STOCK EXCHANGES

A stock exchange is a forum provided by any organization, association, or group of persons for trading in securities representing shares of firms. By providing a trading system, a stock exchange performs two essential services. First, it provides a market for the buying and selling of stock. Second, it provides a way of monitoring the value of a stock investment portfolio.

The statutory definition of exchange as specified by the U.S. Securities and Exchange Commission (SEC) is a "market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange." The SEC carefully revised Rule 3b-16 to define these terms to mean any organization, association, or group of persons that: (1) brings together the orders of multiple buyers and sellers; and (2) uses established, nondiscretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.

A particular trading system may not be recognized as an exchange, depending on the securities laws of the country. Given that differences across countries may exist with respect to legal definitions, a more detailed discussion of what constitutes a trading system is appropriate.

TRADING SYSTEMS

Trading markets may be defined as systems consisting of an order-routing system, an information network, and a trade-execution mechanism. A trading system is a communications technology for passing allowable messages between traders, together with a set of rules that transform traders' messages into transaction prices and allocations of quantities of stock among market participants.

In the United States, the Securities Exchange Act of 1934, the primary legislation covering the securities markets, undertook to update the regulatory requirements for the buying and selling of securities. After the exposure of a concept release in May 1997 to gather ideas from interested parties, final rules effective as of April 1, 2000, were adopted. The regulations for alternative trading systems were promulgated to strengthen the public markets for securities, while encouraging innovative new markets. These new regulations more effectively integrated the growing number of alternative trading systems into the national market system, accommodated the registration of proprietary alternative trading systems as exchanges, and provided an opportunity for registered exchanges to better compete with alternative trading systems.

Exchanges may offer more than one trading system. Types of trading systems are sometimes differentiated by the form of market intermediation provided by entities with direct access to the system. The nature of competition between exchanges is a defining feature, since exchanges may adopt varying market structures in order to compete in different fashions. A stock exchange is a business entity, and the form of its governance arrangements is important in understanding its nature and conduct.

The nature of allowable messages varies with the trading system's (exchange's) rules and technology. A typical message consists of an offer to buy, or to sell, a given number of shares at a certain price. The New York Stock Exchange (NYSE), for example, permits such messages, as well as orders, to buy some amount of stock at current market prices.

The transformation of messages and information from the system into a price and a set of quantity allocations is governed by another set of rules. In open outcry auctions, bids and offers are orally exchanged by traders standing in a single physical location. The acceptance of a bid or offer by another trader generates a transaction. In dealer systems, such as NASDAQ, dealers accept orders by telephone or computerized routing, and transact at prices they themselves set. In batch auctions, such as that of the Arizona Stock Exchange, price is set by maximizing trading volume, given order submission at the time of the auction. In most computerized markets, traders submit orders to a central limit order book, and a mathematical algorithm determines prices and quantities. Examples include the CAC system of the Paris Bourse and the OM system of the Stockholm Stock Exchange.

MARKET INTERMEDIATION

Investors are generally not given free access to trading systems. Entry into the exchange's systems is intermediated by brokers. Brokers may simply route orders to exchanges. They sometimes make decisions as to what exchange, and what system within the exchange, should process various parts of an order. In open outcry markets, brokers also physically represent orders on the floor of the exchange.

Another class of intermediaries is known as market makers. Market makers trade for their own accounts, usually providing an offer to sell and an offer to buy at the same time, but at different prices. In doing so, they both contribute to the pricing process and supply immediacy to the market by a willingness to be a counterparty to an order for which another investor may not be immediately available.

On some exchanges, most notably the NYSE, there is one primary market maker designated by the exchange, known as the specialist. The specialist obtains consideration for the supply of immediacy and the maintenance of an orderly market by having private access to order-flow information through the order book for the stock.

There may be multiple market makers in a given stock, regardless of the precise form of trading system. The prototype example is that of dealer markets, in which the dealers are the market makers. They post bids and offers, and trade out of their own inventory.

Electronic-limit order-book markets offer the possibility of trading without such financial intermediation. In practice, however, market makers exist on electronic markets as well. Multiple market makers in a security are often designated by an exchange, fulfill obligations not dissimilar to those of a specialist, and receive some consideration for the service. Anyone with direct access to the trading system can function as a market maker, however, simply by continuously offering quotes for stock on both sides of the market.

COMPETITION

Exchanges have two clienteles: companies, which list their shares, and investors, who trade on the exchange. Historically, the product (a listing service) offered to companies was a bundle, consisting of (1) liquidity, (2) monitoring of trading against forms of fraud, (3) standard-form rules of trading, (4) a signal that a listing firm's stock is of high quality, and (5) a clearing function to ensure timely payment and delivery of shares. The product offered to investors consists of a combination of liquidity and pricing information, as well as any benefits accruing to the investor from the bundle offered to companies.

Government regulation and increased competition from automated-trading systems lessen the importance of exchange monitoring and standardized rules. Technological advances in information processing allow better signals about company quality than simple listings, permit wide distribution of pricing information outside exchanges, and enable separation of the clearing function from other exchange operations. The result is that exchanges now compete solely along the dimensions of liquidity and cost of trading.

