Y2 S1 Economics of the Financial System

What is direct finance? When and why does it become more imporatant?

Direct finance is when borrowers borrow funds directly from lenders in financial markets by selling them securities (like stocks or bonds).

This becomes more important as countries become richer. Due to:

Financial markets are more developed – richer countries have stronger stock and bond markets, making it easier for firms to raise money directly.

More information transparency – better accounting, regulation, and technology reduce the need for intermediaries to assess borrower risk.

Larger and more sophisticated firms – big firms can issue securities directly instead of relying on bank loans.

Wealthier investors – more people have savings to invest directly in markets rather than through banks.

What is indirect finance?

Indirect finance is when borrowers get funds through financial intermediaries (like banks), which collect funds from savers and then lend to borrowers.

What is equity?

Equity is a residual claim on the firm.

- The payments to equity are not fixed

- Equity is also a share in ownership

- Equity is also a share in ownership

- Can be public or private

What is debt?

Debt is borrowing that must be repaid on a fixed schedule.

Interest is paid as agreed between borrower and lender.

Debt servicing—paying interest and repaying the principal—has a prior claim, meaning it’s paid before equity holders.

Debt can be public (like government bonds) or private (like bank loans).

What are the most to least important sources of investment finance? 

1. Bank lending

2. Corporate bonds

3. Private equity e.g. venture capital investment, private equity funds

4. Public equity

What are transaction costs?

Definition: the costs to buyers and sellers of conducting an economic exchange.

Two categories:

Direct = the time, effort and expense of searching for products and services and for reaching agreements to trade and the contractual costs of enforcing these agreements; and

Indirect = the economic inefficiencies (or frictions) of exchange, resulting from asymmetric information (leading to hidden attributes, adverse selection and moral hazard)

• and also (not a focus in this module) contractual incompleteness (the costs arising because contracts cannot be fully enforced).

Explain Asymmetric information 1 (hidden attributes)

One party knows more about their qualities or characteristics than the other (e.g. borrower knows their true risk, lender doesn’t).

Leads to problems before a transaction happens.

Explain Asymmetric information 2 (adverse selection)

Occurs before a transaction, due to hidden attributes.

Lenders can’t tell risky from safe borrowers.

They charge an average interest rate, which drives away low-risk borrowers and attracts high-risk ones.

Result: more risky borrowers remain — this is adverse selection.

Explain Asymmetric information 3 (hidden action and agency costs)

After a contract, one party’s actions can’t be fully observed.

This creates agency costs — the costs of monitoring or ensuring the agent acts in the principal’s best interest.

Explain Asymmetric information 4 (moral hazard)

A form of hidden action occurring after a transaction.

People take more risks when they don’t bear the full consequences (e.g. managers gamble with company money or banks take risks due to bailouts).

Example: bank moral hazard — safety nets make banks take bigger risks.

What actions may be taken to reduce indirect transaction costs? 

What is liquidity in finance, and how do liquid and illiquid markets differ?

Liquidity refers to how easily an asset can be converted into cash without significantly affecting its market price (Investopedia).

• Liquid market example: eBay for used smartphones in excellent condition — you can sell quickly without lowering the price much.

• Illiquid market example: Residential property — to sell quickly, you may need to reduce the price significantly.

Lack of liquidity (illiquidity) represents an additional transaction cost.

Liquidity in financial markets depends on trade size: a small size trade, easy to find buyers; a large size trade can be very difficult. Why?

Information asymmetry - large trades often signal private information (that a big buyer/seller knows something). This makes the market less willing to absorb the trade.

Holding large positions is risky - to offset risk they demand price concession/hedge which takes time

Fewer buyers and seller at large sizes

For large trades, you quickly exhaust the available order book depth meaning you must accept worse prices, which reduces effective liquidity.

What is the difference between the buy side and the sell side in financial markets?

Buy Side: Institutions such as asset managers, pension funds, life insurers, and sovereign wealth funds that hold and manage investment portfolios.

They are the buyers of securities in primary markets.

