A stock exchange is a forum for trading in securities representing shares of firms. An exchange provides ways by which financing is raised by the sale of shares to outside investors. It provides a mechanism for the valuation of companies through the process of price discovery and a means by which such information is disseminated.
A formal definition of the term exchange is a critical component of law and regulation regarding securities trading markets, discussed by Domowitz (1996) and Lee (1998). In the United States, the New York Stock Exchange (NYSE) is legally an exchange, while the markets operated by the National Association of Securities Dealers (NASDAQ) and Instinet, an electronic communications network (ECN), are not. All three examples nevertheless satisfy the definition of a stock exchange given above. Given differences across countries with respect to legal definitions, a more unified approach is needed to focus the discussion.
The approach taken here is to identify important attributes and functions of institutions satisfying the basic definition in practice. Exchanges provide trading systems and may offer more than one. Types of trading systems are sometimes differentiated by the form of market intermediation provided by entities with direct access to the system. The nature of competition between exchanges is a defining feature, since exchanges may adopt varying market structures in order to compete in different fashions. A stock exchange is a business entity, and the form of its governance arrangements is important in understanding its nature and conduct.
Trading Systems
Trading markets may be defined as systems consisting of an order routing system, an information network, and a trade execution mechanism (Stoll, 1992). A trading system is a communications technology for passing allowable messages between traders, together with a set of rules that transform traders' messages into transactions prices and allocations of quantities of stock among market participants.
The nature of allowable messages varies with the exchange's rules and technology. A typical message consists of an offer to buy, or to sell, a given number of shares at a certain price. The NYSE, for example, permits such messages, as well as orders, to buy some amount of stock at current market prices. The OptiMark system of the Pacific Stock Exchange also allows traders to submit a message indicating the strength of the traders' desire to transact an amount of stock at a particular price. Orders for the shares of a company, contingent on the completion of transactions in other companies, are possible. As technology advances, the ability of trading systems to offer more flexible messages increases.
The transformation of messages and information from the system into a price and a set of quantity allocations is governed by another set of rules. In open outcry auctions, bids and offers are orally exchanged by traders standing in a single physical location. The acceptance of a bid or offer by another trader generates a transaction. In dealer systems, such as NASDAQ, dealers accept orders by telephone or computerized routing, and transact at prices they themselves set. In batch auctions, such as that of the Arizona Stock Exchange, price is set by maximizing trading volume, given order submission at the time of the auction. In most computerized markets, traders submit orders to a central limit order book, and a mathematical algorithm determines prices and quantities. Examples include the CAC system of the Paris Bourse and the OMsystem of the Stockholm Stock Exchange. The range of possibilities here is large, and a taxonomy of rules is given in Domowitz (1993).
Market Intermediation
Investors are generally not given free access to trading systems. Entry into the exchange's systems is intermediated by brokers. Brokers may simply route orders to exchanges. They sometimes make decisions as to what exchange, and what system within the exchange, should process various parts of an order. In open outcry markets, brokers also physically represent orders on the floor of the exchange.
Exchanges are differentiated most by a class of intermediaries known as market makers. Market makers trade for their own accounts, usually providing an offer to sell and an offer to buy at the same time, but at different prices. In doing so, they both contribute to the pricing process and supply immediacy to the market by a willingness to be a counterparty to an order for which another investor may not be immediately available.
On some exchanges, most notably the NYSE, there is one primary market maker designated by the exchange, known as the specialist. The specialist obtains consideration for the supply of immediacy and the maintenance of an orderly market by having private access to order-flow information through the order book for the stock.
There may be multiple market makers in a given stock, regardless of the precise form of trading system. The prototype example is that of dealer markets, in which the dealers are the market makers. They post bids and offers, and trade out of their own inventory.
Electronic limit order book markets offer the possibility of trading without such financial intermediation. In practice, however, market makers exist on electronic markets as well. Multiple market makers in a security are often designated by an exchange, fulfill obligations not dissimilar to those of a specialist, and receive some consideration for the service. Anyone with direct access to the trading system can function as a market maker, however, simply by continuously offering quotes for stock on both sides of the market.
