Fundamentals of Multilateral Investing – Lesson Three

Fundamentals of Multilateral Investing - Lessons, Premium POM

Financial Intermediaries and Expanding RMB Capital Markets

By JC Collins

In Lesson One we reviewed the definition of Capital, the relationship between Savers and Users of Capital, and we learned about Financial Instruments, which act as the Intermediaries between Savers and Users.

In Lesson Two we reviewed the importance of Capital Markets and the need for Efficient Capital Markets, and why this is important for China and other emerging nations to develop in order for a multilateral framework to work effectively.

In Lesson Three we will further review Financial Intermediaries, which serve the purpose of bringing Savers and Users of Capital together.  We will broaden our understanding of why it is important for China to further develop its RMB denominated Financial Intermediaries for the purpose of creating Efficient RMB Capital Markets to work alongside USD denominated Capital Markets.

It is important to remember the differences between the Primary Market and the Secondary Market as we move forward.  For a quick review, the Primary Market deals with new issuance of securities, while the Secondary Market deals with already issued securities.

The full integrated financial market will consist of both the Primary and Secondary Markets, as well as Institutional Investors and Retail Investors.  Remember in Lesson One that Institutional Investors can consist of such Privately Traded Securities as pension funds and endowments.

A good method of remembering this is by segmenting each into blocks. Institutional Investors can deal in both the Primary (new issuance) Market and the Secondary (already issued) Markets, while Retail Investors (you and me) can only deal in the Secondary market.

Institutional Retail
Secondary Dealer Dealer
Primary Dealer Not Dealer

Now let’s look closer at some of the Financial Intermediaries, those Dealers which facilitate the process of transferring Capital from Savers to Users.

First, and largely, there are Investment Dealers.  These Dealers can service two positions.  In one position they act as a Principle and in another position they act as an Agent.

As a Principle the Dealer will maintain ownership over the security and realize a gain and loss over time.  There are three areas which are the focus of the Principle Dealer:

  1. Underwriting
  2. Inventory
  3. Proprietary Trading

Underwriting facilitates the process of transferring securities from the Primary Market to the Secondary Market. As a Dealer function, building and maintaining Inventory adds liquidity.  This will be a vital component of building broader renminbi liquidity in the international system.

As an Agent, the Dealer takes no ownership over the security and charges commission on all Secondary Market transactions.

Another type of Dealer of Financial Intermediaries are Banks.  All Banks serve under whatever national bank act regulates each nation.  As a part of the multilateral transition there are supra-sovereign banking regulations which have to be implemented in each region and nation.  The Basel 3 Regulations of the Bank for International Settlements serve in this function.

The Bank Acts, or Bank Regulations of most nations will consist of those banks which are incorporated within the nation, foreign bank subsidiaries which are incorporated in a nation, and foreign banks which only operate branches in a specific nation.

Trust Companies also serve as Financial Intermediaries by taking on most of the services of a retail bank, such as mortgages, but also acting as a trustee for private individuals or corporations.

Credit Unions are another form of Financial Intermediary.  These institutions have members as opposed to clients.  Under nation specific credit cooperative legislation, Credit Unions are limited to offering financial services to members only.

Insurance Companies can also serve as Financial Intermediaries.  As most know, insurance covers life and property, and serves the purpose of a trustee for funds from policy holders.

The rebalancing of the international monetary system will require a major alignment of independent financial systems of the major nations.  This alignment will require such legislation as the Basel 3 Regulations of the BIS, as well as the 2010 Quota and Governance Reforms of the International Monetary Fund.

China, now the world’s largest economy (at least second), has an underdeveloped financial system which needs to be evolved based on the liberalization of the renminbi and its rise to reserve status alongside the US dollar.  All of the items we are covering in this series are meant to help us understand our own domestic financial frameworks, as well as the changes which are taking place in the financial markets of China, India, and other emerging nations.

Each piece will build on the piece before, and readers will gain a more in-depth understanding of the other material which is presented here on POM.  For those interested in gaining a broader understanding of the Chinese financial system, the Brooking Institute recently (from a monetary change point of view) published an overview and introduction.

In the next installment of The Fundamentals of Multilateral Investing series we will begin reviewing financial regulation in more detail.  As the Basel 3 Regulations would suggest, a broader and deeper regulation of the world’s financial markets will be an important aspect of the multilateral monetary framework.  – JC