What Is a Stock Exchange & How Does It Work?

The idea of a stock market dates back centuries to when merchants wanted to start or grow businesses but couldn’t accomplish this without capital investment. Joint stock companies, like the Dutch East India Company in the early 17th century, became a way for shareholders to buy, sell, and trade their ownership in a company with other investors. Stock markets around the world have used this same model, and businesses in the Industrial Revolution began using jointly held ventures as a way of generating start-up money.

Today, the global stock market is made up of more than 60 stock exchanges around the world, and 21 of them have a market cap of over $1 trillion.

What is a stock exchange?

A stock exchange is a market where securities such as stocks and bonds are bought and sold. Companies issue shares and sell them to the public through these exchanges, and investors buy them with the expectation that the share price will rise. It makes the capital-raising process possible for the company and provides a regulated environment where all those involved have certain assurances about how trades will take place.

Stock exchanges work as primary markets and secondary markets. Companies use the stock market as a primary market to issue its shares of stock via an initial public offering (IPO), which helps it raise capital from investors. Once the company’s shares are listed, those shares can then be bought and sold on the secondary market using the exchange as a trading platform.

Stock exchange vs. stock market: What’s the difference?

The stock market is generally an umbrella term for all the stock exchanges that comprise the market. The market is made up of many exchanges that trade equity securities. Other financial securities, like exchange-traded funds, corporate bonds, and derivatives also trade in the stock market.

What is the purpose of a stock exchange?

The exchange is more than a simple marketplace. It also serves two important market functions:

1. To help companies fund their businesses by selling portions, or shares. The company can avoid the debt of borrowing capital by instead offering its stock.
2. To give investors a regulated way to invest in and share profits of public companies by selling their stock at a profit and/or receiving dividends from their shares.
   

The stock exchange on which a company is listed provides other features to both companies and investors. It publishes real-time pricing information so that investors can make buy or sell decisions. It also publishes company announcements and financial reports. And it bears the burden of ensuring that prices are transparent, that trading is fair, and that there’s liquidity in the market—or plenty of investors looking to trade—which greases the wheels of the financial markets.

Stock exchanges, along with their other functions, maintain indexes like the S&P 500 or the Nasdaq 100. They may support corporate transaction activities, like processing a company’s dividend payments to shareholders.

How do stock exchanges work?

When most people think of a stock exchange, they envision the New York Stock Exchange (NYSE), with its shouting brokers negotiating buys and sells via hand signals. But most exchanges have changed over to electronic trading platforms. Still, the basic idea remains the same: Buyers want to buy a stock low and sell it high for a profit later, and sellers naturally want the best price they believe they can get. The exchange is largely anonymous for the company issuing shares. Rather than borrow money from people they know, they’re inviting the public in—young investors trading on electronic platforms, publicly-traded mutual funds, and everyone in between.

To be listed on an exchange, companies must meet minimum standards. Listing requirements measure the size and market share of the security as a way of determining the company’s viability on their exchange. For instance, the New York Stock Exchange requires firms to have 1.1 million publicly traded shares with a market value of at least $100 million, and a minimum listing price of $4 per share. Stocks that fall below the minimum are subject to delisting.
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In August 2021, the Securities and Exchange Commissionvoted to approve new listing rules submitted by the Nasdaq that would require companies to have a minimum of two board members that identify as “diverse”—at least one who identifies as a woman and one who identifies as an underrepresented minority and/or LGBTQ+.

How stock exchanges makes money

The exchanges are for-profit ventures and charge a fee for the services they provide. Most of their revenue comes from the transaction fees charged for each trade made on their platform. They can also earn fees from companies listing their shares in initial public offerings and the offering stock in follow-on offerings. Along with fees, the exchanges make money from the market data they generate and publish, such as reference data, real-time prices, historical data, and other information that’s used for research.

At a high level, some exchanges offer high-frequency trading to mutual fund clients. They can license their indices for a profit. They can even offer products like data subscription and educational products for a fee.

Benefits and drawbacks of being listed on a stock exchange

Being listed on a major stock exchange earns a company prestige, but it isn’t without cost and risk.

