Capital Markets: What They Are and How They Work

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Suzanne is a content marketer, writer, and fact-checker. She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies for financial brands.

What Are Capital Markets?

Capital markets are those where savings and investments are channeled between suppliers and those in need. Suppliers are people or institutions with capital to lend or invest. They typically include banks and investors.

Those who seek capital in this market are businesses, governments, and individuals. The most common capital markets are the stock market and the bond market. They seek to improve transactional efficiencies by bringing suppliers together with those seeking capital and providing a place where they can exchange securities.

Key Takeaways

• Capital markets refer to venues where funds are exchanged between suppliers and those who seek capital.
• Suppliers in capital markets are typically banks and investors. Those who seek capital are businesses, governments, and individuals.
• Capital markets are used to sell financial instruments, including equities and debt securities.
• These markets are divided into two categories: primary and secondary markets.
• The best-known capital markets include the stock market and the bond market.

Understanding Capital Markets

The term “capital market” is a broad one that’s used to describe the in-person and digital spaces in which various entities trade types of financial instruments. These venues can include the stock market, the bond market, and the currency and foreign exchange (forex) markets. Most markets are concentrated in major financial centers such as New York, London, Singapore, and Hong Kong.

Capital markets are composed of the suppliers and users of funds. Suppliers include households through the savings accounts and products they hold with banks as well as institutions such as pension and retirement funds, life insurance companies, charitable foundations, and nonfinancial companies that generate excess cash.

The users of the funds distributed on capital markets include home and motor vehicle purchasers, nonfinancial companies, and governments financing infrastructure investment and operating expenses.

Capital markets are used primarily to sell financial products such as equities and debt securities. Equities are stocks that represent ownership shares in a company. Debt securities such as bonds are interest-bearing IOUs.

These markets are divided into two categories:

• Primary markets, where new equity stock and bond issues are sold to investors
• Secondary markets, which trade existing securities

Capital markets are a crucial part of a functioning modern economy because they move money from the people who have it to those who need it for productive use.

Primary vs. Secondary Markets

Capital markets are composed of primary and secondary markets.

Primary Market

A company engages in the primary capital market when it publicly sells new stocks or bonds for the first time, such as in an initial public offering (IPO). This market is sometimes referred to as the new issues market. The company that offers the securities hires an underwriting firm when investors purchase securities on the primary capital market. The firm reviews it and creates 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 U.S. Securities and Exchange Commission (SEC) and other securities agencies, and they 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 the available securities in a short period to meet the required volume. 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 a 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 that’s 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 don’t have a part in the secondary market. The New York Stock Exchange (NYSE) and Nasdaq are examples of secondary markets.

The secondary market has two 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’re willing to buy and sell their securities. The NYSE is one such example. People trade through electronic networks in dealer markets. Most small investors trade through dealer markets.

Are Capital Markets the Same As Financial Markets?

There’s a great deal of overlap at times, but there are some fundamental distinctions between these two terms.

Financial markets encompass a broad range of venues where people and organizations exchange assets, securities, and contracts with each other. They’re often secondary markets.

Capital markets are used primarily to raise funding to be used in operations or for growth, usually for a firm.

What Is a Primary vs. a Secondary Market?

New capital is raised via stocks and bonds that are issued and sold to investors in the primary capital market. Traders and investors subsequently buy and sell those securities among each other on the secondary capital market, where no new capital is received by the firm.

Which Markets Do Firms Use to Raise Capital?

Companies that raise equity capital can seek private placements via angel or venture capital investors. However, they’re able to raise the largest amount through an initial public offering (IPO) when shares are listed publicly on the stock market for the first time. Debt capital can be raised through bank loans or securities issued in the bond market.

The Bottom Line

Capital markets are a very important part of the financial industry. They bring together suppliers of capital and those who seek it for their own purposes. This can include governments that want to fund infrastructure projects, businesses that want to expand, and even individuals who want to buy a home.

Capital markets are divided into two categories: the primary market, where companies list new issues for the first time, and the secondary market, which allows investors to purchase already-issued securities. The key benefit of these markets is that they allow money to move from those who have it to those who need it for their own purposes.