Elements of Indian Financial Markets

 

Purpose

The financial markets enable efficient transfer and allocation of resources for productive activities in the economy. Users of funds include businesses, governments and households who seek funds to run their activities. Households, businesses and governments also act as providers of surplus funds. Intermediaries such as banks, financial institutions, mutual funds and insurance companies, among others, channelize the available surplus funds from lenders to the users. The function of the financial markets is to ensure that economic activity is enabled by providing access of funds to those that need it for consumption or productive activity. They provide a way for aggregation of funds from a large number of investors and make it available for productive economic activity. In the absence of financial markets such aggregation may not be possible. An efficient financial market ensures that the transfer of funds happens at a cost that makes it attractive for savers to save and lend and for users to borrow funds. The markets must enable the dissemination of relevant information to all the participants in the market so that the decision on price of funds is made after integrating all available information. It must also allow the participants to review their funding decisions given new information and to re-allocate the resources accordingly. Therefore, providing liquidity and exit options are an important function of financial markets. Financial market regulations and regulators focus on setting up systems and processes in place to streamline the activities associated with the transfer of funds.

The Indian financial market can be illustrated in the figure below:

structure of financial market
Fundamental Players of Financial Markets in India

 

a.    Banking System

The banking system is at the core of the financial structure of an economy and supports its growth. It enables capital growth and formation through financial intermediation by accumulating savings from households, governments and businesses and making credit available for productive activities. The Indian banking has a multi-tier structure. The Reserve Bank of India is the regulator of the banking system and the monetary authority. Its functions include licensing banks and putting in place regulations for a strong and stable banking system, be the note-issuing authority and banker to the government and act as a lender of last resort to the other banks by providing accommodation in the form of advances. It also acts as a controller of credit in the monetary system by effecting changes in the Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR) and other selective credit controls, transact and regulate the foreign exchange market.

 

The primary function of the banking system is to accept deposits and make credit available to those entities that qualify for it. The banks act as an intermediary between those that have excess funds to invest and those that need funds by undertaking the role of mobilizing these surplus funds by taking deposits and lending it on the basis of a credit evaluation done on the ability of the borrowers to pay interest and return the principal. The banks also provide a secure system for settling financial transactions of their customers through a system of checks and electronic payment systems.

 

Apart from these primary banking activities, banks also provide third-party products and services to their clients by offering advice on investments and insurance

 

ü  Commercial banks may be scheduled commercial banks which include public sector banks, private sector banks, foreign banks and regional rural banks or non-scheduled commercial banks that include local area banks. Apart from commercial banks, there are co-operative credit institutions such as the urban co-operative banks and state and district level cooperative banks that cover rural area needs. Payment banks have been notified by the RBI to encourage financial inclusion to low income households, small business and others by providing small savings accounts and payment/remittance services.

 

ü  Small Finance Banks are another category of banks approved by RBI to provide a savings vehicle, banking facilities and to supply credit to small businesses, marginal farmers, micro and small industries and other entities in the unorganized sector. The capital requirements, functions and obligations and regulatory provisions of each category are defined by the RBI.

 

 

b.    Securities Market

The securities market provides an institutional structure that enables a more efficient flow of capital in the system. If a household has some savings, such savings can be deployed to fund the capital requirement of a business enterprise, through the securities markets. The business issues securities, raises the money from the household through a regulated contract, lists the securities on a stock exchange to ensure that the security is liquid (can be

sold when needed) and provides information about its activities and financial performance to the household. This basic arrangement in the securities markets enables flow of capital from households to business, in a regulated institutionalized framework.

 

A security represents the terms of exchange of money between two parties. Securities are issued by companies, financial institutions or the government. They are purchased by investors who have money to invest. Security ownership allows investors to convert their savings into financial assets which provide a return. Security issuance allows borrowers to raise money at a reasonable cost. The market in which securities are issued, purchased by investors and subsequently transferred among investors is called the securities market. The securities market has two interdependent and inseparable segments, viz., the primary market and the secondary market. The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors. The secondary market, also called the stock exchange, facilitates trade in already-issued securities, thereby enabling investors to exit from an investment or to accumulate more, if it meets their expectations. The risk in a

security investment is transferred from one investor (seller) to another (buyer) in the secondary markets. The primary market creates financial assets and the secondary market makes them marketable.

 

Retail investors are individual investors who invest money on their personal account. Institutional investors are organizations that invest large volumes and have specialized knowledge and skills in investing. Institutional investors are companies, banks, government organisations, mutual funds, insurance companies, pension trusts and funds, associations, endowments, societies and such organisations that may have surplus funds to invest.

 

c.    Commodities Market

A commodity market facilitates transactions between buyers and sellers of commodities. These could be agriculture based commodities, commodities for industrial use such as metals and minerals, gas and oil for consumption or production and precious metals for investment or industrial use. Commodities can be traded in the cash market for immediate delivery and payment between the buyer and the seller. Or, transactions in commodities can be done in the forward or futures market for settlement at a future point in time at prices determined at the time of entering the contract. A forward transaction is one where the terms of the transaction, such as the quantity, quality, price and terms of delivery are customized to the requirements of the persons involved. In a futures contract, the terms of

the contract are determined by the exchange which initiates the contract. The price is determined by the parties to the contract. A futures contract is standardized as to quantity, quality and delivery terms. An exchange traded commodity futures contract minimizes the counter-party risk of default that exists in forward contracts. The commodity exchanges adopt risk management measures such as margin system and settlement guarantee funds to

protect the interest of the participants. Forwards and futures in commodities help producers and consumers of the commodity to hedge against the risk of adverse price movements in the future. It helps them streamline and accurately estimate the demand and supply of commodities.

 

d.    Foreign Exchange Market

The growth of international trade made it necessary to be able to determine the relative value of currencies given the differences in their purchasing power. The need for exchanging one currency to another for settling trades in goods and services brought about the term foreign exchange. Since the foreign exchange is the value of a currency relative to other currencies, its value will differ for each combination of currency, called a currency pair. For example, USDINR is the currency pair of US dollars and Indian rupee. The currency quoted first in the currency pair is called the base currency and the currency quoted next is called the quoting currency. The practice in the market is to quote the price of the base currency in terms of the quoting currency. If there is a PRICE quote for USDINR as 61, it means one unit of USD has a value of 61 INR. The Indian foreign exchange market has a spot market and a forward market. The spot market has an interbank segment and a merchant segment. In the interbank segment, banks make market by giving two-way quotes for buying and selling a currency. In the merchant segment, the merchants are price takers who buy or sell currency based on the price given by the banks. The RBI publishes a reference rate for each currency pair based on the bid and offer rates of a set of banks. The reference rate is available for every week day. The settlement of spot market trades happens with actual delivery and receipt of currency on gross settlement basis on the value date. The value date is the second business day after trade date i.e. T+2 day.

