Chapter 1 Key Facts

Question 1

The financial services industry provides four main functions:

Answer 1

► financial intermediation;
► pooling and managing risk;
► provision of payment and settlement services; and
► portfolio management.

Question 2

The main types of financial institutions are:

Answer 2

► central banks;
► deposit institutions (such as banks); and
► investment institutions (such as insurance companies, collective investment funds and pension funds).

Question 3

Governments perform four important economic functions:

Answer 3

► the provision of certain goods and services (e.g. defence);
► regulation of markets to protect consumers;
► improving the distribution of incomes through taxation and welfare payments; and
► maintaining economic stability.

Question 4

The role of securities markets in providing liquidity and price transparency

Answer 4

1. Real assets are physical assets such as land, buildings and gold. Financial assets are claims representing the right to some return (such as a bank deposit or bond) or to ownership of physical assets .

2. The main functions of securities markets are:
» raising capital;
» transferring risk;
» price discovery; and
» creating liquidity.

3. Primary markets are where initial sales of securities are made. Subsequent trading takes place in the secondary market.
4. Round-trip transaction costs are the total costs of completing a transaction, including bid-ask spread, commissions and taxes.

Question 5

Types of financial markets

Answer 5

1. The London Stock Exchange operates an order-driven system called SETS for FTSE 100, FTSE 250 and FTSE Small Cap constituents, and a quote-display system called SEAQ for fixed-interest securities and AIM securities.
2. Less liquid stocks, listed on the main market, are traded on SETSqx, which combines a periodic auction book along with quote-driven market making.
3. UK Government bonds are known as ‘gilts ‘, and the Debt Management Office (OMO) is the department of the Treasury responsible for gilt issuance, usually via an auction.
4. Corporate bonds may be issued via an open offer or private placement. The former can involve a bought deal or fixed price re-offer.
5. Dual listing is when two corporations function as a single operating business but retain separate legal identities and stock exchange listings.
6. An over-the-counter (OTC) market involves trading in a decentralised way rather than on an exchange.
7. CREST is the London Stock Exchange’s electronic settlement system, which settles on a T+2 basis for equities and a T+1 basis for gilts.

Question 6

The UK listing authority and prospectus requirements

Answer 6

1. In the UK, the Financial Conduct Authority {FCA) is the ‘competent authority ‘ (or, colloquially, the UKlisting authority), which decides on the admission of securities to the Official List.
2. Listing on the main market requires at least three years of published accounts, and over £700,000 of listed stock or £200,000 of debt securities.
3. AIM is regulated by the London Stock Exchange, and there is no minimum criterion for size, trading record or shares in public hands.

Question 7

Information disclosure and corporate governance requirements for UK equity markets

Answer 7

1. Directors, major shareholders and concert parties must declare share interests.
2. The corporate governance system in the UK has traditionally stressed the importance of internal controls and the role of financial reporting and accountability, rather than external legislation.
3. When a company is listed on the London Stock Exchange, it agrees to abide by the continuing obligations of listed companies. The rules encourage companies to release new information to the market on a regular basis.
4. Every public company is required to hold an annual general meeting (AGM) within six months of the end of their financial year, and the interval between AGMs must not be more than 15 months.
5. Any meeting of a company other than an AGM is called a ‘general meeting’. General meetings must be called by giving not less than 14 calendar days’ written notice, and companies are permitted to communicate with their shareholders electronically.
6. Any member entitled to attend and vote at a company meeting may appoint another person (the proxy) to attend and vote on their behalf.

Question 8

International markets

Answer 8

1. Government bond trading in other countries often involves local banks trading OTC, with settlement via the central bank. Corporate bonds are often listed and traded through central clearing depositary systems associated with local exchanges.
2. Euroclear and Clearstream are the two main systems currently available for settling Eurobond transactions. All trades must be confirmed T+1 and settled T+2.

Question 9

The principal-agent problem: separation of ownership and control

Answer 9

1. The separation of ownership and control leads to the principal-agent problem.
2. In capital markets, shareholders act as principals and delegate control to managers, who are agents.
3. Other forms of principal-agent relationship in the investment industry include fund advisers or managers acting as agents for investors.
4. Solutions to the agency problem incur agency costs, and include:
   a. aligning the interests of managers and owners through remuneration of the former in shares or stock options;
   b. boards of directors looking after the interests of shareholders; and,
   c. external control through active groups of shareholders or the threat of takeover.