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 all trading for a stock. Similar to how any other auction works, the DMM (auctioneer) matches buyers with sellers but also trades with the public out of their inventory. In any given trade, they can operate in an agency or principal transaction.
Given the specialist can function in either an agency or principal capacity, securities regulators are concerned about the possibility of public orders losing priority to the DMM. For example, let’s assume an investor places a trade to purchase 100 shares at $50, and the order is routed to the DMM. Simultaneously, the DMM receives an order to sell 100 shares at the current market price (known as a market order) from another investor. Instead of crossing the two orders on an agency basis, the specialist steps in front of the selling investor and instead sells their own shares out of their inventory. This is a prohibited action known as trading ahead.
Orders from the public are required to be given priority over principal trades placed by the DMM. However, there are a few exceptions to be mindful of. If the DMM can execute a trade at a better price than an order from an investor, they may step ahead of them. For example, the DMM could sell shares out of their inventory at $50.49 to an investor while stepping ahead of another investor requesting to sell shares at $50.50. Additionally, trading ahead prohibitions do not apply to large institutional trades.
The NYSE only trades stocks that are “listed” on the exchange. To be listed, issuers must meet certain characteristics, like market capitalization and minimum numbers of shareholders. You don’t need to know these listing requirements, but you should be aware that only the largest companies with the most actively traded stocks are traded on the NYSE.
In addition to the NYSE, there are many other exchanges that function similarly. There’s the American Stock Exchange, referred to as NYSE-MKT, which is also a large national exchange. Additionally, there are regional exchanges that are similar to the NYSE, like the Philadelphia Stock Exchange. It’s possible that a stock may trade on the NYSE and another exchange, typically a regional one. These are referred to as 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, which occurs when 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:
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