Christian Edelmann and Shasheen Jayaweera
This chapter provides an introduction to the participants, products, and functioning of global capital markets (Figure 2.1). We also discuss the important role capital markets play in supporting economic growth and development. We start with a detailed discussion of key participants and how capital markets support their economic activities. We then introduce the main product groups offered, describing their key features and uses. Next, the various types of markets are explained, covering how they facilitate the funding and investing needs of participants. Finally, we conclude with a discussion of why capital markets are critical for economic development.
In a narrow definition, capital markets offer two types of funding products to issuers, equities and debt (also called fixed income) through both primary (initial issuance of securities) and secondary (ongoing trading of securities) markets. In a broader definition, capital markets include the trading of physical assets (e.g., commodities) in addition to currencies and derivatives.
Equities, commonly known as shares and stocks, represent an ownership interest in a corporation, hence the term share as each security is a share of ownership. Shares have the same limited liability rights of the corporations they represent, which means that the liability of share owners is limited to their investment amount. Shares are initially created when a corporation is formed, whereby the owners can choose the number of shares appropriate for the corporation's plans and valuation. At this point the corporation is known as a private corporation as all the shares are held by a close group of investors.
As corporations grow, some may choose to become a public corporation, or one that is listed on a public stock exchange, where members of the public can openly buy or sell shares. This process is known as listing, where existing or additional shares may be created and offered to the public through an initial public offering (IPO).
Shares entitle their holders to a share of the dividends declared by the board of directors to be distributed from the corporation's profits. Likewise they also generally entitle owners to a vote on critical decisions at annual general meetings. Shares can be created in different classes with differing rights. There are two broad classes of shares, common and preferred. Preferred shares typically have a higher claim on dividends and on the assets of a firm in the event of liquidation, but typically have no voting rights and have a fixed dividend that will not rise with earnings.
Following an IPO, shares are traded on stock exchanges and their valuation is subject to supply and demand, which in turn is influenced by the underlying fundamentals of the business, macroeconomic factors such as interest rates, and market sentiment.
The return to shareholders is a function of both the dividends paid to them from the corporation's profits, and of any movements in the share price (capital growth). Importantly too, equities have the lowest rights in the default and liquidation of a corporation, being the last to be paid out.
Fixed‐income securities, as the name suggests, promise a fixed return to investors. Fixed‐income funding is similar in nature to the provision of a loan by a bank, but issuers manage to attract a broader investor base through tapping into capital markets, generally lowering the required interest rate or improving non‐price terms for the issuer.
Fixed‐income securities typically have a maturity date when the security expires and the principal or loan amount is paid back to the investor. Most fixed‐income securities also offer interest rate payments (known as coupons) at regular intervals. Some types of securities such as zero‐coupon bonds do not pay out any coupons, while inflation‐indexed (also called inflation‐linked) bonds index the principal amount to inflation, and floating‐rate bonds offer a variable interest rate based on a benchmark market (variable) interest rate plus a premium.
There are two broad types of bonds based on the issuer: Corporate bonds are issued by corporations and Sovereign bonds are issued by governments. A third type includes municipal bonds issued by governments at the subnational level, which are particularly common in the United States. Sovereign securities are also referred to as rates as the main risk is related to movements in market interest rates. This is based on the assumption that the sovereign is risk free—an assumption that has sometimes proven false as we have seen 30 sovereign defaults from 1997 to 2014 alone.1 Corporate bonds are also known as credit securities as they also entail credit risk in the underlying issuer.
Fixed‐income securities are also tradable in the market and are thus subject to market price movements. Given that the interest rate payments are largely fixed, any decline in market interest rates raises the effective yield of the security (coupon payment as a percentage of value of the security). As a result, there would be increased demand for the security, driving its price higher and reducing its yield. Thus, the prices of fixed‐income securities typically move inversely to movements in market interest rates. Furthermore, a change in sentiment about the credit quality of an issuer can result in a decline in the value of those securities.
Foreign Exchange (FX) relates to the trading of currencies in exchange for other currencies. The most basic form of FX transaction is a spot trade where two currencies are agreed to be exchanged immediately at an agreed rate (although the settlement may take further time based on settlement standards). However, the bulk of FX‐related transactions happen in the form of derivatives contracts and these will be discussed in the next section.
FX is frequently broken down into G10 (comprising the 10 largest developed countries) and EM (currencies of all other countries). Trading volumes and market activity tend to be concentrated in the former.
Commodities represent basic goods, typically used in production and commerce. There are many types of commodities traded, with each commodity represented for contract purposes using a variety of sizes and qualities based on historical conventions. When commodities are traded on an exchange, they must conform to strict quality criteria to ensure standardization of each unit. The key groups of commodities include (with common examples):
Commodities are also largely traded in the form of derivatives contracts.
