Over-the-counter Market

The Treasury sells newly issued notes at auction to primary dealers and other bidders. In which market does that sale occur, and who receives the money?

1. A.The secondary market, and the proceeds go to the Federal Reserve.Wrong. Newly created securities are never a secondary transaction, and the Fed is not the seller in an auction.
2. B.The primary market, and the proceeds go to the Treasury.Correct. The notes are newly issued and the government receives the money it is borrowing.
3. C.The secondary market, and the proceeds go to the dealers who resell the notes.Wrong. Dealers pay for the notes at auction and earn their return by reselling them afterward.
4. D.The primary market, and the proceeds go to the dealers as underwriting compensation.Wrong. There is no underwriting spread in an auction, since bidders buy at the price their own bids establish.

Why: An auction of new Treasury securities is the government's primary market: the securities did not exist before, and the cash raised funds federal borrowing. Once bidders own the notes they resell them to investors, and every one of those later trades is a secondary transaction in which the Treasury receives nothing. The two markets serve different purposes, one raising capital and the other providing liquidity and continuous pricing. The same division applies to corporate bonds sold through a syndicate and then traded over the counter.

A customer places an order in an over-the-counter stock, and her firm fills it from the firm's own inventory rather than locating another customer. How is the firm acting, and how is it compensated?

1. A.As an agent, and it charges a commission for arranging the transaction.Wrong. An agent arranges a trade between other parties, and this firm supplied the shares itself.
2. B.As an agent, and it charges a markup added to the prevailing market price.Wrong. The capacity named is wrong, and a markup is by definition how a principal is compensated.
3. C.As a principal, and it charges a commission for locating the shares.Wrong. The capacity is right, but commissions belong to agency trades rather than to sales from inventory.
4. D.As a principal, and its compensation is built into the price as a markup.Correct. A dealer selling from inventory takes the other side and earns the difference between its cost and the price charged.

Why: A firm acts as an agent, or broker, when it arranges a transaction between a customer and someone else, and it is paid a commission disclosed as a separate charge. It acts as a principal, or dealer, when it buys from or sells to the customer out of its own account, and its compensation is embedded in the price as a markup or markdown. Which capacity applied must be disclosed on the confirmation, because the two are compensated differently and carry different obligations. A firm may not charge both a commission and a markup on the same side of the same trade.

Two orders in the same stock are executed, one on an exchange and one through a dealer's over-the-counter desk. What distinguishes how the price was determined in each case?

1. A.The exchange price was set by the listed company; the dealer price was negotiated.Wrong. A listed company does not set the price of its shares at any point after the offering is complete.
2. B.Both prices were set by a dealer, since every trade needs a firm to take the other side.Wrong. On an auction market one customer's order can be filled directly by another customer's order.
3. C.The exchange matched competing customer orders; the dealer quoted a price from inventory.Correct. An auction market matches buyers with sellers, while a dealer market runs on quoted two-sided prices.
4. D.Both were matched against competing orders, since exchanges and dealers share one book.Wrong. There is no single consolidated book, and dealer markets are built on quotations rather than matching.

Why: An exchange operates as an auction market: buy and sell orders compete, and a trade occurs when the highest bid meets the lowest offer, with a designated market maker supplying liquidity where natural orders do not meet. The over-the-counter market is a dealer market, where firms publish two-sided quotations and stand ready to buy at their bid and sell at their offer out of their own inventory. The customer's counterparty is therefore another investor in the first case and the dealer itself in the second. That distinction is also why one trade carries a commission and the other a markup.

A market maker publishes a firm two-sided quotation in an over-the-counter stock. A customer's order arrives at the quoted price and size, and the firm declines to trade. This conduct is:

1. A.Permissible, because a published quotation is only an invitation to negotiate.Wrong. A firm quotation is a commitment, and treating it as an invitation would make quoted markets meaningless.
2. B.Permissible, because the firm may decline any order it judges to be unsuitable.Wrong. Suitability governs recommendations made to a customer, not a market maker's duty to honor its own quote.
3. C.Backing away, since a firm quotation must be honored at its price and size.Correct. Refusing to trade at one's own displayed quotation is the definition of backing away.
4. D.Freeriding, since the firm avoided committing its own capital to the trade.Wrong. That term describes paying for a purchase out of the proceeds of its sale, an entirely different violation.

Why: The secondary market functions because displayed quotations mean something. A market maker publishing a firm bid and offer commits to buy at its bid and sell at its offer for at least the size displayed, and refusing to do so is backing away. The prohibition protects the integrity of quoted prices, since a market of quotes nobody honors supplies neither information nor liquidity. A firm that no longer wishes to trade at a price must update its quotation rather than decline an order arriving against it.