The Role of Financial Markets

Financial markets provide a key role in the growth and development of economies.

The emergence of financial markets in the 16th and 17th centuries coincides with increased commerce, industrialisation and rising incomes.

The health of an economy relies upon having an efficient and robust financial sector. The financial crash of 2008-09 sent many economies into a deep recession, and in the 1930s, many thousands of US banks failed, causing depositors to lose $140 billion. [i]

Weaknesses in the financial sectors of developing economies can clearly as a severe constraint on their growth and prosperity.

Classification of financial markets

Financial markets, which include money and capital markets and markets for insurance and foreign exchange can be classified in several ways.

Primary and secondary markets

Primary markets involve the initial issue or sale of financial assets – such as when companies issue shares. New issues of shares enter the primary financial market.

Secondary markets involve the resale of financial assets or contracts. For example, the stock exchange involves the transfer of ownership of a financial asset from one party to another.

Retail and wholesale markets

Financial markets can also be broken down into retail markets – where day-to-day banking services are offered directly to the public and small businesses, and wholesale markets, where financial assets and services are sold to other financial institutions, larger companies, and governments.

High street banks are retail markets while investment banks operate in the wholesale market. Some financial institutions operate in both retail and wholesale markets.

Financial assets – liquidity and profitability

Financial assets can be categorised in term of their liquidity. Liquidity is defined in terms of how easily an asset can be converted to cash.

Cash itself is perfectly (100% liquid), and there is a spectrum of liquidity as assets become less convertible to cash.

Spectrum of liquidity

For example, ‘on demand’ deposits (also called 'current accounts' and 'checking accounts') can be withdrawn immediately in a cash form, but ‘time’ deposits require customers to give notice – hence 'on demand' deposits are more liquid than time deposits. Other assets are increasingly less liquid, such as bills of exchange (both trade and treasury bills) which only have a life of 90 days, and are relatively liquid even before maturity as they can resold relatively quickly.

Financial capital assets, including bonds and shares (equities) are even less liquid, with real capital assets, such as buildings owned by a bank, the least liquid.

Treasury bills are short term securities issues by the Treasury to provide a flow of funds to the government to cover shortfalls in tax revenue needed to cover on-going public sector expenditure. Bills earn a discount rate, which is the difference between what a bill is resold for, and the final payment made by the Treasury when the bill matures.

Bonds are longer term securities issue by central and local government to enable it to raise revenue over a period of time. Bonds tend to mature somewhere between 10 and 20 years after they are initially issued. Bonds receive a fixed rate of interest on them.


The profitability of an asset runs in reverse, and the least liquid assets provide the opportunity for the most profits. Cash in a bank’s tills earns no reward, but when funds are lent, the lender (the bank) parts with liquidity, and for this the expect a rate of return – an interest rate.

Generally, the longer a lender parts with liquidity the higher the rate of interest expected, although other factors also influence interest rates, including the creditworthiness of the borrower, the purpose of the loan, and whether collateral is supplied.

So, while a mortgage is a long term loan and in this respect should command a high interest rate, mortgages are backed by the property on which the mortgage is borrowed, which reduces the rate of interest.

A prudent bank must balance the need for liquidity – to meet the demand of depositors – and the need for profitability – to meet the need of the bank’s shareholders.

Functions of financial markets

To facilitate saving

Financial markets provide a means by which individuals and firms can save unspent income. Ever since the emergence of the first banks in Italy in the 16th century, accepting deposits and keeping them safe has been a fundamental role of banks. In return, depositors can receive a rate of interest as a return – the ‘savings’ rate.

Saving is important because it provides a flow of funds which can be used by individuals and firms to purchase consumer or capital goods.

According to the Harrod-Domar model of economic growth, sufficient saving must be undertaken in an economy to enable capital accumulation to occur.

To lend to businesses and individuals

Financial institutions also lend to individuals and firms when they require funds to make purchases.

Credit creation

When a bank accepts a deposit it can use this to lend to individuals and businesses, and in so doing create credit.

There is a credit multiplier at work which means deposit takers can lend more than they receive in deposits.

