Order Flow Boot Camp

What is a Market?

The World of Exchanges

With the Order Flow Boot Camp we want to give you the instruments and education to thrive in today’s globally connected financial markets. But before doing that, we need to establish the building blocks for your education. One of these building blocks is the comprehension of what exactly a market is. After all, we’re setting out to become traders: people that exchange something for another. Without markets, there would be no traders. Without traders, there would be no exchanges. So we’re going to understand how markets evolved and what they are today.

1. Markets 101

A market is one of the many varieties of systems whereby parties engage in exchange.

While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services (including labor) in exchange for money from buyers.

It can also be said that a market is the process by which the prices of goods and services are established.

What is a market

Former open air market in Bradford

Source: Bradford Markets

Markets are dynamic. This means that they are always changing. A business must be aware of market trends and evolving customer requirements caused by new fashions or changing economic conditions. A trader must be aware of the current trends, drivers and market dynamics in order to stay on the ball.

For a market to be competitive, there must be more than a single buyer or seller. Competitive markets, as understood in formal economic theory, rely on much larger numbers of both buyers and sellers. A market with a single seller and multiple buyers is a monopoly. A market with a single buyer and multiple sellers is a monopoly. These are the extremes of imperfect competition.

Markets come in all forms, scales (volume and geographic reach), locations, and types of participants, as well as the types of goods and services traded.

Some markets are physical retail markets, such as local public markets, farmers’ markets, street markets, flea markets, bazaars, and other public marketplaces; shopping centers and shopping malls.

There are also markets for intermediate goods used in production of other goods and services, labor markets, international currency and commodity markets, stock markets, etc.

Why is all this important for order flow traders?

We believe in building solid foundations before progressing to more complicated matters.

2. A historical perspective on markets

Now for the boring part. The development of markets was not linear, fast or organized. The period 1050 to 1330 saw a remarkable multiplication and spatial diffusion of formal markets and fairs throughout Europe, accompanying growing population, production, and exchange. Markets in this period are easier to identify in regions where they were a distinct franchise, such as England, and were consequently widely documented, than in areas where they were more closely entwined in a complex series of rights, such as Italy and southern France.

Complementing the rapid expansion of formal markets for local products between the twelfth and fourteenth centuries was a similar growth in the number of fairs providing outlets for longer distance and higher-value trade. Fairs were usually held annually, and as many had their origins in church festivals, the dates were often tied to the dedication of the local church.

As demand grew from the later thirteenth century, however, some of the high-value commodities became available through shops. Shops had higher overhead costs, but they offered a permanent site of exchange and a continuous relationship between the vendor and consumer.

The scope of markets expanded steadily from the fifteenth through to the seventeenth century. There were periods of rapid expansion, linked to the expansion of credit and the growth of international and interregional trade, but there were also periods of stagnation or contraction connected with wars, famines, and political instability.

2.1 A historical perspective on regulation

Regulation is a big thing nowadays. Since the Lehman collapse, regulators have been actively seeking to regain more control of free market forces. But this is nothing new. Douglass North described how institutions “structure incentives in human exchange” through the formal constraints of laws, regulations, and contracts, as well as informal constraints, such as social norms, customs, and moral values.

The institutional framework within which market exchange took place determined to a large extent the risks, opportunities, and costs of marketing.

The development of markets in medieval Europe between 1050 and 1330 was accompanied by growing regulation.

Market authorities sought to secure low food prices for consumers, prevent monopolies, and protect local privileges.

They restricted the location and timing of trading. Market authorities also attempted to regulate supplies and acted against those who attempted to restrict goods or fix prices. They prohibited the interception of goods before they reached the market, a practice known as forestalling, and they controlled the buying and then reselling of goods in the same market, a practice known as “regrating.”

The infrastructure of formal markets symbolized the political and economic power of a settlement and its government, and could range from a simple open space to elaborate covered buildings.

Many of the cultural ideas of medieval markets, such as the moral duty of traders toward the common good, together with many of the regulatory mechanisms, like the assize of bread, remained features of the early modern period.

E.P. Thompson identified the “moral economy of the crowd” in late eighteenth-century England, which was built upon medieval concepts of just price, fair profits, and mutual social responsibility. Middlemen were distrusted, price-raising opposed, and gains at the expense of the poor were condemned.

As market activity grew, the amount of information that had to be collated and processed increased transaction costs and encouraged the move to more efficient forms of organization.

Medieval markets were appropriate for the modest level of medieval trade, but that as the volume of trade expanded and the problems of bringing sufficient buyers and sellers together to generate a competitive price were reduced, a shift to markets was inevitable.

Markets enabled more transactions and larger volumes of goods to be exchanged at lower transaction costs.

3. Where did Wall Street come from?

In 1792, one John Sutton organized a securities exchange at 22 Wall Street.

Sellers would bring in their stocks and bonds each morning, and at noon Sutton would auction them for a commission. The changeover was rapid.

