CHAPTER 2

FINANCIAL MARKETS:
STRUCTURE AND ROLE
IN THE FINANCIAL
SYSTEM
OBJECTIVES

• Discuss the financial system structure and functions.

• Identify the different financial markets and their economic
functions.
• Identify the financial intermediaries and their functions.
• Discuss the financial market structure and financial market
regulations.
FINANCIAL SYSTEM STRUCTURE AND FUNCTIONS

The financial system plays the key role in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare. This is achieved by financial
infrastructure, in which entities with funds allocate those funds to those who have potentially more
productive ways to invest those funds. A financial system makes it possible a more efficient transfer of
funds.
According to the structural approach, the financial system of an economy consists of three
main components:
• financial markets;
• financial intermediaries (institutions);
• financial regulators.

Each of the components plays a specific role in the economy.

ACCORDING TO THE FUNCTIONAL APPROACH,
• Financial markets facilitate the flow of funds in order to finance
investments by corporations, governments and individuals.
• Financial institutions are the key players in the financial markets as they
perform the function of intermediation and thus determine the flow of
funds.
• The financial regulators perform the role of monitoring and regulating
the participants in the financial system.
 • Financial markets studies, based on capital market theory, focus on the financial
system, the structure of interest rates, and the pricing of financial assets.
• An asset is any resource that is expected to provide future benefits, and thus
possesses economic value
• Financial assets, often called financial instruments, are intangible assets, which
are expected to provide future benefits in the form of a claim to future cash.
Some financial instruments are called securities and generally include stocks and
bonds.

Any transaction related to financial instrument includes at least two parties:

• the party that has agreed to make future cash payments and is called the issuer;
• the party that owns the financial instrument, and therefore the right to receive
the payments made by the issuer, is called the investor.
Financial assets provide the following key economic functions.
• 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;
• they redistribute the unavoidable risk related to cash generation among
deficit and surplus economic units.

The claims held by the final wealth holders generally differ from the liabilities
issued by those entities who demand those funds. They role is performed by
the specific entities operating in financial systems, called financial
intermediaries. The latter ones transform the final liabilities into different
financial assets preferred by the public.
FINANCIAL MARKETS AND THEIR ECONOMIC FUNCTIONS
A financial market is a market where financial instruments are exchanged or traded. Financial
markets provide the following three major economic functions:

• Price discovery - function means that transactions between buyers and sellers of financial
instruments in a financial market determine the price of the traded asset.
• Liquidity - function provides an opportunity for investors to sell a financial instrument, since
it is referred to as a measure of the ability to sell an asset at its fair market value at any time.
Without liquidity, an investor would be forced to hold a financial instrument.
• Reduction of transaction costs - is performed, when financial market participants are charged
and/or bear the costs of trading a financial instrument.
THE KEY ATTRIBUTES DETERMINING TRANSACTION COSTS
ARE;
• Asset specificity is related to the way transaction is organized and executed. It is
lower when an asset can be easily put to alternative use, can be deployed for
different tasks without significant costs.
• Transactions are also related to uncertainty,
• external sources (when events change beyond control of the contracting parties);
• depends on opportunistic behavior of the contracting parties.

If changes in external events are readily verifiable, then it is possible to make adaptations to
original contracts, taking into account problems caused by external uncertainty.
• Frequency of occurrence plays an important role in determining if a transaction should take
place within the market or within the firm.
 • When assets are specific, transactions are frequent, and there are significant
uncertainties intra-firm transactions may be the least costly. And, vice versa, if
assets are non-specific, transactions are infrequent, and there are no significant
uncertainties least costly may be market transactions.

Transaction costs are classified into:

• Costs of search and information - search costs fall into categories of explicit costs
and implicit costs. Information costs are associated with assessing a financial
instrument’s investment attributes.
• Costs of contracting and monitoring are related to the costs necessary to resolve
information asymmetry problems, when the two parties entering into the
transaction possess limited information on each other and seek to ensure that the
transaction obligations are fulfilled.
 • Costs of incentive problems between buyers and sellers arise, when there are
conflicts of interest between the two parties, having different incentives for the
transactions involving financial assets.

The functions of a market are performed by its diverse participants. The participants in
financial markets can be also classified into various groups, according to their motive
for trading:

• Public investors, who ultimately own the securities and who are motivated by the
returns from holding the securities.
• Brokers, who act as agents for public investors and who are motivated by the
remuneration received (typically in the form of commission fees) for the services
they provide.
• Dealers, who do trade on their own account but whose primary motive is to profit
from trading rather than from holding securities.
FINANCIAL INTERMEDIARIES AND THEIR FUNCTIONS
• Financial intermediary is a special financial entity, which performs the role of efficient
allocation of funds, when there are conditions that make it difficult for lenders or investors
of funds to deal directly with borrowers of funds in financial markets. The role of financial
intermediaries is to create more favourable transaction terms than could be realized by
lenders/investors and borrowers dealing directly with each other in the financial market.

