- A stock exchange is a central marketplace where stocks and other securities are traded, bought, and sold.
- Exchanges can be either physical or electronic, but electronic exchanges are now the norm.
- The main purpose of an exchange is to connect buyers and sellers, and to bring stability, transparency, and efficiency to the trading process.
- Visit Business Insider’s Investing Reference library for more stories
A stock exchange is a place where shares of publicly traded companies are bought and sold in real-time, either physically or electronically.
When you think of buying stock, the first thing to understand is the stock market is actually made up of a network of exchanges. The leading stock exchanges in the US are the New York Stock Exchange (NYSE) and the Nasdaq.
It’s on these regulated exchanges where a lot of action takes place. Stock exchanges are a major part of the market, and understanding how they work can give you a better handle on the inner workings of the stock market at large.
What is a stock exchange?
A stock exchange is a marketplace where you buy stocks, bonds, and other securities. It provides a platform for companies to sell stocks, and for investors to trade those stocks between each other – all within a regulated space that aims to make everything as efficient and transparent as possible.
There are many stock exchanges around the world, each catering to different markets. The NYSE, for example, is one of many stock exchanges in the world, but it’s also the largest by market capitalization, which measures the total value of securities traded there.
Historically, stock exchanges were primarily physical spaces with men standing on a floor yelling buy and sell orders. These days, exchanges are largely virtual with computers matching buyers and sellers together. The Nasdaq, which began operations in 1971, is a prime example of an electronic exchange.
When a company is “listed” on an exchange, that means the company can be traded on it. Listing requirements vary by exchange, but include meeting minimum criteria, such as number of shareholders, earnings, and stock price.
In return for meeting these requirements, companies enjoy the prestige of being on a major stock exchange. Being listed on a popular exchange gives companies visibility within the global marketplace.
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.
In an auction market, traders bid on the price of a security based on how much they believe in its success, or how badly they want a stake in that company. Typically, buyers strive to get the lowest price possible, so that they can sell for a profit later, while sellers aim to be appraised appropriately.
In a dealer market, multiple dealers, or “market makers,” post the prices at which they’re willing to buy and sell a security, and the differences between the posted bid and ask prices illustrate the cost to investors. Market makers use their own capital to engage in the process and work to provide liquidity, making it quicker and easier to trade.
Trading through a stock exchange tends to be safer than the over-the-counter (OTC) market, where transactions take place directly between two parties rather than being facilitated by an intermediary. Generally, the OTC market is less regulated than a stock exchange and features smaller, riskier companies, like penny stocks.
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 key 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 major 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. Brokers represent their clients’ best interests, aiming to buy or sell at the 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. Dealers 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.
Major stock exchanges
There are many stock changes around the world. Here is a look at a few, along with their most current market cap.
|New York Stock Exchange||United States||$25.6 trillion|
|NASDAQ||United States||$19.5 trillion|
|Shanghai Stock Exchange||China||$6.9 trillion|
|Euronext Stock Exchange||Netherlands||$6.8 trillion|
|Hong Kong Stock Exchange||Hong Kong||$6.1 trillion|
|Tokyo Stock Exchange||Japan||$5.6 trillion|
|Shenzhen Stock Exchange||China||$5 trillion|
|London Stock Exchange||England||$4.3 trillion|
|Toronto Stock Exchange||Canada||$2.9 trillion|
|Bombay Stock Exchange||India||$2.8 trillion|
The financial takeaway
Stock exchanges are physical or electronic spaces where shares of publicly traded 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 regards to a company’s credibility since they regulate the companies listed on the exchange.