Capital

M arkets
 Capital
M arkets

Dr S GURUSAM Y
Professor and Head
Department of Commerce
University opf Madras
Chennai

Tata McGraw Hill Education Private Limited

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Capital Markets, 2/e

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 Contents
Preface................................................................... XV
Chapter 1 Financial Markets
Definition .......................................................................... 1
Location ............................................................................. 1
Role ................................................................................... 2
Functions .......................................................................... 2
Constituents ...................................................................... 3
Financial Instruments ...................................................... 9
Indian Financial Market .................................................. 13
Global Financial Markets ................................................. 18
Review Questions ............................................................. 19

Chapter 2 Capital Market

Money Market .................................................................. 21
Indian Capital Market—Evolution and Growth ............... 23
Constituents of Indian Capital Market ............................. 27
New Financial Institutions .............................................. 29
New Financial Instruments ............................................. 32
Capital Market Doldrums ................................................. 34
Measures of Reactivation .................................................. 36
Measures of Investor Protection ....................................... 37
Recent Initiatives in the Indian Capital Market ............... 38
Indian Capital Market—Major Issues .............................. 40
Rebound in Indian Capital Market ................................... 44
Review Questions ............................................................. 45
vi Ca pi ta l M arkets

Chapter 3 Capital Market Instruments

Meaning ........................................................................... 47
Types ................................................................................ 47
Preference Shares ........................................................... 47
Equity Shares .................................................................. 49
Non-Voting Equity Shares ................................................ 51
Convertible Cumulative Preference Shares (CCPS) .......... 52
Company Fixed Deposits .................................................. 53
Warrants .......................................................................... 54
Debentures and Bonds ...................................................... 55
Global Debt Instruments .................................................. 59
Review Questions ............................................................. 66

Chapter 4 Regulation of Indian Capital

M arket
Genesis ............................................................................. 69
The Factors ...................................................................... 69
The Regulatory Framework ............................................ 72
Committees on Regulatory Framework ........................... 87
Review Questions ............................................................. 89

Chapter 5 D erivatives Market

Meaning of Derivatives ..................................................... 92
Growth of Derivatives Market—Factors ........................... 92
Limitations of Derivatives Market ................................... 93
Functions of Derivatives Market ...................................... 94
Categories of Derivatives .................................................. 95
Forward Contract Vs. Futures Contract ........................ 102
Option Based Derivatives ............................................... 103
Futures and Options—Participants ............................... 105
Benefits of Derivatives .................................................... 109
Risks in Derivatives Market .......................................... 112
Capital Standards for Derivatives .................................. 120
Regulating Derivatives Market ...................................... 120
Advent of Derivatives Market in India ........................... 120
Review Questions ........................................................... 121
 Con t en t s vi i

Chapter 6 SEBI— Functions and Working

Genesis ........................................................................... 124
Features of the SEBI Bill ............................................... 124
Objectives ....................................................................... 124
Management .................................................................. 125
Powers and Functions .................................................... 125
Regulatory Role .............................................................. 131
Role and Relevance ......................................................... 131
Review Questions ........................................................... 137

Chapter 7 Investor Protection

Loss of Confidence of Small Investor—Causes ................ 139
Rights of Investors ......................................................... 141
Facilities by BSE ............................................................ 141
Ombudsman ................................................................... 149
Review Questions ........................................................... 156

Chapter 8 Insider T rading

Rationale ........................................................................ 157
Insiders—Categories ...................................................... 157
Insider Information ........................................................ 158
Connected Persons ......................................................... 158
Need for Control ............................................................. 159
Prohibition of Insider Trading ........................................ 159
Investigation by SEBI .................................................... 160
Action by Corporates ...................................................... 161
Review Questions ........................................................... 163

Chapter 9 Stock Exchange

History of Stock Exchanges ............................................ 165
Meaning ......................................................................... 167
Definition ....................................................................... 167
Functions/ Services/ Features/ Role ............................... 168
Stock Exchange and Commodity
Exchange Distinguished ................................................. 174
vi i i Capi tal Mar kets

World’s Stock Exchanges ................................................ 175

Organization Structure .................................................. 179
Mode of Organization ...................................................... 181
Stock Exchange Traders ................................................. 182
Jobbers and Brokers ....................................................... 185
Jobbers Vs. Brokers ........................................................ 186
Weaknesses .................................................................... 186
Regulation of Stock Exchanges ....................................... 189
Steps in Stock Trading ................................................... 192
Mechanics of Settlement ................................................. 194
Systems of Stock Trading ............................................... 196
Specialists ...................................................................... 198
Recent Developments ...................................................... 200
Interconnected Stock Exchange of India (ISE) ................ 203
Indonext ......................................................................... 204
Review Questions ........................................................... 206

Chapter 10 Indian Stock Exchange

The Bombay Stock Exchange (BSE) ............................... 210
For New Companies ....................................................... 211
For Companies Listed on Other Stock Exchanges .......... 212
For Companies Delisted Already and Seeking Relisting of
this Exchange ................................................................ 213
Safety of market ............................................................. 215
Opportunities for Foreign Investors ............................... 217
Shortages and Objections ............................................... 223
Derivatives Trading ........................................................ 229
Calcutta Stock Exchange ................................................ 230
The National Stock Exchange of India Limited (NSE) ... 233
Review Questions ........................................................... 246

Chapter 11 Prim ary Market

NIM and Secondary Markets—An Interface ................... 249
Services of NIM .............................................................. 250
NIM Vs. Secondary Market ............................................ 251
Review Questions ........................................................... 252
 Con t en t s ix

Chapter 12 Methods of New Issue

Methods of Marketing Securities .................................... 253
Stock Option or Employees Stock
Option Scheme (ESOP) ................................................... 264
Bought-out Deals Vs. Private Placements ...................... 267
Review Questions ........................................................... 269

Chapter 13 Intermediaries in New Issues

M arket
Intermediaries in NIM ................................................... 271
Merchant Bankers/Lead Managers ................................ 271
Underwriters .................................................................. 275
Bankers to An Issue ....................................................... 277
Brokers to an Issue ........................................................ 279
Registrars to an Issue and Share Transfer Agents ......... 280
Debenture Trustees ........................................................ 281
Review Questions ........................................................... 284

Chapter 14 SEBI Guidelines on Primary

M arket
SEBI Guidelines for Listed and Unlisted Companies ...... 287
Review Questions ........................................................... 298

Chapter 15 Listing
Security Listing ............................................................. 299
Security .......................................................................... 299
Stock Exchange .............................................................. 299
Recognized Stock Exchange ............................................ 299
Legal Provisions ............................................................. 300
Steps ............................................................................... 301
Legal Significance .......................................................... 302
Refusal of Listing ........................................................... 302
SEBI Powers .................................................................. 302
Listing and Corporate Governance ................................. 302
Particulars to be Furnished ........................................... 303
x Ca pi t al Ma rkets

Listing Agreement .......................................................... 304

Stock Exchange Powers .................................................. 305
Listing—Benefits ............................................................ 306
Consequences of Non-listing ........................................... 306
New Entry Norms for Unlisted Companies .................... 306
Listing—Suspension / Withdrawal ................................. 307
Review Questions ........................................................... 307

Chapter 16 Underwriting
Definition ....................................................................... 309
Types .............................................................................. 309
Mechanics of Underwriting ............................................ 311
Benefits/Functions ......................................................... 311
Indian Scenario .............................................................. 313
Underwriting Agencies ................................................... 313
Obstacles ........................................................................ 314
Underwriter ................................................................... 315
Underwriting Agreement ................................................ 316
SEBI Guidelines ............................................................. 316
Variants of Underwriting ............................................... 318
Grey Market ................................................................... 321
Review Questions ........................................................... 321