Securities can be classed also as cash and derivatives. Cash securities represent direct ownership or claims on assets such as part of a corporation or a financial obligation from an issuer. Derivatives, as the name suggests, are securities that derive their value from an underlying asset such as other securities, indices, commodities, or currencies (FX).
Derivatives typically represent future claims on assets, for example, if a commodity is bought forward via a forward contract. Hence they are heavily used for hedging purposes by a wide variety of market participants. Hedging involves offsetting some form of risk, such as potential future changes in interest rates or the potential change in the price of a commodity. When used as a hedging tool, derivatives effectively transfer the risk in the underlying asset to a different party. As such, derivatives can also be thought of as providing a form of insurance. Derivatives are also used as a form of (leveraged) investments.
The most common types of derivatives are briefly outlined below:
We described the narrow definition of capital markets as the provision of funding to issuers. In that sense, capital markets serve similar functions to traditional banking. Banks facilitate the provision of funds to customers to support their economic activities. Banks traditionally raise their own funding through customer deposits, and thus match investors supplying funds with issuers requiring funds. They also help transform the maturity or term profile required by each of these parties, with investors typically seeking to part with their funds mostly for short periods and issuers looking for longer‐term funds.
Banks traditionally relied on their deposits for a significant proportion of their lending; thus deposits were the primary limit on lending. However, now, under most modern fractional reserve banking systems (which we will not detail here), banks have the unique ability to also create money. To highly simplify the process, when a bank creates a loan (an asset on its balance sheet), it simultaneously also creates a deposit in the loan customer's account (a liability on its balance sheet). The deposit is effectively new money, created by the bank, which the customer can then utilize. This is known as the money creation effect. Banks could theoretically offer unlimited lending and create unlimited new money; however, they face several regulatory restrictions on their activities. These regulations result in banks having to optimize between several constraints to their lending and deposit‐taking activities based on the quality and quantity of loans, deposits, other funding and capital (can largely be thought of as shareholders' equity and reserves). In effect the deposit base and capital position of a bank serve as key restrictions on overall lending growth. The main regulations have converged globally around the Basel accords and local requirements. These regulations will be discussed further in Chapter 3 but are briefly discussed here:
Given the constraints faced by banks, capital markets offer an important alternative source of funding for issuers and alternative investment options for investors. From an issuer perspective, fixed‐income securities allow a broader range of funding options compared to bank loans. They are highly customizable and allow for a broader issuer base enabling issuers to raise funds which banks may not be willing to provide in the form of a loan given constraints discussed above. Of course, capital markets also offer the option of raising equity funding, which is not available generally from banks. From an investor perspective, both fixed‐income securities and deposits can offer a fixed return. However, fixed‐income securities allow investors to also take corporate credit risk, create a more diversified portfolio, and access different points on the risk/return profile, whereas deposits, which tend to be at least partially insured, typically offer the lowest return for investors.
The mix of bank lending and other forms of capital markets financing differ significantly between countries as demonstrated in Figure 2.2. Countries with more advanced and deeper capital markets such as the United States and the UK see larger shares of capital markets financing when compared to countries like India, China, and South Africa. Countries like Egypt and Nigeria almost completely rely on bank lending with relatively limited capital markets. In some emerging markets such as those in South and Central America, bank lending is extremely difficult to obtain for many businesses, resulting in total funding markets being skewed toward larger firms that utilize capital markets. Capital markets utilization can also vary significantly within countries. Japan's overall funding, for example, is overall largely biased toward capital markets. However, for corporate funding, Japan relies largely on bank loans. This is, however, masked as Japan's financial institutions and government are large users of capital markets.
Capital markets consist of five basic stakeholders:
Issuers represent the demand for funding in capital markets and seek to obtain funding for a variety of reasons, differing based on the type of issuer. In general, issuers seek funds to develop or maintain economic projects which generate cash‐flow. The cash‐flow from these projects is partly used to pay for the cost of funding obtained. There are four main categories of issuers: financial corporations, non‐financial corporations, sovereigns/governments, and quasi‐sovereigns or international multilateral organizations.
Overall, corporations are by far the largest issuers of capital markets and we differentiate here between financial and non‐financial corporations as their needs and use of funds, along with the type of funds used, can differ considerably. Each of these issuers will be discussed in more detail now while the types of capital markets products they use will be covered in the next section.
Non‐financial corporations include both listed (public) and unlisted (private) firms. These firms require funds for carrying out their various economic activities with funding requirements typically differentiated between the term required:
Participation in debt capital markets generally requires a credit rating, which is typically only available to larger firms with sufficient historic financial information. On the other hand, a range of companies access equity funding, with some exchanges even catering exclusively to smaller companies.
