Chapter-10 Financial Markets

Meaning of Financial Market

Financial Market includes whole network of all organizations’ and institutions that provide short, medium and long-term funds. A financial market is a market for the creation and exchange of financial assets.

Financial markets exist wherever a financial transaction occurs. Financial transactions could be either in the form of ‘creation of financial assets’ such as initial issue of securities by a firm or in the form of ‘exchange of financial assets’ such as purchase and sale of existing securities.

Functions of Financial Market

Financial Markets play an important role in the allocation of scarce resources in an economy by performing the following four important functions.

Mobilise savings and channelize them into most productive uses (Allocative Functions):- Financial market facilitates the transfer of savings from savers to investors. It provides the choice of different investment options to savers, which helps them to invest or channelize their surplus funds into the most productive use.
Facilitate Price Discovery:– Price of anything is determined through market forces of demand and supply. In the financial market, households supply funds and business firms make demand. The interaction between them helps to establish a price for the financial asset, which is being traded in that particular market.
Provide Liquidity to Financial Assets:– Financial market facilitates easy purchase and sale of financial assets. So, it provides liquidity to financial assets as they can be easily converted into cash as and when required. Holders of assets can readily sell their financial assets through the mechanism of the financial market.
Reduce the cost of transactions:– Financial markets provide valuable information about securities being traded in the market. It helps to save time, effort and money that both buyers and sellers would have to otherwise spend to try and find each other. Thus, financial market provides a common platform where buyers and sellers can fulfill their individual needs.

Types of Classification of Financial Market

Financial markets are classified on the basis of the maturity of financial instruments traded in them. It consists of two major segments:

Money Market:- It deals with instruments with a maturity of less than one year, i.e. market for short-term funds.
Capital Market:– It deals with instruments with a maturity of more than one year, i.e. market for medium and long-term funds.

MONEY MARKET

Money market refers to market for short-term funds, which deals in monetary assets whose period of maturity is upto one year.

It has no physical location and most of the activities are conducted over telephone and internet.
Money Market satisfies short-term financial requirements of a business (like working capital requirement) and the temporary deployment of excess funds for earing returns.

Major Participants of Money Market

Reserve Bank of India (RBI), Commercial Banks, Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), Non-Banking Finance Companies, State Governments, Large Corporate Houses and Mutual Funds.

Instruments of Money Market

Investment in money market is done through money market instruments. Some common instruments of money market are:

Treasury Bill
Commercial Paper
Call Money
Certificate of Deposit
Commercial Bill

Features of Money Market

It is a market for short-term funds which deals in monetary assets whose period of maturity is up to one year.
Instruments of money market are quite expensive.
Money market instruments are highly liquid.
Money market instruments are less risky.
The expected return from money market instruments is less due to short duration.

CAPITAL MARKET

Capital Market refers to whole network of all organizations’, institutions and instruments that provide medium and long-term funds.

Capital market consists of a series of channels through which saving of the community are made available for industrial and commercial enterprises and for the public in general.
It encourages people to invest their small savings into the most productive use. It leads to growth and development of the economy.
Capital Market consists of development banks, commercial banks and stock exchanges.
Long-term funds are raised and invested in the form of both debt and equity. The instruments used in capital market are: Shares, Debentures, Bonds, Public deposits, etc.
The process of economic development is facilitated by the existence of a well-functioning capital market. In fact, development of the financial system is seen as a necessary condition for economic growth.

It must be noted that capital market does not include instruments or institutions that provide short-term finance upto one year.

Requisites of Capital Market

A Capital Market is ideal when:

Finance is available at reasonable cost.
Financial institutions are fair, competitive and transparent.
Market operations are fair, competitive and transparent.
Sufficient information is provided to the investors.
Transaction costs are minimized.
Capital is most productively allocated.

