Where do you go when you want to purchase some shares in a company? You go to your broker and hit buy, but what actually happens during the transaction? In this Investing 101 article, we’re going to have a look at stock exchanges. What are they? What are the different types?
The function of a stock exchange is simply to bring together people looking to buy shares with those looking to sell. There are a few different types of exchanges that each have their own unique way of working.
Stock exchanges also have another very important function. They allow prices to be set. Depending on the supply and demand of a particular stock, its share price can either increase or decrease. The maximum price an investor is willing to pay is known as the bid price, and the lowest price an investor is wiling to sell for is known as the ask price. The difference between the two is called the bid-ask spread.
Before a company can be listed on a stock exchange, it first has to go through an initial public offering (IPO). IPOs take private companies public and allow anyone to purchase shares.
The New York Stock Exchange
The largest stock exchange in the world is the New York Stock Exchange (NYSE) which currently has a market cap of around $22 trillion. The NYSE is an example of an auction market, or auction exchange, where buyers and sellers are constantly putting in competitive bids and offers.
As an example of how auction exchanges work, imagine there a three people that want to buy shares of an imaginary company, A, along with three additional people that want to sell shares in the same company. The buyers decide that the maximum they are willing to pay for a share is $5.01, $5.02 and $5.04 respectively, and the sellers decide that the minimum they are willing to sell their shares for is $5.04, $5.06 and $5.07. If this was to happen, the two people that want to buy and sell their shares at $5.04 would have their orders executed, and the current share price of company A would be set to $5.04.
OTC Stock Exchanges
Why are there so many different exchanges? Well, each exchange has its own individual rules and regulations surrounding what companies are allowed to list on them. For example, to be listed on the NYSE, a company must have 1.1 million public-traded shares along with a minimum price per share of $4. Large exchanges also come with large listing and yearly fees, putting them out of reach of smaller companies.
Over the counter (OTC) exchanges provide a decentralised market for shares to be traded. With OTC exchanges, there is no central party involved in the transaction. Two people can exchange their shares directly, and there are much lower fees and regulatory requirements when compared to larger exchanges such as the NYSE.
As a general rule of thumb, the main companies listed on OTC exchanges are very small companies in their early stages, however some larger companies choose to list on OTC exchanges to escape the large listing fees. Usually, as a company grows and expands, they will try to meet the requirements to up list to more well-known exchanges as this helps to improve investor confidence.
Stock exchanges are an essential for companies. They help provide public access to shares of companies of all sizes, and as result, can help them to raise capital.