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Basic Functions of Securities Companies in the Financial System

According to the theories of modern financial intermediation and financial functions, roles of the securities companies in the financial system are mainly embodied in the following three aspects:

1. Risk filtration function

2. Products creation and asset pricing function

3. Risk portfolios based on asset appreciation

Risk Filtration Function Risk filtration is the elimination of incorrect information or noise-making information in the capital market through operations of financial intermediations, enabling investors to have correct information for securities investment and to make their best decisions. As an important intermediary in the capital market, securities companies work together with accounting firms, assets evaluation institutes, and credit rating entities, among other financial institutions, to consolidate and analyze information about companies. This ensures that investors can access the operations, management, and future development trends of the securities issuers (companies and institutions) in a correct and prompt manner, which enables them to make correct analysis of the investment values of their targets. In this way, securities businesses work as an effective barrier filtering risk.

The theory of information dissymmetry was applied in the 1970s to justify the existence of financial intermediaries. Economists such as Hayne Leland and David Pyle, Peter Diamond, Douglas Gale, Martin Hellwig, Tim Campbell and William Kracaw, John Boyd and Edward Prescott, and Frederic Mishkin stressed the role of financial intermediaries in solving the problem of information dissymmetry. Leland and Pyle stated that by investing in their specialized field of knowledge, intermediary institutions like securities firms could show their predominance in the area of information. The reputation system was believed to be the guarantee of reliability of information produced by financial intermediaries. Chemmanur and Fulghieri (1999) explained from the angle of reputation generation the reason the reputation of intermediary institutions in the financial market could play a reliable information verification role. Gurley, Shaw, and Enthoven (1960), and Scholes, Benston, and Smith (1976) believed that from the viewpoint of transaction costs, financial institutions could provide clients liquidity with rather low capital conversion costs, reducing the transaction costs in clients' near-term and long-term spending decisions; leverage their specialist know-how and "economy of scale" to reduce assets assessment costs and commissioning and supervisory costs; and reduce the search and information costs by establishing their own reputation system and providing the venues.

Product Creation and Asset Pricing Function In the financial system, investors realize risk dispersing and value appreciation through financial products. Robert C. Merton (1995) pointed out that financial intermediaries could make custom products for clients with special financial needs. Once becoming routinely tradable, these financial products could be traded in the financial market and serve mass clients.

Apart from product creation, financial intermediaries such as securities companies also have the function of asset pricing. From the static point of view, the market-based assets pricing function is realized via the underwriting business and the related financing and M&A services of securities firms. Securities underwriting is the rudimentary business of investment banks. We could easily identify the pricing function of investment banks in companies' financing efforts through bonds and IPOs. The asset pricing function of securities firms is also found in their value discovery function in M&A practices. Securities companies discover and acquire undervalued companies and prompt M&A of companies with appreciation values. From a dynamic point of view, values of some securities change in line with changes in elements such as price, taxes, market, technique, and resource supply in the areas of policies, basics, and techniques, and therefore deviate from their supposed values. This requires securities companies to make prompt discovery of value underestimations and take effective measures to realize the regression of stock values.

Risk Portfolios Based on Assets Appreciation Modern financial intermediary theories have placed more emphasis on the function of financial intermediaries for values appreciation, which is the main driving force behind the development of modern financial intermediaries. The function of risk portfolios based on asset appreciation in the modern financial system is realized through financial intermediaries like universal banks, as well as securities firms, mutual funds, and asset management companies. Scholtens and van Wensveen (2000) believed that financial intermediaries such as securities firms could create financial products, and through conversion of financial risks, terms, scales, locations, and liquidity, could provide added value to clients. Merton (1989) shared the idea that financial intermediaries are able to distribute risks among different participants. Allen and Santomero (1998) pointed out that the main function of financial intermediaries is to represent the transaction of financial assets and manage risk. Financial intermediaries are therefore the propeller of risk diversion and the facilitators for dealing with the increasingly complex financial vehicles and market issues.

The three functions of financial market intermediaries such as securities firms, as previously discussed (risk filtration, product creation and asset pricing, and risk portfolios based on value appreciation) are closely interconnected and logically complete. One function is the foundation for the next, and the next function is the "sublimation" of the former. Without the improvement of information completeness and transparency, investors would not be able to get correct information, create products, and make effective asset pricing choices. Without this, investors could fail to adjust their investment structures and lose the balance between risk and returns of their asset portfolios, which would lose any appreciation of the asset values. As indispensable parts of an intact establishment, these functions together determine the efficiency of the financial system. Our judgment of securities companies could therefore be analyzed along those three basic functions.

 
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