 

e.    Insurance Market

The Indian insurance market consists of the life insurance segment and the general insurance segment. The life insurance sector was opened to private providers in 2001. Currently, there is one public sector life insurance provider, namely the Life Insurance Company and many private insurers. The life insurance products may be broadly categorized as the traditional products, variable insurance products and the unit linked products. Traditional life insurance products include term insurance, endowment policies, whole life policies and the like. Term insurance is a

pure risk protection product with no benefit on maturity. If the insured event occurs, in this case loss of life insured, then the sum assured is paid to the beneficiaries. Other traditional products typically have maturity benefits and have a small savings component. Variable insurance products and unit linked products combine risk protection and investment. A portion of the premium is used for risk cover while the remaining portion of the premium is invested to provide returns linked to an index or based on the performance of the portfolio in which it is invested. On the occurrence of the event or maturity of the policy the sum assured and/or value of the fund created is returned to the policy holder or beneficiary. The products are distributed through multiple channels such as agency, bancassurance,

direct agents, broking and corporate agency, among others. The Insurance Regulatory and Development Authority of India (IRDAI) regulates the insurance sector including registering insurance companies, clearing insurance products,

licensing and establishing norms for the intermediaries and protecting policy holders’ interest. Other entities involved in the insurance sector include insurance brokers, who are licensed to offer policies from any insurance company and are paid a brokerage by the company whose policy is sold. Individual agents are certified and licensed by IRDAI and can sell policies of life insurance and general insurance companies or both. Low financial awareness combined with inefficient distribution lines that are unable to convey the benefits of insurance have continued to keep much of the population without adequate insurance cover.

 

f.     Pension Market

A growing elderly population and a large unorganized employment market are two primary factors that define the pension industry in India. Much of the Indian population is still outside the formal retirement benefit cover provided by the government and its associated organisations, and companies covered under the Employees Provident Fund Organisation (EPFO) rules. The government’s pension plan has moved from defined benefit structure, where all retired employees of a particular rank get the same pension with no contributions by the employee, to a defined contribution structure, where the employee and the employer contribute to the pension fund and the pension received on retirement will depend upon the fund accumulated. The private sector is covered by the Employee

Provident Fund and the Employee Pension scheme or funds managed by establishments allowed to do so by the EPFO. The National Pension System (NPS) is a defined contribution pension scheme now applicable to government employees, where the employee and the government make matching contributions to a fund of the employee’s choice, managed by licensed fund managers. The NPS is also available for the general public to voluntarily contribute periodically and create a retirement corpus. Other voluntary retirement plans available include the Public Provident Fund and retirement plans offered by insurance companies and mutual funds. On retirement, the corpus accumulated in the NPS is used to buy an annuity offered by insurance companies. The annuity provides a pension to the annuity holder according to the terms of the annuity selected. The Pension Fund Regulatory and Development Authority (PFRDA) is the regulator of the pension market.

 

g.    International Financial Services Centre

The Gujarat International Finance Tec-City (GIFT) is the first International Financial Service Centre (IFSC) in India. An IFSC deals with financial products and services for customers outside the domestic economy. Indian as well as foreign stock exchanges, clearing corporations, depositories. Asset Management Companies and other financial institutions and intermediaries can set up subsidiaries to undertake the same business in the IFSC. Some of the services provided in an the IFSC will include fund raising for companies, governments, asset management and global portfolio diversification services, global tax management services, treasury management, risk management and mergers and acquisition activities.

 

Role of Participants in the Financial Markets

Intermediaries in the financial markets are responsible for coordinating between investors and borrowers, and organizing the transfer of funds between them. Without the services provided by intermediaries, it would be quite difficult for investors and issuers to locate each other and carry out transactions efficiently and cost-effectively. The role and responsibilities of intermediaries are laid down in the acts and regulations governing them.

 

ü  Stock Exchanges provide the infrastructure for trading in securities that have been issued at prices that reflect its current value. The existence of the system allows the valuation of their investment and to realize its value when they require funds encourage investors to invest when issuers raise funds. Stock markets such as the NSE, BSE and the Metropolitan Stock Exchange of India Ltd (MSEI)are national exchanges with provide nation-wide broker networks. Trading happens on electronic trading terminals which feature anonymous order matching. Stock exchanges also appoint clearing and settlement agencies and clearing banks that manage the funds and securities settlement that arise out of these trades.

 

ü  Depository participants enable investors to hold and transact in securities in the dematerialised form. Demat securities are held by depositories, where they are admitted for dematerialisation after the issuer applies to the depository and pays a fee. Depository participants (DPs) open investor accounts, in which they hold the securities that they have bought in dematerialised form. Brokers and banks offer DP services to investors. DPs help investors receive and deliver securities when they trade in them. While the investor-level accounts in securities are held and maintained by the DP, the company level accounts of securities issued is held and maintained by the depository. In other words, DPs act as agents of the Depositories.

 

ü  Custodians typically work with institutional investors, holding securities and bank accounts on their behalf. They manage the transactions pertaining to delivery of securities and money after a trade is made through the broker, and also keeps the accounts of securities and money. They may also account for expenses and value the portfolio of institutional investors. Custodians are usually large banks.

 

ü  Stock brokers are registered trading members of stock exchanges. They sell new issuance of securities to investors. They put through the buy and sell transactions of investors on stock exchanges. All secondary market transactions on stock exchanges have to be conducted through registered brokers. Sub-brokers help in reaching the services of brokers to a larger number of investors. Several brokers provide research, analysis and recommendations about securities to buy and sell, to their investors. Brokers may also enable screen-based electronic trading of securities for their investors, or support investor orders over phone. Brokers earn a commission for their services.

 

ü  Investment Banks are financial entities that provide strategic advice to companies, governments and others on their capital requirements and investment decisions and arrange raising such funds on terms that are most suitable to the company. Their activities include advisory services for business expansions, project financing, mergers and acquisition, investment valuation, among others. They charge a fee for their services. Investment banks also deal with large investors and help them manage their portfolios across asset classes, products and geographies.

 

ü  Commercial Banks provide banking services of taking deposits, providing credit and enable payment services. They provide efficient cash management for businesses and meet their short-term financing needs through facilities such as over drafts and bills discounting. They also provide term financing for projects. For individuals and households, banks provide a secure infrastructure for holding their excess funds, making payments, accessing credit and financing facilities.

 

ü  Insurance Companies provide service of insuring life, property and income against unexpected and large charge. Life insurance companies deal with insuring the life of individuals while general insurance covers health, motor, travel and other areas, where a sudden large expense can derail the financial situation of a household or business. Insurance companies use channels such as individual and corporate agents, brokers and banks to sell their products. Given the large resources mobilized by insurance companies by way of premiums, they are an important source of long-term funding for governments and businesses.

