Subject 8. Well-Functioning Financial Systems

Well-functioning financial systems have the following characteristics:

  • Complete markets. The instruments needed to solve investment and risk management problems are available to trade.

  • Liquidity. As asset can be bought and sold quickly (that is, it has marketability, which means an asset's likelihood of being sold quickly) at a price close to the prices for previous transactions (price continuity), assuming no new information has been received. In turn, price continuity requires depth, which means that numerous potential buyers and sellers must be willing to trade at prices above and below the current market price.

  • Operational efficiency. Low transaction costs (as a percentage of the value of the trade) include the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset. This attribute is often referred to as internal efficiency.

  • Informational (or external) efficiency. Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly adjust to new information; thus the prevailing price is fair because it reflects all available information regarding the asset. Prices will be most informative in liquid markets because information-motivated traders will not invest in information and research if establishing positions based on their analysis is too costly.

A well-functioning financial system promotes wealth by ensuring that capital allocation decisions are well-made. It also promotes wealth by allowing people to share risks associated with valuable products that would otherwise not be undertaken.

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