CAPITAL MARKETS

The capital market provides financing to meet the denomination, liquidity, maturity, risk (with respect to credit, interest rate, and market), and other characteristics desired by those who have a surplus of funds and those who have a deficit of funds. The capital market as a whole consists of overnight to long-term funding. The short to medium end of the maturity spectrum is called the money market proper, and the long end is identified as the capital market. The financial instruments range from money market instruments to thirty-year or longer bonds in credit markets, equity instruments, insurance instruments, foreign-exchange instruments, hybrid instruments, and derivative instruments. Since about 1960 an explosion of innovation in the creation and development of instruments in the money and capital markets has occurred in both debt and equity instruments.

Some of the important (by volume) money market instruments are Treasury bills and bonds, federal agency securities, federal funds, negotiable certificates of deposits, commercial paper, bankers' acceptances, repurchase agreements, eurocurrency deposits, eurocurrency loans, futures instruments, and options instruments. Similarly, some of the key capital market instruments are U.S. securities; U.S. agency securities; corporate bonds; state and local government bonds; mortgage instruments; financial guarantees; securitized instruments; broker-dealer loans; foreign, international, and global bonds; and eurobonds.

THE CAPITAL MARKET IN THE UNITED STATES

The capital market in the United States is highly developed, marked by sophisticated technology, specialized financing institutions and functions, wide-ranging geographic locations, and continuous innovation in financial products and services to meet the needs of financial investors and those seeking to acquire funds. There are both direct and indirect markets. Corporations, for example, engage in direct finance when they invest in one another's paper directly without the services of brokers and other specialized intermediaries, similar to the proverbial entrepreneur getting funds from an uncle. Most of the financing in the United States, however, is done indirectly through financial intermediaries who substitute their credit for the credit of the borrower (user) of funds. The total amount of credit for 2005 in the United States was projected to reach approximately $3,000 billion, of which debt instruments accounted for $2,700 billion and equity instruments (net) for $300 billion.

Money and capital market instruments are traded directly among participants, in the over-the-counter markets and in organized exchanges. Many of the exchanges specialize in the type of securities traded, thus giving focus and depth to that instrument or market. The major U.S. exchanges are the New York Stock Exchange (NYSE), Philadelphia Stock Exchange, Pacific Stock Exchange, Boston Stock Exchange, Cincinnati Stock Exchange, Midwest Stock Exchange, Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), International Money Market, National Association of Securities Dealers Automated Quotations System–American Exchange (NASDAQ-AMEX), Globex, Archipelago, and DMA & NYFI.

The regional exchanges—such as Boston, Cincinnati, the Midwest, the Pacific, and Philadelphia—each list a small number of regional companies to facilitate their raising of capital in the market. The national/international markets are the NYSE, NASDAQ-AMEX, CBT, CME, Archipelago, and DMA & NYFI.

The NYSE, organized by twenty-four brokers in 1792, is the oldest exchange in the U.S. capital market. The first traded company on the NYSE was the Bank of New York. It is still traded today, but has not been continuously listed on the NYSE. The NYSE states its mission as:

To add value to the capital-raising and asset management process by providing the highest-quality and most cost-effective self-regulated marketplace for the trading of financial instruments, promote confidence in and understanding of that process, and serve as a forum for discussion of relevant national and international policy issues. (http://www.nyse.com/about/theorganization/1088623922144.html)

According to the NYSE, it is "the largest equities marketplace in the world." The NYSE is home to some 2,800 world-class companies with a total global market value of $20 trillion as of late 2005. It had a daily average of over 1.5 billion shares traded in 2005. In late 2005 the NYSE had 401.6 billion shares listed. These companies include a cross-section of leading U.S. companies, midsize and small capitalization companies. Non-U.S. issuers play an increasingly important role on the NYSE. As of October 31, 2005, 460 non-U.S. companies worth $7.1 trillion were listed on the NYSE.

Organized in 1971, NASDAQ was the world's first electronic stock market. According to its mission statement, NASDAQ-AMEX's purpose is "to facilitate capital formation in the public and private sector by developing) operating and regulating the most liquid, efficient and fair securities market for the ultimate benefit and protection of the investor." Its vision is:

to build the world's first truly global securities market … a worldwide market of markets built on a worldwide network of networks … linking pools of liquidity and connecting investors from all over the world … assuring the best possible price for securities at the lowest possible cost. (http://www.nasdaq.com/about/overview.stm)

In 2005 NASDAQ was the largest electronic screen-based equity securities market in the United States. With

approximately 3,250 companies, it listed more companies and, on average, traded more shares per day than any other U.S. market.

INITIAL PUBLIC OFFERINGS AND ROLE OF VENTURE CAPITAL

The appeal of being a public company, which requires a filing with the U.S. Securities and Exchange Commission (SEC), in accordance with the requirements of the Securities Act of 1933, is closely related to the liquidity of issued securities provided through the stock markets. Companies seeking to "go public" engage an investment bank that will serve as underwriter for an initial issue of stock. Generally, for large offerings, an underwriter will form a syndicate of other investment bankers and brokers who will participate in the initial selling of the issue. Shortly after the sale of the initial offering the stock will be listed on a stock exchange.

Venture capital, which consists of funds raised on the capital market by specialized operators, is one of the most relevant sources of financing for innovative companies. Venture capitalists buy shares or convertible bonds in a company. They do not invest in order to receive an immediate dividend, but rather to allow the company to expand and ultimately increase the value of their investment. Hence, they are interested in innovative small companies with very rapid growth rates. Some venture capitalists specialize in certain business sectors (e.g., biotechnology, information technology). Others may invest only at certain stages in the development of a project or company.

