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Capital Markets – A panacea in the new economy

Posted : May 05, 2016

Portfolio investment is key to the growth of every economy, and with a volatile economy like Ghana’s it is about time to step up education on the need for people to invest. These investments would help make capital available for future expansion of the economy.

African financial markets are dominated by banks but capital markets are slowly developing and increasingly beginning to play an important role. Capital markets help to attract long-term capital for financing economic activities.

Situating it in our context, it is imperative to focus on the capital market now and for the future as it holds potential for great contributions to Ghana’s strong, sustained economic expansion in line with national development. According to Prof. Abor, the development of such interrelated markets would not only contribute to regional financial stability but also strengthen related companies in the economy.

“Capital markets are markets where long-term securities such as bonds and shares are bought and sold. Capital markets facilitate the flow of long-term funds from surplus units to deficit units. Companies that wish to raise long-term capital may either issue bonds or shares, and government can also issue bonds to raise long-term funds to finance government projects.” These are excerpts captured from Financial Markets and Institutions: A Frontier Market Perspective, authored by the Dean of the University of Ghana Business School, Prof. Joshua Yindenaba Abor.

His book, First Edition of Financial Markets, discusses the issues of financial markets and institutions from a frontier market perspective.

According to the book, Ghana’s financial market can be categorised into money and capital markets. Though the money market seems very active, the capital market still holds great prospects for Ghana’s economic growth.

The book discusses the insurance and pensions industries, which are important to development of the capital market. The Ghanaian insurance market is a thriving one, with huge potential for growth in both the life and non-life markets. The new pension law also encourages private participation in the pensions industry, and this has the potential of promoting capital market development. 

Development of the Ghana Stock Exchange and now the Ghana Alternative Market is very critical for overall expansion of the capital market, and this should increase access to long-term debt and equity funds for investment. 

What are Financial Markets?

Financial markets are markets where financial assets or securities are bought and sold or exchanged. Financial markets help in facilitating the flow of funds from an investor to finance investments by individuals, firms, and governments. In other words, financial markets provide the opportunity for those with surplus funds or providers of funds (surplus units) to invest or transfer them to those in need of funds or users of funds (deficit units).

In essence, financial markets are arrangements that bring providers and users of funds together. Users of funds issue pieces of paper which are bought by the providers of funds. This is how funds get transferred from the providers of funds to the users of funds. These pieces of paper traded on the financial market are the financial assets. They are sometimes known as financial securities or financial instruments. Financial assets are intangible assets with the typical benefit or value as a claim to future cash. Examples include Treasury bills, bank loans, bonds, mortgages, shares and derivatives.

Classification of Financial Markets

It is important to understand how financial markets are classified. Financial markets can be classified along these lines: money and capital markets; primary and secondary markets; organised and over-the-counter markets. The classification of financial markets is discussed below.

Money versus Capital Markets

Money markets are markets where short-term securities are bought and sold. Money markets facilitate the flow of short-term funds from surplus units to deficit units. Examples of money market instruments include Treasury bills, commercial papers, negotiable certificates of deposit, bankers’ acceptances, and repurchase agreements. Governments issue Treasury bills, whereas companies can issue commercial papers and banks can issue negotiable certificate of deposits, repurchase agreements, and commercial papers.

Capital markets are markets where long-term financial assets such as bonds and shares are bought and sold. Capital markets facilitate the flow of long-term funds from surplus units to deficit units. Companies that wish to raise long-term capital may either issue bonds or shares.  Government can also issue bonds to raise long-term funds to finance its projects.

Primary versus Secondary Markets

A primary market is one where new securities are issued for the first time. For instance, issuing new shares of a company or new Treasury bills by government is a primary market transaction. Primary markets provide funds to the initial issuer of the securities.

Issuing of securities in the primary market can take the form of a private placement or a public offering. A private placement is where the securities are issued to specific investors (usually large institutional investors).  Fidelity Bank made a private placement of its shares and the issue was targetted at few investors. In the case of a public offering, the securities are made available to the general public. Examples are Ecobank Ghana Limited, UT Bank and GCB Bank share issues, which were made available to the general public.

A secondary market is one where already-issued securities are traded. Secondary markets facilitate the trading of existing securities. 

The sale of a company’s existing shares or debt instruments (bonds and Treasury bills) held by any business or individual is a secondary market transaction.  Secondary markets provide funds for the security’s holder. An important feature of securities that are traded in the secondary market is liquidity. The secondary market enables original investors in the securities to off-load or sell their investments to other investors. 