From an issuer perspective, financial corporations include banks, thrifts (also known as savings and loans in the United States), building societies, and credit unions, but also to a lesser extent, investment managers such as fund‐managers. Financial corporations are also significant users of capital markets and are highly involved as intermediaries, too. While many of them have investment needs as corporates (e.g., for branches or IT systems), we highlight two distinct funding purposes:
Sovereigns and governments (used interchangeably) are also significant users of capital markets in most economies globally although smaller in aggregate than corporates. In larger economies such as the United States, governments at all levels including the federal/national, state/province, and local/municipal level are active users of capital markets while in smaller economies, typically only the national and state governments are in a position to seek funding through capital markets. In some smaller economies and in emerging or developing markets, governments typically are the largest issuers in capital markets. Governments typically require funding from capital markets for two broad uses:
A third but related point is that during times of economic stress (such as recessions), governments often use fiscal measures such as increasing public spending (both consumption and capital), aiming to create extra demand and stimulate economic growth to lift their economies out of recession.
While we have classified governments under issuers, governments can also be investors. In certain countries, where governments accumulate surplus budget funds or foreign exchange surpluses, these are also invested through capital and other markets, typically through central banks or sovereign wealth funds (SWFs), which we will cover under investors.
Government securities are typically issued by their Treasury departments. However, certain sizable government entities which engage in significant financial activities may also seek funding on their own. These include, for example, the Federal National Mortgage Association (FNMA) or “Fannie Mae” in the United States, a publicly traded corporation, which is a government‐sponsored entity (GSE) and supports the national mortgage market.
Quasi‐sovereigns or international multilateral organizations (MLOs) are typically owned and managed by multiple governments with activities focused on projects in multiple nations with significance to more than a single government. Examples include the World Bank Group, the European Bank for Reconstruction and Development (EBRD), the International Monetary Fund (IMF), and regional development banks such as the African Development Bank (AfDB) and the new Asia Infrastructure Investment Bank (AIIB). These institutions largely provide funding to governments in developing and emerging markets to foster economic development, largely for infrastructure or trade and related projects. Some MLOs also provide funding directly to corporates and financial institutions under special programs related to their wider national development agendas. They borrow funds from international capital markets at lower costs than what individual loan recipient countries can typically borrow at.
Furthermore, issuers also use capital markets when they want to sell assets. For example, a corporation may want to divest or de‐merge part of its business and seek new owners for the business. A government may want to privatize a national asset and raise funds for other purposes, thus using capital markets to facilitate the sale and receive funds from investors.
Investors or asset owners represent the supply of funding in capital markets and seek to obtain a return for supplying funds to issuers. Figure 2.3 compares a selection of countries from around the world and their investors' assets expressed as a share of GDP. Investor assets vary widely, with advanced economies having significant investment funds and emerging and developing economies much smaller pools of funds. Some countries like the UK and Singapore are hubs for investment management due to financial infrastructure, legal environments, and tax reasons and have higher‐than‐average investment funds available. Others such as Australia have strong mandatory pension savings regimes and countries such as Japan have strong savings cultures boosting funds.
Investors can be any individual or institution which is in possession of funds and seeks to generate a return from those funds. We see seven types of investors. Individual investors (category 1 below) represent persons (also referred to as retail investors). Institutional investors, on the other hand, invest on behalf of pools of underlying clients, or represent large institutions such as governments. Institutional investors (categories 2–7 below) can typically be very powerful forces in capital markets given the size of funds they represent and their trading activity can influence the activities of issuers (i.e., the strategy and behavior and politics of the underlying issuer firms, and even governments). Institutional investors are thus seen as exceptionally important and issuers from firms to governments dedicate significant time and effort to ensure their confidence and understanding of the issuer's strategies and activities. The key categories of investors are outlined in the following sections.
Individuals have a variety of options for generating returns from their savings. In most countries, the largest investments made by individuals are typically their homes. Individuals may choose to keep any extra savings funds in bank accounts, although these typically yield lower than other options on average. As a result, individuals increasingly participate in capital markets, either directly, such as the purchase of equities or bonds through a broker, or indirectly, through placing their funds with an asset manager. Figure 2.4 demonstrates that individuals in the United States are increasing investing their savings through investment management companies, a trend which is also observed in many other countries.
With the prevalence of online brokers, and the diversification of their offerings, retail investors can now directly participate in many capital markets products. Retail capital markets activity is largely concentrated in equities given their ease of access, low fees, and typically less complex products. Retail investors can easily trade ETFs and basic derivatives such as stock options and contracts for difference (CFD) while in some markets fixed‐income securities are also easily accessible through brokers.
Insurers collect premiums from their policyholders and use these proceeds to invest in assets which will eventually support the payment of claims according to insured events such as life events (death, terminal or critical injury, etc.), property and casualty (fire, injury, etc.) and health events (hospitalization, medical care, etc.) by their claim‐holders.
