In this episode of the SIFMA Podcast Ken Bentsen, SIFMA’s President and CEO, is joined by Katie Kolchin, SIFMA Managing Director and Head of Research, for a discussion around our recently updated and re-published SIFMA Insights Primer series.  This series of reports explains the inner workings of capital markets, breaking down important technical and regulatory nuances. They dive into the Capital Markets Primer, which provides readers with a deeper look at markets and the role of financial institutions.

Transcript

Edited for clarity

Ken Bentsen: Hello, I’m Ken Bentsen, President and CEO of SIFMA. Welcome to our latest episode of the SIFMA Podcast. Today, I’m pleased to be joined by Katie Kolchin, SIFMA Managing Director and Head of Research for a discussion around our recently updated and republished SIFMA Insights Primer Series. This series of reports explains the inner workings of capital markets breaking down important technical and regulatory nuances. Today, we’ll be diving into the Capital Markets Primer, which provides readers with a deeper look at markets and the role of financial institutions. The report analyzes the many different moving pieces of capital markets, primary markets where securities are created or issued, secondary markets where securities are traded, and post-trade infrastructure and operations where securities are cleared and settled. It explains the importance of market structure focusing on the impact of liquidity on trade costs. Finally, the report studies the role of financial institutions which play a critical role in making markets work. So that’s a lot and let’s get started.

Katie, thank you for joining us and I want to start with the big picture. Give us the cliff notes on the capital markets. What is capital, what are capital markets? And then briefly, who are the participants and what’s the life cycle of a trade? And then maybe we can get into some more granular issues.

Katie Kolchin: Thank you, Ken. Broadly speaking, capital is cash that is being put to work for operational or investment purposes, represented in the form of debt or equity securities. Capital is critical to corporations for running day-to-day business operations or financing future growth. Capital enables individuals or companies to turn ideas into usable innovations and new businesses. Capital is crucial for governments to operate their country, state, or city as well as invest in infrastructure projects such as bridges. In short, capital is an integral component supporting job creation and economic development. Moving on to capital markets, which include any marketplace where participants can buy and sell financial assets such as stocks, bonds, or other securities. Capital markets facilitate the transfer of capital from those who seek a return on their assets to those who need capital to grow their enterprises.

Capital markets, put simply, are the way we connect providers of capital, the investors, whether it be institutional such as pension plans or individuals, with users of capital. These are the issuers, including corporations and governments. These relationships are facilitated by financial institution intermediaries, which play a critical role in making capital markets work. Both users and providers of capital benefit from robust and efficient capital markets.

Efficient capital markets allow capital users to receive lower-cost funding over time, while also allowing investors to identify appropriate opportunities to deploy their capital. Therefore, capital markets play a crucial role in a country’s economy. To finish off this question, let me just briefly explain the three phases of capital markets. We begin in the primary markets where securities are created. Firms sell stocks or bonds to investors. For example, through an initial public offering or IPO, to generate funds for operations or growth. Then we move into the secondary markets where securities are traded. Here, existing stocks and bonds are traded among investors without the issuing company’s involvement. The last phase of the trade life cycle is post-trade operations and infrastructure. This involves clearing and settlement of securities and can be thought of as the plumbing of capital markets.

Ken Bentsen: So Katie, a couple of things that I want to just dig in a little bit deeper on some things you talked about. First of all, I think it’s important for our listeners to think about this. You talk about the providers of capital, the investors, and often at a very high level, I think people look at that and they think that those are big corporates or big institutions. But in fact, when you think about it, whether it’s pension funds, for instance, that are very large investors, really who stands behind that or who are they operating on behalf of? It’s the individual pensioners, right, who are members of that. Or retail investors, really at the end of the day, it all, in many cases, trails right back to the retail investor, either directly or indirectly, which I think is often lost in the conversation.