Benefits of being listed on a stock exchange:

• Prestige.

  Because the capital and other listing requirements for major exchanges are notoriously strict, a listing on one of the world’s biggest exchanges is prestigious and provides a company great visibility.
  

Drawbacks of being listed on a stock exchange:

• Cost.

  Stock exchanges do command fees, so a company needs to be trading at a certain volume and price to make paying those fees worthwhile.

• Volatility.

  While exchanges are regulated, which means that there’s low operational risk, being listed on one doesn’t guarantee a company won’t be subject to other risks like market volatility. A company’s stock can suffer from the vagaries of the market because of world events, political circumstances, or even public sentiment that’s unrelated to its fundamentals.

Different types of stock exchanges

There are various ways to run a stock exchange, and the following three are the most common:

• Auction.

  Like any auction, the price of an item (in this case a security) is what the market will command. The highest price a bidder is willing to pay is a bid, and the lowest price a seller is willing to accept is the offer. The auction market is also called the open outcry system, and it operates just as it sounds—with brokers and traders on a physical trading floor communicating by calling out or with signals. Most have phased this system out in favor of electronic trades, but the New York Stock Exchange famously still operates this way.
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• Dealer.

  Dealers post the prices they’re willing to buy or sell specific stocks, and then use their own funds to buy and sell securities. This lends liquidity to the market because a seller doesn’t need to wait for a buyer to free up their cash to buy other securities.
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• Electronic.

  Electronic exchanges operate via a virtual trading floor using automated electronic communication networks (ECNs). Nearly all the exchanges now use this kind of electronic trading, even when they still have physical trading floors.

Major stock exchanges in the U.S.

The leading stock exchanges in the US are the New York Stock Exchange (NYSE) and the Nasdaq. Some companies may trade on multiple exchanges.

• New York Stock Exchange.

  The NYSE is the largest stock exchange in the world. As of July 2021, it had a market capitalization of almost $25.6 trillion. It is famously still an auction-based market and has a physical trading floor at its 11 Wall Street address, although most of the trades happen electronically. There are 2,400 companies listed on the NYSE, and many represent the world’s blue-chip stocks.
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• Nasdaq.

  The second largest stock exchange in the world is also headquartered in New York, and was the first to employ electronic trading when it opened in the 1970s. Among the 3,000 companies that list on Nasdaq are many of the world’s biggest tech companies. It operates via a dealer market system.
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• NYSE American.

  Formerly the American Stock Exchange until it was acquired by NYSE Euronext in 2008, this exchange generally trades small-cap stocks. It is considered a good listing place for early-stage companies. Compared with NYSE and Nasdaq, this exchange trades at lower volumes.

Alternative exchanges

While stock markets were once the only way to trade securities, there are alternative exchanges now that compete with them.

• Dark pools:

  Dark pools are an alternative trading system that are privately organized exchanges where certain investors can make trades anonymously. The rationale for trading this way is that organizations making large trades can avoid devaluing the stock by causing public perception of a massive sell-off.

Blockchain ventures:

Exchanges that trade cryptocurrencies and crypto derivatives have automated the work of traders and can offer zero-cost services.

How to get started in the stock market

One of the first considerations early investors make is how actively they want to manage their investing. Investors can open an online brokerage account if they plan to be completely hands-on. Some investors hire a financial advisor or money manager who can guide them through the process but will complete the actual buy and sell orders with the broker-dealers on the exchange. Some investors opt for a robo-advisor, which is a service provided by many brokerage firms that offers low-cost investment management, investing money based on specific goals.
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Investing in an employer’s 401(k) retirement plan is one way to learn about making small contributions and focusing on the long-term aspects of investing in the stock market. Many investors choose a combination of these strategies, working with an advisor but also on their own for some trades, plus contributing to a retirement plan.

The bottom line

The stock market comprises the many stock exchanges that offer shares of companies’ stock to the public. Investing in companies via a stock exchange is a way to own a piece of a company whose stock investors believe will increase over time. When people begin investing in stocks, they may want to consider whether it’s important to them to stick to stocks that are listed on the largest exchanges and how actively they would like to participate in the process.