What Is a Stock Exchange?

What is a stock exchange?

Since stocks are one of the most popular trading instruments among retail and institutional investors alike, understanding what stock exchanges are can take your trading experience to a whole new level.

Stock exchanges are marketplaces where traders can buy and sell stocks, bonds, commodities, and other assets. Unlike over-the-counter markets, stock exchanges act as intermediaries between investors and companies whose stocks are traded on exchanges.

In the past, all stock exchanges were physical spaces, but today, most modern exchanges operate online as electronic trading platforms. The most well-known among these are the NASDAQ, the New York Stock Exchange (NYSE), the London Stock Exchange (LSE), the Tokyo Stock Exchange (JPX), and several others. Although there are still exchanges with physical trading floors, the global trend overwhelmingly favors electronic trading and digital platforms.

How stock exchanges work

Stock exchanges allow traders and investors to buy or sell securities of well-known companies.

However, before they can do this, the stocks they want to buy must first be introduced to the general public. For this to happen, companies conduct their initial public offerings (IPOs). That’s when a company issues shares for the public to purchase for the first time. The IPO is what essentially transforms the company from a privately owned one to a publicly traded one. IPOs allow companies to raise capital to pay off debt, fund new developments, boost brand recognition, and so on.

After the IPO, new shareholders can sell their shares to other members of the general public through the secondary market, including stock exchanges. That’s where the actual trading occurs. The price of shares changes depending on their supply and demand levels, so the value of the stocks will go up if the public is interested in owning a share in a company.

Stock exchange requirements

Unsurprisingly, stock exchanges are strictly regulated and set high standards for all participants.

To be listed on a stock exchange, companies must meet certain requirements. These conditions allow stock exchanges to eliminate financially unviable candidates and reaffirm their own transparency, security, and reputability.

In return, the companies listed on stock exchanges get:

• increased brand recognition;

• higher liquidity;

• increased capitalization;

• better reputation;

• international recognition.

If a company’s shares are traded on a stock exchange, it automatically gets recognized as a successful business, attracting the attention of influential investors. This is why so many companies aim to get their securities listed on exchanges.

At the same time, stock exchanges also have a number of requirements for potential buyers and sellers. Retail traders can’t access stock exchanges directly. They can only do so through third parties like trading brokers or dealers. To access a stock exchange, brokers must have a valid license, enough capital, and tools to ensure the security of their clients’ funds.

Stringent stock exchange requirements offer numerous advantages. When investors have confidence in a company, its stock price tends to increase, thereby enabling the company to secure greater funds for its growth and development. An exemplary case illustrating this phenomenon is Tesla’s remarkable growth trajectory, depicted in the chart below.

Key players at a stock exchange

A typical stock exchange includes the following participants:

• Brokers. Stock exchange brokers are intermediaries that help traders and investors to purchase or sell securities through an exchange. Brokers receive buy and sell orders from their clients and execute them without interfering with how the market works. For their services, brokers are paid a commission from financial transactions they carry out.

• Dealers. Unlike brokers, dealers trade stocks to earn money for themselves instead of specific clients. Dealers aim to trade with sellers and buyers simultaneously, openly posting their bids and asking prices. The difference between those — the spread — is how dealers make money on stock exchanges.

• Market makers. While market makers aren’t necessarily separate members of stock exchanges, they play an important role in increasing the liquidity of the stock market. Market makers are dealers who buy and sell large volumes of stocks to create more opportunities for trades to occur, facilitating seamless trading.

Types of stock exchanges

There are many ways to organize stock exchanges. Let’s find out which are the most prevalent in the stock market.

Auction exchange

An auction exchange is a marketplace where transactions are based on the highest prices buyers are willing to pay for a stock and the lowest prices sellers are willing to accept for the same stock. If a buyer’s bid price and a seller’s ask price match, their orders are paired together and executed. By avoiding negotiations between the parties, auction exchanges streamline the trading process, making it as fast and efficient as possible.

Another thing worth mentioning is that auction exchanges are sometimes hosted at a physical location.

Electronic exchange

Electronic exchanges don’t require physical contact between buyers and sellers. Instead, the system automatically connects buyers and sellers via online marketplaces, often resulting in nearly instantaneous transactions. Electronic exchanges also help investors save money due to low transaction costs, which is another reason this type of stock exchange has almost replaced traditional trading.

Electronic communication network (ECN)

An ECN is a different type of stock exchange. Unlike other types, ECNs establish direct connections between buyers and sellers and don’t require the presence of market makers. ECNs belong to alternative trading systems and compete with traditional stock exchanges, which helps keep the transactional costs at bay.

While some ECNs allow retail traders and investors to trade, this type of exchange is mainly used by institutional investors who can afford to move large sums of money.

Stock exchanges: summary

Stock exchanges play an essential role in the economy and stimulate the investment process. They ensure transparency and security of trading, facilitate economic development, attract investors, and maintain stock market stability. Nowadays, traders and investors can access stock exchanges through licensed brokers from the comfort of their homes, which makes the stock market one of the most liquid financial markets in the world.