- Date : 28/01/2020
- Read: 6 mins
It’s not as scary as it sounds!
Delve into any financial book or blog and you are likely to encounter the term ‘capital markets’ within the first five minutes. While the structure and operation of capital markets can seem daunting to understand and uncover, these are not as complicated as they sound. A key thing to remember is that a capital market is NOT the stock market. In fact, the stock market is a part of a capital market, and it is important to remember to differentiate between the two.
So what are capital markets?
As the name implies, capital markets are that part of the financial system that helps raise capital. The market enables this by connecting suppliers of funds to users of funds. The users of funds could vary from individuals to companies to governments who are looking to channel the wealth of savers for long-term and productive use. The suppliers of funds could include households and institutions serving them, including but not limited to pension funds, life insurance companies, colleges, hospitals, and religious institutions.
Both the buyers and sellers can engage in trading of any form of financial security, such as bonds, stocks, currencies, debt instruments, or commodity futures, to name a few. Capital markets are pivotal to any economic or financial system as they encourage businesses and enable growth in an economy, allowing individuals, governmental systems, and businesses to flourish. It is important to note that while most capital markets are available publicly, some might be limited only to large-scale institutional investors. Due to the high-volume and sensitive nature of trade in capital markets, this takes place in secured computer-based electronic trading systems.
Are capital markets the same as stock markets?
A key misunderstanding that people often have when they hear the term ‘markets’ is they automatically assume it’s stock markets that’s being referred to. However, it is important to remember that capital markets and stock markets are not the same; in fact, the overall capital market includes stock markets as well as other venues where financial products can be traded, such as investment banks, government departments etc.
Stock markets such as the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) are where investors and banking institutions come together to trade stocks, which are financial instruments representing a part of a company. These stocks can be traded both privately and publicly, and are used by companies globally as an important way of fundraising capital. Just like any other investment, individuals and entities invest in the stock market, hoping they will be able to get higher returns on their savings, and companies use their investments for developing new products and services (or to continue their maintenance). Stock markets hold a very significant portion of the entire volume of trade in capital markets.
How is the capital market structured?
Broadly speaking, the capital market has two main markets: primary and secondary. Primary markets deal with the trade of new issues of financial instruments such as stocks. Secondary markets, on the other hand, deal with the trade of existing securities. In the primary market, the investor deals directly with the company issuing the security, but in the secondary market the company issuing the security is not often involved.
A company that is publicly selling bonds or other securities for the first time will do so in the primary market, often in the form of an initial public offering (IPO). Companies selling in the primary market to raise capital often hire investment bankers to help attract large investors to purchase securities, as they need huge capital in a small period of time. Small investors and individuals usually cannot buy securities in the primary market at this time.
On the other hand, in secondary markets, securities are traded between entities after a company has sold all bonds and securities on the primary markets. This would include all trading on stock markets such as BSE, NSE, New York Stock Exchange (NYSE) etc. Here, small investors have the ability to buy and sell securities. Often investors resort to hiring the services of an intermediary (such as a broker) to buy securities and bonds on their behalf.
Is the capital market regulated?
In India, the regulatory body that deals with the capital market is the Securities Board of India, commonly known as SEBI, which was set up in 1988 in order to reduce malpractice associated with dealing in financial commodities. Due to the rapid expansion of the financial industry and subsequent growth of capital markets, there were a lot of violations in operations of the same, which was when the government decided to set up SEBI.
SEBI is tasked with regulating all activities of capital markets, including protecting rights and safety of investors and their investments. It is also responsible for detecting any fraudulent activities or malpractice, as well as developing rules and regulations to enable intermediaries to function, among several other matters.
Why should you care about capital markets?
As mentioned earlier, the overall macroeconomic advantages of healthy capital markets are plenty, including being a driver for economic growth and development in an economy. Capital markets bring together savers and investors in an economy, and by pooling risks correctly, they allow for long-term projects to flourish in an economy. Even at the level of an individual, whether you are an investor or a business developer, the capital market offers many lucrative advantages.
As a business developer, capital markets offer you the opportunity to help develop and grow your business on a larger scale, including helping you build and launch new products and services. As an investor, the capital market enables you to enjoy returns on your investment (with some risks) through capital gains such as direct dividend payments or capital appreciation, with a relatively high liquidity.
Dividends are payments made to shareholders at the end of a financial year after agreement by company directors. Investors also have the prime advantage in a capital market of being able to access capital gains while avoiding the occupational and management hazards of owning the company. A well-developed capital market provides investors with a wide variety of financial products where they can invest, enabling them to diversify their risk and maximise return on investment.
As mentioned earlier, capital markets serve the fundamental purpose of helping to raise capital for entities, which is crucial for the establishment and flourishing of any entity. While it may sound daunting to understand, capital markets have a fairly simple structure. They aim to connect buyers and sellers, just like any other market.
Writer profile: Manan Vyas is the founder of Qrius, a digital magazine with a monthly readership exceeding a million.