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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. As one party of the transaction may possess
superior information than the other party, it can lead to the information
asymmetry problem and inefficient allocation of financial resources. By
overcoming the information asymmetry problem the financial system
facilitates balance between those with funds to invest and those needing
funds.
According to the structural approach, the financial system of an economy
consists of three main components:
1) Financial markets
2) Financial intermediaries (institutions)
3) 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.
1) Price discovery
2) Liquidity
3) Reduction of transaction costs
1) Price discovery function means that transactions between buyers and
sellers of financial instruments in a financial market determine the price of
the traded asset. At the same time the required return from the investment of
funds is determined by the participants in a financial market. The motivation
for those seeking funds (deficit units) depends on the required return that
investors demand. It is these functions of financial markets that signal how
the funds available from those who want to lend or invest funds will be
allocated among those needing funds and raise those funds by issuing
financial instruments.
2) 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 until conditions arise to sell it or the
issuer is contractually obligated to pay it off. Debt instrument is liquidated
when it matures, and equity instrument is until the company is either
voluntarily or involuntarily liquidated. All financial markets provide some
form of liquidity. However, different financial markets are characterized by
the degree of liquidity.
3) The function of reduction of transaction costs is performed, when
financial market participants are charged and/or bear the costs of trading a
financial instrument. In market economies the economic rationale for the
existence of institutions and instruments is related to transaction costs, thus
the surviving institutions and instruments are those that have the lowest
transaction costs.
The key attributes determining transaction costs are
Asset specificity,
Uncertainty,
Frequency of occurrence.
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, which has (1) external sources
(when events change beyond control of the contracting parties), and (2)
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. In this case there is a possibility to control transaction costs.
However, when circumstances are not easily observable, opportunism
creates incentives for contracting parties to review the initial contract and
creates moral hazard problems. The higher the uncertainty, the more
opportunistic behavior may be observed, and the higher transaction costs
may be born.
Frequency of occurrence plays an important role in determining if a
transaction should take place within the market or within the firm. A onetime transaction may reduce costs when it is executed in the market.
Conversely, frequent transactions require detailed contracting and should
take place within a firm in order to reduce the costs.
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.
The mentioned attributes of transactions and the underlying incentive
problems are related to behavioural assumptions about the transacting
parties. The economists (Coase (1932, 1960, 1988), Williamson (1975,
1985), Akerlof (1971) and others) have contributed to transactions costs
economics by analyzing behaviour of the human beings, assumed generally
self-serving and rational in their conduct, and also behaving
opportunistically. Opportunistic behaviour was understood as involving
actions with incomplete and distorted information that may intentionally
mislead the other party. This type of behavior requires efforts of ex ante
screening of transaction parties, and ex post safeguards as well as mutual
restraint among the parties, which leads to specific transaction costs.
Transaction costs are classified into:
1) Costs of search and information,
2) Costs of contracting and monitoring,
In reality three groups are not mutually exclusive. Some public investors
may occasionally act on behalf of others; brokers may act as dealers and
hold securities on their own, while dealers often hold securities in excess of
the inventories needed to facilitate their trading activities. The role of these
three groups differs according to the trading mechanism adopted by a
financial market.
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. Financial intermediaries include depository
institutions, insurance companies, regulated investment companies,
investment banks, pension funds. 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.
The funds that a financial intermediary acquires become, depending on the
financial claim, either the liability of the financial intermediary or equity
participants of the financial intermediary.
The funds that a financial intermediary lends or invests become the asset of
The financial intermediary. Financial intermediaries are engaged in
transformation of financial assets, which are less desirable for a large part of
the investing public into other financial assetstheir own liabilitieswhich
are more widely preferred by the public.
Asset transformation provides at least one of three economic functions:
Maturity intermediation.
Risk reduction via diversification.
Cost reduction for contracting and information processing.
than one year and perpetual securities (those with no maturity). There are
two types of capital market securities: those that represent shares of
ownership interest, also called equity, issued by corporations, and those that
represent indebtedness, or debt issued by corporations and by the state and
local governments.
Financial markets can be classified in terms of cash market and derivative
markets.
The cash market, also referred to as the spot market, is the market for the
immediate purchase and sale of a financial instrument.
In contrast, some financial instruments are contracts that specify that the
contract holder has either the obligation or the choice to buy or sell another
something at or by some future date. 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.
Secondary markets are also classified in terms of organized stock exchanges
and over-the counter (OTC) markets.
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. The recent regulations
were passed in response to large bankruptcies, overhauled corporate