Capital market

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The trading floor of the New York Stock Exchange, one of the largest secondary capital markets in the world. Most of the trades on the New York Stock Exchange are executed electronically, but its hybrid structure allows some trading to be done face to face on the floor. NYSE-floor.jpg
The trading floor of the New York Stock Exchange, one of the largest secondary capital markets in the world. Most of the trades on the New York Stock Exchange are executed electronically, but its hybrid structure allows some trading to be done face to face on the floor.

A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, [1] in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. [lower-alpha 1] Financial regulators like Securities and Exchange Board of India (SEBI), Bank of England (BoE) and the U.S. Securities and Exchange Commission (SEC) oversee capital markets to protect investors against fraud, among other duties.

Contents

Transactions on capital markets are generally managed by entities within the financial sector or the treasury departments of governments and corporations, but some can be accessed directly by the public. As an example, in the United States, any American citizen with an internet connection can create an account with TreasuryDirect and use it to buy bonds in the primary market. However, sales to individuals form only a small fraction of the total volume of bonds sold. Various private companies provide browser-based platforms that allow individuals to buy shares and sometimes even bonds in the secondary markets. There are many thousands of such systems, most serving only small parts of the overall capital markets. Entities hosting the systems include investment banks, stock exchanges and government departments. Physically, the systems are hosted all over the world, though they tend to be concentrated in financial centres like London, New York, and Hong Kong.

Definition

A capital market can be either a primary market or a secondary market. In a primary market, new stock or bond issues are sold to investors, often via a mechanism known as underwriting. The main entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies). Governments issue only bonds, whereas companies often issue both equity and bonds. The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on their own behalf. In the secondary market, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary markets increases the willingness of investors in primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises. [2]

A second important division falls between the stock markets (for equity securities, also known as shares, where investors acquire ownership of companies) and the bond markets (where investors become creditors). [2]

Versus money markets

The money markets are used for the raising of short-term finance, sometimes for loans that are expected to be paid back as early as overnight. In contrast, the "capital markets" are used for the raising of long-term finance, such as the purchase of shares/equities, or for loans that are not expected to be fully paid back for at least a year. [1]

Funds borrowed from money markets are typically used for general operating expenses, to provide liquid assets for brief periods. For example, a company may have inbound payments from customers that have not yet cleared, but need immediate cash to pay its employees. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long term. [2]

Together, money markets and capital markets form the financial markets, as the term is narrowly understood. [lower-alpha 2] The capital market is concerned with long-term finance. In the widest sense, it consists of a series of channels through which the savings of the community are made available for industrial and commercial enterprises and public authorities.

Capital market versus bank loans

Regular bank lending is not usually classed as a capital market transaction, even when loans are extended for a period longer than a year. First, regular bank loans are not securitized (i.e. they do not take the form of a resaleable security like a share or bond that can be traded on the markets). Second, lending from banks is more heavily regulated than capital market lending. Third, bank depositors tend to be more risk-averse than capital market investors. These three differences all act to limit institutional lending as a source of finance. Two additional differences, this time favoring lending by banks, are that banks are more accessible for small and medium-sized companies, and that they have the ability to create money as they lend. In the 20th century, most company finance apart from share issues was raised by bank loans. But since about 1980 there has been an ongoing trend for disintermediation, where large and creditworthy companies have found they effectively have to pay out less interest if they borrow directly from capital markets rather than from banks. The tendency for companies to borrow from capital markets instead of banks has been especially strong in the United States. According to the Financial Times , capital markets overtook bank lending as the leading source of long-term finance in 2009, which reflects the risk aversion and bank regulation in the wake of the 2008 financial crisis. [3]

Compared to in the United States, companies in the European Union have a greater reliance on bank lending for funding. Efforts to enable companies to raise more funding through capital markets are being coordinated through the EU's Capital Markets Union initiative. [4] [5] [6] [7]

Examples

Government on primary markets

One Churchill Place, Barclays headquarters in Canary Wharf, London. Barclays is a major player in the world's primary and secondary bond markets. Barclays HQ.jpg
One Churchill Place, Barclays headquarters in Canary Wharf, London. Barclays is a major player in the world's primary and secondary bond markets.

