Why Markets Exist
8 min read
A financial market is a mechanism for bringing together parties who want to exchange assets for money, and its existence is not an accident of history but a solution to specific economic problems. Understanding what those problems are explains most of the structure this course describes: why order books look the way they do, why intermediaries exist, and why liquidity is a service someone must be paid to provide.
Gains from trade
Trade happens because the same asset is worth different amounts to different holders. A founder whose wealth is concentrated in one company values a marginal share less than a diversified pension fund does; a farmer values certainty about next season's grain price more than a food producer values it. When an asset moves from someone who values it less to someone who values it more, both sides are better off, and the difference in valuations is the surplus the trade creates. Markets exist to find and complete these trades at scale.
Many trades exchange risk rather than assets as such: one party pays another to bear uncertainty they do not want. Hedging, insurance, and much of derivatives activity are risk transfer, and the premium the risk-bearer earns is the price of the service.
The centralisation argument
Without a central venue, every buyer must search for a seller bilaterally, negotiate a price with limited information about what others are paying, and bear the risk that the counterparty fails to deliver. Search costs grow quickly: participants trading bilaterally face possible pairings to explore, while a central market gives each participant a single point of contact.
Search costs, counted
A hundred participants: 4,950 possible bilateral relationships versus 100 connections to one venue. Centralisation converts a quadratic problem into a linear one.
Centralisation also concentrates information. When all trades print in one place, every participant can see the prices at which exchanges actually happen, and the market produces a public reference price as a by-product. That function, price discovery, is the subject of the next lesson.
Liquidity as a service
The ability to trade quickly, in size, without moving the price much. A liquid market lets a seller find a buyer at a fair price now, rather than waiting for the coincidence of a natural counterparty arriving at the same moment.
Natural buyers and sellers rarely arrive at the same instant wanting the same size. Someone must bridge the gap in time: stand ready to buy when a seller arrives and sell when a buyer arrives, holding inventory in between. That bridging is a service with real costs and risks, and the parties who provide it, market makers, are compensated through the spread between their buying and selling prices. A large fraction of this course is an account of that business.
A holder values a share at 98 (their reservation price); an investor values it at 103. Any price between those bounds completes a trade that creates 5 of surplus, split by the price: at 100, the seller gains 2 and the buyer 3.
A market's throughput of surplus depends on how many such pairs it completes and how little of the surplus is consumed by the costs of trading: spreads, fees, and price impact. The efficiency of a market is measured in exactly those terms.
Quick check
Fifty participants could in principle trade bilaterally. How many distinct pairings is that?
Quick check
A seller's reservation price is 97 and a buyer's is 105. They trade at 100. How much surplus does the buyer capture?