The function of financial markets

The function of financial markets in the economy

A market is a place where supply for a particular good is able to meet demand for it. In the case of financial markets, the good in question is money.

In capital markets, supply agents are those with "positive savings capacity", i.e. mainly households (surprising as that may seem!), and businesses, although the latter generally prefer to reinvest profits or distribute dividends to shareholders. The demand side comes from governments, the modern welfare state having substantial cash requirements, or other companies. Such agents are said to have "financing requirements".

Far from being an abstract entity, often described as both irrational and all-powerful, capital markets are in fact a driving force in the economy since they are places where the fuel, money, is made available to propel the machine forward, in other words generate wealth.

This is the concept, but in practice of course the mechanism is a little more complex.

The first difficulty resides in the fact that an exchange actually needs to take place between agents with savings capacity and agents with financing requirements. For a market to function, it is not enough that a good and its supply and demand exist; agents also have to want to trade it! However, agents with savings capacity, mainly households it should be recalled, are generally deeply averse to risk. An aversion furthermore which can be justified by common sense. Any book on the stock market for budding investors will begin with a warning urging readers to only invest funds in the stock market that will not be needed in the near future. Consequently, the bulk of savings generated by households are held on deposit in demand accounts or savings accounts where money is immediately available.

In contrast, agents with financing needs, i.e. businesses, need to find long-term financing for development. The time horizon of agents with savings capacity is typically a few weeks (next pay day) to a few months (next tax payment date ...). The time horizon of agents with financing requirements is several years! This difference makes actual exchange in markets more complex.

Banks

This is where a third category of economic agents comes in, the banks. Banks are the only agents that have the power to transform very short-term resources (demand deposits i.e. current accounts) into medium and long term resources: bank loans. Banks therefore establish an essential link between households and businesses; they have always played, and indeed still play, a crucial role in the financing of the economy.

Each bank has the right to distribute virtually all of the money deposited by customers on its current accounts (but not all! see below) as loans. However, loans made available in this way by banks do not cancel the deposits that were made, which continue to be available for the customer to use. Banks therefore create money. The loans, granted in the form of demand deposits, increase the cash resources of banks and thus their ability to distribute new loans etc.. Deposits create loans, which themselves create deposits, etc.. This is what is called the "credit multiplier".

Fortunately, the money creation power of banks is not infinite. It is limited firstly by the fact that only part of the loans granted will remain in the form of deposits. The remainder will be converted into cash (notes) through cash withdrawals. Furthermore, to ensure that banks have the capacity to cope with withdrawals, the central bank requires them to lock-up a percentage of their deposits in the form of reserves, not available for lending. The compulsory reserves ratio is one of the instruments used by central banks to control the quantity of money in circulation.

Furthermore, companies cannot finance themselves solely through loans; beyond a certain level of debt, the financial cost has an unsustainable impact on results and banks would no longer be willing to lend. Companies therefore have to find ways of obtaining even longer-term financing, only repayable in the event of dissolution of the company, or debt with very long maturities, for example bonds. The total of the capital and long-term debt of a company constitutes its "equity capital".

Banks, in particular investment banks, are also involved in long-term corporate financing, but it is not their primary purpose which is to ensure that money circulates. To provide companies with equity capital, economic agents ready to lock-up large sums over long periods, obviously with the aim of generating profit, are required: investors.

Institutional investors

The main investors in capital markets today are "institutional investors" (often referred to simply as "institutionals"), namely insurance companies, fund managers (asset managers), retirement funds and their US equivalent, the pension funds. Institutionals also drain public savings, but these savings are locked up and cannot be immediately withdrawn in the same way as sums deposited in current accounts. In addition, the institutions in question generally have a regulatory, contractual or legal obligation to build up savings in order to be able to pay, for insurance companies insurance benefits, and for retirement funds retirement benefits to policyholders.

Instead of distributing loans like banks, institutional investors buy securities issued by companies requiring financing. These securities represent either equity capital: shares, or long-term borrowing: bonds. Purchases are made on the primary market, i.e. at the time the securities are issued, or on the secondary market, more commonly referred to as the "Stock Exchange".

Given the needs of companies to obtain financing from the market and institutional investors' needs to invest savings in their care, it is clear that there has to be a way for supply and demand to meet. However for this to happen, the market has to be organised appropriately to facilitate the process; a number of different players contribute to this. In this regard, banks once again play an important role. As account-keepers and liquidity providers, they assume a key intermediation role.

The issuance of securities

Issuers wishing to raise capital from the market turn to a bank or group of banks (a "bank syndicate") which acts as an agent for the issue. The agent arranges all the economic characteristics of the issue. The agent "underwrites" the issue, in other words undertakes to buy all the securities issued and has a responsibility to find final investors willing to buy the securities issued.

