4.      FINANCIAL INTERMEDIATION

 

 

Financial markets provide a number of key services including valuation, price agreement, payment, exchange and transaction validation. In so doing, a number of ancillary services are carried out in terms of price disclosure, contract or trading, clearing, settlement and regulatory and market reporting (for price disclosure and regulatory oversight purposes).

 

A market is any identifiable location, system (including electronic system) or formalised set of relations through which any product or commodity can be valued and bought or sold. A financial market is then any organised process through which financial assets, instruments or claims can be issued and traded. An exchange more specifically is any identifiable location through which instruments or claims can be issued and traded. A stock market is any organised or regulated marketplace for the trading of government or corporate stock and shares or other financial assets.

 

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(1)       Financial Function

 

Financial instruments and financial markets carry out a number of essential functions without which only the most primitive of economies could operate. Money is necessary to act as a means of valuation and unit of account, store of value and medium of exchange. Other paper based instruments (including bills of exchange, promissory notes and checks) and other electronic systems are essential for payment purposes. Paper securities were used to evidence entitlement to a proportionate share in the aggregate assets of a corporate entity although much of this is now either issued or transferred in an electronic form.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The key functions of financial instruments and markets can be summarised as follows:

 

1. Deposit (savings) or safekeeping (either for custody or safekeeping or income generation);

2. Loan or credit;

3. Payment (paper-based or electronic);

4. Investment (combining return of principal and income either through dividend (on equity) or interest (on debt));

5. Risk cover or insurance.

 

The structure and operation of modern economies would be impossible without these key core facilities and functions.

 

(2)       Financial Assets

 

Financial claims are transferrable, enforceable obligations to transfer monetary value which can ultimately only be discharged in law through the payment of national currency in the form of legal tender in the absence of contrary agreement between the parties concerned.

 

Financial assets include any property with a monetary value. Under English property law, the following classes of asset may be distinguished:

 

1. Real property or land (heritable property in Scotland) including leasehold property under s1(1)(b) of the Law of Property Act 1925 although leaseholds are strictly personality (or chattels real);

2. Personal property including:

 

1. Tangible moveable property (corporeal personality);

2. Intangible moveables including (i) documentary intangibles (in which the right to payment is embodied in the document) and (ii) pure intangibles or ‘choses in action’ (claims).  Documentary intangibles include document of title to payment (financial instruments), documents of title to negotiable securities (bonds and notes) and documents of title to goods   (such as bills of lading).

 

Money would constitute tangible moveable property although most financial assets exist in the form of financial instruments or pure claims. A financial instrument is a document of title to money in which the right to receive payment is held what constituted within the instrument and transferred with the instrument. Instruments may either involve an undertaking to pay a sum of money (including a bank note or promissory note, Treasury bill or bearer bond) or an order to pay another a sum of money (including a bill of exchange or a cheque which is legally a bill of exchange drawn on a bank). Financial instruments are further classified as either negotiable or non-negotiable with negotiability referring to the capacity of the transferee to acquire perfect title subject to having had no notice of any prior defect in title. Negotiability was historically conferred as a matter of practice on bills of exchange and cheques which was essential to their historical value and importance.

 

A security is a financial asset of claim representing either a debt obligation issued by a government or corporate body or an interest in the company concerned. Government debt instruments are generally referred to either as bills or gilts (UK only) and as debentures or bonds by corporate bodies. A security will also include shares or equity issued by companies which constitute a proportionate ownership entitlement in the assets of the company. A share is the interest of a shareholder in the company measured in money with shareholders entering into a series of mutual covenants between themselves (Borland Trustee v Steel [1901] 1 Ch 279, 288 Farwell J). The company is nevertheless a distinct legal entity from its shareholders (Salomon v Salomon & Co Ltd [1897] AC 22) with shareholders holding no equitable interest in the company’s assets directly (Macaura v Northern Assurance Co Ltd [1925] AC 619).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(2)       Financial Redistribution and Allocation

 

Banks, securities firms and other financial institutions are ‘financial intermediaries’ which carry out a number of core functions involving financial assets on financial markets. Financial intermediation refers to the matching or linking of excess with deficit capacity needs. Parties with excess assets (savings or investment) are brought together with those requiring funds (borrowers) to their mutual advantage. Financial intermediation adds value in a number of ways:

1. Savers and investors receive a secure return on their funds;

2. Borrowers are able to pool (increase) and transform (extend) maturities (the time for repayment);

3. Ancillary payment services are provided;

4. Credit risk is properly assessed and priced;

5. Credit risk is subject to specialised management by banks and other financial institutions;

6. Transaction costs are lowered;

7. There is a consequent reduction in counterparty credit risk;

8. Provision of general information management services;

9. Overall increase in credit volumes (through credit multiplier effects) and investment within the economy and consequent increase in welfare.

 

(4)       Financial Advantage

 

Apart from the core functions identified, a number of other advantages can be attributed to financial markets.

