Why Do Stock Exchanges Exist?

Introduction

• Key topic for equity investors
• Importance of stock exchanges
• Impact on investing life

Over-the-Counter Trading vs. Stock Exchange

• Over-the-Counter Trading (OTC):
  • Trading directly with a counterparty
  • Issues: Time-consuming, trust concerns, anonymity concerns, price determination
• Stock Exchange: Benefits
  • Centralized marketplace
  • Reliable pricing
  • Anonymity
  • Central counterparty guarantee reducing risk

Operating Within a Stock Exchange

• Exchanges like clubs with members (e.g., brokers)
• Investors go through brokers, not directly to exchanges
• Brokers: Levels of service
  • Examples: Big banks, independent brokers like Charles Stanley
• Role of brokers in linking investors with exchanges

Functioning of a Stock Exchange (e.g., London Stock Exchange - LSE)

• Matching Trades: Matching buy and sell orders electronically
• Order Book: Automated matching
• Market Makers: Act like second-hand car dealers for less popular stocks
• Electronic vs Manual: Electronic trading more prevalent than manual trading in Europe
• Anonymity and Speed: Important for large or awkward trades

Additional Services by Stock Exchanges

• Guarantee and Settlement Arrangements:
  • Clearing houses like LCH.Clearnet guarantee trade completion
  • Settlement of shares handled by organizations like Euroclear Crest

Main Reasons for Existence

• Price Transparency: Reliable reference prices published daily
• Anonymity: Protects large investors and prevents price movements against them
• Guarantee and Settlement: Ensures smooth completion and legal registration
• Regulation: Ensures trustworthiness and minimizes failed trades

Evolution and Current Trends

• Global Presence: Exchanges worldwide (e.g., NYSE, Chicago for derivatives, commodities)
• Consolidation and Mergers: Exchanges merging to provide one-stop-shops, drive down costs, offer wider range of securities
• Electronic Trading: Increased shift towards electronic platforms for efficiency

Summary

• Importance: Price transparency, anonymity, trade guarantees
• Current Issue: Pressure on exchanges to merge and evolve to offer more services and remain competitive.