When borrowers borrow funds directly from the financial market without using a third-party service, such as a financial intermediary, it is called direct finance. Brokers, dealers, and investment bankers play essential roles in direct financing. This method is different from indirect financing, where a financial intermediary takes the money from the lender against a set interest rate and then lends it to a borrower against a higher interest rate. This enables the borrower to take advantage of lower interest rates. For example, in a household which buys a newly issued government bond through the services of a broker, the bond is sold by the broker in its original state.
In the United States,
Of new bonds issued in the market, less than 5% are sold directly to Households. Direct household participation in the bond market has fallen to 1.3% in 2016, from a low of 5% in 1989, according to a recent study by the St. Louis Federal Reserve.
Of new stocks issued in the market, approximately 50% are sold directly to Households.
Problems with Direct Finance
1. Transaction Costs
Direct finance leads to transaction costs.
2. Information Costs
There are information costs i.e. problems with Asymmetric Information associated with direct finance. Asymmetric Information arises because there is unequal knowledge that each party to a transaction has about the other the party. This creates an imbalance in the transaction.