Capital Markets Industry Profile

Industry sectors

The capital markets industry is divided up into three sectors, each of which has its own role and function.

Investment banking activities

Investment banking firms act as underwriters or agents. This means they act as intermediaries between the corporations or governments that issue securities and the investing consumers. The underwriter purchases new securities from the issuer, and then distributes them to investors. The profit comes from the difference between the purchase price and the public offering price.

Equity capital markets (ECM)

An equity capital market (ECM) exists between a financial institution and a business enterprise, which uses it to raise equity capital. The company might participate in activities such as distribution and allocation of new issues, marketing, public offerings, and private placements. Equity capital markets deal with futures, swaps, and options, as well as stocks. Equity capital markets provide two key products and services – initial public offerings (IPOs) and seasoned offerings.

An initial public offering – or IPO – is the first offering of a private company's stock for sale to the public. Many newer, smaller companies use IPOs to raise the money they need to expand. Larger companies that want to become publicly traded use IPOs as well.

Seasoned equity offerings – also known as secondary equity offerings – are new equities offered by companies that are already traded publicly. This can include the sale of new shares, or the sale of shares by existing shareholders.

Debt capital markets

Companies and governments use debt capital markets to trade debt securities in order to raise long-term funds. These markets, which are also called fixed income markets, include organized markets and exchanges, and private placements. They deal in interest-paying financial instruments, such as bonds and credit lines.

Corporate finance advisory services

Many investment banks provide corporate finance advisory services to their clients. These firms have the experience and knowledge needed to provide corporate financial solutions to both domestic and foreign companies.

Mergers and acquisitions involve a company taking over or merging with another company. This can happen for a number of reasons, and investment banks provide advisory services to ensure the process is successful. For instance, a company might merge with another business to generate value. Some companies buy businesses as a result of restructuring or a change in direction. Mergers and acquisitions can be conducted on public or private companies. They can also be friendly or hostile.

A hostile takeover occurs when a company pursues a merger or takeover without the target company's board approving the offer, or makes a bid without first informing the target company's board. Corporate finance advisory services can be useful to the bidder in the case of a hostile takeover. In a normal takeover, the bidding company would have access to the target company's records, and could conduct due diligence. But in a hostile takeover, the bidding company only has access to publicly available information, and so many banks are unwilling to finance this type of takeover. This is where corporate finance advisory services are useful – they can help the bidding company with the legal and practical matters involved with this type of merger.

Bankruptcy reorganization is a way for companies experiencing financial difficulties to continue to operate, while still pursuing other avenues of restructuring. Bankruptcy laws exist worldwide, but they vary greatly from country to country. In some countries, bankruptcy is known as insolvency. In the US, if a company files Chapter 11 bankruptcy, it doesn't have to go out of business or liquidate its assets. Instead, Chapter 11 is a flexible corporate finance tool that allows a company's management to remain in control. Bankruptcy reorganization may offer existing shareholders more value than by just shutting the business down and selling off all its assets. It may be more valuable to have the business keep running, cancel some of the debt, and hand over ownership of the reorganized company to the creditors. Or the operating business could be sold and the proceeds of the sale could be distributed to the creditors. Corporate advisory services can help guide this process.

Sales and trading services

Sales and trading is where investment banks make most of their money.

Market making

In market making, a company or individual quotes a buy and sell price for a commodity or financial instrument in their inventory. The aim is to make a profit on the difference, also known as the spread, between the offer and bid prices. A market maker makes a profit by purchasing a stock at a slightly lower price than it sells for. A market making firm can make money in both rising and falling markets, depending on the difference between bid prices and offer prices.

Brokerage and securities trading

Brokerage firms buy and sell securities with the goal of making a fast profit – this is known as securities trading. These securities are the same stocks that are available to all investors on public stock exchanges. Brokerage firms, however, try to time the purchase of stocks so they buy at a low price and sell at a high price in a short period of time, in order to make money quickly.

