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ROLE OF CAPITAL MARKETS

The capital market provides financing to meet the denomination, liquidity, maturity, risk (with respect to credit, interest rate, and market), and other characteristics desired by those who have a surplus of funds and those who have a deficit of funds. The capital market as a whole consists of overnight to long-term funding. The short to medium end of the maturity spectrum is called the money market proper, and the long end is identified as the capital market. The financial instruments range from money market instruments to thirty-year or longer bonds in credit markets, equity instruments, insurance instruments, foreign-exchange instruments, hybrid instruments, and derivative instruments. There has been an explosion of innovation in the creation and development of instruments in the money and capital markets since about 1960 in both debt and equity instruments.

Some of the important (by volume) money market instruments are Treasury bills, federal agency securities, federal funds, negotiable certificates of deposits, commercial paper, bankers' acceptances, repurchase agreements, eurocurrency deposits, eurocurrency loans, futures instruments and options instruments. Similarly, some of the key capital market instruments are U.S. securities; U.S. agency securities; corporate bonds; state and local government bonds; mortgage instruments; financial guarantees; securitized instruments; broker-dealer loans; foreign, international, and global bonds; and eurobonds.

THE CAPITAL MARKET IN THE UNITED STATES

The capital market in the United States is highly developed, marked by sophisticated technology, specialized financing institutions and functions, wide-ranging geographic locations, and continuous innovation in financial products and services to meet the needs of financial investors and those seeking to acquire finances. There are both direct and indirect markets. Corporations, for example, engage in direct finance when they invest in one another's paper directly without the services of brokers and other specialized intermediaries, similar to the proverbial entrepreneur getting finance from an uncle. Most of the financing in the United States, however, is done indirectly through financial intermediaries who substitute their credit for the credit of the borrower (user) of funds. The total amount of credit raised annually in the United States is around $2,200 billion, of which debt instruments account for $2,000 billion and equity instruments (net) for $200 billion.

Money and capital market instruments are traded directly among participants, in the over-the-counter (OTC) markets and in organized exchanges. Many of the exchanges specialize in the type of securities traded, thus giving focus and depth to that instrument or market. The major U.S. exchanges are the New York Stock Exchange (NYSE), Philadelphia Stock Exchange, Pacific Stock Exchange, Boston Stock Exchange, Cincinnati Stock Exchange, Midwest Stock Exchange, Chicago Board of Trade (CBT), Chicago Mercantile Exchange (CME), international money market (IMM), National Association of Securities Dealers Automated Quotations System (American Exchange) (NASDAQ-AMEX), and Globex. The regional exchanges—such as Boston, Cincinnati, Midwest, Pacific, and Philadelphia—

each list a small number of regional companies to facilitate their raising of capital in the market. The national/international markets are NYSE, NASDAQ-AMEX, CBT, and CME.

The NYSE, organized by twenty-four brokers in 1792, is the oldest and the largest exchange in the U.S. capital market. It states its mission as follows: "To add value to the capital-raising and asset management process by providing the highest-quality and most cost-effective self-regulated marketplace for the trading of financial instruments, promote confidence in and understanding of that process, and serve as a forum for discussion of relevant national and international policy issues." According to the NYSE, it is "the largest equities marketplace in the world and is home to 3,025 companies worth more than $16 trillion in global market capitalization. As of year-end 1999, the NYSE had 280.9 billion shares listed and available for trading worth approximately $12.3 trillion. Over two-thirds of the roster of NYSE companies have listed here within the last 12 years. These companies include a cross-section of leading U.S. companies, midsize and small capitalization companies. Non-U.S. issuers play an increasingly important role on the NYSE. As of July 1999, 382 non-U.S. companies were listed here—more than triple the number 5 years ago" (www.NYSE.com).

Organized in 1971, NASDAQ was the world's first electronic stock market. According to its mission statement, NASDAQ-AMEX'S purpose is "to facilitate capital formation in the public and private sector by developing, operating and regulating the most liquid, efficient and fair securities market for the ultimate benefit and protection of the investor." Its vision is "to build the world's first truly global securities market … a worldwide market of markets built on a worldwide network of networks … linking pools of liquidity and connecting investors from all over the world … assuring the best possible price for securities at the lowest possible cost." Stocks of over 5000 companies are traded on the NASDAQ-AMEX (www.Nasdaq.com).

