Reading 39

The three main functions of the financial system are:

1. Allow entities to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information.
2. Determine the equilibrium rate of return that equates aggregate savings and borrowing.
3. Allocate capital to its most efficient uses.

Achievement of Purposes

Saving. Individuals save for retirement and other future needs; firms save some of their earnings for future expenditures. Savers can put their savings into bank deposits, certificates of deposit, notes, bonds, stocks, mutual funds, and real assets such as real estate. Savers expect to earn a return on their savings to compensate for the use of their funds, expected future inflation, and the risk that they may not get their funds back.

Borrowing. Individuals may borrow in order to buy a house, fund a college education, or for other purposes. A firm may borrow in order to finance capital expenditures and for other activities. Governments may issue debt to fund their expenditures. Lenders can require collateral to protect them in the event of borrower defaults, take an equity position, or investigate the credit risk of the borrower.

Issuing equity. Another method of raising capital is to issue equity, where the capital providers will share in any future profits. Investment banks help with issuance, analysts value the equity, and regulators and accountants encourage the dissemination of information.

Risk management. Entities face risks from changing interest rates, currency values, commodities values, and defaults on debt, among other things. For example, a firm that owes a foreign currency in 90 days can lock in the price of this foreign currency in domestic currency units by entering into a forward contract. In this transaction, the firm would be referred to as a hedger. Hedging instruments are available from exchanges, investment banks, insurance firms, and other institutions.

Exchanging assets. The financial system allows entities to exchange assets. For example, Proctor and Gamble may sell soap in Europe but have costs denominated in U.S. dollars. P&G can exchange their euros for dollars in the currency markets.

Utilizing information. Investors with information expect to earn a return on that information in addition to their usual return. Investors who can identify assets that are currently undervalued or overvalued can earn extra returns from investing based on their information (when their analysis is correct).

Return Determination

The financial system also provides a mechanism to determine the equilibrium interest rate — the rate at which the amount individuals, businesses, and governments desire to borrow is equal to the amount that they desire to lend. Equilibrium rates for different types of borrowing and lending will differ due to differences in risk, liquidity, and maturity.

Allocation of Capital

With limited availability of capital, one of the most important functions of a financial system is to allocate capital to its most efficient uses. Investors weigh the expected risks and returns of different investments to determine their most preferred investments. As long as investors are well informed regarding risk and return and markets function well, this results in an allocation of capital to its most valuable uses.

Financial assets include securities (stocks and bonds), derivative contracts, and currencies. Real assets include real estate, equipment, commodities, and other physical assets.

Financial securities can be classified as debt or equity. Debt securities are promises to repay borrowed funds; equity securities represent ownership positions.

Public (publicly traded) securities are traded on exchanges or through securities dealers and are subject to regulatory oversight. Private securities are not traded in public markets — often illiquid and not subject to regulation.

Derivative contracts have values that depend on (are derived from) the values of other assets. Financial derivatives are based on equities, indexes, debt, or other financial contracts. Physical derivatives derive value from physical assets such as gold, oil, and wheat.

Markets for immediate delivery are spot markets. Contracts for future delivery include forwards, futures, and options. Options provide the buyer the right, but not the obligation, to purchase (or sell) assets over some period or at some future date at predetermined prices.

The primary market is the market for newly issued securities. Subsequent sales occur in the secondary market.

Money markets refer to markets for debt securities with maturities of one year or less. Capital markets refer to markets for longer-term debt securities and equity securities that have no specific maturity date.

Traditional investment markets refer to those for debt and equity. Alternative markets refer to those for hedge funds, commodities, real estate, collectibles, gemstones, leases, and equipment. Alternative assets are often more difficult to value, illiquid, require investor due diligence, and therefore often sell at a discount.

Assets can be classified as securities, currencies, contracts, commodities, and real assets.

Securities

Securities can be classified as fixed-income or equity securities, and individual securities can be combined in pooled investment vehicles. The initial sale of a security to the public is called an issue.

