What Role Do the Financial Markets Play in the Economy?

The financial markets aren’t just sophisticated tools people use to make money. In the words of the former Managing Director of the International Monetary Fund (IMF), “Their quality is a critical determinant of countries’ economic stability and of their success in a world of financial globalization”. Well-developed financial markets have the power to take small businesses and expand them into enormous operations that employ hundreds of thousands of people, while also providing useful products and services for many households. The role of the financial markets in the economy is to introduce a calming, stabilizing force that facilitates growth and development, and this can be invaluable to a nation and to a society.

A country might have plentiful natural resources and a hardworking population, but this doesn’t necessarily mean its economy will blossom and its citizens will enjoy prosperity. What really matters is how those resources are distributed. If an entrepreneur has a promising business plan, he needs the right amount of finance at the right time. Oftentimes, the only way he or she can secure this is by means of the financial markets. Apple Inc., for instance, would probably never have grown to their present size or anything near it, had they not been able to raise an initial $100 million through a selling their shares on the stock market. The results were more employment, more innovative products, and more robust competition – all of which bring widespread societal benefits. Now, let’s learn more about the role of financial markets and institutions in the broader economy, but also in our individual lives.

IPOs and the Stock Market

When a company like Apple takes the step to selling shares in their business to the public, it’s done through a process called an IPO (Initial Public Offering). The company then takes on a new status as a publicly traded enterprise, parts of which are owned by large segments of the public. The value of the company shares will then vary over time as traders continually gauge their true value, which adjusts the forces of supply and demand behind their prices.

The stock market makes all the relevant information about a company public, and this transparency makes for investor confidence. It also makes it easier for share sellers to find willing buyers and vice versa. If there weren’t a stock market, would-be buyers would have to interact directly with companies to make their purchases happen, which would be much more difficult for many reasons. From the perspective of buyers, the benefit to be sought is a potentially better return on their investments than they would get through, for instance, a savings account. But, aside from this market, what are some of the other financial markets out there in which people might choose to participate?

The Forex (Foreign Exchange) Market

This huge and highly liquid market is the forum in which you can speculate on future fluctuations in the exchange rates between national currencies. Over $7.5 trillion passes through this global market every day, which makes it dwarf both the stock and futures markets combined. There is no central physical location where all this trading occurs. Rather, participants all over the world, including retail traders, companies, central banks, and brokers, use computers to make their trades efficiently and speedily.

Forex trading is always done with pairs like EUR/USD (the euro relative to the US dollar) or the USD/JPY (the US dollar against the Japanese yen). When you read the present value of the EUR/USD, you’re seeing the number of US dollars needed to purchase one euro. In the event the EUR/USD goes up, that means the euro strengthened against American currency. As to the factors that can turn the dials on forex pair values one way or the other, they are varied and require some studying.

The Commodities Market

This can sometimes be a physical location where people who want to buy livestock, corn, or platinum meet with those who have the commodities to sell. Most of the time, however, commodities trading occurs on digital exchanges like the Chicago Mercantile Exchange (CME), where these vital materials are bought or sold as futures, forwards, or options. This kind of exchange can be crucial for companies that needs to buy commodities because it allows them to set a known price for their purchases. Otherwise, the constantly shifting prices of commodities could interfere with their business models.

One very important commodity, as far as the economy is concerned, is oil. Traders are aware that, when oil prices stay elevated too long, the prices of food will likely jump up in several weeks’ time. The impact on gasoline prices will be even more immediate, becoming noticeable in only a week or so. Gold is another commonly traded commodity, and one which tends to grow popular in times of economic uncertainty. 

These days, you can use a trading platform on your PC or mobile phone to make trades in many types of vital commodities, as long as you have an internet connection. The majority of traders in this market never intend to actually take delivery of the oil or gold in which they trade. Rather, their goal is merely to speculate in the commodities’ price changes.

The Cryptocurrency Market

Cryptocurrencies are non-physical assets that exist on digital ledgers called blockchains. The wave of popularity they have undergone in recent years can be accounted to their potential for bringing unusually large returns. At the same time, their notorious price volatility can also trigger large-scale financial losses. Since they are not correlated in clear ways with other markets, as the bond market is, for instance, with the stock market, some people consider them hedges against inflation and risk, similarly to gold. Functionally, cryptocurrencies work as an alternative to fiat currencies like the British pound or the US dollar, but they have yet to gain widespread acceptance in this area.

Crypto tokens are relatively new financial assets, but there are already electronic forums where thousands of them can be bought or sold at almost any time of the day or night. Online exchanges can facilitate these trades, and they also provide clients with digital wallets for holding their cryptocurrency. Centralized exchanges have shown themselves to be susceptible to computer hacks, but there are also decentralized exchanges available. These tend to be safer, and they also make it possible for buyers and sellers to interact without the use of any intermediary exchange.

The Bond Market

Bonds are issued by governments or corporations to raise money for projects that they want to reach completion. As a result, bonds provide some of the liquidity needed to keep the economy dynamic. When you buy a bond, you are essentially buying a contract with the issuer that stipulates how much money you lent them and all the terms by which the loan should be repaid. The loan is invariably made for a fixed period of time and at a pre-established interest rate.

Examples of bonds include Treasury bonds, corporate bonds, and municipal bonds. Usually, bond prices move in an inverse relationship with stock prices, so when stock prices go up, bond prices go down. Traders know that, when Treasury bond values drop, it can portent a dip in the US dollar, which could be a catalyst for inflation.

Over-the-Counter (OTC) Markets

These are the places where you’ll find, for instance, stocks that, for whatever reason, do not fulfil the criteria to be listed on public exchanges. They are also the only addresses to go to if you want to trade in certain derivative financial instruments. Here, securities are traded directly between buyers and sellers without any broker acting as middleman. OTC markets tend to be less transparent than stock markets like the New York Stock Exchange (NYSE), and also less liquid.

Summing Up

As financial markets establish themselves, credit becomes more easily available, which is the fuel needed to grow economies. Without the financial markets, it would be much more difficult for businesses to manage risk and volatility, so their smooth functioning lays the foundation for a degree of economic growth that, otherwise, would be unattainable.

For individuals all over the globe, the markets make it feasible to take out insurance, which removes some of the sting from life’s uncertainty. They also make it possible to purchase a home without having to pay out the full sum in one go, which would be a prohibitive obstacle for many households. When it comes to setting aside money for retirement, the markets have the power to add considerably to the sums people are able to save, thus easing the transaction into old age.

The role of the financial markets has been called into question by events like the 2008 financial crisis, which made manifest their power to do harm (when improperly managed). But we can certainly recognize many of the benefits they provide to society and to ourselves. It’s therefore worthwhile for governments, regulators, and the private sector to act as best they can to ensure the financial markets remain safe, durable, and fertile for all participants, and for years to come.