Chapter 3 - Equities

Company Formation & Administration, Types of Equities, Benefits & Risks of Owning Shares, Corporate Actions, Stock Exchanges, Stock Market Indices, Trading, Holding Title, Clearing and Central Counterparties and Settlement

How to form a company?

Forming a simple company is inexpensive and requires the founders of the company to complete a series of documents and lodge these with the appropriate authority. In the UK, these documents are required to be lodged with the Registrar of Companies at Companies House.

What is the Memorandum of Association?

To form a company requires a Memorandum of Association (incorporation). This confirms the subscribers’ intention to form a company under the Company Act 2006 and that they have agreed to become members of that company and to take at least one share each. It is a legal statement signed by all initial shareholders agreeing to form the company.

What are Articles of Association?

This details the relationship between the company and one of its key sources of finance; in other words, its owners. The articles are written rules concerning the running of the company. They are agreed by the shareholders, directors and the company secretary, and they include details such as shareholder rights, the frequency of company meetings and the company’s borrowing powers.

How to form a company in the US?

You can form a corporation or limited liability company (llc) in any of the 50 States or Washington DC. US companies use Operating Agreements instead of Articles and Memorandum. A SEC Form S-1 is the initial registration form for new securities required by the SEC for public companies that are based in the US. Any security that meets the criteria must have an S-1 filing before shares can be listed on a national exchange, such as the New York Stock Exchange (NYSE).

What are the types of companies?

• Private companies – such as ABC ltd, where ltd is short for ‘limited’. Such companies can have just one shareholder, or

• Public companies – such as XYZ plc, where plc stands for public limited company. Plcs must have a minimum of two shareholders.

Which companies can issue shares to the public?

It is only plcs that are permitted to issue shares to the public. As a result, all listed companies are plcs, but not all plcs are listed. It is perfectly possible for a company to ‘just be’ a plc, and not be listed on a stock exchange.

The global bank HSBC Holdings is a plc and is listed on a number of worldwide stock exchanges including the London Stock Exchange (LSE), NYSE, Hong Kong Exchanges and Clearing (HKEX), Paris Stock Exchange (Euronext) and the Bermuda Stock Exchange (BSX). In contrast, Virgin Holdings, the business empire of Richard Branson, is a plc, but is not listed.

What does ‘Limited’ mean?

‘Limited’, whether as in ‘ltd’ or ‘plc’, means that the liability of shareholders for the debts of the company is limited to the amount that they agreed to pay to the company on initial subscription.

What are company meetings, known as AGMs?

Public companies must hold annual general meetings (AGMs) at which the shareholders are given the opportunity to question the directors about the company’s strategy and operations. Public companies must hold an AGM within six months of the financial year-end.

The Companies Act provides shareholders with the right to attend, speak and vote at the AGM or to appoint a proxy to vote (but not speak) on their behalf at the meeting.

The shareholders are also given the opportunity to vote on matters such as the appointment and removal of directors and the payment of the final dividend recommended by the directors.

What are ordinary and special resolutions?

Most matters put to the shareholders are ordinary resolutions, requiring a simple majority of those shareholders voting to be passed. Matters of major importance, such as a proposed change to the company’s constitution, require a special resolution and at least 75% to vote in favour.

Shareholders can either vote in person, or have their vote registered at the meeting by completing a proxy voting form, enabling someone else to register their vote on their behalf.

What are general meetings?

Companies may also hold other meetings during the year to deal with important issues, such as a takeover or capital raising. These are known simply as general meetings. Until 2009, they were referred to as extraordinary general meetings (EGMs).

What is the capital of a company?

The capital of a company is made up of a combination of borrowing and the money invested by its owners. The long-term borrowings, or debt, of a company are usually referred to as bonds, and the money invested by its owners as shares, stocks or equity. Shares are the equity capital of a company, hence the reason they are referred to as equities. They may comprise ordinary shares and preference shares (eg, UK).

What are ordinary shares?

Ordinary shares carry the full risk and reward of investing in a company. If a company does well, its ordinary shareholders should do well. As the shareholders of the company, it is the ordinary shareholders who vote ‘yes’ or ‘no’ to each resolution put forward by the company directors at company meetings.

What are dividends?

Ordinary shareholders share in the profits of the company by receiving dividends declared by the company, which tend to be paid half-yearly or even quarterly. With the final dividend for the financial year, the company directors will propose a dividend which will need to be ratified by the ordinary shareholders before it is formally declared as payable. The amount of dividend paid will depend on how well the company is doing. However, some companies pay large dividends and others none as they plough all profits made back into their future growth.

What if a company performs badly?