Fixed-income securities typically refer to debt securities — promises to repay borrowed money in the future:

• Short-term: maturity less than one or two years
• Long-term: longer than five to ten years
• Intermediate-term: between the two

Although terms are used loosely, bonds are generally long term, whereas notes are intermediate term. Commercial paper is short-term debt issued by firms. Governments issue bills and banks issue certificates of deposit (CDs). In repurchase agreements (repos), the borrower sells a high-quality asset and has both the right and obligation to repurchase it (at a higher price) in the future, often as short as one day.

Convertible debt is debt that an investor can exchange for a specified number of equity shares of the issuing firm.

Equity securities represent ownership in a firm and include common stock, preferred stock, and warrants:

• Common stock — residual claim on a firm's assets. Dividends are paid only after interest to debtholders and dividends to preferred stockholders. In liquidation, debtholders and preferred stockholders have priority over common stockholders.
• Preferred stock — equity with scheduled dividends that typically do not change over the security's life and must be paid before any dividends on common stock.
• Warrants — similar to options, giving the holder the right to buy a firm's equity shares (usually common stock) at a fixed exercise price prior to expiration.

Pooled investment vehicles include mutual funds, depositories, and hedge funds. They combine the funds of many investors in a portfolio of investments. Investor ownership interests are referred to as shares, units, depository receipts, or limited partnership interests.

• Mutual funds — investors purchase shares either from the fund itself (open-end) or in the secondary market (closed-end).
• Exchange-traded funds (ETFs) and exchange-traded notes (ETNs) — trade like closed-end funds but have provisions allowing conversion into individual portfolio securities, keeping market prices close to the value of the proportional interest in the underlying portfolio. Sometimes called depositories; their shares are depository receipts.
• Asset-backed securities (ABS) — represent a claim to a portion of a pool of financial assets such as mortgages, car loans, or credit card debt. Returns are passed through to investors, with different classes of claims (tranches) having different levels of risk.
• Hedge funds — organized as limited partnerships, with investors as limited partners and the fund manager as general partner. Use various strategies; restricted to investors of substantial wealth and knowledge; often use leverage. Managers compensated based on assets under management and investment results.

Currencies

Currencies are issued by a government's central bank. Some are reserve currencies — those held by governments and central banks worldwide. These include the U.S. dollar and euro and, secondarily, the British pound, Japanese yen, and Swiss franc. In spot currency markets, currencies are traded for immediate delivery.

Contracts

Contracts are agreements between two parties that require some action in the future. Financial contracts are often based on securities, currencies, commodities, or security indexes. They include futures, forwards, options, swaps, and insurance contracts.

A forward contract is an agreement to buy or sell an asset in the future at a price specified in the contract at its inception. An agreement to purchase 100 ounces of gold 90 days from now for $2,000 per ounce is a forward contract. Forward contracts are not traded on exchanges or in dealer markets.

Futures contracts are similar to forward contracts except that they are standardized as to amount, asset characteristics, and delivery time and are traded on an exchange (in a secondary market) so that they are liquid investments.

In a swap contract, two parties make payments equivalent to one asset being traded (swapped) for another:

• Interest rate swap: floating-rate interest payments exchanged for fixed-rate payments over multiple settlement dates.
• Currency swap: a loan in one currency for the loan of another currency for a period of time.
• Equity swap: exchange of the return on an equity index or portfolio for the interest payment on a debt instrument.

An option contract gives its owner the right to buy or sell an asset at a specific exercise price at some specified time in the future:

• Call option — gives the buyer the right (not obligation) to buy an asset.
• Put option — gives the buyer the right (not obligation) to sell an asset.

Sellers (writers) of call/put options receive a payment (the option premium) when they sell the options but incur the obligation to sell/buy the asset if the owner exercises. Options on currencies, stocks, stock indexes, futures, swaps, and precious metals are traded on exchanges. Customized options are also sold by dealers in the over-the-counter (OTC) market.

An insurance contract pays a cash amount if a future event occurs. Used to hedge against unfavorable, unexpected events (life, liability, automobile insurance). Sometimes tradable; often have tax-advantaged payouts.

