Intro: Stock Markets

Stock Markets

The goal of stock markets is to facilitate the exchange of ownership of corporations (common stock). There are primary and secondary stock markets.

Primary: an exchange of stock in which the company is a buyer or seller. This is the market for Initial Public Offerings and Seasoned Equity Offerings.
Secondary: an exchange of stock in which the company is not involved.

The secondary market is the one you see every day in the news, and it’s the one we’ll cover in this presentation.

Secondary Markets

We care how well the secondary market functions because it affects our investments and retirement.

Companies want a well-functioning secondary market because it means they get higher prices for the stock they sell in the primary market (in seasoned equity offerings).

The more money a company can raise in the primary market, the more the company can invest in real assets, research and development, and other uses.

So well-functioning secondary stock markets lead to higher levels of investment and employment, and faster economic growth.

The Market Participants

The market is comprised of the market makers and those wishing to exchange stock.

A market maker, at all times, posts prices at which they are willing to buy (the bid) or sell (the offer or ask).
Those wishing to trade stock could be trading for themselves or on behalf of another party (in which case they are acting as a broker).
The U.S. Securities and Exchange Commission regulates stock markets.

Where are the Markets?

Until recently, the market was a physical place. It was the place where the market maker was literally standing.

Brokers and traders who wanted to trade, say GE, would congregate around GE’s market maker.
The New York Stock Exchange famously started under a buttonwood tree outside 68 Wall Street.

Now stocks are traded in many exchanges throughout the U.S., which means we need mechanisms to ensure investors trade at the best price across exchanges.

The consolidated tape system, implemented in 1976, facilitates this by establishing the central reporting of trades and quotes.

Regulation National Market System (Reg NMS)

Starting in 1975, the SEC began to work on a national market system. In 2005 much of this work was consolidated into Reg NMS, which among other things sought to:

Ensure investors were getting the best price across all exchanges for their purchase or sale of stock (known as the “Order Protection Rule”)
Provide all investors fair access to price quotations, while also setting a limit on access fees (“Access Rule”)
Restrict sub-penny quotations

What is an Exchange Today?

An exchange is a data center that houses computer servers which run an order-matching engine. A good description of an order matching system is provided by the Chicago Stock Exchange.

The order-matching engine is an algorithm which handles orders according to a set of rules. Some rules are exchange specific, and some rules are the same across all exchanges.
In essence, the matching engine receives orders, maintains a ranking of orders according to a set of rules, and looks at whether it can fill the order within the NBBO. If it cannot, it doesn’t execute the order.

There are presently 18 national securities exchanges registered with the SEC (their servers are mostly located in New Jersey and Chicago).

Present Exchange Participants

There are still market makers, brokers, and investors in today’s markets.

What has changed includes where/how they communicate and many of the rules by which they trade (such as order type and who gets to trade first).
Moving to purely electronic communication has also greatly increased the speed at which market participants can trade. In fact, there are now those who specialize in speed – known as High Frequency Traders.

Market Location Interactive Map

The following map shows locations of the exchanges – note this is the location of the servers, not the corporate headquarters.
You can zoom in and move the map with your mouse to see more detail.

Location of U.S. Exchange Servers

Information Flow

Because it takes time for information to travel from one exchange to another, orders at one exchange are not instantaneously reflected at another exchange.

Exchanges which are closer to each other will tend to have more similar quotes (at the millisecond and microsecond level).
This means we can see exchanges as a set of linked groups, where each group has a similar information content.

Exchange Network

The next app that you’ll see will offer a different view of the U.S. stock market. Exchanges are grouped by how similar their quotes will be to other exchanges (based on distance to the other exchanges).

The two exchange groups are light blue for the New Jersey area and dark blue for the CME (where S&P 500 futures are traded) and the Chicago Stock Exchange.
The lines linking the exchanges represent paths of information flow. The longer the line between two exchanges, the longer it takes for information to be exchanged.
Each exchange is identified by its Market Identifier Code. The listing of codes and exchanges is at the end of this presentation.

Information Generation

The orange nodes in the upcoming app represent where a great deal of information, which affects stock prices, is generated. These are Manhattan (NYC) and Washington D.C. (where the Federal Open Market Committee (FOMC) releases its statements on monetary policy).
The closer an exchange is to where the information is generated, the faster it will incorporate that information into prices.
Feel free to move the nodes in the app around to get a better look.
Placing the cursor over a node will show its name.

U.S. Stock Exchanges Grouped by Information Similarity

Dark Pools

In addition to national and regional stock exchanges, some organizations have set up Dark Pools.

If you send an order to an exchange, the order can be seen by the public. Trades on a public exchange also generate information which is then reflected on other public exchanges.
In a dark pool, you can send an indication of interest to buy or sell a stock, and this indication is only available to those with access to the dark pool. Moreover, trades in the dark pool are not quickly made known to public exchanges.

Dark pools are run by (1) independent organizations, (2) broker-dealers such as JP Morgan, Credit Suisse, and Fidelity, and (3) public exchanges.

There are about 40 dark pools today.

Why Trade in Dark Pools?

The benefit of sending an order to a dark pool is that you may be able to hide large orders.

Say you send a large buy order to an exchange. When your intentions become public, the price will tend to increase causing you to have to pay more for the shares.

Despite trading in a dark pool, you should still receive no worse than the best bids and offers among public exchanges.

However, trade data from dark pools are difficult to obtain, and therefore we are constrained in our ability to verify that trades in dark pools are not at prices worse than available from public exchanges.

Information Transfer with Public Exchanges

Dark pools might show up in our network as independent nodes.

This is because trade and quote information is hidden from public exchanges. So trades in the dark pool will not generate information flow to other exchanges.
Dark pools show up in light orange in the following network graphic.
Hovering the mouse over the node will show the Dark Pools’ name.