FINANCIAL MARKETS AND REGULATION [CFI1203]

MODULE SYNOPSIS
The module gives an overview of the characteristics of financial markets, including their structure and
organization. Its aim is to provide a thorough understanding of both the mechanics and the operations of
financial markets, whilst paying particular attention to the trading and evaluation of securities in equity and
bond markets. It also covers a study of the structural features of debt markets, credit analysis for corporate
bonds, term structure analysis of interest rates and bond valuation, assessing sources of risk for debt
portfolios, including the role of duration and convexity in evaluating the effects of interest rate changes. This
module will address the institutional and regulatory framework for capital markets and the role that financial
institutions such as banks, bank holding companies, investment banks, and investment funds perform in these
markets. The role of government regulation and its effects on financial innovation are analysed. The module
will also analyse those elements of financial markets that set it aside from other regulated sectors in the
economy. Upon completion of the course, participants should be able to demonstrate an understanding of
recent developments in the theories and practices of financial sector regulation.

INTRODUCTION
Innovative content of the course
The course has been developed to include the following innovative content:
 Key concepts of financial markets which are explained from an applied perspective, including with
examples and problems from current financial markets practices
 Analytical techniques to be applied in financial markets provide with understanding and tools to decision
makers in the firm;
 Applied exercises, which cover topics such as money market, debt market, equity market instruments,
financial derivatives, foreign exchange, as well as decision making rules in the financial markets.
 It includes basic fundamental and technical analysis, thus preparing students to handle Part IV courses,
such as Institutional Investment Analysis, Risk Analysis, Asset Pricing, Theory and Practice. This
module will address the institutional and regulatory framework for capital markets and the role that
financial institutions perform in these markets.
CHAPTER ONE

FINANCIAL MARKETS: STRUCTURE AND ROLE IN THE FINANCIAL SYSTEM

1.1 Scope of Financial System

 The field of capital markets and capital market theory focuses on the study of the financial system,
the structure of interest rates, and the pricing of risky assets.
 The financial system of an economy consists of three components:
(1) financial markets;
(2) financial intermediaries; and
(3) financial regulators.

1.2 Financial system structure and functions

 The financial system plays the key role in the economy by stimulating economic growth, influencing
economic performance of the actors, affecting economic welfare.
 This is achieved by financial infrastructure, in which entities with funds allocate those funds to those
who have potentially more productive ways to invest those funds.
 A financial system makes it possible a more efficient transfer of funds.
 As one party of the transaction may possess superior information than the other party, it can lead to
the information asymmetry problem and inefficient allocation of financial resources.
 By overcoming the information asymmetry problem the financial system facilitates balance between
those with funds to invest and those needing funds.
 According to the structural approach, the financial system of an economy consists of three main
components:
■ Financial markets;
■ Financial intermediaries (institutions);
■ Financial regulators.
 Each of the components plays a specific role in the economy.
 According to the functional approach, financial markets facilitate the flow of funds in order to
finance investments by corporations, governments and individuals.
 Financial institutions are the key players in the financial markets as they perform the function of
intermediation and thus determine the flow of funds.
 The financial regulators perform the role of monitoring and regulating the participants in the
financial system.

1.3 The structure of financial system

  Financial markets studies, based on capital market theory, focus on the financial system, the
structure of interest rates, and the pricing of financial assets.
 An asset is any resource that is expected to provide future benefits, and thus possesses economic
value. Assets are divided into two categories: tangible assets with physical properties and intangible
assets.
• An intangible asset represents a legal claim to some future economic benefits. The value of an
intangible asset bears no relation to the form, physical or otherwise, in which the claims are
recorded.
 Financial assets, often called financial instruments, are intangible assets, which are expected to
provide future benefits in the form of a claim to future cash. Some financial instruments are called
securities and generally include stocks and bonds.
 Any transaction related to financial instrument includes at least two parties:
1) the party that has agreed to make future cash payments and is called the issuer;
2) The party that owns the financial instrument, and therefore the right to receive the payments made
by the issuer, is called the investor.
 Financial assets provide the following key economic functions.
1. They allow the transfer of funds from those entities, who have surplus funds to invest to those who
need funds to invest in tangible assets;
2. They redistribute the unavoidable risk related to cash generation among deficit and surplus economic
units.
 The claims held by the final wealth holders generally differ from the liabilities issued by those
entities who demand those funds.
 Their role is performed by the specific entities operating in financial systems, called financial
intermediaries. The latter ones transform the final liabilities into different financial assets preferred
by the public.

1.2.1 Financial markets and their economic functions

 A financial market is a market where financial instruments are exchanged or traded. Financial
markets provide the following major economic functions:
 Price discovery
 Asset valuation
 Liquidity
 Arbitrage
 Raising capital
 Commercial transactions
 Investing
 Risk management
 Reduction of transaction costs
1) Price discovery function means that transactions between buyers and sellers of financial instruments
in a financial market determine the price of the traded asset. At the same time the required return
from the investment of funds is determined by the participants in a financial market. The
motivation for those seeking funds (deficit units) depends on the required return that investors
demand. It is these functions of financial markets that signal how the funds available from those who
want to lend or invest funds will be allocated among those needing funds and raise those funds by
issuing financial instruments.
2) Asset valuation. Market prices offer the best way to determine the value of a firm or of the firm‟s
assets, or property. This is important not only to those buying and selling businesses, but also to
regulators. An insurer, for example, may appear strong if it values the securities it owns at the prices
it paid for them years ago, but the relevant question for judging its solvency is what prices those
securities could be sold for if it needed cash to pay claims today.
 3) Arbitrage. In countries with poorly developed financial markets, commodities and currencies may
trade at very different prices in different locations. As traders in financial markets attempt to profit
from these divergences, prices move towards a uniform level, making the entire economy more
efficient.
4) Liquidity function provides an opportunity for investors to sell a financial instrument, since it is
referred to as a measure of the ability to sell an asset at its fair market value at any time. Without
liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or
the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and
equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial
markets provide some form of liquidity. However, different financial markets are characterized by
the degree of liquidity.
5) Raising capital. Firms often require funds to build new facilities, replace machinery or expand their
business in other ways. Shares, bonds and other types of financial instruments make this possible.
The financial markets are also an important source of capital for individuals who wish to buy homes
or cars, or even to make credit-card purchases.
6) Commercial transactions. As well as long-term capital, the financial markets provide the grease
that makes many commercial transactions possible. This includes such things as arranging payment
for the sale of a product abroad, and providing working capital so that a firm can pay employees if
payments from customers run late.
7) Investing. The stock, bond and money markets provide an opportunity to earn a return on funds that
are not needed immediately, and to accumulate assets that will provide an income in future.
8) Risk management. Futures, options and other derivatives contracts can provide protection against
many types of risk, such as the possibility that a foreign currency will lose value against the
domestic currency before an export payment is received. They also enable the markets to attach a
price to risk, allowing firms and individuals to trade risks so they can reduce their exposure to some
while retaining exposure to others.
9) The function of reduction of transaction costs is performed, when financial market participants are
charged and/or bear the costs of trading a financial instrument. In market economies the economic
rationale for the existence of institutions and instruments is related to transaction costs, thus the
surviving institutions and instruments are those that have the lowest transaction costs.

