With an understanding of what financial assets are and the role of financial assets and financial markets, we can now identify who the players are in the financial markets. By this we mean the entities that issue financial assets and the entities that invest in financial assets. We will focus on one particular group of market players, called financial intermediaries, because of the key economic functions that they perform in financial markets. In addition to reviewing their economic function, we will set forth the basic asset/liability problem faced by managers of financial intermediaries.
There are entities that issue financial assets, both debt instruments and equity instruments. There are investors who purchase these financial assets. This does not mean that these two groups are mutually exclusive—it is common for an entity to both issue a financial asset and at the same time invest in a different financial asset.
A simple classification of these entities is as follows: (1) central governments; (2) agencies of central governments; (3) municipal governments; (4) supranationals; (5) nonfinancial businesses; (6) financial enterprises; and (7) households. Central governments borrow funds for a wide variety of reasons. Many central governments establish agencies to raise funds to perform specific functions. Most countries have municipalities or provinces that raise funds in the capital market. A supranational institution is an organization that is formed by two or more central governments through international treaties. Businesses are classified into nonfinancial and financial businesses. These entities borrow funds in the debt market and raise funds in the equity market. Nonfinancial businesses are divided into three categories: corporations, farms, and nonfarm/noncorporate businesses. The first category includes corporations that manufacture products (e.g., cars, steel, computers) and/or provide nonfinancial services (e.g., transportation, utilities, computer programming). In the last category are businesses that produce the same products or provide the same services but are not incorporated.
Financial businesses, more popularly referred to as financial institutions, provide services related to one or more of the following:
1. Transforming financial assets acquired through the market and constituting them into a different and more preferable type of asset—which becomes their liability. This is the function performed by financial intermediaries, the most important type of financial institution.
2. Exchanging financial assets on behalf of customers. 3. Exchanging financial assets for their own account. 4. Assisting in the creation of financial assets for their customers and then
selling those financial assets to other market participants. 5. Providing investment advice to other market participants. 6. Managing the portfolios of other market participants.
Financial intermediaries include: depository institutions that acquire the bulk of their funds by offering their liabilities to the public mostly in the form of deposits; insurance companies (life and property and casualty companies); pension funds; and finance companies. The second and third services in the list above are the broker and dealer functions. The fourth service is referred to as securities underwriting. Typically, a financial institution that provides an underwriting service also provides a broker- age and/or dealer service.
Some nonfinancial businesses have subsidiaries that provide financial services. For example, many large manufacturing firms have subsidiaries that provide financing for the parent company’s customer. These financial institutions are called captive finance companies.
Archive for the ‘Real markets’ Category
OVERVIEW OF MARKET PARTICIPANTS
Tuesday, September 14th, 2010Role of Brokers and Dealers in Real Markets (2)
Saturday, August 14th, 2010The fact of imbalances explains the need for the dealer or market maker, who stands ready and willing to buy a financial asset for its own account (add to an inventory of the security) or sell from its own account (reduce the inventory of the security). At a given time, dealers are willing to buy a security at a price (the bid price) that is less than what they are willing to sell the same security for (the ask price).
In the 1960s, economists George Stigler and Harold Demsetz analyzed the role of dealers in securities markets. They viewed dealers as the suppliers of immediacy—the ability to trade promptly—to the market. The bid-ask spread can be viewed in turn as the price charged by dealers for supplying immediacy, together with short-run price stability (continuity or smoothness) in the presence of short-term order imbalances. There are two other roles that dealers play: they provide better price information to market participants, and in certain market structures they provide the services of an auctioneer in bringing order and fairness to a market.
The price-stabilization role relates to our earlier example of what may happen to the price of a particular transaction in the absence of any intervention when there is a temporary imbalance of order. By taking the opposite side of a trade when there are no other orders, the dealer prevents the price from materially diverging from the price at which a recent trade was consummated.
