What are financial markets?
Financial markets encompass an variety of platforms where securities are traded, including stock, bond, foreign exchange and derivatives markets. These markets are fundamental to the effective functioning of capitalist economies.
How do financial markets work?
In the context of capitalist economies, financial markets have an essential function, as they facilitate the allocation of resources and generate liquidity for companies and entrepreneurs. They allow buyers and sellers to trade financial holdings and develop securities products that provide returns to investors and make capital available to those in need of additional resources.
For example, the stock market is one of several forms of financial markets. The creation of these markets occurs when individuals and entities trade financial instruments such as stocks, bonds, currencies and derivatives. The efficiency of these markets depends heavily on the transparency of information so that prices are established fairly and effectively.
Some financial markets may be small and less active, while others, like the New York Stock Exchange (NYSE), move trillions of dollars daily. In the primary stock market, new issues of shares are sold, while the secondary market is where existing securities are traded between investors.
Types of financial markets
Stock market
Stock markets are perhaps the most recognized, functioning as platforms for companies to list their shares, which are bought and sold by traders and investors. These markets are essential for companies looking to raise capital and for investors looking for returns.
Over-the-counter markets
Over-the-counter (OTC) markets are decentralized, with no physical locations, and transactions are done electronically. Although these markets may trade shares of smaller companies, most stock trading occurs on regulated exchanges. Derivatives markets, on the other hand, operate exclusively in this format, playing a crucial role in the financial system.
Bond markets
Bonds are debt instruments through which investors lend money to an entity in exchange for interest over a predetermined period. Issued by corporations, local governments, states or sovereign governments, they finance various projects and operations.
Money Markets
These markets trade short-term instruments, characterized by high liquidity and safety, but with relatively lower interest returns. They include high-volume trades between institutions and are also accessible to individual investors through mutual funds or certificates of deposit.
Derivatives markets
Derivatives are contracts whose value depends on an underlying financial asset. These markets trade futures, options, among other financial products, and are regulated by entities such as the Chicago Board Options Exchange (Cboe), which guarantees the standardization and security of transactions.
Forex Market
The foreign exchange market, or Forex, is where participants trade currencies, operating the highest volume of daily transactions of any market due to the liquidity of money as an asset.
Commodity markets
In these markets, producers and consumers trade physical goods, from agricultural products to precious metals and energy. Most trading occurs through derivatives that use these commodities as underlying assets.
Cryptocurrency Markets
Cryptocurrency markets operate globally on a variety of cryptocurrency exchanges, offering platforms for exchanging digital tokens for other cryptocurrencies or fiat currencies. These exchanges range from centralized platforms, which can be vulnerable to fraudulent activity, to decentralized ones, which allow peer-to-peer transactions without intermediaries.
Examples of Financial Markets
The previous sections highlighted the broad scope and scale of financial markets. To further illustrate, this segment explores the role of stock markets in launching initial public offerings (IPOs) and the impact of OTC derivatives on the 2008-09 financial crisis.
Stock markets and IPOs
As a company matures and expands, the need for additional capital arises, often in volumes that exceed what can be obtained through ongoing operations, bank loans or venture capital financing. An effective method for raising this capital is through an initial public offering (IPO), where the company sells shares to the public, transforming itself from a private entity to a publicly traded company.
The IPO also provides an opportunity for early investors to monetize a portion of their holdings, often making significant profits. The initial share price is generally established in the pre-market period by the underwriters. Once stocks are listed and begin trading on an exchange, the price fluctuates based on investors' assessment of their intrinsic value and supply and demand dynamics.
OTC Derivatives and the 2008 Financial Crisis: MBS and CDOs
The 2008-09 financial crisis was influenced by multiple factors, one of the most critical being the mortgage-backed securities (MBS) market. These OTC derivatives consist of pooling cash flows from multiple mortgages, which are then segmented and sold to investors. The crisis was precipitated by a series of events that culminated in the near ruin of the banking system, having its roots in the relaxed credit policies imposed by the Community Development Law of the 1970s.
The volume of subprime mortgages increased substantially in the early years of the 2000s, driven by drastic interest rate cuts by the Federal Reserve Board. This scenario, combined with loose credit and cheap capital, fueled a housing boom, resulting in speculation, rising property prices and the formation of a housing bubble. Investment banks, seeking easy profits after the dot-com bust and the 2001 recession, developed collateralized debt obligations (CDOs) from mortgages purchased on the secondary market.
The mixing of subprime and prime mortgages in CDOs obscured the risks involved, leading to a boom in the CDO market. When the housing bubble burst, prices fell and subprime borrowers began to default, accelerating the decline in housing prices. The discovery that MBS and CDOs were backed by toxic debt led investors to dump these securities, but without a market for the CDOs, which led to a series of bankruptcies of subprime lenders. This triggered a liquidity contagion that spread to the upper levels of the banking system, culminating in the failure of large banks such as Lehman Brothers and Bear Stearns, as well as the taxpayer-funded bailout of several large banks.
Conclusion
Financial markets are essential components of global economic infrastructure, providing mechanisms for the efficient allocation of resources and mobilization of capital. From the stock markets that facilitate initial public offerings to the complex derivatives markets that have played a significant role in financial crises, these markets profoundly influence economic stability and growth.
Understanding how financial markets work is crucial for investors, policymakers and the general public, as interactions within these markets can affect not only direct participants but also the global economy writ large. Lessons from the 2008-09 financial crisis highlight the importance of regulation and transparency, showing how a lack of oversight and understanding of financial products can lead to devastating consequences.
FAQ
What are the different types of financial markets?
There are several financial markets, each with specific functions, including stock, bond, foreign exchange, commodity and real estate markets. These markets can be categorized as capital markets, money markets, primary versus secondary markets, and listed versus unlisted markets.
How do financial markets work?
Financial markets operate by bringing together buyers and sellers of various assets or contracts, allowing them to trade with each other, usually through an auction or price discovery mechanism.
What are the main functions of financial markets?
Financial markets play a crucial role in the efficient allocation of capital and assets within a financial economy, facilitating a free market for the flow of capital and financial obligations, and allowing investors to realize capital gains over time.