For example, if a bank knows that, at any one time, depositors will only withdraw 10% their deposits in a liquid form, the bank can lend out a multiple of the initial deposit, determined by the size of its liquid reserve. Hence, a new deposit of £100 can result in lending of a multiple of this initial deposit. How can this be?

Assuming a bank needs only to keep a cash reserve for the 10% of predicted cash withdrawals it expects, a new cash deposit of £100 will form the 10% cash reserve required. Hence, £1000 can be lent out. So, in total the bank can lend £100 x 1/cash ratio = £1000.

1      x    initial deposit   = credit created
reserve cash ratio

Hence;

1      x   100    =   1000
0.1

The importance of credit

Lending is critical to the growth of an economy, and means that current spending is derived from future income (to repay the loan) rather than current income.

Many purchases depend on consumers and businesses having access to credit, including property purchases through mortgages, and the purchase of motor vehicles, and equipment in the case of businesses. Banks can also lend to each other on a short term basis through the interbank market.

In terms of the global economy, and developing and emerging economies, credit is highly important. If the flow of credit dries up this is a sure sign that a recession is likely to follow, or growth to stop. It can, of course, work the other way, and too much credit can be provided to borrowers or to governments who do not use it wisely.

Types of borrowing

The type of borrowing available depends on the specific financial market.

Customers of high street banks may borrow via an overdraft cover short term cash-flow problems, or on a longer-term basis through bank loans.

Borrowing can also be used to fund larger purchases, such as mortgages to enable property to be purchased. Borrowing can also be used to fund short term purchases using credit cards.

To facilitate the exchange of goods and services

Financial markets facilitate the exchange of goods, services and resources. The simplest asset – money – is a medium of exchange, and enables goods and services to be purchased.

Without money, economies would have to use barter to engage in trade, which would act as a constraint on economic development.

To provide forward markets in currencies and commodities

Financial markets can also be broken down into ‘spot’ and ‘futures’ markets.

Spot markets relate to transactions at one point in time – buying ‘on the spot’. For example, an individual may agree a loan from their bank in the morning, with the loan being deposited in their bank account in the afternoon.

However, many markets involve transactions which are finalised at some point in the future.

For example, a commodity trader may purchase a given quantity of a commodity for delivery in 3 months’ time. While the price and quantity are agreed at the time of the initial contract, delivery is later. This gives the owner of the contract the chance to sell it on to someone else before the delivery date.

In this way, traders can make profits from simply holding futures contracts, hoping their value will rise in the secondary futures market.

Options

A ‘call’ option gives the buyer of a security the right to buy an asset at a fixed price at any time before expiration, and a ‘put’ option gives the buyer the right to sell a specified asset at a fixed price before expiration of the contract.

To provide a market for equities

Equities are shares in companies which are initially issued by companies wishing to obtain funding for expansion. While a share is a 'share of a company for the life of the company', shareholders may wish to regain their lost liquidity.

Hence, the emergence of stock exchanges in Europe in the early 17th century provided an important means by which liquidity could be regained. Stock exchanges also created the possibility of making a capital gain from a rise in the price of shares. Hence, shareholders can derive two types of return on dealing in shares – firstly, a dividend payment based on the profits companies earn, and secondly a speculative gain from the increase in the value of traded shares.

The re-introduction of stock exchanges in China in the 1990s provided an important market for trading shares in the newly privatised Chinese companies.

The first stock exchange in China was the Shanghai Stock Exchange (SSE) which opened in 1891 but was closed in 1949 as part of the Cultural Revolution in China, but re-opened again in 1990, and enabled a flow of funds into enterprises and emerging markets.

Today (2021), the SSE is the world’s 3rd largest stock exchange. [1]

The world’s top 10 stock exchanges

  1. New York Stock Exchange
  2. NASDAQ
  3. Shanghai Stock Exchange
  4. Japan Exchange Group
  5. Hong Kong Stock Exchange
  6. Euronext
  7. Shenzhen Stock Exchange
  8. London Stock Exchange
  9. Bombay Stock Exchange
  10. National Stock Exchange

[i] Living History - https://livinghistoryfarm.org/farminginthe30s/money_08.html

[1] https://en.wikipedia.org/wiki/Shanghai_Stock_Exchange