What Is a Stock Exchange?
A stock exchange also called a securities exchange or a bourse, is a marketplace that brings sellers and buyers of securities together to ensure easy, quick, and fair transactions between them in real-time. Although the name suggests that only stocks are traded, other types of securities such as mutual funds, ETFs, bonds, and commodities can be traded at stock exchanges as well.
Exchanges have various rules and regulations to ensure that both buyers and sellers get the best possible deal. Transaction data is available to the public free of charge to create a transparent market. Subsequently, it allows participants to make informed decisions using real-time price information.
Stock exchanges can be physical locations or electronic trading platforms. Most people are familiar with the physical stock exchanges. An example is the New York Stock Exchange (NYSE), where traders yell their bids to one another, and company founders ring the bell after their company goes public. However, many exchanges these days use electronic trading platforms and no longer require a centralized physical location. Today, most trading on exchanges occurs on electronic platforms.
Stock exchanges also enable companies to raise capital through an Initial Public Offering (IPO) by selling shares to a limited number of individual and institutional investors. After the company has gone public, its shares are officially listed on the exchange and publicly available for trading. To trade a security on a certain stock exchange, the security must be listed at that exchange.
Many countries and regions worldwide have stock exchanges, like the Tokyo Stock Exchange and the London Stock Exchange. Companies can list on only one stock exchange or multiple exchanges. When a company lists a security on two or more exchanges, the listing is called a dual listing. Companies use dual listings to have more access to capital or, if the exchanges are in different time zones, to trade their shares longer each day. However, they must meet the requirements and pay all fees for both of the exchanges.
How Does a Stock Exchange Work?
A stock exchange is a marketplace where buyers and sellers get together to trade securities efficiently. Trading helps provide liquidity in the market and offers traders a venue to sell their securities and make a profit.
Companies have to meet significant listing requirements, including financial minimums before they can list their stocks on one of the major stock exchanges. These requirements benefit and protect the investor.
After an IPO, the company’s shares are for sale to the public on the stock exchange where the IPO took place. In a traditional stock exchange, a professional market maker facilitates continuous bids and offers. However, in an electronic exchange, computers automatically match up the buyers and sellers whose prices are the same. As a result, stock prices fluctuate continuously based on the changes in the supply and demand of a particular stock.
Exchanges record all transaction data and make it available to the public. In addition, companies listed on the exchange have to publish financial statements periodically. Investors use this historical data to predict if the stock price and trading volume will be going upward or downward. This is valuable information and helps investors make informed decisions.
It is important to remember that although stock exchanges facilitate the trading process and reduce risk, it does not eliminate risk. Share prices can drop quickly, leaving investors with significant losses.
How Are Prices Set At a Securities Exchange
Stock prices are first dictated by an organization’s IPO. During the IPO process, the company shares are only available to institutional investors and high net-worth individuals. As a result, the shares are offered at a pre-determined IPO price in this primary market, and prices do not fluctuate.
After the IPO, the company’s stock gets listed on the stock exchange. Then, the stocks are available for trading to the public in the secondary market. As a result, stock prices continuously fluctuate during the trading day in this secondary market.
Prices are often set through an auction process. When a buyer’s bid price coincides with a seller’s ask price, the price gets set, and the transaction is complete. At a stock exchange, the laws of supply and demand rule. When the demand is higher than the supply, the stock price will go up. When the demand is lower than the supply, the stock price will go down.
The difference between the highest bid price and the lowest ask price is called the bid-ask spread. If there are more buyers than sellers, one of the buyers might increase his bid price resulting in the stock price going up. If there are more sellers than buyers, the opposite will happen. One of the sellers might decrease his ask price, and the stock price will go down.
Some stock exchanges rely on professional specialists or market makers to maintain a liquid market with continuous bids and offers. However, electronic trading has made it far more efficient to match buyers with sellers. This has resulted in significantly lower trading costs and faster trades.
