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What is the NASDAQ? Here are the basics

At a glance:

  • The NASDAQ trading system

  • Trading on the NASDAQ

  • The NASDAQ and the exchanges

  • Summary of The NASDAQ

It might seem strange, given all the advances in information technology, that the majority of stocks and bonds are still traded by people shouting out prices in a trading pit on an exchange floor.

Although you have likely seen NASDAQ price listings alongside those from major exchanges like the New York Stock Exchange, the NASDAQ is not an exchange, but the world's first and biggest computerized network for securities trading.

As an educated investor, you need to know what the NASDAQ is and how it works.

The NASDAQ trading system

NASDAQ is an acronym for the National Association of Securities Dealers Automated Quotations system.

What is it?

Founded in 1971 by the National Association of Securities Dealers, the member association that regulates over-the-counter securities trading and is now called the Financial Industry Regulatory Authority (FINRA), the NASDAQ was the first computerized stock market, and is still the largest.

The NASDAQ is primarily a phenomenon of the over-the-counter (OTC) securities market, that segment of the secondary market for securities where trades are negotiated directly between buyers and sellers, as opposed to being sold by outcry auction as they are at an exchange.

Because the NASDAQ is such an important feature of the OTC market, people often use the terms OTC and NASDAQ interchangeably. It is important to note that not all OTC securities are listed on the NASDAQ.

As well, some companies listed on the New York Stock Exchange are also traded on the NASDAQ, a phenomenon known as third market trading.

Before the NASDAQ

Prior to the NASDAQ, OTC securities dealers routed information on trades by paper. There was no real way to know the current market price of the security you were buying—unlike on the floor of an exchange, where outcry bidding kept traders informed on market fluctuations instantly. Fragmentation and inconsistent pricing in the OTC market was often the result.

The value of the NASDAQ to investors

The computer network of the NASDAQ provides instant information to FINRA members—and through them, to the rest of the world—about securities and prices in the OTC market and other negotiated trades. More than a half million computer terminals worldwide are connected to the NASDAQ network. In this way, NASDAQ quotations provide some of the same immediate market feedback that traders on an exchange floor get from outcry auctioning.

NASDAQ quotations and indexes are reported in newspapers, on television, on the Internet, and in the financial press, right alongside prices on the major exchanges.

Trading on the NASDAQ

Securities trading in the NASDAQ system is based on the activities of firms called market makers. These are NASD member firms that act as dealers; that is, they own inventories of securities that they can sell to the public or which they are willing to buy.

What do market makers do?

There are over 500 market makers in the NASDAQ system. Their quotations on the more than 3,200 securities issues make the NASDAQ work. The market maker system is supposed to provide more competitive pricing than exchange auctioning—but market makers decide for themselves whether actually to buy or sell a security at any given time, and what the actual trading price will be.

A NASDAQ market maker quotation lists two prices for any given security. The bid price is the highest price the firm is willing to pay at that moment for a unit of a particular security. The asked price is the lowest price for which the firm is willing to sell the security.

How dealers work

It is important to note that dealers often do not pay the bid price, or get the asked price. Bid and asked prices do not tell at what price a dealer is currently buying or selling a security. Instead, the two define a price range known as the spread, in which the actual buying or selling price is negotiated between buyers and sellers.

In addition to the dealers who buy and sell for their own accounts, NASDAQ trades are also handled by brokers, who arrange transactions between dealers and the public.

How brokers work

Brokers receive a commission for their service, while dealers charge a markup (when they are selling) or a markdown (when they are buying) to cover the cost of the transaction. While brokers are not necessarily dealers, there are broker-dealers who serve both functions.

The competition among market makers to provide attractive prices for securities is designed to serve some of the same functions that specialists serve on an exchange floor: regularizing prices and ensuring liquidity of securities.

The NASDAQ and the exchanges

Introduced in 1971, the NASDAQ is a computer network that lists the prices of securities in the over-the-counter (OTC) market. In some ways, the NASDAQ has made OTC trading much like trading on an exchange.

What listing requirements must be met?

To be listed on the NASDAQ, companies must meet certain minimum requirements for asset value and financial practices, although these are not as stringent as the listing requirements for the major exchanges.

The Financial Industry Regulatory Authority provides standards and rules for its members, and the NASDAQ contains electronic surveillance functions that help reveal abusive trading practices.

These regulatory activities serve much the same function for the OTC market that the governing boards of exchanges do—providing for fair and orderly trading and enhancing investor confidence.

Up-to-the-minute information

As well, the immediate information access provided by the NASDAQ plays some of the same market information feedback role that outcry auctioning does on an exchange floor.

But there are some big contrasts

All that said, there are still some significant differences between NASDAQ and exchange trading. Instead of a few specialist dealers who use their accounts to control trading in a particular security at an exchange, the system of many market makers issuing quotations is supposed to make the NASDAQ more competitive.

But while quotations are very public, the actual transaction is still negotiated in private between the dealer and the buyer or seller. Some research has shown, and many investors believe, that auction bidding still provides more immediate market impact on changes in securities prices, resulting in prices that more consistently reflect actual market conditions.

FILE- In this Sept. 4, 2018, file photo a Nasdaq employee monitors market activity in New York. When this bull market was born 10 years ago, just one of the most valuable companies in the market was a technology stock. Now, it's four out of five. (AP Photo/Mark Lennihan, File)
In this Sept. 4, 2018, file photo a Nasdaq employee monitors market activity in New York. (Photo: AP Photo/Mark Lennihan, File)

While the Financial Industry Regulatory Authority (FINRA) does provide some of the same regulatory functions as an exchange board, NASDAQ listing and trading are not as tightly controlled as they are at a major exchange.

In 1996, the Securities and Exchange Commission sued NASDAQ over trading practices it claimed allowed market makers to take advantage of small investors. NASDAQ settled the suit and issued new regulations in 1997 designed to make actual trading prices more accessible to the public.

While the regulation and information flow of the NASDAQ have made over-the-counter trading more like exchange trading, many investors believe the tighter regulation and immediate market feedback of exchange trading still best serve investor interests.

Summary of The NASDAQ

As the largest computerized securities trading network in the world, the NASDAQ uses technology to replace the market feedback information provided by outcry auctioning at an exchange.

The NASDAQ's computer network provides the quotations of market makers on thousands of securities issues.

While the regulation and information flow of the NASDAQ have made over-the-counter trading more like exchange trading, many investors believe the tighter regulation and immediate market feedback of exchange trading still better serve investor interests.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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