How Wall Street works

Wall Street is often thought of as both the symbol and geographic centre of American capitalism. Symbolically, Wall Street refers to all the banks, hedge funds, and securities traders that drive the stock market and the whole American financial system. Geographically, Wall Street is the centre of Manhattan’s Financial District. It runs east/west for eight blocks from Broadway to South Street.

Wall Street includes the stock market, bond market, commodities market, futures market, and the foreign exchange market. The original purpose of the securities market was to raise funds for companies to grow, be profitable, and create jobs. Securities trading has become so profitable in and of itself that trades have been established for just about anything you can think of, and a lot of things you could never imagine.

What changed Wall Street? For one thing, the abolition of the Glass-Steagall Act in 1999. This allowed any bank to use depositors’ savings to invest in complicated securities called “derivatives.” They based their value on different types of loans, including credit card debt, corporate bonds, and mortgages.

Deregulation was one reason for the 2008 financial crisis. The derivatives based on mortgages were called “mortgage-backed securities.” They were guaranteed by another financial innovation called “credit default swaps.” All of these were traded successfully on the secondary market until housing prices started to fall in 2006. The underlying mortgages started to default, and no one knew how to price the mortgage-backed securities. There were so many defaults that the companies, like AIG, who guaranteed the debt ran out of cash.

Wall Street panicked, global stock markets dropped, and banks stopped lending to each other. The only thing that stopped the panic was the federal government bailing out Wall Street with the TARP program in 2008, and restoring confidence with the Economic Stimulus Package in 2009.

The stock market crash of 1929 kicked off the Great Depression. It started on Oct. 24, 1929, a day known as Black Thursday. It worsened on Black Tuesday when the Dow lost all the gains of the year in just a few hours. Wall Street bankers had failed in trying to stop plummeting stock prices.

Many individual investors had put their life savings into the stock market. When they got wiped out, they lost confidence in Wall Street and the American economy. Others withdrew all their savings from banks, which then collapsed. Many people felt that Wall Street was the economy. It was only massive government spending on the New Deal and World War II that revived economic growth.

In 2010, Congress passed the Dodd-Frank Wall Street Reform Act to prevent another financial crisis by giving the federal government more oversight of Wall Street. For example, non-bank financial firms like hedge funds were required to register with the Securities and Exchange Commission and provide information about their trades and total holdings.

If any financial firms got “too big to fail,” Dodd-Frank’s Financial Oversight Committee would recommend they be regulated by the Federal Reserve.

Dodd-Frank required that the riskiest derivatives be regulated by the SEC or the Commodity Futures Trading Commission. It asked the agencies to set up a derivatives clearinghouse, like the stock exchange, to make these transactions more transparent.

The Balance