The role of strong financial markets in the economy

A market is a place where supply for a particular good is able to meet demand fo
r it. In the case of financial markets, the good in question is money.
In capital markets, supply agents are those with "positive savings capacity", i.
e. mainly households (surprising as that may seem!), and businesses, although th
e latter generally prefer to reinvest profits or distribute dividends to shareho
lders. The demand side comes from governments, the modern welfare state having s
ubstantial cash requirements, or other companies. Such agents are said to have "
financing requirements".
Far from being an abstract entity, often described as both irrational and all-po
werful, capital markets are in fact a driving force in the economy since they ar
e places where the fuel, money, is made available to propel the machine forward,
in other words generate wealth.
This is the concept, but in practice of course the mechanism is a little more co
mplex.
The first difficulty resides in the fact that an exchange actually needs to take
place between agents with savings capacity and agents with financing requiremen
ts. For a market to function, it is not enough that a good and its supply and de
mand exist; agents also have to want to trade it! However, agents with savings c
apacity, mainly households it should be recalled, are generally deeply averse to
risk. An aversion furthermore which can be justified by common sense. Any book
on the stock market for budding investors will begin with a warning urging reade
rs to only invest funds in the stock market that will not be needed in the near
future. Consequently, the bulk of savings generated by households are held on de
posit in demand accounts or savings accounts where money is immediately availabl
e.
In contrast, agents with financing needs, i.e. businesses, need to find long-ter
m financing for development. The time horizon of agents with savings capacity is
typically a few weeks (next pay day) to a few months (next tax payment date ...
). The time horizon of agents with financing requirements is several years! This
difference makes actual exchange in markets more complex.
Banks
This is where a third category of economic agents comes in, the banks. Banks are
the only agents that have the power to transform very short-term resources (dem
and deposits i.e. current accounts) into medium and long term resources: bank lo
ans. Banks therefore establish an essential link between households and business
es; they have always played, and indeed still play, a crucial role in the financ
ing of the economy.
Each bank has the right to distribute virtually all of the money deposited by cu
stomers on its current accounts (but not all! see below) as loans. However, loan
s made available in this way by banks do not cancel the deposits that were made,
which continue to be available for the customer to use. Banks therefore create
money. The loans, granted in the form of demand deposits, increase the cash reso
urces of banks and thus their ability to distribute new loans etc.. Deposits cre
ate loans, which themselves create deposits, etc.. This is what is called the "c
redit multiplier".
Fortunately, the money creation power of banks is not infinite. It is limited fi
rstly by the fact that only part of the loans granted will remain in the form of
deposits. The remainder will be converted into cash (notes) through cash withdr
awals. Furthermore, to ensure that banks have the capacity to cope with withdraw
als, the central bank requires them to lock-up a percentage of their deposits in
the form of reserves, not available for lending. The compulsory reserves ratio
is one of the instruments used by central banks to control the quantity of money
in circulation.
Furthermore, companies cannot finance themselves solely through loans; beyond a
certain level of debt, the financial cost has an unsustainable impact on results
and banks would no longer be willing to lend. Companies therefore have to find
ways of obtaining even longer-term financing, only repayable in the event of dis
solution of the company, or debt with very long maturities, for example bonds. T
he total of the capital and long-term debt of a company constitutes its "equity
capital".
Banks, in particular investment banks, are also involved in long-term corporate
financing, but it is not their primary purpose which is to ensure that money cir
culates. To provide companies with equity capital, economic agents ready to lock
-up large sums over long periods, obviously with the aim of generating profit, a
re required: investors.
Institutional investors
The main investors in capital markets today are "institutional investors" (often
referred to simply as "institutionals"), namely insurance companies, fund manag
ers (asset managers), retirement funds and their US equivalent, the pension fund
s. Institutionals also drain public savings, but these savings are locked up and
cannot be immediately withdrawn in the same way as sums deposited in current ac
counts. In addition, the institutions in question generally have a regulatory, c
ontractual or legal obligation to build up savings in order to be able to pay, f
or insurance companies insurance benefits, and for retirement funds retirement b
enefits to policyholders.
Instead of distributing loans like banks, institutional investors buy securities
issued by companies requiring financing. These securities represent either equi
ty capital: shares, or long-term borrowing: bonds. Purchases are made on the pri
mary market, i.e. at the time the securities are issued, or on the secondary mar
ket, more commonly referred to as the "Stock Exchange".
Given the needs of companies to obtain financing from the market and institution
al investors' needs to invest savings in their care, it is clear that there has
to be a way for supply and demand to meet. However for this to happen, the marke
t has to be organised appropriately to facilitate the process; a number of diffe
rent players contribute to this. In this regard, banks once again play an import
ant role. As account-keepers and liquidity providers, they assume a key intermed
iation role.
