Usually, the business entities and governments are fund deficit units and require funds to finance their capital and operational expenditure. The householders as a group are net savers and channelise their savings to the other units through the mechanism of the financial markets. 

The financial system basically facilitates transfer of funds form the cash surplus economic units to those who need it, and does it in the most efficient manner This fund transfer from the surplus units to deficit units may be done in one of the two ways – directly or through financial intermediaries such as banks or insurance companies.  

In case of direct transfer, the deficit units sell financial claims on themselves, which are purchased by the surplus units. An example is the debentures issued by a company. These debentures are sold at a price. These represent financial claims on the issuing company in the form of a promise to pay periodic interest and principal repayment. This method is more cost efficient as no intermediary costs are involved here. However, deficit and surplus units may not be in a position to access each other directly. E.g. the households are interested in a wide array of assets, and evaluate investment vehicles based on their return, risk characteristics as well as tax treatment. The corporate houses want to get the best possible price and keep the cost of funds as low as possible.

Financial intermediaries (FI) such as banks and insurance companies help bring these two together. They pool funds from the investors, invest money on a large scale. They are able to diversify their asset base that is rather difficult for individual investors. These intermediaries also gain expertise in the course of their business that enables them to give a better deal to the investors. In fact, FI typically provide four different types of intermediation services. Thus, FI are able to reap the benefits of Economies of Scale, Lower Transaction Costs, and Reduction in Information Costs due to their intimate knowledge of finance. 

Financial markets can be over the counter (OTC) or organized. In case of an OTC market, the buyer and seller directly meet each other, may negotiate the price and strike the deal. In case of organized markets (say securities exchanges), buyers and sellers give their price quotes and the exchange facilitates matching of buy and sell orders based on compatibility of price quotes. In fact, the same instrument may be traded either way. For example, if an investor buys units of a mutual fund directly from the fund, it is OTC.

However, units of certain mutual funds are also listed and traded on the securities exchange. The term `financial market’ refers to the means through which buyers and sellers are brought together to transact the financial products.