The term ‘financial markets’ is broad, but is widely used in the financial media. If you’re interested in learning the definition of financial markets, including the different types of financial markets, continue to read this financial markets definition article.
Definition of financial markets
A financial market is a physical or digitally enabled forum for buyers and sellers of financial instruments to place and execute trades, typically via intermediaries such as brokers.
A financial instrument is a contract that may result in a future financial benefit or financial obligation for its holder. Prominent examples include stocks & shares, government bonds, corporate bonds, funds and finally; derivatives such as options, forwards and swaps.
Brokers are financial institutions that enable retail or institutional investors to buy or sell financial instruments via financial markets. Member brokers will pay to be members of key exchanges that function as marketplaces. This gives them access to directly connect to the market using specialist software to transact on behalf of their clients. Other brokers may collect trades from clients and place them via member brokers.
What role do financial markets play in an economy?
Financial markets are the beating hearts that pump money through an economy. By freely operating with minimal restrictions, they effectively reallocate money from savers to companies and individuals who can put the money to productive use.
Financial instruments allow the owners of capital to receive a fair return for their money being used, while the entity that receives the capital hopes to produce profits that exceed the cost of capital.
To use the stock market (definition) as an example; as a working adult saves towards retirement, they may contribute a % of their disposable income to a stocks & shares ISA. They may choose to buy shares in a company listing on the stock market through an initial public offering.
The company will use that money to hire more staff, make capital expenditures and create more products and services that will benefit the wider society. Meanwhile, our retirement saver will look forward to receiving a dividend yield and a capital gain when they sell their shares in the future.
The existence of financial markets encourages people like our saver to invest, because investing isn’t a lifelong commitment. We suggest that you only invest if you can commit your money to the stock market for at least 5 years. When you anticipate you will need to use the cash value for your own consumption, financial markets enable you to pass the financial instrument onto someone else who is perhaps at the stage of beginning to save for the future.
As such, financial markets enable long-term capital deposits to be made by a churning group of investors who may only each contribute their wealth for a shorter period. They, therefore, allow for a useful matchmaking process between companies with long-term capital needs and investors with shorter-term horizons.
An overview of the financial markets
Financial markets can be classed as public or private.
A financial instrument offered for sale on a public financial market can be purchased by whoever offers to buy it for the highest price. The ultimate buyer and sellers will likely not know each other’s identities.
The financial instruments that are traded on public markets are standardised so that investors are completely indifferent as to ‘which’ financial instrument they purchase.
A class B share in Nike Inc confers the same rights to its new owner as any other class B share, whether it was purchased from their office janitor or the CEO.
This interchangeability helps to make all financial markets very efficient. Fungible instruments allow for fast trading because investors needn’t evaluate any other factors except price when viewing the buy and sell offers on the market for that instrument.
You can contrast this with the second-hand used car market, where every vehicle is unique due to different manufacturer options. A potential buyer will need to factor in different levels of wear & tear, different ownership or maintenance histories and different vendor experiences when assessing which vehicle offers the best deal.
Examples of public financial markets
Examples of different financial markets that specialise in the trade of different financial instruments are:
- The stock market
- The bond market
- The forex market
- The derivatives markets
- The commodities market
- The public derivatives markets
Public financial markets operate at scale and are highly centralised. The London Stock Exchange, for example, handles the trading of UK shares and processes over a million separate trades per day.
Bringing together thousands of traders at any moment means that one larger seller can be matched to a group of small buyers. When financial media refer to markets offering deep liquidity, they are referring to the capacity of a market to handle large transactions.
Examples of Private financial markets
Not all financial instruments are suitable for trading at scale, mostly because the total market value of all instruments of that type is relatively small and therefore at any given moment, there may not be any counterparties offering a competitive price for the other side of your trade. In other words, liquidity would be low.
Examples include:
- An individual property
- The shares of a small, private company
- A bespoke insurance contract
- A forward pricing agreement for a fixed quantity and maturity date of the buyer’s choosing
The smaller scale of these financial instruments makes them suitable for private financial markets, which are less centralised and involve direct contact between buyers and sellers.
Would-be home buyers may begin their property search on a web portal but will ultimately contact the agent selling their preferred house and begin a transaction process.
A company looking to mitigate a specific risk on their grain purchases may enter into a bespoke forward arrangement with an investment bank to hedge their price risk.
Small start-up companies looking for new capital may use equity crowdfunding platforms such as Funderbeam to sign-up interested parties and sell small quantities of equity and perks in return for cash.
Private financial markets perform a similar role in the overall economy, but due to reduced liquidity, such investments made tend to be higher risk because selling your financial instrument at a later date may be much harder than selling shares via a stockbroker.