Capital markets are used primarily to sell financial products such as equities and debt securities. Equities are stocks, which are ownership shares in a company. Debt securities, such as bonds, are interest-bearing IOUs.
The securities can be bought and sold on two types of markets or divided into two different categories:
- Primary markets is when a company directly issues the securities in exchange for capital. where new equity stock and bond issues are sold to investors. In primary markets, as they know they are likely to be able to swiftly cash out their investments if the need arises.
- Secondary markets is when the security holders trade with other investors in a transaction that is separate from the issuing company. Which trade existing securities.
Primary Market
- In issues are sold to investors, often via a mechanism known as underwriting. The main entities seeking to raise long-term funds on the primary capital markets are governments (which may be municipal, local or national) and business enterprises (companies).
- Governments issue only bonds, whereas companies often issue both equity and bonds. The main entities purchasing the bonds or stock include pension funds, hedge funds, sovereign wealth funds, and less commonly wealthy individuals and investment banks trading on their own behalf.
- When a company publicly sells new stocks or bonds for the first time, such as in an initial public offering (IPO), it does so in the primary capital market. This market is sometimes called the new issues market. When investors purchase securities on the primary capital market, the company that offers the securities hires an underwriting firm to review it and create a prospectus outlining the price and other details of the securities to be issued.
- All issues on the primary market are subject to strict regulation. Companies must file statements with the Securities and Exchange Commission (SEC) and other securities agencies and must wait until their filings are approved before they can go public.
- Small investors are often unable to buy securities on the primary market because the company and its investment bankers want to sell all of the available securities in a short period of time to meet the required volume, and they must focus on marketing the sale to large investors who can buy more securities at once. Marketing the sale to investors can often include a roadshow or dog and pony show, in which investment bankers and the company’s leadership travel to meet with potential investors and convince them of the value of the security being issued.
Secondary Market
- The secondary market includes venues overseen by a regulatory body like the SEC where these previously issued securities are traded between investors. Issuing companies do not have a part in the secondary market. The New York Stock Exchange and Nasdaq are examples of secondary markets.
- In the secondary market, existing securities are sold and bought among investors or traders, usually on an exchange, over-the-counter, or elsewhere. The existence of secondary markets increases the willingness of investors.
- The secondary market has two different categories: the auction and the dealer markets. The auction market is home to the open outcry system where buyers and sellers congregate in one location and announce the prices at which they are willing to buy and sell their securities. The NYSE is one such example. In dealer markets, though, people trade through electronic networks. Most small investors trade through dealer markets.
Auction Markets
- Auction markets are a type of market structure commonly used in capital markets where buyers and sellers come together to trade securities. In an auction market, the prices of securities are determined through the process of competitive bidding.
Here's how auction markets generally work in capital markets:
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Order Placement: Buyers and sellers submit their orders to a central marketplace, such as a stock exchange. These orders specify the quantity and price at which they are willing to buy or sell a particular security.
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Auction Matching: At predetermined intervals, the exchange facilitates an auction process where it matches buy and sell orders based on price and quantity. The auction may be continuous throughout the trading day or occur at specific times.
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Price Discovery: During the auction process, the bids and offers from different participants are compared, and the market price is determined based on the highest price that buyers are willing to pay (bids) and the lowest price that sellers are willing to accept (offers).
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Execution: Once the market price is determined, trades are executed at that price or at the best available price. The exchange matches buyers and sellers based on the order book, ensuring that trades are executed efficiently.
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Transparency: Auction markets provide transparency as the prices at which securities are traded are publicly displayed, allowing market participants to see the prevailing market conditions and make informed decisions.
Auction markets are commonly used for trading various securities, including stocks, bonds, commodities, and derivatives. They provide a fair and transparent environment for price discovery and efficient execution of trades. Examples of well-known auction markets include the New York Stock Exchange (NYSE) and London Stock Exchange (LSE).
It's important to note that there are other market structures as well, such as dealer markets and electronic communication networks (ECNs), which operate differently from auction markets. Each market structure has its own characteristics and benefits, and the choice of market structure depends on the nature of the securities being traded and the preferences of market participants.
Dealer Markets
- Dealer markets are a type of market structure commonly used in capital markets where securities are bought and sold directly between market participants, primarily dealers or market makers. In a dealer market, the dealers act as intermediaries between buyers and sellers, providing liquidity by actively buying and selling securities from their own inventory.
Here's how dealer markets generally work in capital markets:
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Market Making: Dealers act as market makers by offering to buy and sell securities on a continuous basis. They quote bid and ask prices at which they are willing to buy or sell securities, creating a two-sided market.
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Dealer's Inventory: Dealers maintain an inventory of securities, which allows them to provide immediate liquidity to buyers and sellers. When a buyer wants to purchase a security, the dealer sells from its inventory, and when a seller wants to sell, the dealer buys and adds to its inventory.
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Spread: Dealers make money by earning the spread, which is the difference between the bid and ask prices. The bid price is the price at which the dealer is willing to buy, and the ask price is the price at which the dealer is willing to sell. The spread covers the dealer's costs and provides them with a profit margin.
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Negotiation: In dealer markets, prices and terms of the trade can be negotiated between the dealer and the buyer or seller. The dealer has some flexibility in setting the prices based on market conditions and their own assessment of the securities' value.
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Over-the-Counter (OTC) Trading: Dealer markets are typically over-the-counter (OTC) markets, meaning that trades occur directly between the dealer and the counterparty without the involvement of a centralized exchange. OTC markets offer more flexibility and customization compared to exchange-traded markets.
Dealer markets are commonly used for trading a wide range of securities, including stocks, bonds, derivatives, and foreign exchange. They provide liquidity to the market by actively participating in trading and absorbing buy and sell orders. Examples of dealer markets include the bond market, foreign exchange market, and certain segments of the stock market.
It's important to note that dealer markets operate differently from auction markets and electronic communication networks (ECNs), which are other types of market structures. Each market structure has its own advantages and considerations, and the choice of market structure depends on factors such as the nature of the securities, market participants' preferences, and liquidity requirements.