Investors are concerned with immediacy, and they also want to trade at prices that are reasonable, given prevailing conditions in the market. While dealers cannot know with certainty the true price of a security, they do have a privileged position in some market structures with respect to the flow of market orders. They also have a privileged position regarding “limit” orders, the special orders that can be executed only if the market price of the security changes in a specified way.
Finally, the dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market. For example, the market maker on organized stock exchanges in the United States performs this function by organizing trading to make sure that the exchange rules for the priority of trading are followed. The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market.
One of the most important factors that determine the price dealers should charge for the services they provide (i.e., the bid-ask spread) is the order processing costs incurred by dealers, such as the costs of equipment necessary to do business and the administrative and operations staff. The lower these costs, the narrower the bid-ask spread. With the reduced cost of computing and better-trained personnel, these costs have declined over time.
Dealers also have to be compensated for bearing risk. A dealer’s position may involve carrying inventory of a security (along position) or selling a security that is not in inventory (a short position). There are three types of risks associated with maintaining a long or short position in a given security. First, there is the uncertainty about the future price of the security. A dealer who has a long position in the security is concerned that the price will decline in the future; a dealer who is in a short position is concerned that the price will rise.
The second type of risk has to do with the expected time it will take the dealer to unwind a position and its uncertainty. And this, in turn, depends primarily on the rate at which buy and sell orders for the security reaches the market (i.e., the thickness of the market). Finally, while a dealer may have access to better information about order flows than the general public, there are some trades where the dealer takes the risk of trading with someone who has better information This results in the better-informed trader obtaining a better price at the expense of the dealer. Consequently, in establishing the bid-ask spread for a trade, a dealer will assess whether the trader might have better information. Some trades that we will discuss below can be viewed as “information- less trades.” This means that the dealer knows or believes a trade is being requested to accomplish an investment objective that is not motivated by the potential future price movement of the security.
Role of Brokers and Dealers in Real Markets (1)
Monday, August 2nd, 2010Common occurrences in real markets keep them from being theoretically perfect. Because of these occurrences, brokers and dealers are necessary to the smooth functioning of a secondary market.
One way in which a real market might not meet all the exacting standards of a theoretically perfect market is that many investors may not be present at all times in the marketplace. Further, a typical investor may not be skilled in the art of the deal or completely informed about every facet of trading in the asset. Clearly, most investors in even smoothly functioning markets need professional assistance. Investors need someone to receive and keep track of their orders for buying or selling, to find other parties wishing to sell or buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the orders. The broker performs all of these functions. Obviously, these functions are more important for the complicated trades, such as the small or large trades, than for simple transactions or those of typical size.
A broker is an entity that acts on behalf of an investor who wishes to execute orders. In economic and legal terms, a broker is said to be an “agent” of the investor. It is important to realize that the brokerage activity does not require the broker to buy and hold in inventory or sell from inventory the financial asset that is the subject of the trade. (Such activity is termed “taking a position” in the asset, and it is the role of the dealer.) Rather, the broker receives, transmits, and executes investors’ orders with other investors. The broker receives an explicit commission for these services, and the commission is a “transaction cost” of the capital markets.
A real market might also differ from the perfect market because of the possibly frequent event of a temporary imbalance in the number of buy and sell orders that investors may place for any security at any one time. Such unmatched or unbalanced flow causes two problems. First, the security’s price may change abruptly even if there has been no shift in either supply or demand for the security. Second, buyers may have to pay higher than market-clearing prices (or sellers accept lower ones) if they want to make their trade immediately.
For example, suppose the consensus price for ABC security is $50, which was determined in several recent trades. Also suppose that a flow of buy orders from investors who suddenly have cash arrives in the mar- ket, but there is no accompanying supply of sell orders. This temporary imbalance could be sufficient to push the price of ABC security to, say, $55. Thus, the price has changed sharply even though there has been no change in any fundamental financial aspect of the issuer. Buyers who want to buy immediately must pay $55 rather than $50, and this difference can be viewed as the price of “immediacy.” By immediacy, we mean that buyers and sellers do not want to wait for the arrival of sufficient orders on the other side of the trade, which would bring the price closer to the level of recent transactions.