Capital markets are crucial to a business’s financial structure. They fuel local and global economies, help allocate risk, and promote financial health and stability. These benefits offer opportunities for companies and individuals to profit.
To make successful investment and business decisions, you must understand the key players within capital markets and their roles.
Here’s an overview of how capital markets work, their common flaws, and how you can test and implement potential solutions to ensure economic and business success.
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Capital markets are financial markets where assets—such as stocks, bonds, and currencies—are traded, purchased, and sold between investors, business institutions, governments, and individuals.
Capital markets identify, and allocate assets to, the best ideas and businesses. They’re interconnected and can affect trading in markets across the globe. As a result, markets like the New York Stock Exchange (NYSE) and NASDAQ are highly organized and regulated to ensure efficient transactions.
Who Participates in Capital Markets?
Capital markets enable buyers and sellers to trade different forms of financial assets. There are several notable players in transactions:
- Analysts: Equity analysts who evaluate companies and compare their current prices to estimated values to determine whether shareholders should buy, hold, or sell
- Companies: Businesses that participate in capital markets to acquire assets to operate
- Buy-side investors: Institutional investors, such as mutual funds, hedge funds, and pension funds
- Sell-side institutions: Traders, salespeople, and investment banks
- Households: Consumers who invest money in the market by buying or selling individual stocks
Types of Capital Markets
Beyond knowing the different players in capital markets, it’s important to understand which market they participate in. There are two types of capital markets: primary and secondary.
The primary market is overseen by the Securities and Exchange Commission (SEC). It comprises publicly held companies—those publicly selling stocks or bonds—selling securities to investors for the first time. Small-scale investors and households typically aren’t major players in this market because they’re unable to buy large amounts of stock at a time. Therefore, companies promote their securities to larger, more established institutions to ensure bigger returns.
The secondary market is essentially the stock market, where investors of all sizes and statuses trade companies’ previously issued securities among themselves. Companies don’t receive any direct profit from these market transactions since these stocks are traded among investors rather than the companies themselves.
Problems with Capital Markets
Although capital markets are crucial to the modern economy, they can fuel misinformation, greed, and economic downturn. These consequences are often perpetuated by businesses and investors using incentives, which can greatly influence the market.
For example, while bonuses and stock options can motivate investors and employees, they can also encourage unethical decision-making, contribute to pay inequality and turnover, and reduce intrinsic values. Moreover, equity analysts may feel pressured by companies to make extreme evaluations to establish job security.
Even more common is evaluating the market based on others’ feedback and analyses. While top analysts periodically assess the market using this method, doing so often leads to biased and inaccurate evaluations of capital markets. Two major problems arise from these evaluations: asymmetric information and the principal-agent problem.
Asymmetric Information
Asymmetric information occurs in a capital market when a buyer or seller is privy to more information on an investment’s historical, current, or future performance than the public. As a result, the investor can make a more informed and profitable investment decision than their peers.
This occurs when investors or employees within companies have access to proprietary and confidential information and misuse it for profit. Asymmetrical information often leads to imbalances within capital markets. In extreme circumstances, it can cause market failure, such as the 2007–2008 mortgage crisis.
Principal-Agent Problem
Another capital market dilemma is the principal-agent problem, in which conflicting priorities occur between an asset owner and the representative authorized to act on their behalf. Examples of principal-agent problems within business relationships are:
- Shareholders vs. management teams
- Financial institutions vs. rating agencies
- Voters vs. politicians
- Clients vs. lawyers
Companies can handle these problems in several ways. The most common include realigning organizational priorities, changing incentive systems, and improving the flow of critical information.
Finding Solutions
There isn’t yet a clearly defined solution to common problems within capital markets. Many options have been tested that have both benefits and drawbacks.
Here are several ways organizations can better manage asymmetric information and the principal-agent problem within capital markets.
1. Board of Directors
Many companies try to combat capital market challenges by implementing a board of directors to oversee management and ensure shareholders’ interests are properly represented. The drawback is that management typically selects board members, which can lead to manipulation and bias.
2. Stock Ownership
To align business decisions and priorities, companies typically incentivize employees with stock offerings. This can motivate individuals to perform, managers to inspire their teams, and CEOs to make decisions that benefit their businesses and investors.
The downside is that CEOs can become risk-averse when making financial decisions—even when they benefit the organization—to protect their companies’ finances and share prices.
3. Punishments for Misrepresentation
Instead of implementing oversight or motivating leadership, some companies punish managers for misrepresentation. While this tactic can be effective, it can also lower morale and encourage managers to protect themselves by shying away from major decisions.
4. Taking Companies Private
Even if an organization is mature and publicly traded, private equity investors may remove companies from public exchanges through buyouts, then monitor capital markets to determine their next moves. This enables company leaders and investors to review and improve internal goals, controls, and processes, as well as reanalyze the markets and decide when, and if, their companies should go public again.
Yet, a company must be public for an investor to make money. Additionally, there’s no guarantee an investor won’t encounter the same issues of asymmetric information or principal-agent relationships—especially if they possess insider information.
An Uncertain Future
Capital markets are critical to the world’s economy and offer businesses, investors, and individuals the opportunity to succeed financially. Without incentivization strategies to combat issues like insider trading and imbalanced relationships, capital markets can be tumultuous.
Google and Apple are examples of companies contending with growing market challenges. In 2012, Apple paid dividends to shareholders in tandem with profits due to a shareholder dispute. Google took a different approach and retained a large percentage of its ownership by using capital to reinvest in innovation. The company also gave shareholders more voting authority.
It’s unclear which of these approaches is best; their success can only be revealed over time. Given the state of the economy, it’s more important than ever to understand how financial markets work, recognize how to address their problems, and acquire the finance skills needed to ensure you make sound financial decisions.
Want to learn more about the future of capital markets and how it affects financial decision-making? Explore Leading with Finance—one of our online finance and accounting courses—to discover how the uncertainty of capital markets doesn’t have to impair your ability to make informed financial decisions. To continue building your financial literacy, download our free Financial Terms Cheat Sheet.