 

ü  Pension Funds are intermediaries who are authorized to take contributions from eligible individuals and invest these funds according to the directions of the contributors to create a retirement corpus. These funds provide different options for investment of the contribution, such as debt, equity or a combination. Investors select the type of fund depending upon their ability to take risk and their requirement for returns.

 

ü  Asset Management Companies and Portfolio Managers are investment specialists who offer their services  

     in selecting and managing a portfolio of securities (‘Portfolio’ is the collective noun for securities. A portfolio  

     holds multiple securities). Asset management companies are permitted to offer securities (called ‘units’) that 

     represent participation in a pool of money, which is used to create the portfolio of a mutual fund. Portfolio 

     managers do not offer any security and are not permitted to pool the money collected from investors. They act 

    on behalf of the investor in creating and managing a portfolio. Both asset managers and portfolio managers  

    charge the investor a fee for their services, and may engage other security market intermediaries such as 

    brokers, registrars, and custodians in conducting their functions.

 

ü  Investment Advisers and distributors work with investors to help them make a choice of securities that they can buy, based on an assessment of their needs, time horizon return expectation and ability to bear risk. They may also be involved in creating financial plans for investors, where they define the goals for which investors need to save money and propose appropriate investment strategies to meet the defined goals.

 

Regulators of Financial Markets

 

a.    Ministry of Finance

The Ministry of Finance through its Department of Financial Services regulates and overseas the activities of the banking system, insurance and pension sectors. The Department of Economic Affairs regulates the capital markets and its participants. The ministry initiates discussions on reforms and overseas the implementation of law.

 

b.     Ministry of Corporate Affairs

The Ministry of Corporate Affairs regulates the functioning of the corporate sector. The Companies Act, 2013 is the primary regulation which defines the setting up of companies, their functioning and audit and control. The issuance of securities by companies is also subject to provisions of the Companies Act.

 

c.     Registrar of Companies

The Registrar of Companies (RoC) is the authority appointed under the Companies Act to register companies and to ensure that they comply with the provisions of the law.

 

d.     The Reserve Bank of India (RBI)

The Reserve Bank of India regulates the money market segment of securities market. As the manager of the government’s borrowing program, RBI is the issue manager for the government. It controls and regulates the government securities market. RBI is also the regulator of the Indian banking system and ensures that banks follow prudential norms in their operations. RBI also conducts the monetary, forex and credit policies, and its actions

in these markets influences the supply of money and credit in the system, which in turn impact the interest rates and borrowing costs of banks, government and other issuers of debt securities.

 

e.    Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI), a statutory body appointed by an Act of Parliament (SEBI Act, 1992), is the chief regulator of securities markets in India. The main objective of SEBI is to facilitate growth and development of the capital markets and to ensure that the interests of investors are protected. SEBI has codified and notified regulations that cover all activities and intermediaries in the securities markets including stock brokers and sub brokers, merchant bankers, registrars to an issue, share transfer agents, underwriters, portfolio managers, depository participants, custodians, investment advisers and others.

 

Ø  SEBI also register and regulate the working of institutions such as depositories, credit rating agencies, foreign institutional investors, mutual funds, venture capital funds, self-regulatory organisations and others. The Securities Contracts Regulation Act, 1956 and the Depositories Act, 1996 is administered by SEBI.

 

Ø  SEBI also oversees the functioning of primary markets. Eligibility norms and rules to be followed for a public issue of securities are detailed in the SEBI (Issuance of Capital Disclosures and Requirements) Regulations, 2009. The SEBI (ICDR) Regulations lays down general conditions for capital market issuances like public and rights issuances and private placement of securities. The Regulations define the eligibility requirements, general obligations of the issuer and intermediaries, nature and format of disclosures required and the process of making the issue, among others. The listing agreement that companies enter into with the stock exchange has clauses for continuous and timely flow of relevant information to the investors, corporate governance and investor protection.

 

Ø  SEBI has been assigned the powers of recognizing and regulating the functions of stock exchanges. The requirements for granting recognition to a stock exchange include representation of SEBI on the board of the stock exchange and an undertaking to make and amend their rules only with the prior approval of SEBI. Stock exchanges have to furnish periodic reports to the regulator and submit bye-laws for SEBI’s approval. Stock exchanges are required to send monitoring reports daily and for every settlement. SEBI has set up surveillance mechanisms, both internal and at stock exchanges, to monitor the activities of stock exchanges, brokers, depository, R&T agents, custodians and clearing agents and identify unfair trade practices.

 

Ø  SEBI makes routine inspections of the intermediaries functioning in the securities markets to ensure that they comply with prescribed standards. It can also order investigations into the operations of any of the constituents of the securities market for activities such as price manipulation, artificial volume creation, insider trading, violation of the takeover code or any other regulation, public issue related malpractice or other unfair practices.

 

Ø  SEBI has the powers to call for information, summon persons for interrogation and examine witnesses. If the investigations so require, SEBI is also empowered to penalize violators. The penalty could take the form of suspension, monetary penalties and prosecution.

 

Ø  SEBI has laid down regulations to prohibit insider trading i.e. trading by persons connected with a company having material information that is not publicly available. SEBI Regulations require companies to have a comprehensive code of conduct to prevent insider trading. This includes appointing a compliance officer to enforce regulations, ensuring periodic disclosure of holding by all persons considered as insiders and ensuring data confidentiality and adherence to the requirements of the listing agreement on flow of price sensitive information. If an insider trading charge is proved through SEBI’s investigations, the penalties include monetary penalties, criminal prosecution, prohibiting persons from securities markets and declaring transactions as void.

 

Ø  SEBI merged with the Forward Markets Commission on September 28, 2015 and now regulates the commodities markets in India. It is the regulatory body that oversees regulating and promoting forward and futures trading in commodities. The regulator’s role includes monitoring the trading conditions in the forward markets, including demand and supply and prices, and take necessary action to streamline the functioning of the market. It advises the government on granting and withdrawing recognition to associations and undertakes inspection of the associations. It prescribes regulatory measures for limits on open positions of clients and members, circuit filters to control price volatility, managing risk through margins and specifying regulations for physical delivery of contracts and penalty for defaults.

 

f. Insurance Regulatory and Development Authority of India (IRDAI) 

IRDAI regulates the insurance sector in India in accordance with the terms of the IRDA Act of 1999. IRDAI is the licensing authority for insurance companies and defines the capital and networth requirements for insurance companies. It ensure the adherence of insurance products to the rules laid down and defines the rules for the terms and conditions of insurance contracts such as sum assured, surrender value, settlement of claims, nomination

and assignment, insurable interest and others. It regulates the distribution of insurance products by laying down the qualification and training requirements of intermediaries and the payment of commission to distributors. IRDAI supervises the functioning of the Tariff Advisory Committee that determines the rates for general insurance products. It also lays down the modalities for investment of funds by insurance companies.

