Wall Street: A Beginner’s Guide for Liberal Arts Majors: Origins and Function
November, 10 2016
If you are at all like me and studied what you were “passionate” about in college then this brief business lesson may be just the thing you are looking for, or not. But in the off chance it is, and in an effort to try and better understand the throngs of scandals, recessions, depressions, and protest movements held in Wall Street’s honor I give to you Wall Street: A Beginners Guide. Please enjoy.
In order to understand what is now, it is important to understand what has been. Wall Street got its start, not unlike many of the other less famous streets in America. It was a semi-regularly traveled byway partially used to connect the East River to the Hudson ports in what is now lower Manhattan. The midpoint along the route served as a trading post where early merchants bought and sold everyday items including fur, molasses, and other items that no one uses anymore. In 1789 Congress met in a building on Wall Street to doll out $80 million in government bonds to help absorb the cost of the war. (In an ironic twist The Street that has nearly sent us back to the Stone Age on multiple occasions actually helped us pay for our independence.) Two years later bank stocks were added, and there were now securities to be traded, but still no formal market or house of business.
Local merchants on or near Wall Street (think Smith’s Blacksmith Shop or John’s Deli) would keep a list of securities to be bought or sold “over the counter” right next to the tasty bottles of molasses and adjacent from the wool winter jackets. It wasn’t until 1792 that a group of Wall Street leaders met to establish a regulated market which would soon become the New York Stock Exchange. The early days of the NYSE required a $400 ticket for the privilege to trade stocks. In fact the term “owning a seat” is still used today on the NYSE although the price to become a member ranges from $4,000 to over $2 million.
Now that we understand a bit about the origins of Wall Street, what actually happens there is another issue entirely. The easiest way to understand at least one facet of Wall Street is to view a young, start-up company’s dealings with the financial sector. Coding genius George has just created the world’s next big app called Instoogle Force. George has seen some nice early adoption and has some meaningful numbers to back up his company’s story. Now George is at the point where he believes in his company’s product, wants to expand,(maybe hire more talent, move into a new office space, buy more ping-pong tables, etc.) and he needs the finances to do so. George has a couple of options in his pursuit of equity financing. He can search for funds through a private equity or venture capital partner, secure funding through a bank loan, find an angel investor, or if the company has grown large enough consider an IPO.
Now it is important that we pause here to address an important fact. The term Wall Street is merely a moniker to describe the broader world of high finance. The takeaway here is that a few of these options, like small community banks, angel investors, and perhaps even venture capital firms may or may not encompass what has come to be known as Wall Street. For the pros view on this matter click here.
Getting back to Instoogle Force, the company now has two general options to gain the money it needs. Those two options take the form of a debt financing round or an equity financing round. Debt financing, in its most basic terms is a loan or bond that will be paid back in full plus interest (think home mortgages or car loans). Equity financing, on the other hand, provides a lump sum of money in return for partial ownership in the business. Examples of equity financing include venture capital funds or even IPOs. See a live example of equity financing here.
Seeing that this is an article on how Wall Street works, let’s take Instoogle Force down a more traditional Wall Street path, the IPO. Instoogle Force will need to connect with an investment banker who is affiliated with an investment bank (think Goldman Sachs, JP Morgan, Morgan Stanley). The investment banker will guide the company into the marketplace like a hungry man guiding a heavy lobster to the boiling pot. In order to “go public” Instoogle Force will be required to sell some of its previously private shares of owners equity. For a detailed description of how this works please see an excerpt from Investopedia below.
George, the owner of Instoogle Force, gets in touch with Jose, an investment banker working for a larger investment banking firm. George and Jose strike a deal wherein Jose (on behalf of his firm) agrees to buy 100,000 shares of Instoogle Force for the company’s IPO at the price of $24 per share, a price at which the investment bank’s analysts arrived after careful consideration. The investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate paperwork, begins selling the stock for $26 per share. Yet, the investment bank is unable to sell more than 20% of the shares at this price and is forced to reduce the price to $23 per share in order to sell the remaining shares. For the IPO deal with Instoogle Force, then, the investment bank has made $2.36 million [(20,000 x $26) + (80,000 x $23) = $520,000 + $1,840,000 = $2,360,000]. In other words, Jose’s firm has lost $40,000 on the deal because it overvalued Instoogle Force.
As you can see from the example, the investment banker’s skill comes from crafting an accurate valuation of a company so that their firm will be able to make more money selling Instoogle Force’s shares to the public than they bought initially from Instoogle Force. A task that Jose has failed on in this example, and will likely not be able to call himself an investment banker for much longer. Hang in there man.
During Instoogle Force’s IPO, the securities were created in what is known as a primary market. The primary market is where the investment bank will float stocks for the first time (much like Jose in the example), and compile several prospectuses which detail pricing, restrictions and benefits and are provided to investors who first purchase the security. The main point to understand about the primary market is that the shares are purchased directly from Instoogle Force.
The secondary exchange, or more commonly referred to by laymen as the “stock-market” differs from the primary market because securities are traded amongst investors without the involvement of the parent company. For example, Instoogle Force will have no involvement in one investor buying Instoogle Force shares from another investor once in the secondary market.
The secondary market is broken up into distinct parts which are generally referred to auction or dealer markets. An auction market, such as the NYSE, is a place where buyers and sellers meet publicly to negotiate over deals. In the auction market natural prices occur through these public meetings. A dealer market differs from an auction market in that parties are not meeting in a centralized location and are usually connected via the internet or phone lines. In this type of market a dealer will “make a market” by providing a list of prices for which they are willing to buy or sell a security. The market price for any given security will then, theoretically, be created from competition amongst buyers and sellers. The best example of a dealer market is the Nasdaq exchange.
Another term that is thrown around a lot in regards to secondary markets is the Over-the-Counter Market (OTC). This market has it’s origins from the original Wall Street stores (remember Smith’s Blacksmith Shop?) that used to sell securities “over the counter.” This type of market is considered a dealer market as investors did not need to meet in a centralized location, but could buy and sell securities through dealer networks. In 1971 the National Association of Securities Dealers (NASD) was created to provide a more formal exchange for these dealer networks and is what we now refer to as the Nasdaq exchange. Today, any stock that is not traded on a major exchange, ie Nasdaq, NYSE, etc. is considered an “over-the-counter” stock and is the favorite financial vehicle of Wolf’s of Wall Street far and wide.
If after this brief lesson on the workings of Wall Street you find yourself thinking “I’m not a business owner, why do I care about this stuff,” or perhaps “I never want to become a financier why should I care about the difference between an auction or dealer market,” or finally “what is molasses, and who still uses it anyway,” be sure to tune in to the second installment of Wall Street: A Beginner’s Guide for Liberal Arts Majors: Part 2 to understand better how Wall Street affects everyone’s lives.
**Much of the early Wall Street history was taken from Understanding Wall Street 2nd Edition by Little and Rhodes, and is a very good book to understand more about how Wall Street functions.
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