over-the-counter stocks -- 3/18/24

18 Mar 2024

over-the-counter stocks -- 3/18/24

0 COMMENTS

Today's selection -- from Competition Solution by Paul A. London. Competition comes to the New York stock exchange:

“The Securities and Exchange Act of 1934—the New Deal legislation to protect stock investors—was more flexible and less intrusive than the laws aimed at curbing abuses in banking. The Securities and Exchange Commission (SEC), the New Deal's regulatory agency for the stock markets, sought to protect securities buyers by requiring that companies provide more public information than in the past. The SEC enforced transparency, but buyers had to assess the risks for themselves.

“The availability of equity capital for new businesses and ideas was a problem, just as fixed-rate financing was. To avoid regulation, the NYSE had pushed many smaller companies off the exchange by setting strict rules for who could ‘list.’ Thousands of companies that issued stock and followed SEC rules were not listed on the NYSE. They had to sell stock in a less formal over-the-counter (OTC) market that was also less well-policed. These companies also found it more difficult to reach a large community of potential investors.

“Nevertheless, American stock markets were always more open and inclusive than those overseas. Brokers operating in the OTC market bought and sold stocks in companies not listed on the NYSE or other exchanges. They did this based on ‘pink sheets,’ a service for professional stock traders that listed prices daily. Selling stock in this way cost both buyers and sellers more than on a formal exchange, the market was smaller, and it was risky.

“The OTC in the 1950s was a lively place, however. It was then called ‘the electronic market,’ just as today's NASDAQ is called the ‘high-tech’ exchange. It was a source of capital for parts makers selling to big electronics companies like GE, IBM, Sylvania, and RCA in the fast-growing

TV industry, as well as smaller startup companies such as Harman-Kardon, established by Sidney Harman, a pioneer in high-fidelity home stereo equipment, who was still a successful entrepreneur in related areas 2003.

“The expansion of opportunities for smaller firms to sell stock started with efforts to clean up problems in the OTC market. Congress in the 1960s was afraid that investors were being bilked because they were not sure of what they were buying, and the spreads between bid and asking prices (which was the margin for the brokers) tended to be wide; so it asked the SEC to look at the OTC and see what could be done to make it work better. The study began during the Kennedy administration in 1963 and was completed toward the end of the Johnson years.

NYSE traders floor before the introduction of electronic readouts and computer screens, 1963

“In 1971, the SEC imposed new regulatory requirements on the OTC—regulations that helped it grow, rather than placing restrictions on its activities. The SEC told the National Association of Securities Dealers (NASD), the industry group that managed the OTC, that it had to give buyers of stocks more information, and directed it to open up the trading process in order to protect both buyers and sellers. The SEC encouraged the NASD to move from closed, opaque trading based on telephonic communications to an open, transparent, and accessible electronic system offering computerized listings and real-time quotes—a real breakthrough. The OTC market quickly developed such an electronic trading system, expanded, and in 1971 became the NASDAQ.

“The over-the-counter market operated differently than the NYSE even after this transformation. There was no trading floor or auction-style bidding for stocks as there is on the Big Board. Unlike the tightly knit NYSE, the NASDAQ never limited the numbers of brokers who could trade stocks. Any dealer who passed a test for knowledge and probity could trade on the NASDAQ. Also, where the NYSE required companies listed on the exchange to meet certain performance criteria—to be of a certain size and to have significant revenues—the NASDAQ would list companies without profits or even sales, as long as they met the disclosure requirements. NASDAQ required firms to disclose a great deal of information as a condition for listing, but it let investors themselves decide if they wanted to invest in riskier firms. The NASDAQ became a place where newcomers like Microsoft, Intel, and Apple had a chance to raise money before they became large and profitable. Like Milken's junk-bond market, the NASDAQ became the stock market that served the newcomers and the country's most dynamic entrepreneurs.

“The changes imposed on the old OTC traders by the SEC in 1971 began a process that, over the next three decades, made the NASDAQ into a true competitor to the NYSE. The SECs reforms reassured investors and made them more willing to purchase the stocks of companies listed in the new system. Competition between the NASDAQ and the NYSE for new listings also encouraged other innovations. The NASDAQ's computerized processing of stock trades was more modern than the comparable backroom operations of the NYSE. NASDAQ could perform a trade more quickly, in a second or two. To keep up, the NYSE had to add computer capacity and modernize its backrooms. It is also moving away from its traditional open trading floor with live brokers toward computerized trading.

“NASDAQ, for its part, also had to make adjustments to compete with the NYSE. Traders on an auction floor like the NYSE usually received a smaller profit margin than brokers on the OTC/NASDAQ. As the two markets began to compete for listings, brokers on the newer exchange had to narrow the spreads between the bid and asking prices to limit the Big Boards advantages, and the cost of trading became more comparable.

“The existence of the NASDAQ drove other changes. It created a market for the securities of new companies that venture capitalists could turn to quickly once they got a company started. The NASDAQ enabled venture capitalists to sell stock in startup firms more quickly, so they could move on to other projects. It let them sell on a broad and well-run market, long before the startup firms were profitable enough to move onto the NYSE. To some extent, the NASDAQ helped formalize the venture-capital process. Venture capital became a great deal more than just a matter of rich people taking fliers on risky new enterprises.

“The NASDAQ, however, is not just a minor-league stock market, a way-station for firms waiting to graduate to the older exchange. Although eighty or so of the more than four thousand firms listed on the NASDAQ may make the move to the Big Board in a given year, the NASDAQ retains many more companies than it loses, including giants such as Microsoft.

“The desire in Congress and the SEC to curb abuses in the OTC market was one factor that helped create competition for the NYSE and increase opportunities for investors and those who were seeking financing. The courts and the antitrust authorities also encouraged changes in the stock markets, as they did in manufacturing and the regulated industries. In the 1960s, buyers of stocks and, especially, pension funds began to complain about the NYSE’s fixed commission rates, and unhappy business customers proved again to be a powerful force, as they had been in manufacturing and the regulated industries.”