Types of Stock Exchanges
Exchanges like the NYSE are auction exchanges and operate via “open outcry.” This means that stockbrokers and traders physically call out prices to each other. Auction-based exchanges use specialists to match buyers and sellers. These specialists act as auctioneers as buyers and sellers enter their bids simultaneously. Each specialist specializes in a particular stock. The price at which a stock trades is the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.
For example, two sellers offer stock of company X for $100 and $110, while two buyers offer $100 and $98. The specialist matches the $100 seller with the $100 buyer, and that will be the price that company X’s stock will trade at.
Although the NYSE is an auction-based exchange, some of its trades are made these days electronically.
Electronic exchanges are exchanges where the majority and sometimes all trades happen electronically. Buyers and sellers do not physically meet but meet on a virtual platform to exchange their securities. This type of trading is very efficient, accurate, and extremely fast. Other advantages of electronic exchanges are increased transparency, improved liquidity, and reduced transaction costs. These days, most exchanges are electronic, and billions of dollars of equities are traded on these electronic platforms every day.
The NASDAQ (National Association of Securities Dealers Automated Quotations) is the largest fully electronic stock exchange in the United States. It is a dealer’s market, and traders use a dealer or market maker instead of trading directly with each other. A market maker is a firm that is a NASDAQ member that buys and sells securities for itself and its customer accounts (agency trades).
Over-the-counter (OTC) refers to a decentralized market where securities trade between two parties without a broker. There is no physical location for this type of electronic trading network. Companies trading on OTC markets range from penny stock companies to multinational conglomerates.
The OTC Markets Group is the largest OTC trading network in the world. It consists of three different OTC exchanges: the OTC Pink, the OTCQB, and the OTCQX. The companies that trade on these OTC markets don’t meet the requirements to qualify for a listing on a major exchange. OTC markets have significantly fewer rules and regulations than the major stock exchanges.
The OTC Pink markets have very few or no regulations and requirements. As a result, the stocks that trade on these markets are extremely risky, and transactions are private and unpublished. Very little information is available on the companies that trade on these Pink markets, and there is no transparency. One of the main risks you encounter when buying or selling stocks on the OTC Pink markets is counterparty risk. This refers to the risk that one of the participants will likely default on their commitment. Companies that trade on these markets might include companies that have been delisted from a major stock exchange for reasons such as bankruptcy, non-liquidity, and poor performance.
Although trading on the OTC markets is riskier than trading on major exchanges, the popularity of OTC has exploded in the past decade. This is mainly due to the potential for high returns.
Electronic Communication Networks (ECNs)
Electronic Communication Networks (ECNs) are virtual networks for a trade class referred to as an Alternative Trading System (ATSs). ECNs sidestep market makers. In other words, they eliminate the middlemen, as they provide their traders with direct access to other market participants.
These computer-based systems display the highest available bid and ask prices and automatically match the winning bids. Major exchanges use ECNs not only during business hours but also for after-hours trading and foreign currency trading. In addition, they enable trading in different geographic areas, faster transactions, and create a more transparent trading environment.
The main disadvantage of ECNs is that they often charge access fees and commission charges.
History of Stock Exchanges
The history of stock exchanges dates back to the early 1600s. This is when the Dutch East India Company (VOC) in Amsterdam issued bonds and stocks for the first time to the general public to expand the spice trade.
After the success of the Amsterdam Stock Market, other countries started working on creating stock exchanges as well. In the late 17th century, King William III of England started issuing government bonds to help pay for England’s wars. However, government regulations delayed the creation of a formal stock exchange. As there was no central trading place, the sellers decided to move the trading to certain coffee houses. Sellers would post securities’ prices at these coffee houses, and potential buyers could visit and buy the securities there. It wasn’t until 1801 that the London Stock Exchange was founded.
In 1792, the first government bonds and some bank stocks exchanged hands in the U.S. through the Buttonwood Agreement. Then in 1817, the New York Stock and Exchange Board was founded. Later, this became the New York Stock Exchange.
