Understanding Capital Markets

by Greg DePersio

3 min read

“Capital markets” is a broad definition for the markets in which buyers and sellers link up to exchange financial securities. Generally though, capital markets refers to the markets where equity securities, or stocks, and fixed-income securities are bought and sold, and not markets such as the derivatives market or the money market. In honor of Financial Literacy Month in Canada, learn about the general workings of capital markets and why they are important to daily life.

What Do Capital Markets Do?

Capital markets are a critical part in the global financial system. Due to their functionality, they help create jobs, build businesses and infrastructure, help people to buy homes and finance their educations, enable people to save for their retirement, and much more.

These markets for equity and debt match the demand for funds with the supply of funds. The equity markets allow stock of companies, or shares of ownership, to be created, issued, and traded among buyers and sellers. The fixed-income markets, also known as the debt markets, allow companies, governments, and other entities such as cities, universities, or hospitals to raise money by issuing loans in the form of bonds. In the most basic sense, when a person uses the capital market to buy stock, he or she is buying a piece of a company and then owns its. When that same person buys a bond, he or she is effectively lending money to the organization that issued the bond and receives interest payments over time.

Primary and Secondary Markets

Capital markets consist mainly of primary markets and secondary markets. These are distinctly different but equally important. In primary markets, governments and companies create brand new securities to be issued or sold to a first wave of buyers. For stocks, as an example, the process of issuing new shares is called underwriting, and the shares are sold through an initial public offering. Primary markets are used by companies to set up new businesses or expand their current ones.

Secondary markets enable previously issued securities from the primary markets to be bought and sold among all market participants. On secondary markets is where the vast majority of capital market activity occurs on a daily basis. Whenever a security is traded on an exchange, the trade is occurring in the secondary markets. In a simple sense, the secondary market is what people refer to when they discuss “the stock market.”

Third and Fourth Markets

Though not as large as primary or secondary markets, third and fourth markets also exist. Neither of these markets is used by individual investors because the transactions are so large, and for the most part do not have any noticeable effect on individual investors. The third market consists of what is known as “over-the-counter” trades, which are trades done over computer networks that do not involve any sort of stock exchange. This market consists of broker-dealers and other financial institutions that trade directly with each other. Fourth market trades are done only by very large financial institutions and happen directly with each other.

Financial Intermediaries

Financial intermediaries involved in the capital markets link up the buyers and sellers of these financial instruments. Deposit-taking institutions, such as banks; insurance companies and pension funds; and investment dealers and investment funds are all examples of financial intermediaries. Certain government institutions may also be involved. All of these organizations are important in their own way. Banks take in money as deposits and lend out those deposits as loans, enabling vast amounts of economic growth in every industry imaginable. Insurance companies and pension funds allow for protecting capital and saving for retirement. Investment dealers and investment funds help facilitate trading in capital markets, asset price setting and discovery, and the creation of new investment funds. Government organizations are involved in capital markets to set laws and regulate activity. These institutions also play a major role in providing capital market liquidity during the times when a buyer cannot find a seller and vice versa.

Characteristics of Capital Markets

The capital markets are extremely large. For example, in North America, the equity markets are valued at approximately $19 trillion, and the fixed-income markets are valued at approximately $37 trillion. After North America, the European capital markets are the world’s next largest, with $29 trillion in fixed income and about $10 trillion in equity.

As a small business owner, the benefits of the capital markets are vast. As a buyer in the capital markets, a small business owner may invest in his or her own industry or purchase a particular stock as a growth opportunity with plans to use the eventual gains on the business. As a seller, a small business owner can raise capital for the business, enable employees with any stock grants to turn shares into cash, and help value the business by selling shares.

References & Resources

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