Financial Markets and Functions

Many traditional economies failed because they did not allow financial markets to work. But talk about financial markets, it is vital to talk about the financial system. The financial systems operate as economic boosters as it stimulates the economy. It influences the economic performance of different actors while affecting economic welfare. It works through financial infrastructure where the player with fund allocates the funds to individuals who can invest the funds. A financial system ensures a more efficient and easy way for funds transfer. It can also give rise to asymmetry problems and poor assigning of resources since one entity in a financial transaction may have much superior information but the other.

The structural approach suggests that there are three main components of the financial system: Financial markets, financial intermediaries, and; financial regulations. Each has a certain part to play in an economy. The financial markets, which are our focus in the article, act as facilitators of the flow of financial resources in financing investments in different entities. They serve corporations, governments, and individuals with financial institutions as the key players. Financial regulations are simple rules that govern participants in the financial system.

Financial market studies have become an important part of the modern economy. They are based on the capital market theory with a focus on financial systems in which interest rates and pricing of financial services is the main center of discussion. And before students are introduced to the subject, they must learn the most basic terms commonly used by economists in the financial industry. They include the following:

- Asset.

And asset is anything that carries durable value. In other words, it is any item that stands as a means to store value over a long time. There are different types of assets:

- Real assets.

These are tangible assets, like land, equipment, houses, and animals. It also includes human capital like natural abilities, learned skills, and knowledge.

- Financial assets.

As the name suggests, these are valuables stored in terms of money. They are claims against real assets, directly as in-stock share equity, or indirectly as in money holdings.

- Securities.

These are financial assets one can exchange in an auction or over-the-counter markets. They are distributed based on legal requirements and expectations as per the laws of a nation.

- Lenders.

These are individuals who have available resources in terms of money, above their possible expenditures, which they can loan out. The opposite is borrowers; individuals who have a shortage of funds required to meet their expenditures; hence, they need the loan. Borrowers try to borrow funds through the sale of claims against their real assets to the lender.

- Financial markets.

This is simply the market that controls the trading of financial assets. There are places where lenders meet borrowers, just like real markets where a producer of goods meet consumers. Hence financial market facilitates and controls borrowing and lending by initiating the sale by newly issued financial assets. They include markets like the New York Stock Exchange, the U. S government bond market, and the U.S. Treasury bill auction. And we have already talked about financial institutions, which are physical institutions that profit primary through financial transactions.

The Role of Financial Market and Institutions

As stated above, these are players in the financial industry that control monetary transactions. They control borrowing and lending as they allow the transfer of funds from one party to another. In other words, they give purchasing power to different agents involved in the transaction. This happens to facilitate either investment or consumption.

Financial institutions and markets are responsible for setting prices. They are the instruments through which players set prices for both newly issued financial assets and for the current stock of monetary valuables.

They form the link for information aggregation and coordination. If there is, for instance, changes in the price of a certain asset, the involved party must send or receive the information through these markets. They play as collectors and initiators of information about financial asset values and cash flow from lenders and borrowers. In other words, they can either prove or disapprove information about a specific asset.

Financial institutions also control risk sharing. They take charge of risk transfer from those who invest in those who offer the funds to facilitate those investments. This means they are responsible for shielding lenders against potential loss of their money by ensuring borrowers are held accountable for their actions.

Also, financial markets are responsible for the liquidity of assets. When borrowers, for instance, fail to honor their loans, financial assets holders can resell or liquidate the assets to recover their investments. They also protect borrowers from unlawful use of their assets by lenders.

Financial markets are also in charge of controlling transaction costs. By reducing transaction costs and information costs, they ensure efficiency in the industry.

Though the roles discussed are tied to the operations of financial markets, they are not all handled by one sector. There are different categories of financial institutions that work together to create a harmonious system of operation. And one must learn these players when trying to characterize the operation of financial markets. All these participants have various ways of fitting into the structure of the markets.

Major Players

Many economists look at financial institutions as bodies that take part in financial markets. This means they are responsible for the creation and exchange of financial assets. Without the, we would not even be talking about financial institutions.

There are different categories of financial institutions in different parts of the world. The following form the most common players:

- Brokers

When a buyer wants to acquire an asset from the seller, they may not be able to do directly. They need a middleman, someone who will help in the smooth completion of the transaction process, and a broker is that mediator. A broker is described as a commissioned agent or a buyer or a seller, who ensures trade by identifying the seller or a buyer, for the completion of the process.

A broker cannot have any position in the assets they trade. They don’t have any inventories in the assets. All they do is facilitate a meeting between the right buyer and the right seller, and vise versa. Brokers get their profits based on the commission they charge users of their services. An excellent example of a broker is the real estate of a stockbroker.

