Understanding the Stock Market
The stock market allows buyers and sellers of securities to meet, interact, and transact, in person or electronically. The markets allow for price discovery for shares of corporations and serve as a barometer for the overall economy.
Since the number of stock market participants is huge, buyers and sellers are assured of a fair price and a high degree of liquidity as various market participants compete with one another for the best price.
A stock market is a regulated and controlled environment. In the United States, the main regulators include the Securities and Exchange Commission (SEC). Traders are regulated by the Financial Industry Regulatory Authority (FINRA).21
Since the stock market brings together hundreds of thousands of participants who wish to buy and sell shares, it ensures fair pricing practices and transparency in transactions.
While earlier stock markets issued and dealt in paper-based physical share certificates, the modern-day computerized stock markets operate electronically.
Though it is called a stock market and is primarily known for trading stocks, other securities—such as exchange-traded funds (ETFs)—are also traded in the stock markets.
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How the Stock Market Works
In a nutshell, stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence, with zero to low operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and secondary markets.3
As a primary market, the stock market allows companies to issue and sell their shares to the public for the first time through the process of an initial public offering (IPO). This activity helps companies raise necessary capital from investors.
This essentially means that a company divides itself into a number of shares (for example, 20 million shares) and sells some of those shares (say, 5 million shares) to the public at a price (for instance, $10 per share).3
To facilitate this process, a company needs a marketplace where these shares can be sold. This marketplace is provided by the stock market.
If everything goes according to plan, the company will successfully sell its 5 million shares at a price of $10 per share and collect $50 million. Investors will then own company shares, in the expectation that their value will rise or that they will receive dividend payments, or both.
The stock exchange acts as a facilitator for this capital-raising process and receives a fee for its services from the company and its financial partners.3
Following an IPO, the stock exchange serves as a trading platform for buying and selling the outstanding shares. This constitutes the secondary market. The stock exchange earns a fee for every trade that occurs on its platform during secondary market activity.3
Special Considerations
The stock exchange shoulders the responsibility of ensuring price transparency, liquidity, price discovery, and fair dealings in such trading activities.
As almost all major stock markets across the globe now operate electronically, the exchange maintains trading systems that efficiently manage buy and sell orders from various market participants. They perform the price-matching function to facilitate trade execution at a price that is fair to both buyers and sellers.
A listed company may also offer new, additional shares through other offerings at a later stage, such as through rights issues or follow-on offerings. They may even buy back or delist their shares. The stock exchange facilitates these transactions.
The stock exchange often creates and maintains various market-level and sector-specific indicators, like the S&P (Standard & Poor’s) 500 index and the Nasdaq 100 index, which provide a measure to track the movement of the overall market. Other methods include the Stochastic Oscillator and the Stochastic Momentum Index.
The stock exchanges also maintain official websites that host company news, announcements, and financial reporting. A stock exchange also supports various other corporate-level, transaction-related activities. For instance, profitable companies may reward investors by paying dividends that come from the company’s earnings. The exchange maintains that information and may support its processing to a certain extent.
Functions of a Stock Market
A stock market serves the following main functions:
Fair Dealing in Securities Transactions
Depending on the standard rules of supply and demand, the stock exchange needs to ensure that all interested market participants have instant access to data for all buy and sell orders, thereby helping in the fair and transparent pricing of securities. It should also perform efficient matching of appropriate buy and sell orders.4
For example, there may be three buyers who have placed orders for buying Microsoft shares at $100, $105, and $110, and there may be four sellers who are willing to sell Microsoft shares at $110, $112, $115, and $120. The exchange (through automated trading systems) needs to ensure that the best buy and the best sell are matched, which in this case is at $110 for the given quantity of trade.
Or, let’s say a U.S.-based software company is trading at a price of $100 and has a market capitalization of $5 billion. One day, a European Union (EU) regulator imposes a $2 billion fine on the company, which essentially means that 40% of the company’s value may be wiped out.
While the stock market may have imposed a trading price range of $90 and $110 on the company’s share price, it should efficiently change the permissible trading range to account for the possible changes in the share price. Otherwise, shareholders may struggle to trade the stock at a fair price.
Liquidity Maintenance
The stock market needs to ensure that whoever is qualified and willing to trade gets instant access to place orders and that the orders are executed at a fair price.
