Breaking Down the Stock Market: IPOs, SPACs, and Market Participants (part one)

This is a three-part series, see part two and three here.


Imagine the biggest outdoor market you have ever seen. Fruits, vegetables, prepared foods and handmade crafts everywhere you look. There is one big exception to this market that makes it unique, no goods are ever consumed. In this metaphor each vendor, represents a company on the stock market and each apple, vegetable or other good represents one share of that company’s stock. Here’s how the market works:


Entering the market:


Each time a new vendor comes to the market to set up their stand they may want to make sure there will be demand for what they are selling. If so, there are experts who help them determine what price they should charge for their goods. The vendor and these experts will also generate excitement about the goods that are about to come. The experts may even buy the entire lot of goods themselves and sell them to other parties. This process is called an IPO, and the experts are investment bankers (also called underwriters).


Now let’s say instead this vendor is confident that people are going to want to buy what they are selling. He/she wants to skip the use of ‘experts’ and simply show up and sell. This process is called a direct listing.


Lastly, there is another circumstance that someone at the market wants to set up a stand (imagine tables and an awning with no goods) without anything to sell. This person sells the idea of goods to people at the market and talks about how they are going to find goods that are top quality. This person then calls merchants not at the market to buy the entire lot of goods one of them has. Once purchased, these goods are automatically distributed to everyone who bought the idea of goods. This is called a special purpose acquisition company (SPAC).


Participants:


Other than the investment bankers and public companies talked about above, here is who is at the market.

  • The SEC: think of them as the rule makers of how the market works and how the vendors must operate from day one

  • Regulators and financial service firms: these are the police that use the rules (set by the SEC and others) to monitor what is happening. They usually specialize in one function, for instance some might inspect the goods for quality, while others make sure specific parties at the market are playing by the rules

  • Institutional investors (two sub categories):

  • Asset managers: these are people at the market that are buying or selling on behalf of a larger group of customers. Think of these as the Amazon fresh delivery guy who is buying groceries on behalf of 5 different people at one time. The idea is that they will inspect the goods for quality before buying so each individual doesn’t need to. Examples are mutual funds, ETFs, pension funds and hedge funds.

  • Other institutional investors: includes endowments, banks, brokers and companies that are trading on their own behalf (for example tesla buying/selling bitcoin on its own behalf).

  • Market makers: imagine a gigantic robot whose sole job is to create as much market activity as possible. Market makers use algorithms to perform legal arbitrage. For example, they might offer to buy 100 mangos at say $5 each and sell at $5.05 making an instant profit of $0.05 per mango bought and sold. Best case scenario there are 100 customers who each want to buy a mango at $5.05 and another 100 who want to sell a mango at $5. If so, they instantly make $5 ($0.05 x 100) in profit, also called ‘the spread’. This is allowed because often, there will be 50 customers who want to buy a mango at $5.05 and 100 customers who want to sell at $5. If the demand for mangos suddenly falls to $4, the market maker is stuck holding 50 mangos that are now worth $4 each.

  • Retail investors: you and I. These are individuals buying goods on their own behalf.

  • Broker/dealers: imagine trying to figure out who in the market was selling mangos at the cheapest price. Then having to find that person in the market so you could make the exchange. Broker/dealers represent institutional and retail investors in the market to find the best deal for the goods they want and go and collect the goods on their behalf. They also keep those goods in safe keeping until that same investor wants to sell. The largest brokers in the US are Fidelity, Charles Schwab, Wells Fargo, and TD Ameritrade.

  • Exchanges: these used to be actual physical locations (imagine the market itself). I think of this scene from Trading Places. They essentially enable the infrastructure to safely and efficiently buy and sell goods. The two main U.S. exchanges are the NYSE and the NASDAQ.