As a branch of economics, finance has its own research method, and mainly studies financial sector in a national economy. Content of finance can be summarised as currency issue and return; deposit absorb and withdraw; loan disburse and collection; gold, silver and foreign exchange trading; securities issue and transfer; insurance; trusts; domestic and international monetary settlement and other economic activities. (John, G. & Edward, S. 1960) In short, finance is the activity about funds allocation. The place which people engaged in financial activities and funds to flow in was called financial marketing. Although it is not perfect, it relate to a broad area and range of economics. Finance can be divided into two forms, which are direct finance and indirect finance. The difference between these two forms is that whether financial intermediaries get involved. Financial intermediaries are people or institutions which play the roles of intermediary are people or institutions which play the roles of intermediary or bridge between capital supplier and borrower in financial markets. However, to analysis and explain what is the role of financial market and financial intermediaries and why exist, are the main purpose of this essay.
1. What is financial market.
Financial markets are the markets where capital providers and capital demanders transaction through the credit instruments. Broadly speaking, financial markets are the markets can achieve monetary loans and funds allocate, deal with trading of a variety of instruments and securities. More complete definition of the financial markets is: financial markets are organisations which can trading financial assets and determine the prices of financial assets.
2. The introduction to financial market.
The component of financial markets are very complicated, it is a large system which was composed of many different markets. Whereas, generally based on the trading tools period in financial markets, financial markets can be divided in money market and capital market. Money markets are the places that for trading short-term debt securities and capital markets are the places that for trading medium or long-term securities.
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Financial markets also can be classified according to several different features they present: 1) Type of asset traded. There are two kind of financial securities deal by financial markets, one is bonds which issued by government, banks or corporations and another one is equity shares which by government or any kind of public company. 2) The means of settlement include cash market and forward market. Cash market, the place for people to decide of price and settlement all take place today. Forward market, for people to agree price on today, and settlement takes place sometime in the future. 3) The obligation to exchange. The buyers have to pay the price which been settled before for asset on the particular date in the future market. The buyers have right to decided whether to buy asset on the date and at the price agreed in the past. 4) The organisational structure of the market. By this way, financial markets can be divided into regulated markets and over the counter market. In regulated markets, the buyer and seller of each transaction have to enter a contract in exchange such as clearing house; the contract is represented by the clearing house. In an over the counter market, there is no clearing house and dealers just trade between themselves. 5) The method of sale or pricing. Account to this feature, financial market can be classified into market makers and dealers market. 6) The nature of transaction. In accordance with whether the assets traded are newly issued or already issued, financial market be plotted out in two parts, primary market and secondary market. Primary market is the issue of new securities market and secondary market is already issued, in circulation in the securities trading market.
Financial markets have direct and significant impact in all aspects of economic activities. Such as individual wealth, enterprise management, and the efficiency of economic operation are all directly dependent on the activities of financial market.
3. What is financial intermediation.
Financial intermediaries are the units of economy that absorb money from economic agents with a surplus fund and transfer it to economic agents with a deficit and provide various kinds of financial services. The main functions of financial intermediaries are credit creation, settlement of payment, the distribution of resources, information provided and risk management.
4. The introduction to financial intermediaries.
As the medium of capital supplier and capital requester during the process of financial intermediary in the financial market. It has been divided into two parts by John Gurley and Edward Shaw. (1960) They are monetary system and non-monetary intermediaries. As the role of intermediary, monetary system¿½¿½s main function is purchase primary securities and the creation of money. Non-monetary intermediaries perform only the purchase primary securities and the creation of monetary claims on their intermediary role. This kind of claim is about the form of savings deposit, shares, common stock and other form of funds.
There are five main categories of financial intermediaries, deposit institutions, insurance companies, mutual funds or unit trusts, investment companies or investment trusts and pension funds. These five main categories of financial intermediaries carry out the intermediation function according to different methods. 1) Deposit institutions which with the main types like commercial banks, savings institutions and building societies, can take deposits from units in economic agents with a surplus fund and lend the money gathered to economic agents in deficit. 2) Insurance companies are non-deposit institutions which can gathering funds from insurance applicant and invest them in the capital markets. 3) Mutual funds in US or Unit trusts in UK are non-deposit financial institutions; they invest in the equity and bond markets use the money that get by rising from the public. 4) Investment companies in US and investment trusts in US are publicly quoted firms that invest in financial securities. They put the funds from individual investors together and invest them amount a number of securities or other assets. 5) Pension funds. A pension fund is an asset pool that employees put their money in during the non-working years when employees retired. Funds always gathered by employers and handed over to pension funds.
In the modern market economy, financial activities were closely with the economic operation. However, almost all the financial activities treat financial intermediaries as the center. That is why financial intermediaries play an important role in economic activities.
5. Why financial markets and financial intermediaries exist.
Both financial markets and financial intermediaries can facilitate the transfer of funds from surplus to deficit units. The reason why borrowers and lenders have a need for financial markets is that financial marks have two functions, pricing function and discipline function. Financial markets can provide both buyers and sellers a fair evaluation of the assets they are buying or selling. Pricing function can avoid traders been deceived into trading or investing. Financial markets are controlled by it can help financial markets to stop issuers of securities (borrowers) doing the activities which been considered that harmful to the value of their assets.
