What is a Stock Exchange?

Stock exchange
Updated on: July 3, 2020 ; Markets

Stock market or exchange:

The terms “Stock Markets” and “Stock Exchange” are used quite interchangeably. When we use either of them, we mean the same. Consider it to be primarily a market place to buy and sell equity shares of a publicly listed company. It is also the place where a company issues its equity shares for the first time for public participation. Stock markets provide people outside the company with an easy and transparent way to own a small part of a company. Read Ways to invest in equity to know more.

There are other securities as well that are traded on a stock exchange like commodities, derivatives, currencies, bonds, etc. There are exchanges that specialize in certain types of securities or a collection of securities.

What purpose does it solve?

There are a few objectives that a stock exchange meets. We will talk about the 3 key critical ones here:

1. Raise additional capital: We all know that any business needs capital to survive and grow. There are many places a company can raise this capital from. Stock markets are one of these places. Let’s look at an example below.

Mr. Maalik Seth started a company that provides laundry service. He initially started small, with just one outlet. His business did well, and within a few years, he decided to expand his business to add 5 more outlets within the city.

He could not accomplish all of this on his own, so he decided to get in a few partners who put in their money for the expansion.

As expected, the expanded business flourished, and all the promoters, including Maalik, were a very happy lot. They gained great popularity in the state, and everyone was talking about them. This recent success encouraged the promoters and fuelled Maalik’s ambition to expand all across the country.

But this time around, their own money would not be enough to finance their big expansion plans. Such a large scale expansion requires much bigger capital investments. So, Maalik and his promoters would have to look outside for this additional capital requirement. They have a few options in front of them to raise this capital.

One option is to go to a bank or a financial institution that lends money and get a loan. Another option is to go looking for more partners and sell a share of the existing promoters to these new partners. Obviously, there are different risks and benefits associated with each route of capital infusion.

Now, there is another route available, and that is raising capital from the public. If they have a good reputation and have a strong business foundation, if people know about their business, then the public might be willing to invest in the business as well.

In such scenarios, if Maalik’s company meets all the prerequisites, he and the existing promoters might choose to go to the public to raise the additional capital. When I say public, I mean a large variety of entities like retail investors, financial institutions, High Networth Individuals (HNI), other companies, and others.

This might be a better option for Maalik, instead of depending on the big banks or a few wealthy promoters, to get the additional funds. This way, Maalik can retain his position in the company as a large shareholder, as the newly raised capital will be distributed across a large number of participants, each holding a smaller share.

This process of raising capital from the public is done through an Initial Public Offering (IPO) on a stock exchange. The entire process is highly regulated and very transparent. IPO on a stock exchange provides promoters like Maalik and others, with an opportunity to raise huge sums of money from a large and varied group of investors (public in the true sense), that too in a very transparent and unbiased manner. We won’t be discussing here, the requirements and conditions that a company needs to fulfill before it goes public.

2. Participation in growth story: A publicly listed company is available for free trade. Anyone with proper authorization and access to the market can buy or sell the shares of a publicly listed company on a stock exchange. What this essentially means is that the stock markets present a platform for retail investors to own a stake in any listed company.

participation in growth

Photo by Clay Banks on Unsplash

Buying the stock of any company makes you a minority shareowner in the company. I am using the term ‘minority’ here because I assume that most of the people, if not all who are reading this article, would not be buying a majority stake in a company that regularly.

By buying the share of a company, you participate directly in the growth of the company. Along with it, you also share any downside risk in the business. This is a great opportunity for a retail investor to reap the benefits of all the good work of the company.

You don’t have to work for the company or spend any effort for the company to carry on its business. At the same time, you won’t be drawing any salary as well.

But you will enjoy the fruits of the company’s good performance in the form of dividends and appreciation in the share price. Can you think of a simpler way to enjoy a share of a good company’s growth?

3. Price discovery: Millions of transactions on securities take place on stock exchanges worldwide, every day. There are thousands of participants buying and selling shares on these exchanges. These large volumes of transactions create enough supply and demand of shares to determine their fair price value. Let’s illustrate this with an example below.

Our friend Fruity wants to buy some ‘Aprivodoes’. Before you start searching for its meaning, let me clarify that it is an exotic and rare fruit that I just invented.

There is only one merchant in town who sells these rare aprivodoes. So Fruity has to go to him and pay whatever price he demands. Fruity doesn’t have much bargaining power here. Does he?

Now contrast this situation with one where Fruity wants to have some apples. Luckily, apples are not so rare as aprivodoes. There are many merchants in the market selling the same breed of apple you wish to buy.

Now Fruity can go around looking for the best price for his apples. He has some bargaining power here. The sellers, on the other hand, have lesser freedom over setting the price for the apples.

No seller can price the apples much higher than the other sellers. If he does so, he runs into the risk of not getting any buyer. What we see here is that the presence of many sellers will set a range to the market price of apples. But, is this the fair price?

To reach the fair price there has to be enough demand and supply in the market. What we call as the fair price is nothing, but the price at which a trade settles, and that is agreeable to many participants.

So, if there are many Fruitys looking to buy apples and enough merchants with just enough supply of apples to meet their needs, there will be a balance. We can say that the supply-demand dynamics will determine the fair price of the apples. The moment any of these sides go up or down the price will automatically settle to a new fair value.

Similarly, stock exchanges provide a very good platform for price discovery of stocks. Let’s look at the next section, where I explain the basic working of stock exchanges in a very simple manner.

How does a stock exchange work?

Working of stock exchange

Image by Lorenzo Cafaro from Pixabay

We all understand by now that stock exchanges provide a trustworthy and reliable platform for individuals and institutional investors to buy and sell shares of a listed company. It is only on rare occasions like IPO, right issues, buy-backs, etc that a company is directly involved in the buying and selling of its shares. Otherwise, most of the transactions in the stock exchange are on the outstanding shares floating in the market. I am not considering the other securities like derivatives, commodities, currencies, etc here.

So, how does it work? People interested in buying shares of a company place their bid price on the stock exchange through a broker. On the other side, people interested in selling their shares, also place their offer (ask price) with the exchange. This is just like any auction process. The stock exchange then matches the bids with the asks, and as soon as the match is found, the transaction is completed seamlessly.

All of this sounds very simple. But a lot is goes on behind the scenes. The participants are isolated from them, just as a driver is isolated from the complex machinery of a car.

Lots of processes and checks are put in place to ensure the smooth functioning of the stock markets. All of this happens digitally today, so there are lesser chances of any mishaps or errors.

Tightly governed, robust systems and frameworks that have been built over the years. They ensure the smooth functioning of markets.

Just for information: The two key stock exchanges in India are 1) National Stock Exchange (NSE) and 2) Bombay Stock Exchange (BSE). The regulatory body is Securities and Exchange Board of India (SEBI).

Conclusion:

Stock exchanges provide a level playing ground for anyone to invest in publicly listed companies. Anyone with proper authorization can participate in the buying and selling of shares. It provides an opportunity for an individual to reap the benefits of the growth of great companies. All the processes are handled electronically and robust frameworks are in place to protect the investors’ interest.

Happy participation in equity investing !!!


Leave a Comment

Your email address will not be published. Required fields are marked *

Social media & sharing icons powered by UltimatelySocial