Competition
Exchanges have two clienteles: companies, which list their shares, and investors, who trade on the exchange. Historically, the product (a listing) offered to companies was a bundle, consisting of(1) liquidity, (2) monitoring of trading against forms of fraud, (3) standard-form rules of trading, (4) a signal that a listing firm's stock is of high quality, and (5) a clearing function to ensure timely payment and delivery of shares (Macey and O'Hara, 1999). The product offered to investors consists of a combination of liquidity and pricing information, as well as any benefits accruing to the investor from the bundle offered to companies.
Government regulation and increased competition from automated trading systems lessen the importance of exchange monitoring and standardized rules. Technological advances in information processing allow better signals about company quality than simple listings, permit wide distribution of pricing information outside exchanges, and enable separation of the clearing function from other exchange operations. The result is that exchanges now compete solely along the dimensions of liquidity and cost of trading (Domowitz and Stell, 1999; Macey and O'Hara 1999).
Competition through liquidity and cost has led to increased automation of the exchange trade execution process. Automated exchanges are less costly to build and operate, and provide lower-cost trade execution. Liquidity is enhanced by the ability to establish wide networks of traders through communications systems with an automated execution system at the nexus. The drive for increased liquidity through computerization has led to new developments in the structure of the exchange services industry, most notably including mergers and alliances between automated exchanges for increased order flow.
Communications technology and the computerization of trade execution have also globalized trading. The physical location and boundaries of an exchange floor are no longer important to traders. A company does not need to be listed, or even traded, on a domestic exchange. Not only are there many possible execution services providers, but electronic exchanges place their own terminals on foreign soil, allowing direct access to overseas listings, regardless of the nationality of the companies involved. An example is the U.K. electronic exchange, Tradepoint, which conducts operations in the United States.
Governance
Exchanges historically have been organized as not-for-profit membership cooperatives. Exchange governance is shifting to a for-profit corporate structure. Ten such demutualizations globally are listed in Domowitz and Stell (1999), and such initiatives are under investigation by many traditional exchanges, including NASDAQ and the NYSE. Three rationales for this change have been proposed.
Increased competition between exchanges forces the change in ownership structure (Hart and Moore, 1996). This is the view of the exchange services industry, as well. The industry argument is simply that a corporate structure with a profit motive enables faster initiatives in response to competitive advances than a committee-and voting-oriented membership organization.
Changes in the contractual relationship between exchanges and listing companies might outweigh competition as a force behind the shift from cooperative to corporate ownership arrangements (Macey and O'Hara, 1999). The long-term mutual dependency between companies and exchanges no longer exists, and market makers do not make firm-specific investments that might be fostered under a cooperative umbrella.
The third view is that communications and computerized execution technology permit and encourage the change in governance structure (Domowitz and Stell, 1999). Traditional ex changes are limited by floor space, and access is rationed through the sale of limited memberships. In an automated auction, there are no barriers to providing unlimited direct access, with a transactions-fee pricing structure, which in turn lends itself to corporate for-profit operations. All examples of the change in governance begin with a conversion from floor trading technology to automated trade execution. For trade execution services with no prior history of cooperative governance structure, the mutual structure is routinely avoided in favor of a for-profit joint-stock corporation.
Bibliography
Domowitz, Ian. (1993). "A Taxonomy of Automated Trade Execution Systems." Journal of International Money and Finance 12:607-631.
Domowitz, Ian. (1996). "An Exchange Is a Many Splendored Thing: The Classification and Regulation of Automated Trading Systems." In Andrew Lo, ed., The Industrial Organization and Regulation of Securities Markets. Chicago: University of Chicago Press.
Domowitz, Ian, and Stell, Benn. (1999). "Automation, Trading Costs, and the Structure of the Securities Trading Industry." In Robert E. Litan and Anthony M. Santomero, eds., Brookings-Wharton Papers on Financial Services. Washington, DC: Brookings Institution.
Hart, Oliver, and Moore, John. (1996). "The Governance of Exchanges: Members' Cooperatives Versus Outside Ownership." Oxford Review of Economic Policy 12:53-69.
Lee, Ruben. (1998). What Is an Exchange? The Automation, Management, and Regulation of Financial Markets. Oxford: Oxford University Press.
Macey, Jonathan R., and O'Hara, Maureen. (1999). "Globalization, Exchange Governance, and the Future of Exchanges." In Robert E. Litan and Anthony M. Santomero, eds., Brookings-Wharton Papers on Financial Services. Washington, DC: Brookings Institution.
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