Capital Markets

FIRST has thus far provided approximately $6 million in technical assistance for projects in capital markets sector. Most projects aimed to strengthen regulation and supervision of capital markets, while some were designed to promote market expansion and product development, such as bond market development in Azerbaijan, the second tier market development in Mauritius, and provision of strategic guidance for market development in other countries. FIRST has also engaged with projects in other parts of the financial sector that will impact on capital market development: e.g. assistance to launch collective investment schemes; pension reforms and the framework for private pensions; and, expansion of the insurance sector. These projects, which have been summarized elsewhere, help to build the institutional investor base that is a major source of demand for investment product issued and traded through capital markets. Learn More...

What are capital markets?

“Capital markets” is the phrase designed to describe markets where securities, such as shares and bonds, are either issued by both private sector and public sector issuers and/or are traded. These markets usually deal in long-term funds, defined as maturing in more than a year, in order to differentiate them from money markets where maturities are less than one year (although this is not a perfect split in so far as short-term commercial paper is often issued and traded on capital markets). Private sector companies may raise equity capital through the issue of shares or long-term funds through the issue of bonds, and once issued these securities may be traded. Public sector entities, unless being partly or wholly privatized, do not issue shares but can and do issue bonds e.g. “Treasuries” in the USA and “Gilts” in the UK.

Primary and secondary markets

The issue of securities is executed through the primary market and usually involves intermediaries such as investment banks underwriting some or all of the amounts to be raised by the issue and other intermediaries, such as stock brokers, in helping to place the issue with investors. Once issued, the securities may be traded (the secondary market) and this process is also often facilitated by brokers matching buyers and sellers through an exchange – for shares and bonds this may be a stock exchange.

Stock exchanges used to be physical in the sense of a building where stock brokers could meet face to face to face to trade securities. Nowadays it is more common in developed capital markets for most trading to be electronic and buyers and sellers and prices are matched and determined online.

Just because capital might have been raised through issue on the capital markets does not mean that a successful secondary market will develop in the issued securities. If there is scant investor interest in trading the securities, it is deemed that the market in them is illiquid. The level of secondary market illiquidity tends to be greater for securities issued in comparatively small amounts by comparatively small companies and in less developed markets where an investor base (especially institutional investors such as pension funds, mutual funds and life insurance companies) to provide demand for securities is limited. In some developing countries the entire market may have limited liquidity as measured by volumes of trades per day or month.

Clearance and settlement systems

Capital markets need to have a process for enabling securities to change hands and new owners registered, for payments to be made and received and for securities to be held in safe custody. Not so long ago much of this process was also physical and therefore settlement times for a transaction could be as long as two weeks. Nowadays it is more common for securities to be de-materialized (i.e. no need for paper certificates to be issued showing the change of ownership) and stored electronically. Settlements may be made as between brokers by netting off during a day’s trading. So this process needs a clearing and settlements system to be established that operates impartially for all those licensed to trade on the markets.

Regulation and supervision

There is a need for regulation and supervision of markets to protect investors from abuses.  Risk capital is often raised on capital markets and regulators need to be sure that issuers fully describe in prospectuses, the risks and disclose all financial and other information needed to ensure potential investors are well informed before making their investment decisions. There need to be rules for the underwriting of issues and disclosure of fees. The issuers whose securities are listed on the stock exchange will be obliged to continue to disclose financial and other information periodically, promptly inform the market of any material events that could affect the price of the securities, observe certain corporate governance standards, including reporting to shareholders, protection of shareholders rights, and disclosure of related party transactions. Potential abuses such as insider trading need to be monitored and supervised. The systems for prompt and accurate registration of changes in ownership of securities, custody and account settlement need to be robust. Regulators may be divisions or departments within a unified regulator, such as the FSA in the United Kingdom, or be a specialist capital markets regulator such as the Securities Exchange Commission (SEC) in the USA.

