What Are Capital Markets? | Capital Markets Definition
The term capital market refers generally to the place where various parties come together to exchange different financial instruments. In this article, we will provide a detailed answer to the question “what are capital markets?”, explain the different types of capital markets and much more!
Table of Contents
What Are Capital Markets?
So, what are capital markets? The capital markets are a place where savings and investments are exchanged between those who have capital to invest and those that require capital for long term use.
When we refer to those who have capital, we are referring to investors, both retail and institutional, and when we speak of those requiring capital, we are speaking of businesses, governments and people.
In exchange for their capital, investors receive a security, the most common and well known being stocks and bonds.
Why Are They Important?
The capital market plays two important roles in the economy:
- It allows companies and governments to access money more efficiently and, therefore, grow faster; and
- It allows people and institutions to invest surplus savings
Economies without access to the capital markets tend to grow much more slowly and offer fewer attractive investment opportunities.
What Are Shares and Bonds?
Shares are units of ownership in either a private or public corporation. The shares of privately owned companies are initially held by the founders or partners. However, as companies grow, they may take the decision to raise capital by selling shares to the public.
A bond is a fixed income instrument, which represents a loan made by an investor to an entity, usually a corporation or government. Bonds are issued with commitments to both a fixed regular payment and a maturity date by which the loan must be repaid in full. Failing to comply with either commitment means the borrower risks default.
Although their mechanics differ, the purpose of shares and bonds are the same for the issuing party. Both are issued in order to raise capital. For what? In theory, it could be for any reason. For corporations the capital tends to be required for growing the business, funding a particular new project or buying new assets.
Similarly, a government may sell bonds to fund infrastructure, other national projects or to service national debt.
Primary Market vs Secondary Market
The capital markets are made up of two different types of market: the primary market and the secondary market.
The Primary Capital Market
In the primary market, investors purchase securities directly from the issuing entity at the time of issue in what are known as primary offerings.
For example, when a company goes public they traditionally have an Initial Public Offering (IPO), in which they sell new shares at a set price to, mostly institutional, investors.
After going public with its IPO, a company can issue and sell shares in subsequent issuance rounds, providing certain conditions are met.
In both cases, since the new shares are being bought directly from the issuing company, the transactions are part of the primary capital market.
The Secondary Capital Market
In the secondary market, pre-existing securities are traded between investors. For example, existing shareholders can sell their shares to others who want to buy them. The issuing company plays no part in the secondary market.
Stock exchanges, such as the London Stock Exchange, typically provide facilities for the primary and secondary capital markets.
The Connections Between Primary and Secondary Markets
The primary and the secondary markets are not entirely separate and, in fact, are very much connected to each other in several different ways.
- All securities traded in the secondary market were, at some point, issued in the primary markets.
- The existence of a liquid secondary market reassures investors buying shares in the primary market; it provides a place to sell the securities for cash, should they wish to do so in the future.
- If a company that has already gone public wants to issue and sell more shares, the price of the new shares is driven by the price of the existing shares in the secondary market.
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Who Are the Main Players?
We now have an answer to the question “what are capital markets” and understand how they are split into a primary and secondary market.
But who are the main players within the primary and secondary capital markets? In the following sections, we will explore this subject.
The Primary Market Players
1) The Issuing Party
Firstly, we have the party which requires capital in order to grow their business, fund a particular project or some other reason. Most commonly, this would be a company (shares or bonds) or a government (bonds).
In the case of companies who are looking to go public, as we have already mentioned, they would sell their shares via an IPO.
Individual, or retail, investors can sometimes buy new shares and bonds issued in the primary markets, as long as they go through a broker.
In the case of government bonds, the buying process varies from country to country. In the UK, the Debt Management Office (DMO) sells gilts (bonds) via auction. Retail investors who wish to purchase UK gilts need to do so via a Gilt-Edged Market Maker (GEMM).
However, in the US, it is possible for any US citizen to register with the Treasury and buy Treasury bonds directly at auction.
Institutional investors, or institutions, on the “buy side” of the market, consist of fund managers, and other pooled investors who provide the capital required in exchange for the securities being sold. The largest proportion of investments are made by institutional investors.
In the case of shares, whilst sometimes retail investors are able to access shares at an IPO, it is much more common for IPOs to only be accessible to big investors who have a good relationship with the underwriter taking the company in question public.
4) Investment Banks
The investment banks, on the “sell side” of the market, are used to advise and facilitate transactions between the issuing party and institutions. Part of the responsibility of the investment banks is to match institutional investors with the issuing parties based on the respective risk vs. reward profiles, investment styles and other considerations.
5) Public Accounting Firms
Public accounting firms play an important advisory and accounting role to the issuing party in the primary market.
Regulators play a big role in the primary market, protecting investors and the integrity of the market by ensuring that all the above players adhere to the relevant rules and regulations. In the primary market, their main focus would be on ensuring that the new securities are suitable for external investors and that issuers release accurate and sufficient information to the market.
The Secondary Market Players
1) Investors: Buyers and Sellers
The secondary capital markets are far more accessible for most investors. Buyers and sellers can exchange pre-existing securities through a broker in a central marketplace, such as a stock exchange.
2) Investment Banks
As well as being a major player in the primary market, investment banks also play a part in the secondary market. They provide research regarding issuers and securities, helping buyers and sellers make decisions and also trade securities on behalf of their clients.
Regulators also play a big role in the secondary capital market. Their focus is on ensuring that issuers continue to release accurate and prompt information and that buyers and sellers do not do anything to artificially inflate or depress the prices of securities in their favour.
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Other articles that may interest you:
- What Is the Difference Between Stocks and Bonds?
- What Is Market Cap and What Does it Tell Us About Stocks?
- How to Pick Stocks: A Guide For New Investors
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.