Stock Exchange, organized market for buying and selling financial instruments known as securities, which include stocks, bonds, options, and futures. Most stock exchanges have specific locations where the trades are completed. For the stock of a company to be traded at these exchanges, it must be listed, and to be listed, the company must satisfy certain requirements. But not all stocks are bought and sold at a specific site. Such stocks are referred to as unlisted. Many of these stocks are traded over the counter—that is, by telephone or by computer.
Major stock exchanges in the United States include the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), both in New York City. Far more corporations list their stock on the NYSE than on the AMEX, however. Nine smaller regional stock exchanges operate in Boston, Massachusetts; Cincinnati, Ohio; Chicago, Illinois; Los Angeles, California; Miami, Florida; Philadelphia, Pennsylvania; Salt Lake City, Utah; San Francisco, California; and Spokane, Washington. In addition, most of the world’s industrialized nations have stock exchanges. Among the larger international exchanges are those in London, England; Paris, France; Milan, Italy; Hong Kong, China; Toronto, Canada; and Tokyo, Japan. These stock exchanges all have a central location for trading. The major over-the-counter market in the United States is the Nasdaq Stock Market (formerly, the National Association of Securities Dealers Automated Quotation [NASDAQ] system). The European Association of Securities Dealers Automated Quotation system (EASDAQ) is the major over-the-counter market for the European Union (EU).
Stock exchange transactions involve the activities of brokers and dealers. These individuals facilitate the buying and selling of financial assets. Brokers execute trades on behalf of clients and receive commissions and fees in exchange for matching buyers and sellers. Dealers, on the other hand, buy and sell from their own portfolios (inventories of securities). Dealers earn income by selling a financial instrument at a price that is greater than the price the dealer paid for the instrument. Some exchange participants perform both roles. These dealer-brokers sometimes act purely as a client’s agent and at other times buy and sell from their own inventory of financial assets.
|II||THE IMPORTANCE OF STOCK EXCHANGES|
Stock exchanges perform important roles in national economies. Most importantly, they encourage investment by providing places for buyers and sellers to trade securities. This investment, in turn, enables corporations to obtain funds to expand their businesses.
Corporations issue new securities in what is known as the primary market, usually with the help of investment bankers (see Investment Banking). The investment bank acquires the initial issue of the new securities from the corporation at a negotiated price and then makes the securities available for its clients and other investors in an initial public offering (IPO). In this primary market, corporations receive the proceeds of security sales. After this initial offering the securities are bought and sold in the secondary market. The corporation is not usually involved in the trading of its stock in the secondary market. Stock exchanges essentially function as secondary markets. By providing investors the opportunity to trade financial instruments, the stock exchanges support the performance of the primary markets. This arrangement makes it easier for corporations to raise the funds that they need to build and expand their businesses.
Although corporations do not directly benefit from secondary market transactions, the managers of a corporation closely monitor the price of the corporation’s stock in secondary markets. One reason for this concern involves the cost of raising new funds for further business expansion. The price of a company’s stock in the secondary market influences the amount of funds that can be raised by issuing additional stock in the primary market.
Corporate managers also pay attention to the price of the company’s stock in secondary markets because it affects the financial wealth of the corporation’s owners—the stockholders. If the price of the stock rises, then the stockholders become wealthier. This is likely to make them happy with the company’s management. Typically, managers own only small amounts of a corporation’s outstanding shares. If the price of the stock declines, the shareholders become less wealthy and are likely to be unhappy with management. If enough shareholders become unhappy, they may move to replace the corporation’s managers. Most corporate managers also receive options to buy company stock at a selected price, so they are motivated to increase the value of the stock in the secondary market.
Stock exchanges encourage investment by providing this secondary market. Stock exchanges also encourage investment in other ways. They protect investors by upholding rules and regulations that ensure buyers will be treated fairly and receive exactly what they pay for. Exchanges also support state-of-the-art technology and the business of brokering. This support helps traders buy and sell securities quickly and efficiently. Of course, being able to sell a security in the secondary market increases the relative safety of investing because investors can unload a stock that may be on the decline or that faces an uncertain future.
