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The Financial System

Sinclair Davidson

RMIT Blockchain Innovation Hub

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What I’m going to do today

• Describe purpose, functions, and activities

of the financial system.
• Describe various institutions, markets, and
instruments that make up the financial
system.

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Introduction to the Financial System

• The financial system allocates wealth to those individuals who

have investment opportunities, but insufficient wealth, from those
individuals who have surplus wealth, but insufficient investment
opportunities.

• Functions of a financial system:

o screening entrepreneurs to select the “best” projects,
o mobilising resources to undertake investments,
o diversifying investors’ portfolios,
o indicating the benefits of undertaking productivity-enhancing
activities.

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Introduction to the Financial System

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Introduction to the Financial System

• Let’s have a more detailed look.

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Introduction to the Financial System

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Some definitions

• An asset is any resource that is expected to provide future

economic value.
o Tangible assets
o Intangible assets
 Financial assets are intangible.

• Financial assets provide the following key economic functions:

o they allow the transfer of funds from those entities, who have
surplus funds to invest to those who need funds to invest in
tangible assets;
o they redistribute the unavoidable risk related to cash
generation among deficit and surplus economic units.

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Some definitions

• Properties of financial assets:

o Moneyness
o Divisibility
o Reversibility (low transaction costs)
o Yield or Return
o Term to maturity
o Liquidity
o Risk

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Some definitions

• Role of financial intermediaries:

o Brokers
o Asset transformers
 Risk transformation
 Maturity transformation
 Volume transformation
o Payment system
o Trading services
o Investment advice

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Banking

• A bank is an institution whose business consists on granting loans

and receiving deposits from the public.
o Takes deposits
o Makes loans

• Ludwig von Mises (1912, 1981)

o Banks borrow money in order to lend it; the difference
between the rate of interest that is paid to them and the rate
that they pay, less their working expenses, constitutes their
profit on this kind of transaction. Banking is negotiation
between granters of credit and grantees of credit. Only those
who lend the money of others are bankers; those who merely
lend their own capital are capitalists, but not bankers.

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Banking

• Banking is very risky.

o Banks borrow short …
o Banks lend long.

• Fractional Reserve banking

o Money multiplier
o Bank keeps a fraction of deposits and lends out the rest.

• Banks are very reliant on trust.

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What can go wrong?

• https://www.youtube.com/watch?v=xa75BfmXQH4

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Image in the Bitcoin genesis block

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Bank Crisis

• Bank Run – crisis impacting a single bank

o Conventional explanation
 Depositors learn bad news about their bank, they fear
bankruptcy and respond by withdrawing their own
deposits
Fundamental run - bad news is about bank assets
Speculative run – bad news is about large withdrawals

• Bank Panic – crisis impacting the banking system

o Could develop from a bank run

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Bank Crisis

• As long as banks keep enough reserves to cover withdrawals the bank will not
experience a run.

• But – fractional reserve banking is inherently fragile.

o Low cash to assets
o High leverage
o High demand to deposits

• If all depositors attempt to withdraw simultaneously the bank may have to

withdraw its own loans (liquidate its assets or sell them at reduced prices).

• What to do?
o Lender of last resort
o Regulation
o Deposit insurance

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Lender of last resort

• Walter Bagehot - lend freely at a high rate, on good collateral

• Lender of last resort exists to provide emergency liquidity

o the LLR has a role in lending to illiquid, solvent financial institutions;
o these loans must be at a penalty rate, so that financial institutions cannot
use the loans to fund their current lending operations;
o the lending must be open to solvent financial institutions provided they
have good collateral (valued at prepanic prices);
o the LLR must make clear in advance its readiness to lend any amount to
an institution that fulfills the conditions on solvency and collateral
(credibility).

• Lender of last resort should not bail-out insolvent banks

o Illiquid banks are financially distressed
o Insolvent banks are economically distressed

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Alternative views on banking

• Murray Rothbard:
o Since it is convenient to transfer paper in exchange rather
than carry gold, money warehouses (or banks) that build up
public confidence will find that few people redeem their
certificates. The banks will be particularly subject to the
temptation to commit fraud and issue pseudo money
certificates to circulate side by side with genuine money
certificates as acceptable money-substitutes. The fact that
money is a homogeneous good means that people do not care
whether the money they redeem is the original money they
deposited. This makes bank frauds easier to accomplish.
o Fractional reserve banking is ‘fraud’.

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Alternative views on banking

• Free banking (George Selgin and Lawrence White)

o Under free banking, individual banks are free to issue their
own currency supported by reserves.
 Free banking regimes operated in Australia, Scotland,
Sweden and the United States.

