Investopedia/David Harper: Getting to Know the Stock Exchanges

Investopedia
Getting to Know the Stock Exchanges
By David Harper
Share
Loading the player...

A stock exchange does not own shares. Instead, it acts as a market where stock buyers connect with stock sellers. Stocks can be traded on one or more of several possible exchanges such as the New York Stock Exchange (NYSE). Although you will most likely trade stocks through a broker, it is important to understand the relationship between exchanges and companies, and the ways in which the requirements of different exchanges protect investors.


How Does It All Start?

The primary function of an exchange is to help provide liquidity; in other words, to give sellers a place to "liquidate" their shareholdings.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). In an IPO, a company sells shares to an initial set of public shareholders (the primary market). After the IPO "floats" shares into the hands of public shareholders, these shares can be sold and purchased on an exchange (the secondary market).

The exchange tracks the flow of orders for each stock, and this flow of supply and demand sets the stock price. Depending on the type of brokerage account you have, you may be able to view this flow of price action. For example, if you see that the "bid price" on a stock is $40, this means somebody is telling the exchange that he or she is willing to buy the stock for $40. At the same time you might see that the "ask price" is $41, which means somebody else is willing to sell the stock for $41. The difference between the two is the bid-ask spread.
Auction Exchanges - NYSE

The NYSE is primarily auction-based, which means specialists are physically present on the exchange's trading floors. Each specialist "specializes" in a particular stock, buying and selling the stock in the auction. These specialists are under competitive threat by electronic-only exchanges that claim to be more efficient (that is, they execute faster trades and exhibit smaller bid-ask spreads) by eliminating human intermediaries.

The NYSE is the largest and most prestigious exchange. Listing on the NYSE affords companies great credibility, because they must meet initial listing requirements and also comply annually with maintenance requirements. For example, for U.S. companies to remain listed, the NYSE companies must keep their price above $4 per share and their market capitalization (number of shares times price) above $40 million.

Furthermore, investors trading on the NYSE benefit from a set of minimum protections. Among several of the requirements that the NYSE has enacted, the following two are especially significant:

    Companies must get shareholder approval for any equity incentive plan (for example, stock option plan or restricted stock plan). In the past, companies were allowed to sidestep shareholder approval if an equity incentive plan met certain criteria; this, however, prevented shareholders from knowing how many stock options were available for future grant.
    A majority of the board of directors' members must be independent. However, each company has some discretion over the definition of "independent," which has caused controversy. Furthermore, the compensation committee must be entirely composed of independent directors, and the audit committee must include at least one person who possesses "accounting or financial expertise."

The Nasdaq (an Electronic Exchange)

The Nasdaq, an electronic exchange, is sometimes called "screen-based" because buyers and sellers are connected only by computers over a telecommunications network. Market makers, also known as dealers, carry their own inventory of stock. They stand ready to buy and sell Nasdaq stocks, and they are required to post their bid and ask prices.

Nasdaq has listing and governance requirements similar to the NYSE. For example, a stock must maintain a $4 minimum price. If a company does not maintain these requirements, it can be delisted to one of the OTC markets discussed below.

Electronic Communication Networks (ECNs)

ECNs are part of an exchange class called alternative trading systems (ATS). ECNs connect buyers and sellers directly. Because they allow for direct connection, ECNs bypass the market makers. You can think of them as an alternative means to trade stocks listed on the Nasdaq and, increasingly, other exchanges as well (such as the NYSE or foreign exchanges).

There are several innovative and entrepreneurial ECNs, and they are generally good for customers because they pose a competitive threat to traditional exchanges, and therefore push down transaction costs. Currently, ECNs do not really serve individual investors; they are mostly of interest to institutional investors.

There are several ECNs, including INET (the result of an early 2004 consolidation between the Instinet ECN and Island ECN) and Archipelago (one of the four original ECNs that launched in 1997).
Over-the-Counter (OTC)

Over-the-counter (OTC) refers to markets other than the organized exchanges described above. OTC markets generally list small companies, and often (but not always) these companies have "fallen off" to the OTC market because they were delisted from Nasdaq.