Organised versus Over-the-Counter Markets

Organised markets are markets with a comprehensive regulatory framework of traders linked to one platform. They can easily be identified because they have trading floors or electronic platforms where only authorised members can trade in the securities listed. In other words, there is a central location or an electronic platform where buyers and sellers of securities meet to trade in securities.

There are stock exchanges like the Ghana Stock Exchange, Nairobi Securities Exchange, Johannesburg Stock Exchange, Nigeria Stock Exchange, Mauritius Stock Exchange, New York Stock Exchange and the London Stock Exchange. It is however important to mention that in recent developments, stockbrokers or authorised members of the stock exchange do not have to meet at the physical exchange. They simply sit in the comfort of their offices and trade online or through a virtual platform. For example, in recent times the Licenced Dealing Members (LDMs) of the Ghana Stock Exchange have traded through a virtual platform.

An over-the-counter market (OTC) is a largely unregulated market, whereby geographically dispersed traders who are linked to one another via telecommunication systems and computers trade in securities. In other words the securities dealers operate from many different locations across the country, normally linked by telecommunication systems and computers. Securities traded on the OTC are not traded on an organised stock exchange.

Securities Traded in Financial Markets

Different types of financial securities are traded in the financial markets, and these include debt securities, equity securities, and derivatives.

Debt Securities are contractual obligations of a debtor (borrower) to a creditor (lender). The borrower issues a paper for a fixed maturity date and promises to pay the lender interest. Examples are bonds, mortgages and Treasury bills.

Equity Securities are securities with claim to ownership rights and responsibilities. The investor receives dividends if declared. The investor can also make capital gains/losses when the shares are sold at a price higher/lower than the original price at which the investor bought the shares. There is no maturity date on equity securities. An example is an ordinary share or common stock.

Derivatives are financial securities whose value is derived from the value (worth) of underlying assets. They are mostly used in managing or hedging against risk. Investors can also speculate using derivatives. Examples include forwards, futures, swaps, and options.

Participants in the Financial Market

There are a number of players or participants in the financial market. These players participate in the market by either raising finance through the issue of financial securities or by investing in securities issued by others. They include:

Lenders/Investors/Savers: These are surplus units who have excess funds to lend, save or invest. They may include individuals, households, firms, governments, and government agencies.

Borrowers/Issuers: These are deficit units which are in need of funds and therefore issue securities to raise equity or to borrow. They include individuals, households, firms, government, and government agencies.

Financial Intermediaries: These are institutions that assist in the process of transferring funds from the surplus units to the deficit units. Examples of financial intermediaries are banks, savings and loans companies, credit unions, mortgage firms, insurance companies, mutual funds, unit trusts, pension funds, investment banks, securities firms etc.

Regulators: These are government and government institutions that regulate financial markets. In Ghana regulators of the financial market include: the Ministry of Finance, the Bank of Ghana, the National Insurance Commission, the Securities and Exchange Commission, and the National Pensions Regulatory Authority (NPRA).

Supranationals: These are international financial institutions in the international financial market, and they include the World Bank, the International Monetary Fund, and the African Development Bank.

The Role of Financial Markets

There are a number of important roles the financial market plays in any economy. They are as follows:

Transferring funds from surplus units that have excess funds to invest to deficit units that require such funds for investment. Consider an economy where private businesses did not have access to funds and could not expand. In addition, consider another economy in which households did not have access to funds and could not purchase the basic necessities of life and had to depend on government funding.

Economic activity in such a country is most likely to be stifled if not stagnant. Financial markets have been established to ensure that these businesses can obtain funding from surplus units or providers of funds for investment.

Transferring funds as a means of redistributing the risk related to cash flows generated among those in need of the funds and those supplying the funds. Aiding the interactions between buyers and sellers in the financial market and in the price determination of financial assets, through the price discovery process. Offering liquidity to the original buyers of the securities. Liquidity is an attractive feature as it provides the opportunity for initial investors to offload their investments when it becomes necessary. It enables the holder of financial assets to sell before maturity.

Reducing transaction cost by reducing search and information costs. Search costs are the explicit costs, including the funds spent on advertising a firm’s intention to issue or buy securities and implicit costs including the value of time spent in identifying someone who has interest in buying or selling. Information costs are those associated with evaluating the merits of investing in financial securities

Organisation and Structure of Financial Markets

The structure of financial markets is examined in terms of both the primary and secondary markets.