Chapter 17 Book-Building
Concept ........................................................................... 323
Characteristics ............................................................... 323
The Process .................................................................... 325
Allocation Procedure ....................................................... 331
Case I—Initial Public Offer (IPO) Issue ......................... 331
Illustration ..................................................................... 332
Case II—Additional Issue by Listed Company ................ 333
Illustration ..................................................................... 335
Case III—Offer by Unlisted Company ............................ 336
Illustration ..................................................................... 337
Reverse Book-building .................................................... 338
Review Questions ........................................................... 340
 Con t en t s xi

Chapter 18 Over the Counter Exchange of

India (OT CEI)
Genesis ........................................................................... 343
OTCEI Vs. Other Stock Exchanges ................................ 344
Over-the-Counter ............................................................ 345
Need and Objectives ....................................................... 346
Features ......................................................................... 347
Benefits .......................................................................... 351
Securities Traded ............................................................ 353
Players ........................................................................... 354
Members and Dealers ..................................................... 355
Sponsorship .................................................................... 356
Admission of Members—Conditions ............................... 357
Admission of Dealers—Conditions .................................. 358
Registrars and Custodians ............................................. 359
Central Clearing Bank ................................................... 359
Monitoring Agencies ....................................................... 360
Trading Mechanism ....................................................... 360
Settlement Procedure ..................................................... 364
Slow Growth of OTCEI—Causes .................................... 366
Revamping OTCEI ......................................................... 367
Working of NASDAQ ...................................................... 368
Changing Role of OTCEI ................................................ 368
Major Changes in OTCEI Functioning ........................... 369
New Norms .................................................................... 370
Utility of OTCEI’s New Listing Norms to
Entrepreneurs ................................................................ 371
OTCEI MOU with NASSCOM ....................................... 371
Revision in Composite Index ........................................... 372
Clearing and Settlement ................................................. 372
Technology ..................................................................... 373
Review Questions ........................................................... 373
xi i Cap i tal Mark ets

Chapter 19 Stock Market Index

Meaning ......................................................................... 375
Features ......................................................................... 375
BSE INDEX .................................................................... 378
BSE-SENSEX ................................................................. 379
2. BSE-TECk Index .................................................... 383
3. BSE-PSU Index ...................................................... 386
4. BSE-100 Index ........................................................ 387
5. BL-250 Stock Index ................................................ 388
6. BSE BANKEX ........................................................ 389
7. S&P CNX Nifty ...................................................... 390
S&P CNX Nifty Vs. BSE Sensitive Index ....................... 396
Dow Jones Indices .......................................................... 397
NASDAQ Stock Market Indices ..................................... 398
NASDAQ Index Calculation Description ........................ 402
Other Index Descriptions ................................................ 403
S & P 500 Index ............................................................. 406
1. S&P Global 1200 .................................................... 406
2. S&P Global 1200 Sector Indices ............................. 409
Hang Seng Index ............................................................ 410
DAX Index ...................................................................... 410
Straits Times Index ........................................................ 410
KOSPI ............................................................................ 410
FTSE .............................................................................. 410
MSCI (Morgan Stanley Capital International Inc) Index 411
India Index Services Ltd (IISL) ...................................... 413
Review Questions ........................................................... 413

Chapter 20 Stock Market T rading

M echanism
Jobbers and Brokers ....................................................... 415
Jobbers Vs Brokers ......................................................... 416
Stock Exchange Dealings ............................................... 416
Speculative Dealings ...................................................... 417
Share Prices—Factors .................................................... 420
 Con tent s x i i i

Regulating Speculation ................................................... 423

The Securities Contracts (Regulation) Act ...................... 423
Magin Trading ............................................................... 425
Trading of Securities—Steps ........................................... 430
Margins .......................................................................... 435
Badla System ................................................................. 437
Current Trading System—Problems and Palliatives ...... 440
Review Questions ........................................................... 444

Chapter 21 D epository Services

Depository ...................................................................... 447
Bank and Depository—Comparison ................................ 448
Depository Participant (DP) ........................................... 448
Depository (Demat) Services ........................................... 448
Services/Functions ......................................................... 450
Demat (Beneficiary) Account .......................................... 455
Dematerialization ........................................................... 459
Electronic Settlement of Trade—Procedure .................... 461
Demat of Debt Instruments ........................................... 462
Safety System for Demat ................................................ 462
Shortcomings of Demat System ..................................... 463
Indian Depository ........................................................... 466
Role of CDSL .................................................................. 466
Constitution ................................................................... 467
Major Tasks ................................................................... 467
Benefits .......................................................................... 467
Role of NSDL .................................................................. 468
Depository Stock Exchanges ........................................... 468
Legal Framework ........................................................... 469
Review Questions ........................................................... 469

Chapter 22 Speculation
Speculation Vs. Gambling .............................................. 471
Investors Vs. Speculators .............................................. 472
Types of Speculators ....................................................... 473
Review Questions ........................................................... 476
xi v Cap i tal Mark ets

Chapter 23 On-line Stock T rading

Meaning ......................................................................... 477
Features ......................................................................... 477
Current Scenario ............................................................ 478
Internet Trading—Alternatives ...................................... 478
Internet Trading—Some Issues ...................................... 479
Regulating Internet Stock Trading ................................. 490
IPOs on the Internet—Indian Experience ....................... 492
E-IPO Prospectus ........................................................... 492
E-Commerce Act and Internet Stock Trading ................. 494
Review Questions ........................................................... 498

Chapter 24 D ebt Market

Advantages ..................................................................... 499
Risks on Debt ................................................................. 500
Issuers Profile ................................................................ 500
Types .............................................................................. 501
Role of Bond Market ....................................................... 502
Price Determination—Factors ........................................ 502
Yield of Bond ................................................................... 503
Yield and Price ............................................................... 503
Secondary Debt Market .................................................. 503
Repos and Normal Buy or Sell ....................................... 504
Broken Period Interest ................................................... 505
Guidelines for Issue of Debt Instruments ....................... 505
Review Questions ........................................................... 512

Index ---------------------------------------------------------- 515

 Preface
Capital Markets serves as an ideal arena for raising long-term
funds needed for trade and industry. It contributes to the
development and growth of the industry and its role is significant
in a developing country like India, where funds are raised by
issuing various types of securities such as equity, bonds, etc.
This book ‘Capital Markets’ has been authored to present in
lucid details the various aspects pertaining to capital markets
such as types, instruments used for raising long-term funds,
intermediaries etc. The book contains 24 chapters.
A notable feature of the book is that it has been written in a
clear and simple language and is student-friendly. The book
contains topics that are relevant and contemporary. Topics such
as SEBI, Derivatives Market, Insider Trading, Listing,
Book-Building, OTCEI, etc are worthy of mention. In addition,
the book also contains topics such as Depository Services,Stock
Market Index,On-line Stock Trading, etc. I have also taken special
care to ensure that all the concepts and ideas on Capital Markets
have been presented exhaustively and in a simple way.
My deep sense of gratitude goes to my mentor and research
guide (late) Dr N Vinayakam, who was my inspiration for this
work. I am indebted to my beloved parents whose blessings were
the source of strength for writing this book. My acknowledgments
are due to my wife and my children for their excellent cooperation
in making this venture successful.
I take this opportunity to express my sincere thanks to
Mr P K Madhavan and his colleagues at M/s Vijay Nicole Imprints
for ensuring the timely completion of this book.