• The financial intermediaries are engaged in:

• obtaining funds from lenders or investors and

• lending or investing the funds that they borrow to those who need funds.
 • Asset transformation provides at least one of three economic functions: Maturity
intermediation, Risk reduction via diversification, and Cost reduction for contracting and
information processing.

Other services that can be provided by financial intermediaries include:

• Facilitating the trading of financial assets for the financial intermediary’s customers through
brokering arrangements.
• Facilitating the trading of financial assets by using its own capital to take a position in a
financial asset the financial intermediary’s customer want to transact in.
• Assisting in the creation of financial assets for its customers and then either distributing
those financial assets to other market participants.
• Providing investment advice to customers.
• Manage the financial assets of customers.
• Providing a payment mechanism.

FINANCIAL MARKETS STRUCTURE

Financial Instruments
• The use of these instruments by major market participants depends upon their offered risk
and return characteristics, as well as availability in retail or wholesale markets.
• A financial instrument can be classified by the type of claims that the investor has on the
issuer. A financial instrument in which the issuer agrees to pay the investor interest plus
repay the amount borrowed is a debt instrument. A debt instrument also referred to as an
instrument of indebtedness, can be in the form of a note, bond, or loan. The interest
payments that must be made by the issuer are fixed contractually.
• Debt instruments are often called fixed income instruments. Fixed income
instruments form a wide and diversified fixed income market.
• An equity instrument specifies that the issuer pays the investor an amount
based on earnings, if any, after the obligations that the issuer is required to
make to investors of the firm’s debt instruments have been paid.
• Common stock is an example of equity instruments. Some financial
instruments due to their characteristics can be viewed as a mix of debt and
equity
• Preferred stock is a financial instrument, which has the attribute of a debt
because typically the investor is only entitled to receive a fixed contractual
amount.
 • Another “combination” instrument is a convertible bond, which allows the
investor to convert debt into equity under certain circumstances. Because
preferred stockholders typically are entitled to a fixed contractual amount,
preferred stock is referred to as a fixed income instrument. Hence, fixed
income instruments include debt instruments and preferred stock.

The classification of debt and equity is especially important for two legal reasons:
• In the case of a bankruptcy of the issuer, investor in debt instruments has a priority on the
claim on the issuer’s assets over equity investors.
• The tax treatment of the payments by the issuer can differ depending on the type of
financial instrument class.
 CLASSIFICATION OF FINANCIAL MARKETS
There different ways to classify financial markets. They are classified according to the
financial instruments they are trading, features of services they provide, trading procedures,
key market participants, as well as the origin of the markets.

Financial market can be broken down into two:

• The internal market, also called the national market, consists of two parts: the domestic
market and the foreign market.
• External market is the market where securities with the following two distinguishing
features are trading:
• at issuance they are offered simultaneously to investors in a
number of countries; and
• they are issued outside the jurisdiction of any single country.
• Money market is the sector of the financial market that includes financial instruments that
have a maturity or redemption date that is one year or less at the time of issuance. These are
mainly wholesale markets.
• The capital market is the sector of the financial market where longterm financial
instruments issued by corporations and governments trade.
• There are two types of capital market securities:
• equity, issued by corporations, and those that represent indebtedness
• debt issued by corporations and by the state and local governments.
• Financial markets can be classified in terms of:
• The cash market, also referred to as the spot market, is the market for the immediate
purchase and sale of a financial instrument.
 • The “something” that is the subject of the contract is called the underlying (asset). The
underlying asset is a stock, a bond, a financial index, an interest rate, a currency, or a
commodity. Because the price of such contracts derive their value from the value of the
underlying assets, these contracts are called derivative instruments and the market where
they are traded is called the derivatives market.
• When a financial instrument is first issued, it is sold in the primary market. A secondary
market is such in which financial instruments are resold among investors. No new capital is
raised by the issuer of the security. Trading takes place among investors.
• Stock exchanges are central trading locations where financial instruments are traded. In
contrast, an OTC market is generally where unlisted financial instruments are traded.
FINANCIAL MARKET REGULATION
In general, financial market regulation is aimed to ensure the fair treatment of participants.
Many regulations have been enacted in response to fraudulent practices. One of the key aims of
regulation is to ensure business disclosure of accurate information for investment decision
making. When information is disclosed only to limited set of investors, those have major
advantages over other groups of investors. Thus regulatory framework has to provide the equal
access to disclosures by companies.