When a government wants to raise long-term finance it will often sell bonds in the capital markets. In the 20th and early 21st centuries, many governments would use investment banks to organize the sale of their bonds. The leading bank would underwrite the bonds, and would often head up a syndicate of brokers, some of whom might be based in other investment banks. The syndicate would then sell to various investors. For developing countries, a multilateral development bank would sometimes provide an additional layer of underwriting, resulting in risk being shared between the investment bank(s), the multilateral organization, and the end investors. However, since 1997 it has been increasingly common for governments of the larger nations to bypass investment banks by making their bonds directly available for purchase online. Many governments now sell most of their bonds by computerized auction. Typically, large volumes are put up for sale in one go; a government may only hold a small number of auctions each year. Some governments will also sell a continuous stream of bonds through other channels. The biggest single seller of debt is the U.S. government; there are usually several transactions for such sales every second, [lower-alpha 3] which corresponds to the continuous updating of the U.S. real-time debt clock. [8] [9]

Company on primary markets

When a company wants to raise money for long-term investment, one of its first decisions is whether to do so by issuing bonds or shares. If it chooses shares, it avoids increasing its debt, and in some cases the new shareholders may also provide non-monetary help, such as expertise or useful contacts. On the other hand, a new issue of shares will dilute the ownership rights of the existing shareholders, and if they gain a controlling interest, the new shareholders may even replace senior managers. From an investor's point of view, shares offer the potential for higher returns and capital gains if the company does well. Conversely, bonds are safer if the company does poorly, as they are less prone to severe falls in price, and in the event of bankruptcy, bond owners may be paid something, while shareholders will receive nothing.

When a company raises finance from the primary market, the process is more likely to involve face-to-face meetings than other capital market transactions. Whether they choose to issue bonds or shares, [lower-alpha 4] companies will typically enlist the services of an investment bank to mediate between themselves and the market. A team from the investment bank often meets with the company's senior managers to ensure their plans are sound. The bank then acts as an underwriter, and will arrange for a network of brokers to sell the bonds or shares to investors. This second stage is usually done mostly through computerized systems, though brokers will often phone up their favored clients to advise them of the opportunity. Companies can avoid paying fees to investment banks by using a direct public offering, though this is not a common practice as it incurs other legal costs and can take up considerable management time. [8]

Secondary market trading

An employee at the Deutsche Borse. Most 21st century capital market transactions are executed electronically Deutsche-boerse-parkett-ffm008.jpg
An employee at the Deutsche Börse. Most 21st century capital market transactions are executed electronically

Most capital market transactions take place on the secondary market. On the primary market, each security can be sold only once, and the process to create batches of new shares or bonds is often lengthy due to regulatory requirements. On the secondary markets, there is no limit to the number of times a security can be traded, and the process is usually very quick. [lower-alpha 5] Transactions on the secondary market do not directly raise finance, but they do make it easier for companies and governments to raise finance on the primary market, as investors know that if they want to get their money back quickly, they will usually be easily able to re-sell their securities. Sometimes, however, secondary capital market transactions can have a negative effect on the primary borrowers: for example, if a large proportion of investors try to sell their bonds, this can push up the yields for future issues from the same entity. An extreme example occurred shortly after Bill Clinton began his first term as President of the United States; Clinton was forced to abandon some of the spending increases he had promised in his election campaign due to pressure from the bond markets [ citation needed ]. In the 21st century, several governments have tried to lock in as much as possible of their borrowing into long-dated bonds, so they are less vulnerable to pressure from the markets. Following the financial crisis of 2007–08, the introduction of quantitative easing further reduced the ability of private actors to push up the yields of government bonds, at least for countries with a central bank able to engage in substantial open market operations. [8] [10]