1.2.2 The key attributes determining transaction costs are

1. Asset specificity is related to the way transaction is organized and executed. It is lower when an
asset can be easily put to alternative use, can be deployed for different tasks without significant
costs.
2. Uncertainty: Transactions are also related to uncertainty, which has (1) external sources (when
events change beyond control of the contracting parties), and (2) depends on opportunistic
behaviour of the contracting parties. If changes in external events are readily verifiable, then it is
possible to make adaptations to original contracts, taking into account problems caused by
external uncertainty. In this case there is a possibility to control transaction costs. However,
when circumstances are not easily observable, opportunism creates incentives for contracting
parties to review the initial contract and creates moral hazard problems. The higher the
uncertainty, the more opportunistic behaviour may be observed, and the higher transaction costs
may be born.
3. Frequency of occurrence plays an important role in determining if a transaction should take
place within the market or within the firm. A one-time transaction may reduce costs when it is
executed in the market. Conversely, frequent transactions require detailed contracting and should
take place within a firm in order to reduce the costs.
 When assets are specific, transactions are frequent, and there are significant uncertainties intra-firm
transactions may be the least costly. And, vice versa, if assets are non-specific, transactions are
infrequent, and there are no significant uncertainties least costly may be market transactions.
1.2.3 Classification of Transaction Costs
Transaction costs are classified into:
1) Costs of search and information are defined in the following way:
 Search costs fall into categories of explicit costs and implicit costs.
 Explicit costs include expenses that may be needed to advertise one‟s intention to sell or purchase a
financial instrument. Implicit costs include the value of time spent in locating counterparty to the
transaction. The presence of an organized financial market reduces search costs.
 Information costs are associated with assessing a financial instrument‟s investment attributes. In a
price efficient market, prices reflect the aggregate information collected by all market participants.
2) Costs of contracting and monitoring are related to the costs necessary to resolve information
asymmetry problems, when the two parties entering into the transaction possess limited information
on each other and seek to ensure that the transaction obligations are fulfilled.
3) Costs of incentive problems between buyers and sellers arise, when there are conflicts of interest
between the two parties, having different incentives for the transactions involving financial assets

1.3 Participants in Financial Markets

 The functions of a market are performed by its diverse participants. The participants in financial
markets can be also classified into various groups, according to their motive for trading:
1. Public investors, who ultimately own the securities and who are motivated by the returns
from holding the securities. Public investors include private individuals and institutional
investors, such as pension funds and mutual funds.
2. Brokers, who act as agents for public investors and who are motivated by the remuneration
received (typically in the form of commission fees) for the services they provide. Brokers
thus trade for others and not on their own account.
3. Dealers, who do trade on their own account but whose primary motive is to profit from
trading rather than from holding securities. Typically, dealers obtain their return from the
differences between the prices at which they buy and sell the security over short intervals of
time.
4. Credit rating agencies (CRAs) that assess the credit risk of borrowers.
In reality three groups are not mutually exclusive. Some public investors may occasionally
act on behalf of others; brokers may act as dealers and hold securities on their own, while
dealers often hold securities in excess of the inventories needed to facilitate their trading
activities. The role of these three groups differs according to the trading mechanism adopted
by a financial market.

1.4 Financial intermediaries and their functions

 A Financial intermediary is a special financial entity, which performs the role of efficient
allocation of funds, when there are conditions that make it difficult for lenders or investors of funds
to deal directly with borrowers of funds in financial markets.
 Financial intermediaries include depository institutions, insurance companies, regulated investment
companies, investment banks, and pension funds.
 The role of financial intermediaries is to create more favourable transaction terms than could be
realized by lenders/investors and borrowers dealing directly with each other in the financial market.
 The financial intermediaries are engaged in: Obtaining funds from lenders or investors and
lending or investing the funds that they borrow to those who need funds.
 The funds that a financial intermediary acquires become, depending on the financial claim,
either the liability of the financial intermediary or equity participants of the financial
intermediary. The funds that a financial intermediary lends or invests become the asset of the
financial intermediary.
  Financial intermediaries are engaged in transformation of financial assets, which are less
desirable for a large part of the investing public into other financial assets—their own
liabilities—which are more widely preferred by the public.
 Asset transformation provides at least one of three economic functions:
1. Maturity intermediation.
2. Risk reduction via diversification.
3. Cost reduction for contracting and information processing.
 These economic functions are performed by financial market participants while providing the special
financial services (e.g. the first and second functions can be performed by brokers, dealers and
market makers. The third function is related to the service of underwriting of securities). Other
services that can be provided by financial intermediaries include:
4. Facilitating the trading of financial assets for the financial intermediary‟s customers through
brokering arrangements.
5. Facilitating the trading of financial assets by using its own capital to take a position in a
financial asset the financial intermediary‟s customer want to transact in.
6. Assisting in the creation of financial assets for its customers and then either distributing
those financial assets to other market participants.
7. Providing investment advice to customers.
8. Manage the financial assets of customers.
9. Providing a payment mechanism.

