Financial markets encompass various trading venues where transactions in securities like stocks, bonds, currencies, and derivatives occur. They are essential to capitalist economies, ensuring efficient resource allocation and liquidity provision for companies and entrepreneurs. These markets facilitate the exchange of financial assets, making it easier for sellers to divest and buyers to acquire them. They create investment opportunities for those with surplus capital and provide funding avenues for those needing additional resources.

The stock market is a prominent segment of these world financial markets. It includes various platforms where participants buy and sell financial instruments like shares, bonds, and derivatives. These markets depend on the transparent flow of information to set prices that reflect the actual value of these financial instruments.

Market sizes vary significantly. Some are pretty inert, while others, such as the NYSE, involve buying and selling trillions of securities daily. On the one hand, the stock market allows investors to sell and purchase public firm shares. New stock issuances occur in the primary market, while the secondary market handles trading existing shares among investors.

Types of Financial Markets

Financial markets come in various forms, each specializing in different instruments and asset classes.

Stock Markets

These are the most well-known financial marketing. Companies list their shares on stock exchanges, where investors and traders trade them. These markets allow companies to generate capital and offer investors opportunities for returns. Stocks can be traded in informal exchanges such as the New York Stock Exchange (NYSE), Nasdaq, and over-the-counter (OTC) markets. They are the primary venues for most stock trading and are essential in circulating dollars in the economy.

In stock markets, you'll find a variety of participants, including retail and institutional investors, traders, market makers, and specialists. These specialists work to maintain market liquidity and ensure a market for both buying and selling. Brokers also play a crucial role, facilitating trades between buyers and sellers without holding positions in the stocks themselves.

Over-the-Counter Markets

These markets operate electronically and are decentralized, meaning they don't have a physical trading location. Participants trade securities directly in OTC markets, often without a broker's involvement. While some stocks, particularly those from smaller or high-risk companies, are traded over the counter, most stock trading happens through exchanges. However, many derivative markets operate exclusively OTC, forming a significant part of the world financial markets. OTC markets are typically less regulated, less liquid, and more opaque than their exchange-based counterparts.

Bond Markets

Here, investors loan money to an entity for a set period at a predefined interest rate. The bonds represent an agreement binding the lender and borrower on the terms, conditions, and payments. Such securities fund operations and projects through issuance by companies/municipalities/governments, etc. The bond market, the debt, credit, or fixed-income market, includes securities like treasury notes and bills.

Money Markets

These markets deal in short-term, highly liquid financial instruments. They are considered safer and generally offer lower returns compared to other markets. Money markets operate at wholesale (involving large trades between institutions) and retail levels (including money market mutual funds for individual investors and bank accounts). Individuals can also participate in money markets through short-term investment vehicles like certificates of deposit (CDs), municipal notes, and Treasury bills.

Derivatives Markets

Derivatives are contracts whose value is based on underlying financial assets or indices. The derivatives market doesn't trade assets but futures, options, and other financial products that derive value from underlying assets like bonds, commodities, currencies, and stocks.

In futures markets, futures contracts are listed and traded. Unlike forward contracts that trade over-the-counter (OTC), futures are standardized and regulated, with clearinghouses ensuring the settlement and confirmation of trades. Options markets, such as the Chicago Board Options Exchange (CBOE), list and regulate options contracts on various asset classes, including equities, fixed-income securities, and commodities.

Forex Market

The forex or foreign exchange market involves trading in currency pairs. It's the most liquid market globally, with over $7.5 trillion daily transactions. This decentralized market comprises a network of computers and brokers, encompassing banks, commercial companies, central banks, investment firms, hedge funds, and retail forex brokers and investors.

Commodities Markets

These markets are where physical commodities like agricultural, energy, precious metals, and 'soft' commodities are traded. While spot markets deal with immediate physical commodity exchanges, most commodity trading occurs in derivatives markets, using spot commodities as underlying assets. This trading happens both OTC and on exchanges like the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

2008 Financial Crisis and The OTC Derivatives

Mortgage-backed securities (MBS), especially subprime mortgage-backed securities, played a significant role in the 2008 financial crisis. Mortgage cash flows were bundled and sold to investors in these OTC derivatives. The 1970s Community Development Act, which relaxed credit rules for low-income borrowers, set the stage for the crisis, which boosted subprime mortgages.

In the early 2000s, the Federal Reserve substantially reduced interest rates to avert recession, worsening this predicament. This move and the already lenient credit requirements fueled a housing boom. Prices soared, creating a real estate bubble. Investment banks, seeking profits after the dot-com bust and the 2001 recession, began creating complex financial products like collateralized debt obligations (CDOs) from these mortgages.

The problem was the blending of subprime mortgages with prime ones in these CDOs, making it difficult for investors to discern the risks. As the market for these CDOs heated up, the housing bubble burst. The decline in housing prices led to a wave of defaults by subprime borrowers, whose loan values exceeded their home values, further plummeting prices.

However, when it became clear that MBS and CDOs were burdened with toxic debt, their market had dried up. These incidents led to a subprime market collapse, eventually infecting the entire financial system. The fall of some central investment banks, such as the Lehman brothers and Bear Sterns, added to the failure of over four hundred and forty banks in the following years, confirming the crisis's seriousness. It got so bad that several central banks would have collapsed without government-funded bailout programs.