A variety of different players are active in the secondary markets. Individual investors account for a small proportion of trading, though their share has slightly increased; in the 20th century it was mostly only a few wealthy individuals who could afford an account with a broker, but accounts are now much cheaper and accessible over the internet. There are now numerous small traders who can buy and sell on the secondary markets using platforms provided by brokers which are accessible via web browsers. When such an individual trades on the capital markets, it will often involve a two-stage transaction. First they place an order with their broker, then the broker executes the trade. If the trade can be done on an exchange, the process will often be fully automated. If a dealer needs to manually intervene, this will often mean a larger fee. Traders in investment banks will often make deals on their bank's behalf, as well as executing trades for their clients. Investment banks will often have a division (or department) called "capital markets": staff in this division try to keep aware of the various opportunities in both the primary and secondary markets, and will advise major clients accordingly. Pension and sovereign wealth funds tend to have the largest holdings, though they tend to buy only the highest grade (safest) types of bonds and shares, and some of them do not trade all that frequently. According to a 2012 Financial Times article, hedge funds are increasingly making most of the short-term trades in large sections of the capital market (like the UK and US stock exchanges), which is making it harder for them to maintain their historically high returns, as they are increasingly finding themselves trading with each other rather than with less sophisticated investors. [8] [11]

There are several ways to invest in the secondary market without directly buying shares or bonds. A common method is to invest in mutual funds [lower-alpha 6] or exchange-traded funds. It is also possible to buy and sell derivatives that are based on the secondary market; one of the most common type of these is contracts for difference – these can provide rapid profits, but can also cause buyers to lose more money than they originally invested. [8]

Size

All figures given are in billions of US$ and are sourced to the IMF. There is no universally recognized standard for measuring all of these figures, so other estimates may vary. A GDP column is included as a comparison.

Year [12] StocksBondsBank assets [13] Total of stocks,
bonds and
bank assets [14]
World GDP
2013 [15] 62,552.0099,788.80120,421.60282,762.4074,699.30
2012 [16] 52,494.9099,134.20116,956.10268,585.2072,216.40
2011 [17] 47,089.2398,388.10110,378.24255,855.5769,899.22

Forecasting and analyses

A great deal of work goes into analysing capital markets and predicting their future movements. This includes academic study; work from within the financial industry for the purposes of making money and reducing risk; and work by governments and multilateral institutions for the purposes of regulation and understanding the impact of capital markets on the wider economy. Methods range from the gut instincts of experienced traders, to various forms of stochastic calculus and algorithms such as Stratonovich-Kalman-Bucy filtering algorithm. [18] [19]

Capital controls

Capital controls are measures imposed by a state's government aimed at managing capital account transactions – in other words, capital market transactions where one of the counter-parties [lower-alpha 7] involved is in a foreign country. Whereas domestic regulatory authorities try to ensure that capital market participants trade fairly with each other, and sometimes to ensure institutions like banks do not take excessive risks, capital controls aim to ensure that the macroeconomic effects of the capital markets do not have a negative impact. Most advanced nations like to use capital controls sparingly if at all, as in theory allowing markets freedom is a win-win situation for all involved: investors are free to seek maximum returns, and countries can benefit from investments that will develop their industry and infrastructure. However, sometimes capital market transactions can have a net negative effect: for example, in a financial crisis, there can be a mass withdrawal of capital, leaving a nation without sufficient foreign-exchange reserves to pay for needed imports. On the other hand, if too much capital is flowing into a country, it can increase inflation and the value of the nation's currency, making its exports uncompetitive. Countries like India employ capital controls to ensure that their citizens' money is invested at home rather than abroad. [20]

See also

Notes

  1. The idea of governments making investments may be less familiar than the case involving companies. A government can make investments that are expected to develop a nation's economy, by improving a nation's physical infrastructure, such as by building roads, or by improving public education.
  2. Note however that the term "financial markets" is also often used to refer all the different sorts of markets in the financial sector, including those that are not directly concerned with raising finance, such as commodity markets and foreign exchange.
  3. Even if there is no activity from big players, U.S. citizens might be making small investments through channels like Treasury Direct.
  4. Sometimes the company will consult with the investment bank for advice before they make this decision.
  5. This is far more likely to occur with shares, as exchanges that allow the automated trading of bonds are not as common, and bonds are generally traded less frequently.
  6. A mutual fund itself will sometimes purchase securities from the primary markets as well as the secondary.
  7. i.e., either the buyer or the seller.

Related Research Articles

Finance is the study and discipline of money, currency and capital assets. It is related to and distinct from Economics which is the study of production, distribution, and consumption of goods and services. The discipline of Financial Economics bridges the two fields. Based on the scope of financial activities in financial systems, the discipline can be divided into personal, corporate, and public finance.