If the company closes down, often described as the company being ‘wound up’, the ordinary shareholders are paid last, after everybody else. If there is nothing left, then the ordinary shareholders get nothing. If there is money left after all creditors and preference shareholders have been paid, it all belongs to the ordinary shareholders.

What are partly paid or contributing shares?

This means that only part of their nominal value has been paid up.

For example, if a new company is established with an initial capital of £100, this capital may be made up of 100 ordinary £1 shares. If the shareholders to whom these shares are allocated have paid £1 per share in full, then the shares are termed fully paid.

Alternatively, the shareholders may contribute only half of the initial capital, say £50 in total, which would require a payment of 50p per share, ie, one-half of the amount due. The shares would then be termed partly paid, but the shareholder has an obligation to pay the remaining amount when called upon to do so by the company.

What are preference shares?

The company’s internal rules (its Articles of Association) set out the specific ways in which the preference shares differ from the ordinary shares. These differ slightly to what are known as ‘preferred stock’ or ‘preferreds’, issued in the US, which is a class of shares that give the holder a higher claim to dividends or asset distribution than common stockholders.

Preference shares are a hybrid security with elements of both debt and equity. Although they are technically a form of equity investment, they also have characteristics of debt, particularly in that they pay a fixed income. Preference shareholders have legal priority (known as seniority) over ordinary shareholders in respect of earnings and, in the event of bankruptcy, in respect of assets.

What are preference shares normally like?

• Are non-voting, except in certain special circumstances, such as when their dividends have not been paid

• Pay a fixed dividend each year, the amount being set when they are first issued and which has to be paid before dividends on ordinary shares can be paid, and

• Rank ahead of ordinary shares in terms of being paid back if the company is wound up.

• Be cumulative, non-cumulative and/or participating.

What if dividends cannot be paid in a particular year?

If dividends cannot be paid in a particular year, perhaps because the company has insufficient profits, preference shareholders would receive no dividend. However, if they are cumulative preference shareholders, then the dividend entitlement accumulates. Assuming sufficient profits, the cumulative preference shareholders will have the arrears of dividend paid in the subsequent year. If the shares were non-cumulative, the dividend from the first year would be lost.

What can the holder of preference shares do?

Participating preference shares entitle the holder to a basic dividend of, say, 3p a year, but the directors can award a bigger dividend in a year when the profits exceed a certain level. In other words, the preference shareholder can ‘participate’ in bumper profits.

What are convertible and redeemable preference shares?

• Convertible preference shares carry an option to convert into the ordinary shares of the company at set intervals and on pre-set terms.

• Redeemable shares, as the name implies, have a date on which they may be redeemed; that is, the nominal value of the shares will be paid back to the preference shareholder and the shares cancelled.

What is the overall benefit of owning shares?

Holding shares in a company is having an ownership stake in that company. Ownership carries certain benefits and rights, and ordinary shareholders expect to be the major beneficiaries of a company’s success.

How is a dividend beneficial?

A dividend is the return that an investor gets for providing the risk capital for a business. Companies pay dividends out of their profits, which form part of their distributable reserves. Distributable reserves are the post-tax profits made over the life of a company, in excess of dividends paid.

How can a company issue dividends?

Despite only making £3 million in the current year, it would be perfectly legal for ABC plc to pay dividends of more than £3 million, because it can use the undistributed profits from previous years. This would be described as a naked or uncovered dividend, because the current year’s profits were insufficient to fully cover the dividend. Companies occasionally do this, but it is obviously not possible to maintain this long term.

Companies seek, if possible, to pay steadily growing dividends. A fall in dividend payments can lead to a negative reaction among shareholders and a general fall in the willingness to hold the company’s shares, or to provide additional capital.

What is a dividend yield?

Potential shareholders will compare the dividend paid on a company’s shares with the return on other investments. These would include other shares, bonds and bank deposits. A comparison of returns is facilitated by calculating the dividend yield, ie, the dividend as a percentage of the current share price.

Its dividend yield is calculated by expressing the dividend as a percentage of the total value of the company’s shares (the market capitalisation) = (dividend/(market capitalisation))*100.

What could be the reason for a company to have a higher-than-average dividend yield?

• The company is mature and continues to generate healthy levels of cash, but has limited growth potential, perhaps because the government regulates its selling prices, and so surplus profits are paid to shareholders in the form of higher dividends. Examples are utilities such as water or electricity companies.

• The company has a low share price for some other reason, perhaps because it is, or is expected to be, relatively unsuccessful; its comparatively high current dividend is, therefore, not expected to be sustained and its share price is not expected to rise.

What could be the reason for a company to have a lower-than-average dividend yield?

