What is the role of financial markets?

Any place or system that gives buyers and sellers the ability to exchange financial instruments, such as bonds, stocks, derivatives, and different international currencies, is considered a financial market. Financial markets make it simpler to raise money and invest by bringing together investors and those who need funding. Additionally, financial markets support smooth trading and enable risk transfer through derivatives. Capitalist economies cannot function properly without financial markets.

For example, let’s consider a bank where a person keeps a savings account. The bank has the right to charge interest on loans to other people and organisations using their funds as well as the funds of other depositors. The interest that is paid to the depositors also helps them make money and watch it grow. Thus, the bank functions as a financial marketplace that is helpful to both debtors and depositors.

How do financial markets work?

All financial markets work essentially by connecting buyers and sellers in some asset or contract and allow them to trade with one another, even though they cover a wide range of asset classes and have different structures and regulations.

Although financial markets serve a number of purposes, their primary purpose is to facilitate the effective distribution of assets and capital within a financial economy. The financial markets facilitate the free flow of capital, financial obligations, and money, which helps the world economy function more smoothly and enables investors to profit from capital gains over time.

What are the types of financial markets?

Markets come in a variety of forms. Each one concentrates on specific categories of financial instruments that are available for trading.

Stock markets

Stock markets are arguably the most common type of financial market. Companies list their shares on these platforms, and traders and investors buy and sell them. Businesses use stock markets, also known as equities markets, to raise money, and investors use them to look for returns.

Stocks can be traded on over-the-counter (OTC) markets, the New York Stock Exchange (NYSE), or the Nasdaq. Since it is another way for money to move through the economy, the majority of stock trading is carried out on regulated exchanges, which is significant financially as well.

Retail and institutional investors, traders, market makers (MMs), and experts who provide two-sided markets and preserve liquidity are typical stock market participants. Brokers are third parties who help buyers and sellers trade, but they don’t actually own any stock.

Over-The-Counter (OTC) markets

Participants in an over-the-counter (OTC) market trade securities directly, that is, without the use of a broker, in a decentralised market with no physical locations and electronic trading.

The majority of stock trading is carried out through exchanges, though OTC markets may manage trading in specific stocks such as smaller or riskier companies that don’t fit the exchanges’ listing requirements.

However, a significant portion of the financial markets are made up of derivatives markets that are over-the-counter (OTC). In general, over-the-counter (OTC) markets and the transactions that take place within them are more transparent, less liquid, and far less regulated.

Bond markets

A bond is a financial instrument that allows traders to lend money at a predetermined interest rate for a predetermined amount of time. A bond can be thought of as an agreement between the borrower and the lender that specifies the terms of the loan and the payments that must be made.

Companies, states, municipalities, and sovereign governments all issue bonds to fund operations and projects.

For instance, securities like notes and bills issued by the US Treasury are sold on the bond market. The debt, credit, or fixed-income markets are other names for the bond market.

Money markets

A high level of safety and a comparatively lower interest return than other markets are characteristics of money markets, which usually involve products with highly liquid short-term maturities (less than a year).

Large-scale transactions between traders and institutions take place in the money markets at the wholesale level. These include money market accounts opened by bank customers and money market mutual funds purchased by individual investors at the retail level.

Buying short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills are a few more ways that individuals can invest in the money markets.

Derivatives financial markets

A derivative is an agreement between two or more parties whose value is determined by a predetermined set of assets (such as an index) or an agreed-upon underlying financial asset (such as a security).

A derivatives market facilitates the trading of futures and options contracts as well as other advanced financial products that get their value from underlying assets like stocks, bonds, commodities, currencies, interest rates, and market indexes, as opposed to directly trading stocks.

Futures contracts are listed and traded on futures markets. Futures markets are well-regulated, use clearinghouses to settle and confirm trades, and use standardised contract specifications, in contrast to forwards, which trade over-the-counter.

Options contracts are also listed and governed by options markets, like the Chicago Board Options Exchange (Cboe). Contracts on a variety of asset classes, including stocks, fixed-income securities, commodities, and so forth, may be listed on exchanges for futures and options.

Foreign exchange market

Participants in the forex (foreign exchange) market can speculate, buy, sell, and hedge against changes in the value of different currencies. Since cash is the most liquid asset, the forex market is the most liquid market globally. Every day, the currency market processes over $7.5 trillion in transactions, which is more than the combined value of the futures and equity markets.

The forex market is decentralised and made up of a global network of computers and brokers, just like the over-the-counter markets. Banks, commercial enterprises, central banks, hedge funds, investment management companies, and individual forex brokers and investors comprise the foreign exchange market.

Commodities markets

Commodities markets are places where producers and consumers trade tangible goods like energy products (oil, gas, carbon credits), agricultural products (corn, livestock, soybeans), precious metals (gold, silver, platinum), or “soft” goods (cotton, coffee, and sugar). These markets, where tangible goods are traded for cash, are referred to as spot commodity markets.

Nonetheless, spot commodities are used as the underlying assets in derivatives markets where the majority of trading in these commodities occurs. Commodity forwards, futures, and options are traded over-the-counter (OTC) as well as on international listed exchanges like the Intercontinental Exchange (ICE) and the Chicago Mercantile Exchange (CME).

Cryptocurrency markets

Around the world, thousands of cryptocurrency tokens are traded on a network of separate online exchanges. These exchanges provide digital wallets that allow users to exchange cryptocurrencies for fiat currencies like dollars or euros.

Peer-to-peer (P2P) trading is permitted on these exchanges without the need for a real exchange authority to handle the transactions. Major cryptocurrencies also allow trading in futures and options.

What is the role of financial markets?

Establishes the securities’ price

The goal of investing is to potentially generate revenue from securities. However, financial markets set the price of securities, as opposed to the law of supply and demand, which determines the price of goods and services.

Increases the liquidity of financial assets

Securities can be traded at any time by buyers and sellers. They can sell their securities or make any kind of investment they want using financial markets.

Reduces transaction costs

It is possible to obtain a variety of securities-related information in financial markets without having to spend money.

Why are financial markets important?

Financial markets offer participation, capital, and liquidity—all of which are critical for stability and economic growth. Without financial markets, economic activity like trade and commerce, investments, and growth prospects would be significantly reduced, and capital could not be distributed effectively.

Participants in financial markets, such as debtors and investors, will be treated fairly and appropriately regardless of their size. Financial markets make capital available to people, businesses, and governmental entities. Also, since they provide a large number of job opportunities, they help in lowering the unemployment rate.

Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.