• Central banks, owned and managed by the state, gradually

emerged to manage governmental finances and, later, issue
currency and implement government’s monetary policy. Associated
with the diffusion of central banking techniques is the abandonment
of free banking.

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Financial Markets

• Financial Markets exist to trade financial assets.

• Financial markets provide the following three major economic

functions:
o Price discovery
o Liquidity
o Reduction of transaction costs.

• Spot markets exist for immediate (actually 2 days) delivery.

• Futures markets exist for future delivery.

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Equity Markets

• An equity market is a market in which shares are issued and

traded, either through exchanges or over-the-counter markets.

• Equity:
o Represent ownership stake in a company
o Entitled to a dividend (if declared) and/or capital gain/loss
o Entitled to vote

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Bond markets

• Money market is where instruments of less than 1 year maturity

trade

• Capital market is where instruments of more than 1 year maturity

trade

• Bond holders are entitled to coupon payments and face value of

the bond.

• How much they are prepared to pay now for a given future
cashflow determines the interest rate.

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Equity v Bonds

• https://www.youtube.com/watch?v=h9O_x8RhzwE

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Equity v Bonds

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Crytocurrencies trading

• Join a free simulated cryptocurrency trading game

• Download Altcoin Fantasy app on your computer/phone

• Team up with your friends (2-3 students/team)

• Join the newbie 6-minute game

• Trade coins and see who is the winner

• Compare with stock trading?

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Futures and Forwards

• A futures contract is a contract to buy or sell a particular commodity

or asset at a predetermined price at a specified time in the future.
o Futures contracts are standardized for quality and quantity to
facilitate trading on a futures exchange.
o The buyer of a futures contract is taking on the obligation to
buy the underlying asset when the futures contract expires.
o The seller of the futures contract is taking on the obligation to
provide the underlying asset at the expiration date.

• A forward contract is a customized contract between two parties to

buy or sell an asset at a specified price on a future date.

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Options

• An option is a contract giving someone the right, but not the

obligation, to buy or sell a financial instrument, commodity, or some
other underlying asset at a given price, at or before a specified
date.
o At the specified date is an “European option”
o On or before is an “American option”
o Call options allow the holder to buy the asset at a stated price
within a specific timeframe.
o Put options allow the holder to sell the asset at a stated price
within a specific timeframe.

• With call options almost any risk-return profile can be replicated.

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Options

• https://www.youtube.com/watch?v=VJgHkAqohbU

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Options

• Factors that influence option prices:

o Current price of underlying asset
o Strike price
o Time to expiry
o Expected volatility of the underlying asset
o Short-term risk free rate over time to expiry
o Expected cash payments on the underlying asset

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American Depository Receipts

• American Depositary Receipts (ADR) are negotiable security

instruments that are issued by a US bank, that represent a specific
number of shares in a foreign company that is then traded in US
financial markets.

• ADRs pay dividends in US dollars and trade like regular shares of

stock.
o Avoid forex risk.
o Avoid foreign investment restrictions.

• What about Digital Depository Receipts traded on a blockchain?

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Collateralized Debt Obligation

• A collateralized debt obligation (CDO) is a structured financial

product that pools together cash flow-generating assets and then
repackages this asset pool into discrete tranches that can be sold
to investors.
o The tranches in a CDO vary substantially in their risk profiles.
o The senior tranches are generally safer because they have
first priority on payback from the collateral in the event of
default.
o The earliest CDOs were constructed by Drexel Burnham
Lambert in 1987 by assembling portfolios of junk bonds issued
by different companies.

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Collateralized Debt Position

• Collateralized Debt Position (CDP) is a financial-cryptocurrency

concept that lets you invest crypto and simultaneously borrow
crypto.
o Lock up 10 ETH into the CDP vault. In the time of Lockup, the
price of ETH is 400 USD, so you Lock up 4 000 USD.
o Borrow up to 6.6 ETH worth of Dai, which is 2 420 Dai (2 640
USD)
o Repay borrowed 2 640 Dai at any time in the future and get
your deposit back in ETH. The ideal situation would be if the
price of ETH will be higher, for example, 900 USD. So, you
would pay 2 640 Dai to repay your debt but you get 10 ETH
(price per ETH 900 USD) is worth 9 000 USD.

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Financial Innovation

• Types of Innovation
o Market-broadening innovation
o Risk-management innovation
o Arbitrage innovation

• Sources of innovation
o Increased volatility
o Changes in technology
o Increased sophistication of investors
o Competition
o Regulatory arbitrage
o Increased wealth

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