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Money markets and capital markets

Capital markets

1 Money markets and capital markets

Section overview

• Money markets are markets for short-term capital.

• Capital markets are markets for long-term capital.

• The main capital market in Australia is the Australian Securities Exchange (ASX).

• A stock market acts as a primary market (i.e. where securities (debt and equities) are issued for the first time) and as a secondary market for the trading of existing securities (i.e. shares and bonds).

1.1 The role and structure of financial markets

The primary role of the financial market is to provide a medium of exchange where funds transfers can take place between individuals, firms and governments. Funds can flow directly between borrowers and lenders or through third parties known as financial intermediaries.

Financial market participants commonly distinguish between the 'capital market' and the 'money market'.

The money market refers to borrowing and lending for periods of up to a year, whereas the capital market exists for the trading of longer term financial instruments.

Differences between loan terms

Year 0 Year 1 Year 5 Year 10

term

Long term Medium term

Short term

1.2 The money markets

Money markets are markets for:

• Trading short-term financial instruments.

• Short-term lending and borrowing.

The money markets are operated by the banks and other financial institutions. They facilitate short-term financing and provide liquidity for short-term assets. Although the money markets largely involve borrowing and lending by banks, some large companies, as well as the government, are involved in money market operations.

The inter-bank market is a market for very short term borrowing, often overnight, between banks.

The key financial instruments traded are:

(a) Cash deposits – money in the bank accounts of banks and other financial intermediaries, offering a range of different investment periods and rates of return.

(b) Negotiable instruments – a piece of paper representing ownership of debts and obligations. The ownership is passed on with the delivery of the piece of paper. Negotiable instruments traded in the money market include 90- and 180-day bills of exchange, promissory notes and certificates

of deposit, which are written orders promising to pay a specified sum of money at a predetermined time to the order of a specified person or bearer.

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1.2.1 Official and unofficial money markets Definition

The official money market is the market supported and sponsored by the Reserve Bank of Australia (RBA), which is responsible for the conduct of monetary policy, the issue of bank notes and the setting and management of Australia’s foreign exchange reserves.

Features of the official money market are:

• Authorised dealers trade in government securities.

• RBA provides lender of the last resort facilities to authorised dealers.

• Government implements monetary policy changes.

The unofficial money market is less formally organised and does not have official RBA support.

It comprises:

• the intercompany market – involving direct lending between companies.

• the commercial paper market – intermediary trading of commercial bills, promissory notes and negotiable certificates.

1.3 The capital markets

Capital markets are markets for trading in long-term finance, in the form of long-term financial instruments such as equities and corporate bonds. The stock market and bond market are capital markets.

Firms obtain long-term or medium-term capital in one of the following ways:

(a) They may raise share capital (equity). Most new issues of share capital are in the form of ordinary share capital. Firms that issue ordinary share capital are inviting investors to take an equity stake in the business, or to increase their existing equity stake.

(b) They may raise loan capital (debt). Long-term loan capital might be raised by issuing corporate securities in the form of loan notes, corporate bonds, debentures, unsecured and convertible bonds.

These may be issued domestically or in foreign capital markets.

Definitions

Equity securities consist primarily of ordinary shares which entitle the owner to a share of the company’s profits and give them voting rights.

Debt securities are typically fixed interest borrowings with a set repayment date, often secured on the assets of the company.

We will look at sources of long-term finance in more detail in Chapter 4.

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1.4 Capital market participants

The various participants in the capital markets are summarised in the diagram below:

1.4.1 Institutional investors

Institutional investors are institutions which have large amounts of funds which they want to invest. They will invest in stocks and shares or any other assets which offer satisfactory returns and security or lend money to companies directly. The major institutional investors in Australia are superannuation funds and insurance companies and they are the biggest investors on the stock market.

1.5 Functions of the stock market

A stock market acts as a primary market for raising finance, and as a secondary market for the trading of existing securities.

Definitions

The primary market is the market where securities (debt and equity) are issued for the first time.

The secondary market is the market where securities which have been issued in the primary market are traded.

The stock markets serve two main purposes:

(a) As primary markets they enable organisations to raise new finance, by issuing new shares or new bonds. A company must have public company status to be allowed to raise finance from the public on a capital market.

(b) As secondary markets they enable existing investors to sell their investments, should they wish to do so. The marketability of securities is a very important feature of the capital markets, because

investors are more willing to buy stocks and shares if they know that they could sell them easily, should they wish to.

These are the main functions of a stock market, but there are two other important ones.

