Why stock markets exist and how they work
All the basics to get you up to speed with the stock market
There are two kinds of people in this world: those who look at the stock markets as a money making machine, and those who look it as a money destroying machine. While these people aren’t necessarily wrong, their perspective on the markets is rather narrow.
Stock markets are more than just wealth creating or destroying machines, instead, they’re opportunity machines.
They provide all sectors of a country with opportunities. Opportunities for businesses to grow, governments to earn more revenue, people to find better employment, and countries to develop.
That’s all rather great, isn’t it?
But have you ever wondered why the stock markets exist in the first place?
So, why do stock markets exist?
Everybody always only talks about how to play the markets and how to make money off of them, but, rarely does anybody talk about why they exist and their significance. To understand the reason behind their existence better, let’s embark on a journey, following the life of a small fictional company, Country Coffee.
I get it, it’s not the most creative name that I could come up with, but it’ll get the job done.
Country Coffee was founded in 2014 by two college mates, Ramesh and Suresh. They were really into coffee and running their own business, so, a few years after graduating, they decided to buy a coffee estate and manufacture their own blend of coffee.
They bootstrapped their operations, bought a small coffee estate and factory in Karnataka, and within two years, they had built a base of raving fans, who loved their coffee more than anything else. After seeing this response, Ramesh and Suresh were confident that their coffee had something special about it, and, wanted to take it to more people. They planned to expand to the neighbouring states of Tamil Nadu and Kerala.
But, expanding a business is easier said than done. To be able to sell to more people meant that they would have to grow more coffee, process more coffee, transport more coffee, and market more coffee. And all these growing operations need money.
And they had two ways to get this money: take a debt, or, find investors. If they took on a debt, then, they would be burdened with making regular payments to the bank and also lose money in way of interest. But, if they found people who are interested in the company and willing to invest, then, Ramesh and Suresh could sell off some of their stake in exchange for money and mentorship. What makes this option more appealing is that, even though they’d be giving up a part of their stake in the company, they’d be getting a more flexible infusion of capital, unburdened by periodic payments.
After a lot of deliberation, they decided to go ahead with private investment. Up until that point, Ramesh and Suresh owned 100% of the company, but, after getting investors on board, they owned a smaller share.
Fast forward 5 years, Country Coffee has successfully expanded to five nearby states, and wants to grow once more. This time around, they’re eyeing the entire nation. Back then, in 2016, Country Coffee was a small company with small needs, their requirements for capital could be met with money from a handful of investors. But not anymore. Their ambitious plans require a huge amount of money. Amounts so huge that it wouldn’t be feasible to find those many private investors or take on debt.
So, what does Country Coffee do now?
They go big, by going small.
Now what does that even mean?
Instead of going to a couple of big private investors, as they did previously, Country Coffee would go public. They would be seeking investment from a huge number of small private investors, who’re people like us.
But how do they find so many investors? How do they manage all their money? How do they manage their stake?
If only there were a platform that seamlessly addressed all of this.
Well, there is one.
And, you guessed it. The stock market.
All that Country Coffee has to do now, is with the help of the market, offer some stake in their company to these private investors.
The company gets the money it needed, and the investors get an opportunity to grow their money.
And, that is why stock markets exist.
What is a stock market?
Just like a regular market, stock market is a logical entity. It represents a collection of buyers and sellers, along with the intermediaries that enable these transactions.
More on these components, below:
Stock Exchanges
Just a few lines ago, you read about Country Coffee and its plans to go public. What this essentially meant is that the company would seek investment from the general public, in exchange for shares. And once the shares were sold to investors, the company would get its money, and the investors their shares, which would be traded further.
I imagine you can see where I’m headed with all this: the stock exchange. The stock exchange forms the hub for all these activities. There are two major stock exchanges in India, National Stock Exchange(NSE) and Bombay Stock Exchange(BSE).
It manages everything from the initial offering of shares to them being being bought and sold by traders on a day to day basis.
Quite an important component, this.
Buyers and Sellers
These are people like us and organisations, foreign and local, who buy shares, hoping to sell them for a profit.
There’s a lot more to trading than just buying and selling, but more on that later.
There are other intermediaries that form important links in this chain, which you can better understand via the process of making a simple trade.
Making a trade, simplified.
Step 1: Get a Demat account
If you want to trade in stocks, then a Demat account is one of prerequisites. It forms the container which holds the securities that you buy and hold. And, consequently, when you sell you securities, they’re moved from you demat account to the buyer’s. There are 2 demat account providers in India, NSDL(National Securities Depository Limited) and CDSL (Central Depository Services Limited).
Step 2: Find a Stock Broker
A stock broker is someone who buys or sells stocks and securities on your behalf.
Initially, this was all done manually by people, but, in 2021 you just go to the broker’s website and place an order to either buy or sell. After the trade is executed, the security traded is either moved into your demat account or moved out of it, depending on the action. There are various stock brokers like-HDFC Securities, Zerodha, SBI SMart, Groww, Upstox, etc. You get the idea.
And when you open an account with a broker, they configure your Demat account as well.
Step 3: Placing an order
Let’s say you want to buy 100 shares of Country Coffee, which are currently priced around Rs.50 apiece. So, you go to your broker’s account and place a buy order for 100 shares of Country Coffee. You can either set a price at which you’d want to buy, or just buy it whatever the current market price is.
Step 4: Ordermatching
Once your order has been placed, it’s the broker’s job to find a seller who’s willing to sell you at the price you want.
The broker then heads to the stock exchange and submits your order. And once the exchange finds a compatible seller, your order is executed.
This order matching happens digitally, via computers.
Step 5: Settlement
Once the trade has been executed, the money is moved from your account to the seller’s account, via the brokers, and similarly, the stocks are moved from the seller’s demat account to the buyer’s.
This was a very basic picture of how trading works, but, enough to get you started.
Have you made your first investment yet?
If not, read the series of articles covering everything from why you should invest to how you can get started.
Are your parents not cool with you investing in stocks?
This story might explain why.
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To empower you.
Because, we understand the impact that the knowledge of a new tool or skill can have on somebody’s life.
And, financial literacy is one of those tools. It holds the potential, if harnessed, to change the entire course of a person’s life. Which is why we are working towards making the conversation around it more fun and engaging so that we can empower as many people as we can.
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