Sell Side: Investment banks and their clients (companies and governments) that issue and sell securities in primary markets.

The sell side is dominated by large global investment banks, though smaller regional and national firms also operate.

What are the main markets in which investment banks earn money, and how are these markets structured?

Investment banks operate mainly in two types of markets:

1. Primary Market: Where securities (e.g., bonds, equities) are first issued.

2. Secondary Market: Where securities are subsequently traded — includes foreign exchange, derivative, and money markets.

Secondary market structures:

• Order-driven markets: Used for equities and exchange-traded derivatives.

• Quote-driven (dealer or OTC) markets: Used for most other instruments.

Participants: Mostly professional/institutional investors; retail investors access these markets via financial intermediaries.

Investment banks play roles in:

(i) Primary markets,

(ii) Order-driven secondary equity markets, and

(iii) Quote-driven secondary OTC markets.

What are the main sources of investment bank earnings, and how do they compare to revenues on the buy side?

Investment bank earnings come mainly from:

• Core investment banking: Primary market activities (e.g., issuing securities).

• Equities and equity broking.

• FICC: Fixed Income, Currencies, and Commodities trading.

(Source: BCG Global Markets Report)

Buy side revenues (earned by global asset managers):

• Based on assets under management (AUM).

• Average revenues are roughly 0.25% or less of AUM, and have been declining over time.

(Source: WTW 2024 report on global investment managers)

In the primary-market business of the sell side, what recent trends are impacting earnings from advisory and underwriting, and which banks are leading?

Deal activity (e.g., M&A, IPOs, bond issues) plunged after the pandemic and with higher interest rates.

A rebound is underway: advisory and underwriting revenues for the largest global investment banks are expected to rise strongly in 2024 (e.g., equity capital markets up ~30-35% and debt markets up ~40-45%).

On the “sell side” in investment banking:

• JPMorgan Chase & Co. (JPMorgan) is widely regarded as the undisputed leader in core investment-banking.

• Goldman Sachs and Morgan Stanley are very strong across investment banking & equities.

• HSBC, BNP Paribas (BNPP), and Société Générale (SG) are more focused on FICC (fixed-income, currencies & commodities).

• Bank of America (BoA), Barclays, Deutsche Bank (DB) and UBS are strong in equities but less dominant in pure core investment banking.

• Credit Suisse (CS) struggled in 2023 and was replaced in indexes by Wells Fargo & Co. (WFC).

The combination of market-recovery (issuance, M&A) and front-line banks winning share means the sell side’s primary-market earnings are poised for notable improvement.

Econ1: How do investment banks earn revenues in the primary market through IPOs, bond underwriting, and M&A advisory, and what challenges do they face?

Primary market revenues come mainly from:

• IPOs and bond underwriting (through bookbuilding) and M&A advisory work.

Bookbuilding process:

• The key challenge is liquidity.

• Banks use their network of buy-side contacts to gauge investor demand and establish a price.

• Investors indicate willingness to buy (without commitment) and are often offered a price discount (“sweetener”) in return.

Typical fees:

• IPOs: around 7.5% of the value raised.

• Bond underwriting: similar process but with lower fees.

• Advisory/M&A: high fees earned for expertise and access to buy-side networks.

Example:

Google’s 2004 IPO attempted to “go it alone” to save on fees (paid only 3% instead of the usual 7.5%), but may have lost up to 10% of value as a result.

(Source: Slate, 2004 — “Four Ways Google’s IPO Failed”)

How do quote-driven markets in FICC (fixed income, currencies, and commodities) operate, and what factors drive dealer earnings?

• Quote-driven markets are supported by dealers who post bid and ask prices.

  • Dealer profit comes from the spread (margin between bid and ask).

• These markets are used for bonds, foreign exchange, and most derivatives.

Dealer dynamics and risks:

• Dealers face inventory risk because buy and sell orders don’t always match.

• They monitor order flow for informational advantage.

• Risk can be offloaded through interdealer brokers (e.g., TP-ICAP).

Market structure effects:

• Largest dealers have more advantage → less competition → higher earnings.

