Welcome back to our introductory course on U.S. equity markets. In our previous lesson, we talked about the rules and regulators of the game, as well as the playing field and referees.
The Trading Venues
Now that we have the structure set up, it’s time to dig into what we mean when we say U.S. equities – what we’re actually trading, the ball in the game of trading. As you know, when you buy stock in a company you aren’t buying a concrete object. If you buy a share in a pencil-making company, you can’t go to their factory and demand a bunch of pencils or one of their pencil-making machines. Instead, the stock represents an ownership stake in the company. It gives you certain rights, for instance, if the company is sold, you generally get part of the purchase price, and you usually get a vote on certain decisions.
What are U.S. equities?
In general, when we talk about U.S. equities, we are referring to stocks that are registered with the SEC and listed on one of the U.S. stock exchanges. These stocks are publicly traded, meaning that pretty much anyone can go to their broker and buy a share. This is in contrast to private companies which do often sell shares to private investors, but their shares aren’t available to everyone.
There are also some public company stocks that trade only over the counter or OTC usually because they’re too small to qualify to list on one of the major exchanges. Those stocks are not considered part of the national market system. They aren’t NMS stocks and we’re going to put them aside for now.
Most U.S. equities are what is often called single stocks, meaning they represent an ownership stake in a particular company. There are also equities called exchange-traded products or ETPs that allow buyers to buy a share in a set of stocks, often an index, rather than in one company. So, for instance, if you bought a share of an S&P 500 ETF SPY, you are really buying fractions of each of the S&P 500 stocks.
Where stocks trade
We know from the previous lesson that stocks trade on the exchanges and other trading venues. No surprise there. But one thing to keep in mind is that NMS stocks actually trade on all of the exchanges and usually all of the other trading venues too – this is a result of Reg NMS, which we discussed in the first lesson, the regulation that tied all of the exchanges together. In many cases, people assume that stocks only or predominantly trade on an exchange where they are listed. And, in fact, this was the case until a few decades ago. But today, during the regular trading days, stocks can be traded across all the different venues.
If stocks can be traded across all of these trading venues, what does it even mean to be listed on an exchange?
Well, a company’s listing exchange has three main responsibilities:
First, the listing exchange handles a company’s options. The most high-profile auction for a company is usually its initial public offering or IPO. Most companies become public through an IPO which happens when a private company decides it wants to become publicly traded.
There are a number of advantages of being a publicly listed company. It allows owners in the company to more easily sell their shares (they become more liquid), and it gives the company the option to sell more shares thereby raising capital that they can invest in the business. It also gives the company a more liquid currency to acquire companies and other types of M&A transactions. An IPO is a way to both become a publicly traded company and raise capital by selling new shares at the same time. In an IPO, the company offers a large number of new shares in the company for sale through a group of brokers known as a syndicate. The night before the stock starts trading publicly, those shares are priced and sold to a set of large investors.
Shares in that company then become available to the public through a big auction on the company’s listing exchange the following morning, and the company’s stock is then available to trade moving forward. The listing exchange is responsible for the technology and the rules of how that auction is handled fairly and smoothly.
Recently, a few companies, including Spotify and Slack, have opted to become public through what is called a direct listing. The company still has a big auction on its first day of trading, but the auction only includes existing shares that shareholders choose to sell rather than new shares that the company has made available. But the IPO auction isn’t the only auction in the company’s stock. Every weekday, there’s an opening and closing auction in every stock, typically completed at 9:30 A.M. and 4:00 P.M. Eastern Time, respectively.
Before those auctions, brokers send their orders to the listing exchange, how many shares they want, and what price they’d be willing to pay, and the exchange takes in those orders and disseminates data about the interest that is coming in to buy and sell the stock. Each exchange’s process is a little different, but ultimately at the time of the auction, the exchange matches the buyers and the sellers at the single price that allows the most number of shares to be exchanged. That price is the official opening or closing price.
The listing exchange also handles a few other kinds of auctions that occur in specific situations, like if the trading of a stock is halted or paused by the listing exchange because trading is too volatile or because the company needs to disseminate important news.
Second, the listing exchange is responsible for surveillance for its listed stocks. The exchange monitors trading in that stock and refers cases to the regulator’s if it appears there has been some kind of manipulative activity. The listing exchange is also in charge of halting the trading of listed stocks, if needed, and disseminating certain data, like information about dividends.
Lastly, the listing exchange provides services to companies to support them as they navigate the public market. This isn’t required by regulation, but in practice is expected in the market. However, this range is significantly based on the exchange, its particular strengths, and the prices the exchange charges companies to list.
In our next episode, we’ll talk about who actually trades in the U.S. equity market and how – investors and brokers.
Note that videos were recorded in December 2019.
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