Nature of Features of Capital Market

Duration of Investments:- It deals in medium and long-term securities, whose maturity period is more than one year.
Financial Instruments:– In the capital market, the flow of capital takes place through instruments like shares, debentures, bonds, public deposits, etc.
Segments:– Capital market has 2 segments: Primary Market (i.e. market meant for issue of fresh capital) and Secondary Market (i.e. market for sale and purchase of previously issued securities).
Use of Intermediaries:– Capital market functions through several types of intermediaries, like underwriters, bankers, stock brokers, etc.
Helps in Capital Formation:– Capital market offers attractive investment opportunities to those who can invest surplus funds. As a result, it facilitates flow of capital from investors to the borrowers. This process leads to capital formation in an economy.
Provides Liquidity:– Capital market provides liquidity as securities can be bought and sold in the stock exchange as per requirement.

Components of Capital Market

The Capital Market can be divided into two parts:

Primary Market:- Primary market refers to the market wherein securities are sold for the first time. Due to this reason, it is also known as new issues market.

The essential function of a primary market is to facilitate the transfer of investible funds from savers to entrepreneurs (seeking to establish new enterprise or to expand existing ones), through the issue or securities for the first time.
The investors in this market are banks, financial institutions, insurance companies, mutual funds and individuals.
The common securities through which company can raise capital in primary market are Equity shares, Preference shares, Debentures, etc.

2. Secondary Market:- Secondary Market refers to market for sale and purchase of previously issued securities.

It helps existing investors to disinvest and fresh investors to enter the market.
It provides liquidity and marketability to existing securities.
Secondary market also contributes to economic growth by channelizing funds to most productive investments through disinvestment and reinvestment.
It is also known as ‘Stock Exchange’ or ‘Stock Market’.

STOCK EXCHANGE

According to Securities Contracts (Regulation) Act, Stock Exchange refers to an institutions or body of individuals (incorporated or not), which is constituted for the purpose of assisting, regulating or controlling the business of buying and selling or dealing in securities.

Stock Exchange is an institution which provides a platform for buying and selling of existing securities.
It provides liquidity to investments by facilitating exchange of a security into money and vice versa.
It promotes safety of transactions and enhances the credit worthiness of individual companies.

Functions of Stock Exchange

The efficient functioning of a stock exchange creates a favorable climate for an active and growing primary market for new issues. Following are some of the important functions performed by a stock exchange:

Providing Liquidity and Marketability to Existing Securities:- The basic function of stock exchange is to provide a ready market for sale and purchase of existing securities.

The presence of ready market provides liquidity and easy marketability as investments can be converted into cash as and when required.
It gives investors the change to disinvest and reinvest.

2. Pricing of Securities:- Share prices on a stock exchange are determined by the forcers of demand and supply. It makes a continuous valuation of securities and quote prices of various securities. It enables the investors to know present worth of their investments.

For example, Securities of profitable companies are valued higher (due to more demand), whereas, loss making companies are valued at lower price (due to low demand).

3. Safety of Transaction:- The membership of a stock exchange is well-regulated and its dealings are well defined according to the existing legal framework. This ensures that the investors get a safe and fair deal through stock exchange.

A company’s securities can be traded on stock exchange only if they are listed on it. For listing, companies have to fulfill a rigid set of requirements. Even after listing, the company has to operate within the legal framework of stock exchange.

4. Contributes to Economic Growth:- Stock exchange provides a platform on which existing securities are purchased and sold.

Through this process of disinvestment and reinvestment, savings get channelized into their most productive investment avenues.
This leads to capital formation and economic growth.

Advantages of Electronic Trading Systems or Screen-based Trading

It ensures transparency as it allows participants to see the prices of all securities in the market while business is being transacted.
It increases efficiency of information being passed on, which helps in fixing prices efficiently. The computer screens display information on prices and also capital market development that influence share prices.
It increases the efficiency of operations as there is reduction in time, cost and risk of error.
This system has enabled a large number of participants to trade with each other as people from all over the country and even abroad can buy or sell securities through brokers or members without knowing each other. It has improved the liquidity of the stock market.
It provides a single trading platform. All the trading centers spread all over the country have been brought onto one trading platform, i.e., the stock exchange, on the computer. Now, we can buy or sell shares through online trading only.

Physical Form (Share Certificates) Vs Electronic Form (Demat Account)

In the earlier times, share certificate with an investor used to serve as a legal proof of his ownership of shares. Now, it has been shifted to Demat System for electronic storing, because of problems associated with dealing in Physical form.

