Organised markets: Euronext

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Introduction

Définitions

On an organised market, counterparties do not trade directly with each other but place their buy (bid) and sell (ask) orders on display for all market participants.

The market operator defines the rules, authorises membership, organises and supervises trading and ensures the proper functioning of the market and its technical facilities.

Participation in an organised market is limited to market members who are alone authorised by the market operator to trade directly. Market members are responsible for transmitting orders from individual and institutional clients.

A regulated market also operates under the authority of a securities market regulator. In France, that authority is the AMF (Autorité des Marchés Financiers). Issuers of financial instruments traded on a regulated market must comply with rules governing the dissemination of information.

Positioning

Certain private electronic trading platforms constitute de facto organised markets. Market regulators took up this matter in the Market in Financial Instrument Directive (MiFID) which aims, among other things, to regulate their activity while facilitating their development by eliminating the order concentration rule.

Conversely, a regulated market may also provide an unregulated segment on which, for example, newly listed companies too young or too small to be admitted to the regulated segments, may be listed. This is the case with Marché Libre, operated by Euronext, and, to a lesser extent, Alternext (partially regulated).

The distinction between official stock exchanges and private electronic trading platforms is becoming increasingly blurred, following Euronext's acquisition of the MTS platform, various mergers deals (NYSE-Euronext and LSE-Borsa Italiana are examples) and a banking consortium's creation of Turquoise, a new trading platform.

The purpose of this document is to explain the main characteristics of regulated markets via an analysis of how Euronext operates.

Advantages of an organised market

The concentration of buy (bid) and sell (ask) orders in a single place helps optimise the chances of an order being properly transmitted to the market for execution: Market liquidity is the term for this capacity to absorb buy and sell orders.

In principle, this concentration leads to economies of scale for the market operator and, thus, lower transaction fees for investors. However, order concentration facilitates the development of de facto monopolies, leading to less competition, hardly an incentive for lower prices. Market regulators consequently favour the creation of independent trading platforms to encourage more competitive pricing. At the same time, some observers are concerned about the ensuing fragmenting of liquidity. We will see who turns out to be right.

The transmission of orderbooks and prices in real time to all market participants -- in short, the public nature of the trading process -- ensures that all participants will be treated fairly.

The existence of a clearing house and supervision by market regulators constitute real advantages for regulated markets.

The role of the clearing house (examined more fully later in this report) is to guarantee delivery for buyers and payment for sellers within the time frame stipulated in market practices. As such, it ensures transaction security. Moreover, the clearing house's intervention between buyers and sellers (novation, a netting procedure discussed later), serves to guarantee that executions are completed successfully while protecting anonymity.

Regulated markets also operate under the authority of a market regulator.

Organisation

Euronext is organised in the following manner:

  • Shares of the largest corporations are traded on Euronext itself. A company must present three consecutive years of audited accounts and transmit information to investors in accordance with the European Transparency directive to be admitted to the Euronext. The listing combines all equities on a single list. However, equities are sorted into three separate compartments according to their market capitalisation:
    • A: capitalisation greater than €1 billion
    • B: capitalisation less than €1 billion and more than €150 million
    • C: capitalisation less than €150 million
  • Alternext is regulated by Euronext, not by an outside authority. It is tailor-made for small and mid-sized companies.
  • The Marché Libre serves the smallest businesses, which are unable to meet the requirements for joining Euronext.
  • LIFFE is the market in which derivatives are traded (options and futures).

Services offered by the market

Regulation

A regulated market operates within the framework of a body of rules defined by the market operator under the supervision of the regulatory authority. This regulation defines:

  • The terms for admitting financial instruments for trading, particularly the requirements for issuers of securities admitted onto the market.
  • Listing requirements, rights and obligations of market members.
  • Terms of market access
  • Trading rules for the various financial instruments: Timetable, hours of trading, type and order formulation, trading cycles (all-day or at a single fixing), order execution rules, cases in which trading in a security may be suspended, possible trading outside the central orderbook (block trades, trading at weighted average share price), terms of order confirmation.
  • Rules for transmission of market-related information: orderbook details, share prices, transactions executed.
  • Order settlement terms via the clearing house.

