What are Capital Markets?

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Definition:

Capital markets — such as the stock and bond markets — connect governments and companies that want to raise money with investors.

🤔 Understanding Capital Markets

Capital markets are venues that allow governments and companies to raise money by selling financial assets to investors. These include stocks, bonds, commercial real estate, debentures, and more. In primary capital markets, like the markets for company stock prior to an initial public offering, companies and governments can sell new equity or debt for the first time. In secondary markets, such as the New York Stock Exchange, investors can trade existing assets. Only certain institutional and wealthy investors can access primary markets, while the general public can trade in secondary markets.

Example

The US stock market is a capital market in which buyers and sellers come together to trade shares of companies. For example, you can buy shares of Facebook on the NASDAQ or sell shares of Clorox on the New York Stock Exchange (NYSE). Both NASDAQ and the NYSE are secondary capital markets. They are open to all types of investors who can trade stock that was originally issued through an initial public offering (IPO) and is now available to the general public.

Takeaway

Capital markets are like auctions...

Some auctions are open to the general public — Anybody can bid on goods or become a seller as long as they follow the rules. However, some auctions are only accessible to a select audience. Similarly, some capital markets are available to everybody, while others are only open to pre-qualified buyers that meet certain criteria.

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What are capital markets?

Capital markets are channels to buy and sell various forms of financial capital, which fall into two main categories: equity and debt.

An example of equity is a company share that trades on a public stock exchange. An example of debt is a bond — an IOU that companies and governments issue in exchange for cash and that trades in financial markets.

Just like any marketplace, capital markets have buyers and sellers. On the buyer side, you may find pension funds, life insurance companies, individual investors, and others with extra capital available for investment. On the seller side, you can find companies and government institutions looking for capital to finance operations, buy other companies, and generate wealth.

Primary capital markets are reserved for institutional investors (like central banks, financial institutions, and pension funds) and accredited investors (individuals who earned over $200,000 in each of the last two years or have a net worth of over $1M). Secondary capital markets, such as stock exchanges, are open to the general public.

How do capital markets work?

A company entering the stock market for the first time illustrates how capital markets bring together suppliers and users of capital.

Suppose a private company has been expanding for years and now needs to raise a considerable amount of capital to fuel future growth. The company works with an investment bank to go public through an initial public offering (IPO) — a process that makes shares of a private company available to investors in a public stock market for the first time.

The investment bank approaches several institutional and accredited investors in primary markets — markets in which governments and companies sell financial assets to investors for the first time. It discusses the company’s business model, negotiates the first sales of stock, and sets an initial share price for secondary markets.

The company then lists on a stock exchange like NASDAQ or the New York Stock Exchange, and shares become available to the general public.

In summary, in capital markets:

  • Companies and individuals with investment capital (like institutional and accredited investors) are able to invest in primary capital markets with the goal of generating wealth.
  • Users of capital (like private companies going public on the stock exchange) can access the capital they need to continue growing.
  • Eventually, all kinds of buyers and sellers of capital can trade the new financial instrument (in this case publicly traded shares of the formerly private company) in secondary capital markets to further their goal of creating wealth for themselves.

These days, the vast majority of securities in both primary and secondary capital markets trade electronically.

What are the functions of capital markets?

Capital markets play a vital role in a capitalist economy by making it possible for suppliers and users of capital to come together and enter formal contracts. Without capital markets, all these players would have a much harder time accessing or investing capital because they wouldn’t have an established market with clear rules.

Efficiency and trust are essential for capital markets to flourish. Over time, some cities (such as London, Frankfurt, Hong Kong, Toronto, and New York) have become known as hubs for financial markets.

To further strengthen trust in capital markets, governments have created agencies to oversee them and maintain fair play. For example, the Securities and Exchange Commission (SEC) protects individual investors, regulates institutional investors, and promotes fairness in US securities markets.

You can’t spell capitalism without “capital.” Capital markets play an essential role in efficiently making capital accessible to those who need it.

Which financial instruments trade in capital markets?

Some of the financial instruments traded in capital markets include:

  • Stocks: Also known as equity, each share of stock represents a unit of ownership in a company.
  • Bonds: When a company or government sells an IOU promising repayment of funds, it offers a bond. Some bonds make interest payments over a set period, and all are due to be paid back upon maturity.
  • Treasury bills: Also known as T-bills, these are safe, short-term securities sold by the US Treasury and backed by the US government.
  • Municipal notes: Similar to a Treasury bill, municipal notes are issued by local governments.
  • Commercial paper: The corporate equivalent of a T-bill (but likely less safe), this is short-term, unsecured debt companies issue in exchange for short-term funding.
  • Foreign currencies: Most countries issue their own currency, and those currencies can also trade in capital markets.
  • Debentures: A debenture is a type of unsecured debt issued by companies. It’s backed mostly by a borrower’s promise to pay back the debt instead of collateral.

What is the difference between primary and secondary capital markets?

One of the main differences between primary and secondary capital markets is accessibility.

Primary markets are only open to institutional investors (including central banks and pension funds) and accredited investors (wealthy investors who meet guidelines from the Securities and Exchange Commission). Secondary markets, on the other hand, are accessible to the general public.

The idea behind limiting access to primary markets is that regulators want to make sure those involved can understand what’s going on and have sufficient means to survive a potential loss.

Primary and secondary capital markets also trade different types of financial instruments. Primary capital markets often make financial instruments available for the first time, such as company shares prior to an initial public offering (IPO) or new issues of corporate or government bonds. Secondary capital markets (like the NASDAQ or the New York Stock Exchange) only trade financial instruments that have already traded in a primary capital market.

What are the global capital markets?

Global capital markets are those that are interconnected beyond their domestic borders. Two factors contribute to the creation of global capital markets: technology and relationships.

Advances in technology have enabled buyers and sellers of capital to complete transactions across the globe. Think of global capital markets as a “super-network” of capital markets. In the past, foreign investors may have taken a long time to buy or sell stock on the New York Stock Exchange, but now they can do so almost instantly online.

Additionally, global capital markets are built through relationships. For example, institutional investors, such as Morgan Stanley and Goldman Sachs, are able to connect capital users and suppliers around the globe.

What are real estate capital markets?

Real estate capital markets are those that specialize in investment in real estate — land and the buildings and natural resources on that land.

These types of capital markets connect suppliers and users of capital in the form of financial instruments related to real estate, such as ownership of a building or the right to develop a piece of land.

For example, CBRE, JLL, and Colliers are commercial real estate (CRE) companies that operate real estate capital markets of their own. These companies connect buyers and sellers of financial instruments related to real estate.

A real estate capital market is a brokered market — a type of secondary market in which trades are arranged through a broker. The general public can invest in a portion of real estate capital markets through publicly traded real estate investment trusts (REITs), real estate-focused mutual funds, and mortgage-backed securities.

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