potatoes), drying up liquidity in these markets.
? Within 20 minutes of the start of the ”crash,” trading in the E-mini
contract was halted for five seconds, which allowed the market to recover.
? When trading resumed, prices quickly recovered most of their losses.
 Page 84 of Topic 1

Rogue Trading and Rogue Traders

• Rogue trading is systematic unauthorized trading, trading with unapproved
counterparties or trading with unapproved products. Rogue trading normally
is exceeding risk limits and/or loss limits and is accompanied by efforts to
conceal unauthorized actions.
? Nick Leeson, chief derivatives trader at Barings’ Singapore office, single-
handedly brought down the centuries-old Barings Bank.
? In 2008, Jerome Kerviel of SocGen confessed to a eur 4.9 billion fraud
where he misappropriated computer access codes and falsified documents.
? ...list goes on..forever:)
 Page 85 of Topic 1

Trading and Ponzi Schemes

• Ponzi schemes are not trading schemes. However, Ponzi schemes have been
used by rogue traders to mask illegal or unprofitable trading activity.

• In 2007, one of the most respected members of the Wall Street community,
Bernard Madoff revealed to his son that his investment firm, Madoff Securities
was a Ponzi scheme.
? This meant that the Madoff lost or pocketed clients’ money, and when
asked or forced to meet client obligations, used funds raised from other
clients to meet these obligations.
? Madoff pleaded guilty to 11 counts of securities fraud on March 12, 2009.
? Previously, Madoff had maintained a highly successful trading and market-
making business, accounting for as much of 12% of Nasdaq volume.
? He was an active securities market regulator, having served on the
NASD and NASDAQ boards during much of the 1980s, and had
even served in 1990-91 as Chairman of the Board of Nasdaq.
 Page 86 of Topic 1

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