The Stock Exchange acts on two levels - one as a primary market and the other as a secondary market. As a primary market, the Stock Exchange will liaise with investment banks and businesses that are looking to raise capital by selling shares. This process involves the business being 'listed' on the Stock Exchange or 'floating'. In this case, the business will effectively get its capital through the initial sale of its shares.
Much of the Stock Exchange's work, however, is as a secondary market. People buying shares may wish to do so for a variety of reasons - to secure dividends or to see the price of the shares rise, for example. If people wish to sell shares then it would be very inconvenient for the business itself to take the shares back and then sell them on to someone else. Such a process would be extremely disruptive and not help planning.
The Stock Exchange, therefore, acts as a market that puts those wanting to sell shares in touch with those seeking to buy - effectively the Stock Exchange is a market for second hand shares! To facilitate this process the market has two main 'players' - stock brokers and market makers.
Stockbrokers
A stockbroker is referred to as the retail part of the market. Stockbrokers act on behalf of clients and buy and sell shares on their behalf and generally belong to firms who are members of the Stock Exchange.
They earn their money from charging a commission on each transaction. They might also advise clients on the shares that the client might be thinking of trading. Because there could obviously be a conflict of interest with stockbrokers advising clients of trades that might not be necessary to build the commission of the broker, their work is regulated by the Financial Services Authority (FSA). The rules are very tight and strictly observed and enforced. The process of buying and selling for the purpose of generating commission is called 'churning'.
Some stockbrokers may act as 'execution only'. This means they merely buy and sell shares at low commission rates but do not offer any advice.
Market Makers
Market makers do not earn a commission from their activities. They simply buy and sell shares on their own account but make their money on the difference between the price they pay for buying shares and what they sell them for. This difference is called the 'spread'. If a market maker bought 400,000 shares in Marks and Spencer for 290p and later that day sold them for 292p they would have made £8,000.
Image: Both stockbrokers and market makers need access to high quality information and ICT facilities make this much easier. Here information on trades that have occurred, the volume and the changes in share price are available via a system provided by Proquote. Red means prices have fallen and blue means prices have risen. Source: Proquote
Stockbrokers will approach market makers with a view to buying and selling shares. The modern Stock Exchange operates through computer based trading. Both stockbrokers and market makers are able to see very clearly what is happening to prices in shares that they are interested in, who is looking to sell and who is looking to buy.
Anyone looking to buy or sell shares, therefore, might see something similar to the table below and is able to make a decision based on the information they have at their disposal.
| Marks and Spencer | Bid (buying price) | Offer (selling price) |
|---|---|---|
| Market maker 1 | 290 | 295 |
| Market maker 2 | 289 | 293 |
| Market maker 3 | 291 | 294 |
| Market maker 4 | 290 | 294 |
In the example above, the offer price is that at which the market maker will sell and the bid price that at which they will buy. If a stockbroker was looking to buy 250,000 shares in Marks and Spencer it would make sense for them to do a deal with market maker 2 as s/he has the lowest selling price. If they were looking to sell 250,000 shares then it would make sense to deal with market maker 3 as they are offering the highest buying price.
The market makers meanwhile will be constantly looking at movements in the market and changing their prices as a result of those movements. If they think that there is a demand for Marks and Spencer shares they will raise the price at which they will be willing to sell those shares. If they think that there is a likelihood of a downturn in demand for these shares then they are likely to reduce their selling price to get rid of shares they are holding before the price falls too far.
Image source: Proquote
If the demand for Marks and Spencer shares was going to rise in their view, they might increase their selling price to acquire the shares in the hope that they will be able to sell them on at higher prices and vice versa.
They will also be reacting to what other market makers are doing as well - if other market makers are selling at lower prices than you, it is likely that stockbrokers are going to go to them rather than you so you might have to reduce your price as well - but by how much will you need to change the price to remain competitive?
This screen based trading has replaced the original face-to-face contact that used to be the basis of the exchange before 1986. From that time, the movement towards computer based trading - known as 'Big Bang' - made the old trading floor redundant.
Image: The old trading floor of the London Stock Exchange. The boards on the stands were where the market makers would write up the prices of the shares. Title: FT Index. Copyright: Getty Images, available from Education Image Gallery
Post By Premire Group
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