What are financial instruments?

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Markets that make up the financial system

In editorial 1, I wrote: A financial system includes three very important pieces in the “puzzle”.  …….. The system includes a range of financial institutions, a range of financial instruments and various markets that allow the free flow of funds.

In editorial 2, I covered the various financial institutions categories.

In editorial 3 yesterday, I covered the range of financial instruments.

In this editorial, I will cover the markets that make up the financial system.  From my previous editorials, you should now understand how the financial market is integrated. An efficient financial system helps our economy to grow. In this editorial, I will show how the different types of financial transactions take place in the system.

First of all, I must emphasize that for an efficient market to prevail, the matching principle must be followed. This principle, however obvious it may be, is not followed strictly. It states that short term assets should be financed by short term funds. Inventory as a working capital should be funded by short term liability, such as overdraft. Longer term assets such as a building for a factory or manufacturing equipment should be financed through long term liability. An investment that is likely to generate income for the next 10 years would be funded by long term loan. The firm may issue a corporate bond or borrow from an institution.

It sounds logical, doesn’t it? The global financial crisis was one main reason that the matching principle was not followed.  Do you remember the term securitised debt?

Financial institutions and corporations accumulated heaps of assets such as accounts receivable, mortgage backed housing loans, credit card receivables and utility rates, which generate future cash flows over time. So the process of securitisation evolved to allow the sale of non-liquid assets that have specified future cash flows attached.

For example, housing loans (long term assets) have future cash flows attached in the form of interest payments and principal repayments. Securitisation is a form of financing in which the cash flows associated with existing financial assets are used to service funding raised through the issue of asset-backed securities.

For example, the securitisation of mortgage loans involves the bundling together of a group of mortgage loans with similar characteristics such as term to maturity. The loan originator then sells the bundle of mortgage loans to the trustee of a special purpose vehicle. The trustee of the vehicle raises the funds necessary to buy the mortgage loans from the loan originator by issuing new securities to investors (short term), particularly institutional investors who are attracted by the return and risk associated with the investment.

HOWEVER, this is subject to the cash flows continue as expected. What happened in the sub-prime fiasco, was that the cash flows stopped as there was a burst of the housing bubble in the US. Is securitisation good?  YES and NO! It all depends if the cash flows are secured and continue without any interruption.

My next editorial I will have additional information about the markets that make up the financial system.