National and international financial systems are made up of a number of specific markets and sub-markets. These are generally divided into money and capital markets each of which includes a number of separate sub-markets. These may either operate on a formal exchange or off-market over-the-counter (OTC) basis. Almost all will be subject to some formal organisation and regulation.
Financial markets carry out a number of essential services including savings or investments, credit or funding and risk management. Risk cover can be provided either through insurance contracts (including life and non-life or contingent liability insurance) or through specialised instruments including financial derivatives such as futures, options and swaps or other hybrid products. Organised markets or exchanges more specifically carry out a number of important functions including price discovery or disclosure which permits trading or dealing in relevant securities as well as supporting clearing and settlement as well as trade and transaction reporting functions.
A key feature of all of these markets and instruments is that they are based on legally enforceable contracts or claims. This can either be expressed as a form of a debt obligation entered into between a bank (or group of banks) and the customer or in a transferable form of security instrument. While traditionally recorded in the form of a written contract or security instrument, these claims are increasingly being issued in a purely electronic form and transfer or traded through electronic systems. The main types of financial markets that make up any modern economy are reviewed next. The more specific issues that arise with regard to exchange definition, structure, function and operation are then considered.
(1) Capital Markets
An initial distinction has to be drawn between capital or securities markets and money markets. These are the two main markets within any financial system.
Securities or capital markets provide a range of alternative investment and funding mechanisms. The capital markets are made up of a mixture of primary (initial issuance) and secondary (dealing) markets. These principally allow for sovereign or corporate entities to obtain capital through the issuance of transferable debt instruments (principally involving bonds, bills or gilts) that can then be traded on active secondary markets. The debt holder will receive an interest payment during the term of the instrument. Companies can also raise capital in a different way, by issuing shares or equity instruments with the holder owning a proportionate interest in the entity and receiving a dividend payment.
The issuer of debt or equity will receive funds on the first placement of the security in the primary market. These securities can then be bought or sold on active secondary markets with dealers or investors making a profit (or loss) on the rise and fall in the value of the securities. Primary issues and secondary dealing can be carried out either on a formal stock exchange or market or off-exchange (OTC). The capital markets more generally also include other direct sources of investment funds, such as through national or international development or industrial banks or investment vehicles or venture capital providers.
The equity markets consist of the markets for the initial issuance and subsequent purchase and sale of shares in corporate bodies. Equity refers to the equity or share capital of a firm which represents, in total, the interests in the company which correspond with the total amount subscribed by its members. Warrants are transferable certificates that allow the holder to acquire a specified number of shares or bonds. Depository receipts are certificates evidencing ownership of an underlying asset such as a share. The certificate acts as a receipt that becomes a fully transferable security independent from the underlying interest. These include American depository receipts (ADRs) that are cleared through the US Depository Trust and Clearing Corporation (DTCC) as well as global depository receipts (GDRs) and some European depository receipts (EDRs).
Capital markets generally then involve the issuance and trading in debt instruments (bonds or euro bonds), equities, warrants and hybrids as well as depository receipts. Governments principally borrow through debt or bond instruments although these are also commonly issued by large and medium or smaller sized corporate bodies (in which case the instruments are often referred to as debentures). Bonds may either be issued in the local currency or in another currency. The international markets in which large bond issues are denominated in a currency other than the currency of the country of issuance are is referred to as the Eurodollar market.
(2) Money Markets
The money markets generally refer to the wholesale markets in short term bills or paper. Relevant instruments include treasury bills (bills of exchange or promissory notes), local authority or corporate bills, bankers’ drafts (promissory notes issued by banks), certificates of deposit (transferable securities representing underlying deposit amounts) as well as commercial paper (short term marketable unsecured promissory notes) and bankers’ acceptances or bank deposits.
The UK money markets are made up of the primary (or discount) market in which the Bank of England manages the amount of money (credit) in circulation within the financial system as the central bank, and the secondary money markets in which other types of credits are bought and sold. The Bank of England will generally only deal with a limited number of specialist dealers in the primary market. This is referred to as the discount market as this group was originally restricted to discount houses in the City of London. The number of institutions eligible to participate in the primary money market has since been extended with the Bank of England also increasingly using sale and repurchase agreements (repos) to supply funds to banks without the use of the discount market. (A repurchase agreement (RP or repo) is a sale and repurchase agreement that involves a cash or spot sale of a security or other asset with a forward repurchase at an agreed price.)