Credit default swaps (CDS) are a form of insurance that makes a payment if an issuer defaults on its bonds. Used by bond investors to hedge default risk; also used by parties exposed to issuer financial distress; and by speculators on issuer credit quality.

Commodities

Commodities trade in spot, forward, and futures markets. They include precious metals, industrial metals, agricultural products, energy products, and credits for carbon reduction. Futures and forwards allow both hedgers and speculators to participate in commodity markets without having to deliver or store the physical commodities.

Real Assets

Examples of real assets are real estate, equipment, and machinery. Although traditionally held by firms for use in production, real assets are increasingly held by institutional investors both directly and indirectly.

Direct ownership of real assets often provides income, tax advantages, and diversification benefits. However, they entail substantial management costs. Their heterogeneity requires substantial due diligence, and they are illiquid because their specialization may result in a limited pool of investors.

Indirect ownership can be obtained through investments such as real estate investment trusts (REITs) or master limited partnerships (MLPs). The investor owns an interest in these vehicles, which hold the assets directly. Indirect interests are typically more liquid than direct ownership. Another indirect ownership method is to buy stock in firms that have large ownership of real assets.

Financial intermediaries stand between buyers and sellers, facilitating the exchange of assets, capital, and risk. They include brokers and exchanges, dealers, securitizers, depository institutions, insurance companies, arbitrageurs, and clearinghouses.

Brokers, Dealers, and Exchanges

Brokers help their clients buy and sell securities by finding counterparties. Block brokers help with the placement of large trades, helping to conceal client intentions so that the market does not move against them.

Investment banks help corporations sell common stock, preferred stock, and debt to investors. They also advise firms on mergers, acquisitions, and capital raising.

Exchanges provide a venue where traders can meet. They sometimes act as brokers via electronic order matching. Exchanges regulate their members and require listed firms to provide timely financial disclosures and promote shareholder democratization.

Alternative trading systems (ATS) serve the same trading function as exchanges but have no regulatory function. Also known as electronic communication networks (ECNs) or multilateral trading facilities (MTFs). ATS that do not reveal current client orders are known as dark pools.

Dealers facilitate trading by buying for or selling from their own inventory. Dealers provide liquidity and profit primarily from the bid-ask spread (the difference between bid and ask prices).

Some dealers also act as brokers. Broker-dealers have an inherent conflict of interest: as brokers they should seek the best prices for clients, but as dealers their goal is to profit through prices/spreads. Primary dealers trade with central banks when they buy/sell government securities to affect the money supply.

Securitizers

Securitizers pool large amounts of securities or other assets and sell interests in the pool to other investors. Returns net of the securitizer's fees are passed through to investors. This creates:

• A diversified pool of assets with more predictable cash flows than individual assets
• Liquidity because the ownership interests are more easily valued and traded
• Economies of scale in management costs and benefits from manager selection

Common assets securitized include mortgages, car loans, credit card receivables, bank loans, and equipment leases. The primary benefit is to decrease funding costs. A firm may set up a special purpose vehicle (SPV) or special purpose entity (SPE) to buy firm assets, removing them from the firm's balance sheet and protecting them from claims if the firm experiences financial trouble.

The cash flows from securitized assets can be segregated by risk into tranches: senior tranches have the most certain cash flows; junior tranches have greater risk.

Depository Institutions

Examples include banks, credit unions, and savings & loans. They pay interest on customer deposits and provide transaction services such as checking accounts, then make loans with the funds (offering diversification). Other intermediaries (payday lenders, factoring companies) lend on the basis of wages, accounts receivable, and other future cash flows, often financing themselves by issuing commercial paper.

Securities brokers provide loans to investors who purchase securities on margin. When margin lending is to hedge funds and other institutions, the brokers are referred to as prime brokers.

The equity owners of banks/brokers/intermediaries absorb loan losses before depositors and other lenders. The more equity capital an intermediary has, the less risk for depositors. Poorly capitalized intermediaries have less incentive to reduce risk.