Dr S GURUSAMY
 Chapter 1

Financial Markets

A market as defined by economists refesrs to an institution or arrangement

that facilitates the purchase and sale of goods and services, and other
things. A financial market is an institution or an arrangement that facilitates
the exchange of financial instruments, including deposits and loans,
corporate stocks and bonds, government bonds, and more exotic
instruments such as options and futures contracts.
A market wherein financial instruments such as financial claims, assets
and securities are traded is known as a ‘financial market’. Financial market
transactions may take place either at a specific place or location, e.g. stock
exchange, or through other mechanisms such as telephone, telex, or other
electronic media. In financial markets, the price for the use of investible
funds is the interest paid on the funds transacted.
DEFINITION
According to Brigham, Eugene F, “The place where people and
organizations wanting to borrow money are brought together with those
having surplus funds is called a financial market.”
LOCATION
A financial market may or may not have a particular physical existence. For
instance, the New York Stock Exchange (NYSE) is physically located on
Wall Street in New York City. Alternatively, the over-the-counter (OTC)
market for stocks, called the National Association of Securities Dealers
(NASD) has no fixed place of existence. It consists of brokers throughout
the country who track prices via computer and telecommunication lines.
NASD is best known for the newspaper quotes of stock prices it generates
called NASDAQ (National Association of Securities Dealers Automatic
Quotation System).
2 Capi tal Markets

ROLE
One of the important requisites for the accelerated development of an
economy is the existence of a dynamic and a resilient financial market. A
financial market is of great use for a country as it helps the economy in the
following ways:
Mobilization of Savings
Obtaining funds from the savers or ‘surplus’ units such as household
individuals, business firms, public sector units, Central Government, State
Governments, Local Governments, etc is an important role played by
financial markets.
In v e stm e n t
Financial markets play a key role in arranging to invest funds so collected,
in those units which are in need of the same.
National Growth
An important role played by financial markets is that they contribute to a
nation’s growth by ensuring an unfettered flow of surplus funds to deficit
units. The flow of funds for productive purposes ensures growth of
investment and employment.
Entrepreneurship Growth
Financial markets contribute to the development of the entrepreneural
class by making available the necessary financial resources, etc.
Industrial Development
The different components of financial markets help an accelerated growth
of industrial. This contributes to the enhancement of the standard of
living and the society’s well-being.
FUNCTIONS
A financial market renders the following functions:
Intermediary Functions
The intermediary functions of a financial market include the following:
Transfer of resources Financial markets facilitate the transfer of real
economic resources from lenders to ultimate borrowers.
Enhancing income Financial markets allow lenders earn interest/
dividend on their surplus investible funds, thus contributing to the
enhancement of the individual and the national income.
 Fi na nci al M ark et s 3

Productive usage of funds Financial markets allow for the productive

use of the funds borrowed, thus enhancing the income and the gross
national production.
Capital formation Financial markets provide a channel through which
new savings flow to aid capital formation of a country.
Price determination Financial markets allow for the determination of
the price of the traded financial asset through the interaction of buyers
and sellers. They provide a signal for the allocation of funds in the economy,
based on the demand and supply, through the mechanism called ‘price
discovery process’.
Sale mechanism Financial markets provide a mechanism for selling of
a financial asset by an investor so as to offer the benefits of marketability
and liquidity of such assets.
Information The activities of the participants in the financial market
result in the generation and the consequent dissemination of information
to the various segments of the market. This results in reduced cost of
transaction of financial assets.
Financial Functions
The financial functions of a financial market include the following:
1. Providing the borrowers with funds so as to enable them to carry
out their investment plans
2. Providing the lenders with earning assets so as to enable them to
earn wealth by deploying the assets in productive ventures
3. Providing liquidity in the market so as to facilitate trading of
funds
CONSTITUENTS
A typical U.S. financial market comprises the following constituents:
1. Primary Market
2. Secondary Market
3. Money Market
4. Capital Market
5. Debt Market
6. Eurobond Market
7. Equity Market
8. Financial Services Market
9. Depository Market
10. Non-depository Market
4 Capi tal Markets

The following Exhibit 1 shows the constituents of a typical financial

market:
Exhi bi t 1 Fi n an ci al M ar ket — Con st i t u en t s

Primary Market
Primary market deals with the issue of new securities. In this market, the
government or the corporate sector issues securities that change hands
from the issuer to the investor. This way, newly issued financial assets are
bought and sold. For instance, if L&T issues new shares, the shares are
sold in the primary market.
Sec ondar y Mar ket
Secondary market deals with existing claims. There is no new flow of
funds for instruments in this market. No fresh capital is made available to
the producers on account of the transactions in the secondary market, as
they deal only in existing securities.
The secondary market renders a very important service to the primary
market by providing a ready market for trading in securities. The volume
and the magnitude of the transactions taking place in the secondary market
influence the activities in the primary market. For instance, if there is an
 Fi na nci al M ark et s 5

active trading for the scrips of a particular company, it is possible for that
company to raise additional capital with ease and convenience because of
the goodwill already generated for the scrips.
Existing financial assets of a company are bought and sold in the
secondary market. The existence of a secondary market for a financial
asset enhances its liquidity. For example, if a person buys a share of L&T
in the primary market he can easily sell it for cash because, the shares are
actively traded in the secondary market. All that is required is to inform a
broker about the decision to sell the scrips. The broker, in turn, locates a
buyer and sells the scrips for the client.
The presence of a secondary market helps lower the transaction costs,
as finding buyers and sellers becomes an easy job. In the absence of a
secondary market for a stock, one has to personally locate someone willing
to buy the stock. This would not only take considerable time, but it may
not be possible to locate the buyer who is willing to pay the highest
possible price for the stock. A secondary market is, therefore, that which
allows dealing between buyers and sellers of existing shares which
ultimately serves to enhance the liquidity of corporate stock. This induces
investors to own stock and therefore makes it easier for firms to acquire
funds in the primary market.
Money Market
Meaning Money market is a market where short-term instruments that
mature in a year or earlier are traded.
F e a tur e s
1. Short-term financing Money market facilitates short-term financing
and assures the liquidity of short-term financial assets. Money market
meets the working capital (short-term) requirements of industry, trade and
commerce.
2. Nerve centre Money market acts as the nerve center of all the
operations of the central bank of a country. It reflects the changes in
short-term parameters such as interest rates, monetary policy, availability
of short-term credit, etc.
3. Liquidity adjustment Money market provides a mechanism of liquidity
adjustment between individuals, institutions, and government. It serves
as a medium of exchange between the holders of temporary cash surpluses
and temporary cash deficits. Borrowers are assured that short-term funds
can be quickly obtained and lenders are assured that their short-term
financial assets can be quickly converted into cash.
6 Capi tal Markets

4. Central bank The central bank that is responsible for regulating and
controlling the money supply in an economy conducts most of its
operations in the money market. The central bank, occupying a pivotal
position in the money market is responsible for its promotion and
development. The flow of money and credit in the money market is regulated
and controlled by the central bank through a plethora of qualitative and
quantitative measures.
5. Risk Money market offers a low capital loss (money risk), as
instruments traded are short-term in nature, besides offering a low risk of
default (credit risk). This is because, money market instruments are mostly
in the form of the liabilities of the government, central bank and commercial
banks.
6. Submarkets A developed money market consists of specialized
submarkets such as central banks, commercial banks, cooperative banks,
saving banks, discount houses, acceptance houses, bill market, bullion
market, etc.
Capital Market/Securities Market
Meaning The market where long-term funds are borrowed and lent is
known as a capital market, the primary purpose being directing the flow of
savings into long-term investments (mostly for a period of one year and
above).
F e a tur e s
1. Demand for funds Demand for long-term funds arise from individuals,
institutions, central government, state government, local self government
and the private corporate sector.
2. Instruments Funds are raised through issue of financial instruments
such as shares, debentures and bonds.
3. Supply of funds Individuals (household sector), institutions, banks
and industrial financial institutions are the main sources of supply of
long-term funds.
4. Ideal conduit The capital market acts as an ideal conduit for the
transmission of savings of surplus units to deficit units which demand
long-term funds.
5. Economic growth Capital market plays a significant role in the financial
system by promoting savings and investments, which are vital for the
development and growth of an economy. It accelerates the pace of economic
development. The primary capital market helps government and industrial
concerns in raising funds by facilitating the issue of various kinds of
 Fi na nci al M ark et s 7