The primary market deals with newly-issued financial securities and the process of issuing new securities involves the operations of investment banks. In Ghana, the Securities and Exchange Commission regulates primary market activities and the Securities Industry Law 1993 (PNDCL 333), as amended, governs the issuance of securities. Investment banks help firms and government to issue securities in the primary market, and they usually perform three key functions including advising issuers on the terms and timing of the issue, distributing the issue, and bearing the risk involved in the issue (i.e. underwriting the issue).

Advisory Role

The advisory role of the investment bank involves preparing the necessary registration documents, timing the issue, and establishing the right price for the issue. One important requirement of the Securities and Exchange Commission (SEC) for the initial public offering (IPO) or the issue of new securities to the public is for the company to disclose all financial and other relevant information with the assistance of investment banks. This disclosure is done in a prospectus. The prospectus is a legal document that spells out relevant information of the firm issuing the securities; such as its financial condition, the names of its principal officers, and its shareholding structure. It also provides information regarding the firm’s line of business and its plans regarding further expansion.

The timing of the issue is very important. Investment banks usually advise firms to issue shares when the stock market is at its peak. They also advise firms to issue bonds when interest rates are very low, ensuring a high price for the bonds. This is explained by the inverse relationship between bond prices and interest rates.

Investment banks also help in pricing and designing securities to make them attractive to investors. Due to the active engagement of investment banks in the primary market, they are often in a position to advise on the right pricing of new securities. Proper pricing ensures that the issue obtains the highest price possible, which allows the issue to be sold out in a fairly short time.

Distribution Role

Investment banks also help in distributing the issue to the general public. The firm issuing the securities appoints a lead investment bank (lead manager) and a syndicate or group of investment banks (co-managers). In Ghana, shares to be listed on the Ghana Stock Exchange must be sponsored by a Licenced Dealing Member (LDM), which serves as the lead advisor for the issue. The primary responsibility for the issue rests with the lead investment bank.

The syndicate members or co-managers assist the lead bank in the issuing or floatation process. The lead investment bank also puts together a selling group or other LDMs to help with the distribution process. The shares eventually get to the brokers or Authorised Dealing Officers (ADOs) who are mainly in touch with their customers, the final investors in the securities. The LDMs are represented by ADOs or licenced brokers who deal directly with the clients.

Risk-Bearing Role

In addition to the advisory and distribution roles performed by investment banks, they also play the role of risk-bearing. In this case, they buy the securities from the issuing firm and bear the risk of a possible inability to sell all the securities. This function is known as underwriting. When the investment bank buys the securities from the issuing firm at an agreed price, the underwriting arrangement is known as a firm commitment or bought deal or fully underwritten deal.

When the investment bank agrees to use its in-house facilities, expertise and goodwill to sell the issue, it is referred to as best efforts. Under this arrangement, the investment bank does not buy all the securities from the issuing firm. Most share issues in Ghana are through best effort arrangement. The investment bank earns fees from underwriting the issue known as the gross spread or the underwriter discount. This is the difference between the price paid to the issuing firm and the price at which investment banks sells the securities to the investing public.

Investment Banking Activity

The investment banking function is performed in the primary market, mainly by securities firms and certain large commercial banks. 

Securities firms are also actively involved in the secondary market as market makers and stockbrokers. The securities laws and banking regulations in every country regulate the investment banking activities in the respective countries. Major investment banking firms in the US include Goldman Sachs, Merrill Lynch, and Morgan Stanley, Solomon Brothers, and First Boston Corporation. Examples of investment banking firms in Ghana are Databank, Strategic African Securities, Gold Coast Securities, NTHC Securities, FirstBanC Financial Services, EDC Stockbrokers, UMB Investment Holding Limited and Cal Brokers Limited.

To this end, the talk of growing the economy and ensuring that Ghana reaches developed country status rests with our ability to embrace portfolio investments.

Financial Markets and Institutions: A Frontier Market Perspective is authored by the Dean of the University of Ghana Business School, Prof. Joshua Yindenaba Abor.

It is expected that this first edition which was launched at the Accra International Conference Centre on May 4th, 2016 provides an insightful reading for academia, the business community, economists, financial analysts and students alike to appreciate the capital markets’ workings in our part of the world.

Source: Eugene Davis | thebftonline | Ghana






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