Competition through liquidity and cost has led to increased automation of the exchange trade-execution process. Automated exchanges are less costly to build and operate, and provide lower-cost trade execution. Liquidity is enhanced by the ability to establish wide networks of traders through communications systems with an automated-execution system at the nexus. The drive for increased liquidity through computerization has led to new developments in the structure of the exchange services industry, most notably including mergers and alliances between automated exchanges for increased order flow.

Communications technology and the computerization of trade execution have also globalized trading. The physical location and boundaries of an exchange floor are no longer important to traders. A company does not need to be listed, or even traded, on a domestic exchange. Not only are there many possible execution services providers, but electronic exchanges place their own terminals on foreign soil, allowing direct access to overseas listings, regardless of the nationality of the companies involved.

GOVERNANCE

The organizational structures commonly found for exchanges are: nonprofit, the consumer cooperative, and for-profit. Historically, most exchanges have been non-profit organizations, but since the 1990s, there have been trends toward incorporating an exchange as a for-profit organization. Ten such demutualizations globally are listed in Ian Domowitz and Benn Stell's article, "Automation, Trading Costs, and the Structure of the Securities Trading Industry" (1999), and such initiatives are under investigation by many traditional exchanges, including NASDAQ and the NYSE. The NYSE approved its intention of becoming a publicly traded entity after its merger with the Archipelago exchange as of early 2006. (The merger was approved in December 2005.) Archipelago is an electronic trading platform that owns the Pacific Stock Exchange. Shares of the merged company, to be known as NYSE Group Inc., will trade on the exchange's board under the NYX symbol. There is uncertainty about what changes will be made in the traditional process of buying and selling securities at the NYSE as a result of the merger.

Increased competition between exchanges forces the change in ownership structure. This is the view of the exchange services industry, as well. The industry argument is simply that a corporate structure with a profit motive enables faster initiatives in response to competitive advances than a committee- and voting-oriented membership organization. Efforts for mergers and acquisitions among several stock exchanges throughout the globe were in process as of the end of 2005.

Changes in the contractual relationship between exchanges and listing companies might outweigh competition as a force behind the shift from cooperative to corporate ownership arrangements. The long-term mutual dependency between companies and exchanges no longer exists, and market makers do not make firm-specific investments that might be fostered under a cooperative umbrella.

The third view is that communications and computerized execution technology permit and encourage the change in governance structure. Traditional exchanges are limited by floor space, and access is rationed through the sale of limited memberships. In an automated auction, there are no barriers to providing unlimited direct access with a transactions-fee pricing structure, which in turn lends itself to corporate for-profit operations. All examples of the change in governance begin with a conversion from floor-trading technology to automated-trade execution. For trade-execution services with no prior history of cooperative governance structure, the mutual structure is routinely avoided in favor of a for-profit joint-stock corporation.

One important aspect of the exchange's governance in the United States is the concept of self-regulation, a concept that highlights the American approach to the regulation of securities and futures markets. As a self-regulating organization it is subject to constraints with regard to its governance structure. The Securities Exchange Act imposes four major obligations on exchanges: a fair representation of its members in the selection of directors; one or more directors representing issuers and investors who are not associated with members of the exchange; subject to some exception, only brokers and dealers may become members; and its rules are designed to protect investors and the public interest.

see also Stock Indexes ; Stocks

bibliography

Dalton, John (Ed.). (2001). How the stock exchange works. Paramus, NJ: New York Institute of Finance.

Domowitz, Ian, and Stell, Benn (1999). Automation, trading costs, and the structure of the securities trading industry. In Robert E. Litan and Anthony M. Santomero (Eds.), Brookings-Wharton Papers on financial services. Washington, DC: Brookings Institution.

Hart, Oliver, and Moore, John (1996). The governance of exchanges: Members' cooperatives versus outside ownership. Oxford Review of Economic Policy 12, 53–69.

Lee, Ruben (1998). What is an exchange?: The automation, management, and regulation of financial markets. New York: Oxford University Press.

Macey, Jonathan R., and O'Hara, Maureen (1999). Globalization, exchange governance, and the future of exchanges. In Robert E. Litan and Anthony M. Santomero (Eds.), Brookings-Wharton Papers on Financial Services. Washington, DC: Brookings Institution.

Securities and Exchange Commission. (1998, December 8). Final rules: Regulation of exchanges and alternative trading systems (Release No. 34–40760, File No. S7-12–98). Retrieved March 3, 2006, from http://pages.stern.nyu.edu/~jhasbrou/Teaching/SEC/ATS/Reg%20ATS%20Summary.pdf

Stoll, Hans (1992). Principles of trading market structure. Journal of Financial Services Research, 6, 75–107.

Wyss, B. O'Neill (2001). Fundamentals of the stock market. New York: McGraw-Hill.

Anand Shetty

Ian Domowitz