securities. The secondary market provides liquidity to the outstanding/

existing securities.
6. Price mechanism The price mechanism prevalent in the active capital
market ensures optimal allocation of scarce financial resources to the most
productive sectors of the economy. The system of allocation of funds
works through incentives and penalties. Accordingly, companies that
operate efficiently can sell securities at premium (incentives). Conversely,
companies with poor performance face problems in selling their securities
and may have to issue securities at a discount to raise additional funds or
offer higher rates of interest.
Debt Market
The market where funds are borrowed and lent is known as ‘debt market’.
Arrangements are made in such a way that the borrowers agree to pay the
lender the original amount of the loan (called the principal) plus some
specified amount of interest. The use of debt markets is different for
different people. For instance, individuals use debt markets to borrow
funds to finance purchases such as new cars and houses; corporates use
them for obtaining working capital and new equipment; federal, state, and
local governments use them to acquire funds to finance various public
expenditures. Issue of new funds occurs in the primary debt market, and
purchase and sale of debt instruments in the secondary debt market.
Eurobond Market
A market where bonds are denominated in currency other than that of the
country, in which they are issued, is called ‘Eurobond Market’. Eurobond
market is international in character as for example, a French firm may engage
a German investment banking syndicate to sell dollar-denominated bonds
and so on. A striking characteristic of Eurobonds is that, bulk of these
bonds is denominated in dollars. The multiple-currency bonds are
denominated in a weighted average of many currencies.
Equity Markets
A market where ownership securities are issued and subscribed is known
as ‘equity market’. An example of a secondary equity market for shares is
the Bombay Stock Exchange.
Financial Services Market
A market that comprises participants such as commercial banks etc that
provide various financial services like ATM, credit cards, credit rating,
factoring, leasing, stock-broking etc is known as a ‘financial services market’.
8 Capi tal Markets

Individuals and firms use financial services markets to purchase services

that enhance the working of debt and equity markets.
Depository Market
A depository market consists of depository institutions that accept deposits
from individuals and firms, and use these funds to participate in the debt
market, by giving loans or purchasing other debt instruments such as
Treasury Bills etc. It is a special type of loan market in which depositors
“loan” money to depository institutions, which in turn use the funds to
purchase other financial assets. The major types of depository institutions
are commercial banks, savings and loan associations, mutual savings banks,
and credit unions. A brief description of these is given below:
Commercial banks Commercial banks comprise the largest and most
important depository institutions in a depository market. They have the
largest and most diverse collection of assets among all depository
institutions. Their main source of funds include demand deposits, time
deposits and certificates of deposit.
Sav i ng s a n d l oa n a ss o ci a ti o ns Savings and loan associations
were originally designed as mutual associations, (i.e. owned by depositors)
to convert funds from savings accounts into mortgage loans. The purpose
was to ensure a market for financing housing loans.
Mutual savings banks Mutual savings banks are similar to savings
and loans associations, but are owned cooperatively by members with a
common interest, such as company employees, union members, or
congregation members. Originally they accepted deposits and made
mortgage loans.
Credit unions Credit unions are organized as cooperative depository
institutions, in as much the same way as mutual savings banks. Depositors
are credited upon purchasing shares in the cooperative, which they own
and operate. Like savings and loans associations, credit unions were also
originally restricted by law to accept savings deposits and make consumer
loans.
Non-depository Market
Non-depository market comprises of institutions that do not accept
cheques to liquidate deposits. They carry out various functions in financial
markets, ranging from financial intermediation to selling insurance. A brief
description of the various constituents is given below:
Mutual funds Firms that sell shares to investors and invest the
proceeds in a variety of financial assets are called mutual funds. Owners
 Fi na nci al M ark et s 9

of shares receive pro-rata share of the earnings from these assets, minus
management and other fees assessed by the fund. Some mutual funds,
called money market mutual funds, invest in short-term, safe assets such
as U.S. treasury bills and large bank certificates of deposit. Largely, for
historical reasons, money market mutual funds are not considered
depository institutions even though shareholders are often allowed to
write cheques on their accounts. Unlike depository institutions, money
market mutual funds do not promise that the price of a share will stay
constant; but in reality, the price of each share does not fluctuate over
time like prices of stock.
Insurance companies Companies that protect individuals against risk
are called insurance companies. Life insurance companies accept regular
payments from individuals in exchange for contracted payments in the
event of the death of the insured. They hold long-term assets, like long-
term bonds and substantial quantities of commercial real estate. Other
insurance companies, called fire and casualty insurance companies, insure
cars, houses etc against loss from fire, theft, and accident.
Pension funds Funds that are operated by the private and government
employers (including federal, state, and local) and that which provide
retirement income to employees, are called pension funds. Money is
collected by regular contribution from employees, usually via, payroll
deduction. The funds flowing in, are in the nature of fixed deposits. Like
Life insurance companies, these institutions can accurately predict payouts
and hence can hold long-term assets. They hold portfolios consisting
mostly of stocks and bonds. The return on these assets are paid out to
participating individuals when they reach retirement age.
Brokerage firms Brokerage firms bring buyers and sellers of stock
together for the purchase and sale of financial assets. They function as
intermediaries, earning a fee for each transaction. Their main function is to
serve as brokers in the secondary debt and equity markets.
FINANCIAL INSTRUMENTS
The instruments that help in borrowing and lending of money are called
‘financial instruments’. A brief description of some of these instruments
as traded in the U.S. financial market is given below:
Money Market Instruments
The most liquid, short-term debt obligations that are traded in the money
market are called money market instruments. Some of these instruments
are briefly described below:
10 Capi tal Markets

Commercial paper A form of direct short-term finance issued by large,

creditworthy companies is called a Commercial Paper. It is a typical debt
instrument sold by one company to another company or financial institution
to raise immediate funds. It contains a promise to pay back a higher specified
amount at a designated time in the immediate future, say, 30 days. By
issuing Commercial Paper, a corporation avoids the process of applying
for a loan and instead engages in direct finance. To engage in direct finance
effectively, the issuing company must be large and creditworthy enough
to find someone willing to accept its Commercial Paper, which is sold with
the help of brokers. The growing use of Commercial Paper has increased
the competitive pressure on banks, which are finding some of their potential
loan customers turning to the Commercial Paper market.
Certificates of deposit (CDs) These are the debt instruments sold by
banks and other depository institutions. A CD pays the depositor a
specified amount of interest during the term of the certificate, plus the
purchase price of the CD at maturity.
Treasury bills Treasury bills, also called T-bills, are short-term debt
instruments used by the government to obtain funds. They are issued in
3, 6 and 12-month maturities. These instruments do not make regular interest
payments; instead they are sold at a discount. This means that such bills
are sold for an amount that is less than the amount promised by government
at maturity. The difference between the purchase price and the face value
is the return from the T-bill purchase. The advantages of ready market and
zero default risk from the Federal Government makes this instrument very
attractive.
Treasury bonds These are the popular U.S. government securities.
These include Treasury bonds having a maturity of 10 years and T – notes
with a maturity of 1 to 10 years. These bonds also earn implicit interest,
which is the difference between the issue price and maturity value.
Repurchase agreements An agreement by two parties in which the
borrower sells and agrees to buy back a financial instrument, a government
bond, note, or T-bill, is called a repurchase agreement. It is popularly
known as ‘repo’ and is generally used by banks. For instance, if a bank
needs short-term cash today, it can sell some Treasury bills to a firm such
as IBM with the agreement that the bank will repurchase the T-bills in
30 days at a higher price. In effect, this repurchase agreement is a
short-term loan in which the Treasury bills serve as collateral.
Eurodollars US dollars deposited in banks located in countries other
than the U.S. are called ‘Eurodollars’. It is customary for foreign banks and
offshore branches of U.S. banks to hold dollar deposits to service firms
 Fi nan ci a l M ark ets 11

