Fundamentals of Multilateral Investing – Lesson Two

Fundamentals of Multilateral Investing - Lessons, Premium POM

Capital Markets and the Development of Efficient Capital Markets

By JC Collins

In Lesson One we reviewed the definition of Capital, the relationship between Savers and Users of Capital, and we learned about Financial Instruments, which act as the Intermediaries between Savers and Users. In Lesson Two we are going to review the importance of Capital Markets and the need for Efficient Capital Markets.

First, there are multiple types of Capital Markets. There are:

  1. Stock Markets
  2. Bond Markets
  3. Money Markets

These can be further defined by the following:

  1. Auction Market – Investors
  2. Dealer Markets – Financial Institutions

We will review these in more detail below.

What does it mean to have efficient markets?  There are a few main components that are necessary for any market to be considered efficient.  The first two are:

  1. Fast paced transactions.
  2. Low cost of transactions.

Both of these are required for there to be liquidity in any market.  Market liquidity can be further defined as the effect of frequent trading or sales, narrow spreads between bid price and ask price (Auction Market), as well as minimum price variations from sale to sale.

The other main component of any efficient market is Regulation, which we will discuss in another lesson.

The market types as defined above, being stock markets, bond markets, and money markets, can be further segmented. The first of these segments is the Primary Market, which can be further broken down into the following:

  1. New Securities – Indirect financial assets which are sold for the first time, such as Initial Public Offerings (IPO).
  2. Government Bonds – new bond issuance.
  3. Corporate Bonds – new bond issuance.

Remember from Lesson One that governments and business are Users of Capital.  They offer the purchase of bonds to investors, or Savers of Capital.  As such, in a Primary Market the capital flows from the investor to the company or government.

Governments and companies raise funds by tapping into the Primary Market.

The other segment we need to consider is the Secondary Market.  This is where already issued securities are traded between investors.  The Secondary Market does not contain new issuance of indirect assets, and trades are made between investors.

The best way to understand this is that in Primary Markets capital flows from Savers to Users.  In the Secondary Market capital flows between Saver and Saver.

As mentioned above, all markets, whether bond markets, money markets, or stock markets, can also fall under either Auction Markets or Dealer Markets.

Auction Markets are made up of investors and are done on exchanges, or competitive bidding.  Investors enter Bids and Offers for securities.

Bids are considered to be the highest buyer.

Offers are considered to be the lowest seller.

The difference between them is called the Spread.

Note: Auction Markets are made up of Publically Traded Securities.  Reference Lesson One for a review of Publically Traded Securities.

Stock exchanges such as the NYSE and TSX are Auction Markets.  They are made up of senior equities, junior securities, futures/options, and other exchange based securities.

Dealer Markets consist of financial institutions.  These “Dealers” trade with one another and compete with the exchanges in the Auction Markets. Dealer Markets are negotiated as opposed to defined through competitive bidding.

Mostly being used by institutional investors, the Dealer Markets are made up of bonds and debentures, with some equities and customized derivatives.

The above information is important to understand as the difference between the developed nations, or economies, which have largely dominated the international monetary system for decades, already have mature and Efficient Capital Markets.

At least in theory.

Some of the inefficiency which has developed in these markets are because of the systemic imbalances within the international monetary framework.

Which is why it has become extremely important for the multilateral monetary framework to take over piecemeal from the old unipolar framework.

The emerging economies, such as China and India, among many others, need to develop mature and efficient markets in order to facilitate the balancing of the international monetary system.  This is a strategy which is taking years to implement, and must be evolved with patience and care.

Understanding the fundamentals of Capital Markets can help us understand some of the domestic strategies which China is implementing in order to further develop its own markets.  These markets will facilitate the internationalization of the renminbi and increase its fiscal liberalization.

In Lesson Three we will review Financial Intermediaries, which serve the purpose of bringing Savers and Users of Capital together.  We will broaden our understanding of why it is important for China to further develop its RMB denominated Financial Intermediaries for the purpose of creating Efficient RMB Capital Markets to work alongside USD denominated Capital Markets.  – JC