 

g.     Pension Fund Regulatory and Development Authority (PFRDA)

The PFRDA is the authority entrusted to act as a regulator of the pension sector in India under the PFRDA Act, 2013. The PFRDA has been assigned the responsibility of designing the structure of funds and constituents in the National Pension System (NPS). It is responsible for registering the various constituents such as the fund managers, custodians, Central record keeping agency and trustee banks and to define the parameters of their roles and responsibilities. 

 

 

 

 

 

Know your Market Participants

Market Participants in Securities Market include buyers, seller and various intermediaries

between the buyers and sellers. Some of these entities are defined in brief here:

 

 Market Intermediaries

1)            Stock Exchanges – Stock Exchanges provide a trading platform where buyers and sellers can transact in already issued securities. Stock markets such as NSE, BSE and MSEI are nationwide exchanges. Trading happens on these exchanges through electronic trading terminals which feature anonymous order matching. Stock exchanges also appoint clearing and settlement agencies and clearing banks that manage the funds and securities settlement that arise out of these trades.

2)            Depositories – Depositories are institutions that hold securities (like shares, ebentures, bonds, government securities, mutual fund units) of investors in electronic form. Investors open an account with the depository through a registered Depository Participant. They also provide services related to transactions in the securities held in dematerialized form. Currently there are two Depositories in India that are registered with SEBI:

Ø  Central Depository Services Limited (CDSL), and

Ø  National Securities Depository Limited (NSDL)

 

3)            Depository Participant – A Depository Participant (DP) is an agent of the depository through which it interfaces with the investors and provides depository services. Depository participants enable investors to hold and transact in securities in the dematerialized form. While the investor-level accounts in securities are held and maintained by the DP, the company level accounts of securities issued is held and maintained by the depository. Depository Participants are appointed by the depository with the approval of SEBI. Public financial institutions, scheduled commercial banks, foreign banks operating in India with the approval of the Reserve Bank of India, state financial corporations, custodians, stock- brokers, clearing corporations /clearing houses, NBFCs and Registrar to an Issue and Share Transfer Agents complying with the requirements prescribed by SEBI, can be registered as a DP.

 

4)            Trading Members/Stock Brokers & Sub-Brokers – Trading members or Stock Brokers are registered members of a Stock Exchange. They facilitate buy and sell transactions of investors on stock exchanges. All secondary market transactions on stock exchanges have to be essentially conducted through registered brokers of the stock exchange. Trading members can be individuals (sole proprietor), Partnership Firms or Corporate bodies, who are permitted to

become members of recognized stock exchanges subject to fulfillment of minimum prudential requirements. A sub-broker is an entity who is not a member of Stock Exchange but who acts on behalf of a trading member or Stock Broker as an agent for assisting the investors in buying, selling or dealing in securities through such trading member or Stock Broker with whom he is associated. Sub-brokers help in expanding the reach of brokers to a larger number of investors. Trades have to be routed only through the trading terminals of registered brokers of an exchange, to be accepted and executed on the electronic system. Sub-brokers in remote locations who do not have electronic facilities offer trading services to their customers through phone or physical orders formats. The main broker to whom they are affiliated then enters these trades into the system. Broker-members of exchanges can complete transactions on the exchange only electronically. Brokers can trade on their own account too, using their own funds. Such transactions are called proprietary trades. Brokers receive a commission for their services, which is known as brokerage. Maximum brokerage chargeable to customers is fixed by individual stock exchanges.Several brokers provide research, analysis and recommendations about securities to buy and sell, to their investors.

SEBI registration to a broker is granted based on factors such as availability of adequate office space, equipment and manpower to effectively carry out his activities, past experience in securities trading etc. SEBI also ensures the capital adequacy of brokers by requiring them to deposit a base minimum capital with the stock exchange and limiting their gross exposures to a multiple of their base capital.

 

5)            Authorised Person – Authorised person is any person (individual, partnership firm, LLP or body corporate), who is appointed by a stock broker or trading member as an agent to reach out to the investors scattered across the country. A stock broker may appoint one or more authorized person(s) after obtaining specific prior approval from the stock exchange concerned for each such person. The approval as well as the appointment of authorized person(s) is for a specific segment of the exchange.

 

6)            Custodians – A Custodian is an entity that is charged with the responsibility of holding funds and securities of its large clients, typically institutions such as banks, insurance companies, and foreign portfolio investors. Besides safeguarding securities, a custodian also settles transactions in these securities and keeps track of corporate actions on behalf of its clients. It helps in: 

Ø  Maintaining a client’s securities and funds account

Ø  Collecting the benefits or rights accruing to the client in respect of securities held

Ø  Keeping the client informed of the actions taken or to be taken on their portfolios.

 

7)            Clearing Corporation – Clearing Corporations play an important role in safeguarding the interest of investors in the Securities Market. Clearing agencies ensure that members on the Stock Exchange meet their obligations to deliver funds or securities. These agencies act as a legal counter party to all trades and guarantee settlement of all transactions on the Stock Exchanges. It can be a part of an exchange or a separate entity.

 

8)            Clearing Banks – Clearing Bank act as an important intermediary between clearing members and the clearing corporation. Every clearing member needs to maintain an account with the clearing bank. It is the clearing member’s responsibility to make sure that the funds are available in its account with clearing bank on the day of pay-in to meet the obligations arising out of trades executed on the stock exchange. In case of a pay-out, the clearing member receives the amount in their account with clearing bank, on pay-out day.

 

9)            Merchant Bankers – Merchant bankers are entities registered with SEBI and act as issue managers, investment bankers or lead managers. They help an issuer access the security market with an issuance of securities. They are single point contact for issuers during a new issue of securities. They evaluate the capital needs of issuers, structure an appropriate instrument, get involved in pricing the instrument and manage the entire issue process until the securities are issued and listed on a stock exchange. They engage and co-ordinate with other intermediaries such as registrars, brokers, bankers, underwriters and credit rating agencies in managing the issue process.

 

10)         Underwriters – Underwriters are intermediaries in the primary market who undertake to subscribe any portion of a public offer of securities which may not be bought by investors. They serve an important function in the primary market, providing the issuer the comfort that if the securities being offered to public do not elicit the desired demand from investors, they (underwriters) will step in and buy the securities. When the underwriters make their commitments at the initial stages of the IPO, it is called hard underwriting. Soft underwriting is the commitment given once the pricing is determined. The shares that devolve are usually placed with other financial institutions, thereby limiting the risk to the underwriter. Soft underwriting also comes with a clause that provides the option to exit from the commitment in the event of certain events occurring. The risk in hard underwriting is much higher than in soft underwriting.

