How do Stock Markets Work?

Prima facie stock markets appear to be very simple. It seems like there are buyers and sellers who meet on their own and interact during the transaction. However, the reality is that stock markets operate through a complicated mechanism wherein several different players are involved in the process. This is why a central intermediary party called the exchange is required in order to conduct all transactions smoothly.

In this article, we will have a closer look at the different stages which happen when a transaction takes place. We will also identify the different parties which are engaged in the transactions.

Stage #1: Placing Orders

Stage 1 is visible to buyers and sellers. This is why buyers and sellers consider this to be the entire process. The rest of the steps usually take place behind the scenes and hence are not known to the buyers and sellers.

In this stage, buyers interact with their brokers. They place buy and sell orders depending upon the price, which is prevailing in the market.

Stage #2: Price Discovery

In the second stage, the brokers place the order in the open market based on the instructions from the client. The brokers have a connected system wherein they can place, buy, and sell orders. It must be understood that the price at which buy and sell occurs is not the same as the one at which the order was placed.

In most cases, buy and sell transactions happen so fast that the price which was being quoted is the price at which the buying and selling actually happens. This creates the illusion that the price is known first, and the transaction happens later. The reality is that the price is determined during the buy and sell process. Some brokers have buy orders with given prices. Others have sell orders with given prices. If the prices do match, transactions happen, whereas if the prices don't match, the orders are revoked after some time.

Hence, when transactions happen on the exchange, price discovery happens simultaneously.

Stage #3: Position Keeping

If the next stage, the exchange has to provide order confirmation to both parties. Both parties do not know each other. For each of them, the counterparty is the exchange. Also, many exchanges facilitate trading with keeping the lot size as small as one!

This means that a person can even buy or sell a single share! Hence, if a person wants to buy 1000 shares, it could be sourced from different people. The priority is obviously given to sellers who are willing to sell at the lowest price. This is done to ensure that the average price of the purchase goes down.

The exchange not only matches the buy and sell requirement, but it also provides confirmation of orders. Also, in the case of forwards and futures, exchanges provide other crucial services like record keeping and maintaining the margin. Basically, all the services from the execution to the settlement of the trade are provided by the exchange.

Stage #4: Settlement

The next step in the process is called settlement. This step does not take place on the same day as the original trade. When the trading takes place, only the price is locked, and the actual settlement takes place a day or two after the actual trade.

The process of settlement is initiated after the exchange sends the trading information to the depository institution. Buyers and sellers do not directly interact with the depository institution. Instead, the agents of buyers, as well as sellers, interact with them. It doesn't matter if the brokers have to deal with one depository or multiple. This is because, for the outside world, the depository institutions function as one single system.

The actual transfer of shares takes place here. It is the custodian who changes the name of the owner of the shares in their record after receiving instructions from the exchange.

Stage #5: Clearing

The last step in the process takes place between the custodian and the brokers. This is where the entire communication loop is closed. For instance, when a buyer makes a payment to buy shares, the brokers have an open credit and no corresponding debit.

Once the custodian changes the name of the owner of the shares, he sends a communication to the broker. This communication creates an open debit entry. Now, the clearing process is about reconciling the open debits with the open credits. The broker is therefore sure that the money which they paid on behalf of the customer has been used to buy shares which are now in the customer's name.

The confirmation and matching of the buyers' instructions and the custodians' communication are called clearing. This process is of utmost importance to ensure that there are no unfinished transactions.

To sum it up, the stock exchanges have a complicated process in place. This complicated process may seem unnecessary. However, the reality is that this complicated process is actually the backbone of the entire system. This process facilitates the execution of millions of deals without making any errors or causing expensive delays.


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