If you are new to the finance field, you are likely to have questions like what is the architecture of this field, what is the institutional structure of international financial markets, how this function works, what are the market players, etc. Every novice trader needs to learn the basics first, and the basic here is the institutional structure of international financial markets. It states how the market is arranged and how each player works together to gain benefits and find investment opportunities.
When a person enters the financial markets, there are various parties involved with which the person aka trader deals. This includes banks, pension funds, insurance companies, institutional investors, and more. You can expect to learn the following things by reading this article.
- Types of Financial Markets
- Participants of the Financial Market and how they are connected
- Financial Instruments
- Functions of Financial Markets
For a trader gaining the basic information for the market he or she is trading in is essential. For example, if you are planning to enter the forex market, you need to learn the alphabet from scratch. You need to learn from your mistakes and experiences while applying your knowledge. You can also attend webinars, trading courses, or watch articles on forex to gain more understanding.
If you are starting in this market, you need to have your hands on two forms of information which are fundamental analysis and technical analysis. These would help him, in the long run, to sustain in the market. So, you might not need to learn about all the financial markets, but you need to learn about the financial market you are dealing with for sure!
The Institutional Structure of International Financial Markets
What is the financial market?
Financial markets represent a marketplace where traders trade assets such as stocks, bonds, derivatives, foreign exchange, and commodities. All the markets at national and international levels build the financial market.
But, what is the structure of financial markets?
The financial market structure comprises five key components: foreign Exchange Market, credit market, insurance market, investment market, stock market.
Structure of financial market diagram
There are three main parts of the world financial market, namely
- International Exchange Market
- International Debt Market
- International Securities Market
It is further divided into five segments, as below.
1. Foreign Exchange Market (Forex)
In this market, the asset being traded is currency and its relevant equivalent. Many derivative instruments like CFDs also get considered in this market. In the forex market, the settlement of trades can be in cash or non-cash, depending on the form, term of transactions, and market type. There are two types of markets here – Spot Market and Derivatives Currency Markets. For a derivatives market, a contract is
- Forward Contract: It is customized as per the needs of two parties, and the two parties agree to a specific rate. There is no guarantee here and commercial banks are the intermediaries.
- Futures Contract: It is based on the current forex exchange rates. There is a guarantee available and the intermediary is always an exchange body.
- Options and Currency Swaps: All the currency transactions can be done on the exchange or on the over-the-counter market, depending on the trader.
2. Credit market
The credit market in simple words is the redistribution of extra funds from those who have it to those who don’t have it. It is complex compared to the investment market as it has a three-tier structure, and needs higher requirements to fulfill the obligations.
Levels of Credit Market
- Central and Commercial Banks: In this prospect, the bank acts as a regulator. Through loans, the bank circulates the supply and demand of money, aids banks in troubles, and keeps them liquid to eliminate the cash gaps.
- Commercial Bank and Its Clients
- Legal Entities and their Credit Relations
3. Insurance Market
At the global stance, insurance companies have a firm hold on the market being the largest investors, and thus they have a separate market. They give different kinds of services for which they get funds, and they park these funds in the financial markets, metals, etc. to averse the inflation cost and maintain profitability.
4. Investment Market
The investment market is free competition and partnership-based concept between various agents in the investment market. It is similar to the stock market as it involves dealing with funds parked in securities, but unlike the stock market, it also deals with fixed assets, capital investments, and more. In short, the investment market involves dealing with all kinds of financial assets to take advantage of price hikes and dividend payouts.
5. Stock Market
The stock market is a relationship between the market participants and the securities. Securities here can be traded on exchanges as well as over the counter. Though to trade securities on an exchange, it has to be listed. There are various types of securities in the stock market which includes,
- Stocks: These are common stocks or preferred stocks. The difference between the both is that the common stockholders have the right to vote whereas the preference shareholders may not have it. Though preference shareholders enjoy a fixed dividend, which is conditional on profitability and company decisions for common shareholders.
- Bonds: There are various types of bonds as stated below.
Company Bonds – Issued by Company
Municipal Bonds – Issued by the Local Authorities
State / International Bonds – For example, Eurobonds
Bonds also come with preferences for people to have an average of getting the money back in case a company defaults or decided to liquidate. For bondholders, two things are very important – Coupon Rate and Yield to Maturity.
- Indices: Indices are a basket of various securities that shows the average rate stats for a specific sector or industry. For example, Auto Indices, it may have all the major stocks of auto sector firms and shows the average share rate.
- Derivatives: It is a derived instrument, and very complex in nature, mostly used for the purpose of hedging.
- ETF Securities: ETF or Exchange Traded Funds are index funds whose units are being traded on an exchange. The funds can be anything from a company’s stock to a portfolio having gold, and metals. It definitely gives more options to trades.