• The share price is high, because the company is viewed by investors as having high growth prospects, and

• A large proportion of the profit being generated by the company is being ploughed back into the business, rather than being paid out as dividends.

What are capital gains?

Capital gains can be made on shares if their prices increase over time. If an investor purchases a share for £3 and two years later that share price has risen to £5, then the investor has made a £2 capital gain.

However, the shares need to be sold to realise any capital gains. If the investor does not sell the share, then the gain is described as being unrealised, and they run the risk of the share price falling before they realise the share and ‘bank’ the profits.

Uneven split - whereas dividends need to be reinvested in order to accumulate wealth, capital gains simply build up.

What are shareholder benefits?

Some companies provide perks to shareholders, such as a telecoms company offering its shareholders a discounted price on their mobile phones or a shipping company offering cheap ferry tickets. Such benefits can be a pleasant bonus for small investors, but are not normally a big factor in investment decisions.

What is the shareholder right of subscribing for new shares?

Rights issues are one method by which a company can raise additional capital, with existing shareholders having the right to subscribe for new shares.

Under UK legislation, existing shareholders in UK companies are given pre-emptive rights to subscribe for new shares. What this means is that, unless the shareholders agree to permit the company to issue shares to others, they must be given the option to subscribe for any new share offering before it is offered to the wider public, and in many cases they receive some compensation if they decide not to do so.

A right issue is one method by which a company can raise additional capital, complying with pre-emptive rights, with existing shareholders having the right to subscribe for new shares.

What is the shareholder right to vote?

Ordinary shareholders have the right to vote on matters presented to them at company meetings. This would include the right to vote on proposed dividends and other matters, such as the appointment, or reappointment, of directors.

The votes are normally allocated on the basis of ’one share = one vote’. The votes are cast in one of two ways:

• The individual shareholder can attend the company meeting and vote.

• The individual shareholder can appoint someone else to vote on their behalf – this is commonly referred to as voting by proxy.

How do some companies issue and hold shares?

However, some companies issue different share classes, for some of which voting rights are restricted or non-existent. This allows some shareholders to control the company while only holding a small proportion of the shares.

In practice, most shares these days are held in electronic form in stockbrokers’ or investment managers’ nominee accounts operated by nominee companies – these companies are used solely for holding and administering shares and other investments. These do not trade, and so are described as ‘bankruptcy remote’ as the chances of them going into liquidation are low. It is the nominee’s name that appears on the record of ownership of the shares and so, if the shareholder wishes to vote, they will need to arrange for the operator of the nominee account to vote on their behalf.

What are the risks of owning shares?

Shares are relatively high risk but have the potential for relatively high returns when a company is successful.

What is market risk?

The risk that share prices in general might fall. Even though the company involved might maintain dividend payments, investors could face a loss of capital. There are risks associated with equity investment from general price collapses. Any single company can experience dramatic falls in its share prices when it discloses bad news.

What is market-wide falls?

Market-wide falls in equity prices occur, unfortunately, on a fairly frequent basis.

One example is when worldwide equities fell by nearly 20% on 19 October 1987, with some shares falling by even more than this. That day is generally referred to as Black Monday when the Dow Jones index fell by 22.3%, wiping US$500 billion off share prices.

Another instance of a market-wide fall in equity prices was the ‘dot-com’ bubble. The arrival of the internet age sparked suggestions that a new economy was in development and led to a surge in internet stocks. Many of these stocks were quoted on the NASDAQ exchange, whose index went from 600 to 5,000 by the year 2000. This led the Chairman of the Federal Reserve to describe investor behaviour as ‘irrational exuberance’. In the mid-2000s, reality started to settle in and the ‘dot-com’ bubble was firmly popped, with the NASDAQ index crashing to below the 2000 mark.

The subprime crisis and credit crunch brought about another fall in stock markets. In 2008, the NASDAQ had its worst ever fall, declining by 40.54% over the year, the Dow Jones Industrial Average (DJIA) fell 33.84%, and the FTSE 100 tumbled 31% in the largest annual drop seen since its launch in 1984.

More recently, in the first part of 2020, equity markets worldwide fell as markets reacted to the coronavirus (COVID-19) pandemic.

What is price risk?

Varies between companies: volatile shares tend to exhibit more price risk than more ‘defensive’ shares, such as utility companies and general retailers.

What is liquidity risk?

The risk that shares may be difficult to sell at a reasonable price or traded quickly enough in the market to prevent a loss. It essentially occurs when there is difficulty in finding a counterparty who is willing to trade in a share.

When does liquidity risk occur?