- Dealers

Dealers are more or less, just like brokers. They take charge of facilitating trade, whereby they find buyers and match then with asset sellers. They don’t take any part in the transformation of the assets. They only difference is that a dealer can and does ‘take position’ in the assets they trade. This means they maintain inventories in these assets because they are allowed to sell out inventory rather than only locating and matching buyers with sellers. In simple terms, a dealer holds the actual asset, and they can sell directly on behalf of the seller.

Also, dealers do not profit by charging commissions for the service they offer. Instead, they buy the asset at a relatively lower price, increase the cost and then resell and the new price. The profit comes as the current price less than the original price. This difference is called ‘bid-ask spread,’ and it represents the profit margin for the asset in question. Examples of dealers include car dealers, dealers in the U.S. government bonds, among others.

Investment banks

Investment banks play a vital role in ensuring proper control of assets. They help in the initial sale of securities that have been newly issued (Initial Public Offerings, IPOs), by handling several services:

- They advise corporations on bonds offering. They answer the questions of whether or not the bonds or stock should be issued. They also advise on bond issues on specific types of payments for the securities they provide.

- They stand in as guarantors for corporations’ prices on the products they provide. This means they handle underwriting, of either individual or by incorporating various investment banks. They create a syndical to underwrite the problem together,

- Investment banks work as sales assistances, where they help in the sale of securities to the public.

The top investment banks in the U.S. include Morgan Stanley, Salomon Brothers, among many others.

Intermediaries

Financial intermediaries take part in the transformation of financial assets. And this is the major difference that makes them unique from brokers, dealers, and investment banks. In a nutshell, they can purchase a specific type of financial asset from a borrower, for instance, a long-term loan contract, where its terms are in line with certain situations of the borrower and sell a different item to the saver, mostly a relatively tangle claim against an intermediary. For instance, an financial intermediary can but a mortgage from a borrower and sell something like a deposit account.

Besides, a financial intermediary can temporarily own a financial asset to stand in as part of their investment portfolio. They don’t just create an inventory for resale. These institutions profit from offering relatively higher interest rates to the borrower and paying lower interests to saves.

Financial intermediaries are the most common type of financial market in the world. They include Depository Institutions like commercial banks, savings and loan associations, mutual savings banks, and credit unions. There are also Contractual Savings Institutions like life insurance companies, fire and casualty insurance companies, and pension funds, among others. Last but not least, are investment intermediaries like finance companies, stock and bond mutual funds, and money market mutual funds, who mostly connect buyers to sellers of financial assets.

Types of financial market structures

There are four primary forms of financial market structures, which are determined by the cost of collecting and disseminating information. These structures include securities markets, some of which combine the characteristics of more than one of the categories. Consider the following

Auction markets

Auction markets are simply centralized facilities that facilitate trades between buyers and sellers in an open and highly competitive selling process. It works like a cleaning house, not necessarily a physical place, but any institution than enables a clear bidding process between buyers and sellers. There is centralized information about offers to buy, called bid prices, and offers to sell, called asked prices. This means they all come and are controlled from one place, readily available to willing sellers and will buyers. In this error where technology controls everything, computer networks have become very essential in auctions. Note that these markets don’t allow private transactions between parties.

An auction market can be simply described as a public market, where everything is open and available to participants. They can be call markets, like art auctions – the bids and asked prices are all called at once, or continuous markets, like stocks where the prices appear randomly and continually.

Over-the-counter markets

These are very common markets involving public markets with several dealers spread across a region. They can be spread across the world, and they involve the entire market as part of the asset. There is no centralized mechanism in these markets. The dealers themselves take control of posting the prices for assets and then prepare to sell or buy to or from another party who responds. Customers are exposed to more flexibility and choices than in the case with traders.

Intermediation financial markets

Think of these markets simply in terms of banks, like commercial banks and savings banks. They involve financial intermediaries who assist in the fund transfers from savers to borrowers. They do this by giving out specific types of financial assets to savers and taking different forms from borrowers. The financial assets given to lenders are simply claims against financial intermediaries. They, therefore, serve as liabilities on the side of financial intermediaries. On the other hand, the origination of the assets from borrowers, represent claims against the borrower; therefore, they are assets of the intermediaries.

Financial markets are vital in putting savings into more productive use. For instance, in a savings account, money does not just sit in the account; rather, it grows with interest. Also, they are responsible for determining the prices of securities and liquifying financial assets. They are, therefore, a vital part of the economy.  

Author: James Hamilton