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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.

Eureka!

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 matches buyers with sellers
What is 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

What is 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.

Here's a quick video that dives a little deeper into brokerages:
https://www.youtube.com/watch?v=87w_PxqOuYc&ab_channel=OneMinuteEconomics

Market Makers

If we want to buy a stock, market makers are likely the ones who will sell it to us and vice versa.

Market makers provide liquidity by acting as buyers and sellers
What is Market maker?

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.

What is Spread?

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.

Check out this short video on market makers:
https://www.youtube.com/watch?v=1WO1GmrIlS0&ab_channel=OneMinuteEconomics

Exchanges

Our trade gets sent to an exchange after our broker matches us with a seller or a market maker.

What is Exchange?

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.

What is Clearinghouse?

A financial institution responsible for finalizing and reporting the trade.

Clearinghouse finalizes trades and holds the actual stock  for us

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, 

What is 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

Why Robinhood Blocked Gamestop. (Full Explanation) - YouTube

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.

Watch this video for a more detailed look at how it happened:
https://www.youtube.com/watch?v=MJIrACj_1xg&ab_channel=FinanceExplained
 

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

Short squeezes and market makers - Check out our blog coverage for more detail on the GameStop phenomenon!
https://app.getmedes.com/courses/19/lessons/189

Glossary

What is Brokerage?

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

What is Payment for order flow?

When brokerages get paid a commission by market makers for sending our trades to them.

What is Market maker?

Financial institutions or banks that help make trading easier by acting as buyers and sellers. They increase liquidity by increasing the volume of trading.

What is Spread?

The difference between what a market maker sets for a purchase price (bid) and what it sets as a selling price (ask).

What is Exchange?

Where the transaction takes place and where orders are tracked to ensure fairness and secure the transfer of financial information.

What is Clearinghouse?

Institution responsible for finalizing and reporting the trade and act as an intermediary between the buyer and seller to reduce counterparty risk.

What is 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.