UNIT 1 C1

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  • Created by: tadiwa
  • Created on: 19-11-21 12:13

ROLE OF FINANCIAL MARKETS

financial intermediation: acting as middleman in the economy → providing service that links borrowers and savers. intermediaries reduce information and transaction costs by

  • providing services and prodcuts that allow savers to become investors
  • ensuring the adequate provision of informaition
  • allowing borrowers to access a range of savers that can meet a variety of terms.
  • banks and credit institutions- traditionally key soures of financing for individuals, companies and borrowers. they also act as a vehicle for individuals to become savers. also act as intermediaries. banking sector increasingly using securities markets as place to raise capital and invest in securities. 
  • insurance companies, pension funds and ivnestment institutions (OEICs and unit trusts) also can act as intermediaries. 
  • investment companies purchase securitised assets of banks
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ROLE OF FINANCIAL MARKETS

  • pooling and managing risk: financial servuces/ financial markets provide mechanisms to manage risks effectively.  pooled investment products (like CIS- collective investment schemes) allow grouped savers to invest in a wide variety of products; these are products they otherwise wouldn't be able to access. pooled savers investing will reduce each individual savers' risk exposure overall. insurance allows individials and companies to transfer risk exposure to an insurance company rather than to an individual- insurance company recieves premium in return for taking on risk from individuals and companies.
  • payments and settlement: financial system- money and financial assets can be managed, transmitted and recieved. banks= main providers of payment systems allowing money exchange and debt settlement. settlement service= provided by clearing houses. ensuring buyers and sellers complete transacitons. 
  • portfolio management: system allows investors to manage wealth by offering access to markets, specialist advice and investment maangement services. ivnestment advice and ivnestment management are 2 main services provided by investment industry.
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MAIN FINANCIAL INSTITUTIONS

  • CENTRAL BANK  = financial institution that works in setting monetary framework in the financial orgs operate. involves setting short-term interest rates to meet inflation target. CB= lender of last resort to supply liquidity to banking sector - in times of financial crisi (like COVID, GFC)
  • link to roles- financial intermediation involves financial institutions allowing transfer of funds between surplus and deficit agents:
  • surplus agents: typically households- disposable income
  • deficit agents: those who need to borrow (gov'ts and firms)
  • intermediaries= deposit and investment institutions:
  • deposit institutions: incliuding comercial banks and building societies. accept deposits from econ agents. deposits become those institutions' liabilities- lend funds as direct loans OR investments. sector has universal banks (offer financial services and trad deposit and lending facilities) and investment banks (brokers, underwriters and advisers). banks and saving institutions both accept deposits and make loans, but IBs operate under different rules.
  • investment institutions:invest funds raised in tradable securiites (bonds and equities)
  • includes insurance companies (protection from unwanted events), life insurance (death, illness, retirement) and general insurance (loss, damage to propert, homes, vehicles etc).
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ROLE OF GOV'T

1- PROVIDING (PUBLIC SECTOR) SERVICES = services that private firms cant/wont provide (aka market failure). defense/law and order/maitnainence of some infra. gov't policy may involve grants/subsidies to promote issues market doesn't give enough informaito. 

2- REGULATING FIRMS AND MARKETS= mainly to protect consumers. regualtion to promote competition and prevent fraud. govt's can regulate market by restricting entry to markets and enforicng governing rules. main bodies= FCA, PRA, FPC. 

3- INTERVENING IN DISTRIBUTION OF INCOME MADE BY PRIVATE MARKET TRANSACTIONS= redistributing income and wealth is core to gov't policy- transfering payments to households- state benefits and pulic sector provisions. conform to equity in market- minimum wage guarantee. taxation: to achieve better wealth distribution in economy.

4- STABILISING THE ECONOMY= attempting to reduce fluctuation in income and employment. and control movements in general price level (eg controlling inflation through interest rates). BoE Monetary Policy Committee = UK body in charge of this.

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TYPES OF INVESTMENTS

main function of industry= linking savers (have funds to invest as lenders/investors) and borrowers (in need of funds)

  • main lenders=  households with surplus income
  • main borrowers= firms and gov'ts

direct lending uncommon-

more commonly, its households investing indirectly in range of assets through intermediaries.

