The circular flow of money
How does money work in today’s world?
People are typically familiar with stocks, bonds, real estate etc. People are usually know the basics about banks, mutual funds etc. But usually, no one can describe why they exist and how does it all connect.
Money today works similar to how it has for hundreds of years. Essentially — all the money in the world, stays within the world. It’s a closed loop. Simplistically, it just changes hands.
Ultimately it sits with 3 types of entities:
1. People who have it — Employees with personal savings, companies with excess cash, pension funds with retirees’ contributions and governments with tremendous reserves.
2. People who need it — Start-ups looking to grow, people who need to buy homes, companies who need money to expand into new markets or even governments who need money to facilitate infrastructure projects.
3. People who connect the haves with the have nots — banks & money managers
Why do these 3 types of entities exist?
· People who have it — Employees get it from their workplace in salary or bonuses. Governments can issue their own currency or hold those of other governments. Companies like Apple make substantial amounts of profit each year which are its own savings.
· People who need it — Governments need money from either their own citizens or foreigners to build infrastructure, finance ongoing operations etc. Examples would be municipal bonds (states borrowing from their own citizens) or US Treasuries (Japan & China being the US’ largest creditors). Money is also needed to either start, maintain or grow businesses. A entrepreneur needs to money to start a new business or a middle sized company may need it to grow its product set or enter new markets.
· People who connect — You need someone to connect the ones who have money with those that need money. This is where the finance sector and Wall Street broadly sits. They are the middlepersons who connect the two sides and make money by taking a percentage cut of assets managed, an upfront arrangement fee or a share of profits.
Lets look at each category in detail with examples
The ones with the money
1. Employees: The average person working a job with salary/bonuses is in this category. After spending on needs and wants, they keep the remaining in a bank or credit union as cash or under their mattress. For their trouble, they earn a very small amount of interest but know their money is generally safe.
2. Ultra High new worth individuals: These are individuals with a total net worth of USD 50m or more. Nowadays to truly be “in the club”, USD 100m is the benchmark. This group tends to leading business owners. They’ve found a need no one is serving and providing a high quality solution to a great number of people for a long time. They include technology services, industrial packaging, supplying palm oil, senior management of companies, to full-time investors and fast food franchise owners. Many have a small, trusted team of people working on their administrative, tax, legal and investment matters in a “family office”
3. Governments: Though it’s well known that most governments are cash strapped rather than cash rich, it’s important to recognize sovereign wealth funds. This is the arm of the government that is responsible to grow and protect the country’s savings or the collective savings of individuals kept with the government as pensions/retirement funds. Famous examples would be Norway’s Government Pension Fund (USD 1 trillion), Singapore’s GIC (USD ~390 billion) & Qatar Investment Authority (USD ~320 billion).
4. Corporations: Large, well established companies often have more money than they know what to do with. The extra cash in their own savings accounts can be used for investments. This is not the main operations of the company but to ensure they are earning some return on their cash, they can put it to use.
The ones who need the money
1. Governments: Ever hear of Venezuela, Greece or Argentina? If so, you’ve heard of countries who have trouble meeting their bills and need additional borrowing to pay their current loans. Outside of global institutions like the World Bank and International Monetary Fund, they can try and raise money via bonds from individuals and institutions. They offer very high returns but if you lend them money, you’re also taking a lot of risk of not being paid back. Even more stable governments need money such as the US via its Treasury bond auctions. However these are routine, lower return securities as opposed to “crisis finance” Argentina, Greece and Venezuela have faced in the past.
2. Companies: Say a company like Johnson & Johnson needs money to research new medicines. They could either spend their own savings or borrow from outside the company if it isn’t very costly. They could promise to return you money in 5, 10, 20 or 30 years. You’d earn a return higher than your bank’s savings account and take the risk of Johnson & Johnson not paying you back. Alternatively, if you’ve just graduated college without any savings but have a brilliant, actionable idea on the next big thing in technology, you need money to hire personnel, rent an office etc. There are people who would give you funds for a share of future profits.
