The financial system allows traders to solve financing and risk management problems. In a well-functioning financial system:
- investors can easily move money from the present to the future while obtaining a fair rate of return for the risks that they bear;
- borrowers can easily obtain funds that they need to undertake current projects if they can credibly promise to repay the funds in the future;
- hedgers can easily trade away or offset the risks that concern them; and
- traders can easily trade currencies for other currencies or commodities that they need.
If the assets or contracts needed to solve these problems are available to trade, the financial system has complete markets. If the costs of arranging these trades are low, the financial system is operationally efficient. If the prices of the assets and contracts reflect all available information related to fundamental values, the financial system is informationally efficient.
Well-functioning financial systems are characterised by:
- the existence of well-developed markets that trade instruments that help people solve their financial problems (complete markets);
- liquid markets in which the costs of trading—commissions, bid–ask spreads, and order price impacts—are low (operationally efficient markets);
- timely financial disclosures by corporations and governments that allow market participants to estimate the fundamental values of securities (support informationally efficient markets); and
- prices that reflect fundamental values so that prices vary primarily in response to changes in fundamental values and not to demands for liquidity made by uninformed traders (informationally efficient markets).
Such complete and operationally efficient markets are produced by financial intermediaries who:
- organise exchanges, brokerages, and alternative trading systems that match buyers to sellers;
- provide liquidity on demand to traders;
- securitise assets to produce investment instruments that are attractive to investors and thereby lower the costs of funds for borrowers;
- run banks that match investors to borrowers by taking deposits and making loans;
- run insurance companies that pool uncorrelated risks;
- provide investment advisory services that help investors manage and grow their assets at low cost;
- organise clearinghouses that ensure everyone settles their trades and contracts; and
- organise depositories that ensure nobody loses their assets.
