Exchange definition

What is an exchange?

An exchange is an open, organised marketplace for commodities, stocks, securities, derivatives and other financial instruments. The terms exchange and market are often used interchangeably, as they both describe an environment in which listed products can be traded.

A key function of an exchange is to provide fair, efficient and orderly trading opportunities by centralising the buying and selling of a particular type of asset. Instead of dealing directly with exchanges, most traders will use a broker.

Examples of exchanges

Exchanges are located in most countries around the world. They can be a physical location, where traders meet to conduct business, or an electronic platform.

Physical

Traditionally, an exchange was a physical location used for trading securities, which operated via an open outcry or a dual auction system. While less common, there are some exchanges that still offer pit trading – including the New York Stock Exchange (NYSE) and the Chicago Board Options Exchange (CBOE).

Electronic

In line with the rapid digital transformation of today’s economy, the definition of an exchange has significantly evolved too. As traditional exchanges began to handle an increasing amount of trading flow, most trades started to be placed electronically, off the trading floor. An example of a purely digital exchange is the NASDAQ stock exchange.

Pros and cons of exchanges

Pros of exchanges

Exchanges are regulated bodies which means transparency of both pricing and transactions. According to these regulations, every trade on an exchange is guaranteed and settled, usually through a clearing house. Exchanges also have a responsibility to ensure best execution – which means that all participants get equal treatment and all trades are executed at the best available market price.

Cons of exchanges

As transactions are often spread across multiple exchanges, there has been an increase in algorithmic trading and high frequency trading (HFT) models. There has been speculation that these models can provide false liquidity and front-running – which is the practice of illegally executing a personal order ahead of a sizeable client order. In instances when the algorithms trade outside of their expected patterns, these models have also been linked with market crashes.