Market Organization and Structure

The financial system facilitates the achievement of various financial purposes, determines rates of return that balance savings and borrowings, and allocates capital to optimal uses, enhancing economic welfare.

The financial system supports individuals and organizations in achieving goals such as saving for the future, borrowing for current needs, raising equity capital, managing risks, and trading assets for immediate and future deliveries.

The financial system helps in discovering rates of return that equate the total amount of savings with total borrowings, influencing how much money is moved from the present to the future and vice versa.

Efficient capital allocation occurs when financial systems ensure that only the most productive projects receive funding, which is determined by the decisions of savers and investors based on the perceived potential of different investment opportunities.

Assets are broadly classified into financial assets (like stocks, bonds, and currencies) and real assets (such as real estate and machinery). Financial assets are further divided into securities, currencies, and contracts, while real assets include tangible properties.

Markets are classified based on the timing of delivery (spot and forward markets), the nature of the traded securities (primary and secondary markets), and the duration of the instruments traded (money markets for short-term and capital markets for long-term instruments).

Securities are classified into public and private securities, with public securities being traded in more regulated and accessible markets. They are also categorized as debt or equity, based on the nature of the financial claim they represent.

Contracts are primarily derivatives whose value depends on underlying assets. They can be financial or physical based on the nature of the underlying asset.

Fixed-income securities are debt instruments that promise to pay a set schedule of payments. They include bonds, notes, and money market instruments, with varying terms and maturities.

Equities represent ownership in a company and come in the form of common and preferred shares. Common shares confer voting rights and residual claims on assets, while preferred shares have priority in dividend payments and asset claims in liquidation.

Pooled investments are collective investment schemes like mutual funds, hedge funds, and ETFs, allowing investors to pool their money to invest in a diversified portfolio managed by professionals.

Currencies are monies issued by national monetary authorities and include major reserve currencies like the US dollar and the euro. They are traded in foreign exchange markets through spot transactions and institutional trades.

Commodities encompass precious metals, energy products, industrial metals, agricultural products, and carbon credits. They can be traded directly in spot markets or indirectly through forward and futures contracts. The spot markets are primarily used by producers and processors who can handle physical delivery and storage.

Real assets include tangible properties such as real estate, airplanes, and machinery. These are typically held by operating companies but are increasingly included in investment portfolios both directly and indirectly through securities like REITs and MLPs. Real assets are unique due to their heterogeneity and illiquidity.

Contracts are agreements among traders that may involve physical or cash settlements in the future. They include forward, futures, swap, option, and insurance contracts. The value of most contracts depends on an underlying asset, which can be a commodity, security, index, currency pair, or another contract.

Forward contracts are agreements to buy or sell an asset at a predetermined future date and price. They are used primarily for hedging risks and are customized between parties, often without a standardized format.

Futures contracts are standardized forward contracts guaranteed by a clearinghouse. They mitigate counterparty risk and are marked to market daily, requiring maintenance of margin accounts to manage potential losses.

Swaps are agreements to exchange cash flows in the future based on specified variables like interest rates or commodity prices. Types include interest rate swaps, commodity swaps, currency swaps, and equity swaps.

Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price before a specified date. Options are used for speculation or hedging and involve paying a premium for the potential exercise of the contract.

Insurance contracts provide payment upon the occurrence of certain events and are used to hedge against various risks. Credit default swaps (CDS) are a type of insurance against bond default, providing payment if the bond issuer defaults.

Brokers act as agents who facilitate trades for their clients without trading directly with them. They help reduce the costs of finding counterparties for trades.

Dealers trade directly with their clients, providing liquidity by buying from sellers and selling to buyers. They aim to profit from the spread between buying and selling prices.

Arbitrageurs seek to profit from price discrepancies in different markets by simultaneously buying and selling similar or identical assets. They provide liquidity by connecting buyers and sellers across different markets.

Exchanges provide a structured environment for traders to meet and execute trades. They may also regulate the trading activities and financial disclosures of their members.

ATSs, including electronic communications networks and multilateral trading facilities, function like exchanges but typically do not have regulatory authority over their participants. They offer platforms for matching buy and sell orders.

Securitization involves pooling various types of financial assets to create a new security, which is then sold to investors. This process enhances liquidity in the market by allowing investors to indirectly invest in assets like mortgages and loans, which are otherwise difficult to access.

Financial intermediaries such as banks and investment companies facilitate the flow of funds between savers and borrowers, helping to allocate resources efficiently in the economy. They provide services like accepting deposits, making loans, and creating investment products.

MBS are a type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by an accredited credit rating agency.

Insurance companies manage risk by providing insurance policies that protect against potential losses from events like accidents, theft, or natural disasters. They collect premiums from policyholders and pay out claims as needed, effectively spreading risk across a large pool of insured entities.

In the context of securitization, tranches are segments or layers of debt or securities that have varying degrees of risk and rewards. Senior tranches have priority in claim over the cash flows from the underlying assets and are less risky, whereas junior tranches bear more risk.

Clearinghouses are financial intermediaries that arrange for the final settlement of trades. They guarantee contract performance in futures markets and act as escrow agents in other markets, ensuring the secure transfer of money and securities between buyers and sellers.

Brokers and dealers facilitate the trading of securities by matching buyers with sellers. Brokers connect clients to the market, while dealers trade securities for their own accounts, providing liquidity and connecting buyers and sellers who are not present at the same time or place.

Depositories and custodians hold securities on behalf of their clients to prevent loss through fraud, oversight, or natural disasters. They ensure the safekeeping of securities, increasingly in electronic form, to avoid issues like lost certificates.

