Why do we trade?
What people own and what they need at any given moment in time are generally not the same. Bartering your way into the desired outcome is hard and more often than not impossible because it most probably involves a chain of matching interests which may not exist when you need it. To solve this issue, humanity uses two concepts: money (more on this in another article) and markets.
Money allows two people to trade with only one of them having what the other needs, the money filling the gap by being a “medium of value”.
Markets facilitate the discovery of other parties who may want to trade with you.
The main markets
As long as there is at least one buyer and one seller a market exists. Essentially there is a market for everything and anything, from goods to services.
It is commonly accepted that there are four major financial markets divided by the asset classes they support: commodities, foreign exchange, equity and debt.
Commodities are tangible goods such as agricultural products, metals or oil, and probably is the oldest market. Ancient civilisations where farmers could sell grain or cattle used them millennia ago.
This market also introduced insurance contracts to guarantee future income for farmers for example. The insurance contracts are called options and futures and are essentially equivalent to pre-selling and/or -buying the goods (more on options, futures and derivatives in later articles). Today airline companies protect themselves against oil price surges and chip manufacturers against raw metals price volatility using options and futures.
Foreign Exchange (or ForEx) is the largest market by volume, with daily trades in excess of $5trillion. This means that the dollar value of all currencies traded each day is the equivalent of the GDP of Japan.
This market appeared for a simple reason: business is global. If you run a British company with clients in the US and production in mainland Europe, your revenues are in USD while your expenses are in EUR and your shareholders interests are in GBP. You need stable, predictable exchange rates for business planning and at the same time you want as much USD to GBP and as little GBP to EUR as possible to maximize profit. Again buying insurances (options or futures on currencies) is your friend here.
There is a special case for gold and related precious metals. They are considered both as a commodity and a currency by professional market participants. There are both historical and practical reasons for this (see future article on money).
Equities is the first market that comes to the public’s mind when someone says “finance”. This is where companies fund their operations by issuing stock (little pieces of ownership or shares of ownership).
This market is popular because most people have savings (pension or otherwise) invested there. It is also the market most closely related to the performance of the real economy.
Debt is what allows people to spend money they don’t have in order to reach a larger goal. Governments borrow large amounts of money to work on infrastructure projects, companies finance their operations while keeping control of their assets and individuals finance the purchase of a house or a car, all on the primary markets.
The debt secondary market is where lenders offload their holding and where people can buy and sell bonds, most of the time government and corporate bonds.
In some cases lenders repackage the debt into complex products whose prices should reflect associated risks. However risk modeling can be very difficult especially when involving private individual debt (such as mortgage or credit cards) and incorrect or wrong models can have catastrophic outcomes as the 2008 subprime mortgage crash showed.
The market participants
Most markets are regulated and direct access to them is usually reserved for professional and/or institutional players. Individual traders use one or more financial firms to trade.
There are roughly three categories of participants.
The first category of participants are issuers. For example oil producers (commodities), central banks (forex), companies doing IPOs (equity) and government treasury bonds (debt). They are the fuel of the markets and without them no market would exist.
The second category are financial institutions whose job is to facilitate market access to non professional participants, basically investment banks and brokers.
In popular culture, the infamous rogue trader is generally associated with this category. It must be noted that this sector is one of the most heavily regulated and actual rogue traders are extremely rare even though the consequences of their misbehavior are both spectacular (sometimes ending in Hollywood movies) and gruesome (oftentimes ending in company collapses).
The third category are end users, be they professionals, like corporations and trading firms, or individuals, saving for their retirement. This category can be roughly split into two subcategories.
The first one, let’s call them category A, is people using the market to achieve an economic goal, usually long term. For example, corporations raise debt to finance development and buy currency options to hedge against exchange rates moves. Individuals buy shares to try and maximize returns for their pensions. People in this subcategory are usually called investors.
The second set, let’s call them category B, are people focused on making a profit ex-nihilo by taking advantage of market inefficiencies such as temporary mispricing (because participants miscalculate their prices or were too late or too slow when posting their orders). This category does not have any specific economic goals aside from making a profit, short term or otherwise. They are usually called speculators.
It is ironic to note that the former participants technically are speculators because they have a view on where the market will land and buy or sell in advance to profit from their model or intuition. This is the actual definition of speculation: have a view (a prediction model) and enter a position (buy or sell) to profit from it either by making money or by nullifying an adverse move on an already held asset.
The latter category B really are market facilitators as they make sure there is always liquidity when a former category A player wants to trade. The profit they make by providing that liquidity is the price of the service they give to other participants of category A.
What about crypto-assets? The debate is still open. Some claim crypto assets are a kind of currency. Others posit they are more like commodities. And then there are those who make the case for a new asset class. We will explore this topic in the next article.
This article is the first in a series called “Financial Markets 101”, where the SheeldMarket team publishes accurate & straightforward explanations on financial markets for curious readers, regardless of background.
SheeldMarket designs, builds and operates privacy-preserving trading infrastructure, protecting market participants from conflicts of interests, and allowing firms to outsource their infrastructure while keeping control of their data. Our first product is a cryptocurrency Dark Pool.