Equity Markets: Trading, Structure, and Investment

Posted on Feb 21, 2025 in Business Administration and Management (BAM)

Equity: Definition and Shareholder Rights

Equity Definition (Equity = Ownership): Equity represents partial ownership in a company. As an equity owner, you share the risks and rewards of a company’s business.

Equity Introduction: When buying shares, equity shareholders acquire the following rights:

The right to vote on company strategy.
The right to receive a dividend (share of company profit).
The right of transmission (shares may be sold to someone else).
The right of subscription if new shares are issued.

Equity for Shareholders

Risks:

Company failure and bankruptcy: All bank debt, company bonds, corporate loans, pension liabilities (and a long list of etc.) are ahead of equity to be paid in company liquidation. If the company fails, you are likely to lose everything.
Volatility: Shares may never reflect the real value of a business. You may be right, but the market sets the value, and the market may remain wrong longer than you can remain solvent.

Rewards:

The upside for equity holders is literally unlimited, and capital appreciation can be many thousands of times your initial investment.

Equity for Issuers

Advantages:

It’s cheap: No dividend, no cost.
It’s forever: No payback, no redemption dates.

Disadvantages:

It could lose you your company (takeovers).
It’s dilutive: You must share future profits.
It’s transparent: Shareholders and the public will know everything about your company.

Enterprise Value: Market Capitalization + Debt = The Real Value of the Company

Equity Markets

The Equity Markets are the central marketplaces for the exchange and transmission of share ownership. They are supposed to provide:

Efficiency
Regulation
Vigilance
Accessibility

Equity Market: Meeting Place for Capital

Demand for Capital: New share issues (IPOs) or the sale of additional shares to raise capital. The market facilitates replacing the need for debt with the use of equity.

Supply of Capital: Savings and investments not destined for other asset classes.

An Institution for Channeling Investment:

Provides a regulated marketplace, governed by law.
Provides investor protection (as far as possible) via supervision of information and reporting.
Provides a liquid marketplace for capital allocation, allowing greater price-setting efficiency via the correct balance between supply and demand.
Provides a broad market for capital access, allowing investors to invest in assets that would otherwise be unavailable.

Exchange Structure

Exchange structures vary, but all are built around three main pillars:

Regulator – Usually state-owned and supervised.
Manager/Operator – Normally private.
Settlement/Clearing House – Private and often a subsidiary of the manager, or bank-sponsored.

The Regulator (SEC, FCA, CNMV)

Supervision and vigilance of the stock market.
Ensures transparency of information and correct price formation.
Investor protection.
Ensures all relevant legislation is adhered to.
Verification that all securities meet requirements to allow them to trade on the exchange.
Controls the process of takeovers.
Registers and makes public all relevant price-sensitive information.

The Manager/Operator (NYSE, NASDAQ, BME, EURONEXT)

Management of the electronic trading platform. Exchanges are now basically IT companies.
Responsibility for the publication of trading data and maintenance of the market database.
Assures the smooth running of daily trading activity.

The Clearing House (Euroclear, LCH, Iberclear)

Vital role in the management of the settlement and clearing process of stock exchange operations, matching share ownership changes with cash movements.
Payment against delivery: The exchange of share ownership is simultaneous with the exchange of cash.
Precise settlement calendar: Trading is settled two days after execution (T+2). Blockchain will allow instant settlement in the future.
Guaranteed delivery: The Clearing House must assure that buyers and sellers receive shares/cash in a timely manner. Stock lending is used to avoid failed trades. Penalties for non-delivery.

Equity Trading Venues

Trading takes place on:

Primary Market: Initial Public Offerings (IPOs) and capital raises from listed companies.
Secondary Markets: Trading of previously listed shares.
BMEGrowth (originally Mercado Alternativo Bursátil MAB): Small company listing.

Equity Trading Methods

Open Outcry Trading: The original, historic method of trading was present from the founding of the Bolsa de Madrid in 1831 until 2009. 10-minute sessions where buyers and sellers would shout out bid and offer positions until individual agreements were reached.
Still exists in limited markets, such as CBOT and CME commodity options (Chicago). But Equity trading is now nearly 100% electronic via SIBE and equivalent systems.

How Equity Trading Works

Markets are mainly “order-driven” – supply and demand set the price.

Specific stocks and markets still maintain “quote-driven”… a trader sets the price.

It is an open and semi-transparent marketplace, based on a rolling auction model.

It exists:

1. Price Priority: Best-priced orders (highest buys, lowest sales) have priority in the order book.

2. Timing Priority: When prices are the same, the earlier an order is entered into the order book, the higher position it will occupy.

Market orders will always be executed against the best available price on the other side.

Curbs exist to limit volatility and avoid stampedes in both directions.

Phases of Daily Trading

1. Pre-Opening and Opening Auction:

A 30-minute pre-opening period (8:30 – 9:00). Orders to buy and sell may be entered into the system until the official opening, where the equilibrium point of supply and demand is reached (where the greatest volume of buyers and sellers are in agreement). New orders may not be entered during the calculation period. The end of this “auction” has an aleatory end that may vary by up to 30 seconds to avoid price manipulation.

2. Opening Auction:

After matching auction orders at the equilibrium price, unmatched orders remain in the system and form the basis of the open session order book. The market is now open, and further orders may enter.

3. Open Market:

From 9:00 to 17:30 (11:30 – 17:30 for the LatIbex), the market is open, and orders may be entered, modified, or canceled. When buying and selling orders coincide at a determined price, the system matches the orders, and a trade occurs. Price is the first determining factor in the order queue, followed by timing if prices are the same. The order book is “semi-transparent”. All participants can see orders in the system, but not who is buying or selling. Additionally, brokers may hide the full quantity of interest, only revealing it as the order is progressively filled.

