A stock exchange is a marketplace where stocks, bonds, and other securities are bought and sold. But stock exchanges are more than just markets: They provide companies with a valuable way to raise capital, encourage investors and companies to be open and transparent, and help the public understand their investments’ value.
How a Stock Exchange Works
When you think about the stock exchange, you imagine the busy New York Stock Exchange (NYSE) trading floor, with hundreds of brokers milling around, shouting buy and sell orders at each other. That gives you a more or less accurate picture of how a stock exchange works: It’s a place where buyers and sellers gather to trade stocks.
In the past, stock exchanges were physical spaces—like the NYSE trading floor—but today, the overwhelming majority of stock exchanges handle all trading electronically. Not just anyone can show up at a stock exchange and buy shares, however. Trading is handled by brokers and dealers that meet strict stock exchange membership requirements.
Likewise, not just any company can trade on a stock exchange. To be “listed” or be traded on an exchange, a company must satisfy specific minimum standards, like being registered with the U.S. Securities and Exchange Commission (SEC), having a minimum number of shareholders and shares outstanding, plus a range of other qualifications. On the Nasdaq, for example, companies will soon be required to have at least one woman and one person who is not White or heterosexual on their board of directors.
Beyond serving as a forum for buying and selling securities, a stock exchange provides various essential services. It provides liquidity, ensuring that there’s always plenty of capital looking to buy and sell stocks, enabling the broader stock market to function efficiently. A stock exchange also produces real-time pricing information so that investors can make informed decisions about the value of their holdings.
Stock Exchanges and IPOs
Stock exchanges also allow private companies to raise large amounts of money by selling equity shares through a process known as an initial public offering (IPO). When that happens, the company becomes publicly owned, and its shares of stock are listed for trade on an exchange.
There can be a lot of excitement when a new company goes public but invest cautiously. Newly public companies often struggle to maintain their success or grow; some even go out of business. This makes recent IPOs hazardous investments.
Critical Players at a Stock Exchange
Stock exchanges can be complex and require several different roles to facilitate the sales of securities. Here’s an overview of the most prominent players:
- Brokers: An individual or firm representing outside investors’ interests at a stock exchange. Because only stock exchange members are allowed to buy and sell assets on it, brokers act as agents who find buyers and sellers to fill orders for outsiders like you. Brokers generally charge commissions or fees for their services, and a stock exchange employs some to help keep things moving.
- Dealers: A firm or an individual that buys and sells securities for themselves. A dealer always aims to profit from the difference between the prices it can buy and sell securities at. In other words, it aims to buy a stock at a specific price not because it anticipates holding it for the long term but because it thinks it will be able to turn around and sell it for more than it paid. In this way, even though a broker does not represent exchange outsiders, it may end up helping indirectly facilitating trades with them in its pursuit of profit.
- Broker-dealers: The roles of broker and dealer are frequently combined in one firm called a broker-dealer. They buy and sell stocks on behalf of outside investors and may also trade for their own benefit.
- Market makers: This role is filled by dealers who buy and sell stocks for their own benefit, specifically to increase the liquidity of a stock exchange as a whole. This added liquidity helps facilitate more efficient trading and ensures orderly markets. The NYSE has a class of market makers called specialists that only trade in one or a few individual stocks.
Different Types of Stock Exchanges
There are a variety of different ways to organize the trading that happens on a stock exchange, including:
Auction Markets
Much as its name implies, in an auction market, the price of securities is determined by the highest price buyers are willing to pay for them—that’s called a bid—and the lowest price the seller is willing to accept—that’s the offer. In an auction market, broker-dealers make bids and offers and then execute trades for their clients (or selves, if they’re acting as a dealer).
Dealer Markets
In a dealer market, dealers post the prices at which they are willing to buy or sell specific stocks. Dealers then facilitate all transactions by using their own money to buy and sell the securities, which provides liquidity to the stock market.
In other words, in a dealer market, a dealer might buy a stock from you at a specific price, even without having a particular buyer in mind to sell your stock to. Because you don’t have to wait for a buyer to get your money, you’re free to buy other securities from the dealer or use that cash in any other way.
Electronic Exchanges
Instead of requiring brokers to sell on a trading floor, electronic exchanges use technology to connect buyers and sellers in a virtual marketplace. Today, nearly all stock exchanges support electronic trading, and very few still have in-person trading floors.
The automated electronic communication networks (ECNs) most electronic exchanges use to enable the buy and sell orders for stocks and other securities to be made without market makers. In the United States, ECNs must be registered with the Financial Industry Regulatory Authority (FINRA) as broker-dealers.
OTC Exchanges
Over-the-counter exchanges enable securities to be bought or sold outside significant stock exchanges, generally through broker-dealer networks. Typically, stocks traded OTC are smaller companies that don’t meet the listing requirements of the major stock exchanges, like penny stocks. Bonds may also be traded OTC.
Top Stock Exchanges
Though there are more than 60 major stock exchanges in the world, the majority of the action takes place on just a handful, including:
- New York Stock Exchange: The NYSE is the world’s largest stock exchange. Some of the largest companies trade on the NYSE, including household names like Amazon (AMZN) or Apple (AAPL). The NYSE is an auction-based market. While most trading takes place electronically, it maintains a physical trading floor—although in-person trading has been suspended for the Covid-19 pandemic.
- Nasdaq: The Nasdaq is the second-largest stock exchange in the world and employs a dealer market system. The Nasdaq pioneered electronic trading when it opened for business in the 1970s, and today it remains the listing of choice for major technology companies that often choose it for because of its lower barrier to public listing.
- London Stock Exchange: The London Stock Exchange (LSE) is the largest in Europe. Thousands of companies worldwide trade on the LSE, and it maintains a physical trading floor in London.
- Shanghai Stock Exchange: The Shanghai Stock Exchange is the largest in China. The exchange trades two types of company stocks: A-shares and B-shares. B-shares are available for foreign investment and are quoted in U.S. dollars, while A-shares are quoted in yuan. Foreign investors can only invest in A-shares if they meet specific qualifications.
How to Buy Stocks on a Stock Exchange
Opening an online brokerage account lets you start buying and selling securities listed on leading stock exchanges. If you want personalized advice and guidance, select a financial advisor as your stock broker or opt for a full-service brokerage firm.
Whichever model you choose, your broker will transmit buy and sell orders to the broker-dealers who trade on a stock exchange. They always attempt to find a buyer or seller who can meet the price specified in your order, although it may take more or less time to fill your order, depending on the relative levels of market liquidity.
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