Financial Markets: Easily understand its Functions, Types, Participants, Regulations, Process.

Financial markets play a key role in Trading. In this article, tradingcritique.com explains you in detail about all the main Financial markets, briefing out easily the Functions, Participants, Financial instruments, Institutions, Regulations and Process involved in each Financial market. You will not find such consolidated information on Financial markets elsewhere. Read further to Easily understand the Financial markets.

Trading Critique recommends you to read Trading: All you need to know about and Participants involved in trading: 14 Essential participants to increase your understandability of this article.

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Financial Market

A Market is either a physical place or an online platform where the exchange of goods and services takes place. It can be a gathering where buyers and sellers come in contact to execute their trade. Complex institutions such as the stock market also act as a market. A Financial market is where the Financial Instruments like bonds, currencies, stocks, futures, options, hedge funds and commodities are traded. Financial markets are important participants in Financial trading. The trade-in financial market is mostly on liquid assets.

Commodity exchanges, Stock Exchanges, Foreign Currency Exchanges, Bond Markets, Over-The-Counter Markets are some types of financial markets.

Some Financial Institutions such as the Investment Banks act as a Financial Intermediary in Financial Markets. They provide Consultancy and Advisory Services to various participants such as the Issuer, Investor involved in the Financial market. They also help in liquidating the Financial asset and they take Commission for the work they do.

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Classification of Financial Market

Financial markets are of different types according to the type of financial assets that are traded in it. Financial markets are often used to raise money either for short term or long term.

The money can be raised for the following purposes such as: Investment and Capital for companies, Debt for Government and Government agencies, The need for profits for individual Investors and Institutional Investors.

Financial markets are majorly classified into Capital market and Money market. Other types of markets are the Commodity market, Forex, and Cryptocurrency market. Let us now see in brief about the different aspects of these Financial markets such as their Function, participants involved, Financial instruments traded in the market, Regulations and the process involved for each type of Financial Market.

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Capital Market

Primary vs Secondary Capital Market

Capital market is further divided into Primary and Secondary markets, the type of dealings in these markets also differ.

The Primary market is the first and foremost issuer of bonds and stocks. They are introduced and the first exchange of bonds and stocks take place in the primary market. Further buying and selling of the first bought stocks and bonds happen in the secondary market.

The Secondary market involves a lot of transactions than the primary market and also different kinds of trading happen here.

Stock market

Companies issue stocks for raising capital for the development of the company. The first issue of stocks that is made by a company is called Initial Public Offering (IPO). A private company which likes to issue IPO, should go public and become a public listing company. It is essential for the Public listing companies to sell the stocks in a Centralized Stock Exchange such as the New York Stock Exchange and London Stock Exchange. Many regulations must be followed to become a public listing company. Stock market trading is done during the active hours of the Centralized Stock Exchange..

The Stock market, Equity market and Share market mean the same and they are used interchangeably.

Private companies which do not have the eligibility to be Publicly Listed can sell Shares in the Over-The-Counter (OTC) Trading Platforms. Many famous companies have followed this route to raise capital and they became eligible to be publicly listed such as the WALMART. There are also other ways in which a company can raise capital such as through venture capitalist, angel investors, bank loans, etc.

Primary Stock Market

• Function – Issuance of Initial Public Offering (IPO) or primary stocks, selling of these IPOs to the Investors to raise fund for the issuing company.
• Participants

• Financial Instruments – Stocks/Equities/Shares specific to IPO alone.
• Liquidity – Less
• Regulations

USA – U.S. Securities and Exchange Commission Securities Investor Protection Corporation (SIPC)

UK – Financial Conduct Authority (FCA)

• Process

Secondary Stock Market

• Function – Trading of IPOs happen here for Capital appreciation. The IPOs are bought and sold multiple times for making profits by the Investors.
• Participants

• Financial Instruments – Stocks/Equities/Shares, Stock Indices, Stock Exchange Traded Funds (ETF), Exchange-Traded Derivatives and Over-The-Counter Derivatives.
• Liquidity – High
• Regulations

USA – U.S. Securities and Exchange Commission(SEC)
Securities Investor Protection Corporation (SIPC)
Financial Industry Regulatory Authority (FINRA) Clearing houses of various U.S. Stock Exchanges.

UK – Financial Conduct Authority (FCA)
Clearing houses of various U.K. Stock Exchanges.

• Process

1. Investment banks act as an intermediary in providing the stocks to the Stock Exchange and other secondary market platforms.
2. Investors who directly bought the IPOs can also resell them.
3. Derivatives trading happens in Exchanges, Broker-Dealers companies, and online platforms.
4. The trades that happen in the Exchanges are monitored by the Clearing Houses.
5. Companies that cannot be publicly listed can be traded in the Over-The-Counter markets. 
6. Investor’s profit is mostly the spread between the buying and the selling price. Service providers profit from the commission paid by the Investors/Traders for the services they provide.

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Bond market

Bond is another way in which the companies can raise capital but in the form of debt. Bonds are issued by both private companies and government institutions. When debt is needed by the institutions, they issue bonds and Investors buy the bond. After the expiration of the bond, the institutions are in the obligation to pay back the debt with a value more than the initial buy price of the bond. The difference in this amount is a profit for the Investor.

Bonds are sold to Investors at a discount rate lower than the face value of the bond. When the bond matures, Investors are paid back the Face value of the bond. The difference in the Face value and the Discount rate serves as the interest for the debt got through Bond.

Government bonds of developed countries are the best source of investments and are less risky as they are paid back at the correct time as mentioned in the bond. 

Primary and Secondary Markets are present for the Bond Market, which are briefed below.

Primary Bond Market

• Function – Bonds are primarily issued and sold to Investors.
• Participants

• Financial Instruments – Different types of bonds such as Government Bonds, Corporate bonds, Municipal Bonds, etc.
• Liquidity – Less
• Regulations

USA – U.S. Department of the Treasury – U.S government bonds can be bought from TreasuryDirect.
U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA)

UK – United Kingdom Debt Management Office – U.K. government bonds can be bought from Computershare Investor Services PLC.
Financial Conduct Authority (FCA)

• Process

1. When the government and companies need the money and they decide to raise money through debt, they issue bonds. 
2. Investment banks act as an Intermediary in issuing Bonds.
3. Investors buy the bond at the Face value, sometimes it is bought less than the Face value.
4. Investors are either paid interests or get the face value at the maturation of the Bond.
5. Differences in the buying value and a face value or the interest is the profit for the Investor.
6. Bonds are a less risky option to invest in, as the seller has the obligation to pay the debt back after the maturity.

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Secondary Bond Market

• Function – Primary bonds purchased are exchanged and traded in the secondary bond market.
• Participants

• Financial Instruments – Different types of Bonds, Bond Indices, Stock Exchange Traded Funds (ETF), Exchange-Traded Derivatives and Over-The-Counter Derivatives.
• Liquidity
• Regulations

USA – U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA) Clearing houses of various U.S. Stock Exchanges.

UK – Financial Conduct Authority (FCA)
Clearing houses of various U.K. Stock Exchanges.

• Process

1. The bonds bought in the primary bond markets are resold and exchanged multiple times in secondary bond markets such as in the Stock Exchanges, Brokerage firms and Dealer-Broker firms.
2. Derivative trading using bonds as an underlying asset is traded in the stock exchanges and OTC online trading platforms.
3. The Spread or the Difference between the Buying and Selling price of the Bond Market Instruments is the Profit.

Primary and Secondary markets are the Classifications of the Capital Market i.e., the Stock market and the Bond market. The markets listed below do not have this classification.

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Money Market

When capital is needed for a short term, mostly less than a year, it is purchased in the Money market. Even overnight borrowings happen in the Money market. Some Money market instruments are Commercial paper, Treasury bills, Bankers acceptances, Certificate of deposits, etc.  

The major transaction of the money market happens in Interbank Lending by using instruments like Commercial paper and Repurchase agreements. The benchmark for these instruments is often referred to the London Interbank Offer Rate (LIBOR). 

• Function – Money raised through various money market instruments are mostly for very short-term funding which is less than one year. They are called very short-term debt investments.
• Participants

• Financial Instruments

• /Money market instruments such as money market funds, money market accounts, certificate of deposits, commercial paper, Banker’s acceptances, EuroDollars, Repos.
• Derivative contracts like Future Contracts and Interest swaps.

• Liquidity – Highly liquid
• Regulations

USA – Federal Reserve System
Federal Deposit Insurance Corporation (FDIC) – Insures Money market accounts
The National Credit Union Administration
U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA)

UK – Bank of England
Financial Conduct Authority (FCA)

• Process

1. When short term debt is required, money market instruments are issued. 
2.  It mostly deals with borrowing and lending mechanisms that can even happen overnight. 
3. The Money market Instruments are Fixed-income Securities which gives assured returns. 
4. Mostly, large institutions are involved in money market mechanisms at a wholesale level. They adopt Derivative Contracts like Futures contract and Interest Swaps which are dealt between them through Over-The-Counter dealing. A Central Clearing House monitors and regulates these transactions.
5. In the Retail level, individual Investors can buy the money market securities directly from government and banks. E.g., The U.S. Government’s TreasuryDirect website. 
6. Even through Brokerage firms, investments in the Money market can be made for overnight profits.
7. The benefits of these wholesale transactions by institutions in money market reach to the end customers in the form of interest for their bank accounts, interest provided for the term deposits, money market mutual funds and other benefits which the normal customers are unaware of.

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Commodity Market

Commodities are raw materials that are produced from agriculture, mining, and also from the Energy sector. Some examples of Commodities are wheat, fruits and vegetables, gold, oil, petrol, gas, electricity, iron, etc. 

When commodities are traded in financial markets, financial instruments are involved and the trading happens in the Commodity Exchanges and Over-The-Counter platforms. 

• Function – Issuing of Exchanged-Traded Derivatives and Over-The-Counter Derivatives considering the Commodities as the Underlying asset.
• Participants

• Financial Instruments

• Liquidity – High
• Regulations

USA – U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA)
Clearing houses of various U.S. Commodity Exchanges.

UK – Financial Conduct Authority (FCA)
Clearing houses of various U.K. Commodity Exchanges.

In Exchange-Traded Derivatives, Delivery of Physical Commodities and Settlement through cash, both happen at the maturity of Futures and Options Contract. Whereas in OTC commodity derivatives trading, final settlements are made only through cash.

• Process

1. The basic process that happens behind a Commodity Exchange is the Production of Commodities by the Producers which are sold to the Buyers and they finally reach the end consumers. If the Commodities exchange takes place immediately, it is called a Spot Contract. 
2. Financial Instruments in the Commodity Exchanges play a major role in the above-mentioned process for selling or buying the Commodities on a future date.
3. Commodity prices are highly volatile due to its demand and supply. Producers (Sellers) who are mostly Farmers and Buyers who are mostly companies such as the Food Processing Companies, can lock the prices of the Commodities through Future contracts available in the Commodity Exchanges. 
4. So, the products are sold and bought according to the terms mentioned in the Futures contract. This contract clearly defines the Units, Costs, and the Date of Delivery of the Commodities. The delivery of the commodities according to the terms and conditions of the Future contract at the maturity is essential. 
5. When Traders, such as the Speculators or Hedgers are involved in Commodity trading, Delivery of the Commodities does not happen in those Derivative Contracts. The settlements are made through cash at the maturity of the contract. Sometimes Traders exchange those contracts for profits before the maturity of the Contract.
6. This multiple Buying and Selling of the Contracts increases the liquidity of the Commodity market.
7. In Exchange-Traded Derivatives, Delivery of Physical Commodities and Settlement through cash, both happen at the maturity of Futures and Options Contract. Whereas in OTC commodity derivatives trading, final settlements are made only through cash.

Examples of some famous Commodity Exchanges are,
ICE Futures Europe
ICE Futures U.S.
CME group is made up of
1) CME – Chicago Mercantile Exchange
2) CBOT – Chicago Board of trade
3) NYMEX – New York Mercantile Exchange
4) COMEX – Commodity Exchange Inc.
London Metal Exchange (LME)

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Forex Market

Forex market is also called the Foreign Exchange market, FedEx, or currency market. Trading in foreign currencies happens in the Forex market which is based on foreign exchange rates. Foreign exchange rates are determined by the interbank foreign exchange market globally. Forex market is the largest trading market in Over-The-Counter trading platforms.

• Function – Exchange and trading of Currencies, Currency pairs and Currency Indices.
• Participants

• Process

1. Foreign exchange rate of a currency is determined by various factors such as imports and exports between countries, commercial banks, investments made by a company in different countries, etc.
2. Although the above-mentioned factors contribute to the determination of the value of the currency in a country, Daily Monetary exchange rate of a currency is officially fixed by the country’s Central Bank. 
3. Foreign currency exchanges are spot markets where we exchange our currency when we travel from one country to another country. 
4. Trading of Forex happens majorly in OTC trading platforms which are decentralised. 
5. Derivative trading happens in OTC platforms. Mostly the currencies are traded in pairs such as USD/GBP. The value of the Currencies is determined from the International Exchange rates.

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Cryptocurrency Market

Cryptocurrencies are now being used as normal currency and there are Exchanges and ATMs available for cryptocurrency.

Crypto trading happens via Derivatives trading mostly in OTC platforms. Crypto trading happens using cryptocurrency pairs as an underlying asset. The pairs usually contain a cryptocurrency and a Fiat currency. The major cryptocurrency pairs are BTC/USD, ETH/USD, LTC/USD, XRP/USD. They are also known as Crypto-Forex pairs. The trading that happens in Cryptocurrency is similar to that of Forex trading.

• Function – Exchange and Trading of Cryptocurrencies.
• Participants

• Financial Instruments– Crypto-forex currency pairs, cryptocurrency, OTC Derivative trading instruments such as option, CFD, Forwards.
• Liquidity – Differs depending on demand and supply. Varies Geographically too, as some countries do not accept Cryptocurrencies and there are no Exchanges available there to exchange cryptocurrency to Fiat Currency.
• Regulations

Cryptocurrency is Decentralized; hence the creation and exchange of cryptocurrency are not regulated.

OTC Cryptocurrency Trading is Regulated by,
USA – U.S. Securities and Exchange Commission (SEC) Financial Industry Regulatory Authority (FINRA)
UK – Financial Conduct Authority (FCA)

• Process

1. Cryptocurrency is a digital currency that is bought in Cryptocurrency Exchanges using Fiat money.
2. Profit is possible when the cryptocurrencies you own increase in value more than the Buying price and you sell the Cryptocurrency at a favourable time to get more profits.  
3. Cryptocurrency is traded in OTC platforms using crypto-forex pairs as the underlying asset for various derivative contracts.

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Over-The-Counter Market

The Over-The-Counter (OTC) market is where the Financial instruments are traded outside the Centralized exchange. So, they are less regulated and do not have a centralized clearing house as an exchange. So, the financial trades that take place in OTC markets are not as secure as that of a Centralized exchange and involve counterparty risks. All the Financial instruments mentioned above can be traded Over-The-Counter. The trade in the OTC markets mostly happens bilaterally.

• Function – A feasible financial market where the Trader can trade with even less amount. Contains many features such as Margin, Leverage, many Order types, etc.
• Participants

• Financial Instruments– Mostly all types of OTC Derivative contracts are traded in the OTC markets.
• Liquidity – High
• Regulations

USA – U.S. Securities and Exchange Commission (SEC)
Financial Industry Regulatory Authority (FINRA)

UK – Financial Conduct Authority (FCA)

• Process

1. All the financial markets and financial instruments mentioned above can be traded Over-The-Counter.
2. The trade here happens mostly bilaterally, so the buying and selling can happen between the Buyer and Seller themselves. The OTC platform serves as an intermediary in this case.
3. The OTC provider and Broker-Dealer platforms which provide the OTC trading may themselves act as buyers and sellers to their customers to increase the liquidity in the market.
4. The speciality of the OTC market is that all the financial instruments will be available in the same place to trade.
5. You can trade in Stocks, Commodities, Bonds, Cryptocurrencies, Forex at the same OTC platform using the OTC Derivatives. 
6. Some OTC Derivatives platforms will be specialized in a type of Derivative trading. Such as the ig.com and xm.com which provides Contract-For-Difference (CFD) trading in most of the Financial instruments of all the Financial instruments.
7. The retail traders mostly trade in OTC markets. Scalpers and Day traders trade in high numbers in OTC markets.
8. The OTC trades differ in the Money market alone as the Institutional Investors trade Over-The-Counter by themselves using Derivatives contracts such as Interest rate swaps. These trades are regulated by the clearing houses.

At last, this is a highly risky market to trade-in as there are no clearing houses present here (Except for institutional transactions in the Money market) which increases the counterparty risks. Many scams and frauds happen in the OTC markets. You must select a regulated Broker for your OTC trading. You should be highly skilled and educated about trading to trade in these OTC-markets or else there are high chances of losing more than the money you have invested and deposited in the live account of the OTC platform.

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Importance of financial Market

Educating yourself about Financial markets is very important as a Trader and it should be a part of your trading plan and trading strategy. Some Traders just indulge in trading without knowing about the basics of Trading. When Traders don’t have the basic knowledge about trading, they tend to fail.

As a Trader, if you were involved in Trading without knowing what you were trading in, after reading this article you can clearly understand what kind of trading and financial market you were involved in. This knowledge you have obtained here will help you to become a successful Trader.

Knowing about the Regulations is the most important part in Financial markets as they help you to differentiate between legal trading and scams. Scams in trading happen even now though the government takes many efforts to regulate trading. Being aware of the governmental regulations will give security to your investments and will help you to keep away from scams.

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In a Nutshell

All the facts mentioned above will give you clarity about the Financial markets. To know more about the concepts, follow the links provided. If you have any more queries on the Financial market, you can Comment below. You can also ask your questions personally to our Trading Critique Experts by Clicking here.

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Reference

Book name: The Economist Guide to Financial markets: Why they exist and how they work, Author: Marc Levinson, Edition: 7, Year: 2018,  Publisher: The Economist.