NYSE testing systems for Twitter IPO; Here's how it works

A Twitter tweet announcing the company's planned initial public offering (IPO) is pictured on a mobile telephone back-dropped by various twitter logos.
Gerard Julien | AFP | Getty Images

The NYSE is testing its systems this weekend in preparation for the Twitter IPO.

It routinely does testing of the systems on the weekend, but it went out of its way to announce it would be doing a specific testing for the Twitter IPO. Why make the announcement? More than likely it was aimed at Twitter, to make them aware the NYSE was doing everything possible to ensure a smooth open.

Here's what will happen:

First, outside brokerage firms (who are participating on a voluntary basis) will be able to connect to the NYSE systems and run a simulated auction. NYSE will put TWTR in its stock file, test order flow and connectivity, publish imbalances, then open the stock and let messages flow through the system, etc. The exchange may open up the system to do multiple test symbols, meaning it will test other stocks as well.

NYSE to run Twitter test

Second, there will be some level of DMM (designated market maker) participation to ensure a real-time test.

The important thing about this is the NYSE IPO process is very different than the NASDAQ IPO process. At NASDAQ, the IPO process is entirely electronic, but at the NYSE there is a blend of electronic and old-fashioned open outcry that, in my opinion, reduces the chances for a glitch at the open, though like all systems something can still go wrong once trading begins.

Here's how the IPO process works at the NYSE:

Twitter is planning to float 70 million shares at $17-$20. The underwriter begins to build a book (orders to buy and sell) several days before the IPO. On the evening before the stock begins to trade, the underwriters will size up the demand for the stock and set a price for the stock.

Let's say, for simplicity sake, that they price at $20. The lead underwriters have thus agreed to buy (underwrite) 70 million shares and pay the selling shareholders $20.

On the day trading begins, representatives of the lead underwriter will meet with the DMM to go over demand for the stock. The DMM will also be getting indications of interest to buy or sell the stock from "the crowd," i.e. floor traders who have orders to buy or sell.

The rest of the time up until the stock is opened the DMM conducts an open auction...he'll indicate how much there is for sale at the open...say, 20 million shares...and at roughly what price range they might open the stock at. This is called an "indication," and it can be as wide or narrow as the DMM feels is necessary. Let's say the "indication" at 9:30 a.m. ET is there is 20 million shares pricing between $22-$24.

When all orders to buy or sell are in, the DMM will set a price to open. Everyone gets the same opening price.

The DMM will then yell to the crowd and to the underwriters the final price and size—let's say it's $20 million shares at $23--and declare that "the book is frozen," meaning no more orders can be placed.

The stock will then begin trading.

This process may seem cumbersome and old fashioned, and it is, but it works. I have witnessed well north of a thousand IPOs at the NYSE, and because the DMM controls when the stock begins trading it generally ensures a smooth open.

Why the testing then? What they are testing for most of all is what happens after the stock opens...they are going to stress the system with a lot of orders to make sure it can handle the anticipated load.

By CNBC's Bob Pisani