01/12/2023
What Is the Stock Market, What Does It Do, and How Does It Work?
source: investopedia.com
What Is the Stock Market?
The term stock market refers to several exchanges in which shares of publicly held companies are bought and sold. Such financial activities are conducted through formal exchanges and via over-the-counter (OTC) marketplaces that operate under a defined set of regulations.
Both “stock market” and “stock exchange” are often used interchangeably. Traders in the stock market buy or sell shares on one or more of the stock exchanges that are part of the overall stock market.
The leading U.S. stock exchanges include the New York Stock Exchange (NYSE) and the Nasdaq.
Key Takeaways
* Stock markets are venues where buyers and sellers meet to exchange equity shares of public corporations.
* Stock markets are components of a free-market economy because they enable democratized access to investor trading and exchange of capital.
* Stock markets create efficient price discovery and efficient dealing.
* The U.S. stock market is regulated by the Securities and Exchange Commission (SEC) and local regulatory bodies.12
Understanding the Stock Market
The stock market allows buyers and sellers of securities to meet, interact, and transact. The markets allow for price discovery for shares of corporations and serve as a barometer for the overall economy. Buyers and sellers are assured of a fair price, high degree of liquidity, and transparency as market participants compete in the open market.
The first stock market was the London Stock Exchange which began in a coffeehouse, where traders met to exchange shares, in 1773.3 The first stock exchange in the United States began in Philadelphia in 1790.4 The Buttonwood Agreement, so named because it was signed under a buttonwood tree, marked the beginning of New York’s Wall Street in 1792. The agreement was signed by 24 traders and was the first American organization of its kind to trade in securities. The traders renamed their venture the New York Stock and Exchange Board in 1817.5
A stock market is a regulated and controlled environment. In the United States, the main regulators include the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).21
The earliest stock markets issued and dealt in paper-based physical share certificates. Today, stock markets operate electronically.
Though it is called a stock market, other securities, such as exchange-traded funds (ETFs) are also traded in the stock market.
How the Stock Market Works
Stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence, with zero to low operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and secondary markets.
As a primary market, the stock market allows companies to issue and sell their shares to the public for the first time through the process of an initial public offering (IPO). This activity helps companies raise necessary capital from investors.
A company divides itself into several shares and sells some of those shares to the public at a price per share.
To facilitate this process, a company needs a marketplace where these shares can be sold and this is achieved by the stock market. A listed company may also offer new, additional shares through other offerings at a later stage, such as through rights issues or follow-on offerings. They may even buy back or delist their shares.
Investors will own company shares in the expectation that share value will rise or that they will receive dividend payments or both. The stock exchange acts as a facilitator for this capital-raising process and receives a fee for its services from the company and its financial partners.
Using the stock exchanges, investors can also buy and sell securities they already own in what is called the secondary market.
The stock market or exchange maintains various market-level and sector-specific indicators, like the S&P (Standard & Poor’s) 500 index and the Nasdaq 100 index, which provide a measure to track the movement of the overall market.
Following an IPO, the stock exchange serves as a trading platform for buying and selling the outstanding shares. This constitutes the secondary market. The stock exchange earns a fee for every trade that occurs on its platform during secondary market activity.
What Are the Functions of a Stock Market?
The stock market ensures price transparency, liquidity, price discovery, and fair dealings in trading activities.
The stock market guarantees all interested market participants have access to data for all buy and sell orders, thereby helping in the fair and transparent pricing of securities. The market also ensures efficient matching of appropriate buy and sell orders.
Stock markets need to support price discovery where the price of any stock is determined collectively by all of its buyers and sellers. Those qualified and willing to trade should get instant access to place orders and the market ensures that the orders are executed at a fair price.
Traders on the stock market include market makers, investors, traders, speculators, and hedgers. An investor may buy stocks and hold them for the long term, while a trader may enter and exit a position within seconds. A market maker provides necessary liquidity in the market, while a hedger may trade in derivatives.
How Stock Markets Are Regulated
Most nations have a stock market, and each is regulated by a local financial regulator or monetary authority, or institute. The SEC is the regulatory body charged with overseeing the U.S. stock market.
The SEC is a federal agency that works independently of the government and without political pressure. The mission of the SEC is stated as “protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.”8
Companies listed on the stock market exchanges are regulated, and their dealings are monitored by the SEC. In addition, the exchanges set certain requirements such as mandating timely filing of quarterly financial reports and instant reporting of relevant corporate developments, to ensure that all market participants are equally informed.
Failure to adhere to the regulations can lead to suspension of trading and other disciplinary measures.
What Is the Significance of the Stock Market?
The stock market is a component of a free-market economy. It allows companies to raise money by offering stock shares and corporate bonds and allows investors to participate in the financial achievements of the companies, make profits through capital gains, and earn income through dividends. The stock market works as a platform through which savings and investments of individuals are efficiently channeled into productive investment opportunities and add to the capital formation and economic growth of the country.
What Is an Alternate Trading System?
Alternative trading systems are venues for matching large buy and sell transactions and are not regulated like exchanges. Dark pools and many cryptocurrency exchanges are private exchanges or forums for securities and currency trading and operate within private groups.
Who Helps an Investor Trade on the Stock Market?
Stockbrokers act as intermediaries between the stock exchanges and the investors by buying and selling stocks and portfolio managers are professionals who invest portfolios, or collections of securities, for clients. Investment bankers represent companies in various capacities, such as private companies that want to go public via an IPO or companies that are involved in pending mergers and acquisitions.
