Financial markets: structure and role in the financial system

1.2. Financial markets and their economic functions

A financial market is a market where financial instruments are exchanged or traded. Financial markets provide the following three major economic functions:

1) Price discovery
2) Liquidity
3) Reduction of transaction costs
1) Price discovery function means that transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. At the same time the required return from the investment of funds is determined by the participants in a financial market. The motivation for those seeking funds (deficit units) depends on the required return that investors demand. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments.
2) Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However, different financial markets are characterized by the degree of liquidity.
3) The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs.
The key attributes determining transaction costs are
· asset specificity,
· uncertainty,
· frequency of occurrence.
Asset specificity is related to the way transaction is organized and executed. It is lower when an asset can be easily put to alternative use, can be deployed for different tasks without significant costs. Transactions are also related to uncertainty, which has (1) external sources (when events change beyond control of the contracting parties), and (2) depends on opportunistic behavior of the contracting parties. If changes in external events are readily verifiable, then it is possible to make adaptations to original contracts, taking into account problems caused by external uncertainty. In this case there is a possibility to control transaction costs. However, when circumstances are not easily observable, opportunism creates incentives for contracting parties to review the initial contract and creates moral hazard problems. The higher the uncertainty, the more opportunistic behavior may be observed, and the higher transaction costs may be born.Frequency of occurrence plays an important role in determining if a transaction should take place within the market or within the firm. A one-time transaction may reduce costs when it is executed in the market. Conversely, frequent transactions require detailed contracting and should take place within a firm in order to reduce the costs. When assets are specific, transactions are frequent, and there are significant uncertainties intra-firm transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are infrequent, and there are no significant uncertainties least costly may be market transactions.The mentioned attributes of transactions and the underlying incentive problems are related to behavioural assumptions about the transacting parties. The economists (Coase (1932, 1960, 1988), Williamson (1975, 1985), Akerlof (1971) and others) have contributed to transactions costs economics by analyzing behaviour of the human beings, assumed generally self-serving and rational in their conduct, and also behaving opportunistically. Opportunistic behaviour was understood as involving actions with incomplete and distorted information that may intentionally mislead the other party. This type of behavior requires efforts of ex ante screening of transaction parties, and ex post safeguards as well as mutual restraint among the parties, which leads to specific transaction costs. Transaction costs are classified into:
1) costs of search and information,
2) costs of contracting and monitoring,
3) costs of incentive problems between buyers and sellers of financial assets.
1) Costs of search and information are defined in the following way:
· search costs fall into categories of explicit costs and implicit costs.
Explicit costs include expenses that may be needed to advertise one’s intention to sell or purchase a financial instrument. Implicit costs include the value of time spent inlocating counterparty to the transaction. The presence of an organized financial market reduces search costs.

· information costs are associated with assessing a financial instrument’s investment attributes. In a price efficient market, prices reflect the aggregate information collected by all market participants.

2) Costs of contracting and monitoring are related to the costs necessary to resolve information asymmetry problems, when the two parties entering into the transaction possess limited information on each other and seek to ensure that the transaction obligations are fulfilled.
3) Costs of incentive problems between buyers and sellers arise, when there are conflicts of interest between the two parties, having different incentives for the transactionsinvolving financial assets. The functions of a market are performed by its diverse participants. The participants in financial markets can be also classified into various groups, according to their motive for trading:
· Public investors, who ultimately own the securities and who are motivated by the returns from holding the securities. Public investors include private individuals and institutional investors, such as pension funds and mutual funds.
· Brokers, who act as agents for public investors and who are motivated by the remuneration received (typically in the form of commission fees) for the services they provide. Brokers thus trade for others and not on their own account.
· Dealers, who do trade on their own account but whose primary motive is to profit from trading rather than from holding securities. Typically, dealers obtain their return from the differences between the prices at which they buy and sell the security over short intervals of time.
· Credit rating agencies (CRAs) that assess the credit risk of borrowers.In reality three groups are not mutually exclusive. Some public investors may occasionally act on behalf of others; brokers may act as dealers and hold securities on their own, while dealers often hold securities in excess of the inventories needed to facilitate their trading activities. The role of these three groups differs according to the trading mechanism adopted by a financial market.