Unit 3: Financial Markets in Spain

Unit 3:
Financial Markets in Spain

Master in Professional
Development

Author: Juan Laborda y María Sanz

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 Unit 3: Financial Markets in Spain

INDEX

1. Introduction

2. General Description of the Financial System

2.1 The Role of Financial Assets

2.2 Primary Negotiable Assets
2.3 The Financial Markets

3. Institutional Description: Financial Markets in Spain

3.1 Interbank Market

3.2 Book-entry Government Bond Market
3.3 AIAF Private Fixed Income Market
3.4 Foreign Exchange Markets
3.5 Derivatives Markets
3.6 Regulatory Bodies
3.7 Financial Market Participants

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 Unit 3: Financial Markets in Spain

1 INTRODUCTION

The financial system of a country consists of its government institutions, media and markets,
and its primary goal is the channel the savings generated by lenders or surplus units towards
the borrowers or deficit units. This intermediation is carried out by the institutions that make up
the financial system and is essential for transforming the primary financial assets issued by
investors (for obtaining funds to increase their real assets) into indirect financial assets, which
tend to be preferred by savers.
To recap, the components of a financial system are:
- Government institutions (including monetary and financial authorities)
- The financial assets generated
encompass:
- The markets in which they operate To include
Therefore, a financial system encompasses the much, financial
to instruments or assets, the institutions
or intermediaries, and the financial markets: theinclude a
intermediaries buy and sell the assets on the
financial markets. wide or
In a market economy, the financial system serves comprehens
an essential purpose: it captures the surplus
of the savers (surplus units) and channels it to theivepublic
range.
or private borrowers (deficit units). This
task is essential for two reasons. The first is that there is generally no overlap of savers and
investors; in other words, deficit units are different and separate from surplus units. The second
is that the desires of savers and investors rarely coincide in terms of the degree of liquidity,
security and rate of return on the assets issued by the latter, and intermediaries must therefore
transform the assets to make them more appealing to savers.

2 General Description of the Financial

System

The financial system is a dynamic, constantly evolving mechanism; consequently, this overview
is merely a still shot from a never-ending film which one must watch continuously in order to
fully understand it.
In Spain, the highest authority on matters of financial policy is the national administration, and
its Ministry of the Treasury is responsible for all aspects related to the operation of financial
institutions.
This ministry exercises its authority through five executive bodies:
- Directorate-General of Trade Policy and Foreign Investments
- Bank of Spain
- Directorate-General of the Treasury and Financial Policy
- Directorate-General of Insurance
- Spanish Securities Market Commission (CNMV)
The most powerful institution of the five is the Bank of Spain given the size of the financial
institutions under its control and the volume of resources they handle, but also because it is
responsible for making and enforcing monetary policy with total independence from the national
administration or the Ministry of the Treasury, pursuant to the 1994 Bank of Spain Autonomy
Act.

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 Unit 3: Financial Markets in Spain

The Bank of Spain is directly responsible for overseeing the country’s credit institutions which,
in the strictest sense of the term, are characterised by the fact that in the normal course of their
business activity they are able to take possession of the funds of the general public in the form
of deposits or similar instruments, with the obligation of returning said funds at a future time,
and use them to extend credit or conduct similar transactions. This category includes the
following:
- The Official Credit Institute (ICO)
- Private banks
- Public banks
- Savings banks
- Credit cooperatives

Financial credit establishments, or limited-scope credit institutions, also fall under the
purview of the Bank of Spain. This category currently includes the following:
- Financing and Factoring Institutions
- Financial Leasing Companies
- Mortgage Credit Companies

Finally, the Bank of Spain oversees all mutual guarantee companies and the government
guarantee system, as well as some of our main financial markets (the interbank market, the
foreign exchange market and, in part, the book-entry government securities market [the latter is
also governed by the Spanish Securities Market Commission]).
According to economic theory, every economy has two kinds of markets:
a) The product market (goods and services)
b) The factor market (labour and capital)
The factor market includes the financial market—the place where financial assets are traded
and the pillar of any financial system. In the following sections we will look at the role of financial
assets, the financial markets, an institutional description of the same, the regulatory bodies, and
financial market participants.