INITIAL PUBLIC OFFERINGS AND ROLE OF VENTURE CAPITAL IN THE CAPITAL MARKETS

Stock markets provide high-growth, innovative companies with a means of raising large amounts of long-term capital by selling company shares to outside investors. It is said that the company is "floated" on the stock market through an initial public offering (IPO). An IPO offers many companies the best way of financing their continued growth and for most venture capitalists is the preferred exit route (best way of profiting from venture capital investment) for their investments. However, an IPO involves for the entrepreneur some loss of control over the company, proportional to the amount of equity that is sold to outside investors. The entry standards imposed for a full listing on traditional stock markets may be too rigorous for young, technology-based companies. Recently, however, a number of initiatives have been taken by traditional stock markets as well as by new market operators to create new stock markets for high-growth, innovative companies. These offer all the benefits of a public equity market, such as an increased public profile and access to new capital and investors, with simplified entry requirements.

Efficient and liquid risk capital stock markets play a large role as a source of financing for high-growth companies and are necessary for the development of venture capital by offering an exit route for investors. In the United States, the NASDAQ market has been developing for more than twenty-five years and has become the market of choice for raising capital to finance fast-growing enterprises. At the turn of the twenty-first century, the 5,500 companies quoted on it employed approximately 9 million people.

Venture capital, which consists of funds raised on the capital market by specialized operators, is one of the most relevant sources of financing for innovative companies. Venture capitalists buy shares or convertible bonds in a company. They do not invest in order to receive an immediate dividend, but rather to allow the company to expand and ultimately increase the value of their investment. Hence, they are interested in innovative small companies with very rapid growth rates. Some venture capitalists specialize in certain business sectors (e.g., biotechnology, information technology). Others may only invest at certain stages in the development of a project or company.

In the United States, the amount offered in the IPO market has been growing exponentially, from $20.7 billion in 1998 to $47 billion in 1999. The fourth quarter of 1999 alone accounted for $22.3 billion.

FINANCIAL INNOVATION AND THE MARKETS IN DERIVATIVE INSTRUMENTS

Financial innovation was one of the most influential trends in international financial markets in the 1980s and 1990s. A large number of new financial products and instruments were created as the traditional barriers between financial institutions were increasingly eroded. Banks, for example, are increasingly competing with markets for what was once considered to be traditional intermediated credits. Markets are becoming more global, and competition between financial institutions has intensified. This increase in financial innovation has taken place in an environment of steady deregulation coupled with significant advances in information and communication technologies. Securitization, perhaps the most important trend in international financial markets in the 1980s and early 1990s, continues to redefine the operations of banks and has important regulatory implications. Both bank and nonbank financial institutions are relying more on income from off-balance-sheet activities. A greater share of credit now flows through capital-market channels, which are characterized by less supervision in comparison to banks. Deregulation, improved technology, growing competition, and volatile exchange and interest rates are the main stimulus for financial innovation. Innovation can improve the efficiency of international financial markets by offering a broader and more flexible range of instruments for borrowing. It also provides hedging instruments that can help banks, borrowers, and investors to manage the risks associated with volatile exchange and interest rate.

The derivatives market took a major step forward with the formation of the Chicago Board of Trade (CBOT) in 1848. It developed standardized agreements as to the quality, quantity, delivery time, and location, and called futures contracts for trading of grains in 1865. The development of financial futures resulted from a changing world economy following World War II. Futures contracts provide for efficient forward pricing and risk-management.

In the early 1970s, approximately 13 million futures contracts were traded in the United States—most of which were agricultural. By the mid 1980s, the number of contracts being traded exploded to over 230 million, with only a quarter related to agricultural products. Today, there are futures contracts for interest rates, stock indexes, manufactured and processed products, nonstorable commodities, precious metals, as well as foreign currencies. Furthermore, proposals for new contracts continue to grow.

The Chicago Mercantile Exchange (CME) is another major futures exchange in the U.S. The Merc's diverse product line consists of futures and options on futures in agricultural commodities, foreign currencies, interest rates and stock indexes. In the mid-1960s, it introduced a futures contract on a non-storable commodity—live cattle. In 1972 it launched a contract in foreign currency futures.

