A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are 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. Financial regulators like the Bank of England (BoE) and the U.S. Securities and Exchange Commission (SEC) oversee capital markets to protect investors against fraud, among other duties.
Modern capital markets are almost invariably hosted on computer-based electronic trading systems; most can be accessed only by entities within the financial sector or the treasury departments of governments and corporations, but some can be accessed directly by the public. There are many thousands of such systems, most serving only small parts of the overall capital markets. Entities hosting the systems include stock exchanges, investment banks, 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.
Government on primary 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, which corresponds to the continuous updating of the U.S. real-time debt clock
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, 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.
Secondary market trading
An electronic trading platform being used at the Deutsche Börse. Most 21st century capital market transactions are executed electronically; sometimes a human operator is involved, and sometimes unattended computer systems execute the transactions, as happens in algorithmic trading.
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. With the rise of strategies such as high-frequency trading, a single security could in theory be traded thousands of times within a single hour. 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 Clintonbegan 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. 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.
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.
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 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