The issuance of securities
Issuers wishing to raise capital from the market turn to a bank or group of bank
s (a "bank syndicate") which acts as an agent for the issue. The agent arranges
all the economic characteristics of the issue. The agent "underwrites" the issue
, in other words undertakes to buy all the securities issued and has a responsib
ility to find final investors willing to buy the securities issued.
After the issue, and once the securities trade on the market, the paying agent o
f the issuer (which may be the same as the agent or another institution) will be
responsible for ensuring smooth operations throughout the life of the security:
payment of coupons for bond issues or dividends for shares, repayments, capital
increases etc.
Lastly, rating agencies are independent organisations which assess the quality o
f issuers and assign a rating designed to determine their reliability as debtors
.
Custodians
The agent of the issuer manages the relationship with the central custodian, a k
ey player in securities markets. For each issue it manages, the central custodia
n keeps up-to-date records in its accounts of the total amount of securities tha
t have been issued and the amount held by each institution that has a registered
account with it (the total amount held by all institutions clearly has to match
the total amount of the issue!). In France the central custodian for almost eve
ry issue is Euroclear France, formerly SICOVAM.
Each member of Euroclear France is a local custodian. Any investor that does not
have a registered account with Euroclear France must open an account with a loc
al custodian in order to be able to hold securities. However, while investors in
creasingly tend to internationalise their investments, the central custodian pra
ctically only manages securities issued in its own country. As a result, the fun
ction of "global custodian" has developed. A global custodian is appointed by in
vestors to act as account keeper for all transactions involving the purchase and
sale of securities in markets worlwide. To this end, the global custodian works
hand-in-hand with local custodians in every market in the world, each one respo
nsible for maintaining relations with the central depository in its country.
To be a global or local custodian, an institution must be authorised not only to
keep securities accounts on behalf of investors but also cash accounts. Such in
stitutions are therefore usually banks.
Market transactions
Investors typically buy securities through a broker. The broker provides a numbe
r of services to investors. Financial analysts study markets and issuers and mak
e recommendations. Salesmen pass on the recommendations of analysts to investors
and collect their orders. Lastly, traders buy or sell securities in the market.
Trading between brokers is carried out either directly through an "OTC" market o
r organised market, a stock exchange, or through fast-growing electronic markets
.
Once a trade has been completed, the investor turns to a custodian to take charg
e of "after trade" aspects. For a transaction to be registered correctly, securi
ties provided by the seller have to be exchanged for cash provided by the buyer.
This process is referred to as settlement and delivery.
The custodian is also responsible for maintaining the accounts of investor custo
mers to take account of the many transactions that can have an impact on investm
ent portfolios: coupon or dividend payments, repayments, but also exercise of su
bscription rights, takeover bids, exchange offers etc.
Trading floors
Market transactions by institutional investors are not limited to the purchase a
nd sale of securities. Given the sums involved and the large number of markets i
n which investors trade, additional needs arise. An investor may need to obtain
foreign currency, hence the necessity to carry out transactions in currency mark
ets. An investor may also require loans, or on the contrary need to invest liqui
dity on a temporary basis to optimise cash flow. Lastly, he may want to protect
a portfolio against market fluctuations, giving rise to the need for derivative
products.
Non-financial companies ("corporates") face similar types of need: importers may
require foreign currency and processing companies may have to protect themselve
s against fluctuations in raw material prices. All have special cash management
needs and may have to hedge against movements in prices or interest rates.
Banks are able to respond to these needs; at the branch level for small and medi
um-sized companies or directly via the trading room for the largest customers. T
otal cumulative positions generated for the various products are processed by tr
aders in the trading rooms. The activity of a trading room reflects the total am
ount of requests coming from all of the bankâ s customers!
Speculation and arbitrage
Financial institutions and funds dedicated to this type of activity use some of
their resources for speculation. This aspect of trading activity, whether or not
it be as extensive as many claim, nevertheless remains necessary. Speculation i
nvolves taking a position that is contrary to current market trends: it means be
coming a seller when you think that prices will fall (and are therefore at their
highest!), or becoming a buyer when you think they will rise. By adopting a sta
nce, speculators provide liquidity to the market: they are the sellers for inves
tors who want to buy and the buyers for those who want to sell. It is a risky ac
tivity, as, unlike investors or corporates, speculators bet on the future.
Arbitragists also play a harmonising role: they take advantage of price differen
ces between different markets to generate gains. For example, in currency market
s they buy dollars in a market where it is cheap and sell in a market where it i
s most demanded, and therefore more expensive. It is a risk-free activity, since
the assets purchased are immediately resold. However, this requires substantial
financing as capital gains on each transaction are low. The activity of arbitra
gists helps eliminate marketing inconsistencies.
Conclusion
Economic literature, after drawing a sharp distinction between the financing of
companies through bank lending (debt financing) and financing through the issuan
ce of securities (market-based economy), now attributes a complementary role to
both. Studies suggest that for an economy to grow, there is a need for both an a
ctive organised financial market and a reliable banking system.