FINANCIAL INNOVATION AND THE MARKETS IN DERIVATIVE INSTRUMENTS

Financial innovation has been one of the most influential trends in international financial markets since the early 1980s. A large number of new financial products and instruments have been created as the traditional barriers among types of financial institutions have increasingly eroded. Banks, for example, are increasingly competing with markets for what was once considered to be traditional intermediated credits. Markets are becoming more global, and competition among financial institutions has intensified. This increase in financial innovation has taken place in an environment of steady deregulation coupled with significant advances in information and communication technologies.

Securitization, perhaps the most important trend in international financial markets in the 1980s and early 1990s, continues to redefine the operations of banks and has important regulatory implications. Both bank and nonbank financial institutions are relying more on income from off-balance-sheet activities. A greater share of credit now flows through capital market channels, which are characterized by less supervision in comparison to banks. Deregulation, improved technology, growing competition, and volatile exchange and interest rates are the main stimulus for financial innovation. Innovation can improve the efficiency of international financial markets by offering a broader and more flexible range of instruments for borrowing. It also provides hedging instruments that can help banks, borrowers, and investors to manage the risks associated with volatile exchange and interest rates.

The derivatives market took a major step forward with the formation of the CBT in 1848. It developed standardized agreements as to the quality, quantity, delivery time, and location, and called futures contracts for trading of grains in 1865. The development of financial futures resulted from a changing world economy following World War II (1939–1945). Futures contracts provide for efficient forward pricing and risk management.

The CME (also known as the Merc) is another major futures exchange in the United States. The Merc's diverse product line consists of futures and options on futures in agricultural commodities, foreign currencies, interest rates, and stock indexes. In the mid-1960s it introduced a futures contract on a nonstorable commodity—live cattle. In 1972 it launched a contract in foreign currency futures.

The U.S. futures industry operates under an extensive regulatory umbrella. Federal legislation governing the industry has existed since 1924. The Commodity Futures Trading Commission, established under the 1974 amendments to the Commodity Exchange Act, has far-reaching authority over a wide variety of commodity industry activities.

ROLE OF THE SECURITIES AND EXCHANGE COMMISSION

The SEC was organized under the Securities Exchange Act of 1934 to create fair market conditions in the securities markets by setting standards for and requirements of information from the issuer of the security to the general public. The SEC has overall responsibility for this process that creates competitive and fair pricing and trading of securities, and it prevents abuse and fraud by issuers, brokers, and dealers. Issuers are required to file detailed information with the SEC on all publicly traded securities, which becomes available to the public on an equal basis. Privately traded securities and investments by wealthy individuals are exempt from registration, based on the assumptions that these investors understand the risks involved in a given security and that they are able to tolerate the consequences of those risks if they materialize.

ROLE OF THE FEDERAL RESERVE SYSTEM

The Federal Reserve (the Fed) plays a key role in the functioning of the capital market in the U.S. economy and, by extension, in the world economy. It manages the overall liquidity and credit conditions in the U.S. financial system. The Fed strives to maintain a noninflationary level of liquidity in the economy, on an ongoing basis, in order to foster conditions for maximum sustainable growth of the economy. It does so by regulating the money supply through the banking system and its interaction with the public.

The Fed pays similar attention to availability of credit; in that regard it is authorized to set the margin rate on stock purchases, thus exercising a direct role in the use of credit in equity market transactions. The Fed is also the commercial and investment banker to the federal government; in this capacity, it conducts the U.S. Treasury's operations in the Treasury securities bond market through the securities dealers recognized by it and so authorized to be dealers in Treasury bills, notes, and bonds.

ROLE OF THE U.S. TREASURY

The U.S. Treasury is the biggest player in the U.S. credit markets. Because the market in U.S. government securities is the largest, most active, and most liquid market, it creates a base for conditions in the U.S. credit markets. The Treasury operations bridge the timing of the cash inflows and outflows of the government. The extent of activity is related to whether the federal budget is in deficit or surplus. As anticipated, federal debt is expanded when a deficit is faced and is retired when a surplus arises.

REGULATORY REQUIREMENTS

Regulation plays an important role in a fair and orderly functioning of the capital market. Parts of the market are more heavily regulated than other parts. Commercial banking, for example, is one of the most regulated parts of the financial services industries. This heavy regulation came about because large bank failures, due to either fraud or mismanagement, can destabilize banking markets and lead to loss of faith in the banking system—and therefore in the currency and money (as the liability of commercial banks).

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 has reduced or eliminated the need for many of the regulations on commercial banks and their activities and affiliations with investment banks and insurance companies by allowing competition for the same or similar products offered by the three. This act provided for an eighteen-month period for the SEC to implement the provisions related to rule making. A number of new regulations have been issued since 2001 by the SEC.

KEY CAPITAL MARKETS OUTSIDE THE UNITED STATES

The increasing integration of the world economy and the growth of other economies have led to the emergence of several key financial centers, the prime examples of which are London, Tokyo, Frankfurt, Zürich, Paris, Hong Kong, and Singapore. Efforts at cross-border exchanges have been successful, too.

Euronext N.V. was the leading cross-border exchange organization in Europe in 2005. It began in 2000, headed by a Dutch holding company. By 2004 this cross-border exchange was providing services for regulated stock and derivatives markets in Belgium, France, the Netherlands, and Portugal, as well as in the United Kingdom (derivatives only). In late 2005 Euronext was the leading derivative exchange in the world and Europe's leading stock exchange, based on trading volumes on the central order book. The euro area capital market, the U.S. capital market, and the Asian capital market were predicted to be the three key markets in the global financial world of the twenty-first century.

see also Finance

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Surendra K. Kaushik