The Financial Infrastructure
The financial infrastructure is at the heart of the financial system and is required for it to function. The financial infrastructure consists of technological systems that manage payments and transactions involving financial instruments.
The financial infrastructure refers to the environment in which financial decisions are made. Some of the questions often considered about this environment include:
- What are the roles of various financial institutions and markets, and how do they function?
- What are the different types of financial instruments that exist, and why are there so many?
- What do stock market averages represent, and how are they constructed?
- How do the bond markets function, and what is the relationship between bond prices and yields?
Overview of Markets
Capital Markets are those financial markets where long-term debt (bonds) and equity securities (shares of stock) are issued and traded (that is, bought, and sold). The New York Stock Exchange (NYSE) is an example of a capital market.
The money market is the market for short-term, highly liquid debt instruments maturing in one year or less, including Treasury bills, commercial paper, and certificates of deposits. To say that these debt instruments are highly liquid means that the holder of them can quickly and easily sell them to other investors for cash.
The primary market includes securities dealers and financial institutions (such as investment banks) that issue new securities to the investing public. There is both a primary capital market and a primary money market.
For example, when a corporation issues new stock shares to raise capital, it sells them in the primary market with the assistance of an investment bank. Shares of a firm’s stock may be bought and sold many times over by investors in the secondary market. However, the corporation only earns the proceeds from the first sale of the stock shares in the primary market.
The secondary market (also called the “aftermarket”) is where securities are bought and sold after they have been issued. Secondary markets exist for the trading of common and preferred stock, warrants, bonds, and puts and calls. The secondary market includes both (a) primary market participants and (b) over-the-counter (OTC) dealers and organized securities exchanges (such as the NYSE).
Stock market is a generic term for those institutions that facilitate the exchange of stocks between buyers and sellers. A stock market can be a physical location— such as the famous trading floor of the NYSE. However, with the growth of electronic transactions, a large fraction of stock market transactions are now “virtual.”
In addition to the markets described above, there are many specialized financial asset markets. For example, mortgage markets (dealing with loans secured by real estate) and consumer credit markets (dealing with loans to individuals, such as auto loans).
Financial intermediaries are institutions such as:
A financial intermediary* receives cash from savers and issues them shares of its own securities (e.g., mutual fund shares). The financial intermediary then invests the savers’ money on their behalf.
Direct Transfer versus a Financial Intermediary
To better understand the difference between a direct transfer versus a financial intermediary, consider the following two situations.
An individual uses an online brokerage (such as E*Trade) to buy shares in Microsoft. At the end of the transaction, the individual owns shares of Microsoft herself. This is an example of a direct transfer.
An individual invests money with a mutual fund company. The mutual fund company, in turn, buys shares of Microsoft and other corporations with the money. At the end of the transaction, the individual does not own shares of Microsoft; instead, she owns shares of a mutual fund while the mutual fund owns shares of Microsoft. This is an example of a financial intermediary.
Financial assets* include stocks, bonds, rights, certificates, bank balances, deposits, mortgages, etc., (as distinguished from tangible, physical assets— such as machinery, real estate, and commodities).
What Are The Main Functions Of Financial Intermediaries?
A financial intermediary is an entity that acts as the middleman or facilitator between two parties in a financial transaction. Examples include commercial banks, investment banks, mutual fund companies, or pension funds. Financial intermediaries move funds from people who have surplus capital, who can–we refer to as savers or lenders, to those who require liquid funds to carry out a desired activity, referred to as investors or borrowers.
A financial intermediary will typically facilitate the channeling of funds between lenders and borrowers indirectly. The savers give funds to an intermediary institution such as a bank and that institution gives those funds to borrowers. This might take the form of a loan or mortgage. For example, in the sale of a house, a bank usually serves as a financial intermediary by providing a mortgage to the homebuyer.
In the situation where an investor purchases a bond, a stock exchange such as OTC, known as over-the-counter, will act as the financial intermediary to facilitate the transaction. Bonds can be purchased and repurchased and thus have an active secondary market.
Overall, financial intermediaries serve as a vital role by acting as the oil in the machinery of the economy and serve to maintain the continued flow of capital.
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To test your understanding of the content presented.
1. Using a company like E*Trade for stock trades is an example of which of the following?Choose only one answer below.
b. Direct transfer
Correct. Using a company like E*Trade for stock trades is an example of a direct transfer.
c. Capital marketing
d. Indirect transfer
2. Which of the following are traded in the money market?Choose only one answer below.
a. Common Stock
b. Preferred Stock
c. U.S. Treasury Bills
Correct. U.S. Treasury Bills trade in the “money market” since their risk-free nature and liquidity make them virtually the same as cash.
d. Corporate Bonds
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