The currency market accounts for 1/5 share of the financial market. Apart from the classification stated above, one can also classify the financial market in border sense in three categories – the Currency Market, the Stock Market, and the Commodity Market.
The currency market has all the world currency including the new age cryptocurrency. The stock market has all the items related to securities and the last commodity market includes oil, metals, goods, services, and rare investments like art, antiques, etc. These markets are interconnected.
What are the functions of the financial market?
The motive of the financial market is to mobilize the capital, distribute it, control and maintain its reproduction, and increase the overall efficiency of an economic cycle and system. Here is the list of functions that market participants play in the financial market.
But why financial markets matter?
Functions of international financial markets are:
- Monitor and regulate the process of the financial system like overlooking compliance control, maintaining the supply of money, legal supervision, etc.
- Maintains and provides different relationships between the market players including individual investors, institutional investors, private investors, etc.
- Allocating the capital in a way that can increase efficiency and creates more value.
- Reduces the risk, prevents fraud including money laundering, maintains transparency, and tries to erode rate manipulation in the market.
- Creates and maintains liquidity in the market.
- Keeps transactions secured and transparent.
- Provides important information and data.
In simple words, the 7 main functions of financial markets are:
- Price Determination.
- Funds Mobilization.
- Risk sharing.
- Easy Access.
- Reduction in Transaction Costs and Provision of the Information.
- Capital Formation
Financial markets are lean on central banks for controlling the currency rates as they are the ones deciding interest rates. Whereas the stock and the currency market have a direct relationship with the progress and changes of the financial asset being traded. The most interesting market for traders remains the security market as it requires fewer funds and has great volatility as well.
Participants of the Financial Market
The answer to this is simple, all of us are market participants. We work at a place or do a job, and that gets contributed towards GDP (Gross Domestic Product). We buy or sell things, which is associated with the Consumer Price Index (CPI) aka inflation rate. A lot of people also invest money or trade-in forex, or park their money in the banks, take loans, or land money. All of these things are financial activities.
Though in a precise way, financial market participants are classified based on the segment. In layman language, financial markets are nothing but relationships between the buyers and the sellers. It also has one more category known as intermediaries that look after transactions, gives assistance, and necessary facilitation. Through this intermediary can act as a buyer, a seller, and an intermediary all at the same time.
We have classified the players of financial markets for each market. So, let’s dive into it.
1. Forex Market
- Buyers: All sellers, agents, etc. may also perform the role of buyers.
- Sellers: Mostly all the significant sellers and banks or the state bodies. If a state sells currencies by the way of an authorized body, it is said to be performing a regulatory function. A lot of sellers are also large companies here.
- Intermediaries: Here mostly commercial players are involved.
2. Credit Market
- Borrowers: Borrowers in this market on two segments – international level and national level. For the international level, the borrowers are known as states, and here the debt to GDP ratio is considered as the main indicator. At the national level, companies, individuals, and local governments are the borrowers. One such example is the U.S mortgage system, in which banks issue various securities for lending more and secure new capital.
- Lenders: In here, market players are people having extra capital and they aim to create more of it. These individuals are people or companies that would park their capital in investment funds, pension funds, instance, etc. They give money and thus are called lenders; they gain benefits in terms of interest income or dividend. States are also said to be lenders as they try to enhance liquidity and distribute it using the central bank.
- Intermediaries: The intermediaries are the organizations that look after capital distribution like banks, dealers, brokers, and investment management companies. We can also add insurance and pension companies here as they also gather and distribute money. The credit market can be said to be like investment or the stock markets as for example, when we talk about corporate bonds, it is useful for raising capital and security both. Generally, government bonds are said to be a popular option compared to investment funds as they have low risk.
3. Insurance Market
- Insurers: Insurers are the companies that provided the insurance service. There are three types of insurance providers – Open type which provides insurance to all the participants in the market, Captive Insurers (they are controlled by their insureds, and lastly comes reinsurance risk management companies.
- Insureds: These are Individuals, institutions, or companies that buy insurance products to reduce the overall risks.
- Intermediaries: The good thing about this market is that there are no intermediaries as all the transactions take place between the insurer and the insured.
As markets are interconnected, in this case, insurance companies are involved in the investment market too. There are insurance instruments like swaps, futures, etc. which are traded on the stock market.
4. Investment Market
The investment market includes all the people who invest their money in a financial asset as an investor. In this market, banks, exchanges, etc, act as intermediaries.
5. Stock Market
The following are the market participants in the stock market.
- Security Issuers: This category includes firms, companies, etc. who issue securities like bonds, stock, and more. They have to abide by the rules to issue securities at the time of issuing it.
- Investors: These are the people that purchase securities for increasing or creating income. There are two types of investors – Strategic ones who buy a majority in a company’s stock, and minorities who buy securities with the purpose of creating revenues and building a portfolio.