Problems with dealing in Physical form

Dealing of shares in physical form has been stopped due to following problems:

Theft
Fake or forged transfers
Transfer delays
Paper work associated with share certificates or debentures held in physical form.

Dematerializations

Dematerialization is a process where securities held by the investor in the physical form are cancelled and the investor is given and electronic entry or number so that he can hold it as an electronic balance in and account. This process of holding securities in an electronic form is called dematerialization.

For this, the investor has to open a demat account with an organization called a depository.
Now, all Initial Public Offers (IPOs) are issued in dematerialization form and more than 99% of the turnover is settled by delivery in the demat form.
The Securities and Exchange Board of India (SEBI) has made it mandatory for the settlement procedures to take place in demat form in certain select securities.
Holding shares in demat form is very convenient as it is just like a bank account. There is no danger or loss, theft or forgery of share certificates.
Physical shares can be converted into electronic form or electronic holdings can be reconverted into physical certificates (dematerialization).
Dematerialisation enables shares to be transferred to some other account just like cash and ensures settlement of all trades through a single account in shares.
These demat securities can even be pledged or hypothecated to get loans.
It is the broker’s re4sponsibility to credit the invertor’s account with the correct number of shares.

Working of the Demat System

A depository participant (DP), either a bank, broker or financial services company, may be identified.
An account opening form and documentation (like PAN card details, photograph, power of attorney, etc.) is completed.
The physical certificate is to be given to the depository participant along with a dematerialization request form.
If shares are applied in a public offer, simple details of depository participant and demat account are to be given and the shares don allotment would automatically be credited to demat account.
If shares are to be sold through a broker, the depository participant is to be instructed to debit the account with the number of shares.

Depository

Depository is an institution or orgainsation which holds securities (like shares, debentures, bonds, etc.) of investors in electronic form.

A depository also acts like a bank and keeps securities in electronic form on behalf the investor.
In the depository, a securities account can be opened, all shares can be deposited, they can be withdrawn or sold at any time and instruction to deliver or receive shares on behalf of the investor can be given. It is a technology driven electronic storage system.
As there is no paper work relating to share certificates or transfers, all transaction of the investors are settled with greater speed and efficiency.
Both these national level depositories operate through intermediaries, who are electronically connected to the depository and serve as contact points with the investors and are called ‘Depository Participants’.
Financial institutions, banks, clearing corporations, stock brokers and non-banking finance corporations are permitted to become depository participants.
If an investor is buying and selling the securities through a broker or bank or non-banking finance corporation, it acts as a DP for the investor and complete the formalities.

Trading Procedure on a Stock Exchange (Steps in the Trading and Settlement Procedure)

The following steps are involved in the screen-based trading for buying and selling of securities:

Selection of a Broker:- The investor has to first approach a registered broker or sub-broker and enter into an agreement with him. The investor has to sigh a broker-client agreement and a client registration form before placing an order to buy or sell securities. He also has to provide following details and information:

PAN number (This is mandatory)
Date of birth and address
Educational qualification and occupation
Residential status (Indian/NRI)
Bank account details
Depository account details
Name of any other broker with whom registered
Client code number in the client registration form

The broker then opens a trading account in the name of the investor.

2. Opening Demat Account with Depository:- The investor has to open a ‘Demat’ Account or ‘Beneficial Owner’(BO) Account with a depository participant for holding and transferring securities in the Demat form. He will also have to open a bank account for cash transactions in the securities market.

3. Placing the Order:- The investor then places an order with the broker to buy or sell shares. Clear instructions have to be given about the number of shares and the price at which the shares should be bought or sold. The brokers will the go ahead with the deal and issue the order confirmation slip to the investor.

4. Match the share and best Price:- The broker will go online and connect to the main stock exchange and match the share and best price available.

5. Executing the Order:- When the shares can be bought or sold at the price mentioned, it will be communicated to the broker’s terminal and the order will be executed electronically. The broker will issue a trade confirmation slip to the investor.

