What Is a Stock Exchange and How Does It Work?

A stock exchange is a centralized marketplace where financial securities, such as stocks and bonds, are bought and sold. It provides a structured environment for transactions, connecting buyers and sellers globally. This infrastructure facilitates the movement of capital, allowing companies to secure funding for growth and enabling investors to participate in the ownership and debt of businesses.

Core Functions of a Stock Exchange

A primary function of a stock exchange is price discovery, which determines the market value of securities through the continuous interaction of supply and demand. Buyers and sellers place orders, and their alignment establishes the current price. This process reflects available market information, ensuring prices represent market consensus.

Another role of an exchange is providing liquidity. Liquidity ensures investors can buy or sell securities quickly without significantly impacting prices. The constant presence of willing buyers and sellers makes it easier for participants to enter or exit positions, maintaining market stability.

Stock exchanges also play a part in capital formation, enabling companies to raise funds for expansion and operations. Businesses can issue new shares to the public through the exchange, converting investor capital into corporate financing. The exchange facilitates this process by offering a platform for these new securities to be listed and traded.

Exchanges enforce regulatory oversight to ensure fair and orderly trading practices. They operate under strict rules designed to protect investors and maintain market integrity. Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), work with exchanges to establish guidelines and monitor compliance, fostering investor confidence and preventing manipulative activities.

Key Participants in a Stock Exchange

Companies whose shares are traded on an exchange are known as issuers or listed companies. These entities list their shares to raise capital from investors, utilizing the exchange as a platform to access public funding. Listing requires meeting specific financial and governance standards set by the exchange and regulatory authorities.

Investors are individuals or institutions who buy and sell securities on the exchange. This group includes retail investors, who are individual traders, and institutional investors, such as mutual funds, pension funds, and hedge funds, which manage large pools of capital for clients.

Brokers act as intermediaries, executing trades for investors. Since direct access to exchanges is restricted to member firms, individual investors must route their buy and sell orders through a licensed broker. These professionals facilitate the connection between an investor’s request and the exchange’s trading systems.

Market makers are firms or individuals that continuously quote both a buying price (bid) and a selling price (ask) for specific securities. Their role is to provide liquidity by standing ready to buy or sell, ensuring trades can always be executed. Market makers profit from the small difference, or spread, between the bid and ask prices.

Types of Stock Exchanges

Stock exchanges primarily operate within the secondary market, where existing securities are traded among investors after initial issuance. The primary market is where new securities are first offered to the public, often through an initial public offering (IPO), allowing companies to raise capital directly. Once sold, these securities become available for trading on secondary market exchanges.

Stock exchanges operate globally, serving as central hubs for trading in their regions. Examples in the United States include the New York Stock Exchange (NYSE) and the NASDAQ. Other major exchanges worldwide include the London Stock Exchange (LSE), the Tokyo Stock Exchange (TSE), the Shanghai Stock Exchange, and Euronext, which operates across several European countries.

The operational models of stock exchanges have evolved, moving from traditional physical trading floors to predominantly electronic platforms. Historically, trading involved open outcry systems where brokers physically converged to execute trades. Today, most exchanges utilize electronic systems that match buy and sell orders automatically, offering greater speed and efficiency.

Electronic trading has reduced geographical barriers, allowing investors to access markets remotely and trade instantaneously. This shift has also contributed to lower transaction costs, as overhead associated with physical trading floors is minimized. While some exchanges retain a symbolic physical presence, the bulk of trading activity now occurs digitally.

Basic Trading Mechanics

An investor initiates a trade by placing an order through their broker. This order specifies whether to buy or sell a security, the quantity, and the desired price. The broker then transmits this instruction to the stock exchange for execution.

Two common order types are market orders and limit orders. A market order instructs the broker to buy or sell immediately at the best available price, prioritizing speed of execution. A limit order specifies a maximum price an investor will pay to buy or a minimum price they will accept to sell, guaranteeing a price but not immediate execution.

Central to trading are the bid and ask prices. The bid price represents the highest amount a buyer is willing to pay for a security, while the ask price is the lowest amount a seller will accept. The difference between these prices is the bid-ask spread, which can indicate a security’s liquidity.

Once an order reaches the exchange, its electronic system performs order matching. This process pairs compatible buy orders with sell orders based on price and time priority, leading to a completed transaction. If a buy order’s price meets or exceeds a sell order’s price, the system executes the trade.

Following a successful trade, the settlement process begins. This involves the transfer of ownership of securities to the buyer and funds to the seller. This process typically takes two business days (T+2) from the trade date.