What Is a Stock Exchange and How Does It Work?

The stock exchange is the beating heart of modern financial markets. It serves as the central hub where buyers and sellers meet to trade shares, bonds, and other financial instruments, enabling companies to raise capital and investors to grow their wealth. While the concept may sound straightforward, the mechanisms that power stock exchanges are complex and fascinating, blending technology, regulation, and market psychology.

Understanding how stock exchanges operate is crucial for anyone looking to participate effectively in the markets—whether as a casual investor or a professional trader.

Market Structure: Exchange vs Dealer vs OTC

• Auction (order-driven) markets: Central exchanges like the NYSE and London Stock Exchange use a central limit order book (CLOB)—participants submit buy/sell orders that are matched by price-time priority. The highest bid meets the lowest ask, and the matching engine executes trades transparently in real time.

• Dealer markets: Here, dealers quote prices and trade directly from inventory, rather than matching orders between buyers and sellers.

• Over-the-counter (OTC) markets: These are less centralized and less regulated, often used for bonds, smaller stocks, or delisted securities. Trading happens privately via networks rather than on an exchange.

Order Flow and Matching: Order Types, Market Makers, and Matching Engines

• Order book basics: An order book is a dynamic list of buy and sell orders across price levels, revealing depth and liquidity.

• Limit vs Market orders: Market orders execute immediately at the best available price, while limit orders wait until matched at the specified price or better.

• Market makers: These entities continuously post bids and asks to provide liquidity and narrow spreads. They profit from the difference between their buy and sell prices and manage inventory risk. A trader on Reddit described how market makers profit:

"If the spread of Apple shares was 10 cents…the market maker had just profited $12 through these two trades".

• Matching engine: Matches orders based on price and time priority, enabling a transparent and fair process. The CLOB system ensures this operation.

Listing and Delisting: How Companies Join or Leave an Exchange

• Listing (e.g., via IPO): Companies must meet certain thresholds—like minimum market capitalization, shareholder equity, financial reporting, and governance standards—to be listed.

• Delisting types:

1. Involuntary delisting: Occurs when listing standards aren't met. A company usually gets a warning and a grace period to comply (e.g., regain share price levels or file reports) before delisting proceedings begin.

2. Voluntary delisting: Companies may choose to go private or merge, opting out of being public.

3. The relisting process is possible once compliance is restored, though it can be rigorous.

• Example process: For NASDAQ, a deficiency notice triggers a cure period (e.g., 90 days). If compliance isn't met, a delisting letter is issued, followed by potential hearings and public disclosure.

Trading Hours, Electronic Trading & High-Frequency Trading (HFT)

• Trading sessions: Exchanges run scheduled hours (e.g., 9:30 am–4:00 pm ET), sometimes with extended pre- or post-market periods.

• Electronic trading: Most order execution is fully electronic, replacing traditional floor trading.

• HFT dynamics: High-frequency traders use ultra-fast infrastructure—like microwaves and fiber optics—to perform extremely rapid, algorithmic trades across venues. They play a dual role—enhancing liquidity but raising concerns over fairness and stability.

Clearing, Settlement & Counterparty Risk

• Clearinghouse role: Acts as the middleman between buyer and seller, standardizing and guaranteeing trade execution to mitigate counterparty risk.

• Settlement timings: The industry has mostly transitioned to T+1 (trade date plus one business day) in many countries, including the U.S., Canada, and India. Some regions still use T+2. but many plan to move to T+1 soon.

Costs, Fees & Market Regulation

• Fees: Exchanges charge transaction and data-access fees; brokers can levy commissions or markups. Market makers profit via spreads.

• Regulation:

1. Self-regulation: Exchanges enforce compliance among members.

2. Government oversight: Agencies like the U.S. SEC mandate transparency, fairness, and investor protections.

• Dark pools: Private trading venues where large institutional orders are matched away from public order books. They offer anonymity but attract scrutiny over transparency and fairness

Summary Table

Conclusion

Stock exchanges are sophisticated, multi-layered ecosystems that enable the efficient trading of securities worldwide. Their intricate market structures, advanced order matching systems, rigorous listing standards, and strict regulatory frameworks work in concert to provide liquidity, price transparency, and investor protection.

For investors and traders, understanding these mechanisms is not just academic—it empowers better decision-making, sharper insight into market behaviour, and greater confidence navigating financial markets. Whether you're placing your first trade or managing a complex portfolio, the stock exchange remains a foundational pillar of modern finance, continually evolving with technology and regulation.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.