Intro Financial System 2011 (1)

8/6/2019 Intro Financial System 2011 (1)

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Jian WUInvestment Theory Preliminary notions (1)

Preliminary notions on the financial system

1) Vocation of Capital Reallocation

y Indirect Financing through the Banking System

Activity of Banking

y Direct Financing through the Financial Markets

Activity of Traditional Financial Markets

2) Vocation of Risk Reallocation

y Activity of Derivative Markets


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Original purpose of the financial system: set up a BRIDGE

between lenders and borrowers

LENDERS

Individual savers

Institutional investors

(insurance companies,

investment companies,

funds)

BORROWERS

State

Companies

Local collectivities

Bridge

= Financial System

Banking System

Financial Markets

Capital


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Banking system offers an INDIRECT financing

ASSET LIABILITY

BORROWERS

(Companies)

LENDERS

(Individualsavers)

Short-term depositsLong-term credits

The BANK acts as INTERMEDIARY (MIDDLEMAN)

between lenders and borrowers (with fees)

BANQUE


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Financial markets offer a DIRECT financing

LENDERS

(Subscribers)BORROWERS

(Issuers)

A FINANCIAL MARKET is a place where borrowers collect funds

DIRECTLY from lenders by ISSUING FINANCIAL CLAIMS

(such as stocks and bonds).

Capital

Financial claims


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How to classify traditional financial markets? (1)

According to the MATURITY of the financial claim

Traditional

financial

markets

Monetary

Markets

(short-term)

Capital

Markets

(long-term)

BondMarkets

Stock

Markets

Treasury

Bonds

Corporate

Bonds

Negotiable

DebtSecurities

Markets

Interbank

Markets

Treasury Bills

Commercial

Papers

Certificates of

Deposit


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According to the PROPERTY of the financial claim

Traditional

financialmarkets

Debt

Markets

Stock

Markets

Monetary

Markets

Bond

Markets

Treasury

Bonds

CorporateBonds

Interbank

Markets

Markets ofNegotiable Debt

Securities


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According to whether the claim is NEWLY ISSUED OR NOT

y The primary market ( market of first-hand ) is a market in which financial claims

(bonds, stocks) are issued for the first time. It permits the issuer to collect funds from

the subscribers of the claims.

y The secondary market ( market of second-hand ) is a market in which financialclaims, having already been issued, are negotiated between old subscribers and new

ones. As it ensures the liquidity of the claims or the exit for their subscribers, it ensures

the good functioning of the primary market.

Traditional

financial

markets

Primary Markets (Initial

Public Offering, IPO)

Secondary Markets


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According to HOW THE NEGOTIATION IS ORGANIZED in the market

y The regulated market (or the Exchange) is a market in which transactions are

submitted to a certain number of specific regulations defined by the market authority.

Its main advantages consist in its high liquidity and its low counter-party risk .

y The OTC market is a market in which transactions are made according to the

agreement between the two parties, without being submitted to specific regulations. Its

main advantages consist in its flexibility and its accuracy as regard to specific needs.

Traditional

FinancialMarkets

Exchanges

(Regulated Markets)

Over-The-Counter(OTC) Markets

(Private Markets)

Order-driven orAuction Markets

(NYSE, Euronext)

Price-driven orIntermediate Markets

(NASDAQ)


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From Capital Re-allocation to Risk Re-allocation

The ORIGINAL PURPOSE of financial markets was the Capital Re-allocation,

by transferring capital from lenders to borrowers.

With the development of derivative markets since the 70s, such a purpose has

been enlarged to Risk Re-allocation, by transferring risks (ex. market risk and

credit risk) from Risk Givers to Risk Takers.

DERIVATIVE Markets (see Session 7) are an integral part of Financial Markets.

Financial

Markets

Traditional Financial Markets

(Cash markets)

Derivative markets


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Press lecture (1)

1st article: Exchange chiefs seek global powerhouses (Financial Times Jeremy Grant

February 10th 2011)

Even as Xavier Rolet, chief executive of the London Stock Exchange and his counterpart

at Canada's TMX Group were wrapping up a sales pitch in Toronto for the creation of a "true

powerhouse in the global exchange business", two far bigger rivals were plotting to steal their

thunder.