• Earnings peak when trading volumes are high.

• Notably, market power can be as important as skill: “It’s not your skill that earns you money in trading, but the JP Morgan chair you sit on.”

• Raises question of bonus justification in concentrated markets.

Practical note:

• Many markets combine limit-order and quote-driven features (e.g., MTS electronic bond platform).

How do investment banks earn revenues in order-driven equity markets, and who participates in these markets?

• Order-driven market revenues come from executing equity trades for buy-side clients.

Key distinction:

• Brokers: facilitate trades for clients but don’t trade on their own account.

• Dealers: trade on their own account, not as an agent.

Revenue drivers:

• Access to limit order books and alternative trading venues (including dark pools).

• Regulation (e.g., NMS in the US, MiFID I in the EU) creates multiple trading venues.

• Obligation for best execution for buy-side clients (asset managers, sovereign wealth funds, etc.) ensures trades are executed at optimal prices.

Other participants:

• High-Frequency Traders (HFTs)

• Hedge Funds

• Retail investors (especially in the US)

• Revenue depends on execution quality, access to liquidity, and market share in trading venues.

Who provides liquidity in financial markets, and what trade-offs do liquidity providers face?

• Liquidity provision is a business model: a way to earn money regularly from trading.

Fundamental trade-off:

• Immediacy vs. price:

• Buy immediately: get price certainty but possibly worse price.

• Provide liquidity (wait for buyers): potentially better price, but risk that price moves against you.

Markets:

• Quote-driven markets (FICC): liquidity provided by dealers who post bid and ask prices.

• Limit-order (equity) markets: liquidity provided by limit orders placed by market participants (brokers, institutional traders, etc.).

This trade-off exists in both limit-order and quote-driven markets.

Why are short selling and leveraged long positions considered “mirror images”?

Both involve borrowing, posting collateral with a haircut, mark-to-market margining, and rollover risk.

• Short selling: borrow a security, sell it

• Leveraged long: borrow cash, buy a security
  The mechanics and risks are symmetric.

What are the steps in taking a short position?

• Borrow a security (bond or equity)

• Post collateral with a haircut (e.g. borrow $100m security, post $110m cash)

• Sell the borrowed security

• Continuously renew the borrowing

• Post additional collateral if losses occur (mark-to-market)

• Substitute collateral as necessary

What are the steps in taking a leveraged long position?

• Borrow cash

• Post collateral with a haircut (e.g. borrow $100m cash, pledge $110m securities)

• Buy the security

• Continuously renew the borrowing

• Post additional collateral if losses occur (mark-to-market)

• Substitute collateral as necessary

What is a haircut in leveraged or short positions?

The excess collateral posted above the value of what is borrowed (e.g. $110m collateral for $100m exposure).
It protects the lender against price moves and counterparty risk.

How do lenders leverage long and short positions?

Long:

• Buy securities and use them as collateral to borrow much of the purchase price

• Exposure exceeds capital invested

• Leverage can also be achieved using derivatives (e.g. forwards)

Short:

• Sell securities they do not own

• Borrow the security to complete the sale

• Capital committed is only the haircut, not the full value

• Leverage can also be achieved using derivatives (e.g. forwards)

How does settlement facilitate short selling?

• T+2 settlement allows traders to sell first and borrow later

• Securities are borrowed via:

  • Repo markets (fixed income)

  • Securities lending markets (equities)

How can derivatives create leverage for long or short positions?

Derivatives (e.g. forwards) provide economic exposure without full upfront payment, creating leverage without directly borrowing cash or securities.

Should short-selling be banned?

High frequency traders; day traders rely on “short selling”. Close out and settle only end of day position.

Critical to providing liquidity to secondary markets.

Short selling/ leveraged long purchase, ensures price of derivative and secondary markets are aligned.

No arbitrage: “future price = spot price + cost of carry + transaction costs”

BUT Leverage/ short selling associated with and maybe magnifies market instability (The “shorts pushed down the price”

Example:

• May 2010, beginning of the Euro crisis, Germany with support from France announced a ban on naked short selling

• Generally judged to have failed, volatility of Euro, and Eurozone bond and equity markets increased.

