The New York Stock Exchange
Functioning in some form since 1792, the New York Stock Exchange (NYSE) is the world’s largest stock exchange. The NYSE operates as an auction market, where a designated market maker (DMM) (sometimes referred to as the “specialist”) facilitates trading for a stock. Like an auctioneer, the DMM helps bring buyers and sellers together. The DMM also trades with the public out of its own inventory, especially when there aren’t enough buyers or sellers. The DMM always acts in a principal capacity, trading for its own account. It doesn’t act as an agent for public orders: the exchange’s system matches public buy and sell orders with each other automatically.
Before 2008, this role belonged to the NYSE specialist, who could act in either capacity: as an agent matching public orders, or as a principal trading from inventory. When the NYSE replaced specialists with DMMs in 2008, the agency role was eliminated.
Because the DMM doesn’t hold public orders as an agent, it doesn’t have the specialist’s old duty to let them trade first. The rule against putting the firm’s own trades ahead of its customers applies to firms that do hold customer orders, such as market makers. A firm holding a customer’s order may not trade the same stock for its own account at a price that would fill the customer’s order, unless it immediately fills the customer’s order at the same price or better. Putting the firm’s own trade first is a prohibited practice called trading ahead.
For example, suppose a market maker is holding a customer’s order to buy 100 shares at $50. Another investor places an order to sell 100 shares at the current market price (a market order), and the market maker buys those shares at $50. Instead of using them to fill its customer’s order, the market maker keeps the shares in its own inventory and leaves its customer’s order unfilled. This is trading ahead.
Customer orders must be given priority over the firm’s own principal trades. However, there are a few exceptions to keep in mind:
- A firm may trade at a better price than the customer’s order offers, because that price wouldn’t fill the customer’s order. For example, a market maker holding a customer’s order to sell at $50.50 could sell shares from its own inventory at $50.49 to a buyer.
- Trading ahead prohibitions do not apply to large institutional trades.
The NYSE trades only stocks that are “listed” on the exchange. To be listed, issuers must meet certain characteristics, such as market capitalization and a minimum number of shareholders. You don’t need to memorize the listing requirements, but you should know the practical takeaway: the NYSE generally lists larger companies with more actively traded stocks.
In addition to the NYSE, many other exchanges operate in a similar way. For example, the American Stock Exchange, referred to as NYSE-MKT, is also a large national exchange. There are also regional exchanges, such as the Philadelphia Stock Exchange. A stock may trade on the NYSE and on another exchange (often a regional exchange). These are called dual-listed stocks.
As we learned earlier in the common stock chapter, there are different segmentations to the market. Any trade that takes place on the NYSE is considered a first market trade, meaning a listed stock is traded directly on an exchange.
Here’s a video covering the DMM’s role in conjunction with bid and ask spreads: