What Is a Stock Exchange?

As a new investor, you'll discover that many of your stock trades are going to be placed on one of a handful of a stock exchanges.  What is a stock exchange?  How many major stock exchanges are there in the world?  Those are great questions.  Let's take a look so you understand the basics!

What Is an Exchange?

First, what is an exchange?  Put simply, an exchange is an institution, organization, or association which hosts a market where stocks, bonds, options and futures, and commodities are traded.

Buyers and sellers come together to trade during specific hours on business days. Exchanges impose rules and regulations on the firms and brokers that are involved with them. If a particular company is traded on an exchange, it is referred to as "listed".

Securities that are not listed on a stock exchange are sold OTC, which stands for Over-The-Counter. Companies that have shares traded OTC are usually smaller and riskier because they do not meet the requirements to be listed on a stock exchange.  Many giant blue chip stocks, such as Berkshire Hathaway, at one time traded on the over-the-counter market before migrating to the so-called "Big Board", or New York Stock Exchange.

What Is the Purpose of a Stock Exchange?

When a business raises capital by issuing shares, the owners of those new shares are likely going to want to sell their stake someday.  Maybe they have a child going to college and need to cover the tuition bill.

 Perhaps they pass away and their estate is subject to some hefty estate taxes.  They may even leave it to their grandchildren, who get to enjoy the stepped up basis loophole, but the heirs want to liquidate to buy a house.  Whatever is driving their decision, they aren't likely to tie up their funds unless they know somehow, someway, at some point in the future, they'll be able to find a buyer for their holdings without too much trouble in what is known as "the secondary market".

Without a stock exchange, these owners would have to go around to friends, family members, and community members, hoping to find someone to whom they could sell their shares.  (Technically, you can do this.  You don't have to sell your shares on a stock exchange.  You can take physical possession of them in certificate form, endorse them, and sign them over to someone in exchange for payment in your lawyer's office or at your dining room table if you are so inclined.  When the stock exchange was closed during World War I, many people did just that, creating a secondary shadow market.  The downside is that there is no transparency.  Nobody knows what the best price is for a given stock at any given moment in time.  You could be selling your shares for $50 while the guy two towns over is getting $70.)  With a stock exchange, you will never know the person on the other end of the trade.  He, she, or it could be halfway around the world.  It could be a retired teacher.  It could be a multi-billion dollar insurance group.  It could be a publicly traded mutual fund or hedge fund.

The need for convenience is what led to the establishment of the biggest stock exchange in the world.  In the United States, a group of stockbrokers met under a buttonwood tree in New York City.

 On May 17th, 1792, twenty-four of these stockbrokers got together outside of 68 Wall Street to sign the now-famous Buttonwood Agreement, which effectively created the New York Stock & Exchange Board.  Almost three-quarters of a century later, in 1863, it was officially renamed the New York Stock Exchange.  These days, most people refer to it as the NYSE.

What Are the Major Stock Exchanges in the World?

At one time, the United States had thriving regional stock exchanges that were major hubs for their particular part of the country.  In San Francisco, for example, the Pacific Stock Exchange had an open outcry system where brokers would handle buy and sell orders for local investors who wanted to purchase or liquidate their ownership stakes.  Most of these were shut down, purchased, absorbed, or merged following the rise of the microchip, which made electronic networks much more efficient for finding liquidity so that an investor in California could just as easily sell his or her shares to someone in Zurich.