These entities bring knowledge and expertise along with the ability to match buyers and sellers. In return for this service, they take a fee. This could be in the form of a commission, transaction fee, or a management fee.
Some refer these to these institutions as being "rent seekers" since they take a portion of the proceeds.
Types of Financial Intermediaries
- Commercial Banks
- Investment Banks
- Credit Unions
- Pension Funds
- Insurance Companies
- Mutual Funds
- Stock Exchanges
- Clearing Houses
- Financial Advisors
These institutions typically take capital that was not invested and direct it to enterprises through a variety of debt, equity, or hybrid stakeholding structures. This often includes the pooling of securities or other assets.
Corporations tend to be well established firms with the infrastructure required to operate on a global scale. This means being tapped into different financial networks that maintain ledgers of the financial transactions occurring on its system.
- Asset Storage - this can be cash and coins as well as gold or other precious metals. Deposits are also held and custodian services for securities.
- Loans - short and long term lending. This can be auto, mortgages, and the repo market
- Investments - firms engage in the sale of stocks, bonds, derivatives, and commodities
Through financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. This is the process of shifting money from savers, those with excess capital, to those in need of liquid assets. These are typically called investors.
The U.S. Treasury market is one of the most liquid financial markets in the world, and Treasury bonds have long been considered a safe haven for global entities. This is often done using repurchase agreements.
Internationally, this is known as the Eurodollar system. Financial institutions often enter into agreements to gain access to assets that serve as collateral in financial transactions. Banks and other entities often serve as warehouses for securities through direct purchase, collateral transformation, and repledge agreements.
This form of financial intermediation is responsible for he overwhelming majority of short term funding. It is here we funds are acquired to facilitate over 90% of global trade.
Global Financial System
The financial system is responsible for the movement of financial assets. These are a reflection of risk which means the system is nothing more than moving risk from those who do not want it to those who are willing to take it one. Different assets are used to move this around.
Financial intermediaries facilitate these different layers, forming an expansive ecosystem of entities providing services.
The rise of FinTech (Financial Technology) added another aspect to financial intermediation. In the past, this was a human-centric activity. Communication was done between people, mostly through phone calls. There were human traders on the floors of exchanges actually facilitating trades on behalf of clients.
This changed with the advancement of computers. Now machines have often replaced people. For the average person, this means interacting with an application or website. Brokerage firms built out platforms that enable customers to trade assets without interacting with people.
Industries saw the online applications become the major players. The mortgage industry saw the rise of companies such as Rocket Mortgage and Quicken Loans. These are mortgage originators that basically advertise the application in an effort to drive people there.
Over the last two decades, financial intermediation went digital. This was a trend implemented by both start ups and existing financial houses.
Blockchain And Digital Assets
Many believe the next step in the evolution is blockchain. This seeks to alter the financial landscape once again in that it eliminates/reduces financial intermediation.
Blockchains utilize distributed ledger technology (DLT). This means that the ledger is controlled by an unrelated set of node operators. The decentralization of the network means there is no intermediary in the process (other than the blockchain).
With digital wallets, the function of a bank is replicated. Banks allow people to send, receive, and store money. This is what a digital wallet provides.
Coins or tokens can be used as a medium of exchange between different individual (or businesses) without any 3rd party. The same is true for payment systems. Remittance can be made directly to a merchant without the need to deal with an entity such as Visa.
Decentralized Finance (DeFi)
Digital wallets are just the basis for the evolution of decentralized finance. This is the transition away from a system full of intermediaries. The idea is to reduce friction while eliminating counterparty risk.
One of the main areas is relating to exchanges. The traditional financial system as well as the early days of cryptocurrency saw centralized exchanges(CEX) dominating. DeFi is based upon the idea of people being able to swap assets without the need for centralization. Here is where concepts such as decentralized exchanges (DEX) and liquidity pools enter. This reduces the need to depend upon centralized entities.
The concept is believed to be applicable to all financial services. For example, people are experimenting with insurance pools as a way to decentralize the insurance industry. There are also projects relating to real estate, seeking to provide fractional ownership.
- non-fungible (NFTs)
Each can perform a different service in the transformation from a centralized financial system to one that is decentralized.
Non-fungible tokens (NFT) can provide digital ownership. Through the tokenization process, liquidity can be provided enabling assets to be collateralized and traded in a much easier manner. This can apply to real world assets.
The main premise of blockchain is peer-to-peer transactions. Decentralized exchanges allow for the joining of buyers and sellers without a financial intermediary.
A major advantage of blockchain is was created in the digital realm. This means it is global in nature. Cross border payments do not exist since the network does not recognize national boundaries. This is a major step forward since the international payment and money transfer system is rather poor. It is slow, expensive, and inefficient.
Cryptocurrency built on top of blockchain and provide decentralized financial services could be a major disruption.
Few people consider this when engaging in a transaction.
For example, few companies considered the implication of putting their payroll dollars in Silicon Valley Bank. The idea of insolvency did not enter the minds of these business owners. Under US regulation, the banks take out insurance with FDIC. This covers up to $250K in deposits.
The problem is that payroll accounts for many companies exceed this. When the bank went insolvent, many were at risk of losing their money.
Some names that exemplify this are:
It is obvious that more than depository institutions carry counterparty risk. Financial products are created by entities, either financial institutions or governments (as is the case with sovereign debt). There is always a risk of default, even if minimized.
When dealing with investment, especially fixed income instruments, investors will require a higher return, often in the form of an interest rate, to buy the asset. Bonds are an example of where the corporation issuing has to pay more interest to attract money if default is great. When the financial statements are pure, Wall Street institutions will not accept low returns.
These are known counterparty risks. There are a lot within the financial system that people are not aware of.
A population can suffer if a government debases its currency. Fractional reserve banking does aid in this since the expansion of the money supply is mostly out of the governments hands. It does add a different form of risk since the banks run the ledger.
Reduction of financial intermediaries reduced counterparty risk.