This typically occurs in respect of shares in ‘thinly traded’ companies – private companies, or those in which there is not much trading activity. It can also happen, to a lesser degree, if share prices in general are falling, in which case the spread between the bid price (the price at which dealers will buy shares) and the offer price (the price at which dealers will sell shares) may widen.

Shares in smaller companies tend to have a greater liquidity risk than shares in larger companies -smaller companies also tend to have a wider price spread than larger, more actively traded companies.

What is issuer risk?

The risk that the issuing company collapses and the ordinary shares become worthless.

In general, it is very unlikely that larger, well-established companies would collapse, and the risk could be seen, therefore, as insignificant. However, events such as the collapse of Northern Rock, HBOS, Bradford & Bingley, Woolworths, Comet, BHS and Carillion show that the risk is a real and present one and cannot be ignored.

Shares in new companies, which have not yet managed to report profits, may have substantial issuer risk.

What is FX risk?

This risk for investors can be indirect or direct. Indirect relates to investing in a company that has earnings and operations overseas. Investors will be exposed to the risks associated with changes in earnings as a result of this.

The company itself may engage in hedging their exposure to foreign currency risk. Direct foreign exchange risk for the investor relates to investing in shares denominated in foreign currency. Because the relative value of currencies fluctuate, the sterling value of an equity investment denominated in a foreign currency is subject to constant fluctuations.

For example, a US investor holding UK shares would see the dollar value of their holding fall if sterling were to weaken against the dollar, and vice versa.

What is a Corporate Action?

This occurs when a company does something that affects its shareholders or bondholders. For example, most companies pay dividends to their shareholders twice a year.

What are the three types of corporate action?

1. A mandatory corporate action is one mandated by the company, not requiring any intervention from the shareholders or bondholders. The most obvious example of a mandatory corporate action is the payment of a dividend, since all qualifying shareholders automatically receive the dividend.

2. A mandatory corporate action with options is an action that has some sort of default option that will occur if the shareholder does not intervene. However, until the date at which the default option occurs, the individual shareholders are given the choice to select another option. An example of a mandatory with options corporate action is a rights issue

3. A voluntary corporate action is an action that requires the shareholder to make a decision. An example is a takeover bid – if the company is being bid for, each individual shareholder will need to choose whether to accept the offer or not.

What are the corporate actions in the US?

Corporate actions are simply divided into two classifications: voluntary and mandatory. The major difference between the two is therefore the existence of the category of mandatory events with options. In the US, these types of events are split into two or more different events that have to be processed.

What are Securities Ratios?

When a corporate action is announced, the terms of the event will specify what is to happen. This could be as simple as the amount of dividend that is to be paid per share. For other events, the terms will announce how many new shares the holder is entitled to receive for each existing share that they hold.

So, for example, a company may announce a bonus issue whereby it gives new shares to its investors in proportion to the shares they already hold. The terms of the bonus issue may be expressed as 1:4, which means that the investor will receive one new share for each existing four shares held. This is the standard approach used in European and Asian markets and can be simply remembered by always expressing the terms as the investor will receive ‘X new shares for each Y existing shares’.

What are securities ratios in the US?

Here, the first number in the securities ratio indicates the final holding after the event; the second number is the original number of shares held. The above example expressed in US terms would be 5:4. So, for example, if a US company announced a 5:4 bonus issue and the investor held 10,000 shares, then the investor would end up with 12,500 shares.

What are rights issues?

A company may wish to raise additional finance by issuing new shares. This might be to provide funds for expansion, or to repay bank loans or bond finance. In such circumstances, a company may approach its existing shareholders with a ‘cash call’ – they have already bought some shares in the company, so would they like to buy some more?

A rights issue can be defined as an offer of new shares to existing shareholders, pro rata to their initial holding. Since it is an offer and the shareholders have a choice, rights issues are examples of a ‘mandatory with options’ type of corporate action.

How are corporate actions of issuing rights carried out?

As an example of a rights issue, the company might offer shareholders the right that for every two shares owned, they can buy one more at a specified price that is at a discount to the current market price.

The initial response to the announcement of a planned rights issue will reflect the market’s view of the scheme. If it is to finance expansion, and the strategy makes sense to the investors, the share price could well rise. If investors have a very negative view of why a rights issue is being made (eg, to fund activities that investors view negatively) and of what it says for the future of the company, the share price can fall substantially.

The company and their investment banking advisers will, therefore, have to consider the numbers carefully. If the price at which new shares are offered is too high, the cash call might flop. This would be embarrassing – and potentially costly for any institution that has underwritten the issue.

This situation was seen during the financial crisis with HBOS, RBS and, more recently, with Kier Group, when the price of shares on the open market fell below the discounted rights issue price. The rights issues were flops, and the underwriters ended up having to take up the new shares.