Security and Validity of Transactions
The market needs to ensure that all participants are verified and remain compliant with the necessary rules and regulations, leaving no room for default by any of the parties involved.
Additionally, it should ensure that all associated entities operating in the market adhere to the rules and work within the legal framework imposed by the regulator.
Support All Eligible Types of Market Participants
A marketplace is made up of a variety of participants, which include market makers, investors, traders, speculators, and hedgers. All of these participants operate in the stock market, with different roles and functions. For instance, an investor may buy stocks and hold them for the long term, spanning many years, while a trader may enter and exit a position within seconds. A market maker provides necessary liquidity in the market, while a hedger may like to trade in derivatives for mitigating the risk involved in investments. The stock market should ensure that all such participants are able to operate seamlessly, fulfilling their desired roles to ensure that the market continues to operate efficiently.
Investor Protection
The stock market has many wealthy participants and institutional investors, but it also has a large numerous of small investors.
Some of these investors have limited financial knowledge and may not be fully aware of the pitfalls of investing in stocks and other listed instruments. For this reason, the stock exchange implements some measures to shield investors from financial loss and ensure customer trust.
For instance, a stock exchange may categorize stocks in various segments depending on their risk profiles and allow limited in high-risk stocks. Exchanges often impose restrictions to prevent individuals without the necessary credentials to get into risky bets like derivatives.
Balanced Regulation
Listed companies are regulated, and their dealings are monitored by market regulators such as the SEC. In addition, the exchanges set certain requirements—for example, mandating timely filing of quarterly financial reports and instant reporting of relevant corporate developments—to ensure that all market participants are equally informed.
Failure to adhere to the regulations can lead to suspension of trading and other disciplinary measures.
Regulating the Stock Market
Most nations have a stock market, and each is regulated by a local financial regulator or monetary authority or institute. The SEC is the regulatory body charged with overseeing the U.S. stock market.
The SEC is a federal agency that works independently of the government and political pressure. The mission of the SEC is stated as “protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.” 5
Stock exchanges operate as for-profit institutes and charge a fee for their services. The primary source of income for these stock exchanges is the revenue from the transaction fees that are charged for each trade carried out on its platform. Additionally, exchanges earn revenue from the listing fee charged to companies during the IPO process and other follow-on offerings. An exchange also earns from selling market data generated on its platform—such as real-time data, historical data, summary data, and reference data—which is vital for equity research and other uses. Many exchanges will also sell technology products, such as a trading terminal and dedicated network connection to the exchange, to the interested parties for a suitable fee.
Competition Faced by Stock Markets
While individual stock exchanges compete against each other to get maximum transaction volume, stock markets as a whole may be facing competitive threats on two fronts.
Dark Pools
Dark pools, which are private exchanges or forums for securities trading and operate within private groups, are posing a challenge to public stock markets. Though their legal validity is subject to local regulations, they are gaining popularity as participants save big on transaction fees.
Blockchain Ventures
Amid the rising popularity of blockchains, many crypto exchanges have emerged. Such exchanges are venues for trading cryptocurrencies and derivatives associated with that asset class. Though their popularity remains limited, they pose a threat to the traditional stock market model by automating a bulk of the work done by various stock market participants and by offering zero- to low-cost services.
Significance of the Stock Market
The stock market is one of the most vital components of a free-market economy. It allows companies to raise money by offering stock shares and corporate bonds. It lets common investors participate in the financial achievements of the companies, make profits through capital gains, and earn money through dividends—although losses are also possible. While institutional investors and professional money managers do enjoy some privileges owing to their deep pockets, better knowledge, and higher risk-taking abilities, the stock market attempts to offer a level playing field to common individuals.
The stock market works as a platform through which savings and investments of individuals are efficiently channeled into productive investment opportunities. In the long term, this helps in capital formation and economic growth for the country.
Examples of Stock Markets
The first stock market in the world was the London Stock Exchange. It was started in a coffeehouse, where traders used to meet to exchange shares, in 1773.6 The first stock exchange in the United States was started in Philadelphia in 1790.7 The Buttonwood Agreement, so named because it was signed under a buttonwood tree, marked the beginnings of New York’s Wall Street in 1792. The agreement was signed by 24 traders and was the first American organization of its kind to trade in securities. The traders renamed their venture as the New York Stock and Exchange Board in 1817.8
For more information about such history, read The Birth of Stock Exchanges.
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