Stock exchange
A
stock exchange,
share market or
bourse is a
corporation or
mutual organization which provides facilities for
stock brokers and
traders, to trade company
stocks and other
securities. Stock exchanges also provide facilities for the issue and redemption of securities, as well as, other financial instruments and
capital events including the payment of income and
dividends. The securities traded on a stock exchange include:
shares issued by companies,
unit trusts and other pooled investment products and
bonds. To be able to trade a security on a certain stock exchange, it has to be
listed there. Usually there is a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are
electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to
investors is by definition done in the
primary market and subsequent trading is done in the
secondary market. A stock exchange is often the most important component of a
stock market. Supply and demand in stock markets is driven by various factors which, as in all
free markets, affect the price of stocks (see
stock valuation).
There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be
off exchange or
over-the-counter. This is the usual way that
bonds are traded. Increasingly more and more stock exchanges are part of a global market for securities.
In 12th century France the
courratiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. As these men also traded in debts, they could be called the first brokers.
Some stories suggest that the origins of the term "bourse" come from the latin
bursa meaning
a bag because, in 13c.
Bruges, the sign of a purse (or perhaps three purses), hung on the front of the house where merchants met.
However, it is more likely that in the late 13th century commodity traders in Bruges gathered inside the house of a man called Van der Burse, and in 1309 they institutionalized this until now informal meeting and became the "Bruges Bourse". The idea spread quickly around Flanders and neighbouring counties and "Bourses" soon opened in Ghent and Amsterdam.
In the middle of the 13th century
Venetian bankers began to trade in government securities. In
1351 the Venetian Government outlawed spreading rumors intended to lower the price of government funds. There were people in
Pisa,
Verona,
Genoa and
Florence who also began trading in government securities during the 14th century. This was only possible because these were independent city states were not ruled by a duke but by a council of influential citizens.
The Dutch later started
joint stock companies, which let
shareholders invest in business ventures and get a share of their profits - or losses. In 1602, the
Dutch East India Company issued the first shares on the
Amsterdam Stock Exchange. It was the first company to issue
stocks and
bonds.
Raising capital for businesses
The Stock Exchange provides
companies with the facility to raise
capital for expansion through selling
shares to the
investing public.
Mobilizing savings for investment
When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle
deposits with
banks, are mobilized and redirected to promote
business activity with benefits for several economic sectors such as
agriculture,
commerce and
industry, resulting in a stronger
economic growth and higher
productivity levels.
Facilitate company growth
Companies view acquisitions as an opportunity to expand
product lines, increase distribution channels, hedge against volatility, increase its
market share, or acquire other necessary business
assets. A
takeover bid or a
merger agreement through the
stock market is the simplest and most common way to company growing by acquisition or fusion.
Redistribution of wealth
By giving a wide spectrum of people a chance to buy shares and therefore become part-owners (
shareholders) of
profitable
enterprises, the stock market helps to reduce large income inequalities. Both casual and professional
stock investors through
stock price rise and
dividends get a chance to share in the profits of promising business that were set up by other people.
Corporate governance
By having a wide and varied scope of owners, companies generally tend to improve on their
management standards and
efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations by public stock exchanges and the government. Consequently, it is alleged that
public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than
privately-held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors). However, some well-documented cases are known where it is alleged that there has been considerable slippage in
corporate governance on the part of some public companies (
e.g. Enron Corporation,
MCI WorldCom,
Pets.com,
Webvan, or
Parmalat).
Creates investment opportunities for small investors
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small
stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides an extra source of income to small savers.
Government raises capital for development projects
The Government and even local authorities like municipalities may decide to borrow money in order to finance huge infrastructure projects such as sewerage and water treatment works or housing estates by selling another category of
securities known as
bonds. These bonds can be raised through the Stock Exchange whereby members of the public buy them. When the Government or Municipal Council gets this alternative source of funds, it no longer has the need to overtax the people in order to finance development.
Barometer of the economy
At the stock exchange, share prices rise and fall depending, largely, on
market forces. Share prices tend to rise or remain stable when companies and the
economy in general show signs of stability and growth. An
economic recession, depression, or
financial crisis could eventually lead to a
stock market crash. Therefore the movement of share prices and in general of the
stock indexes can be an indicator of the general trend in the economy.
The listing requirements are the set of conditions imposed by a given stock exchange upon companies that want to be listed on that exchange. Such conditions sometimes include minimum number of shares outstanding, minimum market capitalization, and minimum annual income.
