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2.7. Element 4: financial markets

2.7.1. Primary and secondary markets

All the instruments mentioned above are issued in so-called primary markets, and the already-issued marketable instruments of debt (including deposits) and shares are traded in secondary markets. Thus, as depicted in Figure 5, when a primary issue is made the issuer (= borrower) acquires new funds, whereas in the secondary market the seller gets the funds (not the issuer).

Primary and secondary markets

Figure 5: Primary and secondary markets

2.7.2. OTC and exchange-driven markets

Secondary financial markets evolved to satisfy the needs of lenders (investors) to buy and sell (exchange) securities when the need arises. Some markets naturally exist in a safe (i.e. low risk) environment, while for others a safe environment has been created. The former markets are called over-the-counter (OTC) markets, and the latter the formalized (or exchange-driven) markets.

By and large, the foreign exchange and money markets of the world are OTC markets, and they essentially are the domain of the well-capitalized banks, while the share and bond markets are exchange-driven markets. Derivative instruments fall under both categories.

2.7.3. Debt market

The debt market is the market in which debt instruments are issued and exchanged for funds. Interest is paid on debt instruments (hence the other name: interest-bearing market), as opposed to dividends that are paid on shares. The debt markets are also called the fixed-interest markets, but this is a misnomer because interest may be floating, i.e. reset during the life of the instruments. The debt market is comprised of:

- Short-term debt market (STDM, which is a major part of the money market, the other part being deposits).

- Long-term debt market (LTDM, the marketable part of which is called the bond market).

The dividing line between the STDM (money market) and the LTDM is determined according to the term to maturity of the debt instruments, and is arbitrarily set at one year. Thus, the STDM (money market) is defined as the market for the issue and trading of securities with maturities of less than one year, and the LTDM as the market for the issue and trading of securities with maturities of longer than one year.

The securities referred to are marketable (e.g. a treasury bill and bond) or non-marketable (e.g. a non-negotiable certificate of deposit - NNCD - of a bank), and the markets are wholesale markets (i.e. large denomination securities) or retail markets (i.e. small denomination securities). In this respect the money market differs from the bond market.

Thus the money market is the entire STDM (plus the deposit market) and can be defined as follows:

The primary market for the issue of short-term retail and wholesale securities, and the secondary market for the trading of short-term wholesale marketable securities.

The definition of the bond market is:

The primary market for the issue, and the secondary market for the trading, oflong-term wholesale marketable securities.

The reason for including retail and non-marketable securities in the definition of the money market is that the retail money market is as large as the wholesale money market, and that it also encompasses large markets such as the call money (i.e. on-day term) deposit markets (which do not have secondary markets). It also includes the significant interbank market, which encompasses the bank-to bank interbank market, the short-term lending operations of the central bank to the banks at the repo rate for monetary policy purposes, and the reserve requirement (bank deposits with the central bank).

money market

Figure 6: money market

The latter sentence informs that monetary policy is played out in the money market. The essence of monetary policy is that the central bank undertakes transactions in this market in the form of open market operations (OMO) in order to establish a certain desired "liquidity shortage". This is a managed level of "borrowed reserves" (i.e. short-term central bank loans to the banks). These borrowed reserves are provided at the central bank's accommodation rate, called the repo rate in many countries and other names in others (bank rate, base rate, key interest rane, ctecount rate and so on).

bond market

Figure 7: bond market

In summary, the money market encompasses the following markets (ignoring the money market derivative markets):

- Markets in the short-term securities of ultimate borrowers.

- Markets in the short-term securities of financial intermediaries (mainly bank deposits).

- Interbank markets between private sector banks and between the central bank and private sector banks.

This detail on the money market is mentioned here because of the critical importance of money creation and monetary policy which play out in the money market. Also, money market rates, as we shall see, form the foundation of all other financial markets. The money market is depicted in Figure 6 and the bond market in Figure 7.

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