Securities research

Many companies in the capital markets industry have teams dedicated to securities research. Research activities might include economic tracking and financial forecasts, analysis of various fixed income and equity markets, and investment strategies. These teams may be used either for providing information and direction to traders within their own company or by providing information and unbiased advice to investors. They commonly provide their advice through buy, sell, or equivalent ratings on specified securities. These ratings can provide further revenues to their company if clients follow this advice and purchase or sell these securities using their company's trading services

Structured products trading (derivatives)

A structured product, or derivative, is a traditional security whose usual payment features – periodic coupons, for instance – have been replaced by nontraditional payoffs that come from the performance of underlying assets. Structured products are similar to traditional methods of option pricing, but they also contain other derivative types, such as futures and forwards.

Structured products are not designed to make money quickly; rather, they're a "buy and hold" type of investment, since full returns aren't realized until maturity.

Capital markets industry business model

The main players in the capital markets industry's business model are vertically integrated. This means that they offer a wide range of services to clients – such as commercial banking, insurance, and credit cards – but they also use their industry knowledge for their own benefit.

Providing services to corporate clients

Investment banks generate revenue by charging fees for providing services to corporate clients, such as governments and corporations. Fees are usually charged for underwriting, or acting as an agent in issuing securities, and for providing corporate finance advisory services in areas such as mergers and acquisitions; hostile takeovers; and bankruptcy reorganization.

Sell-side services

Investment banks make money by providing sell-side services such as prime and retail brokerage, trading services, and securities custody, to name just a few.

Prime brokerage is a term used to define a bundle of services offered by investment banks to hedge funds and professional investors. These services will vary since each client has different technological needs related to its portfolio management. However, typical services bundled into the prime brokerage package include global custody, securities lending, financing, and operational support.

Investment banks that provide these services make money in three ways. First, they earn fees – or spreads - for financing the client's long and short security and cash positions. Long means the client has cash or own securities, and short means they owe cash or have sold securities that they do not own, but have borrowed them from a broker. Second, investment banks earn money by charging fees for clearing transactions or other services, such as financing, global custody, and operational support. Finally, they earn fees by hypothecating – or pledging collateral to secure a debt - the portfolios of their hedge fund clients, and charging fees to those borrowing investments.

Proprietary activities

Many investment banks engage in proprietary activities such as investing and trading "house" money. Investment banks providing these services buy stock from companies to help them create liquidity, and then sell the same stock on the markets for a slightly higher price. These banks typically aren't concerned with the price of stock - they just aim to resell the same stock for a higher price and earn a marginal profit.

Key competitors

The key competitors in the capital markets industry are large investment banks that offer a wide variety of services, such as investment and portfolio management, research, and buying and selling of stocks. Many of these companies also deal with other products that fall outside the definition of capital markets, such as credit cards and insurance.

Globally, the top five investment banks are

1. Goldman Sachs – Goldman Sachs is a global investment banking and securities firm, with headquarters in New York City. The company provides investment banking services in underwriting and financial advisory. Goldman Sachs not only collects funds for its clients, but is also known for its advisory services in the area of mergers and acquisitions. It is particularly well-known for advising companies on how to avoid takeovers. The clients in Goldman Sachs' Private Wealth Management division include 45% of Forbes' list of the 400 wealthiest individuals in the world. Worldwide, the company has approximately 31,000 employees, and its 2009 reported earnings were $13.3 billion.
2. JP Morgan Chase – JP Morgan Chase was formed in 2000 as the result of a merger between Chase Manhattan Corporation and J.P. Morgan and Co. JP Morgan Chase has millions of clients – both commercial and corporate. Some of the company's services include investment and private banking, asset management, private wealth management, and treasury and securities. In 2008, JP Morgan Chase took over the investment banks Bear Stearns and Washington Mutual, which was a troubled bank that was the largest in history to fail. JP Morgan Chase boasts assets of $2 trillion, and has offices in North America, Asia, Europe, the Middle East, and Africa.
3. Morgan Stanley – Morgan Stanley offers investment banking and retail brokerage services. With headquarters in New York City, Morgan Stanley has four major business segments: institutional securities, financial advisory, asset management, and research. Morgan Stanley has a global presence in 36 countries, with more than 60,000 employees in over 600 offices. As of the third quarter of 2010, Morgan Stanley posted total net revenue of $6.8 billion.
4. Citibank – Citibank is the consumer banking division of the large financial services company, Citigroup. With retail locations in over 100 countries around the world, more than half of which are in the US, Citigroup also offers services such as credit cards, insurance, and investment products. Citigroup's online banking services boast more than 15 million users, making them one of the most successful online divisions in the field.
5. Bank of America – Bank of America is one of the top investment banks. When the company purchased Merrill Lynch in 2008 in a deal worth about $50 billion, it became the world's largest wealth manager.