Initial Public Offerings

The market operator advises issuers during their IPOs (initial public offerings) and puts them in contact with an investment services firm which will help them through the process of listing their shares on the market.

Quotation and trading

Euronext is a fully centralised market: All Euronext cash products are traded on the NSC platform.

Euronext is an order-driven market: The quotation system matches buy (bid) and sell (ask) orders so as to determine the price that results in a maximum of executed orders. The displayed price is that of the last order recorded.

This matching process occurs in real time: any new order with a price limit introduced on NSC triggers a new quotation procedure. This makes it a market of continuous quotation. Securities with the highest trading volumes may be traded on an all-day basis.

Securities trading at lower volumes are traded at auction: orders are introduced into the system without a price being quoted. The quotation and trade execution occur once or twice a day at predefined times.

Suspension of trading: Euronext may suspend trading at the request of the security's issuer or the market regulator - for example, in anticipation of the release of financial information.

Cessation of trading: NSC automatically triggers a suspension of trading, which is called a "reserved status" for a limited time period should the price exceed lower or upper limits

Types of orders: Euronext orders may be formulated in various ways, depending on the goals.

  • Limit order: This order type, which is the most common, is set up with restrictions on the maximum price to be paid or the minimum price to be received. Execution is triggered when another participant makes an offer within the limit. Otherwise, the order for the security is put in the waiting list of orders for execution where it remains until it is executed or expires.
  • Market order: An order to buy or sell immediately at any price when the order reaches the market, assuming sufficient volumes. It takes priority over other orders.
  • Best price order: order is executed at the best available price listed in the share's list of orders for execution.
  • Stop order: These more technical orders will be executed at a specified price (or better) after a given stop price has been reached. Until that price has been reached, these orders are not displayed to traders.

For more information on the various order types, please see Euronext documentation.

Clearing and settlement

The stock market enables players to trade securities with agreement on price, quantity and delivery date (between one and three days from the trading date, depending on the markets and securities traded). The final stage, settlement, entails the actual transfer of the securities from the seller to the buyer and cash from the buyer to the seller. This transaction occurs at the CSD (Central Securities Depository).

The term “clearing” encompasses all the required steps between the trade and settlement: order verification and matching, compensation and possibly novation.

Compensation consists of mathematically adding up the buy and sell orders made in the course of the day by a participant on the same share. A broker who trades in large volumes for his own account and for his clients will transmit a large quantity of orders on the same share in the same day. Clearing reduces the volume of transactions to be processed during the next settlement step.

Clearing may be bilateral which involves calculating a net position for each market member vis-à-vis the others. It is however generally more cost-effective to clear multilaterally, calculating a net buy or sell position for each market member including all counterparties.

In this case, the notion of counterparty is lost since the position is the result of orders executed in counterparty to several different market members. It is thus the clearing house, LCH.Clearnet in the case of Euronext, which will step in and become the buyer for all sellers and the seller for all buyers, with its own position (shares and cash) remaining mathematically nil. This procedure is called novation.

Novation effectively substitutes each market member's bilateral counterparty risk (risk that the seller will not deliver the securities or that the buyer will not transfer payment) vis-à-vis each other, with a single counterparty risk, that of the clearing house.

The latter ends up with a net flat position and is thus not exposed through its own transactions, although it remains exposed to risk of default by one of the market members. The clearing house will thus require that each individual clearing member (market member clearing for its own account or for that of other members) post a security deposit. The individual clearing house member's open positions are re-valued daily, sometimes triggering margin calls.

Data providing

The market also calculates and transmits a number of indices, such as the Paris CAC 40. These indices are the weighted average of the free-float prices, i.e. the percentage of shares available for trading.

They are essential information for investors. Aside from providing market trend information, they are the basis of derivatives (options and futures indices) and serve as benchmarks for investment funds.

This data is made available to investors by market data providers.

The technology

Financial markets require heavy technology investments, given the importance of operational efficiency, speed and reliability.

Euronext's main electronics platform includes four main components (source: Euronext).

  • an order routing system which transmits client orders to the market via an investment firm (market participant);
  • a central listing platform which matches orders and calculates prices;
  • a platform disseminating market information in real time;
  • a system for transmitting executed orders to the clearing house, LCH.Clearnet.

