Why Does A Market Exist?

There are markets in everything. But why do they exist? What purpose do they serve?

In the debate over high speed trading I think the purpose of markets has been lost in the shuffle. Once the purpose is defined, I think that regulators can do a better job drawing up the rules to play by.

The cash equity market is the one that gets all the attention. It’s the stock market. In the US, we think that they are traded at the NYSE and NASDAQ ($NYX, $NDAQ). Except, the price for all the stocks listed on these exchanges is really traded in dark pools and back offices. Exchanges do very little of the volume in listed stocks.

Cash equity exists so that public companies can sell their equity efficiently to people that want to invest in them. It’s an easy way to access a big pool of capital. It is not a casino to buy and sell. Although, the active buyers and sellers do perform a function in the equity market. They provide liquidity, or the grease that allows the crankshaft of the engine to turn.

The cash equity market has matured so that there are some differentiated products being traded called exchange traded funds or ETF’s. ETFs are just baskets of stocks that correlate in some way with each other or another market. For example, the ETF $GLD tracks closely the future, $GC_F. Not every ETF works. There are plenty of examples where investors were burned by an ETF not tracking what the underlying market was doing.

The next step in cash equities is the equity options market. Options are “derived” from the stock, so it’s often called a derivative marketplace. But options don’t have any relation to derivatives like futures, or the derivatives that Warren Buffett calls weapons of mass destruction.

The options market exists for two reasons. It allows investors in cash equity markets a place to hedge their risk of holding the security. It also gives companies another vehicle to pay employees without using cash. Just like every other market, there are active option traders that buy and sell and create liquidity. Just like the stock market, regulations have caused options exchanges ($CBOE) become second rate places for price discovery. The volume is increasingly going into dark pools.

Futures markets exist for one reason ($CME, $ICE). They are places to hedge commodity risk. If I am a farmer, I have a lot of risk. My crop production and the price I receive for it is totally out of my control. Additionally, because every farmer will harvest at the same time I do, there can be seasonality in prices and that piles on additional risk. If I am a manufacturer, I can use the futures market to hedge my risk of buying commodities and turn the variable costs of material into a fixed cost of production. That makes manufacturer’s more profitable. Just like all other markets, there are liquidity providers that buy and sell. They provide liquidity.

There are also options on futures, which function similarly to the options on stock. That market exists to allow market participants a cheaper and better way to fine tune their management of risk. Options markets at futures exchanges are the next big driver of volume growth.

Futures markets don’t trade off exchange like stock and option markets do. The price discovery is actually on a regulated exchange. Futures markets are more transparent. However, there are derivatives of futures. They call it the over the counter derivatives market(OTC). This is where Buffett’s “weapons of mass destruction” are traded. These are relatively unregulated. In trader terms, the OTC market is the wild west. It’s where exotic trades customized for one market participant can be executed. Some people think the OTC market is “bad” because that’s where a lot of the trading and manipulation happened during the financial crisis. AIG credit derivatives were created and traded here.

But, the OTC market is neither bad or good. It’s just a market. If it’s used correctly for the purpose it’s designed for, it’s a great place to micro manage risks that can’t be managed anywhere else. Used improperly, it blows up. Like Humpty Dumpty, when the market blows up it’s tough to reconstruct who owes whom on what trade when and where. This is why regulators want to force regulation into this space.

That’s a primer on the major market sectors of the economy. Tomorrow, how we regulate them and why.