4. Market Close and Closing Auction:

Between 17:30 and 17:35, there is an additional closing auction that follows the same rules as the pre-opening. The resultant price of the closing auction is the closing price for each individual stock that day. The closing auction was established in 2000 to provide a fairer closing price-fixing mechanism. If less than 500 shares trade on the closing auction, the closing price of a stock will be the price traded that is closest to the weighted average of the last 500 shares traded in that session. If fewer than 500 shares trade in a day, the closing price remains that of the previous day.

5. Fixing System for Less Liquid Stocks:

To avoid a long session with little activity, smaller companies use the fixing system, which just uses two auctions:

First Auction: At 12:00, although orders can go into the book from 8:30.
Second Auction: At 16:00, with orders counting from the close of the first auction. The second auction price is used as the stock close for the day. The minimum volume for closing price setting in the fixing market is 200 shares.

6. Block Market:

This parallel market allows the crossing of especially large volume blocks of stock (“Put-throughs”), subject to minimum volumes.

All stocks that trade on the S.I.B.E. can be traded in this system as well. Trading hours for this system are from 9:00 am to 5:30 pm.

Minimum volumes range from €15,000 for illiquid stocks to €650,000 for the most liquid, with a sliding scale in between.

7. Special Operations Market:

Also known as the “After Hours market”, this exists so brokers can register special transactions, such as changes of ownership or new shares being issued. Transactions here must fulfill certain cash and price requirements. The special operations market is open from 5:40 pm to 8:00 pm.

Equity Listing: IPOs

IPO (Initial Public Offering): Public sale of shares in a company. Sale of existing shares, sale of new shares (to raise fresh capital), or a combination of the two.

Timing and Phases of an IPO

Communication to the Regulator and registry of the prospectus.
Management roadshow to explain the business to investors.
Indications of demand.
Price fixing.
Allocation of shares and likely pro-rata in function of demand.
Payment and settlement of IPO shares.

IPO Participants

Global Coordinator: Controlling bank/broker that sets supply and gauges demand. Responsible for price fixing and distribution of shares.
Managers & Co-Managers: Banks/brokers that organize marketing and sell the shares to their clients. Selected on corporate relationship and client types/geographies.
Underwriters: Will guarantee (for a fee) the success of the transaction by promising a minimum income to the issuing shareholder. Will buy any unsold shares directly.

Secondary Market Offerings & Rights Issues

Issue of new shares by a listed company by a similar process to an IPO.
Shares are typically discounted to attract demand and used to raise funds for new investment.
Existing shareholders receive preferential rights to buy new shares, and these rights may be traded separately.
Often done as ABB (Accelerated Book Build), as an after-market auction of new shares. Banks will normally underwrite part or all of the transaction.

Stock Splits and Reverse Splits

Stock Splits: Management may decide on a “Split” when the share value has risen so much as to make an individual share easier to buy. This makes NO difference to the value of the company, as the share price should adjust by the same multiple as the split.

Reverse Stock Splits (Contra-split): Shares in issue are reduced in the same way. This can happen when the share price has fallen to a very low number, especially after issuing large numbers of new shares (“dilution”). Again, there is NO change in the total value of the company.

Dividends and Buybacks

The two ways that companies can “pay” their shareholders.
The dividend is the part of a company’s profit that management decides to give out proportionally among all shareholders.
Two days before payment, shares trade EX the right to receive the dividend, and the share price adjusts down the equivalent amount.
Dividend payment is completely discretionary and subject to management policy, and it may be paid in cash or in new “bonus” shares in the company.

A buyback is also considered part of shareholder remuneration, as the company uses excess cash to buy shares and cancel them. It supports the share price and adds to the proportional amount of the company you own.

Short Selling

Designed to allow investors to make money when share prices decline, not rise.
Custodian banks “lend” shares to investors, principally hedge funds, for a rental fee.
Shares can then be sold in the market, with the hope that the share price will decline and can be bought back cheaper.
The short seller makes (or loses) on the price difference between the sale and repurchase. Borrowed shares are then returned.
Necessary tool of liquid markets or evil tool of speculation?

Index Definition

An indicator of equity market activity, both for the broad economy (country/regional level) and for determined sub-sectors (tech stocks, banks…).

Used for derivative contracts, trackers, and ETFs.

The key factor is for an index to show diversification, as it is the average activity of a group of component companies.

Bias to the upside is caused by the continued re-selection of “winners”.

Floating Capital = Shares open to free market transactions.
Captive Capital = Direct “permanent” holdings of greater than 5% of the company and shares owned by Board Members.

Spain: The IBEX 35

The IBEX 35 is the official index in Spain, composed of the 35 most liquid companies.

Formed in December 1989 (as the FIEX-35) with base 3000.

First real-time index as Indice General de la Bolsa de Madrid used closing prices.

Used as a base for expanding futures and options markets that need a market reference.

Takeover Bids

An offer directed to all shareholders by a potential purchaser to buy some or all shares in a company, with the purpose of reaching a significant position in the ownership of a company. Normally triggered at 30% ownership. This may be friendly (with the support of management) or hostile (against management wishes). May be cash, shares, or a mixture of both. The process may be contested, with various parties bidding at the same time. Management may search for a “White Knight” to counter a hostile approach, or even try to bid for the company making the approach (“Pacman defense”).

Algo Trading