The U.S. futures industry operates under an extensive regulatory umbrella. Federal legislation governing the industry has existed since 1924. The Commodity Futures Trading Commission (CFTC), established under the 1974 amendments to the Commodity Exchange Act (CEA), has far reaching authority over a wide variety of commodity industry activities.

The technology of creating, disseminating, and trading instruments (securities) has increased the efficiency of allocating financing in larger quantities at lower cost of transactions, as well as lower cost of funds because of increased supplies from increased market participation by surplus and deficit units.

ROLE OF THE SECURITIES AND EXCHANGE COMMISSION

The Securities and Exchange Commission (SEC) was organized under the Securities Act of 1934 to create fair market conditions in the securities markets by setting standards for and requirements of information from the issuer of the security to the general public. This process creates competitive and fair pricing and trading of securities, and it prevents abuse and fraud by issuers, brokers, and dealers. Issuers are required to file detailed information with the SEC on all publicly traded securities, which becomes available to the public on an equal basis. Privately traded securities and investments by wealthy individuals are exempt from registration, based on the assumptions that these investors understand the risks

involved in a given security and that they are able to tolerate the consequences of those risks if they materialize.

ROLE OF THE FEDERAL RESERVE SYSTEM IN THE CAPITAL MARKET

The Federal Reserve plays a key role in the functioning of the capital market in the U.S. economy and, by extension, in the world economy. It manages the overall liquidity and credit conditions in the U.S. financial system. The Fed maintains a noninflationary level of liquidity in the economy, on an ongoing basis, in order to foster conditions for maximum sustainable growth of the economy. It does so by regulating the money supply through the banking system and its interaction with the public. The Fed pays similar attention to availability of credit; in that regard it is authorized to set the margin rate on stock purchases, thus exercising a direct role in the use of credit in equity market transactions. The Fed is also the commercial and investment banker to the federal government; in this capacity, it conducts the Treasury's operations in the U.S. Treasury securities bond market through the securities dealers recognized by it and so authorized to be dealers in U.S. Treasury bills, notes, and bonds.

ROLE OF THE U.S. TREASURY IN THE CAPITAL MARKET

The U.S. Treasury is the biggest player in the U.S. credit markets. Because the market in U.S. government securities is the largest, most active, and most liquid market, it creates a base for conditions in the U.S. credit markets. The Treasury operations bridge the timing of the cash inflows and outflows of the government. They are also used to finance the budget deficit, which became routine for three decades up to 1999, and beginning in 2000 to begin to retire the accumulated debt out of the government budget surplus.

REGULATORY REQUIREMENTS ON THE CAPITAL MARKET

Regulation plays an important role in a fair and orderly functioning of the capital market. Parts of the market are more heavily regulated than other parts. Commercial banking, for example, is one of the most regulated parts of the financial services industries. This heavy regulation is based on the fact that large bank failures, due to either fraud or mismanagement, can destabilize banking markets and lead to loss of faith in the banking system—and therefore in the currency and money (as the liability of commercial banks). The Gramm-Leach-Bliler (Financial Modernization) Act of 1999 has reduced or eliminated the need for many of the regulations on commercial banks and their activities and affiliations with investment banks and insurance companies by allowing competition for the same or similar products offered by the three.

THE KEY CAPITAL MARKETS OUTSIDE THE UNITED STATES

The increasing integration of the world economy and the growth of other economies have led to the emergence of several key financial centers, the prime examples of which are London, Tokyo, Frankfurt, Zurich, Paris, Hong Kong, and Singapore. As of 2000, the bourses in Paris, Brussels, and Amsterdam had announced their planned merger, as had the London Stock Exchange and Frankfurt Stock Exchange.

The Euromarket has grown steadily since about 1960 with the emergence and growth of the Eurocurrency (initially Eurodollar) market and followed by the Euronote, Eurobond, and Euroequity markets. The euro, introduced as the currency of the European Monetary Union on January 1, 1999, consists of the currencies of eleven countries—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. It will begin to circulate in 2002 and will eliminate the need for a significant part of the Euromarket market, as the eleven currencies will be replaced by one European currency. The Euromarket will continue to shrink as further European countries join the European Union and adopt its currency. The Eurocurrency market will, however, continue to provide a mechanism for international and global financing in the euro, the dollar, the yen, and other currencies in international trade and finance. The euro area capital market, the U.S. capital market, and the Asian capital market will be the three key capital markets in the twenty-first century.