Stocks are shares of ownership in companies. People who buy a company’s stock may receive dividends (a portion of any profits). Stockholders are entitled to any capital gains that arise through their trading activity—that is, to any gain obtained when the price at which the stock is sold is greater than the purchase price. But stockholders also face risks. One risk is that the firm may experience losses and not be able to continue the payment of dividends. Another risk involves capital losses when the stockholder sells shares at a price below the purchase price.
A company can list its stock on only one major stock exchange. However, options on its stock may be traded on another exchange. Where a stock is traded depends on both the requirements of the exchange and the decision of the corporation. Each exchange establishes requirements that a company must meet to have its stock listed. For example, to be listed on the New York Stock Exchange, a company, among other things, must have a minimum of 1.1 million shares outstanding with a market value of at least $100 million. But not all companies that satisfy NYSE requirements apply to have their stock traded on this exchange. Intel and Dell Computer, two very large and well-known corporations, satisfy NYSE requirements but choose instead to have their shares traded on the over-the-counter Nasdaq.
The different exchanges tend to attract different kinds of companies. Smaller exchanges, such as the Nasdaq, typically trade the stock of small, emerging businesses, such as high-tech companies. In the United States, the AMEX lists small to medium-sized businesses, including many oil and gas companies. The NYSE primarily lists large, established companies.
Most security trading is accomplished through brokerage firms. Persons and organizations that wish to purchase securities will call upon the brokerage firm to execute their transaction. To actually conduct the transaction on the stock exchange, the brokerage firm must have a membership, called a seat, on the exchange. Stock exchanges limit the number of available seats, and the cost of a seat on an exchange is high. During 2002 the price of a seat on the NYSE ranged from $2 million to $2.6 million. Brokerage firms that have seats not only can complete trades on the floor of the exchange but also have the right to vote on exchange policy.
Brokerage firms are willing to pay high prices for exchange seats because of the profit opportunities available from membership in an exchange. Profits can be generated from the fees charged for the execution of trades as well as from trading on the firm’s own account. There are, however, risks associated with brokerage firm activity. For example, brokerage firms can lose money if their clients default on margin loans (loans obtained to purchase securities).
|A||Example of a Trade|
In an example of a trade, an investor wanting to buy 200 shares—also known as two round lots, of 100 shares each—of IBM stock will telephone or e-mail the order to a brokerage firm. This communication is normally made to an individual called a stockbroker. The investor might desire to buy the shares at the market, or current, price. On the other hand, the investor may choose to pay no more than a set amount per share. The brokerage firm then contacts one of its floor brokers at the NYSE, the exchange on which IBM stock is traded. The floor broker then goes to IBM’s stock post—that is, the particular spot on the trading floor where IBM stock is traded. Here other floor brokers will be buying and selling the same stock. The activity around the post constitutes an auction market with transactions typically communicated through hand signals. The most important person at the post is a broker-dealer called a specialist. The job of the specialist is to manage the auction process. The specialist will actually execute the trade and inform the floor broker of the final price at which the trade has been executed. For this service, the investor will pay the original broker a commission, either as a flat fee or as a percentage of the purchase price.
The price of a stock depends on the market forces of supply and demand. With companies issuing only a limited number of shares, price is determined by demand. An increase in demand will raise the price whereas a decrease in demand will lower the price. Normally the demand for a particular stock depends on expectations regarding the profits of the corporation that issued the stock. The more optimistic these expectations are, the greater the demand will be and, therefore, the greater the price of the stock.
A stockbroker is an employee of a brokerage firm. The individual investor contacts his or her stockbroker and provides the stockbroker with the details of the transaction the investor wants to complete. Stockbrokers, however, are more than order takers or sales representatives for their firms; they frequently provide advice to the investor. They may have their own client list and call clients when they see transactions that will fit the client’s investment objectives. Stockbrokers almost always have certification from, or registration with, a state government agency or an exchange or both. For this reason they are sometimes referred to as registered representatives.
Institutional brokers specialize in bulk purchases of securities, including bonds, for institutional investors. Institutional investors include large investors such as banks, pension funds, and mutual funds.
