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 exchanges such as the New York Stock Exchange (NYSE) or the Nasdaq.  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.

Read on to find out more about some of the basics of the different kinds of exchanges where equities and other financial instruments are traded on a daily basis.

Key Takeaways

  • A stock exchange is a centralized location that brings corporations and governments together with investors so trading activity can take place.
  • Auction-based exchanges such as the New York Stock Exchange allow traders and brokers to physically and verbally communicate to execute buy and sell orders.
  • Electronic exchanges take place on electronic platforms so they don't require a centralized physical location for trades.
  • Electronic communication networks connect buyers and sellers directly by bypassing market makers.
  • The OTCBB and Pink Sheets are two different over-the-counter markets where stocks delisted or unlisted stocks trade.

How Stock Exchanges Work

A stock exchange is a place where different financial instruments are traded—stocks, commodities, derivatives, etc.—bringing corporations and governments together with investors. Exchanges help provide liquidity in the market, giving sellers a place to liquidate their shareholdings. They also ensure trading takes place in a fair and efficient manner so important information such as prices can be transmitted to investors and financial professionals.

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

The general public can trade shares on the secondary market after a company's initial public offering.

The exchange tracks the flow of orders for each stock. 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 a stock's bid price is $40, this means an investor is telling the exchange that they are willing to buy the stock for $40.

At the same time, you may see an ask price of $41, meaning somebody else is willing to sell the stock for $41. The difference between the two is the bid-ask spread.

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The History of Stock Exchanges

Auction Exchanges

Auction exchanges—or the auction market—is a place where buyers and sellers put in competitive bids and offers at the same time. In an auction exchange, the current stock price is the highest price a buyer is willing to spend on a security, while the lowest price is what the seller will accept. Trades are then matched and when paired together, the order is executed.

The auction market is also referred to as the open outcry system, where brokers and traders communicate physically and verbally on the trading floor or pit to buy and sell securities. Although this system is slowly being phased out by electronic systems, some exchanges still use the auction system including the New York Stock Exchange  (NYSE).

New York Stock Exchange (NYSE)

The New York Stock Exchange (NYSE) is the world's largest equities exchange. Although some of its functions have been transferred to electronic trading platforms, it remains one of the world's leading auction markets, meaning specialists (called "Designated Market Makers") are physically present on its trading floors. Each specialist specializes in a particular stock, buying and selling the stock in the auction.

These professionals 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.

Companies listed on the NYSE have great credibility because they have to meet initial listing requirements and must comply with annual maintenance requirements. To keep trading on the exchange, companies must keep their price above $4 per share.

Investors who trade 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:

  • Equity incentive plans must receive shareholder approval.
  • A majority of the board of directors' members must be independent, the compensation committee must be entirely composed of independent directors, and the audit committee must include at least one person who possesses "accounting or related financial management expertise."

Electronic Exchanges

Many exchanges now allow trading electronically. There are no traders and no physical trading activity. Instead, trading takes place on an electronic platform and doesn't require a centralized location where buyers and sellers can meet.

These exchanges are considered more efficient and much faster than traditional exchanges and carry out billions of dollars' worth of trades each day. The Nasdaq is one of the world's leading electronic exchange.

The Nasdaq

The Nasdaq is sometimes called screen-based because buyers and sellers are only connected 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 stocks on the Nasdaq and are required to post their bid and ask prices.

The exchange 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 an over-the-counter (OTC) market.

Electronic Communication Networks (ECNs)

Electronic communication networks (ECNs) are part of an exchange class called alternative trading systems (ATSs). ECNs connect buyers and sellers directly. Because they allow a direct connection between the two, ECNs bypass market makers. Think of them as an alternative means to trade stocks listed on the Nasdaq and, increasingly, other exchanges such as the NYSE or foreign exchanges.

There are several innovative and entrepreneurial ECNs that are generally good for customers because they pose a competitive threat to traditional exchanges, and therefore push down transaction costs. ECNs don't really serve individual investors but are mostly of interest to institutional investors.

Examples of ECNs include Nasdaq's Interbank Network Electronic Transfer (INET), Arca Options which is overseen by the NYSE, and E*Trade's Instinet.

Over-the-Counter (OTC)

The term over-the-counter (OTC) refers to markets other than the organized exchanges described above. OTC markets generally list small companies, many of which have fallen off to the OTC market because they were delisted.

There are two OTC markets. The first is the Over-the-Counter Bulletin Board (OTCBB)—an electronic community of market makers. Companies that fall off the Nasdaq often end up here. On the OTCBB, there are no quantitative minimums or no minimum annual sales or assets required to list. The second OTC market is referred to as the Pink Sheets, a listing service that doesn't require companies to register with the Securities and Exchange Commission (SEC). Liquidity is often minimal, and these companies are not required to submit quarterly 10Qs.

Some individual investors are wary of OTC stocks because of the extra risks involved. On the other hand, some strong companies trade on the OTC. In fact, several larger 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. You should be also careful when investing in the OTC if you do not have experience with penny stocks as these primarily trade over-the-counter.

The Bottom Line

Every stock must list on an exchange where buyers and sellers meet. The two big U.S. exchanges are the NYSE and the 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.