The other thing that I think is interesting that you point out and I think would be important for some of our listeners is we talk about debt and equity, right? But they’re very different. Particularly, public entities don’t necessarily issue equity, they primarily issue debt. But corporate entities can issue equity or debt, and maybe dig into that a little bit. I would just note in a broad sense in the U.S., and you’ll correct me if I’m wrong in this, is on the one hand, they are probably seven thousand, eight thousand different equity names or equity issues that are outstanding. Whereas there are probably fifty thousand different individual corporate debt instruments that are outstanding. If you go to the municipal market, there are many multiples of that. But maybe just dig in a little bit on the difference between debt and equity.

Katie Kolchin: Okay, so I just want to back up before I go into the debt and equity on your individual investor comment, because that’s exactly right. I think people forget when they hear the term asset manager, they think big financial institution. But asset managers have clients too, and they come back down to the individual investor, whether that be them servicing them through some sort of portfolio investment strategy, but also they’re the ones that run pooled investment funds such as ETFs, which are very popular investments among the retail grouping.

Now onto debt and equity, and we do go into this in great detail in the primer. Your point to the number of instruments out there, it is very interesting. I like to point out to people that while you’ll have one stock as a corporate, you could have, if you’re a large company, you could have, you know, 40 different debt issuances out there or what they call QCIPs in that world. And if you’re a financial institution, you can get up to the thousands when you include issuance for regulatory capital. So on the one size, the number of securities you are correct is much different across the two, but it’s also an ownership situation, right? So with an equity, you’re getting a share of ownership in that corporation, whereas with the debt, you are the lender. So you are getting a return on your investment just like you would in the capital markets, but it’s really your fixed return that you’ve set up with the debt structure. I’d also point out that debt instruments tend to have longer investment timelines as well. So I think that ownership is the big difference that people have when they look at an investment on the equity or debt side.

Ken Bentsen: Yeah, and that’s really interesting. I think that’s good as we lead into our next question, which is market structure, right? And what is market structure? Why is it important to market liquidity and why does liquidity matter? So maybe dig into that a little bit.

Katie Kolchin: Sure. Liquidity not just matters, it’s crucial. So market liquidity is the ability to efficiently buy or sell securities and this is measured by the speed and ease of execution without causing a substantial change in price. Liquidity impacts everything from the ability to execute a trade to the bid-ask spread. This is the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.

Markets need robust trading volumes to remain liquid. Liquid markets have many buyers and sellers, frequent trading, and narrower bid-ask spreads, to name a few characteristics. In less liquid markets, there are not as many buyers and sellers, and large transactions may lead to large price movements. This can increase volatility. In illiquid markets, low demand can lead to fewer transactions, hindering a trader’s ability to execute quickly and to understand costs efficiently.

Fewer market participants mean traders are not there to step in and adjust prices, or at least not as quickly as they can in liquid markets. This can further limit demand for the securities, keeping volumes depressed. Lower volumes lead to an increased time to execute a trade and therefore wider bid-ask spreads. This increases the cost of a trade. So let’s briefly break down the total cost of a trade equation. There are explicit costs. Examples of this include commissions or regulatory fees as well as implicit costs. This includes the bid-ask spreads as discussed. There are also opportunity costs and price impacts on trades. For example, losses can occur from market prices moving during the time it takes to execute large volumes. Before moving on, I do just want to note that lower liquidity can also increase the cost of capital raising for corporations and governments. So the second part of your question was on market structure. So market structure matters as it can drive liquidity and therefore trade costs. As such, market participants continually strive to create the most efficient markets. This includes adapting new technologies to achieve operational efficiencies, searching for new ways to transact, and sculpting market structure to maximize efficiencies and reduce controllable costs.

Ken Bentsen: So, you said a number of very important things there. One thing that I want to underscore that you said that I think sometimes gets lost when you’re talking about liquidity, and this will be good going into our next question as well about primary markets and secondary markets, is I think a lot of people sometimes think of liquidity as primarily a secondary market issue. And it’s certainly hugely important in the secondary markets, but you made the point underscoring the direct correlation to the primary markets, right, that the initial act of raising capital with the primary issue is often contingent upon the perceived and realized liquidity behind that security. But let’s maybe turn and talk about primary markets, where securities are created, and then the secondary markets where they are subsequently traded.

