THE FINANCIAL MARKET
The financial market is a market in which individuals and institutions can sell or purchase financial instruments from other individuals or institutions. A distinction is often drawn between wholesale users of the market, usually institutions, and retail users, usually private individuals. Since the majority of the products referred to in this discussion are denominated in large amounts, both buyer and seller will normally be a wholesale institution. It is important to realise however that activity in the wholesale market will often be determined by the aggregate of the activities of a large number of retail users who, for example, may have deposited funds for investment with an investing institution. Such an institution might then resort to the wholesale market in order to invest those funds in one lump sum, say a money market deposit.
Whilst an individual purchasing £100 worth of unit trusts is strictly using the financial market our discussion of financial market instruments will revolve around the wholesale market only. Regulation is less stringent here since wholesale users are deemed by the authorities to be professionals, possessing a more advanced understanding of financial instruments and markets than the layman. For instance, it is not a legal requirement for a wholesale participant in the futures market to warn his counterparty that the value of a future contract can go up as well as down, though to offer a retail investor this product without such a warning is illegal.
One possible list of functions performed by the financial markets, both retail and wholesale, is as follows :
a) To intermediate between investors and borrowers, nationally and internationally.b) To offer means of risk transferral, risk reduction or risk increase, (i.e. risk management).c) To offer investment management services.d) To provide a means of procuring foreign exchange.e) To provide a liquid secondary market.f) To provide corporate services such as trade finance, leasing and merger and acquisition advice.g) To provide government with a means of enacting monetary policy.
INSTITUTIONS IN THE FINANCIAL MARKET
The following is a list of the major institutions operating in the financial market :
Commercial banks
Commercial banks are private, or also in some countries publicly owned banks, that deal with business entities, private individuals and other clients principally in taking deposits and making loans. They usually offer a cheque service and 'clear' cheques drawn on or paid into their customers' accounts. Hence the term 'clearing banks' in the UK (and 'money centre banks' in the USA). Such banks increasingly offer their customers products such as trustee and executorship services, life and private health care insurance and estate agency in their efforts to develop a more diversified business income. The process of taking deposits and then lending them out to borrowers is often termed 'intermediation'. The term 'disintermediation' arises in a situation in which borrowers go directly to non-bank lenders in their search for funds. Such may be the case where a corporation raises funds through the issue of a bond or commercial paper instrument
Building societies
Building societies originated as mutual societies and co-operatives where savers would deposit funds that would subsequently be loaned to finance the purchase of (mainly) residential property. Borrowers and savers would all become 'members' of the society upon borrowing or depositing funds and would have a share in ownership of the society. Hence the term 'mutual' which signifies mutual ownership of the society by its members.
The Central Bank
The central bank of any given country acts as a banker to the commercial banks, the government and publicly owned companies. Usually it is also responsible for the issuance of the State's money and, upon government direction or of its own decision, implementation of monetary policy. The central bank will also act on the markets to purchase or sell domestic currency and government debt and deal with other central banks. In some countries the central bank is given independence of the governing authorities in its decisions as to policy, whilst in others it is the government that has ultimate control in these matters. Finally, the central bank will usually have a responsibility to oversee and regulate the activities of banks that operate in the domestic arena.
The Discount Houses
The function of these houses is severalfold, though their name derives from the fact that their major role is to discount bills issued by government or commercial organisations. The price of a bill is calculated with reference to a discount rate, hence the name 'discount house'. Commercial banks will place money with the discount houses on which the latter pay interest and use to fund their purchases of bills. Commercial banks in need of funds will withdraw them from the discount houses at short notice. Such funds are usually referred to as 'money at call' with the discount houses since they can be withdrawn at very short notice. In a situation in which there is a general shortage of liquidity, the central bank (here, the Bank of England) guarantees to repurchase short term bills and/or provide unlimited amounts of funds (usually termed 'assistance') to the discount houses. The latter may then meet the demand of the commercial banks for liquidity. This guarantee gives rise to the term 'lender of last resort' that is one of the functions of the central bank. The market in which the discount houses lend and borrow funds is essential to the liquidity of the commercial banks, although for some years now the commercial banks have relied increasingly upon the 'parallel market' for such purposes. Another name for the parallel market is the 'wholesale money market' in which banks deal not with the discount houses but rather with one another direct (and other non-bank institutions) in their efforts to place or attract funds.
Investment banks
Investment banks' main activities include trading and underwriting of capital market securities.The market in which such securities (bonds or shares, for example) are first issued is often termed the 'primary market', whilst the market in which these banks subsequently trade old issues is termed the 'secondary market'.