Figure 2. Comparison of roles among financial institutions

Depository
Deposits Institutions
(Commercial Banks,
Savings Institutions,
Credit Unions)
Purchase
Surplus Units
Securities
Finance Companies Deficit Units
(Firms,
Government,
Purchase
Mutual Funds Agencies, Some
Shares
Individuals)

Premium
Policyholders Insurance
Companies
Employers
and Employee Pension funds
Contributions
Employees

1.5 Financial markets structure

Financial instruments
There is a great variety of financial instrument in the financial marketplace. The use of these
instruments by major market participants depends upon their offered risk and return characteristics,
 as well as availability in retail or wholesale markets. The general view on the financial instrument
categories is provided in Table 1.
Table 1. Financial instrument categories
Category Risk determinants Expected returns Main participants
Non- In wholesale money In wholesale In wholesale money
tradables and markets: transaction money markets: markets: banks
non- volumes low
transferables
In retail markets: low In credit markets: In retail markets: banks
transparency, lack of low and non-bank firms
standardisation, low and households
creditworthiness
In foreign exchange In foreign In foreign exchange
markets: high volatility, exchange markets: financial
change of currency markets: high institutions, companies
Securities Market volatility, Comparably high Banks and non-bank
individual risks and firms, individuals
failures
Derivatives Market volatility, leverage Very high Banks and non-bank
firms, individuals
Source: Reszat B. (2008). European Financial Systems in the Global Economy

1.6 Financial instruments

 A financial instrument can be classified by the type of claims that the investor has on the issuer.
 A financial instrument in which the issuer agrees to pay the investor interest plus repay the amount
borrowed is a debt instrument.
 A debt instrument also referred to as an instrument of indebtedness, can be in the form of a note,
bond, or loan.
 The interest payments that must be made by the issuer are fixed contractually. For example, in the
case of a debt instrument that is required to make payments in Euros, the amount can be a fixed Euro
amount or it can vary depending upon some benchmark.
 The investor in a debt instrument can realize no more than the contractual amount. For this reason,
debt instruments are often called fixed income instruments.

1.6.1What are the characteristics/properties of financial assets?

There are peculiar characteristics that are inherent in financial assets that are normally used partly to determine their
pricing in the financial markets. These characteristics are identified and discussed below.
1. Moneyness
The moneyness of the financial assets implies that they are easily convertible to cash within a defined time and
determinable value. The cost of transactions involved in securing funds from them before the maturity date can
be likened to agency cost besides the cost of discounting some of them, which reduces their face
value. Therefore, these financial instruments are regarded as near money because of the ease with which they
can be traded for cash. Examples are Treasury bills, Treasury certificates, Trade bills, Commercial papers, and
Certificate of Deposits, among others.
2. Divisibility & Denomination
The financial assets are usually made out in denominations depending on the face value that the corporate
organizations and institutions that are using them to raise funds from the financial markets. The divisibility of
such near money refers to the minimum monetary value in which a financial asset can be liquidated or
 exchanged for money by the holder.
Many bonds can be denominated like $1,000 denomination while that of certificate of deposits are
denominated form $50,000.
3. Reversibility
Financial assets are highly reversible in the sense that they are like deposits in accounts of customers with the
banks. This implies that the cost of investing in the financial assets and getting them back into cash is
negligible. Hence reversibility of financial assets is often regarded as turnaround cost or roundtrip cost. The
most relevant part of the roundtrip cost as associated with financial assets constitutes what is known as the
„bid-ask spread‟ in which commissions cost of delivery an asset is entrenched. In the well-organized financial
market there are market makers who take responsibility of assuming risk in associated with the financial assets
while making the market or carrying inventory of financial assets.
4. Cash Flow
This refers to the return that an investor will derive from holding a financial asset, which invariably depends
on all the cash distributions that the asset will pay holders. This is expressed in terms of the dividend on shares
or coupon yield payments that are associated with bonds.
The return on investment in a financial asset is also affected by the repayment of the principal amount for a
debt instrument and any expected price variation of the stock. In calculation of expected returns on a financial
asset, factors that should be considered include non-cash payments in form of stock dividend yield and options
to purchase additional stock or the distribution of other securities that must be factored in the consideration.
The issue of inflation implies that there is difference between normal effective return and real effective return
on financial assets. Therefore, the net real return on financial assets is the amount of cash returns that are
accruable after adjusting the nominal returns against inflation.
5. Maturity Period
In financial parlance/jargon, the maturity period refers to the length of time within which the corporate entity
or institution that employs a financial instrument to raise funds will use the funds before its payment back to
the holders of such instrument. For instance, a bond can be held by a corporate entity for a period of thirty (30)
years while that of government can extend to a period of ninety-nine (99) years before their repayment to the
holders.
There are some financial instruments being traded in the financial markets that may not reach the stated
maturity dates before they are terminated by the corporate entities that use them to raise funds. There are
reasons that may be responsible for such situation which include the following: Bankruptcy,
Reorganization, and Call Provision
6. Convertibility
This characteristic implies that a financial asset or instrument can be converted into another class of asset
which will still be held by the corporate entity has original used to raise funds for its operations. The
conversion can take a form of bond being converted to bond, preference shares being converted to equity
shares, and a company bond being converted into equity shares of the company.
7. Currency
Financial assets are normally denominated in currencies of the various countries around the world. This
implies financial assets of the United States of America financial system are denominated in Dollars such as
Federal Government Loan Stock, Treasury Bills, Treasury Certificate, Shares and Corporate and State
Government Bonds. Those financial assets in Japan are denominated in the Yen those in the United Kingdom
are in the Pounds Sterling while those in China are in Yuan, etc.
Financial assets as products of transactions in the financial markets can be denominated in various currencies
particularly the local currencies of various economies around the world. Nevertheless, there are those financial
instruments that are traded across international boundaries in some countries especially in highly developed
capital markets in US, UK, Japan, France, and South Africa, just to mention but a few. Such financial assets
are usually denominated mainly in American dollars and any other international money that is acceptable
around the world.
8. Liquidity
You have learned from above that one of the main characteristics of financial assets is the moneyness of such
instruments which implies that they are easily convertible to cash within a defined time and determinable
value. The cost of transactions involved in securing funds from them before the maturity date can be likened to
agency cost besides the cost of discounting some of them, which reduces their face value. Hence, these
financial instruments are regarded as near money because they are highly liquid in terms of the ease with
which they can be traded for cash. Good examples of highly liquid financial instruments include Treasury bills,
 Treasury certificates, Certificate of Deposits, Bills of Exchange, and shares of blue chip companies.
However, there are some financial instruments that cannot be easily converted to cash whenever the holders
need money. Therefore, they are illiquid because the holders may have to retain them till they are matured;
alternatively they can only trade them for very insignificant value in capital markets where there are jobbers
that may be willing to carry them in their stock of securities.
9. Predictable Returns
The return on financial assets must be predictable for the purpose of their being patronized by investors. For
instance, the investors should be able to know the percentage of interest that are attached to certain debt
instruments before they will be prepared to stake their funds on them. This is because performance of a
company cannot be taken for granted due to the mere fact that top management and the boards of directors are
known to be manipulating the accounting records of their companies these days.
However, the returns on bonds, development loan stocks, and preference shares are determinable so that the
investors are aware about the expected returns on their investment. There other government securities such as
Treasury bills and Treasury certificates which are traded in money market that command fixed returns.
The issue of unpredictability of future returns on some securities such as equity shares results from volatility in
earnings by the companies in their operations. However, the unpredictability to future returns can be measured
on how it relates to the level of volatility of a given financial asset. The returns on equity shares like dividends
are the residual payments from the earnings of corporations. Nevertheless, the attraction in these shares is the
possibility of capital appreciation in their value but subject to the performance of their corporations and capital
market operational forces.
10. Tax Status of Returns
The returns on various financial assets are subject to tax status because they are taxable earnings. The tax
authorities are interested in collection of taxes on earnings from financial assets as securities which are
regarded as incomes for investors. However, the tax status on financial assets varies from one economy to
another.
The rate of such taxes on financial assets is also subject to variation from time to time depending on the
interest of the government which must be adhered to by the tax authorities. The tax status on financial assets
also differs from one type of security to another depending on the nature of the issuing companies or
institutions such as Federal, State, or local government.

