Financial markets are defined as the institutions and procedures that facilitate transactions in financial securities. Financial markets can be categorized as either money markets or capital markets. The money market is the market for debt instruments with a maturity of one year or less at the time of issuance. Major examples of money market instruments include: U.S. Treasury bills, commercial paper, and Eurodollar deposits.
The capital market consists of those institutions and procedures that provide for transactions in long-term financial instruments with a maturity of more than one year. Thus, capital markets include the bond and stock markets. The U.S. bond market includes three major issuers: the U.S. government, corporations, and municipalities.
The initial distribution of securities takes place in the primary market. The secondary market is a market for existing securities. Secondary markets may be established in the form of an organized exchange or as an over-the-counter (OTC) securities market. The predominant organized market is the New York Stock Exchange (NYSE), but increasing attention is being directed to other markets. Although bonds dwarf stocks by a ratio of almost five to one in the primary market, secondary stock market volume is much greater than secondary bond market volume. The secondary market for U.S. Treasury securities is the largest, in terms of daily dollar volume traded, in the world.
The trading of exchange-listed securities on the over-the-counter market takes place in the" third market." There is also a "fourth market" in which securities trade without the benefit of a broker. Examples of the fourth market include Instinet and Posit.
A stock exchange is a voluntary organization formed by a group of individuals to provide an institutional setting in which common stock, and other equity securities, can be purchased and sold. Members of stock exchanges own seats on the exchange, and only members or their representatives are allowed to trade on the exchange. A seat on the NYSE recently sold for $2.6 million.
Each stock exchange allows trading only during approved trading hours on the floor of the exchange, which is an actual physical location. A recent trend has been to lengthen the trading hours through the use of off-site electronic trading. The NYSE is the world's largest organized exchange. Only firms meeting certain minimum requirements regarding financial strength, number of shareholders, and total market worth (market cap) are eligible for listing. These requirements mean that only larger firms qualify for NYSE listing.
Trading on the OTC market has been growing faster than trading on organized exchanges, and advances in computer technology are expected to benefit the OTC market more than the organized exchanges. In the OTC market, there is no central trading location, but electronic communications systems are used to link participants. Firms trading OTC tend to be smaller than NYSE firms. The OTC market consists of about 15,000 securities, although many of these have only a local market. The most important stocks, including several large and well-known companies, trade on the Nasdaq, and transactions for these securities are reported more rapidly and more completely than for the less important stocks traded OTC. Most bonds trade OTC, although the NYSE does have a separate room for bond trading.
In a public offering, the security is offered for sale to the public. The issuing process is governed by the Securities Act of 1933. The process requires a registration statement to be filed with the Securities and Exchange Commission (SEC) which involves extensive legal and accounting expense. Further, the registration process can frequently take a long time to be completed and market conditions can change dramatically during it. The SEC has recently adopted a simplified registration process for smaller public offerings. A shelf registration is available to larger firms under which the firm files a master registration statement with the SEC. The company can then sell portions of the offering over the next two years.
In private placements, the entire issue is sold to a single buyer or a small consortium of buyers, frequently financial institutions, without the issue ever being made available to the public.
Issuers may prefer private placements because they do not have to disclose information about the firm or its strategies in registration documents. The process is also much faster since no registration is required. Privately placed securities cannot be resold, since they have never undergone the process of scrutiny required for a public offering. Because the liquidity of these securities is limited, they carry a higher yield. The issuer, however, saves on flotation costs. Thus, the buyer of a privately placed issue forgoes liquidity in order to obtain the higher return paid on privately placed securities.
Investment bankers assist companies and government entities in issuing securities by acting as consultants, forming distribution networks, and bearing risk. Investment bankers often advise on the timing and pricing of securities. The ideal time to issue common stock is near stock market peaks; for bonds, the ideal time occurs when interest rates are low. The objective in determining the original sales price of an issue is to set the highest price that will allow all of the issue to be sold in a short period.
Usually one investment bank is the lead bank, or manager, for the issue. It has the primary responsibility for the issuance of a security. To assist it in the marketing, a syndicate of other investment bankers will be formed. In addition, a selling group consisting of those investment houses that are participating to a smaller degree in the distribution process is also involved. If the issue is underwritten, the syndicate buys the securities from the issuing firm and then attempts to resell them to the public at a profit. Alternatively, the syndicate may distribute the issue on a best-efforts basis whereby it attempts to sell the securities at the best price it can obtain.
The costs of issuing securities are termed flotation costs. Flotation costs include the costs (primarily accounting and legal) to prepare the registration statement and the spread, which is the difference between the price paid by the final investor and the amount the issuing firm receives from the sale of the security. Spreads are generally lower for debt issues than for issues of common stock. Furthermore, the spread, as a percentage of the proceeds, is smaller the larger the size of the issue.
[ Robert T. Kleiman
updated by Ronald M. Horwitz ]
Houtthaker, H. S., and Peter J. Williamson. The Economics of Financial Markets. Oxford University Press, 1996.
Kidwell, David S. Financial Institutions, Markets, and Money. 6th ed. Harcourt Brace Jovanovich, 1997.
Livingston, Miles. Money and Capital Markets. 3rd ed. Blackwell, 1996.
Rose, Peter S. Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace. 7th ed. Irwin, 1999.