What are the consequences of leverage?

A market squeeze.

• Market “shorts” have heavily borrowed a bond .e.g HM Treasury 3 year gilt, overnight in expectation of price fall

• Price fall does not happen. They must either,

1. Go into the market to buy to close their positions,

2. Pay a margin to reborrow and hold their position

 

• Market price may jump substantially for two reinforcing reasons

(a) market news (of many kinds); or

(b) short repurchases plus illiquidity moving price upwards

(lack of sellers of the particular bond in the market)

 

• (a) + (b) = “vicious circle”, forced repurchases as shorts lose money, more price rises. Eventually all shorts pushed out of the market and price stabilises.

• Market squeeze can also affect “longs” relying on leverage for short term gains

  • So unlike a market corner can push price down, until all leverage trades are closed.

 

Examples, (i) Reddit board squeezing of GameStop shorts in 2021. (ii) Government bonds ”on special” (many traders offering cash to repo a particular bond to maintain a short positions leads to repo rate against that particular bond going negative as well as bond price going up)

What is market abuse and manipulation

• Legal terms with meaning established through prosecutions

• Many examples

  • Insider trading

  • Unlawful disclosure of inside information

  • Front running a client trade that is large enough to move the market (e.g. buying before price rises)

• Market manipulation is a sub-category of market abuse.

• Prosecution for market manipulation normally requires establishing two things

1. The market manipulators have created an artificial price that differs from that which would have obtained in the absence of manipulation; and

2. They have done so with the intent of deceiving other market participants and hence conducting market transactions that profit themselves at their expense.

Are ‘market squeezes’ a manipulation?

• Answer usually no, they are not

• Market squeezes can push markets both higher or lower

• But if co-rdinated trading is conducted to create an artificial price and earn a profit, they might be

Which length bonds have higher yields?

Long term bonds have higher risk than shorter ones (more chance for markets to change), therefore higher yields to compensate).

What is a bond’s coupon?

The fixed interest payment a bondholder receives, usually expressed as a percentage of the bond’s face (par) value.

• Example: 5% coupon on $1,000 par = $50/year.

• Paid annually, semiannually, or quarterly depending on the bond.

What is a bond’s yield?

The rate of return an investor earns on a bond.

• Can refer to:

  • Current yield = annual coupon ÷ market price

  • Yield to maturity (YTM) = total return if held to maturity, accounting for coupon payments and any capital gain/loss from purchase price vs par.

What is the difference between a bond’s coupon and its yield?

• Coupon: fixed interest set at issuance, based on face value

• Yield: actual return based on current market price

• Yield changes when bond price changes; coupon does not.

How does a bond’s market price relate to its yield?

• Price ↑ means that Yield ↓

• Price ↓ means that Yield ↑

• Reason: coupon is fixed, so buying at a higher price reduces the effective return, buying at a lower price increases it.

What is yield to maturity (YTM)?

The internal rate of return if the bond is held to maturity.

• Accounts for:

  • All coupon payments

  • Difference between purchase price and face value

• Provides a comprehensive measure of return.

What is par value and how does it relate to premium and discount bonds?

Par value: The face value of a bond, usually $1,000, is what the issuer promises to pay back at maturity.

• The coupon is calculated based on this par value.

• Example: 5% coupon on $1,000 → $50/year.

A discount bond is selling below par value.

• Example: $950 bond with a 5% coupon ($50/year).

• Since you pay less than $1,000 but still get $50/year, your effective return (yield) is higher than the coupon.

A premium bond is selling above par value.

• Example: $1,050 bond with a 5% coupon ($50/year).

• Since you pay more than $1,000 but only get $50/year, your effective return (yield) is lower than the coupon.

• You “overpaid” for the same fixed coupon.

What is the relationship between bond price, coupon, and yield?

• Discount bond: Price < Par → Yield > Coupon

• Premium bond: Price > Par → Yield < Coupon

• At par: Price = Par → Yield = Coupon