Table 2.Fixed-income market

Market Features Issuers

Long Bonds Long-term obligations to make a Governments,
term series of fixed payments firms
Convertibles Bonds that can be swapped for Firms
equity at pre-specified conditions
Asset-backed Securitised “receivables” Financial
securities presenting future streams of institutions, firms
payments
Preferred stock, Debt and equity hybrids Firms
subordinated debt
Medium Notes Medium-term obligations Governments
term
Floating-rate notes Medium-term instruments with Firms
interest rates based on LIBOR or
another index
 Short Bills Short-term obligations Governments
term
Commercial paper Short-term debt instruments Firms
Certificates of Short-term debt instruments Banks
deposit
Source: Reszat B. (2008). European Financial Systems in the Global Economy

 In contrast to a debt obligation, an equity instrument specifies that the issuer pays the investor an
amount based on earnings, if any, after the obligations that the issuer is required to make to investors
of the firm‟s debt instruments have been paid.
 Common stock is an example of equity instruments. Some financial instruments due to their
characteristics can be viewed as a mix of debt and equity.
 Preferred stock is a financial instrument, which has the attribute of a debt because typically the
investor is only entitled to receive a fixed contractual amount. However, it is similar to an equity
instrument because the payment is only made after payments to the investors in the firm‟s debt
instruments are satisfied.
 Another “combination” instrument is a convertible bond, which allows the investor to convert debt
into equity under certain circumstances. Because preferred stockholders typically are entitled to a
fixed contractual amount, preferred stock is referred to as a fixed income instrument.
 Hence, fixed income instruments include debt instruments and preferred stock. The features of debt
and equity instruments are contrasted in Table 3.
 The classification of debt and equity is especially important for two legal reasons. First, in the case
of a bankruptcy of the issuer, investor in debt instruments has a priority on the claim on the issuer‟s
assets over equity investors. Second, the tax treatment of the payments by the issuer can differ
depending on the type of financial instrument class.
Table 3. Debt versus equity
Debt Equity
Characteristic Borrower-lender relation, Ownership, no time limit
fixed maturities
Advantages:
 for the firm Predictability, independence Flexibility, low cost of finance,
from shareholders‟ influence reputation
 for the investor Low risk High expected return
Disadvantages:
 for the firm Debt servicing obligation Shareholder dependence, short-
sightedness, market volatility
influencing management decisions
 for the investor Low returns High risk
Source: Reszat B. (2008). European Financial Systems in the Global Economy

1.7 Classification of financial markets

  People and organizations wanting to borrow money are brought together with those having surplus
funds in the financial markets. Note that “markets” is plural; there are a great many different
financial markets in a developed economy such as ours. We briefly describe the different types of
financial markets and some recent trends in these markets
 There different ways to classify financial markets. They are classified according to the financial
instruments they are trading, features of services they provide, trading procedures, key market
participants, as well as the origin of the markets.
The generalized financial market classification is given in Table 4.

Table 4. Financial market classification

Criterion Features Examples

Products Tradability, transferability, Equity, debt instruments, derivatives
ownership, maturity,
denomination, substance
Services Technical, advisory, IT support, research and analysis, custody
information and
knowledge- based,
administrative
Ways of Physical, electronic, virtual Over the counter, exchange, internet
trading
Participants Professionals, non- Banks, central banks, non-bank financial
professionals, institutions, companies, institutional investors, business
officials firms, households
Origin Domestic, cross- National markets, regionally integrated
border, regional, markets, Euromarkets, domestic/foreign
international currency markets, onshore/offshore
markets

Source: Reszat B. (2008). European Financial Systems in the Global Economy.

1.7.1 Internal vs. External Market

 From the perspective of country origin, its financial market can be broken down into an internal
market and an external market.
 The internal market, also called the national market, consists of two parts: the domestic market
and the foreign market. The domestic market is where issuers domiciled in the country issue
securities and where those securities are subsequently traded.
 The foreign market is where securities are sold and traded outside the country of issuers.
 External market is the market where securities with the following two distinguishing features are
trading:
1) At issuance they are offered simultaneously to investors in a number of countries; and
2) They are issued outside the jurisdiction of any single country.
 The external market is also referred to as the international market, offshore market, and the
Euromarkets (despite the fact that this market is not limited to Europe).
1.7.2 Money Market vs. Capital Market
 Money market is the sector of the financial market that includes financial instruments that have a
maturity or redemption date that is one year or less at the time of issuance. They are the markets for
short-term, highly liquid debt securities. The New York, London, and Tokyo money markets are
among the world‟s largest these are mainly wholesale markets. Typically, money market
instruments are debt instruments and include Treasury bills, commercial paper, negotiable
certificates of deposit, repurchase agreements, and bankers‟ acceptances.
 Capital markets are the markets for intermediate- or long-term debt and corporate stocks. The New
York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a prime
example of a capital market. Here “long-term” refers to a financial instrument with an original
maturity greater than one year and perpetual securities (those with no maturity). There is no hard and
fast rule on this, but when describing debt markets, “short term” generally means less than 1 year,
“intermediate term” means 1 to 10 years, and “long term” means more than 10 years.
 There are two types of capital market securities: those that represent shares of ownership interest,
also called equity, issued by corporations, and those that represent indebtedness, or debt issued by
corporations and by the state and local governments.
 Equity includes common stock and preferred stock.
 Debt securities include (1) bonds, (2) notes, (3) medium-term notes, and (4) asset-backed securities.