Who connects them
1. Banks:
a. Mega banks
Like J.P. Morgan, Bank of America, Wells Fargo, DBS, Sumitomo & Citibank are a one stop shop for finance needs of individuals and institutions.
b. Retail Banking:
They provide day to day checking & saving accounts and credit cards for the average person. From the excess deposit cash they have, they loan it out for home loans to individuals. Earning the difference in rates given vs rates charged. For larger sized accounts, they also provide investments execution and broader wealth management. They can be independent institutions or a sub-division of a megabank.
c. Corporate Banking:
Banks arrange credit and loans for companies from something as short as overnight to daily operational financings as well as long term borrowings. They are typically a sub-division of a megabank.
d. Private Banks:
Ultra high net worth individuals who typically have USD 5 million to USD 500m to invest. They have dedicated advisors at these banks who help them invest to meet their needs (protect the money, grow it moderately, provide a certain income or grow it aggressively). They can be independent institutions or a sub-division of a mega-bank.
e. Investment Banks:
One part of the investment bank deals with public securities i.e. stocks, bonds, currencies. It provides brokerage services, research and trading color to institutional clients. The second deals in confidential deals to help companies be born (initial public offerings), grow and mature (arranging borrowing, further stock issuances) and then fix them when they get old or face problems (restructuring advisors who help fix operational and financial issues so a company remains solvent or dies with dignity). They can be independent institutions or a sub-division of a mega-bank.
2. Money Managers:
a. Index Funds & ETFs:
Administered by large firms like Vanguard, Fidelity and Blackrock, these passive instruments follow stock market indices. Indices are essentially a collection of stocks and the index’s value changes as a reflection of the total change in the value of its underlyings. ETFs and index funds have become very popular since post the 2008 crisis because of their ease of use, low cost and belief that it is better to follow the market than try and beat it. In the end, every dollar invested in an ETF is invested in the underlying companies according to their percent allocation to each stock or bond. Money comes from anyone with a brokerage account or investments portfolio.
b. Mutual Funds:
People who believe they can do better than the market or dedicate themselves to achieving a specific financial aim. In reality, nearly all large finance institutions have their own mutual fund managers for nearly every sector or geography. Only a few consistently beat the market and this is especially true in the past few years. Higher costs have been a drag on performance but there are many benefits of having a human watch over your wealth. Mutual funds can invest in stocks or bonds and the manager selects what goes into the fund. Most 401k programs in the US use these funds as do most unit trusts or annuity products. These can be bought and sold daily. Many retail and institutional investors use these.
c. Hedge Funds:
Hedge funds were meant to be the best investors in finance employed to give returns that were not connected to public markets and with lower risk. Typically they would buy one stock and sell another, making money on both sides of the trade while eliminating risk. Since this “long/short” strategy, other type of funds have emerged making money from mergers, interest rates, currencies and fixed income. Some are even fully driven by algorithms where computers apply pre-set rules to trades hundreds of times a second. These are generally open to “accredited investors” or essentially ultra high net worth individuals and institutions who could give managers broad leeway in complex techniques.
d. Private Equity:
Like the name implies, these managers don’t trade public securities like Apple stock, US Treasury bonds or USD/JPY currency. Their strength lies in understanding a company’s potential, buying private businesses (or taking public ones private), fixing their problems and selling them to someone for more than they bought them for. They raise money from endowments, ultra-high net worth individuals, sovereign wealth funds and other large institutional pools of capital. Investors are usually locked up for 10 years where the first 5 years are spent buying new businesses and the remainder, selling them. All investors in one “vintage” or raise, follow the same legally binding capital requests and distributions.
e. Venture Capital:
A sub-set of private equity, generally accredited investors give money to venture capital funds. These funds are specialists at finding very small companies and giving them money for a part ownership in their company. Think entrepreneurs starting businesses in their garage and growing a company to a few hundred employees. VCs take the approach of investing a little in many companies and hope at least a few become mega successes. Facebook, Uber, Grab, Didi, AirBNB all are examples.
In summary, there are people with money and those who want money. The field of “finance” comprises of entities and individuals who bridge that gap and charge fees for that service. The above is a fairly comprehensive list of the main players involved. Many times, those with money are also those who need it. Hence, the circular flow of money.