Pension funds aggregate the retirement savings of individuals. For pensions which are managed and provided directly by employers, the pension fund represents the employer's contributions to meet their future pension obligations to their employees. Individuals and/or their employers make regular contributions to these funds, usually as a proportion of monthly pay, and this is invested to grow over their working life. Given their size in some countries, pensions represent a powerful class of investors. Upon retirement, individuals either withdraw their pension for usage, or convert their pension fund into an annuity which pays regular cash‐flows. In an increasing number of nations, contributions to pensions are mandated, including Australia (Superannuation), USA (401K), UK (Workplace Pensions), and Singapore (Central Provident Fund) to mention a few. Governments have realized that as the share of the working‐age population declines and as people live longer, the government is less able to fund extensive social security programs and that individuals will need to be responsible. As such, pensions represent a sizable share of available funds and are very important given the millions of individuals who rely on them for retirement income and for saving governments from extensive social security payments. Pensions originally were largely structured as defined benefit where investors were guaranteed a fixed benefit or payment based on their incomes or regular contribution amount. Given fluctuations in asset prices and difficulty in forecasting, together with the fact that life expectancy has increased significantly in the past 50 years, pensions are increasingly adopting a defined contribution structure, where the benefit is dependent on both contributions and the investment performance of the pension.
Banks invest in capital markets products as part of their asset‐liability management (ALM) process (see “Financial Corporations” for an overview). However, banks need to be prepared for any short‐term shortages in liquidity and thus are required to hold a significant amount of highly liquid assets (set to be at least 100% of net stressed cash‐flows over a 30‐day period under the Basel Liquidity Coverage Ratio rules). This should ensure that in the event of a liquidity crisis, banks can convert these assets into cash in capital markets relatively quickly to cover cash shortfalls.
Governments can generate surplus funds, either through budget surpluses, through asset sales (national firms, or commodities, etc.), or through foreign exchange surpluses. Many governments have created state funds tasked with investing these funds, known as sovereign wealth funds (SWFs). The investment of these funds is extremely important given that their income supports national budgets and national investment in infrastructure and facilities such as schools and hospitals. Given the size of these funds, they must tap capital markets to source appropriately sized investments.
Following the financial crisis of 2008, central banks have become significant investors in capital markets through the use of quantitative easing (QE). QE involves the purchase of securities (largely government securities) from banks to reduce yields and enable banks to increase lending activity with the additional funds in order to stimulate economic growth. The United States (Federal Reserve), Europe (European Central Bank), and Japan (Bank of Japan) have all extensively used QE over the past decade to stimulate economic activity.
Some central banks also have significant funds which are used to manage their exchange rates, of which the Chinese State Administration of Foreign Exchange (SAFE) and the Hong Kong Monetary Authority (HKMA) are two key examples. These funds are utilized to buy and sell securities (largely high‐grade government debt, but also increasingly some equities) globally and locally both to effect local exchange rates and to invest their funds and generate a return. SAFE is estimated to manage over US$3 trillion in assets at the time of writing, much of it accumulated through China's large trade surpluses over the past decade.
Central banks also participate widely in capital markets as part of their role to implement monetary policy and in some cases as part of their role in managing exchange rates. In many countries, central banks manage the key overnight reference interest rates through trading activity in overnight repo markets, effectively setting the rates banks lend to each other overnight. Repos, short for repurchase agreements, are short‐term collateralized loans made between two parties where one party borrows money in return for securities (the collateral) and agrees to buy back the securities at a fixed time. Repos are vital instruments for short‐term financing in many capital markets. Through repo and reverse‐repo (the opposite transaction flows to a repo) trading activity, central banks can manage the demand and supply for money and thus the cost of money or the interest rates. Central banks also can influence interest rates through the interest they pay on funds deposited by banks in special accounts at the central bank, known as reserve accounts, for settling payments.
Endowments are trusts made up of funds, usually donated, and dedicated to provide ongoing support for the activities of certain (typically nonprofit) institutions. The most well‐known endowments include those established to support universities or charitable not‐for‐profit organizations. Endowments invest their funds through capital markets and supply a portion of the investment returns to support their beneficiary institution, occasionally also utilizing some of the funds when investment incomes may be low.
Investors/asset owners may directly manage their capital markets investment decisions (using brokers or trading platforms to execute these decisions), or place their funds with asset managers who make investment decisions for asset owners based on various investment strategies. Asset managers either offer segregated and bespoke mandates to institutional investors or aggregate investible funds from numerous investors into funds, each with clearly defined investment policies and principles.
