Introduction to capital markets

The term “capital markets” may be unfamiliar to you. But if you have ever owned stocks or bonds, you have participated in capital markets. 

The main participants in capital markets are capital suppliers – like banks as well as individual and institutional investors – and capital seekers, like businesses, governments and individuals. 

Capital markets facilitate capital trading, which is essential for the global economy. They are the place for seekers of finance, to drum up capital (i.e. investment money) when it’s needed and suppliers to seek a return on money that they are looking to put to use (i.e. earning a return). 

Plus, capital markets let investors gauge how much the markets believe their assets could be worth. Free and open capital markets promote liquidity and investment in the economy – that is why governments around the world tend to exercise care in regulating them.

There are a few key things that influence the health of capital markets: the number of participants, the range of products available, the cost of trade, public trust in the system, and rules and regulations that promote efficient and transparent market practices.

More participants, competition, and financial products tend to be good for capital markets as they generally lower trade costs, make buying/selling cheaper and promote liquidity. 

Sound management is a big part of market health too. Regulation is essential for safe functioning but some believe too much of it can result in higher costs and lower liquidity.

Governing bodies strive to strike the right regulatory balance to ensure markets remain healthy and robust.     

Capital markets can be further split into primary and secondary markets. 

In primary markets, equity or debt issuers (i.e., capital seekers) create new securities and sell them at a specific price to investors (i.e., capital suppliers) in one-off transactions. Initial public offerings (IPOs), direct listings, and government bond issuances all take place in primary markets. 

These new securities are then traded in secondary markets, where prices are determined by supply, demand, and other external factors. Stock exchanges are a great example of a secondary market, like the New York or London Stock Exchanges. 

Secondary markets trade lots of different kinds of products. The three main types that you ought to know are: financial instruments, derivatives, and complex products. 

The most common assets – bonds and equities – fall into the financial instruments bracket. 

Derivatives are securities whose prices are directly dependent on the price of an underlying asset and are typically used to hedge against risk or speculate on price movements.

The other product types – complex products – are securities embedding derivatives. They are typically traded by more sophisticated and experienced investors since they involve more financial engineering and customization. These products are used for more complex strategies to achieve specific, directed goals for an investor. 

There are a number of risks associated with investing in financial products. Asset prices aren’t solely based on the individual entity’s fundamentals. Market volatility can cause huge price shifts due to changes in public sentiment, geopolitical developments, or regulatory changes, despite the underlying company or asset performing well.

In extreme situations, entire stock markets can become worthless. This is rare, but it happened in China in 1917, the US in 1929, and Russia in 1947.

Complex products may be difficult or impossible to liquidate should you need that capital back quickly. Most complex products are intended to be held for the medium- or long-term, often with a specific ‘tenor’ attached to that investment. Selling that asset before the tenor period may result in losing some or all of your initial investment. 

Many equity or debt issuers themselves invest in capital markets – meaning the risks they take on could affect the returns you receive. 

Economic risks, including interest rate changes, inflation, and more influence potential losses as well.  

There are three main ways investors can trade on secondary markets – through exchanges, over the counter (direct from seller to buyer with no intermediary) and electronically. 

How trading takes place will depend on the type of product being bought and the amount of capital being invested. 

Generally, the more bespoke the product, the higher the chances of trading over the counter (OTC). These products aren’t suitable for all investors and are often illiquid in nature. Before buying over the counter products, it’s important to understand the product or strategy’s features, your time horizons, and your liquidity needs. 

Electronic trading through brokerage platforms is becoming more popular too and is now the preferred way of trading in the digital age, thanks to its ease of use and lower costs. 

In the secondary market, depending on the type of product desired, investors could take part in the cash, forward, or futures market segments. 

The cash market is the most common as most secondary market transactions are typically settled in cash on the spot. The futures and forwards markets, on the other hand, deal with products that are set for delivery on a specified future date.

Financial institutions play an important role in a healthy, functioning capital market. 

They may provide guidance, financing, custody, and operational support to market participants. 

For example, a bank may offer its clients research on a company to educate them prior to making investment decisions. It would then be indirectly contributing to healthier capital markets by improving the flow of information and knowledge. 

Financial institutions also give smaller investors access to capital markets by pooling resources and risks. 

Stock market index funds and exchange-traded funds are good examples: both let investors own a part of an investment theme or specific market without having to make large individual investments or design and implement portfolio “baskets” themselves.

Remember, capital markets are dynamic. They’re constantly evolving to keep up with new policies, regulations and innovations. It’s important to be aware of micro and macro factors that can have an impact on capital markets and your investments. 

For instance, interest rates have been low over the past decade or so, which has made the cost of capital cheaper and increased the supply of it in markets. That has benefited capital seekers. 

But it’s also produced inflation, because more money from capital suppliers has been chasing the same number of opportunities. So many capital suppliers have turned to other areas of the market, sometimes taking on higher risks for the same rate of return. But as interest rates rise to curb inflation, such trends can reverse.  

E-trading, meanwhile, is one long-term trend that’s driven trading fees down – and it looks like it’ll stick around. Some financial intermediaries used to make the bulk of their profits from trading fees. 

In more recent times, these firms have had to either change up their business models or specialize in trading more bespoke products that command higher fees. That has led to more product innovation in the market.