30th january 2023 / By Neil Johnson

What are capital markets?

If you’re a big business looking to raise money to finance an acquisition, or a government looking to finance a new railway line, you’ll probably end up in a capital market selling a stake in your business or your country.

If you’re an investor looking to invest capital and make a return on your investment over time, you too will end up in a capital market, funding railways and driving business growth.

What are capital markets?

Capital markets are the places where individuals, businesses, banks and other financial institutions, governments, insurance firms and pensions funds buy and sell financial instruments. These markets are both physical and digital spaces, and include stock markets, fixed income markets, and currency and foreign exchange (forex) markets. Most markets are concentrated in major financial hubs, such as New York, London, Singapore, and Hong Kong.

Capital markets vs money markets

Money markets trade in short-term lending or borrowing, where assets are held by governments, corporations, banks, and financial institutions for as short as overnight and up to a year.

Capital markets are used for long-term assets, where financial institutions, professional brokers and individual investors buy stocks and bonds from companies, entrepreneurs, and governments.

Capital markets vs bank loans

When seeking to raise finance, whether to fund expansion or undertake a merger or acquisition (M&A), corporate entities are presented with a choice: borrow or sell.

Borrowing often comes in the form of loans, such as term loans and revolving credit facilities, from a single or multiple lenders, typically banks.

Selling is issuing shares or debt in the entity to be sold and traded on capital markets. Common types of corporate debt securities are bonds, medium-term notes (MTNs) and commercial paper.

The parties involved in capital markets transactions

On the one side you have the suppliers of capital, and on the other, you have those seeking it. On the capital supply side are typically financial institutions such as banks, individual investors, insurance companies, corporations, and retirement funds.
Individual investors, for example via their pensions, will buy equity and bonds from companies and governments, often indirectly via pension funds who in turn will invest in mutual funds run by asset managers, with the hope of earning a return over the long term to afford a comfortable retirement.

Businesses, meanwhile, can be both a supplier and buyer. On the supply side, corporate entities might seek to invest ‘spare’ capital rather than having it languish in a bank account. Alternatively, a company might need capital and therefore issue shares or debt.
Governments are a key part of the capital demand side. They issue vast quantities of bonds that can go towards financing infrastructure development, for example.

Capital market transaction types

Let’s first look at equity capital markets. The most well-known transaction type is an initial public offering (IPO), which is when a private company lists itself on a stock exchange to be publicly traded. Once made public, a company’s stocks and shares can be easily bought and sold by large institutions all the way down to bedroom traders.

Another equity capital market vehicle is a SPAC, or a special purpose acquisition company. A SPAC is a publicly listed and therefore tradable entity without commercial operations and formed solely to raise capital through an IPO for the purpose of an M&A deal.
For investors who buy into a company’s IPO, they will receive profit as dividends paid by the company, but only when the company is running profitably. Their shares might also increase in value, but investors can only profit from this if a company is being wound up or operating a share buyback, or investors choose to sell their assets in the market for more than they bought them.

Debt capital markets are where companies, banks or governments raise money by selling debt obligations to investors. These are commonly referred to as bonds. Investors receive fixed or floating rate interest payments on the bonds they own at predetermined intervals.

Another financial instrument tradable on capital markets is a derivate. Derivatives are contracts between a buyer and seller, the pricing and end value of which are determined by the fluctuations of an underlying asset, group of assets or benchmark. Businesses use derivatives as a hedge (protection) against future market movements. Types of derivatives include forwards, futures, options and swaps. The simplest derivative is perhaps a forward, in which two entities agree to buy/sell a product at a fixed price and date.

The two types of capital markets

So far, so straight forward, right? Capital markets are where you sell equity and debt securities. Buying equity, or stocks/shares, gives you ownership shares in a company, while buying bonds are IOUs that entitle you to regular interest payments.

But just to muddy the waters a little, capital markets are split into two categories:

• Primary markets: this is where new issuances of equity shares and bonds are sold to investors.
• Secondary markets: this is where trading of existing shares takes place.

Primary market

If we take an IPO as an example, a company wants to sell new stocks or bonds on the capital markets but getting these products to market is not as straightforward as posting a second-hand bike on eBay. The company selling the products will hire an underwriting firm, such as an investment bank, which specialises in raising capital for clients.

An investment bank, perhaps JPMorgan Chase, Goldman Sachs, Morgan Stanley, UBS, Credit Suisse, Deutsche Bank, HSBC, Barclays or Evercore Partners, will advise the client about the product and review it, and then create a prospectus outlining the price and details about the securities. The investment bank will also help with filing new issues to the appropriate regulator for approval, such as the Securities and Exchange Commission (SEC) in the US or the Financial Conduct Authority (FCA) in the UK.

The investment bank is then often closely involved in selling the securities, which on the primary market is typically to large investors. Companies want to sell as many of their new issues as quickly as possible and in as big a volume as possible, something smaller investors can’t really help with.

Secondary market

The secondary market is where more and smaller entities and individuals can get a taste of the action. Issuing companies play no part in the secondary market. Stock exchanges, such as the New York Stock Exchange (NYSE), NASDAQ and FTSE, are secondary market trade facilitators.

There are two categories of the secondary market: auction and dealer markets. The auction market is perhaps the most infamous one, the one that represents what to most people a stock market is — traders in a big room shouting as they buy and sell securities. Dealer markets, on the other hand, are electronic trading networks, where most small investors trade.

Conclusion

Capital markets a crucial element in the financial industry, and perhaps for broader economic health as well. If it weren’t for capital markets, businesses would struggle to find the financing to grow and provide jobs, and our savings would also struggle to grow without access to take part in growing companies or governments selling interest-earning debt.

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