Part A: Markets and capital
Market organisation and structure
Key takeaways
- Financial markets perform price discovery, provide liquidity, allocate capital, transfer risk and aggregate information into prices.
- The money market trades short-term debt of a year or less, such as Treasury bills and commercial paper; the capital market trades longer-term equities and bonds.
- The primary market issues new securities directly to investors, while the secondary market, such as the Nairobi Securities Exchange, trades securities already issued.
- The financial system channels funds from surplus units to deficit units, either directly through the markets or indirectly through intermediaries such as banks and fund managers.
- A well-functioning system is efficient, liquid, stable, transparent and accessible, and Automated Trading Systems now match orders electronically instead of open outcry.
A Certified Secretary working with a listed company, a pension scheme or a regulated financial institution needs to understand the market and regulatory environment those entities sit within. This paper builds that understanding, from market structure through to the specialised institutions in the closing chapter.
Functions of financial markets
- Price discovery: bringing buyers and sellers together to establish a fair market price
- Liquidity: allowing holders to convert securities to cash relatively quickly
- Capital allocation: channelling savings toward their most productive use
- Risk transfer: allowing risk to move (through derivatives, insurance) to those most willing to bear it
- Information aggregation: prices reflect available information about an asset's prospects
Classifications of financial assets and markets
Structure of financial markets
Players within the financial services industry
The industry spans a wide range of institutions, each playing a distinct role:
- Banking: central banks (monetary authority and banking regulator), retail banks, corporate banks, investment banks
- Insurance and retirement: insurance companies and insurance brokers, retirement schemes and pension administrators
- Cooperative finance: SACCOs
- Capital markets intermediaries: securities exchanges, stockbrokers, fund managers, investment advisers, custodians, online foreign exchange brokers
- Specialised vehicles: REIT managers and trustees, collective investment schemes (CIS), crowdfunding platforms
- Oversight and information: industry associations, professional bodies, credit rating agencies
Securities traded in the markets
Flow of funds and financial systems
The financial system channels funds from surplus units (savers, with more funds than they currently need) to deficit units (borrowers and issuers, who need funds), either directly through the markets described above, or indirectly through financial intermediaries (banks, fund managers) that pool and redirect those funds.
Characteristics of a well-functioning financial system
- Efficiency: capital flows to its most productive use at low transaction cost
- Liquidity: assets can be readily bought or sold
- Stability: the system can absorb shocks without systemic failure (see bank runs and liquidity crises in the chapter on regulation)
- Transparency: information relevant to pricing and risk is available to participants
- Accessibility: a wide range of savers and borrowers can participate, supporting financial inclusion (see the chapter on regulation)
Automation of security exchanges
Automated Trading Systems (ATS) match buy and sell orders electronically rather than through open-outcry floor trading, the model the Nairobi Securities Exchange itself now uses, improving speed, transparency and the volume of trading an exchange can handle.
Exam tip
The classification of assets and the structure of markets are overlapping but distinct, money-vs-capital market (by maturity) is a different axis from primary-vs-secondary (by whether the security is newly issued), keep both straight rather than treating them as one classification.
Self-check
(a) An investor buys a 91-day Treasury bill directly from the Central Bank at issuance. Identify which market this trades in on two different classification axes (by maturity, and by whether the security is new). (2 marks)
(b) A shareholder later sells shares they already hold to another investor on the Nairobi Securities Exchange. Identify the market this trades in on the same two axes. (2 marks)
(c) State two functions financial markets perform. (2 marks)
(d) Distinguish an exchange-traded market from an over-the-counter market. (2 marks)
(e) Explain how Automated Trading Systems have changed how the Nairobi Securities Exchange operates. (2 marks)
Show worked answer
(a) By maturity, it is a money market instrument (91 days, under a year); by issuance, it is a primary market transaction, since the bill is being bought directly from the issuer at issuance (2 marks).
(b) By maturity, shares carry no maturity date so this classification does not apply to them in the same way, they are a capital market instrument by nature (equity, longer-term); by issuance, this is a secondary market transaction, since the shares already exist and are being traded between investors, not issued fresh (2 marks).
(c) Any two of: price discovery; liquidity; capital allocation; risk transfer; information aggregation (2 marks).
(d) An exchange-traded market has trading occur on a formal, regulated exchange with standardised rules; an over-the-counter market has trading occur directly between parties without a centralised exchange (2 marks).
(e) Automated Trading Systems match buy and sell orders electronically rather than through open-outcry floor trading, improving speed, transparency and the volume of trading the exchange can handle compared with the manual floor-trading model it replaced (2 marks).