Wholesale capital markets are international exchanges, formal and informal, where banks, nonbank financial intermediaries, and other large institutions such as multinational corporations borrow from and lend funds to one another; also referred to as wholesale credit and wholesale funds markets and distinguished from retail capital markets where individuals and small entities transact a similar but much more fragmented trade, largely through financial intermediaries.
There are two major ways in which entities of any size raise capital: debt or equity. Debt refers to any agreement that obligates a borrower to repay a lender principal borrowed, along with a charge for borrowing the money, typically interest on the principal. Equity refers to the issuance of shares in a business enterprise that promises no fixed principal or interest payments but which entitles the shareholder to the value of the portion of the enterprise that it owns. Debt and equity might be issued either in primary markets (also referred to as original issue markets) in which case they are being issued and offered for exchange for the first time; or in secondary markets in which the original issues trade beyond the initial seller and buyer. Wholesale investors are the almost exclusive players in primary markets.
Debt may be short term (i.e., less than a year in duration for borrower and lender, with the short-term markets referred to as money markets) or long term (longer than a year where such markets are referred to as capital markets, the context of usage usually indicating whether this more precise meaning of the term applies). The most formal method of raising wholesale debt capital is issuance of large blocks of debt such as bonds. If floated openly on secondary markets available to both small and large buyers, the large denominations of individual debt issues will make the issuance de facto wholesale because only large investors can afford to buy the debt.
There are many different types of wholesale debt instruments. One example of a money market instrument is when large corporations issue short-term large denomination bonds called commercial paper, which are sold at a discount to par (i.e., a markdown from face value or principal amount) and typically have maturities of 90 days or less. For longer-term needs, corporations may issue corporate bonds with interest and principal repayment schedules. Banks may go to market short term or long term by issuing interest-bearing jumbo certificates of deposit (CDs), which are like retail CDs (essentially time deposits) offered to individuals but which have denominations of US$100,000 or more. Debt instruments may be privately placed, that is, issued by individual borrowers and then offered directly to selected individual buyers; have a limited placement, that is, offered to a subset of the potential buyers; or as mentioned above, placed on open markets.
Another popular debt instrument is the repurchase agreements (repos), which are agreements entered into by a borrower and lender (technically referred to as party and counterparty) in which one institution will give some sort of collateral such as a government bond for a set price to another and then buy back that collateral at a higher price at some agreed-upon later date. The difference between the sell and buy prices represents the implicit interest cost of the borrowing and if the borrower defaults, the lender gets to keep the collateral.
Institutions may borrow and lend directly to one another without issuing a tradable financial instrument. There are many examples of such markets; for example, there is a large short-term interbank funds market in which banks borrow from and lend unsecured funds to each other through formal and informal networks. In the United States, the U.S. Federal Reserve Bank maintains the Federal Funds Market in which banks can exchange overnight funds with each other (the benchmark borrowing rate being the Federal Funds Rate set by the Federal Reserve). In the United Kingdom and Europe, banks can transact through the London market, where the London Interbank Borrowing Rate (LIBOR), devised by the British Banking Association, is the benchmark rate.
As for equity, in the wholesale context this method of capital raising can take many forms, some of it off formal secondary share exchanges like the New York Stock Exchange. Private equity, in which large blocs of capital are raised from individuals and firms and then invested in business enterprises, either new or existing, is one example. Block share trading, in which institutional investors trade positions in their respective trade portfolios through secondary equity markets, is another example. Hedge funds, which raise capital and take speculative financial positions mostly in derivatives markets, are a third example.
Capital markets in general are global and very large in terms of annual financial flows. The International Monetary Fund estimates that in 2003 the value of the world’s financial assets (including stocks, bonds, and other instruments) was more than $119 trillion, amounting to over three times the world’s annual gross domestic product (GDP) (although it is not possible to break down this number by wholesale or retail markets as these are not formal but practical terms). The flow of funds moving into and out of markets is even larger than the value of assets at a point in time because it represents turnover of assets. For flows between banks alone considering only cross-border flows (i.e., across international borders), the Bank for International Settlements (BIS) estimated such flows at $28.5 trillion for the first quarter of 2007. This considerable number does not include domestic bank flows or nonbank flows.
In general, these large capital movements are salutary, providing necessary liquidity and financing for the world economy, but there are a number surrounding them. In particular, international regulation of wholesale financial markets to ensure stability and efficiency is an ongoing concern. Some institutions, such as banks, are heavily regulated by national central banks in their own country of domicile, with an international regulatory framework established through the BIS. There is also generally strong oversight of most share exchanges. But other entities such as hedge funds or private equity conduct largely unregulated large-scale transactions. There is some debate about whether financial regulation is productive or counterproductive, but the general issue of soundness of financial markets is perennial and most agree on the need for some sort of oversight.
Another issue is securitization, which refers to the process of issuing a financial instrument that is based on another, original underlying financial instrument. Securitization in general can allow institutions to generate more return on a given set of financial instruments by creating new tradable obligations to offer to the market. But this process by definition involves leveraging existing leverage (e.g., a mortgage loan, still outstanding, then put into a pool of mortgages with slices of that pool sold again offering principal and/or interest to the new security buyers), which increases risk as well as reward. In the “subprime crisis” in the United States, mortgage loans were packaged in various ways into other financial instruments, many of which turned out to be ultimately very volatile in terms of value and liquidity. The pricing and assessment of this risk has been a major problem in the subprime crisis and continues to be an issue studied by analysts in the field.
- Bank for International Settlements, BIS Quarterly Reports (BIS, September 2007);
- International Monetary Fund, Global Financial Stability Report (IMF, 2006);
- Maurice Obstfeld and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth (Cambridge University Press, 2004);
- E. Weiss, Government Interventions in Financial Markets: Economic and Historic Analysis of Subprime Mortgage Options (U.S. Congressional Research Service, 2008).
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