The NYSE is by far the largest stock exchange in the world. With capital and global markets expanding, there are now many other stock exchanges located in various parts of the world. As of January 2020, the top 10 global stock exchanges in order of market capitalization are the NYSE, the Nasdaq, the Tokyo Exchange, the Shanghai Stock Exchange, Euronext, the London Stock Exchange, the Hong Kong Stock Exchange, the Shenzhen Stock Exchange, the Toronto Stock Exchange (TSX), and the Saudi Stock Exchange (Tadawul).
Purpose of Securities Exchanges
The main purpose of a stock exchange is to facilitate and regulate the buying and selling of various securities. Regulations help create a market that is fair, transparent, and efficient. Stock exchanges also serve some other purposes. Here are a few:
1. Matching of buyers and sellers – This happens in an organized way
2. Raising Capital – Raising capital can be done in 2 ways. First, capital can be raised through IPOs in the primary market. A second way of raising capital happens on the secondary market, where companies can issue and trade additional shares. Companies raise cash to finance operations, large projects, and future expansion.
3. Fair Trade – Listed organizations on an exchange must adhere to various rules and regulations. They include financial reporting requirements and rules concerning transparency and corporate governance.
4. Risk management – Exchanges reduce risk for the investor in several ways. First, the rules and regulations in place for listed companies reduce the risk for fraud. Secondly, exchanges ensure that trading occurs in an organized and fair way.
Pros and Cons of a Stock Exchange Listing
- Easier and cheaper access to capital – Most companies listed on a major stock exchange can raise more capital at a low cost faster by issuing more shares. They can use the raised capital for future expansion and development.
- Increased value – Most people have high regard for companies on a major exchange. This increase in admiration, will increase the number of potential investors, and increase the demand for the company’s stock. In turn, it results in an increase in the value of the company.
- Enhanced visibility – Going public also improves a company’s visibility. After listing on a stock exchange more people will start to notice and recognize the company. These companies can now entice more new customers and attract more media attention.
- Increased transparency and efficiency – Listing on a major exchange increases a company’s transparency and efficiency. The company now has accountability towards its shareholders and needs to comply with rules and regulations.
- Increased liquidity – Another advantage of listing on a major exchange is that the liquidity of a company’s stock increases. Selling shares will not be a problem anymore because there will be plenty of buyers on the exchange.
- Investor protection – Most exchanges require companies to meet requirements concerning financial reporting, corporate governance, and disclosures. These requirements ensure that listed companies are honest and reputable.
- The ability to attract talented new employees – Going public improves peoples’ perception of the company, and this often makes it easier to attract highly-qualified new employees. Being able to offer stock options to new employees also makes it easier to attract new talent.
- High costs – Listing on an exchange can be costly. There usually is a significant entry fee, a yearly listing fee, and high administrative costs due to compliance and reporting requirements. Different exchanges charge different fees.
- Loss of management control – After listing, even minority shareholders have a say in how the company is managed.
- Time-consuming – regulatory oversight and reporting requirements are very time-consuming to implement and may make it more difficult for the company to be efficient.
- Investors’ short-term goals – Investors’ short-term goals and profit expectations can make a company try to beat earnings expectations in the short-term instead of focusing on the long-term.
For a company to get a listing on a stock exchange and trade its shares, it must comply with that particular exchange’s listing requirements. The listing also requires payment of both the exchange’s entrance fee and its yearly listing fee.
Each stock exchange has its own set of requirements to list its stock on that particular exchange. Some exchanges have stricter requirements than others. It is not easy to fulfill all the requirements, and it often requires hard work and diligence. The most common listing requirements include minimum market capitalization, a minimum number of outstanding shares, a minimum stock price, and a minimum income.
For example, the Nasdaq has the following listings requirements:
- Stocks traded on the Nasdaq must have a stock price of at least $4
- The minimum number of publicly traded shares is at least 1.25 million shares
- The collective market value must be at least $45 million
Other types of requirements can include rules concerning how the company reports its financial information and requirements regarding the makeup of the board of directors.
If a company cannot meet all the exchange’s listing requirements, it will be “delisted” from that exchange. Luckily, there will be other places the stock can trade. Most likely, it can go to the “over the counter” market or through a network of dealers.
