Element 3: financial instruments
As a result of the process of financial intermediation, and in order to satisfy the investment requirements of the ultimate lenders and the financial intermediaries (in their capacity as borrowers and lenders), a wide array of financial instruments exist. The instruments are either non-marketable (e.g. retirement annuities, insurance policies), which means that their markets are only primary markets (see later), or marketable (e.g. treasury bills, bonds), which means that they are issued in their primary markets and traded in their secondary nukes (detailed later).
Figure 4: financial intermediaries & instruments / securities
As indicated in Figure 3, the instruments issued by borrowers are in a broad sense called securities (aka instruments and assets). They represent claims on the issuers / borrowers. Figure 4 presents the detail. As we have seen, the instruments issued by the ultimate borrowers (the ultimate investments) are twofold:
- Debt instruments.
- Share (aka equity and stock) instruments.
Debt and share instruments represent permanent or semi-permanent funds (aka capital) for the borrowers. Generally, debt instruments have a fixed term to maturity and thus represent semi-permanent capital for the borrower, and there are two classes of shares: ordinary shares which are shares in the capital of companies which have no maturity date (= permanent capital) and preference shares which generally have a fixed term to maturity (= semi-permanent capital).
There are variations on the themes, such as perpetual debt and perpetual preference shares (they both have no fixed maturity date) but, as they are rare, we will not cover them in this text. In summary, financial investments are:
- Debt instruments (fixed-term = semi-permanent capital).
- Share instruments:
- Ordinary shares (no fixed-term = permanent capital).
- Preference shares (fixed-term = semi-permanent capital).
Below we present the detail of the financial instruments issued by the ultimate borrowers and the financial intermediaries. Note that here we introduce the concepts marketable debt (MD) and non-marketable debt (NMD) (shares, whether listed or non-listed, are marketable).
The instruments (ultimate investments) of the ultimate borrowers
The instruments of debt and shares (ultimate investments) of the financial system and their issuers (the ultimate borrowers) are as follows:
The household sector issues:
- Non-marketable debt (NMD) securities:
- Examples: overdraft loan from a bank; mortgage loan from a bank.
The corporate sector issues:
- Share securities:
- Ordinary shares (aka common shares).
- Preference shares (aka preferred shares).
- Debt securities:
- Non-marketable debt (NMD).
- Marketable debt (MD)
- Usually only corporate bonds and commercial paper (CP). The government sector issues:
- Marketable debt securities (in most countries MD only)
- Treasury bills (aka TBs and T-bills).
- Bonds (aka T-bonds).
The foreign sector issues (into the local markets):
- Foreign share securities (inward listings).
- Foreign debt securities (inward listings: usually bonds only).
The instruments of the financial intermediaries
As we have seen, there are three groups of financial intermediaries:
- Quasi-financial intermediaries (QFIs).
- Investment vehicles.
The deposit financial intermediaries (central and private sector banks) issue deposit securities:
- Deposit securities: - Central bank:
- Non-negotiable certificates of deposit (NNCDs).
- Negotiable certificates of deposit (NCDs) (central bank securities21).
- Notes and coins22. - Private sector banks:
The quasi-financial intermediaries issue debt securities:
- Debt securities:
- Non-marketable debt (NMD):
- Example: utilized overdraft facility.
- Marketable debt (MD):
- Bonds, commercial paper (CP).
The investment vehicles issue securities to investors as follows:
- Contractual intermediaries (CIs):
- Retirement funds (membership or participation interests - PIs).
- Life insurers (endowment policies & annuities - they are actually PIs in the underlying insurer endowment and annuity funds of the insurers).
- Collective investment schemes (CISs):
- Securities unit trusts (units, which we call PIs).
- Property unit trusts (units, which we call PIs)
- Exchange traded funds (PIs).
- Alternative investments (AIs):
- Hedge funds (PIs).
- Private equity funds (PIs).
Most individual investors do not invest in the ultimate financial instruments (the exceptions is shares). Rather, they invest in these ultimate financial instruments via the investment vehicles.
The above may be summarized as in Table 2.
Table 2: Financial instruments / securities
As seen, these investment vehicle securities are referred to by various names but, in the interests of simplicity, we call all of them participation interests (PIs). As stated, generally, individual investors (lenders) don't buy TBs, CP or bonds, and the majority don't buy shares, directly. Rather, they buy PIs in the investment vehicles, which in turn invest in these (and other) instruments. In fact the investment vehicles (excluding most of the AIs) specialize in providing investments products for individuals.