The Function of Financial Markets in the Economy

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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

Bank facade

This is where a third category of economic agents comes in, namely the banks. Banks are the only agents who have the power to transform very short-term resources, namely sight deposits (from current accounts), into medium or long-term usage: bank credit. Banks therefore build the necessary bridge between households and businesses; historically they have played and still play a vital role in financing the economy.

Each bank has the right to distribute in the form of credit almost all the money (but not all of it! see below) deposited by its customers on demand accounts. However, this loan distributed by the bank does not cancel the deposit, which remains available for the customer. The bank therefore creates money. These loans, granted in the form of sight deposits, increase the banks' cash and thus their ability to distribute new loans, etc. Deposits make loans, which in turn make deposits, etc. This is called the "credit multiplier".

The capacity of banks to create money is obviously, and fortunately, not infinite. It is limited first of all by the fact that only part of the credit granted will remain in the form of a deposit. The remainder will be converted into cash by withdrawals. In fact, it is to guarantee the banks' ability to cope with withdrawals that the central bank requires them to block a percentage of their deposits in the form of minimum reserves, which cannot be used to distribute credit. This reserve requirement rate is one of the instruments used by central banks to control the quantity of money in circulation.

In addition, a company cannot finance itself solely through credit: beyond a certain level of indebtedness, the financial costs end up unbearably penalizing the results and at this point the banks no longer agree to lend. Companies also need to find financing for even longer terms, financing that in fact only becomes due when the company is dissolved: this is capital, or in the very long term, bonds for example. All capital and long-term debt is what is called the equity capital of a company.

Banks, especially merchant banks, are also involved in the long-term financing of companies, but it is not their primary purpose, which is to circulate money. To endow companies with equity capital, economic agents are needed to immobilise large sums of money over long periods of time, obviously in order to obtain a profit: these are investors.

Institutional investors

The main investors on the capital markets today are the so-called "institutional investors", i. e. insurance companies, asset managers and pension funds. They, too, are draining public savings, but these savings are locked in and are not immediately due, as opposed to the amounts deposited in current accounts. Also, these institutions generally have a regulatory or contractual or statutory obligation to grow these savings in order to be able to pay out claims in the case of insurance companies or pensions to their subscribers in the case of pension funds.

Instead of distributing credit like banks, institutional investors buy securities issued by companies in search of financing. These securities either represent equity (in the case of shares), or long-term debt (in the case of bonds). This purchase is made either on the primary market, i. e. as soon as the security is issued, or on the secondary market, which is more commonly referred to as "the Stock Exchange".

Between the decision of companies to find financing on the market on one hand, and the decision of institutional investors to invest the savings they have in custody on the other hand, this time there are clearly a supply and a demand that can only meet. However, it is necessary that the market be organized to facilitate this meeting; several kinds of actors will contribute to this. In this context, the banks are once again showing their strong presence because, as cash account keepers and liquidity providers, they will play a vital intermediation role.

Issue of securities

Issuers wishing to raise funds in the market turn to a bank, or a group of banks (the "syndicate"), which acts as the agent for this issue. The agent is responsible for all the economic conditions of the issue. It takes a "firm commitment underwriting", in other words it guarantees that it will buy all the securities issued, regardless whether it can find investors ready to buy them or not.

After the issue, and once the securities are on the market, the issuer's paying agent (which may be the same as the financial agent or another institution) will be responsible for the smooth running of all transactions involved in the life of the security: payment of coupons for bonds or dividends for shares, repayments, capital increases...

Lastly, credit rating agencies are independent institutions that assess the quality of issuers and give them a credit rating that establishes their reliability as debtors.

Custodians

The issuer's financial agent manages the relationship with the Central Securities Depository, a key player in the securities market. The central depository shall keep up to date in its accounts, for each issue of which it is aware, the total quantity of securities issued and the quantity held by each institution registered with it (the sum of the quantities held by each institution must obviously equal the total quantity!). In France for example, the central depository for almost all issues is Euroclear France.

