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Educational Module Functions of a stock exchange

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What is a stock exchange?

All of us are familiar with the image of the stock exchange in movies and the news: Stockbrokers stand around on the trading floor and wildly gesticulate to each other. They give the impression of frantic, profit-obsessed individuals who care about only one thing: to make money for themselves and their clients in any which way. But this popular image does not tell the whole story. Stock exchanges fulfil vital functions in a modern economy.

Securities exchanges are secondary markets for trading securities such as shares and bonds, which have been previously issued by a firm. They function like the used-car market where cars that have been previously sold by auto manufacturers are bought and sold again. The initial sale of the securities, however, takes place on the primary market. For instance, a bank will first offer shares to capital investors before they are traded on the exchange (this is known as an “Initial Public Offering” or “IPO”). This initial offer is known as an “issue” and it precedes the trading of shares on a stock exchange. The company issuing the stock is advised by a bank. Once the initial sale via the banks is concluded (this is referred to as the “primary market”), the securities issued are admitted to trade on the exchange (the “secondary market”).

Let us now take a look at the functions of the stock exchange from the perspective of companies and capital investors.

Functions of a stock exchange

Bringing together supply and demand (allocation function)A stock exchange brings together investors looking to buy and investors looking to sell their securities. An exchange is basically a regulated marketplace (platform) for equity investors who want to either buy or sell securities. In the absence of an exchange, buyers and sellers would have to first look for each other; then, if they are able to make contact, to negotiate a price for the sale much like on the used-car market. Having an exchange, however, eliminates all these difficulties. The exchange provides a quick, inexpensive and efficient marketplace. It functions in accordance with regulations established by a regulatory authority (usually detailed in the Stock Exchange Act) as well as other rules established for various securities by the respective exchange.

We might compare the stock exchange to eBay, the popular online marketplace for (mostly)second-hand products. Sellers offer their products for sale on eBay; interested buyers then submit a bid. At the end of the auction, the product is sold to the highest bidder. Like eBay, the stock exchange is a platform for setting prices and concluding sales. However, instead of selling physical products, an exchange trades in fungible securities like stocks, bonds, mutual funds, etc. The word “fungible” means that every share or bond of that company is identical and entitles its buyer to the same rights. In contrast, the products offered on eBay will all have different qualities. Likewise, whereas there is only one seller per auction on eBay, there might be several sellers offering the same security at the same time on an exchange. There will also be multiple buyers and the sellers will have to be matched to buyers, leading to different prices being set for the same security. A detailed explanation of the process of price formation at stock exchangescan be found in the educational module „Pricing.“

Educational Module Functions of a stock exchange

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Enabling maturity transformationCompanies would like to have open-ended access to the capital they have raised in exchange for equity in the company. Likewise, they would like to have access to the capital they have raised in the form of debt until the end of the loan period (known as the “maturity” of the bond). Investors, however, may have different investment goals or different investment horizons. They might not want to hold shares in the company indefinitely or they might want to sell their bonds before maturity. By bringing together buyers and sellers for a security, the stock exchange gives them the option to do so. An investor who wishes to liquidate his holdings can sell to someone looking to build up his portfolio. An investor thus does not have to hold on to his securities longer than he wants to. A stock exchange thus creates a win-win situation for both companies and investors. Both sides can make better financing and investment decisions because of the flexibility an exchange provides.

Ensuring transparency and making information availableStock exchanges continuously publish their trading volumes and prices. Investors can thus keep abreast of current price trends. These trends are also widely circulated by newspapers, TV, internet, and other popular media. Stock exchanges also require listed companies to complete registration documentation and fulfill other disclosure requirements - this information is also shared with the public. Furthermore, publicly listed companies are obliged to immediately publish any relevant facts or information that might influence the price of their shares such as profit and sales warnings, changes in management or to the board of directors, acquisitions of other companies and the sale of business units.

Reducing transaction costsRunning an exchange involves certain costs like electronic trading systems (computers, servers, networks, connectivity to banks, intelligence agencies, etc.), monitoring of trading, settlement of securities orders and staff salaries. To cover these costs, exchanges levy a transaction fee on each securities order. The more orders an exchange executes, the better it is able to spread the costs of these services over the individual orders, thus keeping fees low. Furthermore, competition between different exchanges keeps fees low. In contrast, in the absence of an exchange, both buyers and sellers would incur higher costs as they would first have to search for their respective counterparts and they would also not have an easy way to transfer the securities upon sale. Exchanges and a functioning secondary market are therefore essential if companies are to raise sufficient equity and debt. Furthermore, investors would be less willing to buy securities on the primary market if there was not an easy way to sell these securities later on a regulated market like the stock exchange. An exchange also gives listed companies the ability to raise additional capital through issuing “new shares” as new equity to new investors (the educational module “Shares” explains how companies can increase their capital by issuing “new shares”). These features of the stock exchange mean that exchanges play a vital role in companies’ ability to raise capital and in the growth of the economy. Without exchanges, there would be fewer investors and hence less capital investment for growth.

Educational Module Functions of a stock exchange

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Functions of a stock exchange

Bringing together supply and demand

Maturitytransformation

Companies InvestorsTradingon the stock exchange

Debt (bonds)

Buyer

Transparency and information function

Stock exchange turnover and prices Price-relevant information

Reduction of transaction costs

Use of information technology High number executed securities orders

Stock Seller

Publication

Equity (shares)

Demand Supply

Educational Module Functions of a stock exchange

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1. Professional expertise: The ability to name and explain the functions of a stock exchange.

1.1 Name and explain the functions of a stock exchange.

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Educational Module Functions of a stock exchange

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2. Professional expertise: The ability to explain how a stock exchange compares with the functioning of other markets.

2.1 Stock exchangesare marketplaces for trading in shares, bonds, mutual funds and certificates. Exchanges bring together supply and demand for exchange-traded securities. List some other well-known examples of markets which bring together supply and demand.

2.2 Compare and contrast a flea market to the trading of securities on a stock exchange.

Educational Module Functions of a stock exchange

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3. Professional expertise: The ability to check the maturity transformation function

3.1 Which shares would you recommend to the equity investors? Justify your decision.

3.2 Drill AG wants to place two tranches of bonds with capital investors. For one tranche, a stock market listing is required. For the other tranche, a stock market listing is not planned. There is almost zero interest among investors for the second tranche. Why is this so?

You are a capitalinvestor faced with a choice between two investment opportunities. Both companies have positive long-term business prospects but the equity investors want to invest only in one company. You can either buy:

1. Shares in Drill AG. Drill AG is active in the engineering sector. The shares are listed on a stock exchange.

Or you can buy:2. Shares in Screw AG. Screw AG is also active in the engineering sector but its shares are not listed on a stock exchange.

Educational Module Functions of a stock exchange

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4. Professional expertise: The ability to explain how a stock exchange compares with the functioning of other markets.

4.1 Publicly listed companies are required to disclose price-relevant information (ad-hoc publicity). Why is there adisclosure requirement?

4.2 Price-relevant information (ad-hoc publicity) must be made available simultaneously

to all capital market participants in a standardized way across different information sources. Why is it important that all capital market participants should have access to this information at the same time?

5. Professional expertise: The ability to justify lowering of transaction costs

5.1 Stock exchanges charge favourable transaction fees for the execution of securities orders. Give reasons why the transaction fees remain low.

5.2 Some stock exchanges have caps on transaction fees. A cap is an upper limit to the transaction fee levied on a securities order. Why would it be in the exchange’s interest to limit transaction fees?