Brokers, banks, market makers, governments, central banks and you – the retail trader. What do they all have in common? They are all participants in the financial markets. In fact, everyone is a participant in the financial markets in some way and there are few aspects of life today that operate without some interaction with them.
Who Are The Main Participants In The Financial Markets?
- Central Banks
- Institutional Traders
- Retail Traders
- Brokers And Market Makers
In this blog we will look at these main participants in the markets with an overview of their role as well giving you an introduction to some common terms.
This blog is part 4 of our Trading Basics series which is an introduction to all the key topics you need to know as a retail trader.
Table of Contents
Governments And Central Banks
You will often hear about central banks being independent from the government as if the central banks are not a part of, or accountable to the government. This is not necessarily true as central banks are often owed fully or in part by their respective governments. They do in the most part have mandates that allow independent decision making but those mandates are often set by the government or parliament of that country.
Probably the biggest impediment to governments interfering with central banks independence is the reaction of the markets to such a move.
Central banks have a mandate to ensure the financial stability of an economy and if the markets felt that political motives (which are often based around short term election cycles) were taking control then that country is likely to be punished in the international markets.
In order to understand the differences between what each institution does we need to know two key terms:
- Monetary Policy
- Fiscal Policy
What Is Monetary And Fiscal Policy?
Monetary and Fiscal policy describe a range of tools used by governments and central banks that are used to influence a country’s economy.
- Monetary policy is generally implemented by the central banks
- Monetary policy deals primarily with interest rates and the supply of money in an economy
- Fiscal policy is generally implemented by government legislation
- Fiscal policy is in effect government budgets, what they borrow, tax and spend
In general terms there are two outcomes that policy makers are looking to achieve with these policies and that is either to stimulate or slow down the economic growth.
Government Bonds Impact On The Financial Markets
Governments are large and influential participants in the financial markets. One of the main ways they participate directly is via the issue of government bonds (government debt). And there is a lot of it! Tens of trillions of dollars worth.
Government borrowing is a big topic around the world. When a government cannot cover its expenditure via taxes then the only option is to borrow money, this debt is called a bond.
When a country borrows more that it can cover from income (taxes) then it is said to be running a fiscal deficit. The majority of countries in the world run a fiscal deficit and balance current spending promises against future income and the promise or hope of growth.
This is why government debt is sometimes referred to as a tax on future generations.
Legislation And The Financial Markets
The amount of government borrowing obviously this makes them a big participant in the financial markets. But this is not the only thing that makes governments important.
As you all know governments make the rules in their own countries – they regulate through laws and set tax rates. This legislative risk can have huge impacts on the markets.
Governments have the ability to change the tax rates for individuals and businesses, drastically changing the allocation of money in an economy as a result. In addition, legislation can make doing business in a country easier or more difficult depending on what barriers are put up.
Government policies can even create or destroy whole markets. Environmental legislation is a good example of this.
Interest Rates As A Tool To Control Inflation
Interest rates can have a significant impact on the markets and economy. For many years this has been the primary way of expressing monetary policy.
Interest rates are set by a country’s central bank and affect the rate at which money can be borrowed at in the economy.
The general rule is that interest rates are cut/lowered to stimulate lending in the economy and raised/increased to slow down lending.
The main reason to raise interest rates and slow down an economy is to control inflation.
Is Money Creation Inflationary?
And of course Governments can create money.
Now at this point many of you may be saying that I should not call it money but fiat currency. And you would be correct, but this is just an introductory blog so I won’t go into the details of what money is in this blog.
I will however put a link in the resources section below to an excellent video series that explains this better than I can.
Money creation is inflationary. What this means is that when money is created, it causes prices of goods to rise which is the opposite of saying that the value of money is decreasing (you need more money to buy the same thing).
This is common sense as the more of anything that is produced the less value it has (basic supply/demand).
The picture is a lot more complex than this of course as inflation will only occur in this instance if the supply of goods remains constant (more money chasing the same amount of goods).
Inflation may also affect different goods in different ways or may be hidden by the effects of deflation.
For example over the last decade, food prices in the UK have been very stable whereas property prices have increased year on year. In the US especially, the inflation in the stock market has often been at odds with the rest of the economy.
We also live in an increasingly digital world and a lot of the products and services we buy are digital in nature. Such products have completely different dynamics of supply and demand and price elasticity and competition.
As such, a lot of this technological advancement in digitisation and automation of services has been deflationary for many products and services.
Does The Government Have An Incentive To Create Inflation?
Our final note around governments is about their incentive to create inflation. The reason for this? Well think about the trillions of dollars worth of government debt – if you print a lot of money and this reduces the value of currency then you are able to pay off the debt with dollars that are worth less than when you borrowed them.
This also has the effect of stimulating spending in the short term creating an economic boost, which can be great politically.
People may argue that governments are seeking growth, not inflation but decades of running debt based economies has shown that the promise of growth is often overstated.
Inflation has always been a constant and reliable way to debase the value of money and keep a debt based economy rolling over.
Savings, otherwise known as excess capital, are the fuel for economic growth as the markets – through the allocation of capital – move this excess capital from savers to borrowers so that it can be put to effective use – i.e. make a return.
No-one saving for retirement will want to see the value of their capital decrease to such an extent that they can no longer retire when they intended to.
Banks: Participants And Intermediaries
Banks form the bedrock of the financial markets and are both participants and intermediaries – by which I mean they facilitate a lot of the transactions within the financial markets.