There are four types of basic fund structures:
Financial intermediaries enable capital markets to operate across the full breadth of products facilitating the matching of the specific needs of investors and issuers. There are five main categories of intermediaries in capital markets: banks (investment banks), broker‐dealers, exchanges and clearing organizations, custodians, and central securities depositories. Apart from banks and broker‐dealers, these intermediaries are also known as market infrastructure.
In the section “Key Participants in Capital Markets,” we discussed the function of banks as investors and issuers. Banks also play two further significant functions in capital markets. These include the investment banking function (discussed in this section), and the broker‐dealer function (discussed in the next section).
The investment banking function supports firms to raise funding from capital markets and to also broker mergers and acquisitions deals between firms. There are three subfunctions within investment banking broadly:
Broking (brokering) and dealing are two separate functions although they are often discussed together given that their core functions are complementary and often offered in an integrated manner. Broking essentially involves the execution of capital market transactions without taking on any risk. It is also called acting on an agency basis when dealing in equities and riskless principal when dealing in the fixed‐income markets. In essence, brokers connect two parties to a transaction, either through a trading medium such as an exchange, or directly as in over‐the‐counter transactions. For this service they charge a commission.
Dealers in contrast act on a principal basis, willing to use their own balance sheet to make a market for clients (known as market‐making). Dealers quote a spread for each security they are willing to trade in. The spread refers to the difference in the price they would be willing to buy or sell a security at. Dealers thus may have to sometimes serve as the counterparty to a trade until a further counterparty is found. Banks can now largely only undertake such principal transactions for their clients under the “Volcker Rule” in the United States and its equivalents elsewhere. These rules prevent banks from putting their own capital at risk in high‐risk short‐term trading transactions which are not directly related to benefiting their clients (known as proprietary trading) to increase profits.
A subset of brokers are inter‐dealer brokers who only look to serve broker‐dealers themselves as their clients.
Broker‐dealers also provide advice to their clients on which investments to make, often supported by teams of research analysts. The research reports of broker‐dealers are highly important in supporting investor participation through the dissemination of trade ideas while also keeping a close check on the performance of issuers. Research has generally been bundled into brokers' trading commissions and thus not charged for separately, although recent reforms under Europe's MiFID II could see research unbundled and charged for separately to minimize potential conflicts of interest and increase transparency for end investors.
Exchanges are venues where buyers and sellers of securities meet to transact/trade in those securities. Today, most exchanges, particularly for equities, are almost completely virtual; however, some still maintain trading floors where traders representing the brokers of buyers and sellers physically meet and agree to trades. Historically exchanges were typically specialized in certain asset classes, the most well‐known of which are stock exchanges where equities are traded. Other key exchanges include commodities‐focused exchanges such as the Chicago Mercantile Exchange (CME). Increasingly, exchanges have been diversifying over the past decade, with credit fixed‐income products, exchange‐traded funds, and a host of derivatives offered on exchanges. Several exchange groups such as the London Stock Exchange (LSE) and Intercontinental Exchange (ICE) have formed exchange groups with multiple asset classes.
Following the execution of a trade, there are two key post‐trade processes conducted: clearing and settlement. The Bank of International Settlements (BIS) defines clearing as “the process of transmitting, reconciling and, in some cases, confirming payment orders or security transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement.” In essence, clearing is the process of preparing to complete or settle a trade and involves confirming several administrative and legal details between the counterparties and their brokers. The BIS defines settlement as “the completion of a transaction, wherein the seller transfers… securities or financial instruments to the buyer and the buyer transfers money to the seller.” In essence, settlement involves the completion of the trade, thus recording the changes in ownership of the security and undertaking of relevant payments.
Clearinghouses are defined by the BIS as “a central location or central processing mechanism through which financial institutions agree to exchange payment instructions or other financial obligations. The institutions settle for items exchanged at a designated time based on the rules and procedures of the clearing house.” In essence, clearinghouses carry out the clearing stage of a trade preparing for settlement. In the United States, all equities are cleared through the Depository Trust and Clearing Corporation (DTCC) group centrally while multiple clearinghouses exist for other securities, including CME Clearing and ICE Clear. Europe and Asia are more fragmented with multiple clearinghouses, including for equities. Equities clearinghouses are mostly owned by exchanges.
Clearing houses can assume an additional role of acting as central counterparties (CCPs) serving as a direct counterparty to all trades for each side or “an entity that is the buyer to every seller and seller to every buyer of a specified set of contracts” as defined by the BIS. Both the buyer and seller's contracts are novated, in essence, their contract is replaced with two contracts between them and the CCP, and thus are not exposed to risk of either counterparty defaulting. The CCP, serving both sides of numerous trades is able to undertake considerable netting between transactions to minimize exposure, and accepts collateral from each party of the trade to ensure deliveries are met. Netting refers to the process of consolidating multiple positions into a single position, resulting in each party only having to make a single transaction based on the net value of multiple transactions. The benefits from netting alone can be very large, substantially affecting the economics of a trade.