2.1 THE ROLE OF FINANCIAL ASSETS

A financial asset is an intangible asset whose value derives from the right to obtain a future
profit. The party who issues the security—the issuer—accepts a future monetary obligation, and
the party who acquires the security—the investor—obtains future monetary rights. These future
monetary commitments may:
- Depend on the returns obtained by an economic entity (variable income)
- Be unaffected by said returns (fixed income)
It is important to note that this status does not depend on whether the commitments are
quantified in a fixed or variable manner.
The fundamental role is to achieve a balance between economic units with current resources
and those with a promise of generating resources in the future. To this end, securities are
issued.
The second mission is to achieve a balance between units invested in the past but with a
current need for resources and economies with a surplus of resources in need of investments.
This is where the financial assets trading markets come in.

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 Unit 3: Financial Markets in Spain

2.2 PRIMARY FINANCIAL ASSETS

VARIABLE INCOME

Ordinary Shares: these represent equal parts in the ownership of a company. They carry
financial and voting rights (dividends, premiums, right of first refusal, etc.). We must differentiate
between:
- Par or face value
- Market value
- Book value
Preferred Shares: these represent equal parts in the ownership of a company. They carry
exclusively financial rights on dividends, which are usually established in advance.

 FIXED INCOME
Debentures or bonds: these represent equal parts of the debt of an economic unit. They carry
financial rights not subject to profits (coupons, premiums, etc.). We must differentiate between:
- Face value vs. Market value
- Stated interest rate vs. Cash flow discount interest rate
- Maturity
- Implicit vs. Explicit coupon
- Senior vs. Subordinated
- Fixed vs. Variable coupon

2.3 THE FINANCIAL MARKETS

A financial asset is an intangible asset whose value derives from the right to obtain a future
profit. The party who issues the security—the issuer—accepts a future monetary obligation, and
the party who acquires the security—the investor—obtains future monetary rights. These future
monetary commitments may:

- Depend on the returns obtained by an economic entity (variable income)

- Be unaffected by said returns (fixed income)

It is important to note that this status does not depend on whether the commitments are
quantified in a fixed or variable manner.
The financial market is the place or channel where financial assets are exchanged. It serves
three main purposes.

- It determines the price based on supply and demand

- It gives financial instruments liquidity
- It cuts transaction costs:

o Sourcing costs
o Information costs

The price of a financial asset is based on the discounting of expected cash flows. Therefore, the
concept of price depends on the expectation of future returns. The type of financial asset

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 Unit 3: Financial Markets in Spain

determines cash flows and their expected performance. When pricing an asset, we must
consider:

- Risk-free rate of return

- Bankruptcy risk
- Fixed income – variable income
- Inflation
- Variance risk

With regard to the lifetime of the assets, we must differentiate between:

- Primary markets, where recently issued assets are traded.

- Secondary markets, where already issued assets are traded.

According to structure:

- Auction markets
- OTC markets
- Intermediated markets

According to delivery date:

- Spot markets
- Forward markets (primarily dealing with derivatives)

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The most generic system of classification differentiates between

primary and secondary markets.
 The primary market is where a company goes to issue a large
number of securities publicly and quickly. Securities placement is faster
and cheaper in the primary market.
The major players in this arena are usually investment banks which:
 Give the issuer advice with regard to timing and pricing
 Purchase the issued securities
 Market the securities
The bank charges a fee, which is the difference between the price paid
to the issuing company and the price it receives for the sale of the
securities. The process usually involves an underwriting syndicate:
 Lead bank
 Underwriting co-managers
 Marketing co-managers

 The secondary market is where people go to trade securities

after they are initially offered on the primary market and so obtain
liquidity. Transactions are quicker, cheaper and more specific on the
secondary market.
The organised market is known as the securities market or stock
exchange. The success of these markets depends on how efficiently
they are able to do the following:
 Provide liquidity: the easier the trading, the greater the
volume of transactions.
 Allow investors to have a say in how companies are run.
 Determine the value of financial instruments.
 Act as barometers of the general economy.

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3 INSTITUTIONAL DESCRIPTION:
FINANCIAL MARKETS IN SPAIN

3.1 INTERBANK MARKET

The interbank market is the top-level “money-making” money. Participants in this market
include:

- The central bank of each geographic area

- Banks and credit institutions

The key figure in this market is the central bank, which periodically organise auctions. At these
auctions the central bank issues funds and subsequently proceeds to “remove” or “inject”
liquidity.
It can therefore be described as a loan market, where the life of the loans is set in advance. The
average rate at which loans are traded is called the Euribor.

