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Transformation into Today’s Exchanges

June 14, 2017 / Indexes, Investing, stock market, Stocks

If you happened to catch my last post – The Beginnings of the Stock Market – today’s edition is a continuance of that same theme. In my last post, I left off in the some of the earliest trading pits which were located in Sweating’s Alley in London and were the precursor to the London Stock Exchange (LSE). Today I wanted to lay out a few facts (and give a few Copper Street Trivia answers) that led us to into the capital markets environment we all know and love today.

The First “True” Stock Exchanges

The first time we saw trading leave coffee houses and take a venue all of its own was with the birth of the The London Stock Exchange. The differentiator for the LSE was the fact that traders were required to pay an entrance fee, which was very different than earlier models (the coffee house exchanges.) Requiring traders to pay an entrance fee added a layer of qualification to the LSE that had not existed in the coffee houses where anyone with enough cash could buy equity along with their morning coffee.

The New York Stock Exchange (NYSE) was founded in 1792, shortly after the Americans prevailed in the American Revolution. Although the NYSE is the most well-known Stock Exchange – it wasn’t the first in the US – that honor goes to the Philadelphia Stock Exchange (PSE). The NYSE was set up on Wall Street, the famous, or maybe infamous heart of American Capitalism. At the time it was founded it was directly beside the largest Sea Port in the America at the time, it is no surprise the NYSE quickly out shined the PSE. The NYSE has been able to maintain its position at the top of the food chain, today the NYSE boasts a market capitalization in excess of $20 Trillion or $20,000,000,000,000. Compared to the second largest exchange in the world, the NASDAQ (which is also located in New York City and has a market capitalization of around $7 Trillion the NYSE is approximately 3x the size.

As computers became more and more prevalent the demand for speed and digitization became the . The demand led to the birth of the NASDAQ which stands for “National Association of Securities Dealers Automated Quotations” in 1971. The NASDAQ was the brainchild of the National Association of Securities Dealers (NASD) – now called the Financial Industry Regulatory Authority (FINRA). From its inception, it has been a completely different animal. The NASDAQ does not inhabit a physical space, compared to the floor of the NYSE at 11 Wall Street. Instead, it is a network of computers that execute trades completely electronically and it was the first of its kind. Fittingly, as an exchange born form technological progress, most of the technology companies we are familiar with trade on the NASDAQ, such as Amazon, Apple, Facebook, Netflix, etc…

The introduction of a purely electronic exchange made trading more efficient in terms of speed and execution which reduced the bid-ask spread – a spread the NYSE was accustomed to profiting from handsomely. The competition from NASDAQ has forced the NYSE to evolve, both by listing itself as a publicly traded company on itself and by merging with the Euronext Exchange, a European exchange, to form the first trans-Atlantic exchange.

The Center of the Universe

As I stated earlier, the NYSE is the largest exchange in the world with a market capitalization of $20 Trillion – which dwarfs the competition. The floor of the NYSE is frequently used to represent the lifeblood of American capitalism. But what actually happens there?

Contrary to popular belief the vast majority of people on the floor of the NYSE is the funny jackets are not stock traders, they are brokers. Traders buy and sell securities for their own account where brokers, on the other hand, execute trades on their clients’ behalf. You may be wondering why we even need these people given it is 2017 and we can execute trades completely electronically, on exchanges such as the NASDAQ. Imagine you are a hedge fund manager and you have a $10M stake in General Motors, which you have been thinking about selling but you aren’t sure. You ask your broker, who happens to sit on the floor of the NYSE to explore a trade. The broker would then hang out in the GM section of the floor and listen to rumors, assess appetites to trade, etc… Brokers and others on the floor of the NYSE have their finders on the pulse of the market and they often can find the best price and execution for their clients, and when you have $10M in a single stock, pennies and/or fractions of a penny per share add up and certainly matter.

Floor brokers are often referred to as specialists, and for good reason, one of the most confusing aspects of the floor to an outsider is the use of hand signaling in an ‘Open Outcry’ environment. For example, let’s say you wanted to buy or sell some shares…

First, you would hold your hand straight out with our palm facing outward to sell where an inward facing palm with the hand stretched upward sends a buy signal. To indicate the number of shares you would use one of two signals.

For digits one through five you would hold up the number of digits with your fingers pointed upwards.

For digits six through ten you hold your hand sideways and parallel to the ground, counting starts at six when the hand is held this way so two fingers out with a sideways hand give a reading of seven.

If you were to signal the number from your forehead – the numbers are read in blocks of ten, so two fingers from the forehead indicates a trade for twenty shares, if you then place a closed fist to your forehead, twenty quickly becomes 200. Each individual exchange has its own specialized signals that have developed over the years but the numbering system tends to be consistent.

The markets have changed drastically over the past 500 years and they will continue to, understanding changes in the overall environment of the market is an important part of understanding the overall market and individual stocks.

Thanks for reading!

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