Classification of Financial System

1. By Nature of Claim

Markets are categorized by the type of claim the investors have on the assets of the entity in which they have made the investments. There are broadly two kinds of claims, i.e. fixed claim and residual claim. Based on the nature of the claim, there are two kinds of markets, viz.

(i) Debt Market: Debt market refers to the market where debt instruments such as debentures, bonds, etc. are traded between investors. Such instruments have fixed claims, i.e. their claim in the assets of the entity is restricted to a certain amount. These instruments generally carry a coupon rate, commonly known as interest, which remains fixed over a period of time.

(ii) Equity Market: In this market, equity instruments are traded, as the name suggests equity refers to the owner’s capital in the business and thus, have a residual claim, implying, whatever is left in the business after paying off the fixed liabilities belongs to the equity shareholders, irrespective of the face value of shares held by them.

2. By Maturity of Claim

While making an investment, the time period plays an important role as the amount of investment depends on the time horizon of the investment, the time period also affects the risk profile of an investment. An investment with a lower time period carried lower risk as compared to an investment with a higher time period.

There are two types of market-based on the maturity of claim:

(i) Money Market: Money market is for short term funds, where the investors who intend to invest for not longer than a year enter into a transaction. This market deals with Monetary assets such as treasury bills, commercial paper, and certificates of deposits. The maturity period for all these instruments doesn’t exceed a year. Since these instruments have a low maturity period, they carry a lower risk and a reasonable rate of return for the investors, generally in the form of interest.

(ii) Capital Market: Capital market refers to the market where instruments with medium- and long-term maturity are traded. This is the market where the maximum interchange of money happens, it helps companies get access to money through equity capital, preference share capital, etc. and it also provides investors access to invest in the equity share capital of the company and be a party to the profits earned by the company.

This market has two verticals:

• Primary Market: Primary Market refers to the market, where the company lists security for the first time or where the already listed company issues fresh security. This market involves the company and the shareholders to transact with each other. The amount paid by shareholders for the primary issue is received by the company. There are two major types of products for the primary market, viz. Initial Public Offer (IPO) or Further Public Offer (FPO).
• Secondary Market: Once a company gets the security listed, the security becomes available to be traded over the exchange between the investors. The market that facilitates such trading is known as the secondary market or the stock market.

In other words, it is an organized market, where trading of securities takes place between investors. Investors could be individuals, merchant bankers, etc. Transactions of the secondary market don’t impact the cash flow position of the company, as such, as the receipts or payments for such exchanges are settled amongst investors, without the company being involved.

3. By Timing of Delivery

In addition to the above-discussed factors, such as time horizon, nature of the claim, etc, there is another factor that has distinguished the markets into two parts, i.e. timing of delivery of the security. This concept generally prevails in the secondary market or stock market. Based on the timing of delivery, there are two types of market:

(i) Cash Market: In this market, transactions are settled in real-time and it requires the total amount of investment to be paid by the investors, either through their own funds or through borrowed capital, generally known as margin, which is allowed on the present holdings in the account.

(ii) Futures Market: In this market, the settlement or delivery of security or commodity takes place at a future date. Transactions in such markets are generally cash-settled instead of delivery settled. In order to trade in the futures market, the total amount of assets is not required to be paid, rather, a margin going up to a certain % of the asset amount is sufficient to trade in the asset.

4. By Organizational Structure

Markets are also categorized based on the structure of the market, i.e. the manner in which transactions are conducted in the market. There are two types of market, based on organizational structure:

(i) Exchange-Traded Market: Exchange-Traded Market is a centralized market, that works on pre-established and standardized procedures. In this market, the buyer and seller don’t know each other. Transactions are entered into with the help of intermediaries, who are required to ensure the settlement of the transactions between buyers and sellers. There are standard products that are traded in such a market, there cannot need specific or customized products.

(ii) Over-the-Counter Market: This market is decentralized, allowing customers to trade in customized products based on the requirement.

In these cases, buyers and sellers interact with each other. Generally, Over-the-counter market transactions involve transactions for hedging of foreign currency exposure, exposure to commodities, etc. These transactions occur over-the-counter as different companies have different maturity dates for debt, which generally doesn’t coincide with the settlement dates of exchange-traded contracts.

Over a period of time, financial markets have gained importance in fulfilling the capital requirements for companies and also providing investment avenues to the investors in the country. Financial markets provide transparent pricing, high liquidity, and investor protection, from frauds and malpractices.