BROKERS AND EXCHANGES

Brokers

Before we talk about exchanges, let me just tell you what a broker is.  If you’ve ever bought or sold a house, you know already.  A broker is someone who brings a buyer and seller together and facilitates a transaction between them.  A stockbroker is someone who facilitates the buying and selling of shares and receives a commission for the transaction by way of compensation.  A stockbroker is not a financial advisor (though some are certified as such), or a securities analyst.

Many discount brokers are actually "introducing brokers," meaning that they take orders but the trade is actually executed by someone else--a clearing firm.  If you are working with one of these small, online discount brokers, you'll often receive statements from a clearing broker; the introducing broker passes orders through to the clearing broker.

Stock Exchanges and Markets: an overview

The “stock market” is used collectively to mean all markets or exchanges: the NYSE/Euronext, AMEX (which has since merged away), the NASDAQ and so on.  In fact, while it was once called a market, the NASDAQ is now defined as an exchange.
 
Once a company has been brought public, the company is listed on an exchange or a market.  The two big ones are the New York Stock Exchange, NYSE, and the NASDAQ.

Before we talk about the various exchanges or markets, let’s keep in mind what they are.  A stock market is a place where one person sells shares to another.  The market works just like any other market in that the buyer wants the lowest price and the seller the highest.  By aggregating (bringing together) this trading activity, in principle both parties should be happy.  If you have a lot of people selling and buying, you’ll have a range of opinions on an appropriate price for the stock.  Hence, the chance of finding a seller and a buyer who agree on a price is likely to increase.  Tracking the ownership of each share is done by another entity, the DTC, which is described elsewhere.

Another thing to keep in mind is that once a stock is listed, it’s sort of out of the hands of the company.  Bill Gates cannot easily produce a list of all the shareholders.  For one reason, as thousands of shares of Microsoft change hands each day, the names on that list (and the number of shares each person owns) changes continuously.  They are tracked but a few decades ago, Bill likely knew each of the investors by name, not anymore.

The market does perform one important task: it offers a value for each listed company.  For example, if the most recent trade of a company, ABC, is $50 per share and there are 100 million shares outstanding, the “market” is setting a price of $5 billion on the ABC Company ($50 per share by 100 million shares).  This number, $5 billion in the current example, is called the market capitalization of ABC Company.  In this regard, the stock market is like a public opinion poll for the value of each listed company.  Since shares are trade continuously, the value of the company changes minute-by-minute, even second-by-second.  The stock market is like a huge discussion about what a company is worth.

Fundamental investors do not put too much store in what the public thinks; they focus more on the fundamentals that are believed to drive the valuation.  Investors using technical analysis take the opposite approach: they're not as concerned about the fundamentals of the company and what its intrinsic value might be, they're more concerned with trying to predict what other investors will do next, anticipating these moves and profiting from them.

NYSE

The NYSE is one of the oldest stock exchanges in the world.  It’s a classical exchange—an auction market.  Traditionally, companies listed on the NYSE (the big board) have a ticker symbol of up to three letters; however, this situation is changing.  For example, AT&T has a ticker symbol “T”; the ticker symbol for America Online was, surprisingly, AOL.  The NYSE charges fees to companies that want to be listed.  The NYSE is one of the most expensive places to list a company.  The exchange also has more stringent requirements than other exchanges or markets, though this difference is slowly changing too.  For example, the NYSE requires that the company be profitable!  As a result, start up companies, or companies in emerging industries are not generally found on the NYSE.  The company has a minimum share value that a company must maintain.

The NYSE has a trading floor where buys and sells occur.  There are two major classes of people on the exchange, brokers (well traders) and specialists.  These people “buy” a seat on the exchange.  There are a limited number of seats (around 1400) and the price of each seat is based on demand.  The role of the broker is essentially as described earlier.  A specialist is something different.

Each company traded on the exchange has at least one specialist assigned to it.  All trades for that company route through the specialist.  The role of the specialist is illustrated in movies such as Greed.  You have a person—the specialist—standing in the middle of a crowd of traders.  These traders have buy and sell orders at various prices.  The specialist works to ensure orderly trading in the stock; this specialist determines the current buy and sell prices based on supply and demand for that security.  In the unlikely event that there are sellers for a company and no buyers, the specialist purchases the stock for his or her own account.  Naturally, if there were sellers and no buyers you’d expect the price to drop: it does.  The specialist ensures that the shares are purchased at steadily decreasing prices.  He or she buys the shares in the order in which the sell-order is received.  The exchange has guidelines for this activity.  The specialist also determines the opening price for a stock.  On the day the stock trades ex-dividend; that is, people who buy the company that day are not entitled to receive the dividend, the specialist adjusts the requested buy price on open orders by the amount of the dividend; this adjustment changes the equilibrium between buy and sell orders and thus impacts the opening price; however, in most cases, this impact is difficult to spot.

