Video Transcript
Overview of Financial Markets
Broadly defined, financial markets are the systems through which financial transactions occur. They don't have to be in a specific location, although some - like the New York Stock Exchange - partially are. All that is required for a financial market to exist is a buyer, a seller, and a financial asset, such as a bond, stock, or contract, that the buyer and seller want to exchange. When most people think of stocks and financial markets, the picture of Wall Street and electronic tickers probably comes to mind. A few might know that Wall Street has been a central location for many financial markets since the 1700s.
The earliest example of a financial market were the banks and lenders in early 14th century Europe. These markets operated before the idea of stock, the partial ownership of a company obtained by buying shares. For early banks and moneylenders, the financial markets were all debt-based. They would give loans to governments and individuals, then they would buy, sell, and trade the repayment of the loan.
Early Money Lending
How did money lending work long ago? Consider this example: if a moneylender loaned a merchant in Venice 1,000 lira, the agreement might be for the merchant to pay the moneylender back 1,100 lira. The terms might be 50 lira a month for the next 22 months. After collecting 650 lira over thirteen months, maybe that moneylender needed some cash and couldn't wait the remaining nine months for the other 450 lira. In the financial markets of the day, another moneylender or bank might buy those future payments at a discount. Let's say 420 lira.
The first moneylender loaned 1,000 lira and got back 1,070 (650 from the merchant and 420 from the new moneylender). That's a profit of 70 lira for him. The second moneylender will receive the remaining 450 lira. He only paid 420 lira for the right to receive those payments, giving him a profit of 30 lira. When it's all over, the merchant got the cash they needed, when they needed it.
Imagine thousands of transactions like this going on constantly with many buyers, sellers, and borrowers. That is what the first financial market looked like. These early transactions were based on debt. They fundamentally set the structure for numerous market participants to help each other out and make money while doing so.
Stock: Risk vs. Reward
In the 15th century, global exploration and advances in nautical travel led to an increase in the number of explorers hopping on a ship and setting out to seek fortune. While the fortunes did exist, they were neither easy nor cheap to obtain. Rarely could a single individual finance the cost of a ship, a crew, and everything else it took to make a risky venture that could potentially result in a lost or wrecked ship. The potential reward was enormous, but so was the risk.
Nothing spurs people to innovate like money. It didn't take long for trading companies to gather groups of individuals together, have them fund a voyage, and then share the bounty when - and if - it returned. With that, the idea of partial ownership and shared risk/reward, established the practice of issuing stock. As more companies issued stock, it became necessary to have a centralized, physical location where shares could be bought and sold, and dividends collected. Dividends are the payments from profit paid out to shareholders, proportionate to their percentage of ownership.
Learning Through Trial and Error
If money spurs people to innovate, easy money makes people revolutionize. That's exactly what happened when the idea of starting companies with other people's money, through stock, caught on. Wiley and less-than-honest market participants started offering shares of companies that really wouldn't make a profit. The 'founders' of the companies would then keep the money people paid for their shares and not worry about making a profit.
You'd like to think investors would be smart enough to avoid these scams, but with stories of the 'easy money' shareholders in the trading voyages made, the mania of financial markets was born. Investors were even willing to buy shares of companies that had such 'secret operations' (they were often told no information about the company). Before you think about how foolish people were 500 years ago, don't forget these scams continue today.
Stop, Rethink, and Try Again
By the mid-1800s, financial markets that involved stock had become so rigged they were made illegal by British and American governments. Not until Parliament and Congress were able to establish governing agencies, such as the Securities and Exchange Commission, the SEC in the United States, were companies able to issue shares again. With laws and controls in place to protect shareholders from deception and cheating, financial markets were reestablished and again began to thrive.
Within a hundred years, technology had advanced to where financial markets no longer needed a physical location, although most still maintain a trading floor. Financial markets like the NASDAQ were established and created. They rely on technology to connect buyers and sellers and execute trades across the world.
Lesson Summary
The present day structure of financial markets, such as the all-electronic NASDAQ, has not always been the norm. Until regulatory agencies like the SEC were established in the mid-1800s to protect investors from criminals selling fake stock, many governments outlawed financial markets, or at least the ones involving stock.
Before the regulation and greedy frauds, financial markets brought together investors to buy stock, or partial ownership, in a trading voyage that could pay large dividends. Historically, these markets also encouraged the lending of money by providing lenders a way of getting their money back, rather than waiting for the full length of the loan to expire. These earliest financial markets were exclusively debt-based. Capital markets took over 700 years to develop and mature into what they are today.