Sutton’s auctions lost their effectiveness because other traders began to free-ride on them. The interlopers would attend the auctions merely to observe the going prices, then they would hold their own sales, offering the securities at lower commission rates and taking business away from Sutton. This practice soon became self-defeating, as it meant too few securities were passing through Sutton’s auctions for the bids to be meaningful guides to the securities’ true value.

To solve this problem, 24 of Wall Street’s most prominent brokers agreed to form a new auction. They would trade securities at fixed fees. They would not buy or sell in other auctions but only among themselves. They formulated the rules governing how securities were brought and sold, and set up methods of contract enforcement and dispute settlement.

4. Where did the Futures Market come from?

A half-century before Sutton began his auction, rice merchants in Osaka, Japan, had already set up the world’s first futures market.

The idea of forward trading is said to have originated around 1620 when a Nagoya rice merchant named Chozaemon met a friend from Sendai, in the north of Japan. The friend reported the rice harvest in the north was going to be bad. Chozaemon promptly bought the future Nagoya-area rice harvest, paying the farmers 10% upfront and owing them the rest. After the harvest came in, he stored the rice for several months, selling it for a tidy profit once the north’s poor harvest had driven prices up.

5. The role of Information in markets

“The secret of business,” the shipping tycoon Aristotle Onassis remarked, “is to know something that nobody else knows.” The secret of efficient markets, conversely, is to enable information to flow.

In a competitive market, sellers should be rewarded for lowering their prices. This would occur if information were free. But when search costs lock customers in, sellers are penalized if they cut their prices. The cost of shopping around – even if it is small if compared with the value of the purchase – can limit competitive forces. The bottom line is that big effects can come from small transaction costs.

Information is the lifeblood of markets.

One partial solution to informational problems is repeat-businessrelationships. The shopper values the assurance against being cheated that the relationship provides, and the merchant wants to leave the shopper satisfied enough to return tomorrow. The relationships economize on search costs and result in prices being lower for repeat customers. Building channels for the flow of information, both to help buyers and sellers to get together and to allow buyers to verify the quality of what they are purchasing, is a major part of designing a market.

6. The role of prices in markets

Information flow helps generate informed exchanges and hence realistic prices.

Prices serve two main purposes in a market economy. First, they send signals.

A signal is a way to reveal credible information to another party.

Prices send signals to buyers and sellers about the relative scarcity of a good or service.

Second, prices provide incentives to buyers and sellers.

Generally, an incentive is anything that motivates action; an incentive can be either positive or negative.

Everyone remembers the classic movie “Trading Places”. In the final scenes, on the commodities trading floor, the Dukes (bad guys) commit all their holdings to buying frozen concentrated orange juice futures contracts. This was a signal. Suspecting the Dukes have inside information, other traders follow their lead and greatly inflate the price. Valentine and Winthorpe (good guys) begin selling futures at the higher prices, causing it to drop again when other traders do the same. They had some better information and took the higher prices as an incentive to act. When the real crop report is broadcast, the price of orange juice futures plummets. Valentine and Winthorpe buy back their futures at the lower price from everyone but the Dukes, reaping a huge profit. The Dukes fail to meet their margin call at the inflated purchase price and are left owing $394 million.

7. How prices are formed

Interaction between buyers and sellers determines prices in market economies through the invisible forces of supply and demand.

When a market is in equilibrium, the quantity that buyers are willing and able to buy (demand) is equal to the quantity that sellers are willing and able to produce (supply). The price at which supply equals demand at any moment is known as the market-clearing or equilibrium price.

At this price, sellers have sold all they want to sell and buyers have purchased all they want to buy.

To understand how and why prices adjust to the equilibrium price, let’s consider when the market price is not in equilibrium. When the market price exceeds the equilibrium price, the quantity supplied of a good will exceed the quantity demanded of a good. That is, there will be a surplus.

In this case, sellers must decrease their prices to get rid of their excess supply. Buyers will respond to this decrease in price by buying more of the good until the excess supply is gone and the market is back to equilibrium.

Conversely, when the price of a good is too low, a shortage will occur. That is, the quantity demanded of a good will be greater than the quantity supplied. In this case, more buyers will be willing and able to buy the good at the low price than there will be sellers willing and able to supply it. Sellers will view the shortage as a signal that they can raise prices; buyers will then demand less of the good or buy another, similar good instead.

A good example of buyers demanding less of a good is found in bookstores. With the advent of e-books, which cost less compared to paperbacks, people have started to cut back on the amount of physical books purchased and opt for the e-books instead. But the subsequent increase in e-books has caused a shortage of paperback sales. In response to this shortage, the book publishers are trying to cut costs or become more efficient, in order to compete with e-books.

Bottom Line: competitive markets are locations where parties engage in exchange.

They have evolved from simple barter to complex information communication networks that allow exchanges between buyers and sellers located anywhere in the world. Markets have evolved over time, and so has the regulation that governs them – even if honesty remains the best practice. Markets communicate important information: they form prices. Prices are a language that traders use to identify equilibrium prices and prices where supply and demand forces are out of balance. The flow of information cascades upon all of these exchanges generating incentives to act.

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