By unveiling plans for their own merger, NYSE Euronext and Deutsche Brse have not

only put the UK-Canadian tie-up in the shade. They have shown that another wave of exchange

consolidation is cascading through global markets.

The last spasm of merger activity took place five years ago when NYSE Euronext was

created through the takeover by the New York Stock Exchange of Euronext, the network of pan-

European exchanges.

In the US, the Chicago Mercantile Exchange swallowed its cross-town rival, the Chicago

Board of Trade.

This time, there are fewer options and fewer combinations that make sense.


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Press lecture (2)

1st article: Exchange chiefs seek global powerhouses (continued)

Justin Schack, head of market structure analysis at Rosenblatt Securities, a US broker,

said: "There are only so many exchanges out there. People have had to intensify their discussions

and make sure they are not left at the dance without a partner. That's what's happening here.

Like the last wave, the driving force is the need to build global scale as technology is

driving down the cost of accessing markets across the world, sucking in new communities of

traders. Those changes have even reached China, which launched futures trading only months

ago.

Exchanges are generally fixed-cost businesses, so the more trading and clearing they

attract from around the world by expanding their reach, the easier it is to make money.

But there are new forces at work this time. Sweeping regulatory change is bearing down

on exchanges and clearing houses - the "plumbing" that makes much of the markets work - asregulators clean up the system after the 2008 financial crisis.

Vast swathes of off-exchange financial instruments called derivatives are being forced by

new rules such as the Dodd-Frank act, passed by the US government last year, onto exchanges

and clearing houses. This is seen as a way of safeguarding the financial system against big

defaults like Lehman Brothers in 2008. The same is happening in Europe.


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Press lecture (3)

1

st

article: Exchange chiefs seek global powerhouses (continued)

That has sparked a rush to retool the exchange business in anticipation of this landscape.

NYSE Euronext has been trying to build a new clearing house to capture OTC derivatives clearing

in the US, while Deutsche Brse is trying to build a similar business in Europe.

But large exchange groups have also been feeling the heat from competition. In the US the

New York Stock Exchange not only competes against Nasdaq, but at least 10 smaller platforms, aswell as "dark pools" and trading facilities offered by brokers and banks.

The same pattern has played out in Europe since the passage of the so-called "Mifid" rules

that broke exchanges monopolies.

Upstart platforms pose a serious threat to exchanges' share of stock trading: the LSE has

seen its share of the FTSE 100 plunge to under 60 per cent at the hand of nimbler operators such

as Chi-X.

It is a confusing patchwork that raised pressure on exchanges to defend eroding franchises

and caused regulators to question whether having several trading venues threatens price

transparency.


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Press lecture (4)

1st article: Exchange chiefs seek global powerhouses (continued)

Yesterday, NYSE Euro-next and Deutsche Brse took a swipe at those venues, saying the

combined company would "create an important counterweight to the proliferation of alternative

trading venues that operate with less transparency and far fewer regulatory requirements than [our

companies]".

Yet the deal faces obstacles. The proposed structure has Deutsche Brse ending up with

59-60 per cent of a new holding company based in the Netherlands, and NYSE Euronext

shareholders with 40-41 per cent. That may provoke a backlash in Washington, irked by the

prospect of a German group having control over the New York Stock Exchange.

And both exchanges operate the biggest futures and options markets in Europe: the US

group has NYSE Liffe - the former London International Financial Futures Exchange - while the

German group has Eurex. The LSE's Mr Rolet said he wanted to use the deal with TMX to help

compete against this "duopoly".

Merging that duopoly would create a virtual monopoly in European derivatives trading,

which would likely attract scrutiny from antitrust authorities.

But that is unlikely to stop consolidation. "Eventually, when all the M&A is finished, there

will be 3-4 worldwide exchanges," said Jeff Carter, a former board member of the Chicago

Mercantile Exchange and trader. "It will look like the credit card industry."


