The financial system

Table of Contents:

Learning outcomes

After studying this text the learner should / should be able to:

- Elucidate the categories of investments.

- Describe the six elements that make up the financial system.

- Describe the financial instruments / investments in a broad sense.

- Know of the existence of the allied non-principal participants in the financial system.


This section on "The financial system" follows the section "Four phases of the life-cycle" and precedes the sections:

- Investment instruments.

- Investment principles.

The reason for this stand-alone main section is that 70-80% of most portfolios are comprised of financial assets, i.e. these assets are delivered by the financial system. As will be seen, the majority of financial assets held are shares. The reason is simple: return, compared with other asset classes.

One of the reasons for the general disinterest in investments, which leads to the majority not achieving their FSG, is that potential investors are confronted with a maze of terms relating to investments: hedge funds, alternative investments, money market investments, investment policies, bills, bonds, notes, ETFs, SUTs, PUTs, real assets, shares / stocks / equities, fixed-income / fixed-term assets, derivatives, collective investment schemes, and so on and so forth. Most people are confused by these examples of terminology and feel intimidated by the subject matter.

The confusing terminology will be demystified as we progress in this text. The first step is to outline the categories and subcategories of the ultimate investments. By ultimate is meant the actual investments that exist, i.e. investors invest in these either directly or indirectly via financial intermediaries. The ultimate investments are straightforward:

- Financial investment instruments:

- Debt instruments.

- Share (aka stock and equity) instruments.

- Real investments:

- Property (aka real estate).

- Commodities.

- Other real investments (art, rare coins, antique furniture, etc.).

As will be seen in more detail later, financial investments are issued by ultimate borrowers. It will also be seen that financial intermediaries exist to facilitate financing in various forms. There are various types and they all hold ultimate investments and issue indirect investments, such as deposits and participation units (or interests), in order to finance the holding of the ultimate investment instruments. There are three categories of financial intermediaries and they issue indirect securities as indicated:

- Banks: deposit instruments (certificates).

- Quasi-financial intermediaries (QFIs): debt instruments.

- Investment vehicles: participation interests (PIs).

In summary, we have the following investments:

- Ultimate investments:

- Financial investments instruments (issued by ultimate borrowers):

- Debt instruments.

- Share (aka stock and equity) instruments.

- Real investments:

- Property (also called real estate).

- Commodities.

- Other real investments (art, rare coins, antique furniture, etc.).

- Indirect investment instruments (issued by financial intermediaries):

- Issued by banks: deposit instruments.

- Issued by quasi-financial intermediaries: debt instruments.

- Issued by investment vehicles: participation interests.

As we will see below, the ultimate lenders hold the ultimate investment instruments directly or indirectly via financial intermediaries. Also, some financial intermediaries hold the financial liabilities of other financial intermediaries. In what follows, keep in mind that we use the terms investments and assets interchangeably, and that these terms apply to financial and real assets. The terms instruments and securities apply to financial assets only. Keep in mind also that asset means "I own", and that financial assets are the financial obligations / liabilities (liability = "I owe") of ultimate borrowers and financial intermediaries, which may also be termed financial claims on borrowers.

The above may be a little confusing to those unfamiliar with the financial system and investments. These terms will be well understood as we progress in this text.

Generally speaking investment portfolios do not contain a large proportion of real investments. The reason is that real investments do not generate returns in the form of regular cash flows (the exception is one section of the property market = rental properties). Financial investments, on the other hand, generate interest and dividend income. All investments generate capital gains (small, though, in the case of the money market).

For these reasons, the majority of large portfolios (such as retirement funds) are comprised of financial assets - to the extent of around 90%. Individuals' portfolios generally have a smaller proportion of financial assets, mainly because of the need to have a dwelling (property). Because of the dominance of financial assets in portfolios, we need to spend some time on the system that delivers financial assets: the financial system.

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