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Financial markets

The fourth element of the financial system is financial markets. Financial markets are categorized according to the securities issued by ultimate borrowers and financial intermediaries. It was noted above that financial securities are either marketable or non-marketable. Examples are non-negotiable certificates of deposit (NNCDs) (= an ordinary deposit receipt) and negotiable certificates of deposit (NCDs) issued by the private sector banks.

There are two market types or forms (see Figure 4): primary market and secondary market. All securities are issued in their primary markets and the marketable ones are traded in the secondary markets. In the primary market the issuer receives the money paid by the lender / buyer. In the secondary market the seller receives the money paid by the buyer.

primary & secondary markets

Figure 4: primary & secondary markets

financial markets

Figure 5: financial markets

There are a number of markets for financial instruments: the market for life policies (a primary market only), the market for PIs (also called units) of securities unit trusts (a primary market and a partial secondary market: the units are saleable to the issuer), the market for PIs in retirement funds (strictly a primary market), the deposit market (primary market for NNCDs and a secondary market for NCDs), the bond market (secondary market), and so on.

The financial markets are depicted in Figure 5. As we will show later, the money market should be defined as the short-term debt market (STDM = marketable and non-marketable debt), while the bond market is the marketable arm of the long-term debt market (LTDM).

The money market (STDM) and the LTDM together make up the debt market (also known as the interest-bearing market and the fixed-interest market). The terms interest-bearing and fixed-interest oppose the debt market from the share market because the returns on shares are dividends and dividends are not fixed - they depend on the performance of companies. The LTDM and the share market is called the capital market.

The foreign exchange market is not a financial market, because lending and borrowing do not take place in this market. Rather, it is a conduit for foreign investors into local financial markets and for local investors into foreign financial markets.

In addition to these cash or spot markets [where the settlement of deals takes place a few days after transaction date (T+0)] we have the so-called derivative markets. They are comprised of instruments (forwards, futures, swaps, options and "others" such as weather derivatives) that are derived from and get their value from the spot financial markets. Whereas cash markets settle as soon as possible, derivative markets settle at some stage in the future.

financial markets

Figure 6: financial markets

Secondary markets are either over-the-counter (OTC), also called "informal markets" (such as the foreign exchange and the money markets) because there is no exchange involved, or exchange-driven (or formal) markets, such as the share (or stock) exchange. The place of the financial markets in the financial system may be depicted as in Figure 6.

The financial markets do not intermediate the financial lending and borrowing process as do financial intermediaries such as banks; they merely facilitate the primary and secondary markets.

Money creation

The fifth element is creation of money. As this is covered in detail later, we will not give it much attention here. Here follows a brief summary: when banks make new loans / provide new credit (= buy NMD, MD and shares), they create NBPS deposits (= money).

The referee in this game is the central bank which controls the growth rate in money creation (= new bank deposits resulting from new bank loans) by means that differ from country to country (which are elucidated later). The principal method is the interest rate on banks' loans (= bank assets) via the central bank's KIR interest rate, which influences the cost of bank liabilities (i.e. via the bank margin).

Price discovery

The sixth element is price discovery. Primary and secondary markets are important for a number of reasons, the most important of which is price discovery, i.e. the establishment of interest rates for various terms and the prices of shares. Interest rates, as we will see, have an important role to play in the pricing of all assets. The central bank plays a significant role in the establishment of interest rates. These significant issues are addressed later.

Allied participants on the financial system

From the above discussion it will be evident that there are a number of allied participants on the financial system. By this we mean participants other than the principals (those who have financial liabilities or assets or both). As we now know, the principals are:

• Lenders.

• Borrowers.

• Financial intermediaries.

The allied participants, who play a major role in terms of facilitating the lending and borrowing process (the primary market) and the secondary markets are the financial exchanges and their members. Also we need to mention the fund managers, who are actively involved in sophisticated financial market research and therefore play a major role price discovery, and the regulators of the financial markets. Thus the allied non-principal participants in the financial markets are:

• Financial exchanges.

• Broker-dealers.

• Fund managers.

• Regulators.

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