 

1. They increase the total amount of investment capital available nationally and globally;

2. Market liquidity is correspondingly improved;

3. There is a better allocation of resources in all markets;

4. Transaction costs are lowered;

5. Consequent gains in efficiency arise;

6. Market and corporate discipline is strengthened;

7. Market transparency and information management is improved;

8. Market information is better collected, distributed and assessed;

9. Underlying trade and commerce expands;

10. Welfare gains are realised more generally.

 

Financial markets also facilitate and support:

 

(a)         Daily consumer consumption;

(b)        Business and commercial development and innovation;

(c)         The provision of public services and management of public finance;

(d)        National and international trade;

(e)         Public, corporate and household or individual wealth.

 

In so doing, financial markets more specifically provide the basis for:

 

(a)         Individual consumption for the purposes of satisfying core needs in terms of food, water and housing as well as other consumption in the form of close and personal items;

(b)        Employment or service provision by independent contractors;

(c)         Mortgages and property purchase;

(d)        Commercial property construction and development;

(e)         Industrial and scientific investment and innovation.

 

Financial markets can accordingly be considered to add value in the following ways:

 

(a)         They allow the core functions to be carried out referred to in terms of deposit (safekeeping), loan (credit),    payment, investment (return) and risk cover (insurance);

(b)        They support the real economy which could not operate without the functions referred     to;

(c)         They support government and public finance;

(d)        They facilitate welfare provision and social protection through taxation and proportionate welfare redistribution;

(e)         They provide a basis for commercial and larger social and public order based on the market system.

(5)       Financial Disadvantage

 

Against these advantages, however, markets can also be considered to be:

 

1. Inherently unpredictable;

2. Consequently unstable;

3. Inefficient and ineffective (in the absence of perfect information and no transaction costs);

4. Involve high maintenance costs especially with the need for government and central bank support;

5. Fundamentally unfair in terms of wealth accumulation and distribution.

 

Markets can work specifically be considered to be unfair in that:

 

1. Benefits are disproportionately and unevenly enjoyed;

2. Markets operate in a remote and distinct manner from the general public;

3. People have no sense of participation or control;

4. There is no consequent sense of ownership or benefit; and

5. Markets operate without personal, social or cultural responsibility and can be considered to have no ethical content.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other specific difficulties can also be identified at the national and international level:

 

1. National fiscal collection, taxation and welfare distribution systems may not work effectively with many groups paying little or no tax;

2. Cross-border monetary management and relations have to be managed more effectively;

3. Foreign exchange and payment imbalance problems have to be removed;

4. Increased regulatory co-operation and co-ordination of action has to be secured especially with continuing problems ‘moral hazard’ being removed through the reintroduction of some effective market exit (bankruptcy) threat for larger ‘Too Big To Fail’ (TBTF) firms;

5. Emerging markets in developing countries require proper sequencing of investment and market reform.

 

Capital markets have been confused with capitalism which has often, in turn, been linked with earlier instances of historical abuse and exploitation. Capitalism and can be defined in a number of different ways and has been criticised historically by such writers as Karl Marx and Friedrich Engels and other more modern commentators, including many development and environmental writers. Capitalism has then been used to refer to or understood in terms of earlier colonial exploitation and later industrial and post-industrial revolution abuses of workers and collective representation (including trades union) rights.

 

Capitalism simply represents one form of industrial and social organisation and can  be understood in terms of a number of simple operational or component terms. Capitalism can be defined to include the following core elements:

 

(a)         Private ownership of the principal factors of production, including capital and enterprise and of the produce of production principally in the form of earnings;

(b)        Specialised production processes (based on Adam Smith’s Division of Labour);

(c)         A market economy operating mainly on the basis of private markets but with varying degrees of  government involvement, support or regulation and some separate parallel public markets;

(d)        Corporate entities and private and public companies with separate legal personality and limited liability as well as perpetual succession; and

(e)         Cyclic investment in innovation and capital retention.

 

Private capital models can be considered to benefit from a number of advantages and values including:

 

(a)         Individual incentives and rewards;

(b)        Industrial and market expansion and growth;

(c)         Consequent income generation and employment;

(d)        Continuing investment and innovation; and

(e)         Overall welfare benefit.

 

Private capital markets and capitalism can nevertheless suffer from a number of potential disadvantages or problems although these can be dealt with through the imposition of appropriate laws, regulations and other controls. These do not have to be understood in historical terms although elements of this correspond with earlier historical incidents.

 

(a)         Market inefficiency and instability;

(b)        Possible exploitation and abuse;

(c)         Standards dilution and standards avoidance over time;

(d)        Imposition of external costs (free riders) such as through environmental damage and financial instability; and

(e)         Resource dependence and exhaustion longer term in the absence of sustainable    production, extraction and replacement practices.

 

It is essential to ensure that markets operate effectively which includes dealing with all of these potential inefficiencies or defects. Appropriate laws and regulatory requirements have to be developed to contain any damage or potential loss in each of these areas. Much of this will necessarily involve government or public involvement although this should be limited where possible. A modern effective, managed, collaborative and sustainable market economy can be constructed which realises the full benefits of private financial markets but without the earlier instances of abuse and exploitation.

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