What role do underwriters have in corporate actions of issuing rights?

Underwriters of a share issue agree, for a fee, to buy any portion of the issue not taken up by shareholders at the issue price. The underwriters then sell the shares they have bought when market conditions seem opportune to them, and may make a gain or a loss on this sale. The underwriters agree to buy the shares if no one else will, and the company’s investment bank will probably underwrite some of the issue itself.

What are Bonus Issues?

A bonus issue (also known as a scrip or capitalisation issue) is a corporate action when the company gives existing shareholders extra shares without their having to subscribe any further funds. The company is simply increasing the number of shares held by each shareholder, and ‘capitalises’ earnings by transfer to shareholders’ funds. It is a mandatory corporate action. A bonus issue (also known as a scrip or capitalisation issue) is a corporate action when the company gives existing shareholders extra shares without their having to subscribe any further funds. The company is simply increasing the number of shares held by each shareholder, and ‘capitalises’ earnings by transfer to shareholders’ funds. It is a mandatory corporate action.

Why are bonus issues used?

The reason for making a bonus issue is to increase the liquidity of the company’s shares in the market and to bring about a lower share price. The logic is that, if a company’s share price becomes too high, it may be unattractive to investors. Traditionally, most large UK companies tried to keep their share prices below £10, but that is less common today.

What are stock splits and reverse stock splits?

A stock split does not raise extra cash. It simply involves the division of existing shares into smaller denominations, making the share capital more marketable.

For example, a company whose shares have a nominal value of £1 each but a market value of £5 each may decide to split each £1 share into 5 shares of 20p each. The market value of each share then becomes £1. The reverse might be appropriate where the market value of a company’s share is very low. This is known as consolidation of shares or a reverse stock split.

How are dividends used as a corporate action?

Dividends are an example of a mandatory corporate action and represent the part of a company’s profit that is passed to its shareholders.

Dividends for many large UK companies are paid twice a year, with the first dividend being declared by the directors and paid approximately halfway through the year (commonly referred to as the interim dividend). The second dividend is paid after approval by shareholders at the company’s AGM, held after the end of the company’s financial year, and is referred to as the final dividend for the year.

The amount paid per share depends on factors such as the overall profitability of the company and any plans it might have for future expansion.

How are dividends issued to shareholders?

The individual shareholders will receive the dividends by cheque, or by the money being transferred straight into their bank accounts or be paid through CREST.

What is the difficulty when shares change hands frequently?

Determining who the correct receiver of the dividends is. The London Stock Exchange (LSE), therefore, has procedures to minimise the extent that people receive dividends they are not entitled to, or fail to receive the dividend to which they are entitled. The shares are bought and sold with the right to receive the next declared dividend up to a date shortly before the dividend payment is made. Up to that point, the shares are described as cum-dividend. If the shares are purchased cum-dividend, the purchaser will receive the declared dividend. At a certain point between the declaration date and the dividend payment date, the shares go ex-dividend (xd). Buyers of shares when they are ex-dividend are not entitled to the declared dividend.

What is the standard settlement period?

T+2. This means that a trade is settled two business days after it is executed so, for example, a trade executed on Monday would settle on Wednesday.

What is a takeover?

In a takeover, which may be friendly or hostile, one company (the predator) seeks to acquire another company (the target). When they acquire shares in the other company, they are under an obligation to report their share purchases once they reach a certain percentage.

What does the predator company buy in a successful takeover?

The predator company will buy more than 50% of the shares of the target company. When the predator holds more than half of the shares of the target company, the predator is described as having ‘gained control’ of the target company. Usually, the predator company will look to buy all of the shares in the target company, perhaps for cash, but usually using its own shares, or a mixture of cash and shares.

What is a merger?

A similar transaction when the two companies are of similar size and agree to merge their interests. However, in a merger it is usual for one company to exchange new shares for the shares of the other. As a result, the two companies effectively merge together to form a bigger entity.

What is the process of a company listing its shares?

When a company decides to seek a listing for its shares, the process is known by one of a number of terms, namely:

• Becoming listed or quoted

• Floating on the stock market

• Going public, or

• Making an initial public offering (IPO).

When would a company use an IPO?

Typically, a company making an IPO will have been in existence for many years, and will have grown to a point where it wishes to expand further.

What do the terms ‘primary’ and ‘secondary’ market mean when listing shares?

The term primary market refers to the marketing of new shares in a company to investors for the first time. Once they have acquired shares, an investor will at some point wish to dispose of some or all of their shares and will often do this through a stock exchange. This latter process is referred to as dealing on the secondary market.