<span class="mw-page-title-main">Stock exchange</span> Organization that provides services for stock brokers and traders to trade securities

A stock exchange, securities exchange, or bourse is an exchange where stockbrokers and traders can buy and sell securities, such as shares of stock, bonds and other financial instruments. Stock exchanges may also provide facilities for the issue and redemption of such securities and instruments and capital events including the payment of income and dividends. Securities traded on a stock exchange include stock issued by listed companies, unit trusts, derivatives, pooled investment products and bonds. Stock exchanges often function as "continuous auction" markets with buyers and sellers consummating transactions via open outcry at a central location such as the floor of the exchange or by using an electronic trading platform.

The primary market is the part of the capital market that deals with the issuance and sale of securities to purchasers directly by the issuer, with the issuer being paid the proceeds. A primary market means the market for new issues of securities, as distinguished from the secondary market, where previously issued securities are bought and sold. A market is primary if the proceeds of sales go to the issuer of the securities sold. Buyers buy securities that were not previously traded.

<span class="mw-page-title-main">Financial market</span> Generic term for all markets in which trading takes place with capital

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets as commodities.

<span class="mw-page-title-main">Security (finance)</span> Tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants.

<span class="mw-page-title-main">Stock market</span> Place where stocks are traded

A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses; these may include securities listed on a public stock exchange as well as stock that is only traded privately, such as shares of private companies that are sold to investors through equity crowdfunding platforms. Investments are usually made with an investment strategy in mind.

<span class="mw-page-title-main">Investment banking</span> Type of financial services company

Investment banking pertains to certain activities of a financial services company or a corporate division that consist in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client's agent in the issuance of debt or equity securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, FICC services or research. Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket, Middle Market, and boutique market.

A mutual fund is an investment fund that pools money from many investors to purchase securities. The term is typically used in the United States, Canada, and India, while similar structures across the globe include the SICAV in Europe, and the open-ended investment company (OEIC) in the UK.

The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.

<span class="mw-page-title-main">Financial services</span> Economic service provided by the finance industry

Financial services are economic services tied to finance provided by financial institutions. Financial services encompass a broad range of service sector activities, especially as concerns financial management and consumer finance.

A financial system is a system that allows the exchange of funds between financial market participants such as lenders, investors, and borrowers. Financial systems operate at national and global levels. Financial institutions consist of complex, closely related services, markets, and institutions intended to provide an efficient and regular linkage between investors and borrowers.

The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. The initial sale of the security by the issuer to a purchaser, who pays proceeds to the issuer, is the primary market. All sales after the initial sale of the security are sales in the secondary market. Whereas the term primary market refers to the market for new issues of securities, and "[a] market is primary if the proceeds of sales go to the issuer of the securities sold," the secondary market in contrast is the market created by the later trading of such securities.

A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as lead arrangers.

<span class="mw-page-title-main">Securities market</span> Component of the wider financial market

Security market is a component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply. Security markets encompasses stock markets, bond markets and derivatives markets where prices can be determined and participants both professional and non professional can meet.

The bond market is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, but it may include notes, bills, and so on for public and private expenditures. The bond market has largely been dominated by the United States, which accounts for about 39% of the market. As of 2021, the size of the bond market is estimated to be at $119 trillion worldwide and $46 trillion for the US market, according to the Securities Industry and Financial Markets Association (SIFMA).

In finance, securities lending or stock lending refers to the lending of securities by one party to another.

The Banja Luka Stock Exchange or BLSE is a stock exchange which operates in the city of Banja Luka in the Republika Srpska, Bosnia and Herzegovina. The Banja Luka Stock Exchange is a member of the Federation of Euro-Asian Stock Exchanges.

<span class="mw-page-title-main">Financial market participants</span>

There are two basic financial market participant distinctions, investors versus speculators and institutional versus retail. Action in financial markets by central banks is usually regarded as intervention rather than participation.

