Stock Exchange Definition: What It Is, How It Works, and Types Explained

These days, investing is accessible to most people. You can easily find an option that will meet your main requirements and financial opportunities. However, despite numerous saving opportunities, investors still prefer to turn to stock exchanges as the main source of future passive income. Thanks to the presence of such platforms, companies and investors have a place where they can effectively sell and buy shares.

If you are interested in becoming an investor, here you will find the stock exchange definition, information about its functions, and the types you should know about.

What Are Stock Exchanges?

If you wonder how to trade on any market, it’s important to start with the basics. What is the purpose of a stock exchange, and what is it exactly? Stock exchanges are marketplaces where investors can buy different assets, including but not limited to bonds, securities, and stocks. The goal is to bring together companies and investors with a high level of convenience and transparency.

Back in the day, you would need to physically go to the stock market to place or sell your shares. Nowadays, you can do it from the comfort of your own home with a few clicks on your PC or mobile device, although the traditional ones exist too.

Primary and Secondary Markets

The stock exchange economics definition wouldn’t be complete without talking about the concept of primary and secondary markets.

Primary Market

The primary market is where various stocks, bonds, and other securities are created. Also referred to as a new issues market, the primary market is designed to introduce financial assets to the general public. The process is referred to as an initial public offering, and the company’s motivation is to raise sufficient funds for its expansion goals.

Secondary Market

The secondary market is different from the primary one. In this market type, financial assets issued previously are sold and purchased by investors. Also called the aftermarket, this platform is crucial for the global economy.

Examples of secondary markets include stock exchanges and over-the-counter markets.

Functions of Stock Exchanges

As you already have an understanding of the stock exchange meaning, let’s talk about its main functions.

Liquidity

To put it simply, liquidity has to do with how quickly and easily a certain share or other financial asset can be converted to cash without drastic price shifts. For example, low liquidity means fewer people want to buy a particular asset, indicating buyers may have trouble turning it into real money without sacrificing the price.

Price Discovery

Another important function of a stock market is price discovery. When selling and buying financial assets, both parties agree on their value and thus fairly determine their price. The obtained market price directly reflects investors’ ideas about how well they expect a company to perform in the future.

Corporate Governance

In addition to the mentioned functions, stock markets help achieve corporate governance. Not only do shareholders get voting rights in a certain company, but a company also becomes more accountable for its actions by selling shares.

Security and Safety of Investments

The good thing about stock exchanges is their governmental control and the presence of regulations. This helps prevent speculation, fraud, and over-trading. The performed transactions are publicly known, which makes it such a safe option for both investors and companies.

Raising Capital

Last but not least, is the opportunity to raise capital. By issuing stocks, a company can sell them and thus have funds to invest in new projects and for other purposes.

Types of Stock Exchange

Now that the answer to what is the purpose of a stock exchange is clear, it’s also crucial to talk about their different types. Depending on your preferences and what stocks you expect to buy, you can choose the most suitable option.

Traditional

When someone asks “How do stock exchanges work?,” traditional stock exchanges are likely the first that come to mind. This type involves using a separate building and specialists on trading floors who are assigned to specific stocks and thus buy or sell them in the auction.

The most well-known stock exchange example in this category is the New York Stock Exchange (NYSE). Another one worth mentioning is the London Stock Exchange (LSE).

Electronic

Just as the name suggests, electronic stock exchanges rely on the use of computers. Bonds, shares, and more are purchased and sold online. The advantages of this trading include flexibility, error-free settlement, and low cost.

Electronic examples include Euronext and NASDAQ.

Over-the-Counter (OTC) Markets

As opposed to traditional stock exchanges, the peculiarity of over-the-counter markets is that they are decentralized. In this type of market, financial assets are sold through a network of brokers and dealers, which makes it less regulated and transparent.

In the United States, there are several large OTC markets, which include the Pink Open market, OTCQB, and OTCQX.

Regional

It is also worth mentioning regional stock exchanges, which refer to an exchange that is found in a city outside of the main financial center in the country.

Some examples of such regional stock exchanges registered with the SEC include the Miami International Securities Exchange, Long-Term Stock Exchange, and BOX Exchange LLC.

Commodity Exchanges

Commodity markets have the longest tradition in human history. When people trade on such exchanges, they buy or sell commodities — energy products (oil, gas), agricultural products (wheat, cattle, coffee), and metals.

Some examples of commodity exchanges include the Tokyo Commodity Exchange and the Chicago Mercantile Exchange.

Cryptocurrency Exchanges

Cryptocurrency exchange platforms are the newest form of trading created for buying and selling digital currencies (Bitcoin, Tether, Ethereum, etc). The principle of work is similar to that of electronic stock exchanges. It involves the use of digital marketplaces and a range of trading tools.

In the United States, the biggest platform for cryptocurrency exchange is Coinbase while the biggest global platform for this purpose is Binance.