Financial markets are where financial securities are bought and sold. They include the organized exchanges for stocks and futures, and the over-the-counter (OTC) market for bonds, foreign exchange, and derivatives.
Financial markets consist of primary markets where some securities are initially issued and secondary markets where holders of securities can sell at will. Secondary markets provide the liquidity that many investors demand; otherwise, there would be less demand for financial securities. Liquidity is the ease in which an asset can be converted into a means of payment. Without liquidity, few people would be willing to invest in securities, which would lower the efficiency of the markets and the economy.
Liquidity depends not only on the bid/ask spread, the difference between what a security can be sold for and what it costs, but also the transaction costs of a trade. Securities with high liquidity have lower transaction costs, while illiquid assets are both hard to sell and hard to price. Real estate is a good example of an illiquid asset. To sell a house, for instance, takes time and costs money. It takes a real estate appraiser to determine the price of a house, and even then, it is only an estimate. It can cost 6% of the selling price to pay real estate agents to sell the house, and there are additional costs for closing. On the other hand, stocks can be sold quickly and cheaply, and, thus, can quickly be converted to cash.
Financial securities were standardized to increase liquidity and trading. Organized exchanges were instrumental in standardizing contracts for options and futures to increase their business.
Organized financial markets also provide a trusted means of clearing and settlement, which facilitates trade and promotes liquidity. In many financial markets, a clearinghouse takes the opposite side of every trade, so that traders do not have to worry about the counterparty's credit.
Many financial markets started in coffeehouses or taverns in the 17th and 18th centuries, then evolved into businesses, such as banks and organized exchanges. For many standardized financial instruments, the financial market is an electronic exchange.
Financial markets determine prices, and prices determine allocation of economic resources and generally reflect all information about a security, which is the basis of the efficient market hypothesis. For example, if a company has good growth prospects, its stock price will be priced higher than a similar company with the same book value and earnings, but with little potential for growth. If a company has good financial strength to pay interest and principal on its bonds, then its bonds will be priced higher and the company will pay a lower interest rate than the bonds of another company that is financially weak.
The markets also allow the efficient transfer of financial risk from those who want to lower it to those who hope to profit from it. So a stockholder who wants to offset any financial loss caused by a drop in the stock price can buy a put option that increases in value as the stock declines in price; the put writer takes the risk that the stock will not decline so that he can keep the option premium he earned by writing the put.
Since the markets offer investors a wide variety of many different types of securities that have different risk profiles and whose risk varies differently from other securities, investors can lower their overall risk by maintaining a portfolio of securities, each of which have little, no, or negative correlation with the other assets in the portfolio. In this way, a portfolio can be constructed that has less risk than any individual security in the portfolio.
Financial Market Categories
Markets can be categorized by the type of the securities that are sold or by the structure of the market itself.
One primary distinction that is often made is the difference between the primary and secondary market. This difference exists only because newly issued stocks and bonds are usually sold differently from the stocks and bonds held by investors.
The primary market is where newly issued shares of stocks or bonds are sold for the 1st time. Usually, these securities are sold by investment banks who handle the offering directly to their customers or to the customers of their selling groups. If the offering is a hot item, then the investment banks may restrict the sale to their best customers. Generally, the investment banks determine the initial price of the stocks or bonds.
The secondary market is where the securities held by investors are sold, usually through organized exchanges or in the over-the-counter market. The market determines the prices of the securities in the secondary market by equalizing supply with demand. Hence, many hot securities sold in the primary market are flipped for an instant profit in the secondary market.
Note that there are some securities for which there is no distinction between the primary and secondary market, because there is no difference in how they are sold. Options and futures, for instance, are created when a trader decides to go short in those securities and she would do so in the secondary market, because offering these securities for sale only requires that a trader agree to offer the option or future contract for sale. No investment bank is involved.
Hence, another way to categorize markets is whether it is a debt and equity market or a derivative market.
A debt and equity market is where the issue is sold for an immediate cash payment based on the strength of the issuer. A derivative market is a market where the traded contracts stipulate payments in the future and are based on an underlying asset or a benchmark, such as a stock index, interest rates, or some other financial benchmark or event. The counterparty to a contract doesn't matter because the clearinghouse usually takes the opposite side of any trade.
