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 share holdings.

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:

  1. 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.
  2. 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."

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.

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.

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
  1. Personal Finance

    The Birth Of Stock Exchanges

    Learn how British coffeehouses helped give rise to the juggernaut that is the NYSE.
  2. Fundamental Analysis

    Stock Exchanges: A Global Tour

    Check out the history and inner workings of the world's six most well-known stock exchanges.
  3. Economics

    The ABCs Of Stock Indexes

    Indexes can track market trends, but they're not always reliable. Can you trust them?
  4. Economics

    The Stock Market: A Look Back

    The past century was marked by furious economic change. What can it tell us about what lies ahead?
  5. Bonds & Fixed Income

    History Of The Toronto Stock Exchange

    Find out how the third-largest stock exchange in North America came to be.
  6. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  7. Mutual Funds & ETFs

    Best 3 Vanguard Funds that Track the Top 500 Companies

    Discover the three Vanguard funds tracking the S&P 500 Index, and learn about the characteristics and historical statistics of these funds.
  8. Bonds & Fixed Income

    Credit Default Swaps: An Introduction

    This derivative can help manage portfolio risk, but it isn't a simple vehicle.
  9. Forex Education

    Time Value Of Money: Determining Your Future Worth

    Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation.
  10. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  1. How can I buy shares in the primary market?

    If you want to buy shares in the primary market, you need to either be part of a syndicate or one of the lucky few whose ... Read Full Answer >>
  2. What kinds of financial instruments are designated as “Securities” by Cabinet Order?

    In Japan, securities are regulated by the Diet and the Financial Services Agency, or FSA. Rulings about securities come down ... Read Full Answer >>
  3. When did Facebook go public?

    Facebook, Inc. (NASDAQ: FB) went public with its initial public offering (IPO) on May 18, 2012. With a peak market capitalization ... Read Full Answer >>
  4. How do financial advisors execute trades?

    Today, almost every investor invests through online brokerage accounts. Investors often believe that their trades are directly ... Read Full Answer >>
  5. Do penny stocks trade after hours?

    Penny stocks are common shares of public companies that trade at a low price per share. These companies are normally small, ... Read Full Answer >>
  6. What is a stock split? Why do stocks split?

    All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center