Financial system

The financial system puts borrowers in touch with lenders and allocates risks to those who wish to take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. International linkages often add to its complexity by enabling developments in one country to generate consequences elsewhere. Under normal circumstances, national and international financial systems contribute to the economic efficiency of their users, but their malfunction can cause widespread economic damage. Template:TOC-right

Overview

A basic function of a financial system is the transfer of resources from those who own them but do not wish to use them, to those who wish to use them but do not own them. A secondary function is the transfer of risk from those who wish to limit their exposure to it, to those willing to accept it for a fee. The system performs those functions by trading in financial instruments that represent promises to perform services in return for payment. The promises that they represent include promises to make fixed payments (represented by bonds); promises to pay dividends (represented by stocks and shares); promises to provide retirement income (represented by pension agreements); promises to bear some of the costs of accidents (represented by insurance policies ) - and promises concerning other promises (represented by "derivatives"). Trading in the different categories of instrument takes place in different types of market. "Primary markets" for pensions and insurance policies take the form of one-to-one "over-the-counter" (OTC) transactions with their suppliers, and there is seldom any further trading because those instruments are considered to be "non-negotiable". The primary markets in stocks and shares and bonds usually start with an "initial public offering" (IPO) in which the issuers deal directly with professional traders, and through them with the public. Subsequent trading in those instruments can take place, either as one-to-one over-the-counter deals between dealers and individual customers, or in "auction markets" in which numbers of holders trade with each other, or in "dealers markets" in which numbers of holders trade with dealers. (The world's largest auction market is the New York Stock Exchange (NYSE) and its largest dealers market is the National Association of Securities Dealers Automated Quotations (NASDAQ)). Each category of market is characterised by different rules of conduct, and many are subject to oversight by regulatory authorities.

The components of the system

Financial instruments

Bonds

In the terminology of this article, the term "bond" normally refers to an instrument, issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year (but in economics terminology it refers to any of the entire category of fixed-interest loan instruments). The term is also applied in some contexts to investments that do not conform to that definition - such as "investment bonds" (collections of investment funds) and "premium bonds" (a type of lottery). Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer - normally on the bond market (see below). Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.

The simplest form of bond is the "straight" (or "plain vanilla") bond, that makes a regular fixed interest payment and is repaid (or "redeemed") on a predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's coupon divided by its market price is called its "current yield" and its internal rate of return taking account of the eventual repayment is termed its "yield to maturity".

Other forms of bond can be categorised as particular adaptations of the above payment conditions. Strictly speaking an "irredeemable bond" (or "perpetual bond" or "consol") is not a loan, but only an undertaking to make stipulated and indefinitely continuing fixed interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer. Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity. The interest rate paid on a “tracker bond” is related to the bank or Treasury bond rate, and the redemption payment of an “index-linked” bond is related to the current level of a consumer price index.

Bonds can also be categorised according to the degree of security provided to their purchasers. A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the United Kingdom the term "debenture" refers to a company loan secured by a claim on the company's assets, but in the United States the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government. The term "default risk means the risk that the issuer will be unable to repay the loan and the "risk premium" (or "spread") is the difference between the yield on a bond and the yield on a government bond – except that “sovereign spread” is the difference between the yield on a government bond and the yield on the least risky government bond that is available. Default risk premia are linked to risk ratings issued by credit risk agencies (see below). Bonds that are rated below a minimum credit risk level (Baa for Moody’s or BBB for Standard and Poor) are termed "junk bonds" (or "high-yielding bonds") and bonds rated above that level are termed "investment-grade bonds".

Finally, bonds can be categorised according to their currency of denomination. The term "eurobond" (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.

Money market securities

Money market securities are short term loan instruments issued by governments banks and businesses. Those that can be bought and sold during the period between issue and repayment are termed “negotiable”. Those that a marketed on a “yield basis” are repaid on the due date by the amount invested, together with a stipulated interest payment. The category of money market security that are marketed on a yield basis includes "money market deposits" which are repayable after intervals ranging from one day to one year and are not negotiable, and “certificates of deposit” which are receipts from banks for deposits made with them, and are negotiable. Money market securities that are marketed on a “discount basis” are sold at a price "below par" (– ie below the amount to be repaid), but without any additional interest payment. That category includes Treasury bills, which are promises to repay loans to the government – usually after 90 days; "bills of exchange" (or "trade bills", or "commercial bills") which are similar to Treasury bills but are issued by companies; and "bankers acceptances" which are negotiable, and "commercial paper" which consists of unsecured promissory notes issued by companies.

Derivatives

A derivative is financial instrument whose value depends upon the value of another instrument. The principal categories of derivative are "forward contracts", "futures", "options", and "swaps". A forward contract is an agreement to buy or sell a specified quantity of an asset on a specified date, at a specified price. An option is an agreement that gives the holder the right, but not the obligation, to buy ("call option") or sell ("put option") an asset, on or before a specified date . A swap is an agreement to exchange a series of cashflows from one asset with a series of cashflows from another asset. Derivatives may be used as a means of creating leverage, as a means of speculation, or as a means of hedging against risk.

Reform of the system

In preparation for a meeting of the world leaders in November 2008, an ebook was published by an international group of twenty leading financial economists. They agreed on the need to augment IMF resources and to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.