Getting to Know Stock Exchanges

A stock exchange does not own shares. Instead, it acts as a sort of high-tech flea market where buyers connect with sellers. Every public stock trades on one of several possible exchanges such as the New York Stock Exchange (NYSE) or American Stock Exchange (AMEX). Although you will most likely trade stocks through a broker, it is important to understand the relationship between exchanges and companies and the ways in which the requirements of different exchanges provide protection to investors.

How Does It All Start?
The primary function of an exchange is to provide liquidity; in other words, to give sellers a place to "liquidate" their share holdings.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). In an IPO, a company sells shares to an initial set of public shareholders (a.k.a. the primary market). After the IPO "floats" shares into the hands of public shareholders, these shares can be sold and purchased on an exchange (a.k.a. the secondary market).

The exchange tracks the flow of orders for each stock, and this flow of supply and demand sets the price of the stock. Depending on the type of brokerage account you have, you may be able to view this flow of price action. For example, if you see that the "bid price" on a stock is $40, this means somebody is telling the exchange that he or she is willing to buy the stock for $40. At the same time you might see that the "ask price" is $41, which means somebody else is willing to sell the stock for $41. The difference between the two is the bid-ask spread.

Auction Exchanges--NYSE and Amex
The NYSE and AMEX are both primarily auction based, which means specialists are physically present on the exchanges’ trading floors. Each specialist "specializes" in a particular stock, buying and selling the stock in a verbal auction. These specialists are under competitive threat by electronic-only exchanges that claim to be more efficient (that is, execute faster trades and exhibit smaller bid-ask spreads) by eliminating human intermediaries.

The NYSE is the largest and most prestigious exchange. Collectively, its listed companies represent about $18 trillion in market capitalization.

Listing on the NYSE affords companies great credibility because they must meet initial listing requirements and also comply annually with maintenance requirements. For example, to remain listed, NYSE companies must keep their price above $1 and their market capitalization (number of shares x price) above $50 million.

Furthermore, investors trading on the NYSE benefit from a set of minimum protections. Among several of the requirements that the NYSE has enacted, the following two are especially significant:

1. Companies must get shareholder approval for any equity incentive plan (for example, stock option plan or restricted stock plan). In the past, companies were allowed to sidestep shareholder approval if an equity incentive plan met certain criteria; this, however, prevented shareholders from knowing how many stock options were available for future grant.
2. A majority of the members of the board of directors must be independent. However, each company has some discretion over the definition of "independent" (which has caused controversy). Furthermore, the compensation committee must be entirely composed of independent directors, and the audit committee must include at least one person who possesses "accounting or financial expertise."

AMEX is a smaller but quite prestigious exchange. AMEX also has a history of innovating: it pioneered the concept of exchange traded funds (ETFs) and it has the second largest options trading market.

Nasdaq (an Electronic Exchange)
The Nasdaq, an electronic exchange, is sometimes called "screen-based" because buyers and sellers are connected only by computers over a telecommunications network. Market makers, also known as dealers, carry their own inventory of stock. They stand ready to buy and sell Nasdaq stocks, and they are required to post their bid and ask prices. Among several high-technology sections, Nasdaq lists the most companies. Although the NYSE has a far greater total market capitalization, Nasdaq has surpassed the NYSE in the number of both listed companies and shares traded.

Nasdaq has listing and governance requirements that are similar but slightly less stringent than those of the NYSE. For example, a stock must maintain a price of $1 and the value of the public float (number of traded shares multiplied by stock price) must be at least $1.1 million. If a company does not maintain these requirements, it can be delisted to one of the OTC markets discussed below.

Nasdaq Small Cap
Nasdaq has a separate "tier" for small capitalization companies; the average market cap of the 685 companies listed in this tier at the end of 2003 was about $60 million. This is an excellent exchange for investors interested in smaller companies because the Nasdaq Small Cap also has listing and governance requirements.

Electronic Communication Networks (ECNs)
ECNs are part of a class of exchange called alternative trading systems (ATS). ECNs trade Nasdaq-listed stocks, but they connect buyers and sellers directly. Because they allow for direct connection, ECNs bypass the market makers. You can think of them as an alternative means to trade stocks listed on the Nasdaq and, increasingly, other exchanges as well (such as the NYSE or foreign exchanges).

There are several innovative and entrepreneurial ECNs, and they are generally good for customers because they pose a competitive threat to traditional exchanges, and therefore push down transaction costs. Currently, ECNs do not really serve individual investors; they are mostly of interest to institutional investors.

There are several ECNs, including INET (the result of an early 2004 consolidation between the Instinet ECN and Island ECN) and Archipelago (one of the four original ECNs that launched in 1997).

Over-the-Counter (OTC)
OTC refers to markets other than the organized exchanges described above. OTC markets generally list small companies, and often (but not always) these companies have "fallen off" to the OTC market because they were de-listed from Nasdaq.

Some individual investors will not even consider buying OTC stocks due to the extra risks involved. On the other hand, some strong companies trade on the OTC. In fact, several strong companies have deliberately switched to OTC markets to avoid the administrative burden and costly fees that accompany regulatory oversight laws such as the Sarbanes-Oxley Act. On balance, you should be careful when investing in the OTC if you do not have experience.

There are two OTC markets:

• Over-the-Counter Bulletin Board (OTCBB) is an electronic community of market makers. Companies that fall off the Nasdaq often end up here. On the OTCBB, there are no "quantitative minimums" (no minimum annual sales or assets required to list).
• Companies that list on the Pink Sheets (i.e. less than 300 shareholders) are not required to register with the SEC. Liquidity is often minimal. Also, keep in mind that these companies are not required to submit quarterly 10Qs.

Summary
To be traded, every stock must list on an exchange, a central "flea market" where buyers and sellers meet. The two big U.S. exchanges are the esteemed NYSE and the fast-growing Nasdaq; companies listed on either of these exchanges must meet various minimum requirements and baseline rules concerning the "independence" of their boards. But these are by no means the only legitimate exchanges. Electronic communication networks are relatively new, but they are sure to grab a bigger slice of the transaction pie in the future. Finally, the OTC market is a fine place for experienced investors with an itch to speculate and the know-how to conduct a little extra due diligence.