REAL ASSETS AND FINANCIAL SECURITIES

  • real assets- physcial assets eg land, buildings, gold
  • securities= debt and equity
  • representing right to some type of return (bank deposit/bond) or ownership to physical assets
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TYPES OF INVESTMENTS

DEBT CLAIMS

  • loans made by lenders to borrowers
  • lenders expect repayment of loan and in the meantime to make interest payments
  • eg: bank deposit- represents claim of lender to bank- not tradable 
  • most debt claims are tradable= a bond
  • tradable claim aka a security
  • fixed income securities

EQUITY SECURITIES aka shares

  • tradable securities
  • shareholders have ownership stake in comapny they own shares in
  • no repayment obligation to shareholders' investment, but dividends are required as regular payments 
  • investors who buy shares expect return from selling their shares at higher price than price they bought their shares for and through regular dividend payments
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INDIRECT INVESTMENT- INTERMEDIARIES

savers invest in shares and bonds through intermediaries like 1) insurance companies 2) pension funds 3) pooled investment vehicles (aka CIS)

  • ADVANTAGES= Reduction in risk due to:
  • greater diversification
  • reduced transaction costs
  • access to specialsit expertise in financial assets being invested in 
  • able to invest in assets that you'd otherwise not be able to invest in as individual (eg commerical property)
  • UNIT TRUST - type of pooled investment vehicle 
  • open-ended vehicles 
  • investors wanting to join= fund issues new units in exchange for cash, paid by the investor 
  • existing investors wanting to withdraw= fund repurchases their units and pays out cash for unit redemption
  • fund can grow or shrink depending on demand for units
  • if underlying equities increase in value, so does the value of the fund's units=
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INDIRECT INVESTMENT- INTERMEDIARIES

USE OF DERIVATIVES 

intermediaries can use derivatives contracts as a means of risk management 

derivative= financial contrct 'derived' from underlying assets. → price movements of derivative and underlying asset are correlated/linked together

derivative contracts used: 1) to speculate 2) if underlying asset is hard to buy/has high costs associated with- then buying a contract is less expensive than buying the asset itself

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FOREIGN EXCHANGE MARKET TRANSACTION

eg- UK-based portfolio manager wants to buy US securities, needs to convert £ to $

transaction will be carried out in foreign exchange markets

  • for large transactions, the purchase of $ for £ may take place with dealer- dealer will quote bid/offer prices representing the prices they buy/sell in $ related to £
  • for smaller value transactions, purchase of £ for £ will take place with broker who arranges purchase for $s

FUNCTIONS OF SECURITIES MARKETS

 DISTINCTIONS

made between securities= money or capital→ 

  • money market- maturities of shorter than 1yr
  • capital markets- maturities longer than 1yr
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FOREIGN EXCHANGE MARKET TRANSACTION

eg- UK-based portfolio manager wants to buy US securities, needs to convert £ to $

transaction will be carried out in foreign exchange markets

  • for large transactions, the purchase of $ for £ may take place with dealer- dealer will quote bid/offer prices representing the prices they buy/sell in $ related to £
  • for smaller value transactions, purchase of £ for £ will take place with broker who arranges purchase for $s

FUNCTIONS OF SECURITIES MARKETS

 DISTINCTIONS

made between securities= money or capital→ 

  • money market- maturities of shorter than 1yr
  • capital markets- maturities longer than 1yr
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FUNCTIONS OF SECURITIES MARKETS→

  • raising capital- in capital market: firm can raise capital through issuing equities (shares) and (corp) bonds. funds can be used to purchase new resources to enable growth of firm. other essential part= mobilisation of savings- liquidity provided by markets encourages savers to pruchase claims issued by borrowers. this leads to greater flow of savings into prodcutive investments. 
  • transferring risk- in derivatives market: portfolio manager can use derivatives to hedge risk of equity portfolio falling in value (using equity index futures contracts). PM gains protection from risk, which doesn't disappear but is transferred to counterparty (trader) of the deriv. contract
  • price discovery: orders placed by buyers and sellers in market leads to emergence of price that is agreeable for trading to both buyers and sellers. in dynamic markets (equity markets) process takes place continuously while markt is open. if market is efficient= equilibrium price changes only when new info is made available
  • creating liquidity: securities markets allow investors who hold investments to sell (liquidate). ability to sell investment quickly= more attractive investments to hold= encoruages investors to buy in the first place. liquidity in FM= ability to sell a security without causing signfiicant movement in price+ with minimal loss of value. liquid market= market with buyers and sellers. sellers more likely to sell at a price they want to sell at when there's mny buyers willing to trade at same price. 
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PRIMARY AND SECONDARY MARKETS