Specialists have to have the resources to make many purchases in the unlikely event of a marked “crash.”  In October of 1987, specialists on the floor of the NYSE ensured that anyone who wanted to sell shares was able to do so.  The NASDAQ, discussed next, did not have such a mechanism in place at that time, but again, the situation has greatly improved.

I have just described the ideal scenario.  In reality, with billions of trades in a given day many of the activities I’ve just described are handled electronically.

NASDAQ

The NASDAQ has a different structure.  The NASDAQ was started about thirty years ago by the umbrella organization for brokers: the National Association of Securities Dealers.  NASDAQ is actually an acronym: the National Association of Securities Dealers Automated Quotation National Market System.  So, this market is often abbreviated as NASD, NASDAQ or NMS.  Today the NASDAQ is a bone fide exchange and is called "the NASDAQ."     NASDAQ is now a term in its own right.  NASDAQ is a market rather than an exchange.  There are no specialists on the NASDAQ, there is no trading floor—there is no exchange.  The NASDAQ has a series of “market makers.”  A company such as Microsoft (MSFT) might have many market makers assigned to it.  The market makers are responsible for ensuring orderly trading in the shares of a company; they ensure that the prices move in an orderly fashion.  The market makers set the price based on supply/demand criteria.  In this way, they function in a role similar to a specialist.

Market makers often have an inventory of shares; specialists have their accounts too.  Market makers (or other brokers) could sell from this inventory.
Companies on the NASDAQ traditionally had a ticker symbol of four or five letters; five letters often meant a foreign company; however, this distinction has changed.  In some respects, requirements to list on the NASDAQ are less stringent that those on the NYSE.  Companies do not have to be profitable; however, there are minimum requirements for assets. 

The differences between the NYSE and the NASDAQ aren’t too important.  In fact, the structure of these two means of buying and selling share is merging.

Other Regional Exchanges

Aside from the NYSE, there used to be many regional exchanges: Philadelphia, Chicago, San Francisco, etc.  These exchanges, as measured in number of trades per day, were much smaller than the NYSE.  They functioned in a similar role; however, they have all merged, mostly into NYSE/Euronext.  There are also electronic exchanges.  These electronic exchanges are becoming responsible for an increasing number of trades in a given day.  The NYSE has invested heavily into electronic trading platforms.

The OTCBB and the Pink Sheets

The over the counter bulletin board (OTCBB) and the Pink Sheets are two other markets.  The OTCBB is regulated by the NASD, but it doesn't have as demanding listing requirements as does the NASDAQ, but companies listed on this market are required to file financial statements with regulators, usually the Securities and Exchange Commission, but in some cases with an insurance of banking regulator.  It's an electronic exchange.  There is added risk involved in selecting companies on the OTCBB, few are generally suitable for a serious, long-term, buy-and-hold investor.

The Pink Sheets are a different animal altogether: a step down from tht OTCBB!   The first thing that should bring an element of caution is that companies listed on the Pink Sheets aren't required to file financial statements with the SEC.  Companies traded on the Pink Sheets have a suffix .PK.  While this information should create an element of caution, keep in mind that some foreign companies elect to trade their ADRs on the Pink Sheets, so not all companies on this market should be avoided.  The Pink Sheets constitute an electronic market where market makers (described earlier) buy and sell shares in the company.  Companies on the OTCBB but especially the Pink Sheets can trade at fractions of a dollar.  On the Pink Sheets, some companies are quoted as low as $0.0001--that's correct: three zeroes then a one. So, for one dollar, you can buy 10,000 shares.  Companies can't trade below one hundredth or a penny, but they can have a reverse split and being the journey to $0.0001 all over again. 

Pink Sheet companies often suffer from other problems: they may not be DTC eligible.  That is, the DTC which keeps track of who owns what, may not permit the company to use its electronic system of record keeping and demand physical transfer of certificates instead.  This requirement often creates extra costs in the transfer of ownership of shares of company stock.  Some clearing firms transfer these costs, sometimes as high as $700, directly to the seller.  Finally, Pink Sheet companies are often victims of what's called pump-and-dump, where unscrupulous newsletters will talk up a company and encourage the naive or greedy to buy shares, then dump them suddenly when a dramatic rise in price is attained.  In these circumstances, the Pink Sheets is an excellent mechanism to transfer funds from the naive to the greedy.

Finally, many people believe that the Pink Sheets constitute a reservoir of companies, some of which could be the giants of the future.  I know of no company in the S&P 500 that started life on the Pink Sheets.

While there many be a few decent companies on the OTCBB, with the exception of ADRs, the Pink Sheets should be avoided by any serious investor.