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Organizational structure of financial markets
This section is devoted to the types, forms, nature, etc of financial markets, and how they operate / trade in practice ("types" in the heading was placed in inverted commas, because it covers "types, forms, nature, etc."). These words are part of the financial market jargon that is voluminous and quite confusing. A sub-plot of this section is to create some logical order in this regard. This section is comprised of the following exhilarating sub-sections:
• Primary and secondary markets.
• Economic functions of secondary markets.
• Market form: exchange-traded and OTC markets.
• Issuing methods.
• Trading driver: order or quote.
• Trading system.
• Trading form: single and dual capacity.
Primary and secondary markets
The first distinction that must be made is between spot (also called cash) and derivative markets, which we covered in some detail above. These fall under the generic heading market nature. The next level of distinction in the spot markets is primary and secondary markets, which we call market type. With this we are able to make a start with our dazzling illustration which is designed to demystify the jargon (see Figure 9).
Figure 9: organization of spot financial markets (1)
The primary market is the market for the issue of new securities (debt and shares) in order to borrow money for consumption or investment purposes. It will be evident that the markets in non-negotiable instruments such as mortgage loans, savings deposits and life policies, are entirely primary markets, while NCDs and bonds (for example) are issued in the primary market, but are traded in the secondary market.
Secondary market is the term used for the markets in which previously issued financial claims are traded. Broker-dealers usually facilitate these secondary market transactions. In the primary market the issuer receives funds, whereas in the secondary market the original issuer does not receive funds; only the seller does. The primary and secondary markets can be portrayed as in Figure 10.
Secondary markets play the financial custard and the economy. This is covered next.
Figure 10: primary and secondary markets
Economic functions of secondary markets
The economic functions of secondary markets may be summarized as follows:
• Price discovery.
• Liquidity and borrowing cost reduction.
• Support of primary market.
• Implementation of monetary policy.
Price discovery is one of the central functions of secondary markets. It is the route through which securities markets arrive at prices for the securities traded. (It must be kept in mind that prices in the fixed-interest markets are the converse of interest rates.) The "route" refers to the method of trading, and there are various trading methods, which will be discussed later. Price discovery is important because it provides information that influences economic decisions, for example whether a company will expand production and finance this with long-term borrowing or the issue of new shares (rights offer). Price discovery also provides clues as to the prices that need to be offered on new issues of securities.
There are two prices in the various securities markets: bid and offer (or bid and ask in some countries). The bid price is the price that buyers are prepared to pay and the offer price the price at which holders of securities are prepared to sell. The bid price is always lower that the offer price (the opposite applies in the case of interest rates), and the difference between the two rates / prices is called the spread.
The spread is a valuable piece of information, for two main reasons. Firstly, it represents the cost of trading, i.e. it is a transaction cost, and this is significant in the creation or lack of liquidity (see below). Secondly, the spread is a reflection of marketability / liquidity. If the spread is narrow, the relevant market is said to be liquid (some use the word thick, but we will not use it because of its uncharitable connotation), and if the spread is wide the market is illiquid (some say thin).
Liquidity and borrowing cost reduction
Liquidity (some say marketability - these two terms mean the same in the financial markets) refers to the ability to trade a security with ease, i.e. without impacting significantly on its price. It will be apparent that in liquid markets, prices will not be adversely affected by large orders, whereas in thin markets prices may be shifted markedly by small orders. It may be said that a liquid market is more likely to create a state of equilibrium in the market. By this is meant that if the buyers and sellers are equally matched in terms of orders, the price will not be affected adversely (up or down), i.e. the price is a market-clearing price. As indicated, in a thin market, the market may clear at a vastly different price, depending on whether buyer orders outweigh sell orders (higher price), or vice versa (lower price). Equilibrium is disturbed in thin markets.
Liquidity is significant for two main reasons. Firstly, it enables investors to rapidly adjust their portfolios in terms of size, risk, return, liquidity and maturity. This in turn has a major influence of the liquidity premium investors place on liquid securities. This of course means that the issuer is able to borrow at a lower cost than in the absence of liquidity. It is for this reason that many issuers of bonds attempt to create their own markets by acting as market makers (quoting buying and selling prices simultaneously) in their own securities, or by outsourcing this function to an investment / merchant bank/s. It is notable that central governments usually jumpstart the bond market by market making in their own securities (or outsourcing this to the central bank).
An important question is how to enhance liquidity. The answer is, firstly, the active participation of the role-players in the financial markets, secondly, the existence of market makers, and thirdly the existence of arbitrageurs and speculators. These will be covered in more detail in a later text on the broker-dealers
Support of primary market
The secondary market plays an important role in terms of supporting the primary market. We noted above that price discovery in the secondary market assists the primary markets in terms of providing clues as to the pricing of new issues. In addition to this important function, the secondary market provides clues as to the receptiveness of market for new issues (which is reflected in the spread). Clearly, a liquid market improves the ability of issuers to place securities, and lowers the price.
Implementation of monetary policy
An active secondary market enables the central bank to buy and sell securities in order to influence the liquidity of the banking system, with a view the ultimately influencing interest rates. This is termed open market operations, which means that the central bank buys and sells securities in the open market.