Requirements by stock exchange
Companies have to meet the requirements of the exchange in order to have their stocks and shares listed and traded there, but requirements vary by stock exchange:
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London Stock Exchange: The main market of the
London Stock Exchange has requirements for a minimum market capitalization (£700,000), three years of audited financial statements, minimum public float (25 per cent) and sufficient working capital for at least 12 months from the date of listing.
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NASDAQ Stock Exchange: To be listed on the
NASDAQ a company must have issued at least 1.25 million shares of stock worth at least $70 million and must have earned more than $11 million over the last three years ([
1]).
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New York Stock Exchange: To be listed on the
New York Stock Exchange (NYSE), for example, a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years ([
2]).
Stock exchanges originated as
mutual organizations, owned by its member stock brokers. There has been a recent trend for stock exchanges to
demutualize, where the members sell their shares in an
Initial public offering. In this way the mutual organization becomes a corporation, with shares that are listed on a stock exchange. Examples are
Australian Stock Exchange (1998),
Euronext (2000, as of
14 June 2006 in talks to a proposed merger process with the New York Stock Exchange),
NASDAQ (2002) and the
New York Stock Exchange (2005).
In the 19th century, exchanges were opened to trade
forward contracts on
commodities. Exchange traded forward contracts are called
futures contracts. These
commodity exchanges later started offering future contracts on other products, such as interest rates and shares, as well as
options contracts. They are now generally known as
futures exchanges.
The future of stock trading is electronic, seemingly pitting the remaining traditional
New York Stock Exchange specialist system against the relatively new, all
Electronic Communications Networks, or ECNs. ECNs extol their speedy execution of large block trades, while specialist system proponents cite the role of specialists in maintaining orderly markets, especially under extraordinary conditions or for special types of orders.
The ECNs contend an array of special interests profits at the expense of investors from even the most mundane exchange-directed trades. Machine-based systems, on the other hand, are said to be much more efficient, improving the traditional execution mechanism and eliminating the requirement of dealing with an intermediary.
Historically, the '
market' (which, as noted, encompasses the totality of stock trading on all exchanges) has been slow to respond to technological innovation. Conversion to all-electronic trading could erode/eliminate the trading profits of floor specialists and the NYSE's "upstairs traders."
"I'd definitely say the ECNs are winning," declares William Lupien, founder of the
Instinet trading system and the
OptiMark system. "Things happen awfully fast once you reach the tipping point. We're now at the tipping point."
Congress mandated the establishment of a national market system of
multiple exchanges in 1975. Since then, the 'electronic communications networks' have been developing rapidly.
Electronic networks, by executing large trades at lightning speed, reduce the possibility of
front running, or trading ahead of a customer's order, an
illegal practice for which several NYSE floor brokers were investigated and severely fined in recent years. Under the specialist system, when the market sees a large trade in a name, other buyers are immediately able to look to see how big the trader is in the name, and make inferences about why s/he is selling or buying.
That is how the Street anticipates price action.ECNs have changed ordinary stock transaction processing (like brokerage services before them) into a commodity-type business. ECNs could regulate the fairness of initial public offerings (IPOs), oversee Hambrecht's OpenIPO process, or measure the effectiveness of securities research and use transaction fees to subsidize small- and mid-cap research efforts.
Some, however, believe the answer will be some combination of the best of technology and "upstairs trading"â€" in other words, a hybrid model.
Trading 25,000 shares of Lucent stock (recent quote: $2.80; recent volume: 49,069,700) would be a relatively simple e-commerce transaction; trading 100 shares of Berkshire Hathaway Class A stock (recent quote: $88,710.00; recent volume: 450) may never be. The choice of system should be clear (but always that of the trader), based on the characteristics of the security to be traded.
Even with ECNs forming an important part of a national market system, opportunities presumably remain to profit from the spread between the bid and offer price. That is especially true for investment managers that direct huge trading volume, and own a stake in an ECN or specialist firm. For example, in its individual stock-brokerage accounts,
Fidelity Investments runs 29% of its undesignated orders in NYSE-listed stocks, and 37% of its undesignated market orders through the Boston Stock Exchange, where an affiliate controls a specialist post.Fidelity says these arrangements are governed by a separate brokerage "order-flow management" team, which seeks to obtain the best possible execution for customers, and that its execution is highly rated.
The "upstairs market"
Recent research by Kumar Venkataraman, finance professor at SMU's Cox School of Business, and Hendrik Bessembinder offers insight and evidence into new possibilities and difficult issues facing stock exchanges. In
"Does an electronic stock exchange need an upstairs market?" from the July, 2003 issue of
Journal of Financial Economics, the authors find that a large proportion of institutional trading in electronic exchanges is executed away from the
centralized book in the informal 'upstairs market', thus presenting new challenges.