Primary markets exist to raise capital and enable surplus funds to be matched with investment opportunities, while secondary markets allow the primary market to function efficiently by facilitating two-way trade in issued securities.

What are the advantages of listing shares?

• Capital – an IPO provides the possibility of raising capital and, once listed, further offers of shares are much easier to make. If the shares being offered to the public are those of the company’s original founders, then the IPO offers them an exit route and a means to convert their holdings into cash.

• Takeovers – a listed company could use its shares as payment to acquire the shares of other companies as part of a takeover or merger.

• Status – being a listed company should help the business in marketing itself to customers, suppliers and potential employees.

• Employees – stock options to key staff are a way of providing incentives and retaining employees, and options to buy listed company shares that are easily sold in the market are even more attractive.

What are the disadvantages of listing shares?

• Regulation – listed companies must govern themselves in a more open way than private ones and provide detailed and timely information on their financial situation and progress.

• Takeovers – listed companies are at risk of being taken over themselves.

• Short-termism – shareholders of listed companies tend to exert pressure on the company to reach short-term goals, rather than be more patient and look for longer-term investment and growth.

What are the requirements for listing on the LSE?

In the UK, the responsibility for allowing a company to be listed on the LSE rests with a division of the UK regulator, the Financial Conduct Authority (FCA). The division was known as the United Kingdom Listing Authority (UKLA), but the FCA have gradually phased out that name and, instead, refer to the FCA’s ’primary market’ functions. Note that the name may still appear as it may be used by other entities.

LSE offers a choice of markets for listing equity shares and there are three different segments of the Main Market: the Premium, Standard Main and High Growth segments which are each tailored to different capital raising requirements.

A listing on the LSE is known as a full listing. This requires a £30m market cap minimum.

What are the six pre-existing categories retained under the new Listing Rules by the FCA?

• Closed-ended investment funds

• Open-ended investment companies (OEICs)

• Debt and debt-like securities

• Certificates representing certain securities (depositary receipts (DRs))

• Securitised derivatives

• Warrants, options and other miscellaneous securities

What is the ESCC?

The rules for the new Equity Shares (Commercial Companies) (ESCC) listing category are a simplified version of those previously applicable to the premium listing segment.

What other listing categories are there in the new Listing Rules?

• Transition category – maintains the status quo for previous standard-listed issuers that do not fall within the other new categories, which is closed to new applicants and to transfers from other categories.

• Shell companies – designed for shell companies and special purpose acquisition companies (SPACs) whose assets consist solely or predominantly of cash or short-dated securities or whose predominant purpose is to undertake an acquisition or merger.

• International secondary listing – available solely to non-UK incorporated companies with primary listings in other jurisdictions. The shares listed in the UK must be of the same class as the shares listed overseas.

• Non-equity shares and non-voting equity shares category – open to listings of non-equity and non-voting shares, such as preference shares.

What is AIM?

Smaller businesses have a range of alternative sources of finance for expansion, including the private equity/venture capital industry and the AIM market.

AIM was established by the LSE as a junior market for younger, smaller companies. Such companies apply to the LSE to join AIM, as opposed to the FCA.

How can a company join AIM?

A company wanting to gain admission to AIM is required to appoint a nominated adviser (NOMAD) and a nominated broker. The role of the NOMAD is to advise the directors of their responsibilities in complying with AIM rules and the content of the prospectus that accompanies the company’s application for admission to AIM. The role of the nominated broker is to make a market and facilitate trading in the company’s shares, as well as to provide ongoing information about the company to interested parties.

What are stock market indices?

Markets worldwide compute one or more indices of prices of the shares of their country’s large companies. These indices provide a snapshot of how share prices are progressing across the whole group of constituent companies. They also provide a benchmark for investors, allowing them to assess whether their portfolios of shares are outperforming or underperforming the market in general.

How are derivatives used in market indices?

Many indices have provided the basis for derivatives contracts, such as FTSE (pronounced footsie) Futures and FTSE Options.

Indices also provide the basis for many tracker products, such as exchange-traded funds (ETFs).

Generally, the constituents of these indices are the largest companies, ranked by their market value or market capitalisation (market cap). However, there are also indices which track all constituents of a market, or which focus specifically on a segment, eg, the smaller companies listed on that market.

How are broader-based indices calculated?

Based on a greater range of shares which also took into account the relative market capitalisation of each stock in the index to give a more accurate indication of how the market was moving. This development process is ongoing, and most market capitalisation-weighted indices have a further refinement in that they now take account of the free-float capitalisation of their constituents. This float-adjusted calculation looks to exclude shareholdings held by large investors and governments that are not readily available for trading.

