What are ‘Capital Markets’
Capital markets are markets for buying and selling equity and debt instruments. Capital markets channel savings and investment between suppliers of capital such as retail investors and institutional investors, and users of capital like businesses, government and individuals. Capital markets are vital to the functioning of an economy, since capital is a critical component for generating economic output. Capital markets include primary markets, where new stock and bond issues are sold to investors, and secondary markets, which trade existing securities.
BREAKING DOWN ‘Capital Markets’
Capital markets are a broad category of markets facilitating the buying and selling of financial instruments. In particular, there are two categories of financial instruments that capital in which markets are involved. These are equity securities, which are often known as stocks, and debt securities, which are often known as bonds. Capital markets involve the issuing of stocks and bonds for medium-term and long-term durations, generally terms of one year or more.
Capital markets are overseen by the Securities and Exchange Commission in the United States or other financial regulators elsewhere. Though capital markets are generally concentrated in financial centers around the world, most of the trades occurring within capital markets take place through computerized electronic trading systems. Some of these are accessible by the public and others are more tightly regulated.
Other than the distinction between equity and debt, capital markets are also generally divided into two categories of markets, the first of which being primary markets. In primary markets, stocks and bonds are issued directly from companies to investors, businesses and other institutions, often through underwriting. Primary markets allow companies to raise capital without or before holding an initial public offering so as to make as much direct profit as possible. After this point in a company’s development, it may choose to hold an initial public offering so as to generate more liquid capital. In such an event, the company will generally sell its shares to a few investment banks or other firms.
At this point the shares move into the secondary market, which is where investment banks, other firms, private investors and a variety of other parties resell their equity and debt securities to investors. This takes place on the stock market or the bond market, which take place on exchanges around the world, like the New York Stock Exchange or NASDAQ; though it is often done through computerized trading systems as well. When securities are resold on the secondary market, the original sellers do not make money from the sale. Yet, these original sellers will likely continue to hold some amount of stake in the company, often in the form of equity, so the company’s performance on the secondary market will continue to be important to them.
Capital markets have numerous participants including individual investors, institutional investors such as pension funds and mutual funds, municipalities and governments, companies and organizations, banks and financial institutions. While many different kinds of groups, including governments, may issue debt through bonds (these are called government bonds), governments may not issue equity through stocks. Suppliers of capital generally want the maximum possible return at the lowest possible risk, while users of capital want to raise capital at the lowest possible cost.
The size of a nation’s capital markets is directly proportional to the size of its economy. The United States, the world’s largest economy, has the largest and deepest capital markets. Because capital markets move money from people who have it to organizations who need it in order to be productive, they are critical to a smoothly functioning modern economy. They are also particularly important in that equity and debt securities are often seen as representative of the relative health of markets around the world.
On the other hand, because capital markets are increasingly interconnected in a globalized economy, ripples in one corner of the world can cause major waves elsewhere. The drawback of this interconnection is best illustrated by the global credit crisis of 2007-09, which was triggered by the collapse in U.S. mortgage-backed securities (MBS). The effects of this meltdown were globally transmitted by capital markets since banks and institutions in Europe and Asia held trillions of dollars of these securities.
Differentiation From ‘Money Markets’
People often confuse or conflate capital markets with money markets, though the two are distinct and differ in a few important respects. Capital markets are distinct from money markets in that they are exclusively used for medium-term and long-term investments of a year or more. Money markets, on the other hand, are limited to the trade of financial instruments with maturities not exceeding one year. Money markets also use different financial instruments than capital markets do. Whereas capital markets use equity and debt securities, money markets use deposits, collateral loans, acceptances and bills of exchange.
Because of the significant differences between these two kinds of markets, they are often used in different ways. Due to the longer durations of their investments, capital markets are often used to buy assets that the buying firm or investor hopes will appreciate in value over time so as to generate capital gains, and are used to sell those assets once the firm or investor thinks the time is right. Firms will often use them in order to raise long-term capital.
Money markets, on the other hand, are often used to generate smaller amounts of capital or are simply used by firms as a temporary repository for funds. By regularly engaging with money markets, companies and governments are able to maintain their desired level of liquidity on a regular basis. Moreover, because of their short-term nature, money markets are often considered to be safer investments than those made on the equities market. Due to the fact that longer terms are generally associated with investing in capital markets, there is more time during which the security in question may see improved or worsened performance. As such, equity and debt securities are generally considered to be riskier investments than those made on the money market.