What is financial markets function?
What are financial investments and how do they work?
Types of financial investments, risk and information transparency
The importance of diversification against risk
The necessary authorisation of financial services
What is Mifid 2 and how does it work in the UK?
Two important innovations related to Mifid 2
”Financial markets'' is a generic term for all areas in which the buying and selling of financial instruments such as stocks, bonds, derivatives and fund shares takes place. They represent a central financing instrument in modern economies for companies and governments and a potential source of income for professional, private and institutional investors as well as savers. They are aimed at optimising resources through investment, aim to achieve a return and are characterised by a degree of risk that varies depending on the investment1 . One of the biggest risks in the financial markets is volatility, which is the rapid price fluctuation of a financial security. For this reason it becomes essential to rely on figures, such as financial advisors who know the markets really well. The Financial Conduct Authority is the UK’s securities regulator.
Differences between primary market and secondary market Firstly, financial markets can be divided into national and international financial markets. Another important distinction is between primary and secondary markets. On the primary market, securities are bought at the time of issue. On the primary market, companies and governments raise capital for the first time by issuing financial instruments according to an initial public offering (IPO). This raising of capital is handled by a select few participants, such as banks, insurance companies and large mutual funds. The securities are then auctioned and allocated in the secondary markets. This is also where the investor resells. Supply and demand in these secondary markets determine the price. In a nutshell: stocks, bonds and investment units are initially issued on the primary market, while resale takes place on the secondary market.
One of the most important tools for navigating the markets are market indices. They gather a number of financial securities together according to different criteria. Indices typically group together homogeneous asset classes: shares, bonds, commodities, derivatives, and so on. The stock exchange index considered to be most representative of the UK is the FTSE 100, an index grouping the largest one hundred UK companies by capitalisation on the Main Market (see below).
For a long time, the financial markets have ceased to be physical locations, but rather computer platforms known as “trading places”. This is where the offers to buy and sell intersect. In the UK, the stock exchange is based in London and is the London Stock Exchange. LSE’s Main Market is home to over 1,000 companies from 100 different countries2. The other large part of the market represented by the LSE is the Alternative Investment Market (AIM)3, which brings together smaller companies than the Main Market.
However, depending on the subject of the financial contracts traded, one can also differentiate between money, credit and capital markets, without forgetting the foreign exchange market and the so-called OTC market.
In the money market, the supply and demand for money come together between banks and non-banks. In short, money markets have the critical roles of financing trade and industry, investing profitably, enhancing the self-sufficiency of commercial banks, and providing liquidity to central bank policy. The money market typically trades in products (money market papers) with highly liquid, short-term maturities (up to two years). This is also characterised by a high level of security and a relatively low interest yield. The money market rate is based on the interest rate at which the money is traded by the central banks.
The credit market mainly consists of banks that borrow money from the central bank or pool savings. This money is then lent to companies in the form of loans. The banks can therefore also resell their future claims from these loans to financial investors (for example for securitisation). The capital market can be distinguished from the money market in that it is characterised by long-term borrowing or investments. On the organised capital market, longer-term transactions are carried out with the involvement of credit institutions and capital collection agencies. Long-term financial instruments (with a term of at least 2 years) are used on the capital market. However, there’s no clear separation of the time limits between money and capital markets.
The foreign exchange market is the market where participants can buy, sell, exchange and speculate about currencies. The foreign exchange market handles more than $5 trillion in daily transactions. This is more than the sum of the futures- and stock markets. The foreign exchange market, also known as the forex market, is decentralised and made up of a global network of computers and brokers from around the world. The players in the forex market are banks, trading companies, central banks, investment management firms, hedge funds, and forex retail brokers and investors. Since cash is the most liquid capital, the foreign exchange market stands out as the most liquid market in the world.
Then, there are a number of transactions between market participants that aren’t carried out via the stock exchange, such as OTC trading, better known as telephone trading. Even though trading is mostly done electronically, the term “telephone trading” is still widely used today. “OTC” refers to “over the counter”. The OTC markets are characterised by the fact that financial instruments can also be traded through them that don’t need to meet all the relevant requirements on regulated markets. These are markets whose trading takes place outside of the official stock exchange circles.
