The Role of Financial Institutions and Markets

Introduction

The financial world is a complex system that consists of networks, decision-makers, tax regimes, regulators, policies, markets, institutions, and several other components. The environment that supports financial services plays a major role in determining the financial services that are available in a certain economy and their viable alternatives. Consequently, financial decisions are often influenced by market and financial structures. Therefore, it is paramount for financial managers and investors to understand the atmosphere in which they function. The benefits of having a sound financial system have been outlined by financial scholars as being major prerequisites for functional and prosperous economies.

On the other hand, it is customary for the environments surrounding markets and institutions to be used by firms and investors who are trying to raise capital. Globalization has also been a major contributing factor when it comes to the need to understand financial markets and institutions. Consequently, homogenous trading zones such as the European Union (EU), Hong Kong, and North America can influence institutions and markets that are ideally far away. An investor in California can have more interest in understanding financial markets in Hong Kong than an ordinary Chinese citizen. One important piece of the puzzle when it comes to financial markets and institutions is that these entities rely on consumers’ trust. Nevertheless, even in the advent of globalization and increasing technology, financial institutions are subject to malpractices leading to widespread losses and mistrust. This essay seeks to explore financial markets and institutions with the view of understanding them and their respective environments. The essay also explores markets that generate capital and facilitate trade, as well as the institutions that make up these markets.

Financial Markets: Different Types of Markets

A financial market is characterized by individuals and organizations that are either looking to borrow finances or profit from a surplus. Financial markets are also made up of parallel entities that all deal with different monetary products. Therefore, there are different types of financial markets and they are all categorized by the mode of their operations and the products that they offer. An example of the market type is the physical asset market and it offers real-life products such as petroleum and wheat. The contrasting form of this market is the financial assets market, which deals with bonds, stocks, mortgages, and other types of financial securities. An example of a financial asset market is the New York Stock Exchange (NSE), which trades in shares and other forms of security.

Another market juxtaposition involves future versus spot markets and their main difference in operation is if assets are bought or sold on the spot or in the future. In future markets, customers are at liberty to plan to buy or to sell an asset at a later date. An example of spot markets is the usual stock exchange market where a bell signifies the close of transactions (Downes and Goodman 2010). On the other hand, a future market involves contracts between a seller and a buyer, and they mostly involve physical assets.

A market can also be identified either as money or capital market, whereby the former deals with short-term liquid assets and the latter is characterized by long-term assets. Money markets are common in countries that have healthy economies such as the ones in the United States, Japan, and the United Kingdom. The capital markets of these countries are often represented by world-class stock exchange markets. In regards to short-term market classifications, the maturity period of the traded securities has to be less than one year. Markets can also be primary or secondary, whereas the former is concerned with raising capital. Primary markets do not have the intermediary element and they involve corporations selling assets directly with the view of raising capital. On the other hand, secondary markets often involve trades of preexisting securities amongst established investors. When an ordinary citizen wants to buy Facebook shares, he/she can do so from the NSE, a secondary market. All the securities and assets that are sold through the NSE do not belong to the entity, but they are traded on behalf of other companies.

Another defining element of market institutions is whether they are private or public. Private markets involve deals between two individual parties. On the other hand, public markets often involve standard contractual obligations. Some of the products that are found in private markets include private debts and bank loans. The structure of private markets is meant to cater to the interest of two parties while public markets are meant to appeal to huge pools of investors. The mark of a public market is “fairly standardized contractual features, both to appeal to a broad range of investors and also because public investors do not generally have the time and expertise to study unique, non-standardized contracts” (Kidwell et al. 2016, 45).

Products in Money Markets

The most common product in the financial market is money-market security. Money market securities “are debt securities with a maturity of one year or less” (Madura 2014, 29). These products are notable because they are highly liquid and they have low returns. Furthermore, these products carry low-risk levels regardless of their volatility. Another product in the financial market is capital market securities. These products often have a maturity period that is more than one year. Examples of capital market securities include stocks, bonds, and mortgages. These products are known for their high returns on investments and the accompanying high risks. Bonds are generally long-term debt commitments that are often issued and guaranteed by government agencies and corporations. On their part, mortgages are often issued by financial institutions for financing real-estate products. These two securities often come with fixed or predictable interest rates. On the other hand, stocks provide investors with the option of owning part of a publicly-traded company. Stocks come with the possibility of the highest returns and the highest losses. Derivative securities are “products whose value is a contractual obligation based on other underlying values” (Downes and Goodman 2010, 74). Customers buy derivative assets to speculate on the values of associated assets. Good risk management can make derivatives profitable.

