45.k:Characteristics of a well-functioning financial system
A well-functioning market system must ensure:
• Ease of moving money from present to future with adequate rate of return on the risk investor bear
• Ease of borrowing funds to undertake project expenditure with credible promise to repay the funds in future
• Ease of hedging for risks involved in trading
• Ease of trading currencies and commodities
Complete markets have all the assets or contracts available to address the above issues. Operationally efficient markets are those that have a low cost of transactions to settle trades.
Key characteristics of market efficiency:
• Existence of complete markets
• Adequate liquidity which ensures filling of trades and low transaction cost
• Efficient information flow: timely disclosure by companies or other participants allowing traders to value to security appropriately. Such markets are also called informational efficient markets.
• Pricing: The pricing of security in an efficient market must reflect the fundamental value and not the demands for liquidity made by uninformed traders.
The role of intermediaries in the efficient markets:
• Matching buyers to sellers through exchanges, brokerages, trading systems etc
• Providing liquidity
• Lowering cost of borrowing by securitizing assets
• Running institutions that take deposit and give loans (banks)
• Allocate uncorrelated risk through insurance companies
• Settling trades/contracts through clearing houses
• Set up depositories where traders can keep their assets
An efficient market helps match the supply of money to its demand. For e.g. investors to entrepreneurs, savers to borrowers etc.
Further, efficient markets ensure allocation of capital to its most productive use and introduce allocation efficiency. Economies that have allocation efficiency are generally more advanced and have a higher standard of living.
Key checkpoints of an efficient market:
• Financial disclosure by companies on set accounting standards
• Companies allowed borrowing for future projects
• Prices reflecting fundamental changes
• Availability of future, forwards and options to ensure risk hedging
• Small bid-ask spreads
• Trades getting settled in line with investor expectations
• Well financed banks/financing companies to supply capitals
• Traders given flexibility to trade by dealers/arbitrageurs
• Availability of quality investment managers at reasonable fees
• Well capitalized insurance companies to provide risk insurance to participants
• Availability of securitized assets for reasonable credit costs
