Capital Markets Blog Series – Part I: Capital Market Structure and Market Participants
Brexit will almost inevitably initiate a transition towards a new EU27 Capital Market, needed to finance European economic growth and development in times of political uncertainty and technological disruption. Based on the publication of our Thought Paper “The Development of European Capital Markets Post-Brexit”, this blog will focus on EU27 Capital Markets structures and participants. Further posts will focus on the main areas and the progress of the Capital Markets Union (CMU), which we consider the most important regulatory condition for the future development of EU27 Capital Markets.
Capital Markets – Overview
Capital markets fulfill an intermediation function by transforming size, maturity and risk. The intermediation function of Capital Markets leads to risks being transferred directly between market participants while intermediation by banks involves the temporary use of bank’s balance sheet, resulting in a high reliance on banks’ continued capabilities to carry, manage and hedge these risks while owned by them. In times of increasing regulatory capital requirements and low interest rates, both resulting in a reduced risk appetite of banks, this intermediation function is constrained.
On Capital Markets, securities such as shares and bonds are issued to raise medium to long-term financing on what is called the primary market, and securities, commodities, currencies as well corresponding derivatives are traded on what is called the secondary market – disregarding newly developing asset classes and tokenization of real assets. Short-term transactions within a currency take place on the money market.
On primary markets, an issuer usually engages investment banks to place its securities (e.g. bonds and shares) with investors. In secondary markets, an issuer’s bonds and shares as well as other asset classes such as e.g. derivatives and commodities are traded between market participants.
The following diagram shows a holistic overview over the Capital Market structure as well as market participants which will be referred back to throughout the following blogs:
Capital Market Participants – Roles and Responsibilities
In primary markets, issuers (e.g. public sector entities, corporates and banks) use investment banks (so called sell-side banks) in order to support them in structuring IPOs or debt issuances. Investment banks may thus act as intermediaries in the primary market either by connecting the issuer with potential investors (matching function) or by acquiring the issuance and re-selling it to other participants (underwriting function). Furthermore, banks depend on Capital Markets to issue their own debt and equity instruments, needed to fulfill their intermediation function, especially if they cannot attract (sufficient) deposits. The ability of Capital Markets to provide financing is a critical prerequisite of financial intermediation needed to finance economic growth and innovation. Capital issuances in the primary market are usually acquired by large institutional investors including but not limited to asset managers, hedge funds, pension funds and insurance companies. These market participants hold either issued capital instruments directly or structure investment vehicles to pool capital instruments from different investors.
Generally, shares and bonds issued in primary markets are subsequently traded in secondary markets as well as other asset classes such as e.g. derivatives and commodities. In secondary markets, additional investors such as e.g., commodity houses, commodity producers and consumers come into play. As a result of this larger group of investors as well as the increase with regard to the number and complexity of products (e.g. based on restructuring and derivative products), the legal and regulatory requirements for intermediaries are higher in the secondary market than in the primary market. Intermediaries in the secondary market include investment banks’ Sales & Trading divisions, which focus on creating investment and hedging opportunities for investors who are looking at transferring risks. In order to increase market demand for primary market products, these specialized traders use techniques such as financial engineering or structuring, creating new products that allow investors to buy portions of risks and cashflows of the original assets. In addition to investment banks, the group of intermediaries generally includes e.g. trading venues, such as e.g. stock exchanges, Multilateral Trading Facility (MTF) focusing on equity transactions (no operator discretion) as well as Organised Trading Facilities (OTF) focusing on non-equity transactions. Furthermore, FMIs such as e.g. clearing houses (CCPs such as LCH, Eurex Clearing, CME or Iceclear) and Central Securities Depositories (CSDs such as Clearstream, Euroclear or DTCC in the US) play a key role on the secondary market. Besides the intermediaries mentioned above, which usually share part of the risk of the underlying transactions or support the execution of the transaction process, other relevant market players such as rating agencies have emerged in order to enhance transparency and therefore reduce the information asymmetry between issuers and investors. Statutory auditors foster reliance in financial statements and thus reduce disincentives. Law firms and advisors help transfer best market practices between market participants. Furthermore, regulators issue legal requirements and supervisors enforce them contributing to a functioning, stable and integrated, fair and transparent financial system and prevent its misuse for fraud, money laundering and terrorist financing purposes. Shortcomings with regard to the above-mentioned functions may result in severe market disruption with respective effects on the real economy.
Need for action in order to realize the growth potential of EU27 Capital Markets
The different size and structure of Capital Markets often relates back to the underlying economy and market structure, including its market participants. As an example, the majority of EU27 entities are bank-financed in contrast to the US, where Capital Market funding plays a major role for market participants. On average, bank lending represents 78% of corporate debt for EU27 companies and bond markets account for 22% in 2016 (compared to 13% in 2006). This is the inverse of the US with its market-based financial system, where bank lending accounts for 26% of corporate debt in 2016 (compared to 27% in 2006). In the UK, bank lending represents just over half of corporate debt with 54% in 2016 (compared to 63% in 2006) which shows the path the UK has taken to convert from a bank-based to a market-based financial system.
Currently, the EU is facing enormous challenges: Trying to tackle demographic and technological change, border protection and climate change will require significant investments which cannot be provided purely by banks as financial intermediaries. Furthermore, Brexit preparations revealed the extent to which the EU27 member states are dependent or (over-)reliant on the UK Capital Market, which effectively absorbs a large part of Capital Market transactions entered into by European market participants. In order to ensure growth and become more independent in an international context, the European Union needs a genuine, integrated and innovation-friendly Capital Market. Since Capital Markets are fragile constructs with legal, political and social determinants being the main drivers to ensure a stable development, the Capital Markets Union (CMU) introduced by the EU Commission is an important first step towards the creation of an integrated European Capital Market. The subsequent blogs will thus focus on the CMU action plan, analyzing the issues it tries to tackle as well as identifying potential gaps and remediating actions.
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 The authors thank Fabian Faas and Philipp Böhme, both PwC, for their valuable contribution to this blog series.
 Wright, W./Asimakopoulos, P. (2018): A decade of change in European Capital Markets, p. 10.