The parallel or secondary money markets consist of a number of separate wholesale markets for the issuance and trading of other types of short-term bills or money instruments. In the UK these principally consist of the local authority market, finance house market, inter-company market, sterling inter-bank market and sterling certificate of deposit and sterling commercial paper market. These markets generally emerged at the end of the 1950s following the closure of the earlier Public Works Account which required local authorities to issue bills into the market for the first time. Dealings are unsecured and not supported by the Bank of England and are generally conducted by telephone or on screen with no formal trading floor. A number of banks may operate in more than one of these secondary markets.
(3) Eurodollar Markets
1.46 The main international financial markets are the Eurodollar markets which are made up of separate syndicated loan, bond and supporting inter-bank markets. These grew significantly with the expansion of cross-border banking and investment business following the restoration of currency convertibility after the Second World War, beginning in 1958. Growth of the Eurodollar markets was boosted by the massive influx of ‘petro-dollars’ following the oil price increases in 1973 and 1979 as well as the more general demand for investment capital by countries and international corporations especially since the early 1970s.
(4) Currency Markets
The currency markets are the wholesale markets for the purchase and sale of foreign currencies on either an immediate (cash) or future (forward) basis. The currency market is reputedly the largest market in the world with over US$1.9 trillion being transferred daily. The market is screen based with around 350 participating banks in total although the majority of transactions are carried through about 50 banks and between 10-12 brokers. Dealer banks provide continuous bid (buy) and ask (sell) prices on minimum contract sizes of US$1m. Brokers act as intermediaries between corporate or retail customers and the main market. Most transactions are inter-bank with a third involving a dealer and another financial institution. The main financial centres are London, New York and Tokyo with over one-third of the total business being conducted through the City of London.
(5) Financial Derivatives Markets
The financial derivatives markets provide a number of risk management facilities. These can either be used to hedge specific risks such as currency, interest rate or increasingly credit risk or be used for proprietary trading purposes as with other securities. The main instruments involved include exchange and off-exchange futures and options as well as swap contracts. While forwards trading has been available since early times, most of the new more sophisticated instruments only emerged during the early 1970s following the collapse of the Bretton Woods system of managed exchange arrangements between 1971 and 1973. This, in particular, led to the introduction of floating currencies for the first time during the post-War period with associated volatility in foreign exchange and interest rate risks.
(6) Gold Market
The gold market provides for the sale and purchase of gold through a daily fixing in London with physical delivery being managed through other centres including, in particular, Zurich. The Gold Market has traditionally been based at Rothschild’s in London with the five main members meeting at 10.30am and 3pm to fix the daily price to cover outstanding purchase and sales orders. The market now includes 11 market-makers and approximately 50 ordinary members of the London Bullion Market Association (LBMA) that was set up in 1987. Members represent the major gold centres including Zurich, Frankfurt, Sydney, Tokyo and New York with the Bank of China as a member.
(7) Commodity Markets
Other commodities can also be sold on an open outcry or auction basis through various exchanges, salerooms or auctions. This includes oil and metals, as well as consumables (such as sugar, cocoa, copper or coffee) and non-consumables (such as fibres and furs). Ships and shipping and airfreight and aircraft are also sold through shipping and carriage markets such as the Baltic Exchange in London.
(8) Insurance Markets
Insurance markets provide a range of additional risk management services. These principally either include life (pension) assurance or cover and non-life or other contingent liability cover (including property, business, fire, motor and personal injury insurance). Insurance intermediation allows for the receipt of an agreed return in the event of a contingent or unexpected event. The life or insurance companies receive a one-off or annual premium that is invested in the capital markets to produce an appropriate capital base and income stream from which payments can be made. This then allows governments, businesses and individuals to manage their commercial and personal relations more effectively.
G A WALKER