Merchant banks
Merchant banks deal primarily with commercial entities in offering trade finance, corporate finance and related services.
Insurance companies
With a long term bias to investment policy similar to that displayed by the pension funds, although with a greater need for liquidity, life insurance companies take the contributions or 'premiums' of those insured in return for specified pay out commitments. The nature of these commitments is very varied but basically falls into two categories, namely 'life', and 'non-life' (or 'general') insurance. The kinds of risk covered by these two basic types of insurance are self explanatory, but a further two sub-sets of life insurance should be mentioned here. These sub-sets are 'whole-life' and 'term' insurance. A term insurance policy simply takes premiums from the insured in return for a pay out of a stated amount in the event that the insured dies within the term of the insurance. Whole-life insurance guarantees to pay out a stated sum in the event of the insured's death, but also pays out a given sum upon expiry of the term of the insurance even if the insured does not die. Whole-life insurance premiums are higher than term premiums. Whole-life insurance can be arranged on a 'with-profits' (or 'endowment') basis, or on a fixed pay out basis. The latter pays a fixed amount at the end of the term whilst the former pays an amount related to the return achieved on the fund's investments.
Investment trust management companies
In contrast to unit trusts, investment trusts are 'close-ended' investment funds, usually in the form of a limited company. Investors are effectively purchasing shares in this company. Once all the shares of the trust have been purchased it is usual that no further amounts will be raised by the trust. The value of the trust's shares can then fall or rise above the net asset value of the underlying investments held by the fund, according to market supply and demand. The investment trust share price is of course quoted regularly for investors to monitor. Until recent years there was a tendency for investment trust shares to trade substantially below the net asset value per share. This feature became known as the 'discount'. Due to several factors, of which arbitrage is a major one, the discount has become far less marked in recent years, though still exists in many investment trusts
Mutual fund (unit trust) management companies
Unit trusts are funds that take investments predominantly from private individuals, and invest them in them in capital market securities such as bonds and shares and other financial instruments such as money market deposits, both domestically and internationally. The unit trust by virtue of having a large pool of funds to invest can insulate its exposure to poor performance on any one investment by holding a large number of individual investments thereby spreading its risk accordingly. Such a strategy (termed 'diversification') may not be available to a private individual with a limited sum to invest, since minimum dealing sizes and transaction costs may make it impossible or very expensive to do so. The unit trust's assets are valued at net asset value per unit on a regular basis, and the value of each unit in the fund is published for investors to monitor. The trust manages funds invested according to the policy of its management company. Any new contributions are invested according to this policy. Hence there are few limits to the amount of contributions which the unit trust can accept, and the fund is thus said to be open-ended. Investors may redeem their holdings at the net asset value quoted (less any charges) by dealing with the unit trust administration company or department, which will then match the sale with a buyer, or liquidate part of its investments to meet the redemption demand.
Pension funds
Such institutions place invested funds on behalf of retail customers and corporate entities predominantly into capital, money and property markets. The returns derived from what are usually long term investments will be used along with the initial investment to provide pension payments or lump sums on retirement to investors. Generous tax provisions (contributions to a pension scheme are tax deductible) encourage their usage. The government has encouraged individuals to opt out of the State Earnings Related Pension Scheme (SERPS) in favour of their own private pension. This policy has been introduced as it appears on current trends that the burden upon government finances of providing SERPS payments will become increasingly difficult to bear in coming decades. One of the principal causes of this problem has been the 'pay-as-you-go' basis on which both SERPS and the basic state pension (payable to all those individuals above the official retirement age) are funded. This means that each year's current pension payments are provided from the tax revenue of the currently employed population.
Hedge fund companies
In recent years the hedge fund has come to prominence as a player in financial markets. The term is usually used to describe activities of leveraged arbitrageurs. A trader that borrows money in order to buy a bond will find that if the bond price rises, he or she can repay all of his borrowing and interest obligation and keep the remaining capital gain on the bond as a profit. Theoretically, the trader's profit as a percentage of his own funds would then be infinite since the trader had no funds of his own to begin with. The trader who borrows to take a position in a financial market instrument is said to have 'leveraged' him or herself. A fund that operates on the same principal is said to be a leveraged or a 'hedge' fund. Such a fund will usually enact arbitrages in large amounts in various financial markets, perhaps by buying a cash instrument and selling a future on that instrument to exploit some pricing discrepancy. In this sense one might say that the fund is hedged since a purchase and sale of similar instruments has taken place. Hence the term 'hedge fund'.