3.2 BOOK-ENTRY GOVERNMENT BOND

MARKET
ISSUE SYSTEM

- Bonds are issued publicly once a month. Participants wishing to purchase bonds submit
their bids through debt brokers, specifying the desired volume, price and financial
instrument.
- The treasury classifies these requests, establishing a cut-off price that it deems
acceptable and eliminating all requests below that threshold.
- The highest accepted price is known as the marginal rate, under which all orders are
placed.
- The average rate is the arithmetical average of all accepted bids and is established as
the highest accepted bid made by an investor at the auction.

PRINCIPAL CHARACTERISTICS

- The purpose of the primary government bond market is to obtain liquidity for a country’s
public debt.
- Participants are the market creators, the Spanish Treasury and the Bank of Spain.
- All participants are electronically connected and operate via authorised brokers.
- Market creators are required to complete a certain number of transactions and provide
fixed prices to act as public debt indicators.

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3.3 PRIVATE FIXED INCOME MARKET

PRINCIPAL CHARACTERISTICS

- This is the official secondary market on which fixed-income assets are traded. It was
created to permit the trade of fixed-income assets of any duration other than
government bonds.
- The market creates liquidity for fixed-income issues and avoids the high costs
associated with trading on the stock exchange.
- Clearing is based on the book-entry system.

3.4 FOREIGN EXCHANGE MARKETS

PRINCIPAL CHARACTERISTICS

- Foreign exchange markets are where one currency is exchanged for another.
- The primary currencies are the dollar, the euro, the pound sterling, and the yen. Other
currencies are of secondary importance, although the Chinese yuan is steadily gaining
ground.
- In these markets, currencies are traded in two ways:

o Spot
o Forward (depends on the interest rate differential)

- These are usually off-exchange markets where transactions are negotiated by phone.
- There are two kinds of regimes in foreign exchange markets:

o Floating exchange rate or non-intervention regime: Currency parity is

determined by the strength of supply and demand.
o Intervention regime: A government authority establishes currency parity.

 Fixed exchange rate: the government dictates currency prices (China).

 Dollarization: a more important foreign currency is used parallel to or
instead of the national currency (Argentina).
 Crawling bands: the currency rate is allowed to fluctuate in a band
around a central value (Brazil). This band can be fixed or flexible over
time.

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3.5 DERIVATIVES MARKETS

DEFINITION OF EXCHANGE-TRADED DERIVATIVES MARKETS

- Instruments are traded in a regulated manner.

- Guarantee funds that can be updated daily according to the evolution of the underlying
asset (profit/loss adjustment)
- Clearing house which clears completed transactions, acting as the intermediary and
counterparty to both buyer and seller.
- Example: MIFF (Spanish Futures & Options Exchange)

DEFINITION OF OTC DERIVATIVES MARKETS

- Private contract between two parties in which they agree to a transaction involving an
asset where the payoff depends on the performance of an underlying asset. The payoff
can be made in cash based on differences or by delivering the underlying asset.
- Counterparty risk, where there is no profit-and-loss margin
- No clearing house to handle transactions
- No third-party intermediation between the parties
- No regulated trading: problems
o Transfer to a third party
o Valuation price

MOST COMMON TRADABLE DERIVATIVES

- Exchange-traded futures on underlying financial assets: interest rates, exchange

rates, shares, dividends or stock market index.
- Exchange-traded options on the abovementioned assets.
- Forwards on the abovementioned assets, not traded on exchanges.
- Options on any of the abovementioned assets not traded on exchanges, also known
as over-the-counter or OTC options.
- Specific and habitual OTC derivatives and options such as warrants, caps, floors,
etc.
- Various types of swaps or contracts to exchange cash flows.
- Structured notes
- Credit derivatives

Let us take a brief look at these different derivatives:

 EXCHANGE-TRADED FUTURES ON UNDERLYING FINANCIAL ASSETS:

interest rates, exchange rates, shares, dividends or stock exchange index.
- A future is a contract whereby one party (the buyer) commits to sell another party
(the seller) a specific commodity—in this case, a financial asset.
- These futures are characterised by the fact that they are traded on organised
exchanges and they involve a PROFIT/LOSS SETTLEMENT.

 EXCHANGE-TRADED OPTIONS ON THE ABOVEMENTIONED ASSETS

- Contract whereby one party (option buyer) gains the right to buy or sell and the other
party incurs the obligation to fulfil the requested transaction.
- The buyer’s loss is limited to the payment of a premium.

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- These options are characterised by the fact that they are traded on organised
exchanges and they involve a PROFIT/LOSS SETTLEMENT for the issuer with
limited counterparty risk.

FORWARD

- A forward is a contract whereby one party (the seller) commits to sell a specific
asset—in this case, a financial asset—to another party (the buyer) at an agreed
price.
- Forwards are characterised by the fact that they are not traded on organised
exchanges and they do not involve a PROFIT/LOSS SETTLEMENT.

OTC OPTIONS

- Options on the abovementioned assets traded on non-organised markets.

- Private contract whereby one party (option buyer) has the right to buy or sell and the
other party incurs the obligation to fulfil that request.
- The buyer’s loss is limited to the payment of a premium.
- These options are characterised by the fact that they are not traded on organised
exchanges and they do not involve a PROFIT/LOSS SETTLEMENT for the issuer with
unlimited counterparty risk.

STRUCTURED NOTES

- Definition: asset consisting of a current note and one or more derivative assets.
- Valuation is the sum of the:

o Estimated value of the note itself

o Estimated value of the derivative/s

- Example: Convertible bonds:

Fixed income + Call option

Bond Price
Price of
Premium Price
Convertible
Bond

PUBLICLY-TRADED WARRANTS

- Publicly issued assets governed by a trade regulation regime

- Widely traded on the market
- Must be listed for a minimum number of days
- Price-setters

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3.6 REGULATORY BODIES

BANK OF SPAIN

- The Bank of Spain is the authority responsible for supervising all banks and credit
institutions in Spain.
- It monitors and regulates the products offered and the institutions that participate in the
credit market.
- It inspects both products and the credit institutions themselves.
- The Bank of Spain has regulatory as well as supervisory powers and can even
intervene in certain situations.

SPANISH SECURITIES MARKET COMMISSION (CNMV)

- The CNMV is responsible for supervising Spain’s financial markets and the specialised
agents that operate therein.
- It monitors and regulates:

o The markets
o Transactions completed

- The CNMV is authorised to inspect the markets and its agents, but it also has regulatory
powers and can even intervene in certain situations.
- It is also has authority over all collective investment institutions in Spain.

DIRECTORATE-GENERAL OF INSURANCE (DGI)

- The DGI is responsible for supervising all Spanish insurance companies.

- It monitors and regulates the provision of insurance products as well as the investment
processes of these companies.
- In addition to performing inspections, the DGI has regulatory powers and can even
intervene in certain situations.
- It also has authority in the area of pensions and retirement funds.

3.7 FINANCIAL MARKET PARTICIPANTS

CREDIT INSTITUTIONS

The most important participants in investment markets are credit institutions, banks and savings
banks. They act primarily as financial intermediaries: they use different assets to capture funds
from the general public (who have a surplus of resources) and lend these resources to others
(who have a deficit of resources).

They therefore have a dual role as:

- Creators of financial assets: shares, bonds and bank funds (of any kind)
- Investors: loans, holders of financial assets

They also participate in financial markets as intermediaries.

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In addition to channelling savings, credit institutions provide other useful services:

- They market financial products: investment funds, pension funds, insurance, etc.
- They handle bill payment and collection for their customers
- They safeguard financial assets
- They process buy and sell orders of financial products
- They convey the monetary policy of the central bank to the larger financial markets

FINANCIAL CREDIT ESTABLISHMENTS

Financial credit establishments are financial institutions that cannot capture repayable funds
from the general public (whether in the form of loans, deposits, temporary transfers, or any
similar product).

These are special public limited companies whose principal business activity/ies are regulated
by law: providing credit or loans, providing guarantees, financial leasing, factoring and issuing
and managing bank cards.

Financial credit establishments tend to advertise quite heavily. Their aim is to attract customers
who urgently need a limited amount of money (they cannot provide loans in excess of 3,000
euros) and who are willing to pay—though they are not always aware of it—high interest rates,
often over 20% APR (Annual Percentage Rate). The growing rate of consumer debt among
Spanish families, now between 80 and 90% of gross disposable income according to the Bank
of Spain, has driven many people to resort to these establishments.

FINANCIAL DEALERS AND BROKERS

These are financial intermediaries authorised to participate in the financial markets.

Their primary purposes are:

- To trade on primary markets

- To trade on secondary markets
- To act as intermediaries on behalf of third parties
- To act as investors on their own behalf

The main difference between the two is that financial dealers can buy and sell assets for
themselves as well as their customers, while brokers can only act on behalf of their customers.

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