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1.6 Australian capital markets

1.6.1 The stock market

Trading on financial markets is either exchange-based or off-exchange. The major exchange market in Australia is the Australian Securities Exchange (ASX) which brings together buyers and sellers of equity securities (shares) and futures instruments.

The Australian Stock Exchange (as it was known then) was formed in 1987 by the amalgamation of the stock exchanges of the six capital cities. In July 2006, the Australian Stock Exchange merged with the Sydney Futures Exchange (SFE), the major futures and commodities exchange, to form the current Australian Securities Exchange (ASX). As well as a market where the buying and selling of shares and debt securities takes place, the ASX is also the market for dealings in Australian government securities and the trading of derivatives. The ASX itself is a publicly listed company trading on the Exchange.

Trading is conducted by stockbrokers who bring together the buyers and sellers, and is done electronically using SEATS (Stock Exchange Automated Trading System).

Australia's securities markets are supervised by the Australian Securities and Investments Commission (ASIC) through the Federal Government's Corporations law. In addition, all companies listed on the Exchange must also comply with the ASX's own business rules (see Section 3).

The size and importance of financial markets has increased significantly since the early 1980s. Australia's share market is the eighth largest in the world, and the third largest in the Asia-Pacific region; while the Sydney Futures Exchange (SFE) is the largest futures exchange in the region.

All stock exchanges set eligibility criteria for companies wanting a listing. Key criteria generally include those relating to the size of the company and its shareholder base, which are aimed at ensuring an adequate market for trading in the company’s shares.

For example, the ASX requires companies to meet either a profits test (aggregated profit of at least

$1 million from the same business in the last three years, and profit from continuing operations of at least

$400 000 in the last 12 months) or an assets test (net tangible assets of at least $2 million – or market capitalisation of at least $10 million, with less than half of net tangible assets being held in cash).

The ASX also requires the company to have at least 500 shareholders each holding a parcel of shares worth at least $2 000. A lower threshold of 400 shareholders applies if at least 25 per cent of the shares are in public hands. In either case, the practical implication is that a company can’t raise capital solely from institutions, but requires substantial support from retail investors.

Other smaller exchanges have less strict requirements, and are more suitable for smaller organisations:

(a) The National Stock Exchange of Australia (NSX) specialises in small- and medium-sized company public listings, including community-based organisations, and high technology companies.

The NSX only requires a market capitalisation of $500 000, and a minimum of 50 shareholders (among other criteria).

(b) The NSX also manages the Bendigo Stock Exchange (BSX) and the Wollongong Stock Exchange, which both focus on capital growth for regional business such as community banks or property trusts.

(c) Australia Pacific Exchange (APX) is an exempt stock market, which means that a business can have more flexibility on the structure of its shares.

1.6.2 The bond market

The Australian bond market has, until relatively recently, been dominated by the borrowing requirements of the Federal Government. Banks, life insurance companies and superannuation funds, who until the 1980s, were required to hold prescribed percentages of their assets in public sector securities, absorbed most of the debt issued by governments. Since the mid-1990s the bond market has grown in importance as a source of finance for the private sector.

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1.6.3 The foreign currency markets

Foreign exchange is a major sector in the Australian financial markets. The Australian dollar is one of the most actively traded currencies in the world (after the US dollar, yen, euro and Swiss franc).

1.6.4 Derivatives markets

Derivatives markets allow market participants to fix today the price at which trades will be made in the future. Efficient derivatives markets allow financial market participants to manage risk. The Sydney Futures Exchange (SFE), which is now part of the ASX, provides derivatives in interest rates, equities, currencies and commodities. This is covered in more detail in Chapter 10.

1.6.5 Over-the-counter (OTC) markets

Over-the-counter (OTC) or off-exchange trading refers to financial instruments such as stocks, bonds, commodities or derivatives which are traded directly between two parties, as opposed to via an exchange.

Major products traded on OTC markets in Australia include government debt securities, corporate debt securities, currency and derivative instruments.

1.6.6 Trading volumes

The 2011 Australian Financial Markets Report, published by AFMA (Australian Financial Markets Association) summarises the annual turnover by market in AUD billions.

Physical market

$AUD billions

Derivatives market

$AUD billions

Total

$AUD billions

Debt market 13 430 64 636 78 066

Currency market 11 881 33 411 45 292

Equity market 1 339 3 198 4 537

Total 26 650 101 245 127 895

Traded as follows:

OTC financial markets 78 173

Exchange traded equities 2 020

Exchange traded futures 47 702

127 895