Other important investment banks are

• Barclays – Based in the UK, Barclays is that country's second largest bank and is ranked by Forbes as the 25th largest company in the world. Barclays is a holding company listed on both the New York and London stock exchanges. Globally, Barclays is the largest financial services provider, with assets worth $3.7 trillion USD. The company was affected by the global financial crisis - its share price dropped by 90% in that period – but it has recovered substantially since then. Barclays provides services in all types of banking, as well as credit cards and investment management.
• Lazard Capital Markets – Lazard Capital Markets is a large financial advisory and asset management firm that is based in New York City. Lazard has offices in 24 countries and employs about 2,300 people. The company was established in 2005, and since then has advised on 250 restructurings and almost 1,000 mergers and acquisitions. In addition to advisory services, Lazard provides services such as securities underwriting, research, and sales and trading.
• Credit Suisse – Credit Suisse is a financial services company that was founded in 1856 and is based in Zurich, Switzerland. It has offices in over 50 countries and has about 50,000 employees. It emerged from the financial crisis in good fiscal shape as it made changes early in the crisis to reduce its risk exposure through strategic capital allocation and prudent risk management. This allowed it to be one of the few large international banks that did not require a financial bailout from government agencies. Credit Suisse has three banking divisions: investment banking, private banking, and asset management.
• Deutsche Bank – Deutsche Bank is based in Frankfurt, Germany, and offers financial products and services for both private clients and corporations. Over the past few years, Deutsche Bank has been transforming from a small German-centric firm into an international investment bank.
• UBS – UBS is another Swiss financial services company. The second-largest bank in Europe, it's also the world's second-largest manager of private wealth assets. UBS is an international company, with offices in more than 50 countries, including every major financial center in the world. UBS provides services in the areas of wealth management, investment banking and securities, asset management, and retail and commercial banking.

Industry Trends

Consolidation

A key trend in the capital markets industry is bank consolidation. Banks typically consolidate for three reasons. First, it's beneficial to consolidate in order to ease the competition. Second, it enables banks to provide more varied services, as merging two businesses reduces overhead while combining the services offered by both. Finally, banks sometimes consolidate simply out of the desire for enlargement. Bigger banks are often the most successful banks.

Vertical integration

When a company uses vertical integration, it expands its operations to offer similar goods and services, but on a different point on the supply chain. The company is in control of all the different aspects of selling and delivering a product or service.

Use of cutting-edge technology

Many companies in the capital markets industry are taking advantage of innovations in trading technology. In fact, in 2007, spending on technology upgrades was 5% higher than the previous year, a number that's expected to continue to rise as new technology becomes available. One fifth of investment banking firms are expected to upgrade or retrofit their trading technology, with total spending estimated at about $5.9 billion USD.

Expansion in high-growth, emerging economies

The growth of emerging market economies, such as Asia and Latin America, is happening at a faster rate than in more mature economies, a result of large government debt loads in developed nations. This growth is having a significant impact on the global capital markets industry.

Growth of new product lines

Investment banks are increasingly developing new product lines – such as derivatives and credit default swaps – that provide sources of revenue growth. Although these devices may be more complex, they can also be more lucrative than conventional products. In fact, as of 2007, investment banking revenue rose for the fifth straight year, to approximately $84.3 billion USD. As companies develop more new product lines, revenue should continue to increase.