How we benefit from I-Bankers and Hedgefunds (Capital Markets Explained)

New York Stock Exchange, December 2007
Image via Wikipedia

Over lunch, my buddy Andy and I got into a conversation about whether or not I-bankers and traders actually  “create”  value.  The common sentiment is that these actors are nothing more than leeches and speculators that piggyback on value created by others.  While  know less about capital markets than my hard finance friends,  I do understand why “agents of liquidity” such as I-bankers and traders increase value not only for themselves but for society as a whole.   That said, I can also understand why people who live and work outside of the system have such a hard time understanding why this is.   So here is a simplistic explanation:

It’s easy to understand how anyone that creates something or provides a service creates value.  Construction workers build houses, teachers make our kids smarter, artists make the music we love and the guy at Starbucks prepares your coffee so you can do whatever the heck you contribute to the world.  Entrepreneurs and employees create value through the creation and provision of goods and services.

Value creation gets a little more abstract as you move away from the consumer facing end of the value chain but initially it’s still pretty straight forward.   Accountants, IT professionals, and bankers provide the support services that enable businesses and institutions to provide us our coffee, education, and art.  Drilling down on the services provided by financiers, venture capitalists provide value by financing big risky ideas that might otherwise have never gotten off of the ground.  Similarly, private equity firms add value later in the business lifecycle by buying and fixing up underperforming businesses.

Here’s where is gets a little tricky.  Stay with me to see how it affects you.

Investment bankers enable businesses to obtain capital ($$$) via Initial Public Offerings (IPOs) of their stock to public markets.  Public markets are public because anyone is allowed to buy on sell on them- you, your grandmother, or S.A.C capital management (one of the worlds largest and most infamous hedgefunds).  Public markets enable investors to share in the profits of the companies that provide us goods and services.

Markets only work though if there are plenty of buyers and sellers- this is where short term investors (traders and some hedgefunds) and long term investors (Warren Buffet, pension funds, and some other hedgefunds) come in.  By buying and selling stocks, they create what is called market liquidity.

Liquidity…refers to an asset‘s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value, according to Wikipedia.

The more buyers and sellers in a market, the more liquid the market is.  Without buyers and sellers, there is no liquidity, and thus, no market.  Imagine a vendor selling fruit in an empty market.  How much would the fruit be worth?  Nothing.  The same applies to for stock markets.  Even if a company has millions of dollars of profits and thousands of employees,  if there is no one at the market to buy their stock, the company has no way of unlocking the value it has created.  Assets are only worth something if you can find someone to buy them.

In conclusion, if I bankers didn’t exist to help companies tap into capital markets such as the New York Stock Exchange (NYSE) by issuing stock, and traders weren’t buying and selling those stocks (albeit in pursuit of personal profits), then companies would have to get funding from other, more expensive sources.  That would mean more expensive coffee (Starbucks: SBUX on the NASDAQ), burgers (McDonald’s: MCD on the NYSE), and cars (Ford: F on the NYSE ) for everyone.  Investment bankers and traders aren’t providing services directly to us the end user, but we directly benefit from their services.

One reason companies from all over the world base themselves in America is because we have the world’s best (most liquid) capital markets.  There are plenty of other stock markets in the world to chose from but companies come here.  Active investment banking and trading communities keep it this way, enabling the rest of us to benefit from the goods and services these companies provide.

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2 responses to “How we benefit from I-Bankers and Hedgefunds (Capital Markets Explained)

  1. Congrac’s

    The article was really very good…………………

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