Financial markets are generally volatile and they change from time to time. Some trends in financial markets can last for days, while others can last for a few decades. Currently, it has become difficult for governments and other entities to regulate financial markets. Consequently, the level of competition between financial markets has increased drastically as a result of globalization. On the other hand, this competition has fostered better performing money markets. The openness of markets as a result of globalization has also brought about some challenges. According to financial experts, economies have become more vulnerable to unseen and unpredictable forces (Korten 2008, 4). For example, considerable transactions between two random financial players can affect local institutions and interest rates.

One of the most urgent concerns concerning financial markets is the need for cooperation among the major players around the world. Many movers and shakers at the international level are under pressure to harmonize the markets and accommodate more cooperation. Some industry players are of the view that promoting cooperation among different entities would create bigger and more efficient markets. Some of the challenges that stand in the way of cooperation include the dissimilarities that exist between various countries’ financial structures and policies. Furthermore, globalization has created a scenario where most countries such as the ones in the EU are forming blocs, while other nations are seeking to recapture the glory of nationalism including the US and the UK. The issue of globalization versus nationalism is compounded by the fact that some nations want to enjoy the fruits of deregulation while they are still holding on to their national interests (Summers 2010). This lack of harmony exists regardless of the opinions of policymakers, who favor a more globalized world.

In recent years, the use of derivatives has also increased financial markets. The profitability of derivatives is often based on the performance of an underlying asset. As a result of financial markets becoming more complex, players in this field have also become more averse to the risks that accompany derivatives. For example, when an investor is sure about the changing fortunes of the Sterling Pound, he or she is likely to attach this conviction to derivative instead of trading in this currency directly. Statistics indicate that the derivative market is among the fastest-growing ones in the current financial world. The growing demand for derivatives has also been attached to the need for reducing financial risks. Therefore, the use of hedging operations to reduce exposure to risks is one of the driving forces behind the increased use of derivatives. On the other hand, some players trade in derivatives simply because they come with high risks and high returns. Some market participants have made big gains while others have incurred significant losses because of investing in derivatives. Nevertheless, most financial stakeholders are concerned about the complexity surrounding investment in derivatives. For example, most regulators concur that these products can be used to bypass some financial regulations.

The process involving the valuation of securities in the financial markets has also changed in the last few years. Ordinarily, the valuation of securities takes into account “the present value of their expected cash flows and the elements of uncertainty surrounding them” (Sandor et al. 2014, 90). Therefore, one asset can be valued differently by two investors depending on how each of these players interprets information. Valuation has significant impacts on pricing because it takes into account the core aspects of market dynamics. Good information is responsible for upward revisions in regards to prices. On the other hand, the equilibrium price of securities is purely dependent on incoming information. The digital age has had a profound impact on the valuation process. For instance, the internet has made it easier for players to conduct online price quotations. Investors can also be able to track how some assets have been sequentially traded over time. Furthermore, the internet has facilitated faster and more efficient online transactions.

It would be safe to assume that financial markets would be more efficient in the information age. However, even the increased access to facts and information has had only a small impact on market efficiency. A market becomes efficient when the prices of its products reflect all the relevant facts. An efficient market provides investors with the option of purchasing different products by their liquidity, tax status, and risk preference (DeFusco et al. 2015). The element of asymmetric information is also relevant to financial markets. Asymmetric information is responsible for a significant number of financial shocks in the recent past. For instance, the valuation of most stocks is dependent on financial statements that are produced by managers using asymmetric information. Therefore, it is possible to misprice stocks “as a result of flexibility in accounting guidelines or overestimation of earnings” (James 2015, 14). This common anomaly is often mitigated by obligating managers to disclose all relevant information to potential investors. However, the information that is received to the public should also be relevant and accurate. Examples of misrepresented securities as a result of misuse of asymmetric information include the WorldCom and Enron Scandals. It has also become apparent that the current regulatory measures are not enough to cushion investors because information can be manipulated to suit the needs of managers. Proposals to counter the pitfalls of asymmetric information include an insistence on the accuracy of data, pushing more restrictions, and making individuals accountable.