Figure 2.5 depicts the basic trade flow with and without a CCP.
Central securities depositories (CSDs) are registrars responsible for maintaining the original ownership records for securities and facilitating the settlement and transfer of securities between owners. Traditionally, securities were issued on paper with the owners' names registered and stored in large safes by the owners. Trading was complex with certificates having to be physically delivered. As trading volumes increased, storage of the certificates was first centralized and then digitized and today almost all securities globally are stored in electronic databases maintained by CSDs. Transfers of securities are now done through electronic book‐entry, that is, changing the ownership of securities electronically without moving physical documents.
An international central securities depository (ICSD) is a central securities depository that facilitates cross‐border settlement of securities from various domestic markets. ICSDs were originally set up to manage clearing and settlement of the Eurobond business for which there was no supporting market infrastructure. Since their creation over 30 years ago, the business of ICSDs has expanded to cover most domestic and internationally traded instruments, including investment funds. ICSDs usually operate through direct or indirect (via local agents) links to local CSDs. Clearstream Banking in Luxembourg, Euroclear Bank, and SIX SIS in Switzerland are considered ICSDs. Clearstream and Euroclear together dominate the European ICSD/CSD market.
Custodians are banks that are responsible for holding assets such as capital markets securities on behalf of investors. In their safe‐keeping or custody role, custodians ensure that the assets of clients managed by large investment firms are held safely and accurately in their names. In their asset‐servicing role, custodians also support the clearing process, corporate actions processing (such as dividends and stock splits), tax advice, and also assist with transaction accounting and reporting. Typically, investment fund assets and collateral for trades are safeguarded by a third‐party so that they are separated from the assets of the investment manager protecting the underlying investors, and to ensure that they are transacted within the bounds of their various investment mandates. A few large global banks such as BNY Mellon and JP Morgan dominate the custodian industry. There are two types of custodians:
Figure 2.6 depicts how each of these intermediaries support the processing of an exchange‐based trade.
Several other important institutions also exist that support the smooth operation of global capital markets and their broader ecosystem of participants. We have provided a brief overview on some of these institutions here:
Primary markets refer to the initial issuance of equity and debt securities, where the securities are newly created (or originated) and then issued to the market for subscription. The processes for issuance of equities, credit, and government securities was discussed earlier.
Following the initial creation of the securities, subscriptions, and their listing, the ongoing trading of securities on exchanges is referred to as the secondary market. The primary and secondary markets can be seen as substitutes in some ways, as investors can choose to invest in newly created securities or buy existing traded securities, as shown in Figure 2.7. However, each security type can differ considerably.
Secondary market volumes drastically exceed primary markets as they represent the ongoing trading of securities over time for equities. This also holds for many classes of bonds although many bonds are lightly or rarely traded (held to maturity). Both primary and secondary market volumes can fluctuate significantly. Primary market issuance in equities, for example, is highest when economic conditions are best and when issuing companies can demand a higher price. Primary equity markets can sometimes virtually shut down when economic times are challenging. Secondary market volumes, both for equities and fixed income, can also change drastically during periods of economic uncertainty when market participants are changing their expectations and making significant shifts to their portfolios.
Figures 2.8 and 2.9 depict primary and secondary market activity levels in the United States. Primary issuance can be very volatile as market sentiment changes. For example, following the financial crisis of 2008, appetite for investing in new equity issuances almost disappeared, dropping by over 80% from 2007. Issuance volumes have risen since as economic growth and the outlook improved. Trading volumes followed a similar path. Fixed‐income issuance increased significantly following the crisis as the U.S. government had to borrow heavily to fund its budget deficit.
Exchange markets are those where securities are traded over an exchange serving as an intermediary to match buyers and sellers of securities. These include stock, futures, commodities, and other products. Exchanges provide real‐time data on the demand and supply for each listed security in their order books, which display the volume of each security type available for sale/purchase and the corresponding prices asked/offered. Trades are made when there are matching prices from buyers and sellers. Note that the order book, however, does not reveal who the buyers and sellers are. Securities listed on exchanges are standardized in that there are generally only a few (typically between one and three) classes of securities for each issuer. Furthermore, the size of each security unit is typically small, allowing relatively small amounts to be traded at a time. Given the level of standardization, securities transactions are typically settled electronically (mostly within three days of the trade), with buyers and sellers typically having no knowledge of each other. Furthermore, given securities are more standardized and bid and offer prices are visible and published, there is a high degree of price transparency.