Some individual investors will not even consider buying OTC stocks due to the extra risks involved. On the other hand, some strong companies trade on the OTC. In fact, several strong companies have deliberately switched to OTC markets to avoid the administrative burden and costly fees that accompany regulatory oversight laws such as the Sarbanes-Oxley Act. On balance, you should be careful when investing in the OTC if you do not have experience as several penny stocks trade over-the-counter.  (To learn more about penny stocks, read our penny stock series).

There are two OTC markets:

    Over-the-Counter Bulletin Board (OTCBB) is an electronic community of market makers. Companies that fall off the Nasdaq often end up here. On the OTCBB, there are no "quantitative minimums" (no minimum annual sales or assets required to list).
    Companies that list on the OTC Pink are not required to register with the SEC. Liquidity is often minimal. Also, keep in mind that these companies are not required to submit quarterly 10Qs.

The Bottom Line

To be traded, every stock must list on an exchange where buyers and sellers meet. The two big U.S. exchanges are the NYSE and the fast-growing Nasdaq. Companies listed on either of these exchanges must meet various minimum requirements and baseline rules concerning the "independence" of their boards. But these are by no means the only legitimate exchanges. Electronic communication networks are relatively new, but they are sure to grab a bigger slice of the transaction pie in the future. Finally, the OTC market is a fine place for experienced investors with an itch to speculate and the know-how to conduct a little extra due diligence.


Related Articles

    Insights
    The NYSE and Nasdaq: How They Work
    Learn some of the important differences in the way these exchanges operate and the securities that trade on them.
    Investing
    A Look At Primary And Secondary Markets
    Knowing how the primary and secondary markets work is key to understanding how stocks, bonds and other securities are traded.
    Trading
    Activities You Can Take Advantage Of In The Pre-Market And After-Hours Trading Sessions
    A great deal can happen in between the New York close of the market and the open the following morning. Learn how you can access opportunities and hedge against risk outside regular trading hours.
    Investing
    The Dirt On Delisted Stocks
    Listed securities are "the cream of the crop." Find out how a firm can lose that status and why you should be wary.
    Insights
    The Birth of Stock Exchanges
    Learn how British coffeehouses helped give rise to the juggernaut that is the NYSE.
    Investing
    Why Do Penny Stocks Fail?
    Penny stocks are speculative and highly risky investments. Lack of government and stock exchange oversight and general information leaves penny stock investors open to sudden losses.
    Insights
    How The NYSE Makes Money
    We examine how the New York Stock Exchange, the leading US stock exchange, makes money.

RELATED FAQS

    Move from an OTC to a major exchange
    In order to move a company from over-the-counter market to a major exchange, a number of conditions must be met to being ... Read Answer >>
    Does all common stock trade on exchanges?
    Find out about types of common stock that trade on stock exchanges and types that trade in varied over-the-counter (OTC) ... Read Answer >>
    What are the steps to get a company listed on the OTCBB?
    The over-the-counter bulletin board (OTCBB) is a regulated quotation service for over-the-counter (OTC) securities. The securities ... Read Answer >>
    What are the risks involved in OTC (over-the-counter) trading?
    Learn about the significant disadvantages and risks that are involved for investors seeking to trade in over-the-counter ... Read Answer >>
    What does it mean when my broker says that shares are for auction?
    An auction market is one in which stock buyers enter competitive bids and stock sellers enter competitive offers at the same ... Read Answer >>

Trending

    Sohn Investment Conference 2018: Hedge Fund Titans Give Hot Tips
    Everything You Need To Know About Earnings
    How can traders profit from a death cross pattern?
    6 Things We Learned From Jeff Bezos' Annual Letter
    A Stock Sell-Off Vocabulary Guide

Hot Definitions

    Return on Assets - ROA
    Fibonacci Retracement
    Ethereum
    Cryptocurrency
    Financial Industry Regulatory Authority - FINRA
    Initial Public Offering - IPO

    Work With Investopedia
    About Us Advertise With Us Contact Us Careers

© 2018, Investopedia, LLC. All Rights Reserved Terms Of Use Privacy Policy