Capital Markets are a component of the global financial system that connects lenders and borrowers. Although the term “capital” technically indicates a longer duration, the exact moment when “short-term” becomes “long-term” has become a bit of a hazy area. Short-term relates to money markets or, to use a textbook meaning, anything that lasts less than a year. A broad range of market players, fixed income and equity securities, main and secondary markets, local and foreign markets, and private vs public debt are all elements of the capital markets. This blog’s goal is to provide a high-level overview of these many aspects.
Participants in the Market
Borrowing money or capital is required by a broad range of enterprises. Governments, businesses, and financial organizations, for example, all borrow money. Investors, sometimes known as asset managers, are the ones who provide the money/capital. Life Insurance Settlement firms, pension funds, mutual funds, financial institutions (financial organizations, such as banks, may be both borrowers and investors), and endowments are all examples of investors. Middlemen, who are generally investment banks, bring these businesses together. “…We also offer investment banking products to our customers, such as debt and equity underwriting and distribution,” according to Bank of America’s 2018 Annual Report.
The borrower, such as a company, will first choose an investment bank to assist them in raising funds. The word “underwriting” refers to an investment bank taking on the risk of the issue by either purchasing it in its entirety or trying to sell it on a best-efforts basis. Of course, the investment bank is compensated for taking on this risk. However, in many cases, the danger of purchasing the whole transaction completely is too high. By acquiring and subsequently distributing the securities, the “lead” investment bank will ask other investment banks to partake in the risk. This is known as syndication. It’s a really lucrative industry. Bank of America earned the following fees in 2018 and 2017, according to its 2018 Annual Report.
Fixed Income vs. Equity
Equity and fixed income are the two main types of capital. Equity, often known as shares or stock, is a kind of perpetual investment since it has no expiration date. Dividends may or may not be paid on equity. The board of directors of the institution decides whether or not to distribute dividends. Fixed income pays interest in the form of a coupon. The coupon, unlike stock dividends, is legally binding. Furthermore, unlike equities, which has no formal expiry, fixed income has a set maturity date. This is the deadline for the borrower to repay the funds. Finally, if the firm falls bankrupt, fixed income investors will be paid any remaining company values before equity investors.
Markets: Primary vs. Secondary
The main markets are where equity and fixed income instruments are first launched. Lyft, for example, just issued main market stock. It’s known as an initial public offering (IPO) since it was Lyft’s first attempt at obtaining capital. The borrower (the security issuer) will choose an investment bank to underwrite and distribute the offer after opting to seek funds. LYFT decided to list their shares on NASDAQ after consulting with their investment bankers. The secondary market begins when a stock begins to trade on NASDAQ.
In a primary market, fixed income instruments are issued in two ways. The auction/tender approach is one way, while the other option is comparable to the syndication method described above. The US government, for example, conducts auctions via principal government dealers. The government reveals the auction specifics, including the price, the amount offered, and the amount accepted, after the dealers make competing bids.
Corporate bonds are comparable to stock in that they are underwritten by a syndicate led by an investment bank.
Over-the-Counter vs. Exchange Traded (OTC)
The term “exchange traded” refers to a central or physical place where securities (or derivatives) are traded. Exchanges may be conceived of as a central place where transactions can be executed. A physical place is no longer necessary. This is mostly owing to the introduction of computerized trading, which has altered the game. The fact that the New York Stock Exchange (NYSE) uses both a physical/floor location and electronic/computer-based trading is noteworthy.
The exchange establishes trading regulations that all market players must adhere to. It allows market makers to facilitate liquidity of the underlying assets on the exchange. These market makers set prices for the underlying asset, such as Apple shares, at which they are ready to purchase and sell it. “Making markets” is a term used to describe this process.
The term “over-the-counter” simply refers to a security that does not trade on a centralized exchange and is therefore decentralized. They are quite well structured, so this might be a misrepresentation. The transactions may be completed over the phone or electronically, using a computer platform known as an alternative trading system (ATS). The overwhelming majority of fixed income markets, including foreign currency, trade over-the-counter.
Capital Markets in the United States vs. International Capital Markets
Many developing markets, as well as developed ones, will have their own capital markets. Stocks and bonds are only issued in the United States. Lyft, for example, is a publicly traded company in the United States. Investors and issuers increasingly lend and borrow across borders in international capital markets, which are comparable to local capital markets.
Markets: Public vs. Private
The securities will be registered with the local security authority, such as the Securities Exchange Commission (SEC) in the United States, in a public market or public offering. The individual security’s information is available to the broader public, and it will typically trade on an exchange. Stocks or bonds will be offered directly to the investor, such as a pension fund or insurance firm, in a private market or private offering. Private placements are securities that have been issued in the private markets. Information regarding the transaction is not shared with the investing public in the private placement market.
The global financial system includes capital markets. Fixed income and equity, main and secondary markets, local and foreign markets, and private vs public markets are only a few of the characteristics and securities available.
Let us know if you’d like to learn more about capital markets in general or about any of the components of capital markets.