The Stock Markets:

When a company "goes public" its shares are listed on a stock market so that the "public" can buy and sell part ownership (shares) in the company. In the United States, these markets started out as a group of 24 guys meeting under a buttonwood tree on Wall Street in New York to trade stocks. This got bigger and more organized and eventually became the New York Stock Exchange. The NY Exchange became so formal that everyone wore top hats and coats with tails at one point. Some "good old boys" rebelled and started trading stocks outside on the curb- the New York Curb Exchange. This eventually came indoors and became the American Stock Exchange. Lets look at how these classical stock exchanges handle the buying and selling or "exchange" (essentially an auction) of the stocks of hundreds of companies at one time.

All of you have seen on television the floor of the New York Stock Exchange with people running all over the place with scraps of paper in their hands and yelling at the top of their lungs. What is happening? Is there any order amid seeming chaos?

Companies that buy and sell stocks (Merrill Lynch for example) purchase "seats" on the exchange but they seldom actually sit down once the market opens at 9:30 AM Eastern time. The "seat" allows them to have a location around the periphery of the floor where orders to buy or sell come in from their brokers around the country. Perhaps someone in Riner, Virginia wants to buy Genentech stock and calls their Merrill Lynch "Financial Consultant" (fancy name for a stock broker) and places their order. This order is sent electronically to Merrill Lynch's floor broker who is on the floor at the New York Stock Exchange.

One of the floor brokers hand carries the order to a location at one of a cluster of islands in the large floor where this stocks bid and ask prices are shown on an electronic display. There is only one place on the floor where Genentech stock can be traded. He waves his hand and yells what his client is willing to pay for so many shares of Genentech. If a floor broker from another company is there with an order from his client to sell at that price, then the deal is struck then and there. The secretary behind the desk is informed and the electronic board immediately shows the sale, how many shares and the price.

Obviously a floor broker might have to wait around the place for some time to find just the right deal. That wastes time and money. Where there is money to be made someone always steps in. In this case, many years ago, some floor brokers began to "specialize" in one stock and they offered to stay rooted in that one spot trying to do a deal while the other brokers went on to other orders. Obviously they charged something for this service and they became known as Specialists. These fellow soon figured out that they were in a good position to make more money by buying some of this stock themselves. They charged just a little more for the stock or bought it a little lower, but they provided the convenience of sending the floor broker on his way with an immediate deal. The specialist buys shares and sells shares within a very narrow price spread of usually 1/8th to 1/16th of a dollar per share. This is his cut of the deal. There are several "Specialists" for most stocks so the floor broker can negotiate quickly for the best deal. The Specialist takes some risk in buying some shares before he has orders for them. If he doesn't have enough shares the order may go to another Specialist who was willing to buy more shares and take more risk. This provides a buffer and prevents large price swings (theoretically). The Specialists are now controlled by the exchange and have to buy and sell according to certain rules (theoretically) to reduce large price fluctuations.

When the floor broker with the order from the fellow in Riner got to the area in front of the Genentech display, there was no other floor broker present with an offer to sell that number of shares at that price. But since the offer to buy was very near the price of the last trade, one of the Specialists did the deal from his stock. The floor broker then runs back to Merrill Lynch's place on the periphery of the floor and electronically sends a confirmation to the fellows "Financial Consultant" that the deal has been done.

Computers were an obvious challenge to this system. Orders could be sent directly to a Specialist. For that matter why even have a big floor with people running all around with paper orders? This is the idea behind the NASDAQ (National Association of Securities Dealers Automated Quotations). This is a computerized system similar to the classical New York "Big Board" Exchange but without people meeting face to face. Orders from stock brokers still go to specialists but here they are called "Market Makers" and this is the "over the counter" market (OTC). There are usually several Market Makers for each listed stock. Just like the floor Specialists, they buy and sell stock so that they can take advantage of the spread between buy and sell orders. They take an 1/8 to a 1/16th of a dollar for each share they handle. Market Makers can be anywhere in the country behind a computer terminal. Brokers have a choice of which Market Maker they choose to see their order first - so they can get a kick back from the Market Maker for giving him orders. The NASDAQ is trying to change this system by requiring that buy and sell orders be instantly shown online to all the Market Makers - but reform is slow. If you place an order to buy at the current "best" price this is called a "market order". These Market Orders are processed almost instantaneously by computer. Much more common are "Limit" orders. I may want to buy Genentech but I don't want to pay more than $136 1/8 for the stock. The last trade was for $137. I placed a "limit" on what I was willing to pay for the stock. No one may be willing to sell to me at that price so the order will just sit there until someone does come down in their selling price or I take my order off the table. Orders are placed as either Good 'til Canceled (GTC) which means exactly what it says or as a "Day Order" that is automatically canceled at the end of that day of active trading.

Computers and information technology has progressed so fast that soon real auctions can be handled in real time directly between buyers and sellers. This is a threat to the stock markets. The first change brought about by the Internet was the rise of discount brokers who received and placed orders over the Internet. Since they did not need local stock brokers they are willing to place those trades for a lower commission. Local brokers are only needed if you really do need financial advice and you require actually face to face meetings to obtain your trust.

With an online broker (Ameritrade, Schwab, ETrade etc.) If you know that you want to purchase 200 shares of Genentech stock and you are willing to pay 136 1/8, you just fill in the form online for a limit trade with the online broker where you have deposited money.. The order still goes to a market maker but at least the broker commission is much reduced. (Usually by an order of magnitude!) But remember that you lost a little on the transaction since the Market Maker took his cut - in fact he probably paid a little to the online brokerage for the privilege of making that profit. This has allowed some online firms to charge you nothing to trade if you trade often enough. I pay no commissions when I buy or sell on line through American Express because I have a large brokerage account. The more money you have the less you pay - capitalism!

The obvious next move is to establish real time auctions between buyers and sellers (like an EBAY stock exchange!). These already exist and are now used to trade stocks "after hours", in other words, before and after the regular exchanges are open for business.

Increasingly buying and selling stocks is a 24 hr a day deal - not confined to the gentleman hours of 9:30 AM to 4:00 PM. These hours are a pain anyway for people in California and increasingly we buy stocks of companies that trade on the London Exchange or the Hong Kong Exchange while we are in bed. The financial world never sleeps. I believe that these on line auctions are likely to replace the current exchanges and further make the world one big financial auction.