What is a market?
A common market definition is: a market is a trading place where people buy and sell goods and services, and where prices are agreed and communicated. Financial markets are where people trade different kinds of financial assets.
Where have you heard about markets?
You may follow the financial market news, or you may have heard people talk about what’s going on in ‘the markets’. It’s a catch-all term used to talk about moving prices. Prices in markets fluctuate according to supply and demand.
What you need to know about markets...
Markets are where prices are set, where you can make transactions, and distribute goods and services.
Markets can have a physical location, such as the London Stock Exchange, but there are also virtual spaces where people trade online.
The financial markets include stock markets, bond markets, commodities markets, money markets, and derivatives markets.
Each country, or financial centre, has its own markets. The biggest stock markets are in New York, London and Tokyo.
Markets in context
Financial markets operate on the same principle as other markets by bringing together a critical mass of buyers and sellers who wish to trade goods and services. This eliminates the need for bilateral deals where the counterparties would have to spend a lot of time and effort trying to find their opposite match.
Not only does it save time and effort. Markets are more efficient through their scale, can be regulated to offer greater protection, encourage competition and promote price transparency.
In financial markets, academics at the Open University defined a fair return on investment as “one that offers the investor just the right level of compensation for the expected risk of the investment (in addition to the time preference rate and an adjustment for expected inflation)”.
A whole subject has grown up around whether financial markets offer “fair” prices and has led to the efficient markets hypothesis (EMH). Researchers many years ago examined closely how share prices moved to see if they could predict future trends. Several studies concluded that there was no discernable correlation, which was coined the random walk theory as it likened share price movements to the walk of a drunk person.
Some argued that this was proof that the markets were efficient and immediately priced in all relevant information, which became a central tenet of the EMH. The belief was that stock markets were largely efficient, especially in the US and the UK.
Later research explained the theory in terms of how effectively new market information was being reflected in the share price. If there was a delay in the news reaching everyone, the price would not shift immediately but would instead trend in that direction as participants caught up. If this was true, it meant that clued up investors could make excess returns rather than just fair returns.
Billionaire investor Warren Buffett seems to agree with the second theory. He famously said: “I'd be a bum on the streets with a tin cup if the markets were efficient.” Meaning he found a way of making excess returns over time.
Investors can sometimes gain extra knowledge and information by looking at financial markets in the right context, which can be a big help when making trading decisions. This is no easy task given the hundreds of variables at play and even professional investment managers struggle to outperform the market over an extended period. Investors might consider macroeconomic and political influences, the performance of share prices over time, market bias, the balance-sheet fundamentals of a company and so on.
Markets in the context of the wider economy
A booming economy will often have a beneficial effect on financial markets overall. In the case of stock markets, if companies perform well, they will have strong fundamentals and are likely to deliver higher earnings and potentially more dividends. More companies are likely to come to market to borrow by issuing shares through Initial Public Offerings (IPOs), growing the investment base.
A strong stock market does not necessarily mean the economy is thriving however. Many other factors such as alternative investment options and market bias can boost shares.
Conversely, financial markets play an important role in supporting the economy. They help channel savings and investment into businesses to create capital that leads to the production of goods and services.
Market size in context
The benefits of scale in financial markets become evident when you compare their operation to those in developing countries where they are more limited. There are likely to be fewer institutions and products in developing countries and legal systems may be less well defined, increasing the cost of capital for borrowers and presenting higher risk and potentially lower return to investors.
For institutional investors, it will be harder to build a diversified portfolio given a smaller range of financial assets or products to select. Trading levels are likely to be lower, reducing liquidity in the market, and it will be harder to find investments that match the investor’s risk appetite, required return and desired maturity.
Market linkages in context
If the great recession taught us anything, it is that markets are linked, both geographically and between investment types.
Stock exchanges for example are not discrete. They are interlinked by participants such as institutional investors and the companies listed. Say a hedge fund loses a lot of money when a given country’s major stock index falls in price. An investment bank lent the hedge fund the money in the first place and calls in the debt. The hedge fund therefore ends up selling shares in other countries to raise the funds to repay the debt, thereby affecting prices in other markets.
The securities market is a very large subset of the financial markets and includes equities, bonds and derivatives. It can be further split into two: primary markets are where new securities are issued, and secondary markets are where existing securities are traded.
Companies and government entities can come to the primary market to raise funds by issuing shares/ stock or bonds, for example. A syndicate of securities dealers will usually organise the sale. If a company is issuing new stock, it is called an initial public offering or IPO and the process to sell these shares is termed underwriting.
The secondary market in turn can be split into two: organised exchanges like the LSE and over-the-counter, where parties trade directly.
The secondary market is good for investors because they know they can sell on their security when they want. They are therefore more likely to buy shares, which is good for the companies issuing them.
The below graphics from the LSE show the differences between key securities markets and the products accepted across them.
Market participants on stock markets can be split into those involved in the trading and those who provide infrastructure to make it happen. Retail investors, investment managers, brokers and market makers fall into the first camp. Examples of the latter are clearing houses and securities depositories. Below we explain some of the key participants.
Investment managers: A type of institutional investor but a couple of points of interest here. They manage a wide array of assets on behalf of investors according to their goals. Assets can be anything from shares and bonds to property. Their clients can be anything from companies and pension funds to private investors. Many private investors join through collective investment schemes such as mutual funds and exchange traded funds.
Note that an asset management usually refers to collective investment schemes. Fund management is a more generic term for all institutional investors. Investment managers undertake the whole investment workflow from financial analysis, product selection to monitoring the portfolio.
Broker: This is an intermediary between the buyer and the seller of the security. They serve investors wishing to trade in shares and other products through agent stockbrokers. A full service firm not only carries out the trade, but will also research markets and recommend investments. Traditional firms have also grown a service of providing live stock prices.
Broker-dealer: This is a broker as defined above that also trades on its own account for profit.
Discount broker: Offers investors the ability to trade at greatly reduced commissions by providing an online service where they can make automated trades. The online broker may also aggregate investor orders to place block trades in order to reduce transaction costs.
Who are market makers?
Market makers are also known as liquidity providers. They quote both a buy price and a sell price for a security that is held in inventory. They aim to gain from the bid-offer spread, also known as the “turn”.
“Third market makers ” are firms ready at any time during the trading day to buy and sell stocks, say on the London Stock Exchange. Most exchanges work on an “order driven” or “matched bargain" basis however. When the buyer’s bid price matches the seller’s offer price, a deal is triggered on the exchange and there might not be an official market maker.
The LSE nevertheless has official market makers for many securities. Some firms always make a two-way price in the shares in which they are making markets. Their prices are shown on the Stock Exchange Automated Quotation (SEAQ) system. These firms usually deal with the brokers discussed above. Advocates of official market making argue that it adds depth and liquidity to the market because they take a long or short position for a while and assume some of the risk. On the LSE, every stock always has at least two market makers and they must deal.
Unofficial market makers can operate freely and are not obliged to make a two-way price, but then brokers are not obliged to deal with them either. Well-known UK market making names include Peel Hunt LLP, Liberum Capital, Shore Capital, Fairfax IS and Altium Securities.
Find out more about markets…
The Economist Guide to Financial Markets provides a good overview of the different types of financial markets. The introduction discusses why markets matter, who the main players are and the agents of market changes and is available here.
Goldman Sachs provides an excellent interactive guide to capital markets here.