Preliminary notions on the financial system

1) Vocation of Capital Reallocation

 Indirect Financing through the Banking System

 Activity of Banking

 Direct Financing through the Financial Markets

 Activity of Traditional Financial Markets

2) Vocation of Risk Reallocation

 Activity of Derivative Markets

Investment Theory – Preliminary notions (1) Jian WU

 Original purpose of the financial system: set up a “BRIDGE”
between lenders and borrowers

LENDERS Capital
BORROWERS
• Individual savers
• Institutional investors • State

(insurance companies, Bridge • Companies

= Financial System • Local collectivities
investment companies,
funds) • Banking System
• Financial Markets

Investment Theory – Preliminary notions (2) Jian WU

 Banking system offers an “INDIRECT” financing

ASSET LIABILITY

Long-term credits Short-term deposits

BANQUE

BORROWERS LENDERS
(Companies) (Individual
savers)
The BANK acts as INTERMEDIARY (MIDDLEMAN)
between lenders and borrowers (with fees)

Investment Theory – Preliminary notions (3) Jian WU

 Financial markets offer a “DIRECT” financing

Capital

LENDERS
BORROWERS
(Subscribers)
(Issuers)

Financial claims

A FINANCIAL MARKET is a place where borrowers collect funds

DIRECTLY from lenders by ISSUING FINANCIAL CLAIMS
(such as stocks and bonds).

Investment Theory – Preliminary notions (4) Jian WU

 How to classify traditional financial markets? (1)

 According to the MATURITY of the financial claim

Treasury Bills
Negotiable
Debt
Securities Certificates of
Monetary Deposit
Markets
Markets
(short-term) Commercial
Interbank Papers
Traditional Markets
financial
markets Treasury
Bonds
Bond
Capital Markets
Markets Corporate
Bonds
(long-term) Stock
Markets

Investment Theory – Preliminary notions (5) Jian WU

 How to classify traditional financial markets? (2)

 According to the PROPERTY of the financial claim

Interbank
Markets
Monetary
Markets Markets of
Negotiable Debt
Debt Securities
Markets
Traditional Treasury
financial Bonds
markets Bond
Markets
Corporate
Stock Bonds
Markets

Investment Theory – Preliminary notions (6) Jian WU

 How to classify traditional financial markets? (3)

 According to whether the claim is NEWLY ISSUED OR NOT

Primary Markets (Initial

Traditional Public Offering, IPO)
financial
markets
Secondary Markets

 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.
 The secondary market (« market of second-hand ») is a market in which financial claims,
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.

Investment Theory – Preliminary notions (7) Jian WU

 How to classify traditional financial markets? (4)

 According to HOW THE NEGOTIATION IS ORGANIZED in the market

Order-driven or
Auction Markets
Exchanges
(NYSE, Euronext)
Traditional (Regulated Markets)
Financial
Markets Over-The-Counter Price-driven or
(OTC) Markets Intermediate Markets
(Private Markets) (NASDAQ)

 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 .
 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.

Investment Theory – Preliminary notions (8) Jian WU

 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.

Traditional Financial Markets

(Cash markets)
Financial
Markets
Derivative markets

Investment Theory – Preliminary notions (9) Jian WU

 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 Börse 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.

Investment Theory – Preliminary notions (10) Jian WU

 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 - as
regulators 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.

Investment Theory – Preliminary notions (11) Jian WU

 Press lecture (3)

 1st 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 Börse 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, as well 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.

Investment Theory – Preliminary notions (12) Jian WU

 Press lecture (4)
 1st article: Exchange chiefs seek global powerhouses (continued)

Yesterday, NYSE Euro-next and Deutsche Börse 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 Börse 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."

Investment Theory – Preliminary notions (13) Jian WU

 Press lecture (5)

 2nd article: Exchange group sees future in derivatives (Financial Times – Jeremy Grant – February 16 th
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 Börse 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.“

Investment Theory – Preliminary notions (14) Jian WU

 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 Börse 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 Börse 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.

Investment Theory – Preliminary notions (15) Jian WU

 Press lecture (7)

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

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-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.“
Reto Francioni, Deutsche Börse'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.

Investment Theory – Preliminary notions (16) Jian WU

 Press lecture (8)

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

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."

Investment Theory – Preliminary notions (17) Jian WU