Financial intermediation involves entities standing between parties who wish to trade but find direct trading challenging. Intermediaries facilitate these trades by offering various services, managing relationships, and reducing the costs and risks associated with trading.

Long positions occur when investors own assets or contracts. These positions benefit from an increase in the asset's or contract's price.

Short positions occur when investors sell assets or contracts they do not own, typically by borrowing them. These positions benefit from a decrease in the asset's or contract's price.

Involves borrowing an asset or contract, selling it, and later repurchasing it at a lower price to return to the lender, aiming to profit from the price difference.

Short positions carry significant risk, particularly because potential losses are unbounded if the asset's price increases substantially.

Short sellers borrow securities from lenders who are long on those securities. Lenders earn from short rebate rates and take collateral as security.

The leverage ratio measures the proportion of the total value of a position that is financed by borrowed funds. It indicates how many times larger a position is than the equity that supports it.

This rate measures the performance of an investment made with borrowed funds, taking into account the price change of the security, dividends or interest received, interest paid on the margin loan, and transaction costs.

A margin call occurs when the value of the investor's equity in a margin account falls below the broker's required minimum (maintenance margin). This prompts the investor to add more funds or securities to the account to meet the minimum equity requirement.

Market orders are instructions to buy or sell a security immediately at the best available current price. They do not specify a price and are executed quickly, but the execution price may vary, especially in volatile markets.

Limit orders specify a maximum or minimum price at which the trader is willing to buy or sell a security. These orders are not guaranteed to execute, as they only fill if the market reaches the specified price.

Validity instructions determine the period during which an order is active. Common types include day orders (valid only for the trading day they are placed), good-till-cancelled orders (remain active until executed or cancelled), and immediate or cancel orders (must be executed immediately or cancelled).

Clearing instructions outline how trades should be settled post-execution. These instructions are crucial for ensuring that the securities and cash are transferred appropriately between buyer and seller.

A stop order is activated only when a security reaches a specified price, known as the stop price. Once activated, it becomes a market order and is executed at the next available price.

Validity instructions determine when an order may be executed. Common types include day orders (valid only on the day they are placed), good-till-cancelled orders (remain active until executed or cancelled), immediate or cancel orders (must be executed immediately upon receipt or they are cancelled), and good-on-close orders (executed at the closing price).

Stop orders activate at a specified price level. For sell stop orders, the order executes when the market price hits or falls below the stop price. For buy stop orders, the order executes when the price rises above the stop price. These orders can be combined with limit orders to set a minimum or maximum acceptable price, providing control over execution prices.

Clearing instructions specify how trades should be settled. They often designate which broker or custodian is responsible for the settlement of the trade. These instructions are crucial for ensuring that trades are settled correctly and efficiently, often involving different entities for executing and settling trades.

Primary markets are venues where securities are sold for the first time by the issuer to investors. This includes initial public offerings (IPOs) and seasoned offerings.

Secondary markets involve trading securities among investors after the initial issuance. These markets provide liquidity and enable price discovery, which are essential for the functioning of primary markets.

Public offerings are when corporations sell securities to the public, often assisted by investment banks through processes like book building and underwriting.

In private placements, securities are sold directly to a select group of qualified investors, usually with less regulatory requirements compared to public offerings.

Secondary markets are crucial for primary markets as they provide liquidity and pricing information, which helps in reducing the cost of capital for issuers in primary markets.

Secondary markets provide a platform for the trading of securities post their initial issuance in primary markets. They add liquidity, making securities more attractive to investors, which in turn reduces the cost of capital for issuers.

Trading sessions can be organized as call markets, where trades are executed at specific times and places, or as continuous markets, where trades can occur anytime during open hours. Call markets can be highly liquid during the session but illiquid at other times.

Securities, contracts, and currencies can be traded in different market structures: quote-driven markets where trades occur with dealers, order-driven markets that use a system to match orders, and brokered markets where brokers facilitate trades between clients.

These systems vary in the type and quantity of data they provide. Markets can be pre-trade transparent, showing real-time data about quotes and orders, or post-trade transparent, publishing trade prices and sizes after trades occur.

Markets that have the necessary assets or contracts available to solve financing, saving, and risk management problems.

Markets where the costs associated with trading, such as commissions, bid-ask spreads, and order price impacts, are low.

Markets where prices of assets and contracts reflect all available information related to their fundamental values.

Entities that facilitate the functioning of financial markets by organizing exchanges, providing liquidity, securitizing assets, running banks and insurance companies, and ensuring the settlement of trades and safety of assets.

Economies where resources are used where they are most valuable, largely facilitated by informationally efficient prices in the financial markets.

Regulators implement measures to protect unsophisticated and poorly informed customers from fraud, which is prevalent in complex financial markets due to asymmetries in knowledge and sophistication.

Regulation addresses agency problems by setting minimum standards of competence and practice for financial agents to ensure they act in the best interests of their clients.

Regulations like insider trading laws are designed to create a level playing field, preventing those with advanced knowledge from exploiting others, thus maintaining market liquidity and integrity.

Regulators and standard-setting bodies like IASB and FASB develop common financial reporting standards, facilitating easier comparison and assessment of company performances globally.

Financial firms are required to maintain minimum levels of capital to ensure they can meet their obligations and mitigate overly risky behaviors that could lead to market disruptions.

Regulations ensure that insurance companies and pension funds maintain adequate reserves to meet future liabilities, protecting against underestimation of these reserves by management.