Importance of capital markets

The importance of the financial sector as a component of a country’s economy varies widely as between the most developed and the least developed countries. For example, the range of total assets (and market capitalization) of the financial sector to GDP in OECD countries is between 100% and 450%, whereas in developing countries the range is between 2% and 90%. Similarly, the relative importance of capital markets by capitalization (or by trading volumes) to the financial sector varies widely as between developed and developing countries.

In Sub-Saharan Africa, for example, in 2005 the market capitalization of securities listed in 12 out of 15 different country stock exchanges was below 30% of GDP – the exceptions being South Africa, Nigeria and Zimbabwe. But market liquidity was much less than these levels – with 12 countries experiencing trading volumes of less than 10% of GDP. Effectively this means that in many of the least developed countries businesses need to rely mainly on re-investing their own profits and on bank finance to meet growth capital needs, since the structure of the economy has not yet provided the environment for a strong capital market as a source of funding. In many early-stage financial sectors the banking system accounts for over 80% of institutional external funding. Hide...

Summary of Lessons Learned

Development of a country’s capital market can be seen as an important step in deepening the financial sector and extending access to longer term finance (bonds and equity) for private sector and public sector business. However attempts to kick start this by simply providing market infrastructures such as stock exchanges, trading platforms and efficient registration and settlement systems are not sufficient. This approach was tried many times following mass voucher privatizations in former Soviet bloc countries and elsewhere in the world without much success, if other basic pre-conditions were lacking. Some of these pre-conditions include the structure of the economy itself (diversity, size, savings levels, poverty levels, foreign direct investment); some conditions include the structure of the financial sector (is there an institutional investor base including insurance, pensions and mutual funds that need investment product); is there an adequate regulatory environment to protect investors from abuse.

Donors need to target the funding of technical assistance to take account of the stage of economic and financial sector development in a particular country or region. Often such technical assistance will target some of the building blocks needed to satisfy some of the pre-conditions for capital market growth: regulatory infrastructure; product development; market awareness; regional harmonization and so on. Learn More...

Lessons Learned

• A thorough market and economic analysis may be needed before embarking on some capital markets projects. This is especially relevant for FIRST where its own resources are limited and need to be deployed where the greatest impact can be achieved. In some instances a country may demand the establishment of institutions such as stock exchanges or the development of laws and regulations for certain capital markets activities, such as collective investment schemes, when the stage of development of the market is not yet ready for it. There may be other and better ways to raise long term capital than going down some of these paths. There are many low-income countries where elaborate structures for securities listing and trading have been developed where following implementation only a very few companies get listed and where trading volumes are sometimes so small that even the exchanges and clearance and settlement systems run at substantial deficits.
• Many of the building blocks for well-rounded capital markets need to be developed in tandem. For example, rapid development of potential institutional investors such as pension funds, life insurance companies and some collective investment schemes in a market where there is a lack of suitable investment product may lead to asset bubbles or investment in higher risk assets.
• FIRST is essentially designed as a provider of shorter term technical assistance, and therefore, some of the market development needs for capital markets may be too large and long-term to be suitable for FIRST support. Advice on improving regulation and supervision, preparation of laws and regulations and other market rules such as listing rules, tend to be a better fit for FIRST’s funding objectives.
• There are some regions where economies of scale and broadening of investment product (for example through cross-listing on exchanges in the region), could be achieved by adopting a regional approach to capital market development. FIRST supported strategic recommendations for harmonization between the stock exchanges of seven countries in South Asia. One of the objectives of the Southern African Development Community is to harmonize regulations among its members countries. Similar opportunities arise in East Africa and among some Caribbean countries. Political obstacles sometimes interfere with this process though. For example, if there was to be a regional stock exchange there can be turf issues over its location. Hide...

Selected Project Profiles and Reports

FIRST disseminates project outputs that are potentially of value to other countries concerned with regulatory and supervisory capacity building and product development in the area of banking. The project examples shared in this section are chosen because they may apply to other countries' development context and the outputs could provide helpful guidance.