Katie Kolchin: Sure, Ken. And I just add on to that, I like to think of it as primary and secondary markets are symbiotic in nature and we’ll go into that in this section. So beginning with primary markets, companies may need capital for various business purposes. This could include financing day-to-day operations, paying down existing debt, investing in organic growth, funding expansion plans, or funding mergers and acquisitions. Now firms have several ways they can acquire capital.

Outside of generating cash from operations, firms can go to either the capital markets or loan markets on the debt side. With capital markets, debt issuance is a more efficient and less restrictive form of borrowing for corporations than standard loan transactions. Capital markets typically function as shock absorbers during times of economic or market stress, whereas bank lending can dry up under strain. This makes capital markets a more stable source of funding. In the U.S., debt capital markets represent around 75% of total financing for non-financial corporations. On the equity side, another capital markets vehicle is an initial public offering or IPO, during which a private company raises capital by offering its common stock to the public in the primary markets for the first time. So moving on to secondary markets. Here investors can generate returns in managed risk healthy and liquid secondary markets also give issuers confidence that their capital needs will be met at a good price level in the primary markets. So this goes back to your point, Ken, having a good secondary market, strong trading activity ensures a cost-efficient primary market for issuers.

We really don’t have time to go into all the details that are included in the primary and secondary markets but I just want to let our listeners know that this primer does walk readers through many aspects of secondary markets. This includes type of trading that’s exchange traded versus over the counter markets, cash or also called the spot market versus futures and forwards and products. We explain the differences across securities, derivatives, securitized products and structured products. And this primer also provides a high-level overview of market structure for equities, options, and fixed income markets. And again, just noting for readers of the primer series, if you’re looking for greater specifics in the different markets I just mentioned, we have written a primer for each one.

Ken Bentsen: Yes, that’s right. And thank you for raising that. Just before we get to our next question, just in terms of size, you talk about 75% of non-financial commercial activity funded through the debt markets in the U.S., that’s the inverse of what you see in other major economic jurisdictions around the world, and that is viewed as a hallmark of the U.S. economy. If you think about the, particularly in the debt markets, the important areas, obviously the largest being the U.S. Treasury market, which is critical, not just to the U.S. economy, but it underpins much of the financial markets around the world. But then you think about the mortgage-backed market, you think about the asset-backed market, the corporate market, which is enormous in the U.S., and then the public market of in the public finance sector, state and local governments, which itself is a very large market. So it’s very critical to the U.S. economy, and the primers go into that detail.

We’ve talked about why it comes to fruition, how it works, structure but it doesn’t end there, right? I mean, there’s a life cycle of a trade, and just as important as the ability to connect capital investors and users and market structure, the products, is the life cycle of a trade and the post-trade infrastructure and operations. Maybe we can talk a little bit about that because again, that’s something where the U.S. really has a very strong system.

Katie Kolchin: Yes. We like to say that the U.S. markets, no matter which asset class you’re looking at, are among the largest, deepest, and most efficient in the world. So the life cycle of a trade begins with execution or the buying and selling of securities. We then move into the clearing phase, and then the trade is closed out at settlement where security ownership is transferred. Once entering the clearing phase of the trade lifecycle, counterparty risk is introduced. Now, clearing can get a bit technical, but essentially the value of security can fluctuate between trade and settlement dates. So to reduce this risk, trades are submitted to a clearing house and are netted. This netting process offsets the value of multiple positions or payments to be exchanged between counterparties, minimizing these payments and securities due.

During the clearing phase, it is important to manage the risk of price fluctuations or a counterparty default, which is when a clearinghouse member is unable to fulfill its obligations. Margin payment obligations are calculated to reflect security price movements and net cash flows are exchanged across counterparties to mitigate this risk.

