The financial system involves financial institutions such as banks and insurance. Other elements are financial instruments, financial markets, and central banks. In addition, it also requires a regulatory body.
Do you know the stock exchange? It is the regulatory body for securities trading. More precisely, we call it a Self-Regulatory Organization (SRO), which has the authority to make regulations related to activities in the capital market.
Lastly, there are payment systems in which currency flows from one party to another. The economy requires payment systems and infrastructure to transfer funds easily and quickly.
This article will cover the main components of the financial system covering four main parts, including:
- Financial market
- Financial assets
- Financial institutions
- Financial services
- Central bank
- Payment system
In the financial market, savers and fund users interact and trade financial assets such as stocks and bonds. Financial markets include:
- Money market
- Capital market
- Forex market
- Derivatives market
In addition to the above, the real estate and commodity markets are also included in the financial market because several financial products have exposure to both, such as commodity ETFs and Real estate investment trusts (REITs).
Bonds offer fixed returns. When you buy it, you get a coupon return, which is paid regularly. In addition, you have the potential to get capital gains.
Bond issuers may be corporations, both financial and non-financial. Or they are governments, such as national governments or local governments. International institutions such as IMF and the World Bank also issue bonds. They issue bonds to fund projects such as capital and infrastructure investments.
Bonds are debt securities. When you buy government bonds, you lend your money to the government. As compensation, the government will pay returns (coupons) regularly. And at maturity, you will get your principal back.
However, there are risks when you buy bonds. You are potentially exposed to credit risk. The bond issuer may not be able to fulfill its obligations on time. They may fail to pay coupons or interest.
In addition, you also have exposure to interest rate risk when holding bonds. If interest rates rise, bond prices fall (yields rise) and vice versa.
Meanwhile, the stock market trades equity securities, representing company ownership. If you buy stock, you own the company. You become a shareholder.
If bonds represent a financial obligation to the issuer, shares represent ownership. As a shareholder, you are entitled to dividends distributed. And you have the potential to get capital gains when the stock you buy goes up in price.
Like bonds, companies sell their shares to the public to raise funds. When they do it the first time, we call their offering an initial public offering (IPO), and for the offering after that, we call it a rights issue.
Unlike the capital market, the money market trades short-term instruments. For example, when you buy commercial paper, you are involved in the money market. Other instruments include:
- Treasury Bills
- Central bank bills
- Certificates of deposit
- Bankers’ acceptances
When long-term bonds or debentures are nearing maturity (less than one year), they are also traded in the money market.
The money market provides short-term liquidity. Issuers, for example, corporations, access this market to meet short-term needs such as working capital.
Compared to instruments in the capital market, instruments in the money market carry a lower risk. However, it also comes with lower returns.
So, when you buy treasury bills, for example, don’t expect you will get as much interest as when purchasing bonds. But, their returns are usually higher than bank deposits. So, they can be an attractive option for optimizing your return on money.
The derivatives market trades derivative instruments such as options, swaps, futures, and forwards. Their value comes from the underlying assets.
The derivatives market allows you to manage risk. For example, you buy a credit default swap (CDS) to protect you when purchasing bonds. Your CDS will enable you to reduce credit risk when the issuer defaults on its financial obligations.
In the derivatives market, you can also enter a short position when you expect the underlying asset to decrease in price. A short position makes you profit if the underlying asset moves in your favor. But, if it’s the other way around (the price goes up), you suffer a loss.
Then, the derivatives market also allows you to amplify profits by taking leverage. So, you can invest with small capital to get big profits by borrowing funds from brokers. For example, you have a capital of $ 100. If you take 2x leverage, you will have $300 to invest.
The forex market exchanges international currencies. For example, you are trading euros against US dollars. Say, you hold more euros and expect their value against the dollar to appreciate. If the EUR/USD did appreciate, you could buy more US dollars for the same euros.
The forex market is considered the most liquid because it spans trades worldwide and operates 24 hours. Apart from the spot market, the forex market offers derivative contracts such as forwards, futures, options, and currency swaps.
Market participants typically use the forex market to hedge against exchange rate risk on their primary transactions. For example, you export to America and get US dollars. When your domestic currency (the euro) appreciates against the US dollar, you can take derivative contracts in the opposite direction to minimize losses when translating US dollars to euros.
Financial assets refer to non-physical assets through which funds pass from savers to users. Examples are stocks, bonds, time deposits, and commercial paper.
Financial assets are the means by which savers get a return on their funds. Meanwhile, users issue or offer to collect funds.
For example, you buy stocks to get dividends or capital gains. Or, you buy corporate bonds to get regular coupons and principal at maturity.
On the other hand, financial assets are the means by which users of funds collect money. For example, companies issue stocks or bonds and sell them to the public through the capital market.
When you buy their stock, money passes from you to them. Likewise, when buying government bonds, money goes to the government, which may be used to finance infrastructure spending or other expenditures.
Meanwhile, the company uses the funds for working capital. Or they use it to invest capital goods by buying machinery or building new factories.
There are various financial institutions with their various services. They may provide services to mobilize funds from savers to users as banks do. Likewise, stock exchanges facilitate transactions for companies to offer their shares to the public. Meanwhile, others may provide other financial services to support the financial system’s operation without being directly involved in mobilizing funds.
Here are some examples of financial institutions:
- Financing company
- Brokerage company
- Trust company
- Insurance company
- Investment dealers
- Pension fund
- Investment banks
- Mortgage loan companies
- Credit union
Financial services are non-physical products provided by financial institutions. These services may be related to savings and loans such as those carried out by banks. Or they provide contract services such as those offered by insurance companies and pension funds.
In addition to services from the above institutions, financial services may include:
- Cash and wealth management
- Investment Management
- Accounting services
- Financing services
- Payment system
The central bank is responsible for monetary policy to influence the money supply. In addition, those who have the authority to print money.
Central banks play a vital role in exercising control over key aspects of the financial system. In addition to controlling the money supply, the central bank may be authorized to:
- Manage foreign exchange and gold reserves
- Providing credit to banks
- Act as lender of last resort
- Supervise the banking system.
- Oversee, regulate, and set standards for payment systems
Central banks are generally independent within the government system. They are not under an executive agency such as a government agency.
The payment system is through which money circulates from one hand to another. Its definition involves institutions, instruments, banking procedures, and funds transfer systems.
Advanced payment systems allow us to transfer money quickly and at a low cost. In addition, it is the foundation for financial stability. On the negative side, the payment system is the conduit through which shocks are transmitted throughout the financial system and economy.