Money and Capital Markets – Comparative Table

Basis for Comparison Money Market Capital Market

It is the part of financial market where lending Capital market is part of the financial market where
Definition and borrowing takes place for short-term up to lending and borrowing takes place for the medium-
one year term and long-term

Money markets generally deal in promissory

notes, bills of exchange, commercial paper,
Treasury bills, call money, Certificate of
Types of instruments Capital market deals in equity shares, debentures,
deposit, Repurchase agreements, Eurodollar
involved bonds, preference shares, Government securities, etc.
deposit, Federal funds, Municipal notes,
Foreign Exchange Swaps, short-lived mortgage
and asset-backed securities.

Institutions The money market contains financial banks, It involves stockbrokers, mutual funds, underwriters,
involved/types of the central bank, commercial banks, financial individual investors, commercial banks, stock
investors companies, etc. exchanges, Insurance Companies

Nature of Market Money markets are informal Capital markets are more formal

Liquidity of the market Money markets are liquid Capital Markets are comparatively less liquid

The maturity of capital markets instruments is more

The maturity of financial instruments is
Maturity period than 1 year and usually do not have stipulated time
generally up to 1 year
frame, i.e., can also include life-time of a company.

Since the market is liquid and the maturity is Due to less liquid nature and long maturity, the risk is
Risk factor
less than one year, risk involved is low comparatively high

The market fulfills the short-term credit needs The capital market fulfills the long-term credit needs
Purpose
of the business of the business

The money markets increase the liquidity of The capital market stabilizes the economy due to long-
Functional merit
funds in the economy term savings
 The returns in capital markets are high because of
Return on investment The return in money markets are usually low
higher duration
1.7.3 Cash Market vs. Derivative Markets
Financial markets can be classified in terms of cash market and derivative markets.
 The cash market, also referred to as the spot market, is the market for the immediate purchase and
sale of a financial instrument.
 In contrast, some financial instruments are contracts that specify that the contract holder has either
the obligation or the choice to buy or sell another something at or by some future date. The
“something” that is the subject of the contract is called the underlying (asset).
 The underlying asset is a stock, a bond, a financial index, an interest rate, a currency, or a
commodity.
 Because the price of such contracts derives their value from the value of the underlying assets, these
contracts are called derivative instruments and the market where they are traded is called the
derivatives market.
 Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps, caps, and
floors.
 The primary role of derivative instruments is to provide a transactionally efficient vehicle for
protecting against various types of risk encountered by investors and issuers.

1.7.4 Primary vs. Secondary Market

 Primary versus secondary markets. Primary markets are the markets in which corporations raise
new capital. If GE were to sell a new issue of common stock to raise capital, this would be a primary
market transaction. The corporation selling the newly created stock receives the proceeds from the
sale in a primary market transaction. Secondary markets are markets in which existing, already
outstanding, securities are traded among investors. Thus, if Jane Doe decided to buy 1,000 shares of
GE stock, the purchase would occur in the secondary market. The New York Stock Exchange is a
secondary market because it deals in outstanding, as opposed to newly issued, stocks and bonds.
Secondary markets also exist for mortgages, various other types of loans, and other financial assets.
The corporation whose securities are being traded is not involved in a secondary market transaction
and, thus, does not receive any funds from such a sale.
 Trading takes place among investors.
 Secondary markets are also classified in terms of organized stock exchanges and over-the-counter
(OTC) markets.
 Stock exchanges are central trading locations where financial instruments are traded. In contrast, an
OTC market is generally where unlisted financial instruments are traded.
1.7.5 Physical asset versus financial asset markets.
 Physical asset markets (also called “tangible” or “real” asset markets) are those for products such as
wheat, autos, real estate, computers, and machinery.
 Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, and other
claims on real assets, as well as with derivative securities whose values are derived from changes in
the prices of other assets.
 A share of Ford stock is a “pure financial asset,” while an option to buy Ford shares is a derivative
security whose value depends on the price of Ford stock.

1.7.6 Spot versus futures markets.

 Spot markets are markets in which assets are bought or sold for “on-the-spot” delivery (literally,
within a few days).
 Futures markets are markets in which participants agree today to buy or sell an asset at some
future date
 For example, a farmer may enter into a futures contract in which he agrees today to sell 5,000
 bushels of soybeans six months from now at a price of $5 a bushel.
 On the other side, an inter- national food producer looking to buy soybeans in the future may enter
into a futures contract in which it agrees to buy soybeans six months from now.

1.7.7 Private versus public markets.

 Private markets are where transactions are negotiated directly between two parties, are differentiated
from public markets, where standardized contracts are traded on organized exchanges.
 Bank loans and private debt placements with insurance companies are examples of private market
transactions.
 Because these transactions are private, they may be structured in any manner that appeals to the two
parties. By contrast, securities that are issued in public markets (for example, common stock and
corporate bonds) are ultimately held by a large number of individuals.
 Public securities must have fairly standardized contractual features, both to appeal to a broad range
of investors and also because public investors do not generally have the time and expertise to study
unique, nonstandardised contracts. Their wide ownership also ensures that public securities are
relatively liquid. Private market securities are, therefore, more tailor-made but less liquid, whereas
publicly traded securities are more liquid but subject to greater standardization.

In developed nations, a set of highly efficient financial intermediaries has evolved. Their original roles were
generally quite specific, but many of them have diversified to the point where they serve many different
markets. As a result, the differences between institutions have tended to become blurred. Still, there remains
a degree of institutional identity, and therefore it is useful to describe the major categories of financial
institutions here:

1.8 FINANCIAL INSTITUTIONS

Direct funds transfers are more common among individuals and small businesses, and in economies where
financial markets and institutions are less developed. While businesses in more developed economies do
occasionally rely on direct transfers, they generally find it more efficient to enlist the services of one or more
Financial institutions when it comes time to raise capital.