 

Institutional Participants

An investor is the backbone of the securities market in any economy as the one lending surplus resources to companies for their productive activities. Investors in securities market can be broadly classified into Retail Investors and Institutional Investors. Institutional Investors comprise domestic financial institutions, Banks, Insurance Companies, Mutual Funds and Foreign Portfolio Investors. Some of them are defined here in brief:

 

1)            Foreign Portfolio Investors (FPIs) – A Foreign Portfolio investor (FPI) is an entity established or incorporated outside India that proposes to make investments in India. These international investors must register with the regulator – Securities and Exchange Board of India (SEBI) to participate in the Indian Securities Market.

 

2)            P-Note Participants – Participatory Notes (P-Notes or PNs) are instruments issued by SEBI registered foreign portfolio investors to overseas investors, who wish to invest in the Indian stock markets without registering themselves with the market regulator – Securities and Exchange Board of India. P-Notes provide access of Indian securities to these investors.

 

3)            Mutual Funds – A mutual fund is a professionally managed collective investment scheme that pools money from many investors to purchase securities on their behalf. Mutual fund companies invest the pooled money in stocks, bonds, and other securities, depending upon the investment objective of the scheme which is stated upfront. A fund manager, with the help of a research team, takes all the major decision in terms of which companies to invest in, the percentage of each stock in the portfolio, when to exit and so on. Each investor owns units, which represent a portion of the holdings of the fund. Diversification of investments is an important aspect of Mutual Funds investing. It helps in reducing the risk in investment for the investor. As a result, the investor is less likely to lose money on all the investments at the same time.

 

4)            Insurance Companies – Insurance companies’ core business is to ensure assets. Depending on the type of assets that are insured, there are various insurance companies like life insurance and general insurance etc. These companies have huge corpus and they are one of the most important investors in the Indian economy by investing in equity investments, government securities and other bonds. Like mutual funds, each Insurance company also has designated people who are responsible for investment decisions.

5)            Pension Funds – A fund established to facilitate and organize the investment of the retirement funds contributed by the employees and employers or even only the employees in some cases. The pension fund is a common asset pool meant to generate stable growth over the long term, and provides a retirement income for the employees.

Pension funds are commonly run by a financial intermediary for the company and its

employees, although some larger corporations operate their pension funds in-house. Pension

funds control relatively large amount of capital and represent the largest institutional

investors.

 

6)            Venture Capital Funds – A venture capital fund refers to a pooled investment vehicle like mutual fund but with mandate to invest money in enterprises that are in the early stage of development but with the potential of long-term growth. The longer gestation period and higher risk of failure make it difficult for such companies to access conventional sources of finance, such as banks and the capital markets. Venture capitalists bring managerial and

technical expertise as well along with capital to their investee companies.

 

7)            Private Equity Firms – Private equity is a term used to define funding available to companies in the early stages of growth, expansion or buy-outs. Investee companies may be privately held or publicly traded companies. The term private equity includes venture capital firms. The money in the fund is contributed by investors, called limited partners, and invested and managed by the general partner(s). Some of the private equity funds are specialized funds with competence in a particular industry, stage of the company, or targeted deals such as funding buyouts.

 

8)            Hedge Funds – A hedge fund is an investment vehicle that pools capital from a number of investors and invests that across the assets, across the products and across the geographies. These fund managers generally have very wide mandate to generate return on the invested capital. They hunt for opportunities to make money for their investors wherever possible. In that sense, actually, term hedge fund is misnomer as these funds may not necessarily be hedged.

 

9)            Alternative Investment Funds – Generally, investments in stocks, bonds, fixed deposits or real estate are considered as traditional investments. Anything alternate to this traditional form of investments is categorized as alternative investment. Even within investments in stocks, if the investments are in the stocks of small and medium scale enterprises (SMEs), it gets categorized as alternative investments in many jurisdictions (For instance, the SME exchange is called as Alternative Investment Market (AIM) in UK). In India, alternative investment funds (AIFs) are defined in Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. It refers to any privately pooled investment fund, (whether from Indian or foreign sources), in the form of a

trust or a company or a body corporate or a Limited Liability Partnership (LLP) which are not presently covered by any Regulation of SEBI governing fund management (like, Regulations governing Mutual Fund or Collective Investment Scheme) nor coming under the direct regulation of any other sectoral regulators in India – IRDAI, PFRDA, RBI etc.

10)         Investment Advisers – Investment advisers work with investors to help them decide on asset allocation and make a choice of investments based on an assessment of their needs, time

horizon return expectation and ability to bear risk. They may also be involved in creating

financial plans for investors, where they help investors define their financial goals and propose

appropriate saving and investment strategies to meet these goals.  

 

 

Retail Participants

Retail Investors include individual investors who buy and sell securities for their personal account, and not for another company or organization. HNIs or High Net-worth Individuals and UHNIs (Ultra High net-worth individuals) are individual investors who invest large sums of money in the market. Reserve Bank of India has also granted general permission to Non Resident Indians (NRIs), Person of Indian origin (PIOs) and Qualified Foreign Investors (QFIs) for undertaking direct investments in Indian companies under the Automatic Route.

 

 

Know your Transactions

We may undertake several kinds of transactions in the securities market ranging for immediate settlement to the distant settlement. Transaction types also vary based on transactions in the stock market or outside the stock market (called OTC Trades). A brief description about different kinds of transaction is given below:

 

1.    Cash trades are the trades where settlement (payment and delivery) occurs on the same trading day (T+0, where 0 defines the time gap in days between trade day and settlement day). Cash trades in Financial Markets are unusual as most contracts are settled between two to three days from the date of trade. However, we see cash transactions in our normal day to day life all the time when we buy groceries, vegetables and fruits from the market.

 

2.    Spot trades are the trades where settlement (payment and delivery) occurs on the spot date, which is normally two business days after the trade date. Equity markets in India offer Spot trades. FX markets, globally, by default, offer spot transactions in the foreign exchange.

 

3.    Forward transactions Forward contracts are contractual agreement between two parties to buy or sell an underlying asset at a certain future date for a particular price that is decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of settlement. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts.

 

4.    Futures Futures are standardized exchange traded forward contracts. They are standardized as to the market lots (traded quantities), quality and terms of delivery – delivery date, cash settlement or physical delivery etc. As these contracts are traded and settled on a stock exchange and the clearing corporation provides settlement guarantee on them, they are subject to stringent requirements of margins by the clearing corporations. Futures contracts are available on variety of assets including equities and equity indices, commodities, currencies and interest rates.

 

5.    Options An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying asset on or before a stated date and at a stated price. The buyer or holder of the option pays the premium and buys the right, the writer or seller of the option receives the premium with the obligation to sell or buy the underlying asset, if the buyer exercises his right.

Based on the type of contract, options can be divided into two types.

Ø  Call gives the buyer the right, but not the obligation, to buy a given quantity of the underlying asset, at a given price on or before a given future date.

Ø  Put gives the buyer the right, but not the obligation, to sell a given quantity of the underlying asset at a given price on or before a given date.

Options can be transacted both in OTC Market and Exchange Traded Markets.