- Intermediaries: Here stock exchanges, underwriters, banks, auditors, rating agencies, etc. act as intermediaries. They help in issuing and placing the securities in the market.
We can also classify all these categories in a group as stated below.
- The Central and State Banks: This includes regulatory organizations as well. They manage the capital and overlook the performance and regulatory requirements.
- Regulators: These are the participants that do not take part in performing any transactions, but have a controlling duty over them. The same part can also be plated by a state or central bank, government, or there can be a separate organization for that, i.e. Self-regulatory Organization (SRO).
- Financial Service Companies: These are companies that give financial services and also act as an intermediary. They look after various aspects and include players such as stocks, forex, and commodity exchanges, brokers, auditors, underwriters, registrars, clearinghouses, consulting firms, etc.
- Banks: They act as financial intermediaries. They look after the distribution of cash and regulate and supervise the market in order to abide by the compliance set by the regulatory authorities.
- Legal Entities: These include borrowers, investors, lenders, etc. Also, companies that are involved in parking or investing clients’ funds in various funds like pension schemes, insurance, hedge funds, trust management firms, brokers, individual organizations, dealers, etc, are also called legal entities.
- Individuals: Individuals also include borrowers, investors, and lenders. In a broader perspective, these people are traders, speculators, long term investors, asset managers, or common people.
Just having the basic information is definitely not enough for a trader, there is a lot more to it and one of such things is market indicators. The indicators here include micro and macroeconomic data, forecasts, analysis, and much more which get released from time to time. The unemployment rate, GDP, inflation rate, securities growth, currency rates, etc. act as indicators.
Read more in our article Key economic indicators.
That’s the reason that most of the traders consider economic indicators an essential part of their trading. If you are still not clear, about the indicators and its impacts, worry not as we have got you covered.
1. Interest Rate
The interest rate can be said to be the most significant economic indicator as it helps in managing the money supply and helps in adjusting the inflation rate. At this rate, the loans are given to commercial banks by the central bank. A high rate increases the rates of deposits and credits and motivates customers to invest more. This also reduces the rate of inflation.
There are broader benefits of this rate increase as well. For example, in an advanced economy like the U.S, if the Federal Reserve hikes the rates, it also boosts the value of the dollar. This move also helps in reducing the stagnation and interest of more investors.
2. Non-farm Payrolls
Non-farm Payrolls suggest the change in the total number of employees in the non-farm sectors of the U.S. It is very important data and impacts the dollar rate highly. It gets released on the first Friday every month around 1:30 pm GMT.
It is said that if the actual data deviates more than 40,000 in number compared to the expectations, it affects the U.S dollar exchange price. Though, in reality, it depends on the data and how investors react.
3. Consumer Price Index (CPI)
CPI is a stat that shows a change in the price of consumer goods and services being bought by a nation’s households. It shows the change in the cost of living due to changes in the price of goods and services. It is compared to the benchmark indicator for knowing the performance.
Generally, this base is referred to by EBRD, IMF, UN, etc. There are various calculation methods as well like Paasche, Lowe Index, or Laspeyres Price Index. The decline in this index suggests lower consumer purchasing power along with higher inflation growth.
If the indicators are positive, investors are going to react strongly to that and it will eventually impact the financial markets. Though remember that along with all these, you should also keep yourself aware of the economic calendar.
It keeps a list of all the main economic events around the world, and you should form your strategies around it to avoid any repercussions. When the news gets released, it increases the volatility, and thus knowing it in advance can help you enter and exit the market on time.
Tips for Trading on Economic Indicators
Here are a few tips that would help you out if you want to trade around economic events.
You should compare the released data with the forecasted data. For example, if the GDP of the U.S is forecasted to be 3% but it came out only 2.4%, then it is negative news. But be aware of the fact that the data can also be revised.
Evaluate your expectations and reality. Many times, the news is already traded and thus no major impact is seen at the time of releasing the news. I.e. when the Fed is likely to increase the interest rate in the forthcoming meetings, investors would already be suspecting and trading accordingly. So, when the Fed finally raises the rates, there would not be as high volatility as you may have expected.
Be observant and keep yourself updated with other factors as well. Sometimes a lot of big events overshadow important data releases and have no impact on the market. For example, at the time of the U.S- China trade war, the U.S crude oil stockpile data was released which generally affects the exchange rates and other financial assets as well. But due to the trade tensions, it went unnoticed.
We hope that we have helped you understand the institutional structure of international financial markets. There are many layers that you have to pill to get to the depth of this realm.
With consistency and hard work, you can do wonders in this field while enjoying it. So, brace yourself, keep yourself updated, and learn from your mistakes. Hasta La Vista, until the next time!