engaged in international trade and use it for other purposes as well. US

banks sometimes borrow Eurodollars when they need short-term funds.
Banker’s acceptances An arrangement whereby a bank promises to
pay on a specific date, which is accepted, and guaranteed by another bank
is known as ‘bankers’ acceptance’. It is essentially a letter of credit. It is
similar to a post-dated cheque or a bank draft. However, a banker’s
acceptance is more valuable as a medium of exchange than a standard
cheque. This is because, there is a greater certainty of the acceptance
being honored. The party issuing a banker’s acceptance pays a fee to the
bank for its guarantee. Banker’s acceptances are particularly valuable in
international transactions. It provides a measure of protection for firms in
ensuring due payment by the importers. There is a relatively small
secondary market for banker’s acceptances, which essentially operates as
a scaled-down version of the market for Treasury bills.
Capital Market Instruments
The principal capital market instruments are described below:
Corporate stock An equity instrument that represents ownership of a
share of the assets and earnings of a corporation is called ‘corporate
equity’. A firm undertakes sale of stock when it wishes to mobilize capital
required for taking up new investment projects or for modernization and
expansion projects. The profits earned by a corporation and paid to share-
holders are known as dividends. Unlike interest payments, dividends can
vary with the health of the company. A company would receive money
only when shares or stock are issued by it. Shares are also offered to
underwriters or investment banks that guarantee the firm a certain price
for the issue. The Investment banker then sells the stock to individual
investors, with the assistance of brokers, at what they hope is a higher
price than the guaranteed price. Effectively, the underwriters provide in-
surance to the company issuing the new stock and bear the risk associ-
ated with the low price investors pay for the stock.
When a new issue is in the hands of individual investors, the stock
can be sold and bought by another investor (with the help of a broker) in
a secondary stock market such as the New York Stock Exchange or the
American Stock Exchange. In this connection, funds transferred in the
secondary markets pass between individual buyers and sellers of the
stock rather than to the corporation. Individuals own the majority of stock
in the United States and, pension funds, insurance companies, and mutual
funds own the rest.
12 Capi tal Markets

Corporate bonds A corporate bond is a debt instrument issued by a

corporate entity that contains a promise that the firm will make specified
interest payment, and, a principal amount or the “face value” on the
maturity of the instrument. The original purchaser of a bond buys this
promise from the firm for an up-front amount, known as the price of the
bond. Unlike stockholders, bondholders own no share of profits.
Bondholders are entitled only to the interest payments and the face value
due on maturity. The firm’s “promise” is valuable to the purchaser of the
bond only if the firm does not go bankrupt. This presupposes that only
strong and credible corporations tend to issue bonds.
Corporate bonds, like corporate stock, provide funds to the issuing
firm when sold in the primary market. Like stocks, new bond issues are
underwritten by investment banks, which sell these bonds to individual
investors. When bonds are bought and sold in the secondary bond market
(for example, the New York Bond Exchange), money changes hands among
individual investors, and no funds flow to the corporation that issued the
bond.
Mortgages A debt instrument used to finance the purchase of a home
or other form of real estate where the underlying real estate serves as a
collateral for the loan, is known as a ‘mortgage’. If the borrower defaults,
the lender receives title to the real estate towards payment of the debt. The
two major types of mortgage instruments are fixed-rate and adjustable-
rate mortgages. Each type of mortgage specifies a term (the length of the
mortgage), and a down payment (usually expressed as the fraction of the
house value that must be paid up-front as prepaid interest).
A fixed-rate mortgage specifies an interest rate that is fixed during the
term of the loan, whereas the rate on an Adjustable Rate Mortgage (ARM)
can change (usually every one or three years). An adjustable rate mortgage
also stipulates a margin that reflects the premium above some index of
interest rates (usually one-year U.S. Treasury bills) that will be used to
adjust the interest rate at a specified time during the term. It also stipulates
a cap, which is the maximum amount by which the rate can change at any
adjustment point, and a ceiling and floor, or the maximum and minimum
interest rate.
Co m m e r c i a l l o a n s
Commercial loans are loans obtained by
individuals for intermediate-term purchases such as the purchase of
merchandise etc with credit cards. Commercial loans are essentially credit
lines issued to businesses. There is a less active secondary market for
consumer and commercial loans, making them the least liquid of all capital
 Fi nan ci a l M ark ets 13

market instruments. However, there has been a growing movement to

securitize (convert to marketable securities) some consumer debt.
Municipal bonds State and local governments issue municipal bonds to
obtain long-term funds for financing such projects as highways and
schools. Interest payments these bonds receive are exempt from Federal
income tax (although some state and local governments do collect income
tax on municipal bond interest earnings). This makes municipal bonds an
attractive investment for lenders in high-income tax brackets.

INDIAN FINANCIAL MARKET

The Indian financial market mainly comprises of the money market and
capital market. A brief description of the different contours of the Indian
financial market is presented below:
Indian Money Market
The features of the Indian money market, which is composed of organized
and unorganized markets, are presented below:
Or g a n i ze d m o n e y m a r ke t
a. Constituents The constituents of organised Indian money
market include Reserve Bank of India, State Bank of India and its
subsidiaries, commercial banks, finance corporations, bill market
and bullion market.
b. Principal centers The principal centers of the organized money
markets are Mumbai, Kolkata and Delhi. Mumbai is considered
to be the ‘financial capital’ of India because of the presence of
the head office of Reserve Bank of India and some commercial
banks, leading stock exchanges, well organized market for gilt
edged securities, and bullion market.
c. Banking system The banking system is the most dominant
force in this part of the Indian money market. The banking system
consists of scheduled banks and non-scheduled banks.
Scheduled banks comprise of state cooperative banks and
scheduled commercial banks. Scheduled commercial banks
include both foreign banks and Indian banks. They exist both in
public as well as private sector.
The scheduled banks constitute the largest banking group in
terms of offices/branches, deposits, and advances in India. The
share of non-scheduled banks is very small in terms of the
afore-mentioned banking indicators. Within the scheduled
14 Capi tal Markets

commercial banks, the public sector banks, i.e. State Bank of

India and its subsidiaries, and twenty nationalized banks account
for a major portion of the banking business. State Bank of India is
the largest bank among the public sector banks. Thus, the
government owns the major part of the banking business in India.
d. Rural banking A new category of banks called Regional Rural
Banks (RRBs) primarily sponsored by commercial banks, was
conceived in 1976. They were set up to provide credit for
agricultural purposes, to small entrepreneurs engaged in trade
and industry and other productive activities in rural areas, besides
catering to the needs of weaker sections of the society.
e. RBI The Reserve Bank of India, being the Central Bank in India
occupies the pivotal position in the organized money market.
RBI exercises adequate control over the operations of the
organized money market through various monetary and credit
instruments such as Cash Reserve Ratio (CRR), Statutory
Liquidity Ratio (SLR), Credit Authorization Scheme (CAS), Non-
resident Indian Investment Incentive Scheme, etc.
Unorganized money market The unorganized money market consists
of indigenous bankers and moneylenders. The indigenous bankers and
moneylenders are active in the small towns and villages, and partly in big
cities, where farmers, artisans and, small traders do not have an access to
the modern banks.
The indigenous bankers and moneylenders advance loans against
collateral security and/or to people who are personally known to them.
They are outside the control of the RBI. They charge exorbitant rates of
interest on their advances.
Indian Capital Market
The market where financial securities are bought and sold is known as the
‘capital market’. It is also known as ‘securities market’. The securities are
shares, bonds, debentures, etc. It plays a vital role in facilitating the free
flow of funds from the surplus to deficit units and provides liquidity,
marketability, safety, etc to the investors and accelerates the rate of capital
formation.
A legal instrument that represents either an ownership or a debt claim
is known as a financial security. Ownership securities comprise equity and
preference shares while debt securities include bonds and debentures. A
debt security is used to raise a loan and promises to repay the borrowed
money. The owner of a debt security is a creditor. Following are the features
 Fi nan ci a l M ark ets 15

of Indian capital market:

