Page 99 - Encyclopedia of Business and Finance

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Capital Markets

diate dividend, but rather to allow the company to expand rates, and stock indexes. In the mid-1960s it introduced
and ultimately increase the value of their investment. a futures contract on a nonstorable commodity—live cat-
Hence, they are interested in innovative small companies tle. In 1972 it launched a contract in foreign currency
with very rapid growth rates. Some venture capitalists spe- futures.
cialize in certain business sectors (e.g., biotechnology, The U.S. futures industry operates under an extensive
information technology). Others may invest only at cer- regulatory umbrella. Federal legislation governing the
tain stages in the development of a project or company. industry has existed since 1924. The Commodity Futures
Trading Commission, established under the 1974 amend-
FINANCIAL INNOVATION AND THE ments to the Commodity Exchange Act, has far-reaching
MARKETS IN DERIVATIVE authority over a wide variety of commodity industry activ-
INSTRUMENTS ities.
Financial innovation has been one of the most influential
trends in international financial markets since the early ROLE OF THE SECURITIES AND
1980s. A large number of new financial products and EXCHANGE COMMISSION
instruments have been created as the traditional barriers
The SEC was organized under the Securities Exchange
among types of financial institutions have increasingly
Act of 1934 to create fair market conditions in the secu-
eroded. Banks, for example, are increasingly competing
rities markets by setting standards for and requirements
with markets for what was once considered to be tradi- of information from the issuer of the security to the gen-
tional intermediated credits. Markets are becoming more eral public. The SEC has overall responsibility for this
global, and competition among financial institutions has
process that creates competitive and fair pricing and
intensified. This increase in financial innovation has taken
trading of securities, and it prevents abuse and fraud by
place in an environment of steady deregulation coupled
issuers, brokers, and dealers. Issuers are required to file
with significant advances in information and communica- detailed information with the SEC on all publicly traded
tion technologies.
securities, which becomes available to the public on an
Securitization, perhaps the most important trend in
equal basis. Privately traded securities and investments
international financial markets in the 1980s and early
by wealthy individuals are exempt from registration,
1990s, continues to redefine the operations of banks and
based on the assumptions that these investors understand
has important regulatory implications. Both bank and the risks involved in a given security and that they are
nonbank financial institutions are relying more on able to tolerate the consequences of those risks if they
income from off-balance-sheet activities. A greater share
materialize.
of credit now flows through capital market channels,
which are characterized by less supervision in comparison
to banks. Deregulation, improved technology, growing ROLE OF THE FEDERAL RESERVE
competition, and volatile exchange and interest rates are SYSTEM
the main stimulus for financial innovation. Innovation The Federal Reserve (the Fed) plays a key role in the func-
can improve the efficiency of international financial mar- tioning of the capital market in the U.S. economy and, by
kets by offering a broader and more flexible range of extension, in the world economy. It manages the overall
instruments for borrowing. It also provides hedging liquidity and credit conditions in the U.S. financial sys-
instruments that can help banks, borrowers, and tem. The Fed strives to maintain a noninflationary level of
investors to manage the risks associated with volatile liquidity in the economy, on an ongoing basis, in order to
exchange and interest rates. foster conditions for maximum sustainable growth of the
The derivatives market took a major step forward economy. It does so by regulating the money supply
with the formation of the CBT in 1848. It developed through the banking system and its interaction with the
standardized agreements as to the quality, quantity, deliv- public.
ery time, and location, and called futures contracts for The Fed pays similar attention to availability of
trading of grains in 1865. The development of financial credit; in that regard it is authorized to set the margin rate
futures resulted from a changing world economy follow- on stock purchases, thus exercising a direct role in the use
ing World War II (1939–1945). Futures contracts provide of credit in equity market transactions. The Fed is also the
for efficient forward pricing and risk management. commercial and investment banker to the federal govern-
The CME (also known as the Merc) is another major ment; in this capacity, it conducts the U.S. Treasury’s
futures exchange in the United States. The Merc’s diverse operations in the Treasury securities bond market through
product line consists of futures and options on futures in the securities dealers recognized by it and so authorized to
agricultural commodities, foreign currencies, interest be dealers in Treasury bills, notes, and bonds.

76 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION