Introduction to financial markets: What are markets, and why do they exist?

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How do the financial markets work?

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Markets have been around for centuries as buyers and sellers came together to exchange goods. Originally, market participants traded in person, but today most financial trading is done electronically. Still, the concept remains the same: Two or more parties decide on the value of an asset and make an agreement to exchange a good for money or barter.

Markets can be as familiar as haggling over the price of apples at your local farmers market or bidding for an antique dresser on an auction website. They can also be difficult to understand, especially if you’re new to the financial markets. Consider, for instance, all the recent hype around cryptocurrencies or the complexities of trading options.

If a product exists, you can be almost certain it’s traded in a market somewhere.

Markets allow the exchange of goods, services, or other valuable assets between two or more parties. Most markets evolved as an exchange of goods for money at an agreed-upon price, but not all exchanges involve legal tender. Bartering remains common, with two parties agreeing to trade one good or service for another.

There are market parallels to everyday life. Negotiating is often part of markets, even informal ones.

Markets help establish the price of goods, services, and other assets. At least two parties are needed to trade, and three or more parties help to spur competition. Competition helps with price discovery, which is the process of determining the price for an asset. When more people participate in a market, it’s considered more liquid, and the determined price will have more influence.

For instance, crude oil futures that are electronically traded at CME Group’s (CME) NYMEX by thousands of participants each day set the accepted benchmark price for U.S. crude oil. That benchmark is used as a reference point for crude oil that’s changing hands in local markets across North America and the world—from drilling operations and refineries, all the way to the gas prices at your local station.

Supply and demand—and expectations for future supply and demand—have always been and remain the basic price-setting principles. Sellers supply an asset, whether it’s corn, cars, stocks, or bonds. Buyers create demand by bidding for the supply. High supply often leads to lower prices, while tight supply usually means higher prices. If, for instance, floods ruin millions of acres of corn, prices tend to rise amid short supplies. If it’s a perfect year for the corn crop and more bushels end up in grain elevators than the market needs for processing, the price is likely to fall.

Just as there are many assets to trade, from corn to crude to antique dressers, there are lots of ways to trade them. Here’s a rundown of some types of markets where price discovery takes place.

Auction markets. In auction markets, buyers and sellers meet to exchange money for goods in a structured exchange. Listed financial exchanges, such as stock markets or commodities markets, use the auction process to match the bids and offers of buyers and sellers. The U.S. Treasury also has daily and weekly auctions to sell government notes and bonds to fixed-income buyers. Wall Street is probably the first place you think of when it comes to “auction” markets; legend has it that trading there began under a buttonwood tree in 1792.

Outside of financial markets, there are other auction markets, such as those for art, wine, livestock, foreclosed homes, or a number of other assets sold at a central location, either a physical space or online. In the 20th century, Chicago became the center of the world for agricultural futures trading in a system that allowed farmers and processing companies to offset (i.e., hedge) their price risk on future prices for crops and livestock. Nowadays, a high percentage of futures market activity is in financial products such as stock indexes, Treasury securities, and foreign exchange.

Over-the-counter (OTC) markets. Unlike structured markets, OTC markets use broker-dealer networks that exist outside of an exchange to trade securities. Dealers quote prices at which they will buy or sell securities to other dealers or customers. Deals can be negotiated by phone, email, messaging services, or through electronic bulletin boards.

Several types of securities are available OTC, including stocks, bonds, currencies, cryptocurrencies, and derivatives (whose value is based on an underlying asset).

But most trades in stocks, bonds, commodities, and crypto are matched on exchanges or other trade execution platforms—a modern but much faster version of an auction market. A few decades ago, before the advent of electronic trading, trades were matched on exchange floors through an “open outcry” process. While some exchange trading still occurs via open outcry, the vast majority of transactions are done electronically.

Stocks and bonds trade through both primary and secondary markets. For stocks, the best-known example of a primary market is when a private company goes public with an initial public offering (IPO). This is the first time the company offers stock to outside investors, and it’s a chance for investors to buy securities from the bank that completed the initial underwriting of the stock.

Bonds are also available on the primary market. New debt issuance offered directly from a company or a government is considered a primary market offering.

Once a company issues stock, the shares trade in the secondary market between investors on a listed exchange. A secondary market is also available for bonds. Bond holders can hang onto their debt instruments and receive par value at maturity (if there is no default), or they can sell the bonds to other investors.

Markets help people and entities set prices for a variety of assets. The financial markets have different purposes depending on what you’re trading. Price discovery can happen through auction processes or over the counter.

These basic market principles—how they work and why they’re essential—lay the groundwork for understanding how a market-based economy functions. If you’d like more on the topic of market structure, you might start with a look at the different market participants or the importance of robust market regulation.