How The Stock Market Works?

In a nutshell, stock markets provide a secure and regulated environment where market participants can transact in shares and other eligible financial instruments with confidence with zero- to low-operational risk. Operating under the defined rules as stated by the regulator, the stock markets act as primary markets and as secondary markets.

As a primary market, the stock market allows companies to issue and sell their shares to the common public for the first time through the process of initial public offerings (IPO). This activity helps companies raise necessary capital from investors. It essentially means that a company divides itself into a number of shares (say, 20 million shares) and sells a part of those shares (say, 5 million shares) to common public at a price (say, RS10 per share).

To facilitate this process, a company needs a marketplace where these shares can be sold. This marketplace is provided by the stock market. If everything goes as per the plans, the company will successfully sell the 5 million shares at a price of RS10 per share and collect RS50 million worth of funds. Investors will get the company shares which they can expect to hold for their preferred duration, in anticipation of rising in share price and any potential income in the form of dividend payments. The stock exchange acts as a facilitator for this capital raising process and receives a fee for its services from the company and its financial partners.

Following the first-time share issuance IPO exercise called the listing process, the stock exchange also serves as the trading platform that facilitates regular buying and selling of the listed shares. This constitutes the secondary market. The stock exchange earns a fee for every trade that occurs on its platform during the secondary market activity.

The stock exchange shoulders the responsibility of ensuring price transparency, liquidity, price discovery and fair dealings in such trading activities. As almost all major stock markets across the globe now operate electronically, the exchange maintains trading systems that efficiently manage the buy and sell orders from various market participants. They perform the price matching function to facilitate trade execution at a price fair to both buyers and sellers.

A listed company may also offer new, additional shares through other offerings at a later stage, like through rights issue or through follow-on offers. They may even buyback or delist their shares. The stock exchange facilitates such transactions.

The stock exchange often creates and maintains various market-level and sector-specific indicators, like the S&P 500 index or Nasdaq 100 index, which provide a measure to track the movement of the overall market.

The stock exchanges also maintain all company news, announcements, and financial reporting, which can be usually accessed on their official websites. A stock exchange also supports various other corporate-level, transaction-related activities. For instance, profitable companies may reward investors by paying dividends which usually comes from a part of the company’s earnings. The exchange maintains all such information and may support its processing to a certain extent

Investor Protection

Along with wealthy and institutional investors, a very large number of small investors are also served by the stock market for their small amount of investments. These investors may have limited financial knowledge, and may not be fully aware of the pitfalls of investing in stocks and other listed instruments. The stock exchange must implement necessary measures to offer the necessary protection to such investors to shield them from financial loss and ensure customer trust.

For instance, a stock exchange may categorize stocks in various segments depending on their risk profiles and allow limited or no trading by common investors in high-risk stocks. Derivatives, which have been described by Warren Buffett as financial weapons of mass destruction, are not for everyone as one may lose much more than they bet for. Exchanges often impose restrictions to prevent individuals with limited income and knowledge from getting into risky bets of derivatives.

Balanced Regulation

Listed companies are largely regulated and their dealings are monitored by market regulators, like the Securities and Exchange Commission (SEC) of the INDIAN. Additionally, exchanges also mandate certain requirements – like, timely filing of quarterly financial reports and instant reporting of any relevant developments – to ensure all market participants become aware of corporate happenings. Failure to adhere to the regulations can lead to suspension of trading by the exchanges and other disciplinary measures

Regulating the Stock Market

A local financial regulator or competent monetary authority or institute is assigned the task of regulating the stock market of a country. The Securities and Exchange Commission (SEC) is the regulatory body charged with overseeing the INDIAN stock markets. The SEC is a federal agency that works independently of the government and political pressure. The mission of the SEC is stated as: “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Stock Market Participants

Along with long-term investors and short term traders, there are many different types of players associated with the stock market. Each has a unique role, but many of the roles are intertwined and depend on each other to make the market run effectively.

  • Stockbrokers, also known as registered representatives in the INDIAN are the licensed professionals who buy and sell securities on behalf of investors. The brokers act as intermediaries between the stock exchanges and the investors by buying and selling stocks on the investors’ behalf. An account with a retail broker is needed to gain access to the markets.
  • Portfolio managers are professionals who invest portfolios, or collections of securities, for clients. These managers get recommendations from analysts and make the buy or sell decisions for the portfolio. Mutual fund companies, hedge funds, and pension plans use portfolio managers to make decisions and set the investment strategies for the money they hold.
  • Investment bankers represent companies in various capacities, such as private companies that want to go public via an IPO or companies that are involved in pending mergers and acquisitions. They take care of the listing process in compliance with the regulatory requirements of the stock market
  • Custodian and depot service providers, which are institution holding customers’ securities for safekeeping so as to minimize the risk of their theft or loss, also operate in sync with the exchange to transfer shares to/from the respective accounts of transacting parties based on trading on the stock market.
  • Market maker is a broker-dealer who facilitates the trading of shares by posting bid and ask prices along with maintaining an inventory of shares. He ensures sufficient liquidity in the market for a particular (set of) share(s), and profits from the difference between the bid and the ask price he quotes.