An investment consists of the productive use of economic resources. In the financial sector, this can be defined as the stake of a certain amount of money in the financial markets in the form of a financial product. A more comprehensive definition could be as follows: financial investments are the productive use of an asset for a certain period of time with the aim of increasing its value. In this way, mortgage loans can also be classified as financial investments.
There are many types of financial investments. A common thread to orient yourself between them can be to classify them according to duration, risk and return. There are long-term, medium- or short-term investments. Investments can also have a low-, medium- or high-risk profile. The decisive factor for the investor is always the risk/return ratio, i.e. how high will the distribution – whether in the form of dividends or interest – be in relation to the capital invested and the probability of getting it back? On the basis of the statutory provisions, the investment products must be presented to investors as transparently as possible, both from a risk perspective and with regard to fees.
For those looking for safe investments, there are certain forms of investing assets (e.g. the Guaranteed Capital Funds). However, the most common way of protecting yourself from risk is to diversify your investments. Diversifying investments means building an investment portfolio made up of stocks from different markets that may have little or no correlation with one another.
There are many financial service providers that are authorised to offer financial products and therefore enable investments by both companies and private investors. Banks should be mentioned first, but investment companies and asset management companies shouldn’t be forgotten either. Financial advisors are professionals who are qualified to develop saver-focused and financial product-based investment strategies. They can be employees of banks and companies, work in their own name or be independent. To be sure that you are dealing with a financial investment professional, it is certainly useful to consult the list made available by the Financial Conduct Authority (FCA) or to check that the financial services provider has an authorisation recognised by the FCA.
On 3 January 2018, the new European Financial Markets Directive MiFID 2 (Markets in Financial Instruments Directive) came into force throughout the European Union. The directive regulates the financial markets of the European Union and replaces the previous European regulation. The Union’s aim was to improve the transparency of European financial markets (including Liechtenstein, Iceland and Norway). The ultimate goal, that is, the main reason why European legislators moved forward with this decision, was of course to protect savers and retail investors. To make the markets more transparent, MIFID 2 has imposed new rules on banks, brokers and asset managers, especially with regard to products and services.
Mifid 2 is a regulatory framework developed by the European Union and also transposed in the UK. On how it has been transposed, it is worth quoting what the Financial Conduct Authority writes: “The EU MiFID framework was transposed and implemented in the UK by a combination of Handbook rules , Treasury legislation, and directly applicable EU regulations (in the latter case, notably by EU MIFIR (No 600/2014), the MiFID Org Regulation ((EU) 2017/565) and a number of RTSs/ITSs)”4 .
First, it was necessary to create some kind of detailed and explicit labelling of financial assets. The service providers, who, with the previous guideline, only had to prepare an analysis prospect for the individual products or instruments, now have to prepare a key information sheet that contains an explanatory summary of the financial package made available to customers. The express aim of this is to compare the customer’s risk profile with their willingness to lose. In short, the European legislators want to provide savers with details on both the return and the risks. These details contain an explanatory summary of the financial package made available to customers. The express aim of this is to compare the customer's risk profile with their willingness to lose. In short, European lawmakers want to provide savers with details on both returns and risks. These details contain an explanatory summary of the financial package made available to customers. The express aim of this is to compare the customer’s risk profile with their willingness to lose. In short, the European legislators want to provide savers with details on both the return and the risks5.
The second important innovation concerns the transparency of the commissions: all cost groups must be shown in detail with a price. With previous legislation it so happened that, for example, only the issuing commission of an investment fund was expressed in euros/pounds – the rest was expressed in percent. Even in the reports and periodic updates that are sent to customers must now be shown separately and expressed in monetary terms. The KID (Key Information Document)6 must, in fact, always contain all cost elements, the analysis prospect on the return on individual products and the analysis methods (whether market-related or more specific), as well as the explicit declaration of the service – an independent consultation. The KID is also provided for in The Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation (in force since 1 January 2018) according to the PRIIPs Regulatory Technical Standards (RTSs)7.
Related topics: behavioural finance