A non-banking financial institution (NBFI) or non-bank financial company (NBFC) is a financial institution that is not legally a bank; it does not have a full banking license or is not supervised by a national or international banking regulatory agency. NBFC facilitate bank-related financial services, such as investment, risk pooling, contractual savings, and market brokering. Examples of these include hedge funds, insurance firms, pawn shops, cashier's check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations. Alan Greenspan has identified the role of NBFIs in strengthening an economy, as they provide "multiple alternatives to transform an economy's savings into capital investment which act as backup facilities should the primary form of intermediation fail."

<span class="mw-page-title-main">Securities market participants (United States)</span>

Securities market participants in the United States include corporations and governments issuing securities, persons and corporations buying and selling a security, the broker-dealers and exchanges which facilitate such trading, banks which safe keep assets, and regulators who monitor the markets' activities. Investors buy and sell through broker-dealers and have their assets retained by either their executing broker-dealer, a custodian bank or a prime broker. These transactions take place in the environment of equity and equity options exchanges, regulated by the U.S. Securities and Exchange Commission (SEC), or derivative exchanges, regulated by the Commodity Futures Trading Commission (CFTC). For transactions involving stocks and bonds, transfer agents assure that the ownership in each transaction is properly assigned to and held on behalf of each investor.

References

  1. 1 2 O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action . Upper Saddle River, NJ: Pearson Prentice Hall. p.  283. ISBN   0-13-063085-3.
  2. 1 2 3 Privatization and Capital Market Development: Strategies to Promote Economic Growth, Michael McLindon (1996)
  3. Lena Komileva (2009-09-16). "Market Insight: Can the rally end the crisis?" . The Financial Times . Archived from the original on 2022-12-10. Retrieved 2012-09-06.
  4. "EU's capital markets union 2.0, explained". POLITICO. 2017-06-08. Retrieved 2018-03-07.
  5. "What is the capital markets union?". European Commission – European Commission. Retrieved 2018-03-07.
  6. "EU Capital Markets Union". Financial Times. Archived from the original on 2022-12-10. Retrieved 2018-03-07.
  7. White, Lucy (2018-04-24). "EU's Dombrovskis ignites fresh row over City's market access post-Brexit". Archived from the original on 2018-04-24. Retrieved 2018-04-25. Regarding Capital Markets Union, the European Commission's plan to improve access to non-bank financing across the EU, he said the "departure of the UK makes this project even more important and even more urgent. It will have to compensate for the EU's largest financial centre not being in the EU and not being in the single market any more"
  8. 1 2 3 4 5 An Introduction to International Capital Markets: Products, Strategies, Participants, Andrew M. Chisholm, (2009), Wiley, see esp Chapters 1, 4 & 8
  9. "U.S. National Debt Clock : Real Time". usdebtclock.org.
  10. Gillian Tett (September 28, 2014). "After a life of trend spotting, Bill Gross missed the big shift". The Financial Times . Archived from the original on 2022-12-10. Retrieved October 14, 2014.
  11. Jonathan Ford (2012-08-24). "The hedge funds are playing a loser's game" . The Financial Times . Archived from the original on 2022-12-10. Retrieved 2012-09-06.
  12. Refer to the references used for each year to find a breakdown of capital market size for individual countries and regions.
  13. Bank assets are mainly regular bank loans. The IMF reports used to source these figures do recognize the distinction between capital markets and regular bank lending, but bank assets are traditionally included in their tables on overall capital market size.
  14. The table may slightly overstate the total size of the capital markets, as in some cases the IMF data used to source the reports may double-count stocks and bonds as bank assets.
  15. "IMF Global Financial Stability Report Oct 2014" (PDF).
  16. "IMF Global Financial Stability Report Oct 2013".
  17. "IMF Global Financial Stability Report Oct 2012".
  18. Clive Cookson (2016-09-19). "Man v machine: 'Gut feelings' key to financial trading success". Financial Times . Archived from the original on 2022-12-10. Retrieved 2016-09-19.
  19. Paul Wilmott (2007). Paul Wilmott Introduces Quantitative Finance. Wiley. ISBN   978-0470319581.
  20. Carmen Reinhart & Kenneth Rogoff (2010). This Time Is Different: Eight Centuries of Financial Folly. Princeton University Press. pp. passim, esp. 66, 92–94, 205, 403. ISBN   978-0-19-926584-8.