Exchanges: Investing Essentials

Find out what you need to know about stock exchanges and why investors should care about them.

Aug 4, 2014 at 9:59AM

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New York Stock Exchange. Source: Wikipedia.

Wherever people seek riches, there's often as much money to be made helping people seek their fortunes as there is in looking for fortune yourself. During gold rushes, sellers of picks and shovels often made out quite handsomely no matter how much of the yellow metal turned up in the vicinity.

With millions of investors looking to the stock market and other financial markets to become wealthy, the exchanges on which stocks and other securities trade hands have become quite profitable in their own right. Among exchanges, those that trade stocks, such as the New York Stock Exchange, are the ones that the general public knows best. But exchanges span the entire breadth of the financial market, with different opportunities for exchanges serving different niche specialties. Let's take a closer look at exchanges and how they can actually make money for the shareholders who own their stock.

What are exchanges?

Exchanges are places where members can buy or sell certain types of securities, with the most common including stocks, bonds, commodities, options, futures, and foreign currency. Some exchanges specialize in just one specific area, while others pride themselves on having several different types of assets available for market participants to trade.

New York Stock Exchange.

From an investing standpoint, exchanges earn money primarily in a couple of ways. First, they sell the right to make transactions through the exchange, with some selling permanent "seats" on their exchanges while others use short-term licenses to earn recurring revenue. Historically, members were willing to pay millions for seats on the most popular exchanges. Exchanges also often collect listing fees from the companies that want their securities to be available on a given exchange. For instance, the NYSE charges as much as $500,000 annually for listing fees, with the exact fee based on total numbers of shares outstanding and available for trading.

What is the history of exchanges?

Securities exchanges have existed for centuries, with some looking at the early Western European colonial period as the first major use of share trading as investors bought into exploratory expeditions. Others argue that the Roman Empire had securities resembling modern-day stock to some extent, with various ways to trade those securities constituting exchanges of a sort.

Most modern stock exchanges have come into being over the past several hundred years, with the forerunner of the London Stock Exchange taking shape in the late 17th century. The New York Stock Exchange traces its origins to the signing of the Buttonwood Agreement, under which 24 New York City brokers agreed to trade five different securities at a location on Wall Street.

Not all exchanges have such a long history, though. The Nasdaq Stock Exchange began trading in 1971, with the National Association of Securities Dealers creating the first electronic stock market in the world. In the commodities market, the Chicago Board of Trade was started in 1848, while the New York Mercantile Exchange dates its origins to a dairy-products exchange started in 1872 that broadened its scope 10 years later.

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Nasdaq Stock Exchange.

How many exchanges are there?

Around the world, there are dozens of major stock exchanges, as well as numerous exchanges trading other financial assets as well. For just about any type of asset, you can find an exchange that either specializes in that asset or includes that asset among a broader list of services.

Recently, though, mergers in the exchange industry have led to consolidation and shrinking numbers of ever-larger exchanges. Internationally, several exchanges in different countries have joined forces to create larger entities with global scope, while other mergers have focused on broadening product lines and creating one-stop shops for every type of security. Even as exchanges consolidate, though, the advent of more sophisticated technology has led to new electronic exchanges becoming even more popular, posing competitive threats to existing companies in the industry.

Why invest in exchanges?

Cbot Public Domain

Trading Floor, Chicago Board of Trade.

The success of exchanges is connected to the success of the markets to which they are tied, but well-managed exchanges can make money regardless of whether the prevailing direction of their underlying market is up or down. What exchanges rely on more than anything is volume, as well-used, liquid exchanges have much more value to members than exchanges that have little activity.

The wave of M&A activity in the exchange industry has also raised interest in their shares. If the trend continues -- and there are plenty of reasons to believe that it will, given the disparate conditions for investors in different areas of the world right now -- then shares of the companies that run major exchanges could continue to see more of the gains that they've enjoyed in recent years. With so many opportunities for expansion, exchanges are worth a closer look from investors looking for the companies that will drive financial innovation for years to come.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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