Banks are where the majority of borrowers and lenders come together at ALL levels, from individuals through to large corporations and institutional investors all the way up to central banks and government securities.
It is actually surprising for many people to find out that the majority of money creation in the economy is in the form of bank loans. In fact up to 97% of money is created in this way!
What Is Fractional Reserve Banking?
Most people believe that banks only lend money that they have in the form of deposits from savers. In reality, banks only need to maintain a ratio of net assets to lending – this ratio is known as a reserve requirement and is usually set by central banks (and is a form of monetary policy). This is known as fractional reserve banking.
Banks literally have a license to create money. Not to print money though, because this is digital money. When a bank creates a loan, such as a mortgage they are creating money from nothing (other than the reserve requirement).
Corporations (companies) are also significant participants in the financial markets. Companies interact with the markets in two main ways:
- Through the debt market. This can be in the form of short term funding via the money markets or through the issuance of bonds in the debt capital markets.
- Through the issuance of share capital in the equity markets.
So companies are either raising capital in the form of shares or borrowing money for short or long term financing of the business.
Both of these markets are significant in size however the corporate debt market (bond market) is the larger of the two. In 2020 the size of the global corporate bond market was over $40 trillion dollars.
Institutional Investors are the other big players in the financial markets. These terms refer to a whole range of institutions which are all seen as professional investors.
Who are institutional investors?
- Pension Funds
- Hedge Funds
- Investment Banks
- Other Large Institutions
One of the key features of institutional investors is that they invest other people’s money – such as in the case of pension funds.
Often, people who work for these institutions are called professional investors. This often has a specific meaning in the law (regulation) of a country meaning that they hold a specific set of qualifications or experience to allow them to work in these institutions and manage other people’s money.
Due to the fact that these are professional investors, they will have preferential access to markets and products that the everyday person would not.
However, the enhanced access that they have to markets and sophisticated products comes with this burden of regulation.
Retail investors are everyone else that invests in the markets with their own money.
This can range from having a savings account to investing in pension or mutual funds through to buying and selling stocks or even day trading.
Retail investment products are any financial products that are sold to the general public. Retail investors are often defined as non-professional investors.
This doesn’t mean that there are no full time retail investors, just that retail investors do not work for an institution or a company that handles other people’s money.
There is an assumption by regulators that retail investors need more protection when accessing the market in comparison to institutional investors. As such retail investors have less access to the markets and the products they can access are often more regulated and as such have a higher cost to them.
This covers the main participants in the markets. However we can’t leave out brokers and market makers. These are both examples of parties within the markets that facilitate trading – they help the market to function.
What Is The Role Of Brokers As Financial Market Participants?
Brokers are there to facilitate trades between two parties as an intermediary. For example, if you as a retail trader wanted to buy some Apple stock, you couldn’t just walk up to the NYSE floor with a few hundred dollars in your hand and hope to make a deal! You would need to go through a broker.
Brokers are regulated and licenced organisations that have direct access to markets and they facilitate the buying and selling of assets for their clients. Many brokers offer more services than just market access and may also provide investment advice or research. Brokers generally make money by taking a commission for their service.
With new technology there are more options for investors to access the market via low cost brokers that are almost like having direct access or via derivative products like CFDs and Options that can give you market exposure without holding the actual assets.
In either case it is important to remember that the opposite side of greater access is greater individual responsibility. If you are going to do your own investing then you need to be responsible for your own research, education and risk.
What Is The Role Of Market Makers In The Financial Markets?
Market makers serve an important function in the markets. Market makers are often large institutions such as banks. They are there to ensure that there is enough liquidity in a market for trading to take place.
What Is The Importance Of Liquidity?
Liquidity is basically the market’s ability to satisfy demand – it means that when you go out to buy or sell an asset there will be someone on the opposite end of the trade. When there is low liquidity in a market the result can be that you cannot find a seller for your asset or have to wait a long time to sell or you may want to buy something but can’t find a seller.
The consequence of this is that it can create price fluctuations or can cause an asset to trade at a discount to its market value. Property is a good example of an asset with low liquidity. Imagine you have a house, you know that the market value is $500k, all you have to do is put it up for sale and you will get your money as quickly as… 3 months?, 6 months? It will take time, but that is how the property market works.
However, if you were desperate for money and needed $300k within the next two weeks then despite having an asset worth a lot more, you are going to have a liquidity problem! If you were very desperate, this may cause you to sell your asset at a steep discount in order to access your money sooner – this is also known as a liquidity premium.
Bid Offer Spread Explained
Market makers can make money by charging a commission for their services, however the main way a market maker makes money is via bid offer spread. The spread is basically the difference between what the market maker will pay for an asset (bid price) and the price they will sell an asset (ask or offer price).
So in the example of Apple stock, the market may be $320.50 offer and $320 bid. If you want to buy, the market maker is selling. So you will pay the ask price of $320.50, if you sold straight away, the market maker’s bid is $320. The difference between the two – $0.50 is the spread and the market maker’s profit.
Resources / Related Links
- YouTube: Hidden Secrets of Money
This excellent series of videos from Mike Maloney will give you a great overview of the debt based monetary system. He explains the difference between hard money and fiat currency and explains how fiat money is created.
It is well worth a watch for your financial education and will be an amazing eye opener if this is your first foray into the world of money creation.
- Recommended Read: The Bitcoin Standard by Saifedean Ammous (Amazon).
Another great read that will further consolidate your understanding of what money is.
More Trading Basics
There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series. Read our previous or next unit.