 

6.    Swaps A swap in the financial markets is a derivative contract made between two parties to exchange cash flows in the future according to a pre-arranged formula. Swaps help market participants manage risks associated with volatile interest rates, currency rates and commodity prices.

 

7.    Trading, Hedging, Arbitrage, Pledging of Shares

Ø  Trading – Trading or speculating is an act of purchase or sale of an asset in the expectation of a gain from changes in the price of that asset over a short period of time. Traders or speculators seek to benefit from acting on information which bring about changes in prices. Their actions increase liquidity in the market. Traders or Speculators typically leverage their trading activity with borrowed funds, which magnifies their gains as well as losses.

Ø  Hedging – Hedging is an act of taking position in the financial transactions to offset potential losses that may be incurred by another position. A hedge can be constructed from many types of financial instruments, including insurance, forward/futures contracts, swaps, options etc. A hedged position limits loss as well as gains, since appreciation in one position is squared-off by depreciation in the other position and vice versa.

Ø  Arbitrage – Arbitrage is simultaneous purchase and sale of an asset in an attempt to profit from discrepancies in their prices in two different markets. Buying a stock in the spot market and simultaneously selling that in the futures market to benefit from the price differential is an example of an arbitrage transaction. An important point to understand is that in an efficient market, arbitrage opportunities may exist only for short period or none at all. The existence of an arbitrage opportunity will increase buying in the lower-priced market leading to a rise in prices, and increased selling in the higher-priced market leading to a fall in prices ultimately resulting in closing the gap and elimination of the arbitrage opportunity between two markets.

Ø  Pledging of shares – Pledge is an act of taking loan against securities by the investor. The investor is called as ‘pledgor’ and the entity who is giving the loan against the securities is called as ‘pledgee’. Securities held in a depository account can be pledged/ hypothecated to avail of loan/credit facility. When dematerialized securities are pledged, they remain in the pledgor’s demat account but they are blocked so that they cannot be used for any other transaction. Pledged securities can be unpledged, once the obligations under pledge are fulfilled. In case of default, the pledgee can invoke the pledge.

 

Know your Marketplace – Primary Market

Primary market is used by companies (issuers) for raising fresh capital from the investors. Primary market offerings may be a public offering or an offer to a select group of investors in a private placement program. The shares offered may be new shares issued by the company, or it may be an offer for sale, where an existing large investor/investors or promoters offer a portion of their holding to the public. Let us understand various terms used in the Primary Market.

 

Ø  Public issue – Securities are issued to the members of the public, and anyone eligible to invest can participate in the issue. This is primarily a retail issue of securities.

 

a.      Initial Public Offer (IPO) – An initial public offer of shares or IPO is the first sale of a corporate’s common shares to investors at large. The main purpose of an IPO is to raise equity capital for further growth of the business. Eligibility criteria for raising capital from the public investors is defined by SEBI in its regulations and include minimum requirements for net tangible assets, profitability and net-worth. SEBI’s regulations also impose timelines within which the securities must be issued and other requirements such as mandatory listing of the shares on a nationwide stock exchange and offering the shares in dematerialized form etc.

b.      Follow on Public Offer (FPO) – When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, it is called FPO. When a company wants additional capital for growth or desires to redo its capital structure by retiring debt, it raises equity capital through a fresh issue of capital in a follow-on public offer. A follow-on public offer may also be through an offer for sale, which usually happens when it is necessary to increase the public shareholding in the company to meet the regulatory requirements.

 

Ø  Private Placement – When an issuer makes an issue of securities to a select group of persons and which is neither a rights issue nor a public issue, it is called private placement. This is primarily a wholesale issue of securities to institutional investors. It could be in the form of a Qualified Institutional Placement (QIP) or a preferential allotment.

 

Ø  Qualified Institutional Placements (QIPs) – Qualified Institutional Placement (QIP) is a private placement of shares made by a listed company to certain identified categories of investors known as Qualified Institutional Buyers (QIBs). QIBs include financial institutions, mutual funds and banks among others. SEBI has defined the eligibility criterion for corporates to be able to raise capital through QIP and other terms of issuance under QIP such as quantum and pricing etc.

 

Ø  Preferential Issue – Preferential issue means an issue of specified securities by a listed issuer to any select person or group of persons on a private placement basis and does not include an offer of specified securities made through a public issue, rights issue, bonus issue, employee stock option scheme, employee stock purchase scheme or qualified institutions placement or an issue of sweat equity shares or depository receipts issued in a country outside India or foreign securities. The issuer is required to comply with various provisions defined by SEBI, which inter-alia include pricing, disclosures in the notice, lock-in, in addition to the requirements specified in the Companies Act.

 

Ø  Rights and Bonus Issues – Securities are issued to existing shareholders of the company as on a specific cut-off date, enabling them to buy more securities at a specific price (in case of rights) or without any consideration (in case of bonus). Both rights and bonus shares are offered in a particular ratio to the number of securities held by investors as on the record date. It is also important to understand that rights are like options and investors may or may not choose to exercise their rights i.e. apply for additional shares offered to them. On the other hand, in case of bonus, additional shares are conferred on to the existing shareholders (without any consideration) by capitalization of reserves in the balance sheet of the company.

 

Ø  Onshore and Offshore Offerings – While raising capital, issuers can either issue the securities in the domestic market and raise capital or approach investors outside the country. If capital is raised from domestic market, it is called onshore offering and if capital is raised from the investors outside the country, it is termed as offshore offering.

 

Ø  Offer for Sale (OFS) – An Offer for Sale (OFS) is a form of share sale where the shares offered in an IPO or FPO are not fresh shares issued by the company, but an offer by existing shareholders to sell shares that have already been allotted to them. An OFS does not result in increase in the share capital of the company since there is no fresh issuance of shares. The proceeds from the offer goes to the offerors, who may be a promoter(s) or other large investor(s). The disinvestment program of the Government of India, where the government offers shares held by it in Public Sector Undertakings (PSUs), is an example of OFS. It may be stated that OFS is a secondary market transaction done through the primary market route.

 

Primary market ensures

 

o   Wider Investor Participation: A primary market issue enables participation of a wider group of investors. Companies move away from known sources of funding that may be restrictive in terms of the amount available or the terms at which capital may be made available. They may be able to raise the funds they require at much more competitive terms. For example, when an Indian company issues a global depository receipt (GDR) in the Euro markets, it reaches out to institutional and retail investors in those markets who may find the investment in a growing Indian enterprise, attractive.

 

o   Foster Competitive Processes: Securities are issued for public subscription, at a price that is determined by the demand and supply conditions in the market and the perceived fundamental strengths of the issuer to honour their commitments. The rate of interest a debt instrument will have to offer and the price at which an equity share will be purchased are dependent on the pricing mechanisms operating in the primary market. For example, government securities, which are issued by RBI on behalf of the government, are priced through an auction process. Banks and institutional investors are the main buyers of government securities, and they bid the rates they are willing to accept and the final pricing of the instrument on offer depends on the outcome of the auction. This enables fair pricing of securities in the primary market.