1. Investment banking houses such as Merrill Lynch, Morgan Stanley, Goldman Sachs, or Credit `Suisse
Group provide a number of services to both investors and companies planning to raise capital. Such
organizations (a) help corporations design securities with features that are currently attractive to
investors, (b) then buy these securities from the corporation, and (c) resell them to savers. Although the
securities are sold twice, this process is really one primary market transaction, with the investment
banker acting as a facilitator to help transfer capital from savers to businesses. Commercial banks, such
as Bank of America, Wells Fargo, Wachovia, and J. P. Morgan Chase, are the traditional “department
stores of finance” because they serve a variety of savers and borrowers. Historically, commercial banks
were the major institutions that handled checking accounts and through which the Federal Reserve
System expanded or contracted the money supply. Today, however, several other institutions also provide
checking services and significantly influence the money supply. Conversely, commercial banks are
providing an ever-widening range of services, including stock brokerage services and insurance.
2. Financial services corporations are large conglomerates that combine many different financial
institutions within a single corporation. Examples of financial services corporations, most of which started in
one area but have now diversified to cover most of the financial spectrum, include Citigroup, American
Express, Fidelity, and Prudential.
3. Savings and loan associations (S&Ls) traditionally served individual savers and residential and commercial
mortgage borrowers, taking the funds of many small savers and then lending this money to home buyers and
other types of borrowers. In the 1980s, the S&L industry experienced severe problems when short-term interest
rates paid on savings accounts rose well above the returns earned on the existing mortgages held by S&Ls and
commercial real estate suffered a severe slump, resulting in high mortgage default rates. Together, these events
forced many S&Ls to merge with stronger institutions or close their doors.
4. Mutual savings banks, which are similar to S&Ls, operate primarily in the northeastern states, accepting savings
primarily from individuals, and lending mainly on a long-term basis to home buyers and consumers.
5. Credit unions are cooperative associations whose members are supposed to have a common bond, such as
being employees of the same firm. Members‟ savings are loaned only to other members, generally for auto
purchases, home improvement loans, and home mortgages. Credit unions are often the cheapest source of funds
available to individual borrowers.
6. Pension funds are retirement plans funded by corporations or government agencies for their workers and
administered primarily by the trust departments of commercial banks or by life insurance companies. Pension
funds invest primarily in bonds, stocks, mortgages, and real estate.
7. Life insurance companies take savings in the form of annual premiums; invest these funds in stocks, bonds,
real estate, and mortgages; and finally make payments to the beneficiaries of the insured parties. In recent years,
life insurance companies have also offered a variety of tax-deferred savings plans designed to provide benefits
to the participants when they retire.
8. Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term
bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds and
thus reduce risks by diversification. They also achieve economies of scale in analyzing securities, managing
portfolios, and buying and selling securities. Different funds are designed to meet the objectives of different types
of savers. Hence, there are bond funds for those who desire safety, stock funds for savers who are willing to accept
significant risks in the hope of higher returns, and still other funds that are used as interest-bearing checking
accounts (money market funds). There are literally thousands of different mutual funds with dozens of different
goals and purposes.
9. Hedge funds are similar to mutual funds because they accept money from savers and use the funds to buy various
securities, but there are some important differences. While mutual funds are registered and regulated by the
Securities and Exchange Commission (SEC), hedge funds are largely unregulated. This difference in
regulation stems from the fact that mutual funds typically target small investors, whereas hedge funds
typically have large minimum investments (often exceeding $1 million) that are effectively marketed to
institutions and individuals with high net worths. Different hedge fund managers follow different
strategies. For example, a hedge fund manager who believes that the spreads between corporate and
Treasury bond yields are too large might simultaneously buy a portfolio of corporate bonds and sell a
portfolio of Treasury bonds. In this case, the portfolio is “hedged” against overall movements in interest
rates, but it will do well if the spread between these securities narrows. Likewise, hedge fund managers
may take advantage of perceived incorrect valuations in the stock market, that is, where a stock‟s market
and intrinsic values differ.

1.9 Financial market regulation

1.9.1Introduction
In general, financial market regulation is aimed to ensure the fair treatment of participants. Many regulations
have been enacted in response to fraudulent practices. One of the key aims of regulation is to ensure business
disclosure of accurate information for investment decision making. When information is disclosed only to
limited set of investors, those have major advantages over other groups of investors. Thus regulatory
framework has to provide the equal access to disclosures by companies. The recent regulations were passed
in response to large bankruptcies, overhauled corporate governance, in order to strengthen the role of
auditors in overseeing accounting procedures.
 The Sarbanes-Oxley Act of 2002 in US was designed particularly to tighten companies‟ governance
after dotcom bust and Enron‟s Bankruptcy. It had direct consequences internationally, first of all
through global companies.
 The US Wall Street Reform and Consumer Protection Act (Dodd-Frank) of 2010 aims at imposing
tighter financial regulation for the financial markets and financial intermediaries in US, in order to
ensure consumer protection. This is in tune with major financial regulation system development in
EU and other parts of the world.

1.9.2 Regulating Financial Activities

Most governments throughout the world regulate various aspects of financial activities because they
recognize the vital role played by a country‟s financial system. Although the degree of regulation varies from
country to country, regulation takes one of four forms:
 1. Disclosure regulation requires that any publicly traded company provide financial information and
nonfinancial information on a timely basis that would be expected to affect the value of its security
to actual and potential investors.
2. Financial activity regulation comprises rules about traders of securities and trading on financial
markets. Probably the best example of this type of regulation is the set of rules prohibiting the
trading of a security by those who, because of their privileged position in a corporation, know more
about the issuer‟s economic prospects than the general investing public (insiders). Another example
of financial activity regulation is the set of rules imposed by the SEC regarding the structure and
operations of exchanges where securities trade.
3. The regulation of financial institutions is a form of governmental monitoring that restricts their
activities. Such regulation is justified by governments because of the vital role played by financial
institutions in a country‟s economy. The justification for such rules is that it reduces the likelihood
that members of exchanges may be able, under certain circumstances, to collude and defraud the
general investing public.
4. Government regulation of foreign participants involves the imposition of restrictions on the roles
that foreign firms can play in a country‟s internal market and the ownership or control of financial
institutions.

