What Are Capital Markets And How Exactly Do They Work? – Piggyvest Blog (2024)

You might have heard of capital markets and maybe even read a passionate rant (or two) about their importance to the global financial system. Well, there’s some truth to that. In fact, modern finance as you know it might not exist without them. But what are capital markets exactly?

Capital markets are financial markets where individuals, institutions and governments trade long-term financial securities (like stocks, bonds and derivatives). They provide a platform for these actors to raise capital, as well as for investors to buy and sell financial instruments for a profit.

These markets play a vital role in facilitating the flow of capital — both savings and investments — between investors and issuers (those seeking capital), and allow businesses and governments to raise funds for growth and development. In this article, we’ll explain how capital markets work in Nigeria and answer some of the top questions you might have around the subject.

How do capital markets work?

The best way to understand capital markets is to think of them as your regular market — complete with buyers and sellers haggling over items. However, unlike Katangua with its cheap sneakers and thrifted sweatshirts, capital markets feature individuals, companies and governments looking to buy and sell various financial instruments.

These instruments include stocks and bonds but they trade derivatives as well.

Now, capital markets exist for one main purpose — to help raise long-term financing (capital) by moving funds from savers and investors to those in need of capital for investment or operational purposes.

Therefore, while you might visit a PocketApp Shop to buy yourself a refreshing drink, investors and issuers go to capital markets to trade financial resources.

However, both regular and capital markets work similarly.

In a capital market, buyers and sellers interact through exchanges (like the Nigerian Stock Exchange for trading stocks) or via over-the-counter markets to facilitate the exchange of these instruments. This trading process is facilitated by brokers and dealers who act as intermediaries between both parties.

Just like in regular markets, the forces of supply and demand determine prices since the markets are influenced by various factors, including economic conditions, investor sentiment, and regulatory policies.

What are the functions of the capital market?

We already mentioned that the capital market is primarily for raising capital — which is true — but it does have some other functions. In this section, we’ll provide a complete list.

The following are the functions of the capital market:

• Raising capital. Capital markets enable all kinds of entities to raise funds by issuing securities to investors.
• Price discovery. They provide a platform where prices for financial instruments are determined based on supply and demand forces.
• Facilitating investment. Investors can allocate their funds across various assets in capital markets — enabling diversification and potential returns.
• Enhancing liquidity. Capital markets offer liquidity by allowing investors to easily buy and sell securities and ensure that all investments can be easily converted into cash.
• Facilitating risk management. They also provide tools like derivatives that allow investors to hedge against risks associated with market fluctuations.

Now, let’s jump into the types.

What are the two types of capital markets?

Capital markets fall under one of two types, depending on the history of the traded security.

The two types of capital markets are:

1. Primary market. This is where new securities are issued and sold for the first time. These transactions are typically done through initial public offerings (IPOs) or by issuing corporate bonds. In the primary market, issuers raise capital by selling their securities directly to investors.
2. Secondary market. Previously issued securities are bought and sold among investors in this market. Trading in the secondary market does not provide funding to issuers, but it provides liquidity (and profit) to investors by allowing them to sell their securities to other market participants.

So, we’ve mentioned the term “instruments” a few times in this article. What exactly are they?

What are capital market instruments?

Capital market instruments (or simply instruments) are financial assets you can trade in the capital markets.

They can be categorised into two main types:

1. Equity instruments. These include stocks that represent ownership in a company. By purchasing equity instruments, you become a shareholder and can benefit from capital appreciation as well as dividend payments.
2. Debt instruments. These capital instruments include bonds, treasury bills and other fixed-income securities. When you buy debt instruments, you essentially lend money to the issuer in exchange for periodic interest payments and principal return at maturity.

You can learn more about how these instruments work by checking out our ultimate guide to the types of investments in Nigeria.

Who are the participants of the capital market?

We’ve mentioned issuers and investors, now let’s highlight all the various participants in capital markets. Each of these entities play a specific role and knowing what they do will ensure you understand how the market works.

The participants of the capital market are:

• Issuers. These are individuals or institutions that need to raise capital and issue securities to investors. They may include governments, corporations and financial institutions.
• Investors. Investors are entities who buy and hold securities in order to generate returns. They can include individuals, mutual funds, pension funds and hedge funds.
• Intermediaries. Middlemen (like investment banks, brokerage firms and financial advisors) facilitate the buying and selling of securities on behalf of investors.
• Regulators. Regulatory bodies oversee and regulate capital markets to protect investors and maintain market integrity.

The capital market in Nigeria is regulated by the Securities and Exchange Commission, Nigeria (SEC). This agency is responsible for ensuring fair and transparent capital market operations, protecting investors and maintaining market stability.

What are the benefits of the capital market in Nigeria?

If you’ve been following the gist of this article, you should know that capital markets are great for everyone involved — especially the countries the participants operate in. But how exactly are they beneficial?

The benefits of the capital market in Nigeria include:

• Facilitating economic growth. By providing avenues for businesses and governments to raise long-term capital, the capital market stimulates economic growth and job creation.
• Attracting foreign investment. A well-regulated and transparent capital market attracts foreign investors, contributing to increased foreign direct investment (FDI) and capital inflows.
• Enhancing financial inclusion. Capital markets promote financial inclusion by providing individuals with opportunities to invest in securities and participate in wealth creation.
• Supporting government financing. The capital market enables the government to fund public projects and initiatives without solely relying on conventional borrowing methods.

This isn’t an exhaustive list, but it does touch on some of the top benefits of capital markets in the country.

Summary

Capital markets provide a platform for raising capital, facilitate investment and risk management, and enhance liquidity as well as price discovery. With a wide range of participants and instruments, they play an important role in supporting economic growth and development.