OTC markets refer to the trading of contracts through a dealer network as opposed to on a centralized exchange. OTC contracts are typically highly customized (non‐standardized) and there is a broad array of securities available within each asset class. Furthermore, each security is typically larger in value and they are thus typically only traded by wholesale investors. There are two main types of OTC traded securities: fixed‐income securities and OTC derivatives.
A single listed corporation, for example, may have hundreds (or even thousands for the largest corporations) of fixed‐income instruments issued, each issued at a different time, for a differing term, with a differing face value and coupon payment. As a result liquidity is more dispersed and less suitable to a central order book approach.
The vast majority of derivatives also trade on OTC markets, with only equity derivatives having a significant presence on exchange markets. Given the high degree of customization, varied liquidity, and large trade sizes in OTC markets, pricing can be an art and rely on complex formulas together with significant judgment. Banks and brokers employ numerous Sales and Trading staff who specialize in certain asset classes, and often certain geographies for certain asset classes to serve the trading needs of clients.
Given the high degrees of customization and involvement of significant manual effort for OTC transactions, trades can typically take longer to settle. Significant amounts of manual verification work are required for trades to be processed, including for the details of counterparties to be exchanged, for trade contract details to be verified, for payments to be processed, and for the trade to be recorded. One factor which exacerbated the effects of the 2008 financial crisis was that, facing default, several banks and other market participants struggled to trace the final counterparties to many of their OTC derivatives transactions and struggled to completely settle outstanding trades. This led to the virtual freezing of market trading activity, increasing risk to all participants. A key pillar of reform efforts since the crisis has focused on increasing automation of trade processing, mandatory clearing (through a central counterparty), improved (and increasingly mandated) trade reporting, and the centralization of trade, counterparty, and settlement details. As an example, the bulk of interest rates and credit default swaps are now centrally cleared with regulations introducing penalties for uncleared swaps in the form of increased and/or mandatory exchange of margin.
While exchange trading is virtually electronic at this time, OTC trading is becoming increasingly electronic to reduce risks and to increase speed and accuracy. Major dealers offer proprietary platforms for their clients known as dealer‐client platforms, allowing their clients to quickly access their pricing information and to process trades. Alternative types of exchanges have also been emerging rapidly. One such type is a swap execution facility (SEF) in the United States (in Europe, SEFs are comparable to multilateral trading facilities or MTFs). SEFs are non‐exchange venues facilitating the trading of swaps between many member participants. SEFs allow greater price and trading transparency by allowing participants to see other participants' bids and offers and the movement in prices and volumes.
Figure 2.10 shows how trading venues vary by asset class and the variety of trading options available. Trading is increasingly facilitated through electronic means such as exchanges and trading platforms versus manual means such as voice brokers, although the most complex assets still require more manual processing.
Dark pools are a further category of markets. Dark pools are a type of alternative trading system (ATS) in U.S. regulation, and fall under multilateral trading facilities (MTFs) in Europe. Dark pools are a type of exchange where traders can buy and sell securities privately without revealing their identities and without revealing transactions to the public.2 Dark pool trading has increased significantly in recent years, rising to over 30% of trading by some estimates in the United States,3 and 10% in Europe.4 Proponents of dark pools argue that they allow for larger trades without disrupting regular markets, and improve liquidity, particularly for larger orders. However, opponents of dark pools argue that they reduce transparency, reduce liquidity, and can lead to pricing impairments.
As discussed throughout this chapter, capital markets provide an important source of funding for several types of issuers thus supporting their economic activities and growth. In essence, capital markets channel capital to productive investments. The larger the capital market, the more investment that can be supported, and the more investment supported, the more capital and infrastructure in the economy, which results in increased economic output. As such, building and maintaining robust capital markets is often a key priority to support economic growth.
Capital markets offer a diverse range of investment opportunities, helping investors achieve increased portfolio diversification. This helps to support a better matching of the needs of investors with those of issuers. Furthermore, capital markets can help support more longer‐term investment opportunities. The diversification of investment opportunities and increased investment expertise required can stimulate the development of the local asset management industry. With fund managers, pension funds, and insurers growing, economies can benefit tremendously from increased access to new financial products provided by these firms. Furthermore, these firms offer additional options for transforming maturity (more longer‐term investment appetite to fund longer‐term funding needs) and for matching investors and issuers, contributing to more effective markets. In the longer run, the provision of this range of asset management services, combined with more individual ability to directly invest, can decrease dependence on social welfare.
The diversification of investment opportunities also diversifies the sources of credit and associated risks. Rather than being concentrated in firms that banks choose to lend to, credit risk is spread across a range of issuers and projects. Furthermore, with a broader base of investors, credit risk is also diversified across the issuer base, placing less stress on the banking system. This can improve stability during difficult economic conditions.