1.9.3 Financial Regulation and Supervision in Zimbabwe

Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain
requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. This may
be handled by either a government or non-government organization.
 Financial regulation has also influenced the structure of banking sectors by increasing the variety of
financial products available.
 Financial regulation forms one of three legal categories which constitutes the content of financial law,
the other two being market practices, case law.
 In Zimbabwe there are five principal agencies charged with the responsibility of financial regulation and
supervision. These are
1. Reserve Bank of Zimbabwe (RBZ),
2. The Ministry of Finance and Economic Development
3. The Deposit Protection Corporation,
4. The Securities Exchange Commission (SEC) and
5. The Insurance and Pensions Commission.
Main reasons for financial system regulation: Regulation is necessary
1. To ensure consumer‟s confidence in the financial industry.
2. To ensure system stability i.e. the safety and soundness of the financial system;
3. To provide smaller (individuals), retail clients with protection. Caveat emptor does not apply to
financial contracts due to their complex and opaque nature, and;
4. To protect consumers against monopolistic exploitation.
The deregulation of the financial sector and emergence of new financial instruments and services offered by
financial institutions has blurred boundaries between different types of financial institutions such as banking,
insurance and securities.
1.9.4 A brief history of the Zimbabwe financial system
 Zimbabwe‟s current financial regulation and supervisory architecture was inherited from the
Rhodesian Government at independence in 1980.
 Specifically, the Reserve Bank of Zimbabwe, the Commissioner of Insurance and Pension Funds and
the Zimbabwe Stock Exchange as regulator of the capital markets.
 Since then, the financial system has undergone several changes in recent years. The Commissioner
of Insurance was superseded by The Insurance and Pension Fund Commissioner through Act 7 of
2000 and The Zimbabwe Stock Exchange has been superseded by the Securities and Exchange
Commission through the Securities Act 17 of 2004.
  This regulatory and supervisory regime served Zimbabwe well until 1990 as the financial sector was
stable and witnessed no financial crisis or bank collapses.
1.9.5 Zimbabwe's Financial Regulatory and Supervisory System
 In Zimbabwe there are five principal agencies charged with the responsibility of financial regulation
and supervision. These are the Reserve Bank of Zimbabwe (RBZ), The Ministry of Finance and
Economic Development, The Deposit Protection Board, The Securities Commission (SEC) and The
Insurance and Pensions Commission, and Ministry of Finance and Economic Development.
 The Ministry of Finance and Economic Development is the ultimate supervisor of the financial
system. In other words, all the regulators and supervisors of the financial system fall under the
purview of the Ministry of Finance and Economic Development.
1.9.6 Reserve Bank of Zimbabwe (RBZ)
 The Reserve Bank of Zimbabwe (RBZ) is the primary institution responsible for the regulation and
supervision of banks.
 Prior to 2000 registration of banks was the responsibility of the Ministry of Finance whilst
supervision was the purview of the Central Bank.
 However, the Banking Act of 2000 and Statutory Instrument 205 of 2000 (Statutory Instruments of
Zimbabwe) transferred all responsibility to the Reserve Bank of Zimbabwe but by 2004, the Reserve
Bank was required to consult with Ministry of Finance before withdrawing a bank license.
 By 2006 the Central Bank adopted the risk-based supervision of banks. Moreover, the Reserve Bank
of Zimbabwe was also responsible for ensuring that Zimbabwe‟s financial system remains up-to-date
with International Standards that are set by the Bank for International Settlements.
 However, Zimbabwe faced challenges in fully implementing the Basel II Accord. Implementation
was hampered by the 2000-2008 economic crises and by the liquidity problems bedeviling the
financial sector during that period.
 Under the RBZ Act, the RBZ is empowered to supervise the operations of all banks in the country.
Its Bank Supervision and Surveillance department scrutinizes periodic returns under its risk-based-
supervision (off-site examination) and undertakes regular examinations of the books and records of
the bank through on-site examinations in order to ensure conformity with statutory regulations as
well as with RBZ Prudential Guidelines. However, it is not an independent Central Bank and its
objectives are, inter alia, not narrowly focused on price and financial stability.
1.9.7 The Deposit Protection Corporation (DPC)
 The Deposit Protection Corporation came into being through Act 7 of 2010, is tasked with the
responsibility of protecting depositors thereby ensuring safety and soundness of the banking system
by preventing bank runs.
 Moreover, the Corporation has power to obtain information from financial institutions that will allow
it to detect early signs of difficulties within the financial system;
 The Corporation also has power to administer failed or failing institutions and, where possible,
restore them to financial health.
 The Deposit Protection Fund was established in 2003 in terms of Section 66 of the Banking Act
Chapter 24:20 as read in conjunction with Section 4 of the Deposit Corporation Act Chapter 24:29 of
2011.
 Membership is mandatory and premiums are levied at a rate of 0.03 per cent per annum or 0.075 per
cent per quarter with a minimum and maximum contribution of USD500 and USD 30 000
respectively. The maximum insurable limit was USD150.00 per depositor per bank.
 Deposit accounts which are covered by the scheme include; demand, time and savings deposits;
class B and class C shares of building societies. However, interbank deposits, negotiable certificates
of deposit and banker‟s acceptances are excluded. The cover provided secures individuals, corporate
and trust accounts.
 (NB latest information is found on https://www.dpcorp.co.zw/deposit-protection.html)
1.9.8 The Securities and Exchange Commission (SEC)
  The Securities Act (SA) 24: 25 took effect on 01 June 2008. It governs the regulation of securities
services in Zimbabwe to include securities exchanges, Central Securities Depositories (CSDs) and
the respective members, misuse of inside information, and improper trading practices. The securities
Act does not apply to Collective Investment Schemes investments regulated by the Collective
Investment Schemes Act [Chapter 24:19] (Act No. 25 of 1997).
 SEC was formed with the following objectives inter alias; investor protection, reduce systemic risk,
and promote market integrity.
 Read updates on seczim.co.zw
1.9.9 The Insurance and Pensions Commission (IPEC)
 The IPEC was formed with the objectives, inter alias, of regulating and monitoring the insurance and
pension industries in Zimbabwe.
1.9.10 Zimbabwe's Financial Regulatory and Supervisory System (Conclusion)
It is clear from the foregoing multiple regulators that the regulation and supervisory architecture in
Zimbabwe is determined by the type of institution or functional lines-such as banking, insurance and the
securities industry determining under which regulator they fall under. As a point of fact securities trades now
transcend the securities industry to encompass the entire financial system. Furthermore, there is no
harmonization of accounting practices. For instance IPEC wants returns at cost whilst banking insists on
mark-to-market.
Read:
1. Financial regulation and supervision in Zimbabwe: an evaluation of adequacy and options by John
D.G Nhavira Evengelista Mudzonga Everisto Mugocha
2. The composition and regulation of the financial services sector in Zimbabwe by Miriam Zhanero
Mugwati, Doreen Nkala, Costain Mukanganiki
3. https://www.zse.co.zw/rules-and-regulations/

