“Wall Street is a street running west to east from Broadway to South Street on the East River in Lower Manhattan in the financial district of New York City. Over time, the term has become a metonym for the financial markets of the United States as a whole, the American financial sector (even if financial firms are not physically located there), or signifying New York-based financial interests.” —Wikipedia

If you have ever wondered how Wall Street works, this is the closest explanation you can find.

Originally shared by Tikhon Jelvis on Quora in response to the question: How does Wall Street work?

This is at once a very complicated and a very simple question. So let’s go for the simple version :).

Wall Street is largely based on a single idea: markets. A market is just a system for buying or selling something, and that’s all people on Wall Street do: buy and sell. In a sense, they’re like the merchants of yore, except that they don’t usually even deal with shipping!

So what do they buy and sell? Well, a market can exist for anything–and there’s probably a trader somewhere trading on it! But the main thing people work with are contracts. A contract is just a promise to do something. This allows people to trade all sorts of things without always dealing with the physical details of a transaction. Here are a few examples:

  • Stocks: A stock is a contract representing partial ownership of a corporation. You own a “piece” of the company and usually have a (very small) say in how it’s run via voting rights.
  • Bonds: A bond is essentially a loan that can be bought and sold by its creditors. When the government wants to borrow money from the population, it issues bonds: it sells some number of contracts for $x, promising to pay $x+y ten years from now. The original person to buy a bond can sell it to somebody else later on–ten years from now, the government will pay whoever owns the bond, not the person who originally bought it.
  • Futures: A future is a promise to buy or sell something in the future, at a price that’s set now.

There are lots of other contracts–these are the simplest, just to illustrate what a contract is. And, very importantly, what a contract isn’t: it isn’t a physical good; it’s just an abstract agreement.

So, traders are just like merchants: they buy something from one person and sell it to someone else. Except they don’t actually physically ship anything. And they don’t even trade in physical things–they trade in promises and promises about promises. So what’s the point?

Essentially, financial markets like this exist for the purest economic reasons: determining how to allocate scarce resources. We only have a finite amount of most things, so how do we decide who gets what? It is very important that our system for making these decisions is decentralized, unbiased, hard to control for any individual or group and efficient. We need a system that lets people with different priorities and needs coexist and come as close to satisfying these priorities as possible.

In essence, a market is exactly this system.

You can think of the whole resource allocation problem as being an incredibly gigantic numeric optimization problem. A market is a system that can approximate solutions to this problem by harnessing the reasoning powers of everybody trading on the markets–largely Wall Street.

In essence, the main role of Wall Street is to figure out who should get what in our society. Of course, this task is too difficult for any one person or group! Moreover, if any group had too much control over the whole system, they could abuse it to their own advantage rather than helping everyone. This is why the problem is solved using basically distributed computing just like Folding@Home or SETI@Home–each individual firm and trader only works on a small part of the puzzle at a time.

One of the main things most Wall Street firms do is fundamental research. They look into various technologies, commodities and companies to figure out who’s going to need what in the near future. If they’re correct, they can trade on that information and make money. But the trick is that they can only ever make money if somebody else is willing to take the other end of the deal–which will only happen if the research was correct.

So the most fundamental task of Wall Street is probably price discovery. Figuring out how much things should cost.

Of course, in real life, everything is much more complicated. For example, many firms don’t actually trade based on the fundamentals of an asset–instead, they may provide liquidity. Essentially, this just translates to matching up buyers and sellers even if they are in different locations, operate on different markets or just want to buy/sell at different times.

Firms also buy and sell risk. In essence, many financial contracts are actually used by companies as insurance. In this case, Wall Street firms either take on the risk themselves (acting basically like an insurance company) or help match people who want to take opposite sides of a contract. This creates a decentralized insurance system which is actually more transparent than normal insurance companies because everything can happen on public markets.

Banks also specialize in loaning money to people. This is perhaps one of the oldest financial services. This involves evaluating people and businesses based on how likely they are to repay their loans.

If you really want to understand what’s going on, you pretty much have to take an economics class or at least pick up an economics book. I hope I gave a good intuitive understanding, but I’m definitely glossed over many important points–and I’m not even sure everything is correct! Either way, there’s far too much to fit into a single Quora answer.

Image courtesy, Jason Laboy photography