Financial Markets

What are the main roles of financial markets?

• Facilitating savings: financial markets provide a means for people to transfer their money power from the present to the future. For example, you can put aside some money for savings or invest in bonds and shares to earn future interest.
• Providing loans: in the capital market, corporations or the government can issue loans and bonds in exchange for public money. Bonds, in the case of a corporation, are loans made by an investor to a business in need of cash for operations and growth.
• Allocating capital to more productive use: people can invest their extra cash in a business function to collect interests instead of sitting idle in a bank account.
• Facilitating transactions: financial markets provide a way for buyers and sellers to interact and exchange funds for their transactions.
• Providing forward markets: in forward markets, you can offer to buy a product in the future at a pre-determined price to avoid price volatility.
• Providing a market for equities: an equity market is a market of shares. A company can sell shares to the public in exchange for capital to grow. An individual investing in the company’s shares can also earn a return on investment, usually in the form of dividends - a fixed amount of money paid at a certain period provided the business performs well.

In the Financial Sector explanation, we discussed briefly the different financial markets in the UK.

Let’s review with a diagram:

The UK’s money market

The assets in the money market are highly liquid, meaning they can be converted to cash easily without losing value. Some examples include treasury bills (short-term securities issued by the governments) and commercial bills (short-term securities issued by commercial banks). In the money market, banks serve as an intermediary between savers and borrowers.

London interbank market is a major component of the UK’s money markets. It sets the LIBOR (London Interbank Offered Rate) interest rate which is the interest rate banks charge when lending to each other.

The UK’s capital market

There are two types of capital markets: primary markets of newly issued bonds and shares and secondary markets trading existing financial assets.

One major secondary market in the UK is the London Stock Exchange (LSE) which allows public limited companies (PLCs) to raise capital for their long-term growth. Government finance is facilitated by the bond market through gilts (UK government bonds).

We can classify foreign exchange markets into spot markets and forward markets. Spot markets handle current foreign exchanges, whereas forward markets buy and sell foreign exchanges that will take place at a later date. The foreign exchange rate in forward markets is settled now but applied in the future when the transaction is carried out.

Large international and commercial banks are major participants in foreign exchange markets.

Examples of financial markets

Let’s now take a look at some examples of financial markets.

Money market example

Treasury bills are debt securities issued by the Debt Management Account in the UK on a weekly or ad hoc basis.¹

The maturity of Treasury bills can range from one day to a year. However, most bills mature in one, three, or six months.

Capital market example

Bonds are a component of a capital market. A bond is a loan that investors give to a firm or the government to cover their long-term financial needs.

In the UK, government bonds are referred to as gilts. Gilts are safer to invest in than most financial assets, though they are not risk-free due to inflation, interest rate, and liquidity issues.

Fig. 2 - British government stock (gilts). Source: Office for National Statistics UK, ons.gov.uk

Forex market example

The forex market is the global market for foreign exchange transactions. Foreign exchange is the trading of one currency for another. For example, in Figure 3, we see the exchange rates between the British pound GBP and Euro over a 20-year period.

In 2000, the exchange rate was 1.6, which means for every British pound you could acquire 1.6 Euros. Ten years later, it had dropped to 1.2: one British pound was equivalent to 1.2 Euro. Such a fall in the exchange rate is called depreciation - a decline of one currency’s value relative to another.

Fig 3. - Average Sterling Exchange Rate: Euro, from 2000 to 2020. Source: Office for National Statistics UK, ons.gov.uk

Financial markets’ failures

Like many types of markets, the financial market is largely influenced by a price mechanism. That is, the system through which the prices of goods and services are determined based on the market demand and supply. When the price of a financial asset deviates too far from its actual value, financial market failures will occur.

Financial market failures are grouped into four main types: financial crisis, market bubbles, asymmetric information, and market rigging.

Financial crisis

A financial crisis happens when the prices of financial assets reduce sharply, leaving businesses and consumers alike unable to pay off their debts. During a financial crisis, banks and other financial institutions may experience liquidity shortages. Financial crises can be triggered by systemic failures, uncontrollable human behaviours, or the lack of governmental regulations.

Some examples include the Argentine Great Depression and the Lebanese Currency Crisis.

Market bubble

A market bubble happens when a financial asset is overvalued due to overly optimistic projections about the future, followed by a drastic drop in the price.

The Dot-com Bubble is a famous example of a market bubble. In the 1990s, there was a surge in investment in technology-based companies and the Internet, which quickly drove up the price of the stock in this sector. However, after the market peaked, the price nosedived, sparking a panic among investors and up to 10% of loss in the stock market.

Asymmetric information

Asymmetric information is the state where one party has information that the other does not have. In a transaction, when either the buyer or seller has asymmetric information, they can use this to drive more benefits for themselves.

For example, an owner of a used laptop doesn’t reveal to their buyer its defects. As a result, the buyer may pay a higher price than they should.

Market rigging

Market rigging happens as firms raise or fix prices to generate higher profits for themselves. The practices of market rigging are often referred to as price-fixing or collusion.

In the case of price-fixing, a market leader can increase the price of a product, which allows smaller firms to raise the price as well, causing customers to pay a higher price for the commodity.

References:

1. Georgina Hutton and Ali Shalchi, Financial services: contribution to the UK economy, House of Commons Library, 2021.