How the financial markets function
Lesson in Course: Investing basics (advanced, 4min)
Buying and selling on Craigslist can feel sketchy. Here are all the players involved when we buy and sell investments.
What it's about: There are several key players involved when we make investments.
Why it's important: These players are there so our trades happen safely and smoothly.
Key takeaways: Be aware of whether our broker is also a market maker.
Craigslist helps connect people looking to sell something with those looking to buy. This type of market makes us execute our own transactions, whether by driving to someone’s house or meeting in a parking lot to exchange the goods for cash.
It can be risky: What if the buyer doesn’t bring enough money? or What if the seller doesn’t show up with everything I wanted to buy?
We are responsible for making sure the trade goes smoothly, or we’ll have to walk away if the other person doesn’t hold up their end of the deal. Luckily, institutions protect us from these risks when we decide to buy and sell investments.
Key Players
With $60 trillion (yes, twelve zeros and four commas) worth of stocks traded worldwide in 2019, $23 trillion of which in the US, these key players make it safer and more accessible for us to invest.
Brokerages
If we want to buy or sell an investment, we usually go through a broker or brokerage.
Stock brokerages take our request to buy or sell a stock and find a prospective buyer or seller to make the trade on our behalf.
Stock brokerages make money by charging us fees and commissions for actions and services we use on their platform. However, some brokers allow us to trade commission-free. In this case, they are being paid by market makers through payment for order flow.
When brokerages get paid a commission by market makers for sending our trades to them.
Another instance where we might encounter a broker is when we're looking to buy a home. We might talk to a real estate broker to show us the available homes.
Market Makers
If we want to buy a stock, market makers are likely the ones who will sell it to us and vice versa.
Financial institutions or banks that help make trading easier by acting as buyers and sellers. They increase liquidity by increasing the volume of trading.
Market makers can be individuals but usually aren’t due to the number of investments needed to support a large trading volume. Brokers can also be market makers. These players look to make a small fee for providing the service of faster transactions. They capture a profit based on the spread of a transaction.
The difference between what a market maker sets for a purchase price (bid) and what it sets as a selling price (ask).
Market makers profit regardless of whether the market is going up or down. For them, it's all about trading volume completing more transactions.
Exchanges
Our trade gets sent to an exchange after our broker matches us with a seller or a market maker.
Where the transaction takes place and where orders are tracked to ensure fairness and secure the transfer of financial information.
They are like the gas station parking lot of our Craigslist dealings. Most exchanges are electronic, so buyers and sellers from around the world can meet instantaneously.
It’s where companies sell their shares to the public in an IPO or where commodities, currencies, and debt gets traded. They track our orders for fairness and to securely transfer financial information.
Clearinghouses
Our final major player is the clearinghouse.
A financial institution responsible for finalizing and reporting the trade.
Clearinghouses also act as an intermediary between the buyer and seller to ensure both sides deliver their end of the deal. This way, clearinghouses help us reduce our counterparty risk,
The risk of one person not holding up their end of a transaction. For example, the buyer showing up short on cash, or the seller not providing the number of shares they promised.
The clearinghouse manages the risk for both sides by having margin requirements or extra cash on hand from brokerages to guarantee the transaction.
GameStop - what happens when brokers break
While the system has become increasingly efficient, it isn’t without weaknesses. One was exposed when many brokerages had to halt trading on GameStop and other “meme” stocks as prices spiked in early 2021.
The prices of these stocks rose so quickly that some brokerages, like Robinhood, didn’t have enough collateral (cash as a percent of the stock’s value) that clearinghouses required to execute the trade. As a result, they had to halt trading, specifically the buying, to raise more cash and reduce the collateral they needed.
Actionable ideas
When opening up a brokerage account, it’s important to know if your broker is a market maker. It can affect how well your brokerage will be able to execute trades and at what price. It may also impact the investments they recommend, the services they provide, and how they are able to price those services. In fact, it's a good idea to make sure there is a clear separation between your broker and the market maker.
Your broker will likely recommend investments they make a market for if they are also a market maker. If you place a market order to buy a stock, you can be sure that market makers will fill your order with the highest price possible and you probably won't even know. This is one of the reasons it's a good idea to place limit orders instead.
Supplementary materials
Glossary
In addition to holding our investments, stock brokerages help us by taking our request to buy or sell a stock and begin to make the trade on our behalf.
When brokerages get paid a commission by market makers for sending our trades to them.
Financial institutions or banks that help make trading easier by acting as buyers and sellers. They increase liquidity by increasing the volume of trading.
The difference between what a market maker sets for a purchase price (bid) and what it sets as a selling price (ask).
Where the transaction takes place and where orders are tracked to ensure fairness and secure the transfer of financial information.
Institution responsible for finalizing and reporting the trade and act as an intermediary between the buyer and seller to reduce counterparty risk.
The risk of one person not holding up their end of a transaction. For example, the buyer showing up short on cash, or the seller not providing the number of shares they promised.