Introduction to Financial Markets
If you’re looking for a simple guide to understanding the financial markets – what they are, how they operate and their role in creating wealth, you’ve found the right place. We’ll explain the definition of financial markets, share some examples you should know, and deconstruct how financial markets operate in the interests of all their stakeholders.
Definition of financial markets
A financial market is a marketplace that brings together buyers and sellers of financial instruments. They allow for efficient transfers of assets from the seller to the buyer, which is usually underpinned by a cash transfer from the buyer to the seller that takes place within days of the agreed deal.
A financial instrument is a contract that provides two or more parties with clear expectations of the financial risk and rewards they are exchanging.
An example is a share in a company. A share provides investors with defined rights to receive a share of future dividends from company profits. An investor takes a personal financial risk when buying the share, because it may turn out to be worth less than the price they paid if business profits are much lower than expected.
Financial markets tend to specialise in the trade of an individual asset class so that the rules can be tailored to the unique qualities of those assets and the needs of the brokers, traders and other institutions involved. Therefore you’ll often hear about commodities/metals exchanges, stock exchanges and bond exchanges.
Sometimes people might confuse financial markets with online gaming companies like Bovada, as both contain a mixture of thrill and risk.
Examples of financial markets
The term ‘financial markets’, when used in the broad sense will refer generally to the ownership and trade of a specific type of instrument. When financial journalists or traders refer to the ‘stock market’ or the ‘bond market’, they mean the global picture.
Practically speaking, financial markets are institutions (and potentially specific buildings) that enable trade.
Examples of financial markets in the UK include:
- The London Stock Exchange (LSE), founded in 1801
- The London Metal Exchange (LME), founded in 1877
- Lloyd’s of London Insurance Market, founded in 1688
As the world of investments has become digitised, so too have their markets. A stock exchange is now better thought of as a piece of software with active users rather than a physical location with attendees.
How do financial markets work?
Like any market, a financial market allows buyers and sellers to bid and ask for the opportunity to buy or sell goods. If a buyer sees an offer for sale at the right price, they’ll accept. Likewise if a seller sees an offer to purchase at the right price, they’ll accept.
Buyers and sellers place orders for specific quantities and specify the best price that they are prepared to accept. If, upon seeing the order book, someone on the opposite side of the transaction is happy with the price, they will accept the offer and the exchange will facilitate the deal, which will be made using universal terms and conditions to speed things up.
Rather than allow millions of investors to clog up the platform, financial markets prefer to restrict access to all except intermediaries known as brokers. Brokers in turn will process trades on behalf of their clients. This significantly reduces the number of relationships needed to form an orderly market and increases the level of trust between participants, as each broker will be trading frequently on the platform.
The original reason for this structure was that early financial markets were physical rooms and there was naturally a clear constraint on the number of people who could physically occupy the space.
When you place an order with the best UK stockbrokers, that broker will communicate with the exchange and accept the best available offer available for the trade you are about to make. They may also route the order through other intermediaries who may be able to offer a better price than the live market price. A broker is duty-bound to execute at the best possible price for their client, this is known as a ‘best execution policy.
How are prices set in financial markets?
The market prices of financial instruments, such as the stock price of Marks & Spencer PLC, is not dictated by any institution or a panel of experts. It is purely set by ‘the market’, which means that the activity of buying and selling determines the going price, which will fluctuate constantly.
After a market begins trading, a ‘market price’ will quickly be established. This price represents a state of equilibrium, as it is the price at which no likely buyers or likely sellers wish to trade.
If that sounds odd, here’s a quick illustration to demonstrate how that works:
Imagine a room with three potential buyers and three potential sellers of a contract.
The maximum price the buyers are willing to pay is £20, £23 and £30 respectively.
The minimum price the three sellers would be willing to sell for is £25, £27 and £30 respectively.
All of these expectations are known to each party as they are written on a board.
When trading commences, the buyer willing to pay up to £30 and the seller willing to sell for more than £25 will naturally reach a deal somewhere in the range of £25 – £30. After trading, they will leave the room. This price will be made public as a reference point to the rest of the members.
After that initial trade, the action would cease, because all remaining parties are unsatisfied.
That’s because the next most generous buyer was only prepared to pay £23, and the second-most willing seller would only part ways with their contract for £27. For now, at least, the potential sellers will be keeping hold of their contracts for another day.
Now imagine that a new buyer and a new seller entered the room. Regardless of their own preferences, they can see that a contract can be immediately purchased for £27, and a contract could be sold for £23. These become the market prices for this contract.
If the buyer bought for £27, the final seller (offering £30) is the only offer left on the table, meaning the market price has increased.
After witnessing just a handful of people creating a dynamic market price by simply following their own instincts, you can scale this idea up to picture a marketplace with thousands of offers and bids being constantly updated and accepted, creating a buy and sell price. Exchanges take the mid-point between these two prices and call this the market price.
What makes a financial market successful?
Financial markets are successful when buyers and sellers have trust. Trust in the quality of the assets being traded, and trust that deals made will be strictly adhered to.
When trust is high, buyers will be able to pay more and sellers will be able to accept less. If trust is absent, buyers may heavily discount their offers in anticipation of being caught out by poor quality or non-payment. Likewise, sellers may hike their sell prices to equally compensate them for potential poor outcomes. When trust is low, traders receive a worse price and less deals will be done.
The London financial markets listed above have evolved over the years to solve the problem of trust.
The exchanges themselves will also have a clear set of rules that they will enforce. The London Stock Exchange rules cover almost 100 pages. Because access to the exchange is so key for their business to continue, the threat of penalties or even disbarment from the exchange is a highly effective deterrent.
Many of the brokers that operate on the LSE are mature firms that have been operating for hundreds of years. The oldest broker in London can trace their roots back to pre-1800.
Furthermore, brokers use independent clearing houses to act as a middleman in the exchange of cash, ensuring that brokers aren’t exposed to significant levels of credit risk while trading, which reduces costs for everyone.
Automation and digitisation have also significantly lowered the costs of trading for firms, and these savings have been passed on to investors. The best CFD brokers sometimes offer real share trading for zero commission, for example.
How to trade on the financial markets
If you would like to learn the basics of buying shares or investing in property, take a look at our beginners guide to investing.
Below, we’ll link to our current pick of the best stockbrokers that will allow you to open an account and trade on the financial markets today:
Buy and sell funds at nil cost with Fidelity International, plus simple £10 trading fees for stocks & shares and ETFs.
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Trade stocks & options on the advanced yet low-cost Freedom24 platform that arms retail investors with the tools to trade like professionals.
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