Type of securities Financial securities may be broadly classified into
government securities and industrial securities. Securities that are issued
by the central government, state governments and local self governments
such as municipalities, autonomous institutions like Port Trusts,
Improvement Trusts, State Electricity Boards, Metropolitan Authorities,
Public Sector Corporations, and other government agencies like IDBI,
IFCI, SFCs, SIDCs, Housing Boards, etc are called government securities.
The government securities market is the most dominant and occupies a
significant position in the Indian capital market.
The instruments for raising funds in the industrial securities market
are bonds, debentures, preference shares and equity shares. The size of
the industrial securities market in India is relatively smaller than that of the
other industrialized countries, because of investment habits, level of
education and industrial structure. Industrial securities are not a popular
mode of investment when it comes to safety and return parameters.
Composition The Indian capital market, like its counterpart, the Indian
money market, is composed of organized and unorganized sectors. The
unorganized sector consists of indigenous bankers and moneylenders.
The organized capital market consists of nonbanking institutions, and
special and development financial institutions. A notable feature of the
Indian capital market has been the dominating presence of development
banks, which besides providing finance also extend other services such
as consultancy, technical know-how, and training.
Role The Indian capital market causes accelerated development of the
economy by undertaking such functions as stimulating the general financial
market conditions, providing risk capital and seed capital, direct
subscription and underwriting of issues, promoting broad-based
entrepreneurship, encouraging new industries, modernizing the existing
industries, encouraging export promotion and import substitution
industries, and promoting backward area and regional development.
Special institutions A number of special institutions of finance,
development and promotion came to be set-up after independence. The
first development bank, the Industrial Finance Corporation of India (IFCI)
was established in 1948. The SFCs Act was passed in the year 1951, in
order to enable the establishment of development institutions at provincial
levels. In 1955, the Industrial Credit and Investment Corporation of India
(ICICI) was established with the main objective of enlarging underwriting
facilities for public issue of capital, foreign currency loans and direct
subscriptions to shares and debentures.
16 Capi tal Markets

After 1960, a number of state governments set up SIDCs to undertake

developmental and promotional function at the state level. The IDBI was
established in 1964, to operate as the central coordinating agency for
industrial financing. Apart from these development banks, other non-
banking institutions, which were set up, included the Unit Trust of India
(UTI), the Life Insurance Corporation of India (LIC), the General Insurance
Corporation (GIC), Investment companies, the financing and the leasing
companies. They all actively participate in the capital market.
For the purpose of directing the growth in rural development, the
National Bank for Agriculture and Rural Development (NABARD) was
established in 1982. To cater to the financial needs of the importers and
exporters for financing international trade, the Export-Import Bank of India
(EXIM Bank) was also established in 1982.
Types of market The securities market is divided into primary or new
issue market and secondary market. The new issues of government and
private corporate sectors are floated in the primary market. New issues
take place through public offer, offer for sale, private placement, and rights
issues in the primary market. Underwriters play a vital role in floating the
new issues. The secondary market provides liquidity to the outstanding
or existing securities. Once the new issues are floated and subscribed by
the public, they are then traded in the secondary market. The securities
market consists of organized stock exchanges and over-the-counter
exchanges. Stock exchange is a place where members, on their own or on
behalf of their clients, buy and sell securities. Stock exchanges are auction
markets. The exchange neither buys nor sells the securities but merely
provides a trading place where members through bids and offers, trade in
securities. In the stock exchange only listed securities, which are permitted
by the governing body of the stock exchange, are traded.
a. National stock exchange (NSE) The National Stock Exchange
works on the standardized system software used all over the
world. It is a state-of-the-art technology. Exchanges around the
world such as Vancouver, Mexico, Istanbul, and Caracas use the
base line software adopted by the NSE. The systems support is
being provided by the TCS (Tata Consultancy Services). The
exchange works with the help of the satellite communication
network. The network is used to link all the national stock
exchanges. The exchange also provides networking around the
globe.
The NSE, through its versatile trading solutions, allows
trading to take place by the brokers and members by simply
 Fi nan ci a l M ark ets 17

sitting in their own offices. This helps the market participants to

take advantage of the support of their back office and facilitates
getting in touch with their constituents. All the options, which
are available on a trading floor or through telephone trades, are
available through the trading software. All the market information
relating to the trading will be available continuously on the screen
at the press of a button. This is possible through the online
updating of information pertaining to the depth of the market, the
types of orders floating into the system, the best buy order value,
the best buy price, all previous trades that have taken place,
outstanding orders of the concerned trading member, etc. The
identity of the trader is concealed.
b. Third market The Over-the-Counter (OTC) market for listed
stock is known as ‘Third Market’. Any exchange-listed security
in the OTC market can be traded in this type of market. Members
of an organized stock exchange can deal in the third market.
Shares traded are the same as those traded on a regular stock
exchange. As prices are fixed through negotiations, dealers have
no responsibility of market-making. Trading takes place even
after the trading hours.
The ‘third market’ had its origin in the U.S., when in 1970, the
New York Stock Exchange permitted non-members of the
exchange to trade in securities without having to pay huge
commissions.
Institutional investors such as investment institutions,
insurance companies, pension funds and mutual funds are the
main customers of the third market. It is possible for these investors
to reduce the cost of transaction so as to obtain better prices.
Transactions take place more rapidly than at the organized
exchanges. Small brokers/dealers, private individuals and small
odd lot customers who are not members of an organized exchange
can also actively take part in the third market. They can buy and
sell the listed stock at negotiated prices. Usually, large stock
transactions are conducted in third market in order to benefit
from lower commissions.
c. Fourth market In the ‘fourth market’ institutions and wealthy
investors who directly buy and sell securities among themselves.
Originated in the US, an essential feature of this type of market is
that buyers and sellers directly deal in securities without the help
of brokers. Only two parties are involved in the transactions as
18 Capi tal Markets

the deals are direct. The market eventually comprises a

communication network among block traders. Direct deal is
facilitated through a negotiated price. Many institutions have
dispensed with brokers and exchanges completely for
transactions in listed stocks.
Transactions are facilitated by computer communications
system which automatically provides quotations and executions.
Under this mechanism, offers made by the parties are recorded in
the system and the transactions are automatically recorded as
two orders are matched. The system then sets up the paper work
for completion. It is also possible for the subscriber to find
partners for a trade and then conduct negotiations by telephone
with the help of this system. ‘Ariel’ is the monitor system that
exists in U.K. The main advantages of the ‘Fourth Market’ are
less commission, better price through direct negotiation, and
rapid execution of the deal.
GLOBAL FINANCIAL MARKETS

Meaning
Financial markets that are integrated and operated worldwide by using
uniform trading practices are known as ‘Global Financial Markets’. Under
the global financial market dispensation, it is possible for firms to raise
funds in international arenas.
F a c to r s
The factors responsible for causing the emergence of global financial
markets are:
1. Deregulation Deregulation or liberalization of markets and the activities
of market participants in key financial centers of the world.
2. Science and technology Technological advances for monitoring
world markets, executing orders, and analyzing financial opportunities.
3. Institutionalization Shift from retailing to increased institutionalization
of investors in financial markets.
4. Competition Global competition which forces governments to
deregulate various aspects of their financial markets.
5. Information flow Free and unrestricted flow of market information
around the world owing to advancement in telecommunication systems.
 Fi nan ci a l M ark ets 19

Classification
Global financial markets may be classified into internal and external markets
as described below:
Internal market Internal market, also called national or domestic market,
is a market where the capital issues and issuers are domiciled within the
boundaries of a particular country.
External market External market, also called foreign market or
international market or Euro market or offshore market, deals with issue of
securities not domiciled in the country but are sold and traded throughout
the world. The rules governing the issuance of foreign securities are
imposed by regulatory authorities where the security is issued.
Accordingly, where an Indian firm wishes to raise capital in the global
market, it has to follow the regulations of Indian authorities. The external
markets are called by different names as: Yankee Market in the U.S., Samurai
Market in Japan, Bulldog Market in UK, Rembrandt Market in Netherlands,
and Matador Market in Spain.
REVIEW QUESTIONS
Section A
1. State the meaning of a financial market
2. How is a financial market defined?
3. Where does a financial market exist?
4. State the financial functions of a financial market
5. What are the constituents of a financial market?
6. What is a capital market?
7. What is a money market?
8. What is a debt market?
9. What is a Eurobond market?
10. What are equity markets?
11. What is a financial services market?
12. What is a depository market?
13. What are pension funds?
14. What are insurance companies?
15. What are financial instruments?
16. What is a commercial paper?
17. What are certificates of deposits?
18. What are repos?
19. What are Eurodollars?
20. What are bankers’ acceptances?
21. What is a corporate equity?
22. What are corporate bonds?
20 Capi tal Markets

