FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE

FINANCIAL SYSTEM
• The financial system plays the key role in the economy by
stimulating economic growth,
• influencing economic performance of the actors, affecting
economic welfare.
• This is achieved by financial infrastructure, in which entities with
funds allocate those funds to those who have potentially more
productive ways to invest those funds.
• A financial system makes it possible a more efficient transfer of
funds. As one party of the transaction may possess superior
information than the other party, it can lead to the information
asymmetry problem and inefficient allocation of financial
resources. By overcoming the information asymmetry problem
the financial system facilitates balance between those with funds
to invest and those needing funds.
 Cont.
• According to the structural approach, the
financial system of an economy consists of
three main components:
1) financial markets;
2) financial intermediaries (institutions);
3) financial regulators.
 Cont.
• Financial markets facilitate the flow of funds
in order to finance investments by
corporations, governments and individuals.
• Financial institutions/Intermediaries are the
key players in the financial markets as they
perform the function of intermediation and
thus determine the flow of funds.
• The financial regulators perform the role of
monitoring and regulating the participants in
the financial system.
Cont.
 Cont.
• An asset is any resource that is expected to
provide future benefits, and thus possesses
economic value.
• Assets are divided into two categories:
tangible assets with physical properties and
intangible assets. An intangible asset
represents a legal claim to some future
economic benefits. The value of an intangible
asset bears no relation to the form, physical or
otherwise, in which the claims are recorded.
 Cont.
• Financial assets, often called financial
instruments, are intangible assets, which are
expected to provide future benefits in the form of a
claim to future cash.
• Any transaction related to financial instrument
includes at least two parties:
1) the party that has agreed to make future cash
payments and is called the issuer;
2) the party that owns the financial instrument,
and therefore the right to receive the payments
made by the issuer, is called the investor.
 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
 Cont.
• 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.
 Cont.
• 2) Liquidity function provides an opportunity for
investors to sell a financial instrument, 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.
 Cont.
• 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.
 Cont.
• 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.
 Cont.
• 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. The higher the
uncertainty, the more opportunistic behavior
may be observed, and the higher transaction
costs may be born.
 Cont.
• 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.
 Cont.
• 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 in locating 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.
 Cont.
(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 transactions involving financial assets.
 Cont.
• The functions of a market are performed by its diverse participants. They
can be 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.
 Cont.
• 1.3. Financial intermediaries and their functions
• Financial intermediary is a special financial entity, which
performs the role of efficient
• allocation of funds, when there are conditions that make it
difficult for lenders or investors of funds to deal directly with
borrowers of funds in financial markets.
• Financial intermediaries include depository institutions,
insurance companies, regulated investment companies,
investment banks, pension funds.
• The role of financial intermediaries is to create more
favourable transaction terms than could be realized by
lenders/investors and borrowers dealing directly with each
other in the financial market.
 Cont.
The financial intermediaries are engaged in:
• obtaining funds from lenders or investors and
• lending or investing the funds that they
borrow to those who need funds.
• Asset transformation
Maturity intermediation.
Risk reduction via diversification.
Cost reduction for contracting and
information processing.
Cont.
 Other services by financial intermediaries
include: Cont

• Facilitating the trading of financial assets for the financial

intermediary’s customers through brokering arrangements.
• Facilitating the trading of financial assets by using its own
capital to take a position in a financial asset the financial
intermediary’s customer want to transact in.
• Assisting in the creation of financial assets for its customers
and then either distributing those financial assets to other
market participants.
• Providing investment advice to customers.
• Manage the financial assets of customers.
• Providing a payment mechanism.
Financial markets structure
Financial instruments
Cont.
Cont.
Cont.
 Cont.
• 1.5. Financial market regulation
In general, financial market regulation is aimed to ensure the fair treatment of
participants.
Many regulations have been enacted in response to fraudulent practices. One of the
key aims of regulation is to ensure business disclosure of accurate information for
investment decision making. When information is disclosed only to limited set of
investors, those have major advantages over other groups of investors. Thus regulatory
framework has to provide the equal access to disclosures by companies.

Monetary Law Act (MLA) No. 58 of 1949

Banking Act No. 30 of 1988

Finance Business Act No. 42 of 2011

Finance Leasing Act No.56 of 2000
Financial Transactions Reporting Act No. 6 of 2006