The New York Stock Exchange Versus the Nasdaq
The two most popular stock exchanges in the world are the New York Stock Exchange and the Nasdaq. They are the ones that drive the United States financial markets.
New York Stock Exchange (NYSE)
The NYSE is the world’s largest stock exchange based on the market cap of its listed securities. Its estimated market cap as of June 30, 2018, was $28.5 trillion. It was established in 1792, it has a physical location and is situated on Wall Street in New York.
The NYSE used to be a private company but became public in 2005 by acquiring the electronic trading exchange Archipelago. Its parent company is the Intercontinental Exchange.
The NYSE is an auction-based exchange and uses specialist market makers who act as auctioneers as buyers and sellers simultaneously bid. Each security has one Designated Market Maker (DMM) who ensures efficient trading and liquidity for that particular security. The NYSE sometimes also uses Supplementary Liquidity Providers (SLPs).
The price at which a stock trades is the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept.
It has 21 rooms, and for a long time, there was only floor-trading using the open outcry system. These days, many NYSE trades have moved to its electronic platform. However, floor trades are still common for high-volume institutional trading.
Listed companies on the New York Stock Exchange must meet several listing requirements. For example, they have to have at least 400 shareholders who own more than 100 shares of stock, have at least 1.1 million shares of publicly traded stock with a collective market value of at least $100 million, and have a stock price of at least $4 a share.
The companies on the NYSE are less volatile than the companies on the Nasdaq. This is because its listings include many large blue-chip firms that have been around for a long time.
Entry fees and yearly listing fees are pretty steep for the NYSE. For example, the entry fee can be up to $500,000.
Currently, the NYSE is open for business Monday through Friday from 9:30 a.m. to 4:00 p.m. ET.
Nasdaq (National Association of Securities Dealers Automated Quotation system)
The Nasdaq was the first global electronic marketplace and is still the biggest electronic stock exchange in the world. It was established in 1971 to enable a faster, more transparent, and efficient trade of securities on an electronic platform. Nasdaq’s electronic trading model is THE standard for markets worldwide.
The Nasdaq is a dealer’s market in which traders use a dealer or market maker instead of trading directly with each other. A market maker is a firm that is a NASDAQ member that buys and sells securities for itself and its customers. The Nasdaq has multiple market makers per stock.
The Nasdaq Stock Market has three tiers: Nasdaq Global Select Market® (large cap), Nasdaq Global Market® (mid-cap), and Nasdaq Capital Market® (small-cap). Each tier has its listing requirements concerning financials, liquidity, and corporate governance. Listing requirements for small-cap companies are less stringent than for other Nasdaq markets.
Companies selling shares to the public market for the first time through an (IPO) are most likely to use the Nasdaq. Most of the world’s prominent tech companies and many healthcare and biotech companies are on the Nasdaq. Examples of companies listed on this exchange are Apple, Google, Amazon, Oracle, and Microsoft. Tech stocks on this exchange are typically fast-growing and more volatile than most stocks on the NYSE.
Entry fees and yearly listing fees are significantly lower for the Nasdaq than the NYSE. This is probably one reason why tech companies with lower initial capital prefer to list on the Nasdaq.
Please note that the term “Nasdaq” also refers to the Nasdaq Composite index. This is an index of more than 3,000 stocks on the Nasdaq exchange. The Dow Jones Industrial Average (DJIA) is a stock market index that tracks 30 large blue-chip companies trading on the New York Stock Exchange (NYSE) and the Nasdaq.
Stock exchanges serve an important role in the world’s financial system. Exchanges match buyers and sellers of securities and enable easy, fair, and quick transactions among them. Stock exchanges also make it possible for public companies to raise capital through Initial Public Offerings. It is clear that technology has had a big impact on stock exchanges. These days, the bulk of trading occurs electronically instead of on the floor. This enhanced trading system has been a good development because more people than ever before invest in the stock market and need a place to trade their securities.