Institutional brokers generally charge their clients a lower fee per unit than brokers who trade for individual investors. This is the case because the total cost of both large and small transactions is much the same. When this total cost is spread over a larger number of shares, then the cost per share is lower. Given the lower per-share cost, institutional brokers can charge a lower per-share fee.
|V||TRADING IN OTHER SECURITIES|
Exchanges trade in all forms of securities. Although the general operations of exchanges apply to all securities trading, there are some differences. In particular, trades in nonstock securities, such as bonds and options, are often managed by financial intermediaries other than brokers.
Bonds provide a way for companies to borrow money. Companies obtain funds when they initially issue bonds. As with the initial issue of stocks, companies use the services of investment banks in primary market transactions for bonds. Once issued the bonds are then traded in secondary markets or on exchanges and the company is no longer directly involved. See also Bond (finance).
Options are traded on many U.S. stock exchanges, as well as over the counter. Options writers offer investors the rights to buy or sell, at fixed prices and over fixed time periods, specified numbers of shares or amounts of financial or real assets. Writers give call options to people who want options to buy. A call option is the right to buy shares or amounts at a fixed price, within a fixed time span. Conversely, writers give put options to people who want options to sell. A put option is the right to sell shares or amounts at a fixed price, within a fixed time span. Buyers may or may not opt to buy, or sellers to sell, and they may profit or lose on their transactions, depending on how the market moves. In any case, options traders must pay premiums to writers for making contracts. Traders must also pay commissions to brokers for buying and selling stocks on exchanges. Options trading is also handled by options clearing corporations, or clearinghouses, which are owned by exchanges. See also Option (finance).
Futures contracts are also traded on certain U.S. exchanges, most of which deal in commodities such as foods or textiles. Futures trading works somewhat like options trading, but buyers and sellers instead agree to sales or purchases at fixed prices on fixed dates. After a futures contract is made, the choice to buy or sell is not optional. Instead, there is an obligation to buy or sell. Futures contracts are then traded on the exchanges. Commodities brokers handle this trading.
Futures and options traders often judge market trends by monitoring compiled indexes and averages of stocks, usually organized by industry or market ranking. Among the most closely watched U.S. indexes are the Dow Jones averages and Standard & Poor’s. See also Futures.
|VI||THE OVER-THE-COUNTER MARKET|
Thousands of companies do not list their stock on any exchange. These stocks make up the over-the-counter (OTC) market. The largest of these companies are traded on the Nasdaq Stock Market. Nasdaq stands for National Association of Securities Dealers Automated Quotation system. The member countries of the European Union (EU) have an equivalent market, called EASDAQ. Nasdaq is a shareholder in and provides operational advice to EASDAQ. Nasdaq and EASDAQ operate like exchanges, but instead of having central locations, their specialists are located at computer terminals all over the United States and Europe. Trades are carried out primarily online through computer networks. Companies that list their stock on Nasdaq and EASDAQ are generally smaller than those listed on centralized exchanges. However, some of the financial instruments of large high-tech corporations also trade in this market.
Exchanges started in Western Europe and then spread to other parts of the world. Some of the older exchanges, dating back as far as the 1100s, are the Paris Bourse in France; the Amsterdam Bourse in The Netherlands; the Deutsche Stock Exchange (formerly the Börse) in Frankfurt, Germany; the London Stock Exchange (LSE) in England; and the Borsa in Milan, Italy. Other European exchanges opened in the 1600s and 1700s, including those in Belgium, Spain, Portugal, and Sweden. Because stocks were uncommon before the 1800s, all of these early exchanges traded in commodities and currencies. In 1785 Amsterdam’s Bourse was the first to formally begin trading in securities. By the mid-1800s, many countries outside of Europe traded in securities, including Canada and Australia. During the 19th and 20th centuries, major exchanges opened in Asia, Eastern Europe, and parts of Africa and Latin America.