Despite the efficiencies of computerized markets, virtually every stock market is accompanied by a parallel "upstairs" market,
where larger traders employ the services of brokerage firms to locate counterparties and negotiate trade terms. Upstairs markets are based on relationships. Rather than submitting an electronic order to effortlessly attract counterparties, the upstairs brokers seek out counterparties (from traders known to them who might be interested). They then negotiate transactions that might otherwise be executed at an inordinate cost or delay. An electronic trading system lowers the fixed costs of trading for relatively liquid stocks in block sizes not likely to overwhelm the current market. However, it does not allow for the informal exchange of information (?) that is important for certain types of large trades and for illiquid stocks.
In electronic markets,
traders don't get a sense of who they're trading with, how much more the other party is trading, etc., and that information can be very important to some traders. Large (institutional) traders therefore seek other trading venues such as the 'upstairs market' to lower the risk of exposing their order positions, to insure symetric transfer of information, and to retain some of the give and take of the old
open outcry market.
Approximately 70% of block-size trade transactions are executed in the upstairs market in Paris.The
Paris Bourse provides an excellent illustration of the use of
upstairs intermediation markets, because its
electronic limit order market closely resembles the downstairs (electronic) markets envisioned by theorists. The best evidence from the Paris Bourse is that:
(1) Upstairs brokers lower the risk of
adverse selection by "certifying" block orders as uninformed (i.e., as not having access to nonpublic information).
(2) Upstairs brokers are able to tap into pools of hidden or unexpressed liquidity (they frequently 'go looking' for buyers or sellers not currently in the market).
(3) Traders strategically choose across the upstairs and downstairs markets to minimize expected execution costs (including
slippage, etc.).
(4) Trades are more likely to be routed upstairs if they are large or are in stocks with low overall trading activity.
The second result is the most novel and arguably the most important. The upstairs broker completes transactions by searching for institutional investors who may be interested in the stock, but who have not as yet formally expressed their trading intentions. It is documented that executions costs of transactions completed by the upstairs broker average only 35% of what they would have paid if completed against limit orders in the centralized electronic exchange, suggesting that trading relationship and the informal exchange of information between upstairs brokers and institutional traders helps lower execution costs. One major challenge facing electronic markets is the lack of a comparable mechanism of certification of traders and information exchange.
The
Euronext market allows large transactions in some stocks to be executed outside the quotes. Such outside-the-quote transactions are not permitted in U.S. markets. For eligible stocks in Paris, market participants agree to outside-the-quote execution mainly for more difficult trades and at times when downstairs liquidity is lacking. These likely represent trades that probably could not have been otherwise completed, suggesting that market quality can be enhanced by allowing participants more flexibility to execute blocks at prices outside the quotes.
These findings are particularly relevant to U.S. markets because quoted spreads and depths have decreased substantially in the wake of decimalization.The upstairs market in the
Paris Bourse completes two-thirds of block trading volume, compared with 20% on the New York Stock Exchange (NYSE). A likely explanation is that the NYSE floor allows large traders to execute customized strategies through a floor broker, while avoiding the risks of order exposure. If orders submitted to electronic markets do not allow block initiators to limit order exposure and trade strategically, then order flow is likely to migrate to alternative trading venues such as the upstairs market. If you're a liquidity trader, you don't want the system to be anonymous. If you're an informed trader you like anonymity because you can hide in the order flow.
To compete with broker-intermediated markets, the next generation of electronic trading systems needs to include features that better meet the needs of large traders, particularly the lack of anonymity. To allow large investors to manage order exposure in an electronic exchange, a wider range of order types that include state contingent exposure and execution algorithms need to be made available. The NYSE's recently introduced "Conversion and Parity" (
CAP) orders which are intended to be "smart" orders for large lots of stocks that are executed gradually through the day, contingent on market conditions, are a step in this direction.
The future role of the specialist
The specialist trades in circumstances when others do not or will not, and therefore takes on a risk which warrants compensation. The current debate centers on the model of compensation. The specialist at the Paris Bourse is compensated in cash and with investment banking business. In contrast, the NYSE specialist is compensated in the form of privileged information on order flow.
In recent months, several U.S. institutions have alleged that the NYSE trading abuses is an outcome of this compensation structure. The Paris model overcomes this criticism and presents an alternative for the NYSE to consider. Results show, however, that there continues to be a role for the specialist (or, at least, an 'upstairs trader') in electronic markets. Investors value the presence of a specialist because they can get in and out of a stock with greater ease.
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