6. Issue of Control Note:- After the trade has been executed, the broker issues a contract note within 24 hours. This note contains details of number of shares bought or sold, price, date & time of deal & brokerage charges. This is an important document as it is legally enforceable & helps to settle desputes or claims between the investor & the broker. A Unique Order Code number is assigned to each transaction by the stock exchange & is printed on the contract note.

7. Delivery of Shares or Making Payment:- Investor has to deliver the shares sold or pay cash for the shares bought. This has to be done immediately after receiving the contract note or before the day when the broker shall make payment or delivery of shares to the exchange. This is called the Pay-in Day.

8. Settlement Cycle:- Cash is paid or securities are delivered on pay-in day, which is before the T+2 day as the deal has to be settled and finalized on the T+2 day. The settlement cycle is on T+2 day on a rolling settlement basis, w.e.f. 1^st April, 2003.

Securities and Exchange Board of India (SEBI)

SEBI was established by Indian Government in 1988 under the administrative control of the Finance Ministry. Later, it became a statutory body having perpetual succession and a common seal under the Securities and Exchange Board of India Act, 1992. SEBI was established to promote orderly and healthy growth of securities market and for investor protection.

Reasons for the Establishment of SEBI

In 1980, the capital market witnessed a tremendous growth due to increasing participation of the public. The expanding investors population resulted in variety of malpractices by companies, brokers, merchant bankers, etc.

Some Example of Malpractices include:

Unofficial private Placements
Price Rigging: It refers to making manipulations with the basic motive of inflating or depressing market price of securities.
Insider Trading: It refers to a practice, in which the insider (Direcotrs, Promoters, etc.) uses the sensitive information about securities of a company to make personal profits.
Unofficial Premium on New Issues;
Non-adherence of provisions of Companies Act;
Violation of rules and regulations of Stock Exchanges;
Delay in delivery of shares.

Purpose and Role of SEBI

The basic purpose of SEBI is to facilitate efficient mobilization and allocation of resources through securities market. It also aims to stimulate competition and encourage innovation. This environment includes rules and regulations, institutions and their interrelationships, instruments, practices, infrastructure and policy framework.

Basically, SEBI aims to meet the need of the three groups of securities market:

Issuers:- It aims to provide a market in which they can confidently raise finance in an easy, fair and efficient manner.
Investors:- It aims to provide protection to their rights and interests through adequate, accurate and authentic information and disclosure of information on a continuous basis.
Intermediaries:- It aims to offer a competitive, professionalized and expanding market with adequate and efficient infrastructure so that they are able to render better service to the investors and issues.

Objectives of SEBI

The overall objective of SEBI is to protect the interests of investors and to promote and regulate the securities market. The objectives of SEBI are stated as under:

To regulate stock exchanges and the securities industry to promote their orderly functioning.
To protect right and interests of investors and to guide and educate them.
To prevent trading malpractices and to achieve a balance between self-regulation by the securities industry and its statutory regulation.
To regulate and develop a code of conduct for intermediaries like brokers, merchant bankers, etc. to make them competitive and professional.

Functions of SEBI

SEBI perform the following functions:

Regulatory Functions

These functions aim to regulate the functioning of the securities market. They include:

Registration of brokers and sub-brokers and other players in the market.
Registration of collective investment schemes and Mutual Funds.
Regulation of stock bankers, portfolio exchanges, underwriters, merchant bankers, business in stock exchanges and any other securities market.
Regulation of takeover bids by companies.
Calling for information by undertaking inspection, conducting enquiries and audits of stock exchanges and intermediaries.
Levying fee or other charges for carrying out the purposes of the Act.
Performing and exercising such power under Securities Contracts (Regulation) Act 1956, as may be delegated by the Government of India.

2. Development Functions

These functions aim to promote the development the securities market. They include:

Training of intermediaries of the securities market.
Conducting research and publishing information useful to all market participants.
Undertaking measures to develop the capital markets by adapting a flexible approach.

3. Protective Functions

These functions aim to protect the interest of the investors. They include:

Prohibition of fraudulent and unfair trade practices like making misleading statements, manipulations, Price Rigging, etc.
Controlling Insider Trading and imposing penalties for such practices.
Undertaking steps for investor protection.
Promotions of fair practices and code of conduct in securities market.

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