Insurance Companies

Insurance companies collect insurance premiums in return for providing risk reduction. They diversify risk across a pool of policyholders whose risks of loss are typically uncorrelated. Insurance firms also manage the risks inherent in insurance:

• Moral hazard — the insured may take more risks once protected
• Adverse selection — those most likely to experience losses are the predominant buyers of insurance
• Fraud — the insured purposely causes damage or claims fictitious losses

Arbitrageurs

In its pure (riskless) form, arbitrage refers to buying an asset in one market and reselling it in another at a higher price. Arbitrageurs provide liquidity to participants and transfer assets between markets.

In markets with good information, pure arbitrage is rare. More commonly, arbitrageurs exploit pricing differences for similar instruments (e.g., a dealer selling a call option may also buy the stock since call and stock prices are highly correlated). Many use complex models for valuation and risk control. Creating similar positions using different assets is called replication — also a form of intermediation.

Clearinghouses and Custodians

Clearinghouses act as intermediaries between buyers and sellers and provide:

• Escrow services (transferring cash and assets to the respective parties)
• Guarantees of contract completion
• Assurance that margin traders have adequate capital
• Limits on the aggregate net order quantity (buys − sells) of members

Through these activities, clearinghouses limit counterparty risk. Custodians improve market integrity by holding client securities and preventing loss due to fraud or events affecting the broker or investment manager.

An investor who owns an asset, or has the right or obligation under a contract to purchase an asset, has a long position. A short position can result from borrowing an asset and selling it (a short sale), or from being the party who must sell or deliver under a contract. In general, long positions benefit from price increases and short positions benefit from price declines.

Hedgers use short positions in one asset to hedge an existing risk from a long position in another asset whose returns are strongly correlated. For example, wheat farmers may sell wheat futures contracts. If wheat prices fall, the gain on the short futures position offsets the loss in the value of the farmer's crop.

The buyer of an option contract is long the option. The seller is short the option (also said to have written the option). An investor long a call profits when the underlying asset rises; the writer has losses. An investor long a put profits when the underlying falls; the writer has losses.

In swaps, each party is long one asset and short the other, so the designation is often arbitrary. Usually the side that benefits from an increase in the quoted price/rate is the long side.

In a currency contract, each party is long one currency and short the other. For example, the buyer of a euro futures contract priced in dollars is long the euro and short the dollar.

Short Sales and Positions

In a short sale, the short seller:

1. Simultaneously borrows and sells securities through a broker
2. Must return the securities at the lender's request or when the short sale is closed out
3. Must keep a portion of the proceeds on deposit with the broker

Short sellers profit when the security price falls — they buy at a lower price to repay the loan. Repayment of the borrowed security is called "covering the short position".

The short seller must pay all dividends or interest the lender would have received — these are called payments-in-lieu of dividends or interest. The proceeds of the short sale are deposited as collateral. The broker earns interest on these funds and may return a portion to the short seller at the short rebate rate (typically 0.1% less than overnight rates; usually only for institutional investors). If the security is hard to borrow, the rate may be lower or negative. A short sale may also require additional margin in the form of cash or short-term riskless securities.

Leveraged Positions

The use of borrowed funds to purchase an asset results in a leveraged position. Investors who buy securities by borrowing from their brokers buy on margin; the borrowed funds are a margin loan. The interest rate on the funds is the call money rate, generally higher than the government bill rate; lower for larger investors with better collateral.

At the time of a margin purchase, investors must provide a minimum equity called the initial margin requirement, set by the government, exchange, clearinghouse, or broker. Lower portfolio risk often means the broker will lend more.

The use of leverage magnifies both gains and losses. The additional risk from borrowed funds is called financial leverage risk.

The leverage ratio of a margin investment is the value of the asset divided by the value of the equity position. An investor who satisfies an initial margin requirement of 50% has a 2-to-1 leverage ratio: a 10% increase (decrease) in the asset price results in a 20% increase (decrease) in equity.