The primary and secondary market distinction exists only in debt and equity markets because there is no difference in selling a newly issued derivative from one that was held from a prior purchase.
Financial Market Structure
There are 3 basic market structures today: the over-the-counter market, centralized exchanges, and electronic communications networks. These markets also have convenient means of clearing and settlement. Clearing is the exchange of documents, such as stock or bond certificates, and settlement is the exchange of funds for the trade.
The over-the-counter (OTC) market is the largest market both in the number of transactions and in the number of securities sold. Virtually all securities and other assets can be sold in the OTC market. Some assets, such as currencies, can only be traded in the OTC markets. Most of the securities actually sold in the OTC market are usually illiquid and thinly traded. Most of the traders in this market are large institutional traders, such as banks, funds, and pension funds and securities dealers, and many wealthy individuals also trade in this market. Retail investors use this market when they buy penny stocks through the OTC Bulletin Board or through Pink Sheets.
The OTC market is now an electronic network of dealers that display bid/ask prices for the securities or other assets that they make a market in. Generally, no commissions are charged, since the dealers make their money from the bid/ask spread, which is the difference between what they are willing to pay and what they are willing to sell for, so the bid price is always lower than the ask price.
What the OTC lacks is a centralized pricing platform that shows the best bid and offer prices. Instead, a trader using the OTC must search for the best prices.
Organized exchanges aggregate all bid and ask prices for listed securities and display the highest bid and the lowest ask price. Listed securities are securities that have been accepted by the exchange for trading, and are based on the average number of trades, the market capitalization of the issuer, and the solvency of the issuer in addition to other criteria that is established by the exchange.
However, an exchange can list the securities of any other exchange, if it so chooses. To increase pricing competition, the Securities and Exchange Act of 1934 contains a provision referred to as unlisted trading privileges (UTP) that allows any exchange to list any securities listed on any other exchange.
Generally, only members of an exchange can trade on the exchange and each member maintains an account for clearing and settlement. Most members are brokers or dealers. If a broker who is not a member wants to trade on that exchange, then he must use the services of a member of the exchange.
Most organized exchanges have a trading floor, where members of the exchange or their representatives communicate buy and sell orders for their customers to members who make a market in that security. For instance, each security listed by the New York Stock Exchange (NYSE) is handled by a specialist whose job it is to maintain an orderly market for that security. NASDAQ is a stock exchange that has no trading floor, but is an electronic network of dealers that act as market makers for the securities listed in the NASDAQ. When a broker wants to buy or sell a listed stock, she communicates that information over the network to 1 or more market makers for that stock, selecting the best price—if the broker is ethical—for the customer.
Electronic communication networks (ECNs) are entirely electronic networks where buyers and sellers can directly interact with each other. (They probably should be called electronic trading networks, since that is a more accurate description.) Although the NASDAQ is an electronic network, it doesn't allow traders to deal with each other. Instead, they must use the services of a broker and a dealer, which increases the cost of trades, which is why transaction costs on ECNs are much lower.
ECNs are the future of trading. By allowing buyers to buy directly from sellers, trading costs are minimized, and an ECN itself has lower costs because it employs fewer people. Furthermore, ECNs allow traders to see some of the limit orders listed in their book instead of just the best bid/ask prices and the volume at each limit price.
There had been great resistance by the organized exchanges against ECNs because it threatened the livelihood of the exchange members. Even though the trading floor or even using a network of dealers is not as efficient as ECNs, it has persisted because of the political and financial influence of the major exchanges. However, the organized exchanges are finally succumbing to competition, especially from ECNs in Europe and elsewhere and are starting to embrace ECNs. The NYSE has recently merged with Archipelago (ArcaEx), becoming the NYSE Group, then merged with Euronext, becoming NYSE Euronext while NASDAQ has bought Instinet. ArcaEx, Euronext, and Instinet were 3 of the largest ECNs. The NYSE has become a publicly traded company instead of a company owned only by members, partly to allow mergers so that they can expand their business.
Due to the improvements in technology, financial markets will continue to change, providing faster service and lower costs to traders the world over.