The cash trading system, NSC, is used on all Euronext cash markets. This platform is the result of a technology exchange with the CME (Chicago Mercantile Exchange), which provided the Clearing21 platform for the clearing house, Clearnet.

Euronext also provides a centralised platform, LIFFE Connect, for derivatives trading.

Instruments traded on Euronext

A financial instrument must have been fully operational for a certain time , traded in sufficient volume and be somewhat adaptable to standardisation for it to be traded on an organised market

Options, for example, were initially created as OTC contracts. Later, standardised option contracts were created so as to make them tradable. The advantage of tradable contracts is that they can be sold at any time, thus enabling the investor to "exit" from the contract easily as opposed to much less marketable OTC contracts.

Tradable products can be divided into cash products and derivatives. Cash products are investment units representing a portion of equity (shares) or debt (bonds or other debt securities). These products are traded on traditional financial markets, i.e. stock and bond markets. Thanks to the development of ETCs (exchange traded commodities), investors may gain exposure to an increasing range of commodities in the form of cash products.

The value of derivatives (options, futures, warrants, etc.) depends on the market value of their underlying assets, which may be commodities (oil, wheat, etc.) or securities (share, indices, etc.).

Regulated markets have also introduced ETFs (exchange traded funds) of late, investment vehicles representing a portion of a fund's value traded directly on stock exchanges.

Market players

The market operator

The market operator, Euronext, is responsible for making sure that the regulated market operates well. As such, it:

  • Establishes market rules under the supervision of the market regulator;
  • Decides upon and organises the admission of tradable securities to the market;
  • Decides upon and organises admission of market members;
  • Manages electronic quotation and trading platforms;
  • Disseminates share prices and orderbooks to the market;
  • Transmits executed order to the clearing house, LCH.Clearnet
  • Helps issuers raise capital on the market: IPO and other operations.
  • Ensures compliance with market rules and has the power to discipline market members.

Although direct access is reserved exclusively to market members, proper market operations are essential for companies who come to the market to raise capital as well as for individual and institutional investors. The market operator thus performs a public service.

Issuers

Issuers appeal to the market to raise capital via share or bond issues. IPOs are a means for growing companies to diversify their financing sources and build their corporate name recognition. Issuers must meet certain requirements to disseminate their companies' financial information for their shares to be granted entry on the regulated market.

Market members

Only duly authorised financial intermediaries can trade directly on a regulated market. Other market participants are required to use the services of an authorised financial intermediary. In France , the law categorises them as “investment firms” and they are considered to be “investment services firms”. In the past, they were referred to as “stock market firms” and they are still referred to as “brokers”. They must all be legal persons.

On Euronext, market members can play one of the two following roles: trading member or clearing member. Trading members transmit buy (bid) and sell (ask) orders for their own or their client's account. Clearing members are intermediaries who transmit traders' executed orders for which they are responsible to Clearnet and who ensure clearing and settlement. The two roles are not mutually exclusive, so a market member can be both a trading/clearing member for his own account and a clearing member for one or more other members.

Market makers

The role of market markers is to promote market liquidity by continuously displaying indicative bid/ask spreads for minimum quantities of the stocks they have undertaken to follow.

On Euronext, they are also called “liquidity providers”. They quote indicative bid/ask spreads for a minimum quantity of shares of their choosing on a continuous basis.

Regulatory authorities

The market regulator exists to protect the investor by ensuring that the market operates in a fair and sound manner while preventing fraudulent or manipulative transactions.

Euronext, a product of the merger of the French, Dutch, Belgian and Portuguese stock markets to which the London derivatives market (LIFFE) was later added, operates under the authority of five market regulators:

  • In France, the AMF (Autorité des Marchés Financiers)
  • In The Netherlands, the AFM (Autoriteit Financiële Markten)
  • In Belgium, the CBFA (Commission Bancaire, Financière et Assurances)
  • In Portugal, the CMVM (Comissao do Mercado de Valores Mobiliários)
  • In the UK, the FSA (Financial Services Authority).

The clearing house

The clearing house clears the executed orders, which entails verification, matching, payment and transmission of offset balances to the CSD (Euroclear) for settlement. We have explained its role more fully above (see Clearing and Settlement/Delivery section).

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