Electronic Stock Exchanges & Auction Markets

Instructor: Yusuf Abdullah

Yusuf has taught Science and Mathematics at school level and Finance and Economics at University level. He has recently earned his Ph.D in Financial Econometrics field.

The lesson deals with the different types of stock exchanges prevalent today. Learn about auction markets, electronic exchanges and over-the-counter exchanges.

Stock Exchange

Boris is an NYC broker and has his own brokering house. He recently met his old college friend, Pete, who wants investment advice from him. Pete wants clarifications about the transactions related to the equity market done on the stock exchange.

Boris tells him that stock exchanges act as an intermediary to a trade but do not buy or sell stocks themselves. The exchange is a neutral entity that honors the trades from both sides. This results in trades with nearly zero credit risk.

But if shareholders can buy and sell among themselves, Pete wonders, what's the use of an exchange? Well, Boris replies, it provides liquidity to the asset being traded.

Stocks are listed on an exchange as an initial public offering (IPO). The new stocks are sold in a primary market, and as soon as they exchange hands on the exchange, a secondary market transaction takes place. The buyers and sellers put forward their prices, which are known as bid and ask, kind of like an auction.

Auction Markets

The New York Stock Exchange (NYSE) is an example of an auction market. The buyers and sellers, including investors, brokers, and dealers, come together on the exchange and stocks are put forward at a given quote. The sellers put forward the ask price and the buyers provide the bid price. When the prices match and are paired, the trades are completed.

Often, a trade might not be completed and the quotes just sit on the exchange or are removed. Physical communication between buyers and sellers is known as an 'open outcry system'.

Electronic Exchanges

Pete always had traded through an online broker and never needed to go to an exchange to buy or sell stocks. Boris states that auction exchanges across the world have been replaced by electronic exchanges. Naturally, with an electronic exchange, there's higher liquidity and better matching of trades. NASDAQ is an electronic exchange, for example.

Electronic Communication Networks (ECNs)

Can investors trade for themselves on the electronic exchange? Well, Boris replies, there is an alternative class of exchanges known as electronic communication networks (ECNs), which allows the investors to bypass the market makers (brokers and dealers). ECNs are usually used by institutional investors and offer reduced transaction costs. An example of an ECN is the Interbank Network Electronic Transfer (INET).

Trading on ECNs can result in dark pools of liquidity, where large orders are executed by the institutional investors. The orders are hidden until they are executed and do not reflect on the exchange. This results in liquidity being unavailable to investors on exchanges and increases the bid-ask spread and transaction costs. Dark pools are always under scrutiny because can be used to affect stock prices illegally.

Over-The-Counter (OTC) Exchange

Pete wonders what happens when the stocks are delisted, as there is still a market for them. The three types of exchanges mentioned are the traditional ones, but many small stocks do not trade on them due to a number of reasons such as listing requirements, liquidity issues, etc. Many previously listed stocks that are delisted also trade over-the-counter (OTC). There are two types of OTC exchanges:

1. Over-The-Counter Bulletin Board (OTCBB)

The Over-The-Counter Bulletin Board (OTCBB) is an electronic exchange that provides quotes for stocks and is provided by the Financial Industry Regulatory Authority (FINRA). OTCBB started in the early '90s to provide an opportunity for small stocks that could not meet listing requirements of major exchanges. OTCBB includes brokers, dealers, market makers, buyers, sellers and traders using electronic exchange and telecommunication networks.

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