Archimedes Finance

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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.

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. When looking to buy a home, we often talk to a broker who shows us the available homes. 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. 

We can learn more in the lesson about brokerage accounts.

Tap to view a quick video that dives a little deeper:

 

Market Makers

Market makers are 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 often aren’t due to the number of investments needed to support a large trading volume. A market maker can also be a broker.

If we want to buy a stock, they will sell it to us and vice versa. Market makers look to make a small fee for providing the service. The difference between what the market maker sets for a purchase price (bid) and what it sets as a selling price (ask) is known as the spread and is how they make money.

Tap to check out a short video:

 

Exchanges

Our trade gets sent to an exchange after our broker matches us with a seller or a market maker. Exchanges are where the transaction takes place, 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. Orders are tracked to ensure fairness and secure the transfer of financial information.

 

Clearinghouses

Our final major player is the clearinghouse, responsible for finalizing and reporting the trade. They also act as an intermediary between the buyer and seller to ensure we are good on the deal. This way, we reduce the counterparty risk, the risk of the buyer showing up short on cash, or the seller not bringing 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 are broke

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.

Tap to take a look at how it happened in more detail:

Check out our blog coverage for more detail on the GameStop phenomenon!

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.

Glossary

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 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.

At Archimedes, our goal is to make investment literacy accessible and free for everyone.

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