What is a Stock Exchange? Definition, How It Works & Examples

What is a Stock Exchange?

A stock exchange is a marketplace or platform that allows traders to buy and sell shares of publicly listed companies. It is usually centralized, thus reducing counterparty risks that are present in transactions that take place only between two parties.

Examples of Stock Exchanges

There are several well-known stock exchanges across the world today, such as:

New York Stock Exchange (NYSE)
London Stock Exchange (LSE)
Shanghai Stock Exchange
S&P 500
NASDAQ

Out of these, the New York Stock Exchange and NASDAQ are the biggest, with a market capitalization of $25 trillion and $21.7 trillion, respectively, as of August 2023.

The NASDAQ index mostly contains tech giants such as Apple, Meta, and Alphabet. The S&P 500, on the other hand, is mostly considered a gauge of how the US stock market is doing.

Types of Stock Exchanges

Stock exchanges may appear in a variety of types, as highlighted below.

Electronic Exchanges

Electronic exchanges operate mostly or completely electronically. This eliminates the need for buyers and sellers to meet face-to-face. As such, there is no physical market either. This makes transactions much quicker, more efficient, and safer.

The volume of trade per day can also be significantly more than in a physical market, often going up to billions.

The NASDAQ stands tall as a beacon among electronic exchanges, well-known not just for its prominence but also for its stringent listing criteria, governance benchmarks, and requisite stock price thresholds.

Auction Exchanges

Auction exchanges, or open-outcry markets, are some of the oldest in the world. In these types of exchanges, buyers and sellers meet face-to-face in trading rooms or pits. They then bid out loud for the prices of stocks. The lowest price is the absolute minimum a seller is prepared to take, whereas the current or highest price is the most a buyer is willing to offer.

The convenience and speed of electronic exchanges have led to a decline in the prevalence of auction-style trading platforms.

Nevertheless, a small cluster of exchanges, exemplified by the prestigious New York Stock Exchange, remains dedicated to upholding the traditional auction method.

Alternative Trading Systems (ATSs)

The most common alternative trading systems are Electronic Communication Networks (ECNs). These usually provide direct connections between buyers and sellers without going through other market middlemen.

They enable access to most of the same stocks traded on the NASDAQ or other well-known stock exchanges such as the NYSE.

Some investors prefer ECNs as they reduce transaction costs and operate outside usual trading hours. Institutional investors use these networks the most at the moment.

How do Stock Exchanges Work?

Stock exchanges can usually be divided into two markets, primary and secondary.

The primary market is for newly-listed companies issuing shares and bonds for the first time. These can be in the form of initial public offerings (IPOs), preferred allotment, private placement, or a rights issue, amongst others.

This gives investors an opportunity to buy securities straight from the issuer, sometimes at a discounted price. Companies also use this as an opportunity to raise funds or increase their credibility and visibility.

Following the initial issue, the secondary market is where the bulk of stock and securities trading is done. This is usually between the investors themselves rather than between the issuer and the investor.

Investors can range in size from giant institutional investors and financial corporations to retail investors and individuals. The secondary market is what is most commonly recognized or associated with stock exchanges.

Compliance Measures

Listed corporations often face various compliance measures. Among these is the necessity to uphold a minimum stock price consistently throughout the year.

Additional requirements can be contingent upon the regulatory authorities within a given country. These typically encompass financial obligations, adherence to regulations, and benchmarks related to the company’s reputation and performance.

Stock exchanges provide a variety of financial information, such as:

Dividend yield
Net income
Revenue
Market capitalization
Profit margin
Price/earnings ratio (P/E ratio)
Earnings estimates
Debt
Trading volumes

From Application to Trading: Understanding Online Brokerages

Investors usually have to either use a broker or create an account with a brokerage firm in order to trade on exchanges. This is due to the investor regulations imposed by most stock exchanges. A broker acts as a middleman by taking trade orders from the client and placing or executing them on the exchange.

Nowadays, online brokerages have made the signing-up process simpler. Investors usually fill out application forms with their details, and when they are verified, they can make their first deposits. They can also use free demo accounts before using real money to get a better feel of the stock market.

Once they’ve made their deposits, they can simply select whatever stocks they want to trade and start trading. Online brokerages also have facilities, such as stop-losses, to help investors not lose more than they can afford.

Pros and Cons for Investors

Benefits

Ease of buying and selling: Most stock exchanges have millions of participants worldwide, which can contribute to purchases and sales of shares being made quickly and smoothly.

Organized and Regulated: Stock exchanges are very organized and strictly regulated. This means that they follow regular trading hours and trading processes. This reduces operational bottlenecks. It also allows brokers and investors to find all of their trades in the same place on a centralized system, which greatly simplifies trading.

Diversity of Investments: Investors have a wealth of choices through stock exchanges and can choose to invest in several companies or types of securities at the same time. This goes a long way in reducing risk while at the same time providing much greater access.

Transparency: Exchanges are usually transparent with their financial transactions. This reduces the risk of fraud, as well as unfair manipulation of prices or trading volumes. It also goes a long way in instilling trust in investors.

Drawbacks

Volatility: Stocks, as with most other asset classes, can be very volatile at times. They are usually impacted by consumer sentiment and current news. The central bank and other regulatory authority decisions can also have a negative impact on stocks.

Skewed Markets: Traders who have the most capital and best reputations have a way of dictating the sentiment and even direction of markets, sometimes through their own trades. This can cause quite unpredictable price swings, creating more risk for smaller traders.

Variety of Fees: Trading on any stock exchange can quickly get expensive, especially for novice traders, who may need brokerages, which come with commissions.

Differences Between Stock Exchanges and OTC Markets

Aspect	Stock Exchanges	OTC Markets
Trading Venue	Established exchanges	Broker-dealer network
Securities Traded	Bonds, stocks, derivatives, etc.	Bonds, stocks, derivatives, etc.
Listing Requirements	Stringent, typically for larger companies	Less stringent, often for smaller companies
Regulations	More regulated	Fewer regulations but not completely exempt
Company Size	Usually, bigger companies listed	Often smaller companies listed
Reason for Listing	Companies meeting set criteria	When a company fails to continue maintaining its annual or other regulatory requirements, an exchange may demote it to OTC
Investor Access	Limited to bigger, established companies	Access to shares of companies that may not be on other exchanges
Stock Type	Mostly established, stable stocks	Includes low-cost penny stocks, potentially risky
Trade Volume	Generally high	Can be low, leading to liquidity issues
Safety Concerns	More regulated, generally safer	Riskier due to the potential inclusion of unstable firms