Friday, June 1, 2007

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, stock exchanges are part of a global market for securities.

Contents

[hide]

[edit] History of stock exchanges

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 13th century 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 ruled by a council of influential citizens, not by a duke.

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. In 1688, the trading of stocks began on a stock exchange in London.

[edit] The role of stock exchanges

Stock exchanges have multiple roles in the economy, this may include the following:[1][2]

[edit] Raising capital for businesses

The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public.

[edit] 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.

Facilitating 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 one of the simplest and most common ways for a company to grow by acquisition or fusion.

Redistribution of wealth

Stocks exchanges do not exist to redistribute wealth although casual and professional stock investors through stock price increases and dividends get a chance to share in the wealth of profitable businesses.

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 imposed 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).

Creating 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 the opportunity for small investors to own shares of the same companies as large investors, and to enjoy similar rates of return(s).

Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to finance infrastructure projects such as sewage 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, thus loaning money to the government. The issuance of such municipal bonds can obviate the need to directly tax the citizens in order to finance development, although by securing such bonds with the full faith and credit of the government instead of with collateral, the result is that the government must tax the citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature.

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..

Major stock exchanges

The major stock exchanges in the world include:

See also: Category:Stock exchanges

[edit] Listing requirements

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.

[edit] 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:

  • 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.
  • 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]).
  • 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]).
  • Bombay Stock Exchange: Bombay Stock Exchange (BSE) has requirements for a minimum market capitalization of Rs.250 Million and minimum public float equivalent to Rs.100 Million([3]).

[edit] Ownership

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).

[edit] Other types of exchanges

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.

[edit] The future of stock exchanges in the United States

The future of stock trading appears to be electronic, as competition is continually growing between the remaining traditional New York Stock Exchange specialist system against the relatively new, all Electronic Communications Networks, or ECNs. ECNs point to 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 that an array of special interests profits at the expense of investors in even the most mundane exchange-directed trades. Machine-based systems, they argue, are much more efficient, because they speed up the execution mechanism and eliminate the need to deal 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."

William Lupien, founder of the Instinet trading system and the OptiMark system, has been quoted as saying "I'd definitely say the ECNs are winning... 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, ECNs have been developing rapidly.

One example of improved efficiency of ECNs is the prevention of front running, by which manual Wall Street traders use knowledge of a customer's incoming order to place their own orders so as to benefit from the perceived change to market direction that the introduction of a large order will cause. By executing large trades at lightning speed without manual intervention, ECNs make impossible this 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. All traders who are quick enough are able to use that information to anticipate price movements.

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"— 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.

[edit] The "upstairs market"

NASDAQ in Times Square, New York City.
NASDAQ in Times Square, New York City.

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 ensure symmetric 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 United States 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.

[edit] 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.

References

  1. ^ ROLE OF THE EXCHANGE IN THE ECONOMY, NAIROBI STOCK EXCHANGE, source: Nairobi Stock Exchange website, accessed February 2007
  2. ^ The Role of a Stock Market in a General Equilibrium Model with Technological Uncertainty, Peter A. Diamond, The American Economic Review, Vol. 57, No. 4 (Sep., 1967), pp. 759-776, source: JSTOR website,