 

o   Diversify Ownership: As new subscribers of equity capital come in, the stakes of existing shareholders reduces and the ownership of the business becomes more broad-based and diversified. This enables the separation of ownership and management of an enterprise, where professional managers will be brought in to work in the broad interest of a large group of diverse shareholders. The presence of independent directors on the boards of companies, representing public shareholders, enhances the governance standards of companies.

 

o   Better Disclosures: A business that seeks to raise capital from new investors, who may not be familiar with the history and working of the enterprise, has to meet higher standards of disclosure and transparency. Regulations that govern primary markets prescribe the nature and periodicity of disclosures that have to be made. Investors will need adequate, relevant, accurate and verifiable financial and other information about the business to be able to buy the securities being offered.

 

o   Evaluation by Investors: An issuer that raises money from outside investors will be open for evaluation by a large number of prospective investors, who would assess the information provided. This forms another layer of scrutiny of the operations and performance of the company, apart from its auditors and regulators. Publicly disclosed financial statements, reports, prospectus and other information also come up for scrutiny and discussion by analysts, researchers, activists, and media apart from investors.

 

o   Exit for Early Investors: Primary markets provide an exit option for promoters, private and inside investors who subscribed to the initial capital and early requirements for capital of a business. Such investors will be able to realize the value of the investment made by offering their shares, fully or partly, when the company makes an issue in the primary market. It provides them the opportunity to exit their investments at a profit. A vibrant primary market is thus an incentive for such investors who invest in early-stage business with the intent to nurture the business to a level at which public and other investors would be interested.

 

o   Liquidity for Securities: When capital is held by a few inside investors, the equity and debt securities held are not liquid, unless sold in a chunk to another set of interested investors. A primary market issue distributes the securities to a large number of investors and it is mandatory to list a public issue of securities in the stock exchange. This opens up the secondary market where the securities can be bought and sold between investors, without impacting the capital raised and used by the business.

 

o   Regulatory Supervision: Inviting outside investors to subscribe to the capital or buy securities of an issuer comes under comprehensive regulatory supervision. The issue process, intermediaries involved the disclosure norms, and every step of the primary issue process is subject to regulatory provisions and supervision. The objective is to protect the interest of investors who contributes capital to a business, which they may not directly control or manage. While there is no assurance of return, risk, safety or security, regulatory processes are designed to ensure that fair procedures are used to raise capital in the primary market, adequate and accurate information is provided, and rights of all parties is well defined, balanced and protected.

 

 

Know your Marketplace – Secondary Market

While the primary market is used by issuers for raising fresh capital from the investors through issue of securities, the secondary market provides liquidity to these instruments. An active secondary market promotes the growth of the primary market and capital formation, since the investors in the primary market are assured of a continuous market where they have an option to liquidate/exit their investments. Thus, in the primary market, the issuers have direct contact with the investors, while in the secondary market, the dealings are between investors and the issuers do not come into the picture.

 

Ø  Over-The-Counter Market (OTC Market) – OTC markets are the markets where trades are directly negotiated between two or more counterparties. In this type of market, the securities are traded and settled over the counter among the counterparties directly.

 

Ø  Clearing and Settlement – Clearing and settlement are post trading activities that constitute the core part of equity trade life cycle. Clearing activity is all about ascertaining the net obligations of buyers and sellers for a specific time period. And, settlement is the next step of settling obligations by buyers and settlers – Paying money (if transaction is a buy transaction) or delivering securities (if it is a sell transaction). While OTC transactions are settled directly between the counterparties, clearing house or corporation is the entity through which settlement of securities takes place for all the trades done on Stock Exchanges. The details of all transactions performed by the brokers are made available to the Clearing house by the Stock exchange. The Clearing House gives an obligation report to Brokers and Custodians who are required to settle their money or securities obligations within the specified deadlines, failing which they are required to pay penalties. In practice, the clearing corporation provides full novation of contracts between buyers and sellers, which means it acts as buyer to every seller and seller to every buyer. As a result, the operational risk of the transaction is substantially reduced.

 

Ø  Risk Management – In OTC transactions, counterparties are supposed to take care of the credit risk on their own. In exchange traded world, the clearing corporation, as defined above, gives settlement guarantee of trades to the counterparties (all buyers and sellers). This exposes the clearing corporation to the risk of default by the buyers and sellers. To handle this risk, the clearing corporation charges various kinds of margins, most prominent among these margins are Initial or upfront margin and mark to market (MTM) margins. Initial margin is a percentage of transaction value arrived at based on concept of “Value At Risk” philosophy and MTM margin is the notional loss which an outstanding trade has suffered during a specified period on account of price movements.

 

 

Secondary Markets ensures

  

o   Liquidity: Secondary markets provide liquidity and marketability to existing securities. If an investor wants to sell off equity shares or debentures purchased earlier, it can be done in the secondary market. Alternately, if new investors want to buy equity shares or debentures that have been previously issued, sellers can be found in the secondary market. Investors can exit or enter any listed security by transacting in the secondary markets. A liquid market enables investors to buy perpetual securities such as equity that are not redeemed by the issuer or long-term instruments maturing far into the future without the risk of the risk of the funds getting blocked. Where investors invest in risky securities whose future performance is unknown, a secondary market enables exit if the expectations are not met. Investors can sell their securities at a low cost and in a short span of time, if there is a liquid secondary market for the securities that they hold. The sellers transfer ownership to buyers who are willing to buy the security at the price prevailing in the secondary market.

 

o   Price Discovery: Secondary markets enable price discovery of traded securities. The price at which investors undertake buy or sell transaction reflects the individual assessment of investors about the fundamental worth of the security. The collective opinions of various investors are reflected in the real time trading information provided by the exchange. The continuous flow of price data allows investors to identify the market price of equity shares. If an issuing company is performing well or has good future prospects, many investors may try to buy its shares. As demand rises, the market price of the share will tend to go up. The rising price is a signal of expected good performance in the future. If an issuing company is performing poorly or is likely to face some operating distress in the future, there are likely to be more sellers than buyers of its shares. This will push down its market price. Market prices change continuously, and they reflect market judgments about the security.

 

o   Information Signaling: Market prices provide instant information about issuing companies to all market participants. This information-signaling function of prices works like a continuous monitor of issuing companies, and in turn forces issuers to improve profitability and performance. Efficient markets are those in which market prices of securities reflect all available information about the security. A large number of players trying to buy and sell based on information about the listed security tend create a noisy and chaotic movement in prices, but also efficiently incorporate all relevant information into the price. As new information becomes available, prices change to reflect it.