After the issue, and once the securities trade on the market, the paying agent of the issuer (which may be the same as the agent or another institution) will be responsible for ensuring smooth operations throughout the life of the security: payment of coupons for bond issues or dividends for shares, repayments, capital increases etc.
Lastly, rating agencies are independent organisations which assess the quality of issuers and assign a rating designed to determine their reliability as debtors.

Custodians

The agent of the issuer manages the relationship with the central custodian, a key player in securities markets. For each issue it manages, the central custodian keeps up-to-date records in its accounts of the total amount of securities that have been issued and the amount held by each institution that has a registered account with it (the total amount held by all institutions clearly has to match the total amount of the issue!). In France the central custodian for almost every issue is Euroclear France, formerly SICOVAM.

Each member of Euroclear France is a local custodian. Any investor that does not have a registered account with Euroclear France must open an account with a local custodian in order to be able to hold securities. However, while investors increasingly tend to internationalise their investments, the central custodian practically only manages securities issued in its own country. As a result, the function of "global custodian" has developed. A global custodian is appointed by investors to act as account keeper for all transactions involving the purchase and sale of securities in markets worlwide. To this end, the global custodian works hand-in-hand with local custodians in every market in the world, each one responsible for maintaining relations with the central depository in its country.

To be a global or local custodian, an institution must be authorised not only to keep securities accounts on behalf of investors but also cash accounts. Such institutions are therefore usually banks.

Market transactions

Investors typically buy securities through a broker. The broker provides a number of services to investors. Financial analysts study markets and issuers and make recommendations. Salesmen pass on the recommendations of analysts to investors and collect their orders. Lastly, traders buy or sell securities in the market.

Trading between brokers is carried out either directly through an "OTC" market or organised market, a stock exchange, or through fast-growing electronic markets.

Once a trade has been completed, the investor turns to a custodian to take charge of "after trade" aspects. For a transaction to be registered correctly, securities provided by the seller have to be exchanged for cash provided by the buyer. This process is referred to as settlement and delivery.

The custodian is also responsible for maintaining the accounts of investor customers to take account of the many transactions that can have an impact on investment portfolios: coupon or dividend payments, repayments, but also exercise of subscription rights, takeover bids, exchange offers etc.

Trading floors

Market transactions by institutional investors are not limited to the purchase and sale of securities. Given the sums involved and the large number of markets in which investors trade, additional needs arise. An investor may need to obtain foreign currency, hence the necessity to carry out transactions in currency markets. An investor may also require loans, or on the contrary need to invest liquidity on a temporary basis to optimise cash flow. Lastly, he may want to protect a portfolio against market fluctuations, giving rise to the need for derivative products.

Non-financial companies ("corporates") face similar types of need: importers may require foreign currency and processing companies may have to protect themselves against fluctuations in raw material prices. All have special cash management needs and may have to hedge against movements in prices or interest rates.

Banks are able to respond to these needs; at the branch level for small and medium-sized companies or directly via the trading room for the largest customers. Total cumulative positions generated for the various products are processed by traders in the trading rooms. The activity of a trading room reflects the total amount of requests coming from all of the bank’s customers!

Speculation and arbitrage

Financial institutions and funds dedicated to this type of activity use some of their resources for speculation. This aspect of trading activity, whether or not it be as extensive as many claim, nevertheless remains necessary. Speculation involves taking a position that is contrary to current market trends: it means becoming a seller when you think that prices will fall (and are therefore at their highest!), or becoming a buyer when you think they will rise. By adopting a stance, speculators provide liquidity to the market: they are the sellers for investors who want to buy and the buyers for those who want to sell. It is a risky activity, as, unlike investors or corporates, speculators bet on the future.

Arbitragists also play a harmonising role: they take advantage of price differences between different markets to generate gains. For example, in currency markets they buy dollars in a market where it is cheap and sell in a market where it is most demanded, and therefore more expensive. It is a risk-free activity, since the assets purchased are immediately resold. However, this requires substantial financing as capital gains on each transaction are low. The activity of arbitragists helps eliminate marketing inconsistencies.

Conclusion

Economic literature, after drawing a sharp distinction between the financing of companies through bank lending (debt financing) and financing through the issuance of securities (market-based economy), now attributes a complementary role to both. Studies suggest that for an economy to grow, there is a need for both an active organised financial market and a reliable banking system.

The purpose of this website is not to discuss the whys and wherefores of financial markets or their beneficial or harmful role. Instead, the content of this site focuses on "how" aspects: who are the players, how do they interact, the financial products that are traded, and the functions that they provide.

Published on: June 10, 2009
Translated from French by Offshore Translation
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