Understanding the stock exchange

As you flick over the share lists in your daily newspapers, many of you would strike blanks when it comes to having any understanding of the concept and role of the stock exchange. Even some people who are investors in shares may be unclear as to the stock exchange’s function.

So why do stock exchanges exist? What is their function and why do companies list their shares on the stock exchange?

Listing on the stock exchange is not without burdens for companies. There are stock exchange reporting requirements to be satisfied and the need to establish and manage costly share registers. There is also a greater level of scrutiny of activities and management (particularly by investment analysts and the media) than in the case of unlisted companies. The stock market can do funny things to share prices and there is, for many companies, a real prospect that they could be taken over. Yet companies still choose to be listed.

Stock exchanges have been around for at least seven centuries, since the Italian city of Florence converted some of its loans to securities that were tradeable. Some experts claim share market-style trading dates back to the ancient Greeks and beyond.

Their rise to prominence came with the industrial revolution, when new methods of production required investment in plant and machinery beyond the means of wealthy individuals or families. This led to the rise of "joint stock" companies, owned by numerous investors who had pooled capital for their establishment. Australian law has its roots in British law, but for a long period in Britain — until well into the 19th century — the law in relation to companies was quite unclear.

Over time, the roles of the stock exchange and corporations became progressively more recognized in law, to reach the level of centrality they have today. Globally, the company is a basic unit of industrial organization, and stock exchanges play a pivotal role in the supply and exchange of capital for companies.

Companies thus came into being as a means of assembling capital for the development of businesses on a much larger scale than could otherwise have been possible. Without corporate structures, many of the good ideas of inventors and innovators, from James Watt to Henry Ford to Bill Gates, may well have remained just good ideas, left on the shelf because the capital required for their application was not available.

The development of stock exchanges was inevitable as companies became the basic units of business organization.

In essence, a stock exchange is a marketplace serving two important functions.

The first is that it is effectively a meeting place where "entrepreneurs" (usually in the non-pejorative sense of the word) seeking to raise capital for specific commercial applications can link up with investors who are willing to supply some of their available funds by becoming part-owners — "shareholders" — of an entity that has been created to fulfill such objectives. In this fashion, the stock exchange plays a crucial role in the provision of the capital required for the formation of companies. This is the primary function of the stock exchange.

The float of BHP on the stock exchange in 1885 was a good example of the stock exchange fulfilling its primary function. Another example of the stock exchange’s primary function in action is when BHP seeks to expand its capital base (as it has from time to time) to support the funding of new ventures and makes a cash share issue to its shareholders.

Investors will be much more inclined to subscribe capital for a company when they know they can readily sell their investment if this becomes their desire — particularly if the price at which they can sell may reflect the success of the company in which they have invested, giving the opportunity for profit. The provision of a market on which shares can be exchanged between buyers and sellers is the secondary function of the stock exchange.

Casual observers could hardly be blamed if they overlook the stock exchange’s primary role, because the focus of day-to-day activity, and the bulk of the large volumes of money involved in stock exchange transactions, is directed to the trading of shares of companies already listed on the stock exchange.