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A stock exchange is a marketplace where people can buy and sell shares of companies. It is a place where stockholders can trade stocks, bonds, and other securities. The most famous stock exchange in the world is the New York Stock Exchange (NYSE). It is located in New York City and is the largest stock exchange in the biosphere by market capitalization.
How Does a Stock Exchange Work?
To understand the basics of how a stock exchange works, it’s helpful to understand the concept of primary and secondary markets.
Primary market: In a primary market, companies sell new shares of stocks to the public for the first time, such as an initial public offering (IPO). One of the most important things to note is in a primary market. Securities are purchased directly from the issuing company.
Secondary market: After the issuance of new securities, the secondary market is where investors buy and sell securities to each other. This is where exchanges come in. The NYSE and the Nasdaq are both secondary markets. Secondary markets are essentially what’s understood as the “stock market.”
While an IPO on the primary market allows private companies to raise large amounts of capital, subsequent trading on the secondary market informs the current value of the stock through supply and demand.
Broadly speaking, a stock exchange can work as either an auction market or a dealer market.
Functions of a Stock Exchange
Securities are among the most intensely regulated industries in the US, and the SEC is responsible for regulatory oversight and investor protection.
More broadly, the government agency ensures that listed companies do not partake in fraud by overseeing the registering of new securities and coordinating appropriate filings, like quarterly earnings reports, so that companies remain transparent to potential buyers.
Stock exchanges serve a few essential functions to both investors, traders, and listed companies.
- Transparent securities pricing: Exchanges must ensure that buyers and sellers have access to accurate, up-to-date pricing and order information to make informed investment decisions. They play a significant role in providing fair and transparent securities pricing while also matching buyers and sellers efficiently.
- Liquidity: Stock exchanges help new companies raise capital while providing instant order access to investors. Exchanges promote market liquidity, allowing for the rapid exchange of stock without significantly affecting its price.
- Secure transactions: Although being accessible to many market participants is a crucial piece of the puzzle. It’s also important that buyers and sellers are credible and appropriately verified. Stock exchanges ensure that participants meet necessary requirements and follow regulations as directed in order to reduce the risk of default.
- Investor protection: Exchanges are accessible by both institutional and less experienced investors and must offer protections, like appropriately categorizing stocks by level of risk, to those with limited financial knowledge. This promotes consumer trust and protects less experienced investors from severe financial loss.
Important Stock Exchange Participants
Stock exchanges have quite a few moving parts, and everyone involved plays a specific and necessary role. Here’s a breakdown of who’s who:
Brokers
Brokers are professionals or firms that act as intermediaries between outside investors who don’t have access to the inner workings of the exchange and the market. They represent their client’s best interests. Aiming to buy or sell at a price most beneficial to the investor, and are usually paid on a commission basis.
Dealers
Dealers are firms or individuals who execute trades for themselves, rather than for a client or third party, in an effort to maximize their own profits. They make money by selling stocks at higher prices than they initially paid.
Market Makers
Market makers are dealers who aim to increase the liquidity of the entire exchange, buying and selling a large volume of stocks to ensure trades occur. This heightened liquidity benefits all parties involved by making trading more efficient.
Broker-dealers
As the name suggests, these individuals or firms are a combination of brokers and dealers. Serving the interests of both themselves and their clients.
The Bottom Line
Stock exchanges are physical or electronic spaces where shares of publicly trade companies are bought and sold in real time. These exchanges are highly regulated and generally safer than the OTC market because regulations make companies less likely to default in paying investors back.
Exchanges simplify the process of finding buyers and provide these investors with peace of mind. With regard to a company’s credibility since they regulate the companies listed on the exchange.
