Markets and Exchanges

Today's markets are a dynamic mixture of tradition and innovation.

A stock transaction may take place on the floor of a traditional exchange, as the result of a telephone or electronic communication between two brokers, or whenever a buy order is matched electronically with a sell order.

Floor-based stock exchanges, such as the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are physical locations. Traders buy and sell stock auction style, competing with one another for the best price.

A number of trading posts, where one or more individual stocks are traded, are located across the exchange floor. Traders who want to buy or sell a stock gather at the post where that stock trades, directing their ask or bid price to the stock's specialist. On many exchanges, orders are also sent electronically to the specialist for execution.

Trading specialists are among the most important people on the exchange floor. It's their job to know, with the help of the order book to which they have exclusive access, the constantly changing supply and demand for their stock. They must make certain that buy and sell orders are in balance, and that trading moves smoothly.

However, traders interested in the same stock may strike a deal before making it to the specialist's post.

Instead of trading on an exchange floor, buyers and sellers in electronic stock markets operate through a vast international computer and telecommunications network.

The world's first electronic stock market, the Nasdaq Stock Market, was founded in the US in 1971 by the National Association of Securities Dealers (NASD).

The Nasdaq is an open market, multiple dealer system. This means that trade orders are routed to multiple dealers, called market makers, rather than going through a single specialist.

The market makers compete with each other electronically to buy and sell a particular stock. Prices are posted and matched at a rapid pace, which is one reason that trading volume on the Nasdaq market is often significantly greater than on traditional exchanges.

Many stock markets around the world are totally electronic and nearly all handle at least some transactions by computer. That not only allows markets to work together across national borders, but it has helped make many markets more transparent. Transparency means the uniform transaction standards are in place and investors have access to relevant information. And, since trades are cleared, or finalized, electronically rather than by using written records, there tend to be fewer errors than in the past.

In recent years, a revolution in electronic trading has followed in the footsteps of Nasdaq innovations. One of the biggest changes has been the arrival of electronic communication networks (ECNs). When an order is placed through an ECN, it's added to an electronic record of orders. If a matching order exists, the ECN executes the deal automatically and anonymously, without involving specialists or market makers.

ECNs have introduced several innovations. First, by keeping activity internal among its users, an ECN functions much like a stock exchange, doing away with the notion that an exchange must be a physical place. In fact, some ECNs have applied to become exchanges, which would allow them to trade securities listed on traditional exchanges such as the NYSE and AMEX.

By making all of the orders on their systems visible, ECNs provide investors a better sense of a stock's current market value. And, their computer and network-based systems permit after-hours trading, which is trading after the regular markets are closed. One potential problem of multiple, competing ECNs is that each of them individually tends to have lower trading volumes than the larger markets. As a result, buy and sell orders on ECNs might be settled at higher prices than trading in those same stocks on larger markets, where trading is more active.

Financial markets in most developed countries and in some emerging markets are constantly supervised to make sure that information is available and accurate, and that all investors are treated equitably. In the US, that's the job of the Securities and Exchange Commission (SEC).

Market regulators also monitor the markets for signs of fraud in securities transactions. For example, they police insider trading, which occurs when individuals buy or sell stock based on tips or special knowledge of the company's products, business developments, or merger or acquisition plans.

It is perfectly legal for corporate officers to buy and sell their company's stock as long as they follow certain rules and notify regulators. In fact, many news sources track trading by key employees as a barometer of a company's prospects.

However, when corporate officers or others with access to nonpublic information attempt to profit on the basis of what they know, they're breaking the law. For example, it's illegal for employees of a law firm that works for a corporation about to announce a major change to use private information to make personal investment decisions or to advise other people to buy or sell.

Both electronic and traditional exchanges have listing requirements, which means that corporations have to meet specific size and other criteria to be traded there. Smaller companies and many newer firms that don't make the cut are traded over the counter (OTC), which actually means over the telephone or computer.

Trading in OTC stocks may be thinner, or less frequent, than in listed stocks, and there is typically less information about these stocks available in the financial press.

OTC price information, and the names of dealers making a market in each stock, are available in one of two places: from the Pink Sheets' Electronic Quotation Service at www.pinksheets.com or the FINRA OTC Bulletin Board at www.otcbb.com.

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