23. What are mortgages?

24. What are global financial markets?
Section B
1. Explain the role of a financial market
2. What are the functions of a financial market?
3. State the features of a capital market
4. State the features of a money market
5. What are the various constituents of a non-depository market?
6. Describe briefly the money market instruments
7. Describe briefly the various capital instruments
8. Write a note on the organized money market in India
9. What are the features of Indian capital market?
10. How is a ‘third market’ different from a ‘fourth market’?
11. What are the factors responsible for the emergence and the growth
of global financial markets?
12. How are global financial markets classified? Explain
Secti on C
1. Make a detailed discussion on the financial instruments
2. Discuss the contours of Indian financial market
 Chapter 2

Capital Market

Capital market may be defined as a market for borrowing and lending long-
term capital funds required by business enterprises. Capital market is the
market for financial assets that have long or indefinite maturity. Capital
market offers an ideal source of external finance. Capital market forms an
important part of a country’s financial systems too.
Capital market represents all the facilities and the institutional
arrangements for borrowing and lending medium-term and long-term funds.
Like any financial market, capital market is also composed of those who
demand funds (borrowers) and those who supply funds (lenders).
MONEY MARKET
According to the Reserve Bank of India, a money market is a “centre for
dealings, mainly of a short-term character, in monetary assets; it meets the
short-term requirements of the borrowers and provides liquidity or cash to
lenders. It is the place where short-term surplus investible funds at the
disposal of the financial and other institutions, and individuals are bid by
borrowers, again comprising institutions and individuals and also by the
Government”.
C h a r a c te r i s ti c s
Following are the characteristic features of a capital market:
Securities market The dealings in a capital market are done through
the securities like shares, debentures, etc. The capital market is thus called
securities market.
Security prices The price of securities that are dealt with in the
capital market is determined through the general laws of demand and
supply. The equilibrium in demand and supply of securities is brought
about by the prices. The price depends upon a large number of factors
such as the following:
1. Yield on securities
2. Extent of funds available from public savings
22 Capi tal Markets

3. Level of demand for funds

4. Flow of funds from the banking system
5. Price situation in general
6. Attitude towards liquidity on the part of investors
Participants There are many players in the capital market. The par-
ticipants constitute a plethora of institutions, which provide access to
capital market. The capital funds are either directly supplied or arranged
through financial intermediaries. The intermediaries form the edifice of a
capital market. The participants in the capital market include:
1. Financial intermediaries like insurance companies, investment
companies, pension funds, etc
2. Non-financial business enterprises
3. Ultimate economic units like households and Governments
Location It is interesting to note that the capital market is not confined
to certain specific locations, although it is true that parts of the market are
concentrated in certain well-known centers known as Stock Exchanges. It
exists all over the economy, wherever suppliers and users of capital get
together and do business.
Functions
The functions that are performed by the capital market are detailed below:
Allocation function Capital market allows for the channelization of the
savings of innumerable investors into various productive avenues of in-
vestments. Accordingly, the current savings for a period are allocated
amongst the various users and uses. The market attracts new investors
who are willing to make new funds available to business. It also allocates
and rations funds by a system of incentives and penalties.
Liquidity function Capital market provides a means whereby buy-
ers and sellers can exchange securities at mutually satisfactory prices.
This allows better liquidity for the securities that are traded.

Other functions In addition to the functions of funds allocation and

liquidity, capital market also renders the following functions:
1. Indicative function A capital market acts as a barometer showing not
only the progress of a company, but also of the economy as a whole
through price movements of securities.
2. Savings and Investment function Capital market provides a means of
quickly converting long-term investment into liquid funds, thereby
 Ca pi ta l Ma rket 23

generating confidence among investors and speeding up the process of

savings and investments.
3. Transfer function Capital market facilitates the transfer of existing
assets, tangible and intangible, among individual economic units or groups.
4. Merger function Capital market encourages voluntary or coercive
take-over mechanism to put the management of inefficient companies into
more competent hands.
INDIAN CAPITAL MARKET—EVOLUTION AND GROWTH
Standing the test of time, the Indian capital market has undergone
phenomenal changes. Since the mid-eighties, a metamorphic transformation
involving multidimensional growth has taken place in an otherwise dormant
Indian financial system. The magnitude of growth could be gauged in
terms of massive jumps in funds mobilization, the turnover on the stock
exchanges, the amount of market capitalization, and the expansion of
investor population. The regulatory framework has been strengthened
and streamlined in order to tackle effectively the problems associated with
the massive growth of the market.
The evolutions in the realm of capital market in India could be broadly
discussed as follows:
Infrastructure Stage
The period between 1947 and 1973 was the period of the development of
infrastructure for capital market. The stage saw the process of strengthening
of capital market through the establishment of a network of development
financial institutions such as IFCI (1948), ICICI (1955), IDBI and UTI (1964),
SFCs (during the fifties and sixties) and SIDCs (during the sixties and early
seventies). A number of important enactments covering the functioning of
different segments of capital market were legislated during this period.
These include: Capital Issues (Control) Act, 1947, Securities Contracts
(Regulation) Act, 1956 and Companies Act, 1956.
Development of an organized indigenous capital market was inhibited
in the initial years owing to a variety of factors as stated below:
1. Insignificant demand for long-term funds owing to weak industrial
base and low savings rate
2. Dependence of many foreign companies upon the London capital
market for raising funds rather than on the Indian capital market
3. Adverse consequences of the managing agency system, which
performed different functions of promotion, management and
underwriting of new capital issues
24 Capi tal Markets

4. Lukewarm interest shown by Indian corporates for mobilizing

capital through the instruments of shares and debentures from
capital market and more reliance of the industry on the bank
credit which offered credit at relatively lower (often subsidized)
rates of interest; and
5. Hazards of administered interest rate structure
N ew Iss ue s Stag e
This stage heralded the enactment of the Foreign Exchange Regulation Act
(FERA) between the period 1973 and 1980. Under this Act, shareholding of
foreign firms in joint ventures was restricted to 40 percent if the companies
wanted to be recognized as Indian companies. This period saw many well-
managed multinational companies offering their equities to the public at a
relatively low price. This encouraged a large number of domestic public
limited companies to come out with the offer of new capital issues for
public subscription. All these culminated in the stock market exhibiting an
upward trend with share prices displaying a high level of buoyancy. This
also created, for the first time, an awareness among the common investors
about the potential of equity investments as a hedge against inflation and
a source of higher earnings compared to the other forms of investments.
The SEBI Stage
This stage of development during the period between 1980 and 1992
brought about rapid changes in the Indian capital market. This period
marked a period of change, signifying the widening and deepening of the
market. Debenture emerged as a powerful instrument of resource
mobilization in the primary market. The public sector bonds, which came
to be introduced since 1985-86, imparted an additional dimension to the
market. The impressive growth witnessed in this stage was responsible
for bringing into existence a number of stock exchanges, phenomenal
increase in the listed companies with a quantum jump in their paid-up
capital and market capitalization. This signified a momentous growth in
the secondary market.
New financial services An important part of development under
this stage was the emergence of SEBI as an effective regulatory body to
set right many ailments afflicting the secondary and the primary markets
and afford a measure of protection to small investors. New financial services
such as credit rating, etc came to be introduced. Several credit rating
institutions such as CRISIL, CARE and ICRA were set up in order to help
investors make a right choice of investment. Similarly, Stock Holding
Corporation of India was set up to provide custodial services; IL&FS was
 Ca pi ta l Ma rket 25

