Fool's Eye View

[ February 21, 2000 ]

Just What is a Stock Exchange?

By Alan Oscroft (TMFAlan)

Bournemouth, Dorset -- It's time to continue with our educational series on the actual mechanics of the stock market and the role of its various components. We have already had a look at what market makers do, and how the electronic trading system, SETS, has changed the way dealing is done. Today, we'll go back to the most important part of the whole thing and ask what a Stock Exchange really is and how they came about. Let's start with a little history.

With the growth of the world's wealth and the progress of capitalist economies of one form or another, the advent of "joint-stock" companies (perhaps better known today as public companies) in which private investors can purchase a stake was inevitable, but the first one, the Muscovy Company, was not formed until 1553, in London.

Growth of private firms is pretty much limited by the amount of capital that its owners can raise for expansion, and the joint-stock approach to obtaining further capital from outside investors became more and more important as the Industrial Revolution followed its course. The number of joint-stock companies steadily rose, and a mechanism for buying and selling shares became more and more important. A market place was needed.

In 17th century England, that market place took the form of the coffee houses of London, where private investors could meet with company owners trying to raise capital, or with other investors, in order to buy and sell shares. This dealing came to be facilitated by a growing number of intermediaries, or brokers, whose job was to introduce buyers and sellers to each other, and different groups held court in different coffee houses.

The London Stock Exchange, the world's oldest, had its origins in one of these groups of brokers. In 1760, a group of 150 formed an organisation at a London coffee house known as Jonathan's, and a few years later, in 1773, voted to change the name from Jonathan's to the Stock Exchange. This exchange went on to become a vital part in financing the next 150 years or so of Britain's industrial growth.

Regional stock exchanges sprang up across the country, acting independently of the London Stock Exchange, and amalgamation into a single exchange did not happen until as late as 1973.

But what are the responsibilities of a modern stock exchange? They fall into three basic categories. The first of these is the facilitation of the raising of capital, and that requirement is exactly the same as it was back in the eighteenth century. But the number and types of investments that are currently listed on stock exchanges has come a long way since the days of Jonathan's. Sticking with the London Stock Exchange, its most important listings are indeed equities (or shares in joint-stock companies), including both the main market and the Alternative Investment Market, AIM, set up in 1995 as a means for smaller, less heavily regulated companies to come to market.

In addition to equities, the London Stock Exchange (the LSE) also lists the following...

• UK Gilts. These are UK Government issued loan instruments, via which the purchasers lend money to the government. Gilts are considered very low risk investments (though the Russian Government may default on repaying its borrowings, it is extremely unlikely that the UK Government will ever do so).
• Sterling Bonds. Another form of loan instrument, these are issued by private companies or by local authorities.
• Eurobonds. Loan instruments issued by both UK and other European companies.
• Options. Traditional options for gambling on the future movements in share prices, or (more Foolishly) to hedge against unfavourable movements in the underlying shares.
• Depositary Receipts. Certificates issued by companies listed on overseas markets, usually emerging markets in the case of UK listed receipts, that represent ownership of the underlying shares. The most widely known Depositary Receipts in the world are the American variety, ADRs, which enable many of the world's large companies to be traded on USA exchanges.

The second important category of the LSE's responsibilities is that of providing Trading Services. Listing equities and other instruments of investment is not sufficient if there are no mechanisms to trade them. We have looked at the electronic trading system, SETS, before, but the LSE also provides a number of other services. The services offered are:

• SETS, the electronic order book used for efficient matching of FTSE 100 trades.
• SEAQ, the Stock Exchange Automated Quotation system, for tracking market makers' quoted prices.
• SEATS PLUS, the Stock Exchange Alternative Trading System. Used for trading AIM companies and some others that are not covered by SEAQ.
• SEAQ International, an electronic quote system for international equities.
• Trading Information, including daily lists of closing prices, historical data, company news, and a lot more

Historically, the LSE also provided settlement services for settling up trades, but that responsibility has now been transferred to CRESTCo, which operates CREST, the electronic settlement system.

The final main category is that of Regulation. The LSE (along with its counterparts in other countries) lays down the rules that companies must follow in order to first obtain and then maintain a listing for their shares. The LSE monitors companies' adherence to the rules, enforces the rules when necessary, and investigates suspected abuses of its markets.

One important part of the Regulation facilities is the Regulatory News Service (RNS), which is the official medium for publishing company announcements, including results, profits warnings, directors' dealings, and so on. Companies listed on the LSE are obliged to adhere to the requirements of the RNS, and must make certain information available via the service.

Well, that's about all I can fit into the space available today. This series will be updated and featured in the Fool's School in due course, and one reason for starting it off in the Fool's Eye View is to get some feedback on what people want. So, if you have any suggestions or any questions that you want answered, or if there are any areas that you would like to see expanded on, please let us know on the Fool's Eye View message board.

Related Links
• Fool's Eye View -- Market Makers
• Fool's Eye View -- SETS
• Fool's Eye View message board
• The London Stock Exchange (external link)