Financial markets and institutions - Role of intermediaries ...

Learning Outcomes

After reading this article, you will be able to explain the structure and purpose of financial markets and institutions. You will distinguish between types of markets, describe how financial intermediaries operate, and summarise the main regulatory mechanisms designed to ensure market integrity. You will also understand the relevance of these topics to financial decision-making for the ACCA Financial Management (FM) exam.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the nature, structure, and regulation of financial markets and the central role played by intermediaries. In particular, you should be able to:

• Identify and describe the purpose of money and capital markets, both within the UK and globally
• Explain the functions of financial intermediaries—such as banks, investment funds, and insurance companies—in channelling funds between savers and borrowers
• Distinguish between primary and secondary markets, and outline the significance of each
• Discuss the impact of regulation on financial markets and institutions, including the objectives of market regulation and how regulators operate
• Describe primary financial market instruments and their uses (e.g. shares, bonds, money market instruments)
• Outline the implications of market structure and regulation for financial management decisions

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes the main function of a financial intermediary?
   1. Setting share prices
   2. Collecting taxes
   3. Connecting savers and borrowers
   4. Issuing government policy
2. What distinguishes a primary market from a secondary market?
   1. A primary market is for retail investors only
   2. Primary markets issue new securities; secondary markets trade existing securities
   3. Primary markets are unregulated
   4. Secondary markets offer government bonds directly
3. Why are financial markets regulated?
   1. To ensure fair and efficient market operation
   2. To determine interest rates
   3. To increase bank profits
   4. To eliminate all risk for investors

4. True or false? Investment banks act as financial intermediaries by assisting firms in raising capital and advising on mergers.

Introduction

Financial markets and institutions form the backbone of the modern economic system. They enable the movement of funds from those who have surplus (investors) to those who need funds (borrowers), supporting business investment and economic growth. The efficiency of these flows relies on the presence of financial intermediaries such as banks and other institutions, and is maintained by a framework of regulations designed to keep markets orderly, transparent, and fair.

Understanding how financial markets are structured, the types of instruments and securities traded, the role of intermediaries, and the importance of regulation is fundamental for financial management and your ACCA exam. This article explains these core concepts clearly and concisely.

Key Term: Financial market
A platform or system that facilitates the buying, selling, and issuance of financial securities such as stocks, bonds, and money market instruments, connecting lenders and borrowers.

FINANCIAL MARKETS: STRUCTURE AND PURPOSE

Financial markets facilitate the transfer of funds between parties with surplus capital and those who need capital. They can be grouped by the type and maturity of the instruments traded.

Money Markets

Money markets deal with short-term funds, typically with maturities under one year. They provide liquidity for businesses, governments, and financial institutions. Examples include Treasury bills, commercial paper, and certificates of deposit.

Capital Markets

Capital markets handle long-term finance, such as shares and bonds, used for funding companies and public sector projects over several years.

Primary and Secondary Markets

Key Term: Primary market
The market for new securities issued by companies or governments, where funds are actually raised.

Key Term: Secondary market
The market where existing securities are bought and sold among investors, providing liquidity and price discovery.

In a primary market, organisations sell new securities to raise funds for investment or expansion. Secondary markets, such as major stock exchanges, allow these securities to be traded among investors, increasing their marketability and helping determine their current value.

THE ROLE OF FINANCIAL INTERMEDIARIES

Financial intermediaries are institutions that connect parties with capital to invest and parties seeking capital. They provide essential services that reduce risks and costs for both savers and borrowers.

Key Term: Financial intermediary
An institution—such as a bank, pension fund, or insurance company—that channels funds from savers to borrowers, reducing risk, aggregating funds, and transforming maturities.

Main functions of financial intermediaries include:

• Pooling savings from many individual investors to finance larger loans or investments
• Assessing and managing the risk associated with lending
• Matching the needs and preferences of borrowers and savers (such as loan size, duration, and risk appetite)
• Offering payment, settlement, and safekeeping services

Types of Financial Intermediaries

• Commercial banks: Accept deposits and provide loans to individuals and businesses.
• Investment banks: Advise companies on raising capital, undertake underwriting, and facilitate mergers and acquisitions.
• Pension funds and insurance companies: Invest pooled premiums and contributions in capital markets to meet future contractual obligations.

These institutions reduce costs through economies of scale, manage information more efficiently than individuals, and help stabilise the financial system.

FINANCIAL SECURITIES AND INSTRUMENTS

Markets operate through the trading of securities—financial contracts representing a claim on future cash flows.

Key Term: Security
A tradable financial instrument, such as shares, bonds, or money market instruments, conferring rights to future cash flows or ownership.

Key types include:

• Shares (equity): Ownership stakes in companies
• Bonds: Loan instruments issued by companies or governments
• Money market instruments: Short-term debt such as Treasury bills or commercial paper
• Derivatives: Contracts whose value depends on a reference asset (e.g., options or futures)

HOW REGULATION AFFECTS FINANCIAL MARKETS

Financial markets are regulated to protect participants, bolster confidence, and ensure orderly operations.

Key Term: Financial regulation
The set of laws, rules, and oversight frameworks that govern how financial markets and institutions operate to protect investors, maintain stability, and encourage fair trading.

Regulators seek to achieve several objectives:

• Protect investors and maintain market confidence
• Reduce system-wide risk and the chance of market failures
• Ensure transparency and the fair treatment of market participants
• Prevent financial crime, such as insider trading or market manipulation

Typical regulatory bodies include national authorities (e.g., Financial Conduct Authority in the UK), central banks, and international standard-setters.

Key regulatory requirements may include:

• Licensing and supervision of financial firms
• Disclosure and reporting obligations for issuers and intermediaries
• Capital and liquidity requirements for banks
• Enforcement actions for rule violations

Worked Example 1.1

A company wishes to issue new shares and is considering listing on a stock exchange. What regulatory requirements must it satisfy prior to listing?

Answer:
Before listing, the company must comply with the stock exchange's rules, which generally include: producing a prospectus containing detailed and audited financial information; meeting minimum capital or shareholding thresholds; disclosing ownership and management structures; and agreeing to ongoing reporting and governance standards. Approval is enforced by the relevant market regulator.

Worked Example 1.2

An investor considers buying a corporate bond in the secondary market. How does financial regulation protect the investor in this transaction?

Answer:
Regulation requires accurate and timely disclosure by the issuer, prohibits misleading statements, and may mandate that intermediaries act in clients’ best interests. Market surveillance and enforcement mechanisms also deter fraud and manipulation, helping ensure a fair marketplace.

Exam Warning

Failing to distinguish between primary and secondary markets, or misunderstanding the functions of financial intermediaries, is a frequent exam error. Be precise when answering questions about how funds flow and who facilitates that flow.

Summary

Financial markets channel funds from savers to borrowers using a range of instruments facilitated by financial intermediaries. Intermediaries—such as banks and investment funds—provide services that lower costs and risks and increase market efficiency. Regulations exist to safeguard participants, support confidence, and maintain orderly markets, all of which are critical for financial management and exam success.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify and explain the main types of financial markets and instruments
• Distinguish between primary and secondary markets
• Explain the role of financial intermediaries in connecting savers and borrowers
• State key regulatory objectives and mechanisms affecting financial markets and institutions
• Apply these concepts to financial management scenarios in the ACCA FM exam

Key Terms and Concepts

• Financial market
• Primary market
• Secondary market
• Financial intermediary
• Security
• Financial regulation