Maintenance Margin and Margin Calls

To ensure the loan is covered, an investor must maintain a minimum equity percentage — the maintenance margin requirement — typically 25% of the current position value (higher for volatile stocks). If equity falls below this level, the investor receives a margin call: a request to bring equity back up to the required percentage by depositing additional funds or unmargined securities. If unmet, the broker must sell the position.

In a short sale, the investor must deposit initial margin equal to a percentage of the value of the shares sold short to protect the broker if the price increases. An increase in the share price can decrease the margin percentage below the maintenance margin and generate a margin call.

Securities dealers provide prices at which they will buy and sell shares:

• Bid price — the price at which a dealer will buy
• Ask (or offer) price — the price at which a dealer will sell
• Bid-ask spread — the difference between bid and ask; the dealer's compensation

The bid and ask are quoted for specific trade sizes (bid size and ask size).

The market quotation is the highest dealer bid and lowest dealer ask among all dealers in a particular security. More liquid securities have tighter bid-ask spreads (lower as a percentage of price) → lower transactions costs. Traders who post bids and offers make a market; those who trade with them at posted prices take the market.

Orders specify the size of the trade and whether to buy or sell. Orders can also include:

• Execution instructions — how to trade
• Validity instructions — when the order can be filled
• Clearing instructions — how to settle the trade

Execution Instructions

The most common are market or limit orders:

• A market order instructs the broker to execute the trade immediately at the best possible price.
• A limit order places a minimum execution price on sell orders and a maximum execution price on buy orders. A buy order with a limit of $6 will be executed only if shares can be purchased for $6 or less.

Market order — appropriate when the trader wants to execute quickly (e.g., trader has information not yet reflected in prices). Disadvantage: may execute at unfavorable prices, especially in low-volume securities. The price concession is the cost of immediate liquidity, and is unpredictable.

Limit order — avoids price execution uncertainty. Disadvantage: may not be filled. If a buy limit at $50 finds no seller at $50, it will not execute, and the trader misses any subsequent gains.

Limit order classification by relation to the market:

• Marketable / aggressively priced: a limit buy above the best ask, or a limit sell below the best bid — likely to execute immediately.
• Making a new market / inside the market: limit price is between the best bid and best ask.
• Standing limit orders: limit orders waiting to execute.
• Make the market: a limit buy at the best bid, or a limit sell at the best ask.
• Behind the market: a buy with limit price below the best bid, or a sell with limit price above the best ask — unlikely to fill until prices move.
• Far from the market: limit price considerably away from the best quote.

Other execution instructions concern volume and visibility:

• All-or-nothing orders execute only if the whole order can be filled.
• Orders can specify a minimum size when trading costs depend on the number of trades.
• Hidden orders — only the broker/exchange knows the size; useful for large trades.
• Display size / iceberg orders — part is visible, the rest hidden, with the rest potentially executed once the visible part has executed.

Validity Instructions

Validity instructions specify when an order should be executed:

• Day orders — expire if unfilled by the end of the trading day (most common).
• Good til canceled (GTC) — last until filled.
• Immediate-or-cancel (IOC) — also known as fill-or-kill; canceled unless filled immediately.
• Good-on-close orders — only filled at the end of the trading day; if market orders, called market-on-close. Often used by mutual funds (portfolios valued at closing prices).
• Good-on-open orders — filled at market open.
• Stop orders — not executed unless the stop price has been met. Often called stop loss orders.

Stop-sell order: an investor purchasing a stock at $50 who wants to sell if the price falls 10% to $45 enters a stop-sell order at $45. If the stock trades down to $45 or lower, this triggers a market order to sell. There is no guarantee of execution at $45 — a rapidly falling stock could be sold significantly lower.

Stop-buy order: entered with a stop (trigger) above the current market price. Used by:

1. A trader with a short position to limit losses from rising prices
2. An investor who believes the stock is undervalued but wants to wait until market participants agree (entering at some percentage above the current price)

Note that stop orders reinforce market momentum: stop-sells execute when prices are falling, stop-buys when rising. Execution prices for stop orders are often unfavorable.