Primary→ 

  • New securities (bond/share) that haven’t been offered before being traded for the 1st time. 
  • Securities initially sold to investors→ shares for cash. Company may raise capital by issuing new ordinary shares to raise capital. 
  • If it’s the first issue into markets, this is an Initial Public Offering (IPO). 
  • Secondary aka seasoned offerings also occur within the primary markets→ previously floated but offering new shares. 

Secondary→ 

  • Where other trading takes place, after initial issue
  • Secondary market important for providing liquidity and information (price discovery) to investors.
  • This makes it likely that issuers of securities can make first issue to raise capital and could increase price securities are initially sold at. 
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PRICE TRANSPARENCY + LIQUIDITY

  • price discovery= If a market is efficient, the equilibrium price will change only when new information arrives in the market

TYPES OF PRICE DISSEMINATION in market

  • pre-trade transparency → info on data and quotes published in real time  
  • post-trade transparency → info on trade prices and sizes published (shortly) after trades occur
  • buy-side traders prefer transparency as it allows them to 1) manage trading 2) understand market values 3) estimate potential transaction costs
  • sell-side traders prefer opaque markets to trade in bc they are frequent traders that have informational advantage over counterparties

organised markets (eg LSE) are more transparent than the OTC market such as CDS (credit default swap) market where investor swaps/offsets their credit risk with another investors'. 

in europe, pre- and post-trade transparency for securities (esp. equities) is required under MiFID II. 

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LIQUIDITY-

investors assess market liquidity through bid/ask price spreads

  • spread is wider in opaque markets (eg OTC trading) which works better for sell-side traderrs
  • transparency reduces spreads= benefitting to investors

in order driven markets, liqudiity judged by difference between best buy + sell prices in order book (optimal price for buyers and sellers)

  • market also considered liquid when there's willing/ready buyers and sellers

market depth - measure of the size of order needed to move market by a certain amount- is connected to market liquidity

  • aka how large an order has to be to make an impact on the market that changes market position

example of liquid markets = US Treasuries market, defined by having:

  • 1) large void transactions 2) low spreads 3) high depth= low impact of trade= makes transaction costs very low
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ILLIQUID ASSETS

  • illiquid asset= difficult to sell bc there's uncertainty of its future value in market and potential lack of market depth 
  • during periods of market uncertainty, when most securities fall in value, those securities could be diffiult to sell and most traders have pessimistic opinions of future value of these securities 
  • ILLIQUID ASSETS then demand a higher return bc of liquidity risk= risk of not being able to sell assets quickly and potential for value loss (usually accounted for in price of security)

well functioning financial markets tht are transparent and liquid = give significant benefit to traders, consumers and wider society

  • markets where trades are easily arranged with low transaction costs= operaitonally efficient 
  • these markets= small spreads and can absorb large orders w/o substantial price impact
  • encourages traders to trade and encourage savers to invest funds in claims issued by borrowers, increasing capital flows for productive uses in the economy
  • byproduct of operational efficiency= informational efficiency: trading leads to asset price reflecting all relevant information on asset's value. informational efficiency= enhanced by price transparency. more invetors can access good quality, timely info about securities- price more liekly to reflect fundamental info about value
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PRICE TRANSPARENCY + LIQUIDITY

  • in well functioning markets, highest returns likely based on securities issued by firms investing in most productive assets. so; funds will be allocated to most productive uses in society. 
  • TRANSACTION COSTS (implicit)
  • trading costs= critical ingredient to any investment strategy
  • can be difference between successful and unsuccessful portfolio 
  • misconception= only cost of tradign = explicit brokerage commission that is paid when they buy/sell assets
  • OTHER COSTS INCURRED (minimise commission costs) 1) bid/ask spread- set by dealers to cover costs and make profit. dealers' costs include processing order and holding stock
  • price impact of trade: large volume of stock is brought, can create imbalance in demand nd supply- resovled only by upwards price change which brings in more supply
  • market maker will only trade up to a specified quantity at a quoted price before reserving right to price change
  • resulting price impact= deviation of transaction price from the 'unperturbed' price  that would have prevailed had transaction not occured (volume-weighted average of transactions surrounding the trade)
  • price imapct- also can be caused by the information trade provides to the market. large 'buy' may be owing to new positibve information trader hears about- signalling further demand
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PRICE TRANSPARENCY + LIQUIDITY

  • opportunity costs= cost of waiting eg buy trade spread over days to prevent adverse price impact BUT price could rise anyway and the identified value depletes with delay in executing trade
  • results in= full original order now being cancelled while it has been part-completed, some identified value hasn't been captured and has been 'lost' 
  • EXPLICIT COSTS= 
  • commission- charged by brokers between 10-20bps for large institutional trades, (can sometimes  be 0) and 100-150bps for smaller trades
  • commissions don't have VAT connected to them 
  • STAMP DUTY RESERVE TAX- simple purchase tax, payable on all trasnactions by buyers only, rate of 0.5% 
  • for CREST (central securities depository) transactions- levy rounded to nearest 1p, or otherwise to the nearest £5. 
  • PTM (panel on takeovers and mergers) levy of £1 on all buys and sells over £10k. Flat rate paid by buyers AND sellers
  • market makers exempt from paying SDTR and PTM levy 
  • Price impact of trade→ costs reduce with larger trades- but not with price impact. If a large volume of stock is bought, it can create imbalance in supply and demand.
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DIRECT COSTS

since MiFID II= growth of trading channels (eg LSE, BATS CHI-X Europe, Turqouise) and trade clearing venues (eg LCH.Clearnet, EMCF, EUROCCP)

study found transacions via LSE/LCH.Clearnet/EUI channels incur 83%  of costs via trading at 17% at post-trade level

The breakdown in pence per transaction is:

  • Trading platform: 23.8p
  • CCP (including netting, clearing and settlement): 4.2p
  • CSD (Including settlement and stamp assessment): 0.6p

For the BATS Chi-X/EMCF/EUI channel, 41% of costs are incurred at trading level and 59% at post trading

Breakdown in pence per transaction to the LSE route above is

  • Trading platform: 3p
  • CCP: 3.8p
  • CSD: 0.4p

This gives 7.3p in total compared to 28.5p for the LSE route. The differences in the channels are driven largely by the differences in costs arising at the trading platform level

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TRANSACTION COSTS

  • difference of channels costs= bc of different costs associated at a trade platform level
  • implicit costs are N/A here, but may be less on the larger LSE market
  • post-trade costs= broadly in line between different channels
  • costs- subject to chagne, esp when theres trasnformation and change in the exchange environment. 
  • users with different profile from this broker face different costs

purchasing GILTS= different transaction charges

  • commission rate from 0.5-1% of value of purchase for purchases (below £5k)
  • gilts settled T+1 (next business day after trade executed)
  • gilt purchases exempted from SDRT. 
  • other SDRT exemptions= loan stocks, foreign securities, registered outside UK, bearer securities and deals in traded options through ICE  futures europe

derivatives (OTC and exchange-traded) transaction costs= included in transaction costs

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TRANSACTION COSTS

POOLED INVESTMENT VEHICLES- 

including unit trusts and OIECs- generally have 2 transaction costs

  • entry costs and ongoing charges figure (OCF)
  • over time, OCF beome highest component of transaction costs
  • active funds= higher OCF 
  • FCA study= average OCF for passive= 0.15% of investment, and active= 0.9%

Transaction costs for direct property investments include stamp duty, legal costs and ongoing maintenance. Market participants can use various techniques to reduce their transaction costs:

  • -Employ skillful brokers
  • -Use algorithms
  • -Use hidden orders or dark pool trading systems to hide their size
  • Round trip transaction costs are the total costs of completing a transaction, including spread, commissions and taxes
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TYPES OF FINANCIAL MARKETS- UK EQUITY MARKETS

uk shares

  • SETS order-driven, continuous trading= used in FTSE Allshare, most liquid AIM and Irish securities
  • SETSqx hybrid system of periodic (10mins) trading in electronic order book + quote-driven market making= used for securities that are less liquid securities than SETS shares
  • SEAQ quote-driven- electronic display on market maker quote + telephone execution between market makers and participants= used in fixed interest securities and AIM (alternative investment market) securities

types of order execution vnues under MiFiD= 1) regulated markets 2) multilateral trading faciltiies (MTFs) 3) systematic internalisers

  • central counterparty= LCH.Clearnet for all SETS and SETqx trades at point of execution
  • clearing members acting on behalf of firms trading on SETS are then not exposed to risk in case of of clearing member defaulting
  • counterparty asusmes risk itslef and does do bc it gets margin from its members
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TYPES OF FINANCIAL MAKRETS- INT'L

intl shares- traded on LSE using int'l order book intl shares- use int'l order book →order book creates electronic orderbook for int'l securities in LSE depository reciept. 

  • american depositary reciepts (ADR)- FOR USD and US-traded shares
  • global depositary reciepts→ allow british investors to buy GDRs through an investment bank; returns linked to int'l stock but 

European Quoting Service (EQS)- quote-driven market-making and trade reporting platform supporting all EU liquid securities that aren't on SETS/SETSqx

allows market makers to enter non-electronically executable quotes during mandatory quote period

European Trade reporting service, provided by LSE, allows clients touphold MiFID post-trade reporting obligations (for both OTC and exhcange trading)

  • on exchange: off-book trade publication- all trades regulated under relevant exchange rules 
  • OTC trade: publication- for any unregulated trades executed away from exchange markets, whether systematic internaliser or not 
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GILTS AND CORP BONDS

GILTS= UK gov't bonds→ used to fund shortfall between gov't expenditure and gov't revenue→ issued by treasury agency (Debt Management Office)→ issued via auction to Gilt-Edged Marker Makers (must continually quote bid/ask prices and trade at these prices= for continual source of liquidity

  • dividend date- 7 days before coupon payment
  • gilts pay semi-annual coupon payments, and are paid gross (tax paid individually, not automatic)
  • GILT settlement= via CREST 
  • held by 1) insurance companies 2) pension funds 3) overseas investors 4) UK banks and building societies 5) private individuals

CORP= mainly in decentralised, dealer-based OTC markets

  • sold as open offer for sale (syndicate of banks where 1 is lead manager buying + reselling to investors) OR directly to syndicate for private placements (banks buy issuance together and resell to investors) as
  • 1) bought deal- 1 investment bank buys entire bond issuance + syndicate members can sell at own prices OR
  • 2) fixed price reoffer= lead bank + syndicate buy together and offer to sell portions of issuance to other banks in syndicate at fixed price
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TRADING VENUES

Exchange= 1) centralises communication of bid/offer prices to all direct participants- they can then respond by buying/selliung at one of the quotes or replacing with different quote 2) sets instititional rules governing trading and info flows on that trading 3) linked to clearing facilities where post-trade activities are completed (for securities and derivs) on the exchange

communication: voice, hand signal, electronic message, computer-generated electronic commands. when parties agree, price of transaction execution is communicated through market

OTC trading= bilateral contract where 2parties agree on trade/agreemnt will be settled in future→ 

  • Decentralised trading (telephone/fax/ electronic network)
  • Securities not listed on any exchanges 
  • equity trading= off-book/ upstairs trade = large/off exchange trading so won't move price

MTF→ multilateral trading facilities= bringing together 3rd party buyers+sellers (banks/investors) 

  • Trading platforms organised by investment firms e.g. BATS Chi-X Europe, Turquoise
  • operated either by operator of regulated market or investment firm
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TRADING VENUES

OTF→ organised trading facilities→ multilateral system

  • Outside a regulated market or MTF= 3rd party buying/selling interacts resulting in a contract
  • New type of trading facility introduced through MIFID II= capturing trading in bonds and types of derivatives not traded on organised markets and MTFs. 
  • Trading regulated markets and MTF governed by rules BUT OTFs is discretionary and less bound by rules

Dark pools→ type of MTFs that opt out of pre-trade transparency requirements 

  • Allows large trades to happen w/o price impact→ this potentially allows better price on larger orders→ only order at the top of the list made visible 
  • SETTLEMENTS
  • LSE equity transactions= Settle T+2 through CREST(2 business days after deal is done)
  • Gilts • Settle T+1 through CREST( 1 business day after deal is done)
  • CREST= Computerised system allowing electronic holding/transfer of shares→ no need for paper certificates
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LISTING REQUIREMENTS

  • Public companies only (plc). Governed by the FCA; who decide on admission to the Official List (OL). FCA approve details of listing OR  prospectus before listing is ‘live’, UNLESS: - The offer is made to qualified investors (no retail); or - The offer is made to < 150 persons (more bespoke/specific to under 150 ppl); or - The minimum investment per investor is ≥ €100,000 (= or more than); or - The total offer consideration is < €5m
  • Conditions for listing on OL
  • Expected aggregate market value - Equity securities : at least £700,000 - Debt securities: at least £200,000 - ‘Free float’: at least 25% of issued shares in the hands of the public (public must be able to buy ¼ of shares in the company)- Published accounts: must cover at least three years + Working capital: sufficient to cover at least the next 12 months + Sponsor (investment firm) must be appointed (these can be relaxed for standard listing)
  • Conditions for listing on AIM (Alternative Investment Market; for smaller companies) → 1) Administered by the LSE - Nominated advisor (Nomad; duty outsourced to this advisor by the LSE) 2)Provision of admission document with all details 

Conditions for listing on Aquis Stock Exchange Growth Market→ 

  • Appoint and retain a AQSE corporate adviser - Have at least 24 months’ audited accounts- Have at least 10% free float - Corporate governance- 12 months’ working capital- No restrictions on the transferability of shares - Shares eligible for electronic settlement

Conditions for listing on AQSE Main Market→

•Same as the Official List

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INFORMATION DISCLOSURE- FCA RULES

  • People in managerial roles/ with managerial responsibilities must report any of their personal share transactions in company’s securities within 4 days of transaction
  • Listed companies must notify market no later than end of following business day 
  • Information on significant stakes should be made available to the public 
  • Investors must notify the company WITHIN 2 BUSINESS DAYS when a holding: 
  • • Reaches 3% • (Once above 3%) goes up or down to the next whole % point (e.g. 3% to 4%) • Falls below 3% (e.g. 5% to 4%, from 4% to 3%).
  •  After its below 3%, disclosures are no longer required 
  • Public companies must maintain a register of disclosures
  • Companies may require confirmation of interests held anytime in the last 3 YEARS
  • ‘Continuing obligation’ requirements of the Listing Rules- designed to keep shareholders of public companies properly informed 
  • Requirements
  • • Submit drafts of meetings and circulars (other than routine) to the UKLA (listing authority) for approval 
  • • Release price sensitive information to the market via a Regulatory Information Service (RIS) or Primary Information Provider (PIP)
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GENERAL MEETINGS

ANNUAL GENERAL MEETING→ must be held by a company - within 6 months of year end - no longer than 15 months between meetings - called by directors - no less than 21 days written notice - electronic communication= delviered 48hrs after sending

GENERAL MEETINGS→  no less than 14 days written notice - called by directors, or otherwise by 5% or more of shareholders

  • ordinary resolution: standard/recurring decision= needs simple majority more than 50% of votes cast
  • special resolution: larger, constitutional decisions= needs over 75% of votes in favour to be cast

PROXY (valid for GMs)- vote by show of hands (each member= 1 vote) or in a poll (1 vote per share). poll voting requested by 5 members OR over 10% of shareholders → proxy form is returned without an indication as to how the proxy is to vote, then the proxy is deemed to be a general proxy

  • special proxy= can vote as specified by the person/people they are representing as proxy
  • general proxy= appointed to vote as they generally see fit, in context of meeting 
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