Other users of the financial markets
The following users of the financial markets should also be noted as they play an important part in providing turnover and revenue in a variety of markets. Investment bankers and professional trading houses often refer to the users of their products and services as 'retail' customers and it is important to note that the word 'retail' does not usually refer to private individuals in the earlier sense of our discussion. Along with insurance, hedge and pension funds, and a variety of other users, any of the following institutions could be classified as retail customers for any other professional market trading institution.
a) Foreign central banks
b) Supra-national entities (e.g. World Bank, European Investment Bank)
c) State sponsored and sovereign institutions
d) Local authorities
e) Corporate users
f) Private individuals
CLASSIFICATION OF MARKETS
Financial market instruments can be classified in a number of ways. Sometimes participants in the same market adopt different classifications which can lead to confusion for the outsider. Here are some of the various classification systems that one comes across, listed according to the main differentiating feature.
Time of delivery and settlement
A cash market is one in which the instrument traded is delivered more or less immediately. 'More or less' is a rather hazy phrase usually signifying between one and seven days according to the appropriate market convention. A future of forward market is one in which the delivery of the instrument occurs at some date in the future in excess of the cash market delivery dates.
Type of asset
Some participants will describe the market that they are involved in according to the nature of the asset or liability that is being traded. This classification system gives rise to an enormous number of categories, comprising all of the possible underlyings that can be traded in any market. Thus traders of gold futures, physical gold and gold options would all describe themselves as being involved in the gold market.
Derivative markets
A derivative product is one whose price (or rate, where the instrument is rate quoted) is derived from the price or rate of another product or set of products. Hence a gold option is a derivative product since its premium is derived from the price of gold. Traders involved in the derivatives market could naturally be involved in an enormous variety of different underlying instruments since most are capable of supporting several types of derivative product.
Discount and parallel markets
As discussed earlier, banks have access to two main markets for short term funds, these being the discount market and the parallel (or wholesale) money market Participants may classify their activities along these lines when describing their market area.
Primary and secondary markets
The issue of capital market instruments is often said to take place in the primary market, whereas the subsequent trading of such instruments takes place in the secondary market.
Accounting treatment
The accounting treatment applied to the instrument being traded can also form a basis of market classification. In this case, an instrument will either be an 'on-balance-sheet' instrument or an 'off balance sheet' instrument. The former includes any asset or liability that is shown on the holder's balance sheet at the accounting date and includes items such as bonds and shares and physical commodities. The latter term includes items such as swaps that are not shown on the holder's balance sheet at the accounting date. Such off-balance-sheet instruments usually involve contingent liabilities on contracts for differences, and their existence is stated in a set of notes to the accounts. Such accounting treatment may be of vital importance to a bank, for example where a bond purchase will show on the balance sheet and may affect capital requirements, but a swap position gaining a similar exposure to long term interest rates has no impact on the balance sheet and subsequent capital requirements.
Time horizon
Participants may well classify their market area according to the time horizon of the underlying instrument being traded. Typically, traders divide the financial markets into two sectors, namely that dealing with short term instruments where the words 'short term' describe any instrument or contract that redeems within one year of the trade date, and long term signifying instruments and contracts with longer than one year to redemption. Often the short term sector is called the 'money market' and the longer term sector the 'capital market'. The money market includes such underlying instruments as FRA's, deposits and foreign exchange, whilst the capital markets include bonds, shares and swaps. Naturally there is an ambiguity where bonds or swaps with less than one year to maturity, or deposits and FRA's with over one year to settlement are concerned, hence the basic terminology is frequently interpreted in a variety of ways.
On-exchange and off-exchange markets
Here the classification relates to the trading of forward and futures prices. Futures prices are those agreed today for the delivery of a given instrument at a given future date. A futures price is therefore a kind of forward price, since forward prices are also prices agreed today for the delivery of a given instrument at a given future date. Whilst the word 'forward' is used in the sense quoted above, it is also used in the following context, a context which explains the difference between futures and forward prices. Futures prices are those agreed in trading on a futures exchange, whilst forward prices (in their second sense) are agreed outside an organised futures exchange. Thus we have the terms 'on-exchange' and 'off-exchange' markets. An example of a futures market is Liffe (the London International Financial Futures Exchange) whilst an example of a forward market is the FRA market. The latter has no single geographically located exchange, but operates informally through the use of telephone, telex and fax contact between participants who are located in many different geographical locations. For example, banks in New York, London, Tokyo and other locations, may telephone banks and brokers in London to agree a £ FRA contract. Those same banks might equally have used the Liffe to gain similar exposures by trading short term interest rate futures contracts. Both products involve the trading of a forward rate of interest but, in the former case, the bank deals in a forward (i.e. off-exchange market) and in the latter case, a futures market (i.e. an on-exchange market). |