Clearing Instructions

Clearing instructions tell the trader how to clear and settle a trade. They are usually standing instructions and not attached to an order. Retail trades are typically cleared and settled by the broker, whereas institutional trades may be settled by a custodian or another broker (the trader's prime broker). Using two brokers allows the investor to keep one as her prime broker for margin and custodial services while using a variety of others for specialized execution.

One important clearing instruction is whether a sell order is a short sale or long sale: in the former, the broker must confirm the security can be borrowed; in the latter, that it can be delivered.

Primary capital markets refer to the sale of newly issued securities. New equity issues involve either:

• New shares issued by firms whose shares are already trading — seasoned offerings or secondary issues
• First-time issues by firms whose shares are not currently publicly traded — initial public offerings (IPOs)

Secondary financial markets are where securities trade after their initial issuance. Placing a buy order on the London Stock Exchange is an order in the secondary market — it results in purchase of existing shares from their current owner.

Primary Market: Public Offerings

Corporate stock or bond issues are almost always sold with the assistance of an investment banking firm. The bank finds investors who provide indications of interest (not actual orders). When indications exceed (fall short of) shares offered, the offering price is adjusted upward (downward). This process is book building; the lead is called the book runner in London. In Europe, an accelerated book build occurs when securities must be issued quickly. The investment bank disseminates information about financials and prospects, and the issuer must make disclosures including how funds will be used.

Two main forms of underwriting:

• Underwritten offering: the bank agrees to purchase the entire issue at a negotiated price. If undersubscribed, the bank must buy the unsold portion. For an IPO, the bank also makes a market for a period after issuance to provide price support.
• Best efforts offering: the bank agrees to distribute the issue but is not obligated to buy any unsold portion.

Conflict of interest in underwritten offers: as the issuer's agent, the bank should set the price high to maximize proceeds; as underwriter, it prefers the price low enough to ensure the issue sells (and to allocate undervalued shares to clients). This typically leads to IPO underpricing. Issuers may also prefer underpricing to avoid the negative publicity of a "broken" IPO. An IPO that is oversubscribed and expected to trade significantly above issue price is a hot issue.

Primary Market: Private Placements and Other Transactions

In a private placement, securities are sold directly to qualified investors (substantial wealth and investment knowledge), typically with investment bank assistance. Disclosure requirements are lower than public offerings; issuance costs are lower; the offer price is also lower because the securities cannot be resold in public markets.

In a shelf registration, a firm makes its public disclosures as in a regular offering but issues the registered securities over time when capital is needed and markets are favorable.

A dividend reinvestment plan (DRP / DRIP) allows existing shareholders to use their dividends to buy new shares from the firm at a slight discount.

In a rights offering, existing shareholders are given the right to buy new shares at a discount to the current market price. Shareholders dislike rights offerings because their ownership is diluted unless they exercise. However, rights can sometimes be traded separately.

Governments also issue short-term and long-term debt, either by auction or through investment banks.

Importance of the Secondary Market

Secondary markets provide liquidity and price/value information. The better the secondary market, the easier it is for firms to raise external capital in the primary market — resulting in a lower cost of capital for firms with adequately liquid shares.

Trading can be examined according to when securities are traded and how they are traded.

Call markets — the stock is only traded at specific times. Potentially very liquid when in session (all traders present) but illiquid between sessions. All trades, bids, and asks are declared, and one negotiated price is set that clears the market. Used in smaller markets and to set opening prices and prices after trading halts on major exchanges.

Continuous markets — trades occur at any time the market is open. Price set by the auction process or dealer bid-ask quotes.

Market Structures

There are three main categories of securities markets:

1. Quote-driven markets (also dealer markets, price-driven markets, or over-the-counter markets) — investors transact with dealers (market makers) who post bid and ask prices. Dealers maintain an inventory. Most securities other than stocks trade in quote-driven markets. Trading often takes place electronically.