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Although financial markets such securities are bought and sold, it sometimes cannot guarantee that to transfer enough capital from lenders to borrowers. Because of two clearly barriers can be identified to the direct finance process. First one is difficulty and expense of matching the complex needs of individual lenders and borrows. Second one is the financial need of lenders and borrowers are complete incompatible. Lenders require to have minimisation of risk and costs, maximisation of returns and translate financial claim into cash with the value more than or equals to capital value itself. Whereas borrowers hope the cost of funds at a particular for a period of time can be lowest.
In order to deal with these problems, financial markets need financial intermediaries exist. Size transformation, maturity transformation, risk transformation, liquidity provision, costs reduction and provision of a payments system are six main functions that can help financial intermediaries to be as a bridge links borrowers and lenders easier. The explanation of those six functions will be displayed below. A) Transform the size. Because amount of the deposit which saved by depositor a small than amount of loans required by borrowers. It will be difficult for lenders to pool their money together. However, financial intermediaries can collect small amount of money and put them together to lend to people who need large amount of money. B) Maturity transformation. Most depositors prefer putting their money in short-term for safety, but borrowers generally need long-term loans for their business. Financial intermediaries can satisfy both savers and lenders by working capital. C) Risk transformation. Financial intermediaries would like to take the risks if can be offered some compensation. It ensures the implementation of many risky (but profitable) projects. Because savers not willing to take great risk when they investing money but borrowers choose to borrow money when doing risk projects. D) Liquidity provision. Cash have liquidity because of saving or withdraw by depositors; it is not safe for lenders to hold highly illiquid assets to finance borrowers if financial intermediaries are not exist. E) Costs reduction. Financial intermediaries broaden the choice of the transaction side of trading, increase transaction rate under a given terms of transaction costs. It not only reduces the cost of time spent on the road, but also reduces the contingency transaction and waiting time cost in some extent. Thus, greatly reduce the transaction cost of unit. F) Provision of a payments system. Financial intermediaries provide a payments system for some non-cash payment such as cheques, debit cards and so on.
Hans Wijkander (1992) thought that the main reason why financial intermediaries exist is a result of asymmetric information and expensive information products. (Hans 1992) The first category of information asymmetric is compare to other investors entrepreneurs have the information advantage of their investment, and other investors have to spend some resources for access to information. Another type of asymmetric information is about the profit which already gets by investment project. Entrepreneurs can as well as other investors have to spend time and money in order to know it. Information production on technically have professional features. It makes some individuals may become agents of other investors, is product information and obtain benefit. Therefore, this arrangement have some problem which is how can investors ensure that their agents have done their best to pass on their information. When these agents become financial intermediaries, the problem of asymmetric information can be solved. Financial intermediaries can gather money from public investors and invest. Under this contract structure, ethical issues have been solved. (Hans, 1992)
In a word, financial markets as an important part of unified market system, can offer securities are bought and sold, and use financial intermediation to achieve the goal of transfer money from economic agents with an extra fund to economic agents with a deficit. In carrying out this function, financial intermediates can help to improve the level of investment and savings. From the lending perspective, financial intermediaries engaged in investment or primary securities investment business, its unit cost can be much lower than most of individual investor¿½¿½s investment. Only in respect of its asset size, can greatly reduce risk through diversification. Financial intermediaries have a large number of depositors which can guarantee normal payment requirement. Because of the importance of scale economy, assets and liabilities of financial intermediaries are highly specialized. These specializations not only improve their competitiveness, but also help increase their chance of survival. Information economists and transaction cost theorists thought uncertainty and the existence of transaction led to emergence of financial intermediaries, and make them have various functions like reduce transaction costs; eliminate uncertainty and the resulting risk. (Web 1) In the modern market economy, no matter trade of means of consumption or means of production, technical and labour mobility etc., they all have to be achieved by currency transfer and closely with financial markets. In this sense, developments of financial markets have a pivotal role in restricting of the development of the whole market system.
In conclusion, financial market and financial intermediates exits to guarantee the normal operation of economic activity. Although financial markets and financial intermediaries have very important functions on the healthy development of economic and society, there are some arguments of them. Like the story of ¿½¿½blind men touching an elephant¿½¿½, someone sees a part of the world, and overstate it, believes that he is the only correct one. In the financial markets, this kind of argument happens every day. Lot of people make decision just based on the information they have exposure to and does not consider the information from other angles. After subprime mortgage crisis, former chairman of the Federal Reserve Alan Greenspan said that ¿½¿½we have done the best, but you cannot believe that we know everything and never make mistakes¿½¿½forecasting cannot always 100% accurate.¿½¿½(Gao mu, 2009) It is can be seen that though the people wisdom as the characters Greenspan, they make mistake in the view of financial markets. This shows that financial markets are difficult to mastery. To find out a way to forecast financial markets and avoid crisis can be an issue for the whole financial systems.
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