So let’s move on to settlement. Trade settlement is a two-way process, which comes at the final stage of the trade life cycle. Once the buyer receives the securities and the seller receives the payment, the trade is said to be settled. And you can think about this as an equation. So the official trade happens on trade date called T and the settlement date is when the final ownership is transferred. So for example, in U.S. equities, settlement now occurs on T+1 or trade date plus one day.

Ken Bentsen: So let’s talk about the role of financial institutions in our capital markets. And financial institutions is a broad term. It is not a homogenous group, it’s a heterogeneous group when you think about it. They’re broker-dealers, they’re asset managers, they’re inter-dealer brokers, they’re fit banks, et cetera. What are the services and functions that are provided in making our markets operate?

Katie Kolchin: Sure, thank you, Ken. And so just on your point, we do in the primer try to give as many examples if we can of the many different types of financial institutions in the market today. And really we would be remiss to discuss capital markets without analyzing the critical role financial institutions play in making markets work. So acting as financial intermediaries, these firms provide advice and connect clients needing capital with those providing capital.

Financial institutions provide many services and functions to clients, constantly innovating to meet clients’ needs and the changing market environment. So on a high level, we’ve bucketed these services and functions into advising, financing, managing, investing and transacting, and in general, supporting the clients. Across all of these services is an overlay of technology solutions and data science analytics. So the primer takes a look at the different divisions and activities for a full service financial institution. But before going into that, I just would like to make a note about broker-dealers, which are the capital markets arm of a full-service financial institution. A broker-dealer buys and sells securities on behalf of its clients to enable trading activities and the flow of securities in markets.

Now as to the services and functions for a full service financial institution, these may include investment banking personnel in this division act as corporate financial advisors. They provide advisory and financing services to corporations, governments, boards of directors, public authorities, and many other client types. We spoke about IPOs earlier. This would be the division handling these deals. Markets and securities. Personnel in this division understand clients’ needs and then connect them with the right products to fit their investment objectives. Staff roles can include, among other things, executing trades, making markets, managing risk, and providing investment advice across multiple asset classes. Investment research. Research analysts provide insight on a diverse range of topics and make security recommendations. Research can be offered for equity or credit markets on an individual company basis. Staff may also include economists or market strategists. For example, an equity strategist provides an investment view across the whole market, all companies and sectors.

Then we have asset management. Personnel in this division provide institutional client solutions. This can include investment strategies, risk management, asset allocation, and other functions. On the private wealth management side, these private wealth managers service individual investors through holistic wealth planning. They offer tailored investment advice as well as online tools and platforms for their clients. And finally, a financial services firm may also have a banking and lending division. So we’ve gone through a lot of information in a short time, so I’m gonna stop here, Ken.

Ken Bentsen: Yeah, that’s quite a bit. And again, the primers provide a lot of detail. One thing I want to add on all in your discussion of the markets ecosystem, which is broad and diverse, it goes without saying, but it should be said that it is also the markets in the U.S. operate under a very extensive and robust regulatory regime at virtually every step of the transaction through federal regulation, registration, massive compliance operations built on a decades long regulatory framework, rule book and legal and statutory background.

Importantly, I think it’s important for our audience to take time to really dig in deeper. Katie gave an outstanding 40,000-foot description, but the primers really dig deep into the points that she was making. To see them, go to sifma.org/primers to learn more about these topics. In addition to what we discussed today, as Katie mentioned, there are reports on comparing to global equity markets, capital formation, listing exchanges, equities options, exchange-traded funds, and fixed income markets and electronic trading. So with that, Katie, thank you very much for your time today, and thank you to our audience for listening.

Katie Kolchin: Thank you for having me, Ken.

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Kenneth E. Bentsen, Jr. is President and CEO of SIFMA. From 1995 to 2003, he served as a Member of the United States House of Representatives from Texas. Prior to his service in Congress, Mr. Bentsen was an investment banker specializing in municipal and housing finance. 

Katie Kolchin, CFA is Managing Director, Head of Research for SIFMA and the author of SIFMA Insights.

Related Resources

• Insights

  SIFMA Insights Primer Series