What is the equal weighted methodology?

An equal investment in each stock in the index is assumed. This means that a percentage rise in the share price of any constituent company will have an equal impact on the index as that in any other.

What is trading of shares?

Trading of shares and bonds takes place either on-exchange or off-exchange. As the name suggests, on-exchange trading is when trading is conducted through a recognised stock exchange. Trades can, however, be undertaken directly between market counterparties away from an exchange in which case they are referred to as ‘over-the-counter’ trades.

What is stock market trading?

• Quote driven

• Order driven

What are Quote-Driven Systems?

Employ market makers to provide continuous two-way, or bid and offer, prices during the trading day in particular securities, regardless of market conditions. Market makers make a profit, or turn, through this price spread. Compared to electronic order-driven systems, many practitioners argue that quote-driven systems provide liquidity to the market when trading would otherwise dry up. The NASDAQ and the LSE’s Stock Exchange Automated Quotation (SEAQ) trading systems are two examples of quote-driven equity trading systems.

What are Order-Driven Systems?

Employs either an electronic order book, such as the LSE’s Stock Exchange Electronic Trading Service (SETS), or an auction process, such as that on the NYSE floor, to match buyers with sellers. In both cases, buyers and sellers are matched in strict chronological order by price and the quantity of shares being traded and do not require market makers. Most stock exchanges operate order-driven systems and how they operate can be seen by looking at the LSE’s SETS system as an example.

What are Retail Service Providers (RSPs)?

Brokers providing services to retail clients utilise a trading approach known as the Retail Service Provider (RSP) system. Firms, such as FIDESSA, provide RSP gateways that, on demand, harvest prices from a broker-defined range of RSPs and respond to the broker with the best price available.

The system’s primary role is to provide electronic quotation and dealing facilities for retail stockbrokers and it is a quote-driven system operated by UK market makers.

How do clients use RSPs?

A client places an order with a stockbroker who then uses the system to connect to competing RSP firms, requesting the most competitive quote for their client’s order. The broker then selects the most competitive price, enabling clients to benefit from price competition and obtain best execution for the client. RSPs run highly automated systems and up to 30 market makers may be competing for each order. A key element of the model is the price calculation system used by RSP firms. Price data is gathered electronically from different exchanges in order to build a consolidated view of the best bid and offer prices and to quote competitive prices.

What other systems does the LSE have for trading?

• The Stock Exchange Electronic Trading Service – quotes and crosses (SETSqx) for less liquid shares that are not traded on SETS

• SEAQ for fixed-interest securities and AIM stocks not traded on SETSqx, and

• The electronic order book for retail bonds (ORB), which offers continuous two-way pricing for trading in UK gilts and retail-size corporate bonds.

What are MTFs?

As an alternative to trading on a stock exchange, trades can be conducted through multilateral trading facilities (MTFs). MTFs, sometimes referred to as ‘alternative trading systems’, are non-exchange trading venues which bring together buyers and sellers of securities.

Subscribers can post orders into the system and these will be communicated (typically, electronically via an electronic communication network (ECN)) for other subscribers to view. Matched orders will then proceed to execution. Examples of MTFs include Cboe Europe Equities and Turquoise.

What is a ‘systematic internaliser’?

A firm executes client trades against its own account. Instead of sending orders to a stock exchange, it can match them with other orders on its own book. This means it is able to compete directly with stock exchanges and automated dealing systems, but it has to make such dealings transparent – ie, it has to show a price before a trade is made and has to give information about the transaction, just like conventional trading exchanges, after a trade is made.

What is holding title?

Shares can be issued in either registered or bearer form.

How are shares held in registered form?

Holding shares in registered form involves the investor’s name being recorded on the share register and, often, the investor being issued with a share certificate to reflect their ownership. However, many companies which issue registered shares now do so on a non-certificated basis.

How are shares held in bearer form?

As the name suggests, the person who holds, or is the ‘bearer’ of, the shares is the owner. Ownership passes by transfer of the share certificate to the new owner. This adds a degree of risk to holding shares in that loss of the certificate might equal loss of the person’s investment. As a result, holding bearer shares is relatively rare, especially in the UK.

In addition, bearer shares are regarded unfavourably by the regulatory authorities owing to the opportunities they offer for money laundering. Consequently, they are usually immobilised in depositories such as Euroclear, or by their local country registries.

What is a registrar?

A listed company is required to maintain a share register. This is simply a record of all current shareholders in that company, and how many shares they each hold. The share register is kept by the company registrar, who might be an employee of the company itself or a specialist firm of registrars. An electronic register is also kept by CREST so that trades can be settled electronically.