1.10 Summary
The financial system of an economy consists of three components:
(1) Financial markets; (2) financial intermediaries; and (3) financial regulators.
 The main function of the system is to channel funds between the two groups of end users of the
system: from lenders („surplus units‟) to borrowers („deficit units‟). Besides, a financial system
provides payments facilities, a variety of services such as insurance, pensions and foreign exchange,
together with facilities which allow people to adjust their existing wealth portfolios.
 Apart from direct borrowing and lending between end-users, borrowing and lending through
intermediaries and organized markets have important advantages. These include transforming the
maturity of short-term savings into longer-term loans, reduction of risk and controlling transaction
costs.
 The field of financial markets and its theoretical foundations is based on the study of the financial
system, the structure of interest rates, and the pricing of risky assets.
 The major market players are households, governments, nonfinancial corporations, depository
institutions, insurance companies, asset management firms, investment banks, non-profit
organizations, and foreign investors.
 Financial markets are classified into internal versus external markets, capital markets versus money
markets, cash versus derivative markets, primary versus secondary markets, and private placement
versus public markets, exchange-traded versus over-the-counter markets.
 The financial markets and intermediaries are subject to financial regulators. The recent changes in
the regulatory system are happening in response to the problems in the credit markets and financial
crisis that struck 2008.

1.15 Review questions and problems

1. What are the functions of a financial system?
2. Distinguish the difference between deficit and surplus units.
 3. What is the difference between „saving‟ and a „financial surplus‟?
4. Discuss the advantages to deficit and surplus units of using organized financial markets and financial
intermediaries.
5. How are financial intermediaries able to engage in maturity transformation?
6. Explain briefly the difference between deposit-taking and non-deposit-taking intermediaries.
7. Why do people simultaneously hold financial assets and liabilities?
8. Why is the average size of broker/ dealer operations in general smaller than that of asset
transformers?
9. Examine the economic significance of financial markets
10. What is the economic significance of financial intermediaries
11. Critically analyse the standard justification for governmental regulation of financial markets.
12. In Zimbabwe, who are the regulators of financial markets?
13. Identify and briefly explain the forces of change that shape financial markets of the future
14. The following is an excerpt taken from a January 11, 2008, speech entitled “Monetary Policy
Flexibility, Risk Management, and Financial Disruptions” by Federal Reserve Governor Frederic S.
Mishkin (www.federalreserve.gov/newsevents/speech/mishkin20080111a.htm):

Although financial markets and institutions deal with large volumes of information, some
of this information is by nature asymmetric. . . .
Historically, banks and other financial intermediaries have played a major role in reducing the
asymmetry of information, partly because these firms tend to have long-term relationships with
their clients. The continuity of this information flow is crucial to the process of price discovery. .
. . During periods of financial distress, however, information flows may be disrupted and price
discovery may be impaired. As a result, such episodes tend to generate greater uncertainty.

Answer the following questions pertaining to the statement:

a. What is meant by asymmetric “information by nature”?
b. What is the problem caused by information asymmetry in financial markets?
c. How do you think banks have historically “played a major role in reducing the asymmetry of
information”?
d. What is meant by “price discovery”?
e. Why is the continuity of information flow critical to the process of price discovery?
15. The following is an excerpt taken from a November 30, 2007, speech entitled “Innovation, Information,
and Regulation in Financial
Markets” by Federal Reserve Governor Randall S. Kroszner
(www.federalreserve.gov/newsevents/speech/kroszner20071130a.htm):

Innovations in financial markets have created a wide range of investment opportunities that allow
capital to be allocated to its most productive uses and risks to be dispersed across a wide range of
market participants. Yet, as we are now seeing, innovation can also create challenges if market
participants face difficulties in valuing a new instrument because they realize that they do not have
the information they need or if they are uncertain about the information they do have. In such
situations,
price discovery and liquidity in the market for those innovative products can become impaired.

Answer the questions pertaining to the statement:

a. What are the information costs associated with financial assets?
b. What is meant by “liquidity”?
c. Why do you think that for innovative financial products price discovery and liquidity could
become impaired?
16. The following is an excerpt taken from a November 30, 2007, speech entitled “Innovation, Information,
and Regulation in Financial
Markets” by Federal Reserve Governor Randall S. Kroszner
(www.federalreserve.gov/newsevents/speech/kroszner20071130a.htm):
Another consequence of information investments is a tendency towards
greater standardization of many of the aspects of an instrument, which
can help to increase transparency and reduce complexity. . . .
Standardization in the terms and in the contractual rights and obligations
of purchasers and sellers of the product reduces the need for market participants
to engage in extensive efforts to obtain information and reduces the need to verify
the information that is provided in the market through due diligence. Reduced
information costs in turn lower transaction costs, thereby facilitating price discovery
and enhancing market liquidity. Also, standardization can reduce legal risks because
litigation over contract terms can result in case law that applies to similar
situations, thus reducing uncertainty.

Answer the following questions pertaining to the statement:

a. What does Governor Kroszner mean when he says standardization “reduces the need for market
participants to engage in extensive efforts to obtain information and reduces the need to verify the
information that is provided in the market through due diligence”?
b. How do “Reduced information costs in turn lower transaction costs, thereby facilitating price
discovery and enhancing market liquidity”?
c. Answer the questions pertaining to the statement:
d. What are the information costs associated with financial assets?
e. What is meant by “liquidity”?
f. Why do you think that for innovative financial products price discovery and liquidity could become
impaired?