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Press lecture (5)

2nd article: Exchange group sees future in derivatives (Financial Times Jeremy Grant

February 16th 2011)

If there is one statement that sums up why two of the biggest exchange groups from the US

and Europe are combining to create the world's biggest bourse, it was what Duncan Niederauer,

NYSE Euronext chief executive, said on the floor of the New York Stock Exchange on Tuesday.

"I've never thought the future of exchanges was just about trading equities," he said, as

equities traders worked orders behind him.

The deal to combine NYSE Euronext with Deutsche Brse of Germany has little to do with

creating a giant stock exchange. It is more about bulking up in the more arcane - yet more lucrative

- world of futures and options contracts, and post trade services such as clearing.

It is also about burying all notions of wrapping the national flag around an exchange. Mr

Niederauer said it would be another two months before a decision is made on what to call the new

group. But he admitted: "It is an emotional decision for everyone, let's be honest about it.


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Press lecture (6)

2nd article: Exchange group sees future in derivatives (continued)

The group, to be run from New York and Frankfurt, will get 37 per cent of its net revenues

from derivatives and the clearing of them, with cash equities trading and listings next on 29 per

cent. Settlement and custody, which Deutsche Brse brings to the deal with its Luxembourg

Clearstream business, will provide 20 per cent of group revenues, with market data and technology

making up the rest. Exchanges face such stiff competition in cash equities that they have little

alternative but to grow derivatives and expand globally to battle myriad competitors.

Five-year-old upstart BATS Exchange has captured 10 per cent of US share trading,

closing in on NYSE Euronext's 28 per cent. Then there are operators of "dark pools" and other off-

exchange networks that have fragmented markets.

In a conference call, Mr Niederauer took a swipe at such venues operating with "less

transparency". But he admitted there was "no doubt" the two bourses faced competition in equities.

Merging would put them "in a better position to play defence".

Yet exchange-traded derivatives are growing faster than equities. Deutsche Brse and

NYSE Euronext plan to combine trading of their Liffe and Eurex derivatives exchanges and, in a

potential blow to London, appear set on moving clearing of Liffe's contracts from Liffe Clear in

London to Eurex Clearing in Frankfurt.


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Press lecture (7)


Both groups are also coming together as regulators are pushing over-the-counter

derivatives on to exchanges and through clearing houses, providing more of an incentive for

exchanges to expand in this area. Paul Edmondson, of law firm CMS Cameron McKenna, said:

"The exchanges are reacting to regulatory as well as market developments.

Both groups are also coming together as regulators are pushing over-the-counterderivatives on to exchanges and through clearing houses, providing more of an incentive for

exchanges to expand in this area. Paul Edmondson, of law firm CMS Cameron McKenna, said:

"The exchanges are reacting to regulatory as well as market developments.

Reto Francioni, Deutsche Brse's chief executive who is set to be chairman of the new

group, also suggested Asia was next: "The most volume in derivatives is OTC. Together we are

much stronger to tackle OTC in trading area but also in the clearing area. Together with this

potential, that's also a story combining US, Europe and probably soon to [an] extent Asia.

The group also intends to wield power in derivatives through exclusive ownership of the

Stoxx index. Ownership of an index allows exchanges to spin off new derivatives contracts. But

rivals wanting to offer products on indices owned by other exchanges risk being locked out.


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Press lecture (8)


Indeed the combined group's sheer market power in derivatives and clearing, as well as in

the index business, sparked concern on Tuesday. The two exchanges are creating a large

integrated business in derivatives and clearing - a "vertical silo", in industry jargon. The Association

for Financial Markets in Europe, which represents banks and brokers that are exchanges'

customers, said its members had "concerns about potential limits on competition in the derivatives

space".

"In the derivatives market, competition is less likely to naturally occur for two main reasons:

firstly, barriers to entry are higher and secondly, the attention of regulators has been fixed towards

centrally clearing derivatives."

Documents

Intro Financial System 2011 (1)