2. Order-driven markets — orders are executed using trading rules (necessary because traders are usually anonymous). Exchanges and automated trading systems are examples. Two sets of rules:

• Order matching rules — establish an order precedence hierarchy:
  • Price priority: highest priority to highest bid (buy) and lowest ask (sell)
  • If prices are equal, secondary precedence: non-hidden orders first, then earliest arriving orders first
  These rules encourage aggressive pricing, full display, and early trading — improving liquidity.
• Trade pricing rules — determine the actual trade price:
  • Uniform pricing rule: all orders trade at the same price (the price that maximizes trading volume)
  • Discriminatory pricing rule: the limit price of the order that arrived first is the trade price
  • Derivative pricing rule: in electronic crossing networks, orders are batched and crossed at fixed times at the average of the bid and ask quotes from the security's main exchange (typical traders are institutions)

3. Brokered markets — brokers find counterparties to execute trades. Especially valuable when the security is unique or illiquid (large blocks of stock, real estate, artwork). Dealers typically don't carry inventory and trades are too few for order-driven markets.

Market Information

A market is pre-trade transparent if investors can obtain pre-trade information regarding quotes and orders. Post-trade transparent if investors can obtain post-trade information regarding completed trade prices and sizes.

Buy-side traders value transparency because it allows better understanding of values and trading costs. Dealers prefer opaque markets because this provides them an informational advantage. Transactions costs and bid-ask spreads are larger in opaque markets.

A well-functioning financial system allows entities to achieve their purposes. Complete markets fulfill the following:

• Investors can save for the future at fair rates of return
• Creditworthy borrowers can obtain funds
• Hedgers can manage their risks
• Traders can obtain the currencies, commodities, and other assets they need

If the market performs these functions at low trading costs (commissions, bid-ask spreads, price impacts), it is operationally efficient. If security prices reflect all information associated with fundamental value in a timely fashion, the system is informationally efficient. A well-functioning system is complete, operationally efficient, and informationally efficient, with prices reflecting fundamental values.

A well-functioning system has financial intermediaries that:

• Organize trading venues — exchanges, brokerages, alternative trading systems
• Supply liquidity
• Securitize assets so borrowers can obtain funds inexpensively
• Manage banks that use depositor capital to fund borrowers
• Manage insurance firms that pool unrelated risks
• Manage investment advisory services that assist investors with asset management inexpensively
• Provide clearinghouses that settle trades
• Manage depositories that provide for asset safety

Benefits of a well-functioning system: savers fund entrepreneurs; risks are shared so risky companies can be funded; transactions can occur among strangers, widening capital formation and risk sharing.

In informationally efficient markets, capital is allocated to its most productive use — they are allocationally efficient. Informational efficiency is brought about by traders who bid prices up and down in response to new information. Operationally efficient → more informationally efficient because low costs encourage trading on new information. Accounting standards and reporting requirements also reduce information costs and increase security values.

Without market regulation, several problems could persist:

• Fraud and theft: investment managers and others can take advantage of unsophisticated investors. With random returns, investors find it difficult to evaluate agent performance.
• Insider trading: if investors believe insiders will exploit them, they exit the market and liquidity declines.
• Costly information: if information is expensive, markets are less informationally efficient and investors invest less.
• Defaults: parties might not honor their obligations.

To solve these problems, market regulation should:

• Protect unsophisticated investors so trust in markets is preserved
• Require minimum standards of competency and make it easier to evaluate performance (the CFA Program and the Global Investment Performance Standards are part of this effort)
• Prevent insiders from exploiting other investors
• Require common financial reporting requirements (e.g., IASB) so information gathering is less expensive
• Require minimum levels of capital so participants can honor long-term commitments — especially insurance and pension funds. With capital at stake, participants have incentive to be careful about risks.

Regulation can be provided by governments and industry groups. Most exchanges, clearinghouses, and dealer trade organizations are self-regulating organizations (SROs), regulating their members. Governments sometimes delegate regulatory authority to SROs.

When regulation fails, financial markets do not function well: liquidity declines, firms shun risky projects, new ideas go unfunded, and economic growth slows.