What happens when a shareholder sells some or all of their shareholding?

There must be a mechanism for updating the register to reflect the buyer and effect the change of ownership and for transferring the money to the seller. This is required in order to settle the transaction – accordingly, it is described as settlement.

What is a certificated settlement?

Historically, each shareholder also held a share certificate as evidence of the shares they owned. When shares were sold, the seller sent their share certificate and a stock transfer form, providing details of the new owner, to the company registrar. Acting on these documents, the registrar would delete the seller’s name and insert the name of the buyer into the register. The registrar then issued a new certificate to the buyer. This was commonly referred to as certificated settlement because the completion of a transaction required the issue of a new share certificate.

How were certificated settlements dematerialised?

Most markets have moved to having a single central securities depository which hold records of ownership, with transfer of ownership taking place electronically. In the UK, settlement has moved to a paperless, dematerialised (or uncertificated) form of settlement through a system called CREST.

What happens to settlement if an investor still holds a physical copy?

They have been unable to benefit from shorter settlement periods. Settlement of these trades usually takes place at T+10 or a shorter period to allow all of the paperwork to be completed.

What is clearing?

The process through which the obligations held by buyer and seller to a trade are defined and legally formalised. In simple terms, this procedure establishes what each of the counterparties expects to receive when the trade is settled. It also defines the obligations each must fulfil, in terms of delivering securities or funds, for the trade to settle successfully.

What does the clearing process include?

• Recording key trade information so that counterparties can agree on the trade’s terms.

• Formalising the legal obligation between counterparties.

• Matching and confirming trade details.

• Agreeing procedures for settling the transaction.

• Calculating settlement obligations and sending out settlement instructions to the brokers, custodians and central securities depository (CSD).

• Managing margin and making margin calls. (Margin relates to collateral paid to the clearing agent by counterparties to guarantee their positions against default up to settlement.)

How can trades be cleared?

Trades may be cleared and settled directly between the trading counterparties – known as bilateral settlement. When trades are cleared bilaterally, each trading party bears a direct credit risk against each counterparty that it trades with. Hence, it will typically bear direct liability for any losses incurred through counterparty default.

What is a central counterparty (CCP)?

The alternative is to clear trades using a central counterparty (CCP). A CCP interposes itself between the counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. As a result, buyer and seller interact with the CCP and remain anonymous to one another. This process is known as ‘novation’.

How is clearing through CCPs more favourable?

Regulators are increasingly keen to promote the use of CCPs across a wide range of financial products. While this does not eliminate the risk of institutions going into default, it does spread this risk across all participants, and is making these risks progressively easier to monitor and regulate. The risk controls extended by a CCP effectively provide an early warning system to financial regulators of impending risks, and are an important tool in efforts to contain these risks within manageable limits. CCP services have been introduced in a range of markets in order to mitigate this risk. For example, LCH provides CCP services in the UK and Euronext European markets for trading in equity, derivatives and energy products.

What is settlement?

The process through which legal title (ie, ownership) of a security is transferred from seller to buyer in exchange for the equivalent value in cash. Ideally, these two transfers should occur simultaneously, known as delivery versus payment (DvP).

What is CREST?

The term that is commonly used to refer to the system operated by Euroclear UK & International, the central securities depository for UK and Irish equities.

What are some of the features of CREST?

• Holdings are uncertificated; that is, share certificates are not required to evidence transfer of ownership

• There is real-time matching of trades

• Settlement of transactions takes place in sterling, euros or dollars

• Electronic transfer of title (ETT) (see below) takes place on settlement

• Settlement generates guaranteed obligations to pay cash outside CREST

• Coverage includes shares, corporate and government bonds and other securities held in registered form

• A range of corporate actions is processed, including dividend distributions and rights issues, and

• It also provides a mechanism to facilitate the settlement of trades when the investor holds paper share certificates.

What are the 4 stages of CREST?

1. Trade Matching

2. Stock Settlement

3. Cash Settlement

4. Register Update

What is Stage 1 - Trade Matching in CREST?

• The buying and selling members input instructions in CREST detailing the terms of the agreed trade.

• CREST authenticates these instructions to check that they conform to the authentication procedures stipulated by CREST. If the input data from both members matches, CREST creates a matching transaction.

What is Stage 2 - Stock Settlement in CREST?

• On the intended settlement date, CREST checks that the buying member has the funds, the selling member has sufficient stock in its stock account and the buyer’s CREST settlement bank has sufficient liquidity at the Bank of England to proceed to settlement of the transaction.

• If so, CREST moves the stock from the selling member’s account to the buying member’s account.