Financial Institutions

Within less developed economies, financial institutions are synonymous with facilitating transfers of money between individuals, companies, and countries. However, within developed economies the essence of financial institutions takes on a different meaning. One main function of financial institutions in more developed economies is to raise capital for various uses. Over time, the essence of the financial institution has evolved into an entity that can act as a high functioning financial intermediary. A single institution is also in a position to serve various types of financial markets at the same time. A modern financial institution is too diverse and this makes it difficult for institutions to be distinguished. However, some institutions have managed to sustain one major distinction even as they seek to diversify their portfolios. The role of any financial institution depends on the nature of the market under which it operates. Therefore, in perfect market conditions institutions help in supplying information to investors and provide a wide range of security options. Nonetheless, financial institutions are more useful because they address the challenges of imperfect market conditions.

There are several categories of financial institutions and this classification depends on the problems that they solve concerning markets. Investment banking houses represent a form of the financial institution that provides services to individual investors and any other entity that is trying to raise capital. Examples of investment bankers include Goldman Sachs, Morgan Stanley, and Merrill Lynch. The roles of investment bankers include assisting corporations to come up with products that might appeal to investors. These institutions are also involved in the buying and selling of assets by acting as brokers in these types of transactions. Overall, investment-banking houses are involved in the acquisition and transfer of capital.

Commercial banks are the most common financial institutions in the world. These institutions are at the doorstep of the financial world and they serve various functions to both individual and corporate clients. Examples of commercial institutions include Wells Fargo, Barclays, and Bank of America. Traditionally, a commercial bank was entrusted with linking individuals with the Federal Reserve System through a central bank. However, in the modern financial regime, most of the tasks that were traditionally left to commercial banks have been absorbed by other smaller or bigger financial institutions. In some parts of the world, the advent of mobile banking has almost eclipsed the role of commercial banks as providers of checking services (Lusardi and Mitchell 2014). Banks are often in a position to serve both the private and public sectors. One of the roles that banks have managed to hold on to is the transfer of money through various mediums.

A financial services corporation is a big organization that provides different services through various types of institutions under one roof. A financial corporation can combine insurance, banking, lending, brokerage, and investment services under one company. Some examples of financial services corporations include Citigroup and Fidelity. Savings and loan associations (S&Ls) are companies that are focused on providing credit facilities by collecting money from small savers and providing it to a wide range of borrowers. The types of services that are provided by S&Ls include facilities for commercial and residential mortgage borrowers. Incidentally, S&Ls have been responsible for several financial crises including one in the 1980s and another one in 2008 (Borio 2014). In the 1980s, the S&L was involved in a crisis as a result of imbalanced interest rates in terms of borrowing and lending. This increased the rates of defaulted mortgages leading to a real-estate market meltdown. Another type of financial institution is mutual savings banks. These types of institutions are similar to S&Ls but they have less focus on real estate.

Mutual funds are one of the most popular types of financial institutions and they are organizations that “accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units” (Hull and Pitt 2013, 19). Mutual funds are institutions whose focus is to avoid risks through diversification. Mutual funds operate using the concept of economies of scale and high expertise in analyzing securities and their performance. Hedge funds are another financial product that involves collecting money from potential investors. However, hedge funds differ from mutual funds because they have to be regulated by a Securities and Exchange Commission (SEC). Furthermore, while mutual funds are designed with small investors in mind, hedge funds are meant for bigger investors with a worth of more than 1 million dollars. Institutions are a core element of hedge funds because they are their main clients as opposed to individuals.

Conclusion

All financial services occur under an environment that fosters the cooperation between markets and institutions. These two factors are responsible for supporting current and future market dynamics. A market type is determined by various factors including its interaction with securities and its mode of operation. Some of the common market types include spot, capital, future, and money markets. Various forms of securities are traded in financial markets including money and capital market securities. The interaction between a market and securities is important in determining the valuation of different products within this environment. Several trends apply to modern financial markets and institutions and they are all courtesy of the role that is played by organizations such as commercial banks, financial corporations, and hedge funds.

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