Each member of Euroclear France is a local custodian. Any investor who is not directly registered with Euroclear France must open an account with a local custodian in order to hold securities. However, the central depository manages almost exclusively securities issued in its own country, while investors tend to internationalise their investments. Hence the development of the function of global custodian. The global custodian is appointed by the investor to be its account keeper for all its securities buying and selling operations on all markets. To do this, the global custodian contacts local custodians in all the world's markets, each local custodian being in charge of the relationship with the central custodian of their country.

To be a global or local custodian, it is necessary to be entitled to maintaining not only securities accounts but also cash accounts in the name of investors. These institutions are therefore usually banks.

Market operations

Investors generally buy securities through a broker, which provides several services to investors. Financial analysts study the market, the issuers and make recommendations. Sellers pass on the analysts' advice to investors and collect their orders. Finally, traders buy or sell securities on the market.

Trading between brokers takes place either directly "over-the-counter", or through an organised market, a stock exchange, or on one of the electronic marketplaces that are currently developing strongly.

Once the trade has been negotiated, the investor turns to his or her custodian to take over the "post-trade" phase. In order for the transaction to be duly registered, the securities supplied by the seller must be exchanged for the cash provided by the buyer. This is settlement.

The custodian will also be responsible for passing on to the accounts of its client investor the impact of the multiple securities transactions occurring in its portfolio: coupon or dividend payments, repayments, but also detachment of subscription rights, takeover bids, public exchange offers....

Trading rooms

Salle de marché

Market transactions carried out by institutional investors are not limited to buying and selling securities. Given the sums invested, and the multiplicity of markets in which investors operate, this activity generates additional needs. The investor must acquire foreign currencies, hence the need to intervene on the foreign exchange market. He may also need credit, or on the contrary want to temporarily invest cash in order to optimize cash flow. Finally, he wants to protect his portfolio of assets against market fluctuations, hence a need for derivatives.

Non-financial firms face the same type of needs: importers want to obtain foreign exchange, processing industries need to protect themselves against fluctuations in the price of raw materials. All of them have cash management needs, and the need to hedge against price or interest rate movements.

Banks support this demand at the agency level for small and medium-sized companies, or directly at the trading floor level for larger clients. The cumulative positions generated on the various products are then taken over by traders in the trading room. The activity of a room is first determined by the sum of the requests of all the customers of the bank!

Speculation and arbitrage

Bull or Bear market
Bet against the current market trend...

All financial institutions as well as funds dedicated to this activity devote part of their resources to speculation. This share of the market activity, with its nefarious reputation, is nonetheless a necessity. To speculate is indeed to take a position contrary to the current trend: it is to be a seller when you think that the prices will go down (and that they are therefore at their peak!), a buyer when you think that they will go up. By taking a position, speculators bring liquidity to the market: they are the sellers of investors who want to buy, the buyers of those who want to sell. This is a risky business, since unlike investors or non-financial corporations, speculators are betting on the future.

Arbitrageurs also play a harmonising role: they take advantage of price differences between different markets to make gains. For example, in the foreign exchange market, they buy the dollar on a place where it is cheaper and sell it where it is more in demand, so more expensive. This is a risk-free activity, since the assets purchased are immediately resold, but which requires significant funds since the capital gains per transaction are low. The activity of arbitrageurs erases market inconsistencies.

Conclusion

The economic literature, after opposing corporate financing by bank credit (credit-based economy) and financing by issuing securities (market economy), now tends to assign them complementary roles. Studies tend to show that to develop, an economy needs an active and organised financial market and a reliable banking system.

The purpose of this Web site is not to discuss the why of financial markets and their harmful or beneficial role. The content focuses instead on the how: who are the actors, how they interact, the financial products they negotiate, the functions around which they organize themselves... and the regulations they need to comply with.