Author: Ken Kapner
The Capital Markets are part of the global financial system that brings together investors and borrowers. Technically, the word capital implies a longer term, but the timing of when “short-term” actually becomes “long-term” has become a bit of a gray area. Generally speaking, short-term refers to money markets, or for a text book definition, less than one year. The capital markets have many different features including a wide variety of market participants, fixed income and equity securities, primary and secondary markets, domestic and international markets, and private versus public debt. The purpose of this blog is to give a high-level overview of these different features.
A wide variety of entities need to borrow money or capital. For example, governments, corporations, and financial institutions all borrow money. Investors are the suppliers of the money/capital and are sometimes referred to as asset managers. Some examples of investors include insurance companies, pension funds, mutual funds, financial institutions (financial institutions, such as banks, may be both borrowers and investors), and endowments. These entities are brought together by middlemen which are typically investment banks. As Bank of America states in their 2018 Annual Report, “…We also provide investment banking products to our clients such as debt and equity underwriting and distribution…”
Initially the borrower, such as a corporation, will choose an investment bank to help them raise the money. The term underwriting refers to the investment bank taking on the risk by either buying the entire issuance or attempting to sell it on a best effort’s basis. Of course, for taking on this risk the investment bank gets paid a fee. Often though, the risk to outright purchase the entire deal is too risky. The “lead” investment bank will invite other investment banks to share in the risk by purchasing and then distributing the securities, known as syndication. It is a pretty profitable business. According to Bank of America’s 2018 Annual Report, it earned the following fees in 2018 and 2017:
Equity and Fixed Income
There are two major forms of capital: equity and fixed income. Equity, sometimes referred to as shares or stock, are considered permanent funds as they have no final maturity. Equity may or may not pay dividends. The decision to pay dividends rests with the institution’s board of directors. Fixed income pays interest, formally called a coupon. Unlike stock dividends, the coupon is legally binding. In addition, where equity has no formal maturity, fixed income has a definitive maturity date. This is the date the borrower must pay back the money. Lastly, if the corporation goes bankrupt, fixed income investors will get paid any residual values of the bankrupt company before equity investors.
Primary versus Secondary Markets
Equity and fixed income securities are initially issued in the primary markets. For example, Lyft recently issued equity in the primary market. Since it was Lyft’s first go around for raising equity, it is referred to as an initial public offering or IPO. Upon deciding to raise money, the borrower (the issuer of the security) will choose an investment bank to underwrite and distribute the deal. In consultation with their investment bankers, LYFT chose to list their stock on NASDAQ. Once the stock starts trading on NASDAQ it is considered the secondary market.
There are two ways fixed income securities are issued in a primary market. One method is by auction/tender and the other method is similar to the syndication explained above. For example, the US government uses an auction process through primary government dealers. The dealers submit competitive bids and the government announces the details of the auction such as price, the amount tendered, and the amount accepted.
Corporate bonds are similar to equity in that an investment bank will lead a syndicate to underwrite the notes and bonds.
Exchange Traded versus Over-the-Counter (OTC)
The traditional definition of exchange traded refers to a central or physical location where securities (or derivatives) trade. Exchanges may be thought of as a central location to execute trades. There is no longer a need for a physical location. This is primarily due to electronic trading, which has changed the ballgame. It is interesting to note that the New York Stock Exchange (NYSE) employs both a physical/floor location and electronic/computer-based trading.
The exchange provides rules that govern trading that market participants are obliged to follow. It facilitates liquidity of the underlying securities on the exchange via market makers. These market makers make prices where they are willing to both buy and sell the underlying security, such as Apple stock. This is commonly referred to as “making markets.”
OTC simply means the security does not trade on an organized exchange and is therefore decentralized. This might be a misrepresentation as they are very well organized. The trades can be executed via phone or electronically, i.e., via a computer platform which may me referred to as an alternative trading system (ATS). Foreign exchange and the vast majority of fixed income markets trade OTC.
Domestic versus International Capital Markets
Developed countries and many emerging markets will have their own capital markets. Stocks and bonds are issued domestically. For example, Lyft trades in the US domestic equity market. International capital markets are similar to domestic capital markets, but now investors and issuers lend and borrow across different countries.
Public versus Private Markets
In a public market or public offering, the security will be registered with the local security regulator, such as the Securities Exchange Commission (SEC) in the US. The information about the specific security is open to the general public and will generally trade on an exchange. In a private market or private offering, stocks or bonds will be sold directly to the investor, such as a pension fund or insurance company. Securities issued in the private markets are sometimes referred to as private placements. In the private placement market, information about the deal is not disseminated to the investing public.
Capital markets are part of the global financial system. There are many features and different securities such as fixed income and equity, primary and secondary markets, domestic and international markets, and private versus public markets.
If you’d like to learn more about capital markets in general, or about any of the capital markets components, let us know.