Most of the world’s major exchanges have become highly efficient, computerized organizations. Each has a charter for regulating operations and some are integrated within regional economic unions. For instance, the EU was instrumental in organizing the EASDAQ and drafted its charter. In addition, exchanges now trade securities from companies around the world. Computerization has enabled brokers to instantaneously monitor activities on foreign exchanges. Many exchanges also list indexes and averages—such as the Nikkei 225 Stock Average of the Tokyo Stock Exchange (TSE) and the Financial Times Stock Exchange 100 of the LSE—that are closely followed by options and futures investors.
|VIII||HISTORY OF U.S. STOCK EXCHANGES|
|A||The Early Years|
In the 1700s groups of brokers in Philadelphia, Pennsylvania, and New York City began to meet in parks and coffeehouses to buy and sell securities. In open auctions, traders called out names of companies and numbers of shares available. Shares went to the highest bidders. After the American Revolution (1775-1783) the number of securities traded increased dramatically. Brokers decided to organize in order to handle the growing volume. In 1800 the Philadelphia Board of Brokers drew up regulations and a constitution and set up central offices where trading could take place. The organization they created, the Philadelphia Stock Exchange, is the oldest exchange in the United States. In 1817 brokers in New York formed the New York Stock and Exchange Board (renamed the New York Stock Exchange [NYSE] in 1863).
As the United States grew and prospered during the 19th century, many more companies began to issue stocks and bonds. More people began to invest, and dozens of exchanges were formed across the country. Some of these are still in existence, but many others were short-lived. For example, the California gold rush of 1849 gave birth to a number of small exchanges where the public could buy shares in the new mining companies. As the gold rush subsided, these companies went out of business and the exchanges closed.
During the second half of the 19th century, New York City emerged as the primary financial center of the United States. The NYSE became the most successful exchange. Its members concentrated on trading the securities of the largest corporations. At that time, stocks of smaller companies were traded by brokers on the streets of downtown New York. In 1908 these brokers formed an organization called the New York Curb Agency, which became known as the American Stock Exchange in 1953.
|B||The Crash of 1929|
During the 1920s millions of Americans began to purchase stocks for the first time. Many new investors entered the stock market with borrowed money. Stock prices rose steadily as inflated market demand outpaced increases in the value of the real assets of these businesses as well as their profits. Investors eventually realized that a large imbalance existed between stock prices and the real assets available to back them up, including profits, and decided to sell. On October 29, 1929, great numbers of people tried to sell their stocks all at once. Prices tumbled so drastically on the NYSE and other exchanges that the event became known as the crash of 1929. Millions of investors lost their savings in the crash, and many found themselves deeply in debt because they could not repay the money they had borrowed to buy stocks.
During the years immediately following the crash, most investors refused to put any more money in stocks. Without the flow of new funds, many businesses failed, and others laid off many workers because they could not afford to pay them. The lack of investment funds contributed to the Great Depression of the 1930s, an economic crisis that left one of every four American workers unemployed and resulted in widespread poverty.
|C||Regulation of Exchanges|
Investors lost faith in the stock markets partly because of unfair practices and a lack of strict rules in the exchanges before and during the 1920s. Large investors were able to cheat small investors because few laws existed to forbid these practices. For the laws that did exist there was little in the way of enforcement. Recognizing that regulation was insufficient, the U.S. Congress passed the Securities Act of 1933. This act regulated the issuing of new securities. It mandated registration for all securities to be sold and required that a prospectus be prepared providing detailed information about each security to be issued.
Further protections came in 1945 when the U.S. Federal Reserve Board established that investors who seek a loan to finance the purchase of securities must pay a margin, or percentage, of the actual market price. Margin can be considered a down payment. The difference between the dollar value of the margin and the total price of the securities being purchased represents a loan from the broker to the investor. Investors pay margin to brokers, either in cash or by using other securities. This margin protects brokers from excessive losses. Before the Great Depression, investors had often borrowed heavily to make trades. These trades had very low margin requirements. With the stock market crashing investors were forced to sell securities at a price that was below the price they had paid. So when brokers tried to recover the money investors owed them, investors were unable to meet their obligations. Brokers, therefore, lost large sums of money on their loans.
From 1945 to the 1980s investors were required to make initial margin deposits for securities they wished to trade. The National Association of Securities Dealers (NASD) and the NYSE subsequently established their own minimum margin maintenance requirements. For the NYSE, the requirement is that investors must keep 25 percent or more of the market value of the securities in which they are trading in a margin account. Also, for certain stocks—especially those that trade heavily, often, and for widely varying amounts—the exchange may increase margin requirements. Investors must keep their margin accounts current, meeting the requirements, or else brokers may sell off their securities. Brokerage firms also have their own margin maintenance requirements for their clients. The requirements of firms are often higher than those of the exchanges. Overall, the government, exchanges, and brokerage firms have worked to protect the exchange system from excessive borrowing. However, in the late 1980s exchanges established new markets for stock index futures, and these markets had relatively low margin requirements.