Even countries that boast large capital markets are on a constant path of reform to continue to drive improvements, as demonstrated through recent reform efforts across major advanced economies. This section provides a brief overview of the drivers of capital markets development. We draw heavily on recent work completed by Oliver Wyman and the World Economic Forum on capital markets development in this section.5
In essence, capital markets development rests on three pillars:
A range of options are available to improve each of these three pillars and we'll next briefly discuss these options. However, none of these options can be truly successful on their own. For example, several initiatives can be undertaken to increase issuer participation, but unless investor participation is also improved, issuers will not be able to successfully raise the funds they seek. Capital markets are an ecosystem, and a combination of policies and actions across each of the key pillars is required to drive development.
First, initiatives targeted at streamlining the listing process can help to facilitate increased issuer participation. However, these initiatives should also ensure that adequate disclosure standards are maintained. The listing process involves registration, prospectus preparation, and approvals, all of which can be costly and take significant time. Furthermore, for smaller firms seeking to list, these processes can be even more costly, deterring use of equity markets. Second, the privatization of state‐owned enterprises through public offerings can dramatically increase equity participation particularly when equity market depth is limited. As further larger firms are listed, the depth of investment options rises, drawing more investors and thus encouraging more firms to list. Singapore and Malaysia both followed this route. Third, even in the most advanced economies, small‐to‐medium enterprises may struggle to source capital, finding the listing process too expensive and onerous. Furthermore, they may struggle to draw attention in the midst of bigger names. Many countries have seen separate exchange markets develop to cater to smaller firms while some exchanges have created specific segments to bring more attention to smaller firms, including Korea, Thailand, China, Malaysia, South Africa, and Singapore. Finally, a further policy commonly undertaken includes facilitating broader types of listed investments, from infrastructure funds to other exchange‐traded funds (ETFs).
Many of the policy initiatives discussed above for equity markets also apply to fixed‐income markets. However, given the closer substitutability to bank loans, investor participation is much more a function of relative cost. Approval and security issuance processes are all extremely important, too.
Improving investor participation likewise is complex; investors require a broad range of capital markets products (see discussion on increasing issuer participation). Furthermore, there also needs to be sufficient wealth in an economy for investment. An early method of stimulating investor participation includes opening up markets to more foreign capital. This requires FX and capital account liberalization and so must also be coordinated closely with macroeconomic policy. Singapore and Korea both were strong proponents of this approach. However, foreign capital can also be volatile, being drawn away during uncertain economic times, and should be carefully balanced with growing domestic investor participation, too. Initiatives to boost savings also vastly support investor participation. Countries which have mandatory pension savings programs have amassed significant savings, also further boosting the asset management industry. Likewise, initiatives to boost the wider adoption of insurance further support increased participation. Finally, investor education initiatives can also support broader awareness of savings and investment, increasing particularly retail use of asset management, and also direct capital markets participation. Countries such as the United States, UK, Australia, and New Zealand have wide‐ranging investor education programs boosting participation.
Needless to say, a strong regulatory and supervisory framework with clear, fair, and prudent standards for governing capital markets is fundamental. As discussed earlier, capital markets involve a multitude of supporting infrastructure, from exchanges to ratings agencies, from data providers to custodians. Trust is a fundamental characteristic and ensuring the stability and robustness of each of these institutions, together with ensuring the highest standards of their work, is fundamental for strong capital markets. As mentioned earlier, even the most advanced economies are still continuing to refine their capital markets frameworks. This process is unlikely to pause as markets, their products, and their participants evolve. The details of regulation and market infrastructure will be covered in subsequent chapters.
Capital markets also facilitate improved market discipline and transparency. Public fundraising involves high disclosure and transparency standards together with improved corporate governance. Issuers are subject to market sentiment with the price of their securities directly affected by their performance, hence keeping them focused on effectively managing their organizations. In effect, capital markets can also serve as a barometer of economic risks based on how investments are being priced. Increasing credit spreads can be a result of increasing credit risks, as are declining equity prices, suggesting the outlook for firms may be declining.
While vital to economic development, capital markets also are subject to market forces and have proven to be extremely volatile. During the Financial Crisis of 2008, global credit markets shut down temporarily or came close to shutting down. Equity markets can also fluctuate vastly as market sentiment shifts, significantly affecting the value of investments of pensions and other investments while also impacting consumer confidence and the ability for firms to source new equity funding. Thus, while capital markets support economic activity and growth, they can also harm it, and as a result, effective regulation of capital markets is vital. In the years since 2008, there has been a renewed (and more coordinated) focus on stringent regulation globally. A more detailed discussion on relevant global regulations will be covered in a subsequent chapter.
Figure 2.11 depicts the growth of capital markets globally since 1990. Even in this relatively recent timeframe, the growth of capital markets is evident across all participants despite significant fluctuations along this journey.