 

o   Indicating Economic Activity: Secondary market trading data is used to generate benchmark indices that are widely tracked in the country. A market index is generated from market prices of a representative basket of equity shares. Movements in the index represent the overall market direction. The S&P BSE-Sensex, MSEI-SX40 and the NSE-Nifty 50 are the most popularly watched indices in India. A stock market index is viewed as a barometer of economic performance. A sustained rise in key market indices indicate healthy revenues, profitability, capital investment and expansion in large listed companies, which in turn implies that the economy is growing strongly. A continuous decline or poor returns on indices is a signal of weakening economic activity.

 

o   Market for Corporate Control: Stock markets function as markets for efficient governance by facilitating changes in corporate control. If management is inefficient, a company could end up performing below its potential. Market forces will push down shares prices of underperforming companies, leading to their undervaluation. Such companies can become takeover targets. Potential acquirers could acquire a significant portion of the target firm’s shares in the market, take over its board of directors, and improve its market value by providing better governance. An actual takeover need not happen; even the possibility of a takeover can be an effective mechanism to ensure better governance.

 

 

Know your fellow Traders

Both retail and institutional investors participate. The following are the various categories of investors who buy securities:

ü  Resident individuals

ü  Hindu undivided family (HUF)

ü  Minors through guardians

ü  Registered societies and clubs

ü  Non-resident Indians (NRI)

ü  Persons of Indian Origin (PIO)

ü  Qualified Foreign investors (QFI)

ü  Banks

ü  Financial institutions

ü  Association of persons

ü  Companies

ü  Partnership firms

ü  Trusts

ü  Foreign portfolio investors (FPIs)

ü  Limited Liability Partnerships (LLP)

 

Investors require a PAN card issued by the Income Tax authorities to be able to apply in a primary market issue of securities. If the securities are to be issued in only dematerialized form, then the investor needs to mention the demat account details in the application form.

 

 

 

Know & Understand your Risks

When a large volume of trades happen on a stock exchange it makes the market very liquid, efficient and low cost. However, the systemic risk also increases. Default of a member can have disastrous and catastrophic impact on the other members and the exchange as a whole. Risk management systems of stock exchanges are set up to mitigate the risk of members of the exchange defaulting on payment or delivery obligations. Stock exchanges have risk management systems to insure against the event that members of the exchange may default on payment or delivery obligations. Strategies such as maintenance of adequate capital assets by members and regular imposition of margin payments on trades ensure that damages through defaults are minimised. Exchanges thus enable two distinct functions: high liquidity in execution of trades and guaranteed settlement of executed trades.

 

o   Capital Adequacy Norms: In order to be eligible to be trading and clearing members, individual and corporate entities have to meet and maintain minimum paid-up capital and net worth norms prescribed under the regulations. Members of a stock exchange have to deposit and maintain liquid assets with the stock exchange and the clearing corporation. Total liquid assets of members are divided into Base Minimum Capital (BMC) and additional capital. BMC is fixed by the concerned exchange and is not available for margin payments. Additional capital is brought in over and above the BMC which has to be adequate to cover all margin payments.

 

o   Margins: A margin is the amount of funds that one has to deposit with the clearing corporation in order to cover the risk of non-payment of dues or non-delivery of securities. The margin on equity shares traded on an exchange is imposed on a daily basis, and is the sum of value at risk margin, extreme loss margin and mark to market margin. Margins are collected by adjusting payments due against total liquid assets of a member (excluding base minimum capital).In case of shortfall of margins, the terminals of the trading member are immediately de-activated.

 

o   Circuit Breakers: If there is an abnormal price movement in an index, defined in percentage terms, the exchange can suspend trading. This is called hitting the circuit breaker. Index-based market wide circuit breakers are set daily based on the previous day’s close at index movements either way. NSE and BSE are required to compute the market-wide indices the NIFTY and SENSEX, respectively, after each trade in any of their constituent stocks and check for breach of circuit breaker after each computation. In the event of a breach, the exchanges should stop all order matching in order to bring about a trading halt. The period for which trading is suspended depends upon the extent of movement and the time when such move occurred. Stock exchanges also impose price bands on individual securities to limit volatility in prices. Daily price bands are applicable on securities are as follows:

ü  Daily price bands on 2%, 5% or 10% either way on securities as specified by the exchange.

ü  No price bands are applicable on scripts on which derivatives products are available or scrips included in indices on which derivatives products are available. In order to prevent members from entering orders at non-genuine prices in such securities, the exchange may fix operating range of 10% for such securities.

ü  Price bands of 20% either way on all remaining scrips. The price bands for the securities in the Limited Physical Market are the same as those applicable for the securities in the Normal Market.

 

o   Pay-in Shortfall Penalties: If the member has a shortfall in the pay-in amount due, and the shortage exceeds the BMC, then his trading facilities are withdrawn and securities pay-out is withheld. The same penalty is levied if the shortage in pay-in funds is greater than a percentage of BMC (Base Minimum Capital) but less than the BMC. The exchange will also levy a penalty for the shortfall on a daily basis.

 

o   Settlement Guarantee Mechanism: The clearing house is the counterparty to all trades in the stock exchange. This implies that it assumes counterparty risk completely, by settling all trades even if the trading member defaults on pay-in or pay-out. Some of this counter party risk is managed through the levy of margins. Any residual risk is funded by a separate pool of funds known as the Trade Guarantee Fund (on BSE) or Settlement Guarantee Fund (on NSE). Contributions from trading members are used to build up the corpus of this fund. Members contribute a small fixed amount from their BMC and a continuous contribution based on gross turnover. In addition, each member provides a bank guarantee for an amount specified by the clearing corporation from a scheduled commercial or cooperative bank to the corpus of the Fund. The existence of such a fund protects investors from member defaults. The concept of guaranteed settlement gives investors the confidence that settlements will be completed irrespective of defaults by few members.

 

o   On-line Monitoring: Regular on line monitoring of brokers’ transactions and positions is carried out. The system is designed to give alerts if members build up abnormal sale or purchase positions or if margins are inadequate relative to exposure. The clearing house can pro-actively carry out a detailed check of members trading and reduce his open positions, if necessary. Any news or media information that leads to unusually large price/volume movements are also scrutinized and investigated by surveillance officers of the stock exchange.

 

o   Price Monitoring and Action: On surveillance of abnormal price movements, stock exchanges can take the following actions to minimise volatility:

ü  Imposition of special margins on scripts that have shown unusually large movements in price or volume. Depending on the situation, the margins may be imposed on client-wise net outstanding purchases, or sales or both.

ü  Circuit filter limits may be reduced to keep prices under control. This will ensure that trading will halt with a smaller rise in prices than usual.

ü  Shifting a scrip from settlement to the trade-to-trade segment forces members to give/take delivery in that scrip, and so minimises any volatility due to intra-day closing.

 

o   Inspection of Books: The stock exchange conducts an inspection of the books of trading members of each market segment at least once a year. Any violations observed result in disciplinary action by the Exchange.

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