In addition, by the 1970s it was clear that the NYSE, then the world’s largest stock exchange, in many ways did not perform the theoretical function of an exchange, to help facilitate the efficiency of trading. The NYSE tightly controlled its members with fixed commission rates and limited floor access. Nonmembers were required to trade only through member firms and to pay commissions. The exchange also rarely permitted members to trade in other regional exchanges or in the OTC market. Also, many NYSE firms increasingly traded in blocks of 10,000 shares or more. Taking advantage of loopholes in exchange regulations, firms often privately arranged these block trades. This created an essentially exclusive, limited-access market.
In the 1970s the Securities and Exchange Commission (SEC), Congress, and other government and private institutions were instrumental in establishing further regulations on stock exchanges. In 1972 the SEC developed a Consolidated Tape System, which provides trading information to investors from all exchanges and the OTC market. In 1975 Congress created the National Market System, which provides that prices of stocks and bonds from all exchanges be available simultaneously at each exchange. This encouraged competition among exchanges. A particular provision of this system also required that all commissions be competitively negotiated rather than fixed. In response to this provision, many discount brokerage firms opened. Discount brokers provide less financial advice to investors and therefore can charge lower commission fees than were available under the fixed-fee system. Ultimately, the enforced competition among exchanges has opened them to smaller investors who want to trade without paying for, or being limited by, various exclusive exchange privileges.
Reforms were also initiated in futures trading. The Commodities Futures Trading Commission (CFTC) was created in 1974 in response to the growth in futures trading and the start of several new futures markets. The general purpose of the CFTC is to ensure that prices in futures markets are free from manipulation and that the futures markets remain financially sound.
|D||Computerized Trading and “Circuit Breakers”|
In the 1980s and 1990s stock exchanges achieved new levels of market efficiency through their increased use of fast and inexpensive computers. Computer networks allowed exchanges to connect to each other, both within countries and internationally. Electronic exchanges fostered the growth of an open, global securities market.
Although the overall value of the U.S. stock market has increased substantially since 1946, occasional downturns have occurred during recent decades. In 1987 the stock market experienced a brief, but major crash, marked by a more than 20 percent decline, over one day’s trading, in the Standard & Poor’s index of stock prices. (An index is an average of the stock prices of a selected group of companies.) Markets in other countries have experienced periods of severe decline as well. The market in Tokyo, for instance, plummeted over a period from the end of 1989 to late 1990. The Nikkei index of the TSE declined almost 50 percent during that period. Even with reforms instituted by the Japanese government, the TSE had failed to recover by 2002.
Economists linked the 1987 U.S. crash to the use by traders of new markets for low-margin stock index futures. Exchanges had opened these markets earlier in the decade in response to increased margin requirements on securities trading. Later in the decade traders began to sell their securities on the new futures markets when stock prices dropped. After the government released pessimistic economic forecasts in October 1987, traders rushed to sell their stocks on the futures markets with low margin backing. After the crash, the government established new rules for higher margin requirements across markets, including futures trading.
The 1987 crash also led to the institution of so-called circuit breakers on the NYSE. A circuit breaker is a temporary suspension of trading when prices fall by a particular amount. Beginning in 1998, the price declines necessary to trigger a circuit breaker were expressed in percentage terms. In one example of a circuit breaker, a 10-percent fall in the Dow Jones Industrial Average (DJIA) by 2 pm Eastern Standard Time (EST) would halt trading for one hour.
|E||Longest Bull Market and the Internet Bubble|
The period from 1990 to early 2000 saw a significant rise in stock prices. The growth resulted in the longest period of average increases in stock prices in the history of the United States. The market value of the outstanding shares of domestically issued stock rose from about $3.5 trillion to approximately $20 trillion. But then stock prices began to decline. By the middle of 2002 the market value of the outstanding shares of domestically issued stock stood at about $13.3 trillion.
The earlier period of rising stock prices, from 1990 to the first part of 2000, was known as a bull market. The bull market was linked to the strong national economy. A continued expansion of production and employment made investors optimistic about business profits and increased the demand for securities. This growth in demand was especially true for technology companies. In the latter half of the bull market the dot.com phenomenon developed. Small startup companies specializing in sales on the Internet began to issue stock. The prices of these stocks rose rapidly with strong demand, based on the belief that this new way of doing business would generate enormous profits.
The end of the bull market in 2000 and the beginning of a bear market (period of declining stock prices) was marked by several factors. One was the end of the national economic expansion with a decline in production and a rise in unemployment. Another was the end of the dot.com phenomenon when investors recognized that it was going to be much more difficult than originally forecast for these companies to become profitable. In 2001 the September 11 attacks by terrorists on the World Trade Center and the Pentagon also had predictable negative consequences for securities markets.
A fourth factor associated with the bear market involved a series of revelations regarding the accuracy of financial statements issued by corporations and the integrity of the independent public accounting firms that audit these financial statements. The best known of these cases involved the Enron Corporation and the Arthur Andersen LLP accounting firm. Enron, an energy company that traded in derivatives, engaged in a series of money-losing partnership transactions that were not reflected in its financial statements. Arthur Andersen, one of the nation’s largest accounting firms and Enron’s auditor, overlooked these questionable accounting practices, providing credibility to Enron’s misleading financial statements. The losses were finally revealed in the fall of 2001 when Enron officials admitted that the company’s net worth had been overstated by more than $1 billion. With the revelations the price of Enron stock fell from $83 per share in December 2000 to less than $1 per share in December 2001. Arthur Andersen was convicted of obstruction of justice charges in June 2002 in connection with its Enron activities. The loss of its reputation as an independent auditor was even more telling, causing Arthur Andersen to discontinue much of its auditing activity. At the same time that the Enron scandal was being reported, similar problems with financial statements were reported at a number of other companies including WorldCom, Inc. and Global Crossing.
The accounting fraud uncovered at WorldCom proved to be the largest in U.S. history. The company overstated its earnings by $11 billion, and its subsequent bankruptcy cost investors an estimated $200 billion. The United States Department of Justice brought criminal charges against WorldCom’s former chief financial officer, and the SEC filed civil lawsuits against four former WorldCom executives.
One result of these revelations of accounting and financial irregularities was the passage of the Accounting Reform and Investor Protection Act of 2002, often referred to as the Sarbanes-Oxley Act of 2002 for the legislators who sponsored it. The legislation sought to improve the accuracy of financial statements and to ensure full disclosure of information in these statements. It also created an oversight board for accounting practices, strengthened the independence of public accounting firms in their auditing activities, increased corporate responsibility for the accuracy of financial statements, and sought to protect the objectivity of securities analysts and to improve the SEC’s resources and oversight functions. See also Accounting and Bookkeeping.
As the accounting fraud scandals were occurring, the role of stock analysts also came under scrutiny. These analysts worked for investment banks and issued research reports on stocks along with recommendations to buy, hold, or sell the stocks. Curiously, even after Enron executives admitted to accounting fraud, most stock analysts kept a buy recommendation on Enron stock.
The fact that few stock analysts issued sell recommendations during the bear market led the New York attorney general to conduct an investigation. Most Wall Street firms and investment banks came under the New York attorney general’s jurisdiction because they were based in New York City. The investigation led to the discovery of e-mails and other evidence showing conflicts of interest. Stock analysts gave favorable recommendations to companies that were clients or potential clients of their investment banks. At three firms—Credit Suisse First Boston, Salomon Smith Barney (part of Citigroup, Inc.), and Merrill Lynch—investigators found that stock analysts were guilty of fraud. Privately these analysts had disparaged or even ridiculed the stock value of certain companies, while publicly they had recommended the stocks in an effort to win investment-banking business from these companies.
In 2003, in a settlement with the New York attorney general’s office and the SEC, ten of the nation’s leading investment banks agreed to pay a total of $1.4 billion in fines and to change certain practices. The firms pledged to strictly limit contact between a firm’s investment bankers and its stock analysts and to compensate analysts for their research rather than their ability to attract investment-banking clients. The settlement established a $432.5 million fund to provide independent stock research for investors. Two stock analysts were barred from the industry for life and fined a total of $20 million.