What’s a stock exchange?

As the sixth edition of my book The Economist Guide to Financial Markets is published this week, I’ve been thinking about how financial markets have changed since the first edition was published in 1999. One of the most remarkable changes involves exchanges. Although computerized trading was already quite important at the time, there were three distinct types of ¬†exchanges that traded financial products: stock exchanges, futures exchanges, and options exchanges. To be sure, there was some overlap, but not much; the Chicago Board Options Exchange traded options contracts but not futures contracts, and the Brazilian Mercantile and Futures Exchange traded options and futures but not stocks. The New York Stock Exchange, right there on Wall Street, was indisputably the most powerful of the world’s financial markets.

Today, matters are quite different. Then, most exchanges still had trading floors populated by specialists who kept the market moving; whether you wanted to buy orange juice futures or sell IBM common, someone at the exchange, usually attired in a distinctive vest, would take the other side of your trade if no other customer was at hand. These days, only a handful of exchanges still have trading floors, and the even there most business takes place off the floor. The specialists whose personal interaction made exchanges so fascinating are largely gone. Modern exchanges are essentially computer systems that bring buyers’ and sellers’ orders together, confirm trades, and make sure money and financial assets are credited to the correct accounts. And once the exchange has gone to the trouble of building its technological infrastructure, it can trade almost anything. NASDAQ, the Korea Exchange, and the National Stock Exchange of India all are heavily involved in futures and options trading as well as share dealing. Last year, the venerable New York Stock Exchange, dating to 1792, was gobbled up by IntercontinentalExchange, or ICE, an all-electronic upstart that began by trading energy options in 2000. ICE owns 23 different exchanges, so it can get an awful lot of bang for its technology buck.

Large and sophisticated as they are, these far-flung exchanges face some challenges of their own. Their systems are being overwhelmed by buy and sell orders placed by the computers of high-frequency trading firms; in many cases, those orders are placed to confuse the market and then quickly withdrawn before being executed, so an exchange may collect no revenue from posting them. Meanwhile, a large and growing share of trades, especially in stocks, is being arranged privately, through so-called dark pools owned by investment banks or others, rather than on exchanges subject to public disclosure requirements. I have a hunch that by the next time I revise The Economist Guide to Financial Markets, the world of financial exchanges will have changed a good bit more.

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