set up to offer infrastructure financing and leasing services; and TDICI,

RCTC and TFCI were also constituted as specialized financial institutions.
The OTCEI was established to provide screen-based stock exchange
facility to investors. Similarly, mutual funds and venture capital fund/
companies were also set up.
Committees/Working groups An important part of growth during
this period was the constitution of a number of committees in order to
suggest measures to revamp and restructure the working of the secondary
market and cause buoyancy in the primary market so as to instil confidence
in the investing community. These included the following:
a. A Committee on Organization and Management of Stock
Exchange, 1986 under the chairmanship of Mr. G.S. Patel
b. A Working group on the Development of the Capital Market,
1989 under the chairmanship of Dr. Abid Hussain
c. A Study Group for Guidelines Relating to Valuation and New
Instruments, 1991 under the chairmanship of Mr. M.J. Pherwani
d. A High Powered Study Group on Establishment of New Stock
Exchanges, 1991 under the chairmanship Mr. M.J. Pherwani
e. A Committee on Trading in Public Sector Bonds and Units of
Mutual Funds, 1992 under the chairmanship of Mr. S.S. Nadkarni
A number of recommendations of the above committees were
implemented to help streamline the operations of the capital market.
However, this period witnessed one of the worst crises in the Indian capital
market with a major scam in securities breaking out. Large-scale irregularities
in securities transactions that took place in 1992 exposed the loopholes in
the existing systems and procedures of stock trading. This necessitated
the overhauling of the regulatory framework of the capital market for
preventing recurrence of such irregularities in the future. The Securities
and Exchange Board of India (SEBI) which was set up as a regulatory
body of the Indian securities market in 1988 was vested with statutory
powers for regulating capital market only in 1992 after the enactment of the
SEBI Act, 1992. Ever since its inception, SEBI has been focusing its attention
on policy-making, based on wider consultations through the mechanism
of a number of committees to examine the various aspects/segments of the
capital market.
The Structural Transformation
The structural transformation started taking place since1992. Many
technological innovations on par with the developed countries of the
world began to be introduced in the realm of trading operations in the
26 Capi tal Markets

Indian stock market. Some of the significant forces/happenings that were

responsible for the structural transformation were:
1. Financial sector liberalization, adoption of market oriented
approach and opening up of areas to private sector hitherto
reserved for the public sector
2. Computerized on-line trading and setting up of clearing houses/
corporations by most of the stock exchanges
3. Constitution of a depository to facilitate scripless trading
4. Overhauling and strengthening of regulatory structure of stock
exchanges with the establishment of SEBI
5. Permission to Indian companies to raise resources abroad
through the issue of Global Depository Receipts (GDRs) and
Foreign Currency Convertible Bonds (FCCBs) after obtaining
specific approval from the Government of India, since May 1992
6. Disinvestments by Government of its holding in public sector
undertakings commencing from 1992-93
7. Opening up of the market for portfolio investment by foreign
institutional investors and encouraging foreign private
participation in financial services including stock-broking
8. Restructuring of the corporate sector and increasing resort to
mergers and takeovers
9. Abolition of the Capital Issues Control along with setting up of
norms for information disclosure requirements, establishment of
regulations for various market intermediaries, prohibition of
insider trading and fraudulent practices and modernization of
stock exchanges
10. Global recessionary trend and portfolio diversification by the
international fund managers
11. Entry of new institutions like merchant banks, leasing and hire
purchase companies, venture capital funds/companies, etc and
greater participation of banks and financial institutions in capital
market related activities
12. Growth in saving of households backed by changing attitudes
and investing habits towards investment in shares
13. Introduction of innovative financial instruments such as
warrants, cumulative convertible preference shares and a host of
hybrid bonds/debentures
14. Measures initiated by the Government, SEBI and stock exchange
 Ca pi ta l Ma rket 27

authorities for protecting the interests of investors, i.e. setting up

of investor protection funds at the stock exchanges, restructuring
of various committees on the stock exchanges with larger
participation of public nominees of clearing corporations/houses
on the stock exchanges, making merchant bankers responsible for
the contents of offer documents and laying down the code of
conduct for market intermediaries including brokers/sub-brokers
SEBI issued separate set of guidelines for different categories of
intermediaries such as brokers/sub-brokers, merchant bankers, registrars to
issue, portfolio managers, under writers to issue, mutual funds, bankers to
issue, debenture trustees and venture capital funds/companies. Detailed
guidelines were issued by the SEBI for disclosure and investor protection in
respect of new issues and for regulation of insider trading and prohibition of
fraudulent and unfair trade practices.
CONSTITUENTS OF INDIAN CAPITAL MARKET
The Indian capital market is composed of the following:
1. The gilt-edged market
2. The industrial securities market
The constituents of the Indian Captial Market are shown in Exhibit 2.
Exhibit 2 Consti tuents of Indi an Capi tal Market

Gilt-edged Market
‘Gilt-edged Market’ also known as Government Securities market, is the
market for Government and semi-Government securities. An important
feature of the securities traded in this market is that they are stable in value
28 Capi tal Markets

and are much sought after by banks (as banks are obligated under the
Banking Regulations Act to maintain a proportion of total deposits in
Government securities).
Some of the special features of the gilt-edged market are as follows:
1. Guaranteed return on investments
2. No speculation in securities
3. Institutional based investors which are compelled by law to invest
a portion of their funds in these securities
4. Predominated by such institutions as LIC, GIC, the provident
funds and the commercial banks
5. Heavy volume of transactions necessitating negotiation of each
transaction
Industrial Securities Market
The market for industrial securities is known as ‘Industrial Securities
Market’. It offers an ideal market for corporate securities such as bonds
and equities. Industrial securities market comprises of the following
segments:
1. Primary market
2. Secondary market

Primary Market

Meaning Primary market also known as New Issues Market (NIM) is a

market for raising fresh capital in the form of shares and debentures. Cor-
porate enterprises, which are desirous of raising capital funds through the
issue of securities, approach the primary market. Issuers exchange finan-
cial securities for long-term funds. The primary market allows for the for-
mation of capital in the country and the accelerated industrial and eco-
nomic development.
M odes of r ai s in g c ap ita lFollowing are the popular ways by
which capital funds are raised in the primary market:
1. Public issue Where the securities are issued to the members of the
general public, it takes the form of ‘public issue’. It is the most popular
method of raising long-term funds.
2. Rights issue Where the issue of equity shares of a body corporate is
made to the existing shareholders as a pre-emptive right, it takes the form
of ‘rights issue’. Under this method, additional securities are offered for
subscription to the existing shareholders.
 Ca pi ta l Ma rket 29

3. Private placement Where the shares of a body corporate are sold to

a group of small investors, it takes the form of ‘private placement’.
The Secondary Market

Meaning A market, which deals in securities that have been already

issued by companies, is known as ‘the secondary market’. It is also called
the stock exchange or the share market.

Importance The importance of the secondary market springs from the

fact that it acts as the basis upon which rests the edifice of the primary
market. In other words, for the efficient growth of the primary market, a
sound secondary market is an essential requirement. This is because the
secondary market offers an important facility of transfer of securities.
Stock Exchanges
The activities of buying and selling of securities in a secondary market are
carried out through the mechanism of stock exchanges. Stock exchanges
form an integral part of the secondary market in India. There are at present
24 stock exchanges in India recognized by the government. They are
located at Mumbai, Calcutta, Delhi, Chennai, Ahmedabad, Bangalore,
Hyderabad, Indore, Pune, Kanpur, Cochin, Ludhiana, Mangalore, Patna,
Guwahati, Bhuwaneshwar, Jaipur, Saurashtra, Surat, Baroda, Coimbatore,
Rajkot and Meerut, and OTC Exchange of India and NSE at Mumbai.
In addition, there is also a ring-less and automated stock market
operating at the national level known as ‘Over the Counter Exchange of
India’ (OTCEI) which has been established to give a major fillip to the
capital market. The Exchange operates through a number of electronically
linked counters at different locations giving rise to a national trading
system. It aims at helping small and start-up companies to overcome the
problems of raising capital through a public issue at exorbitant cost. It also
helps investors to overcome the problems of illiquidity, inaccessibility,
delayed settlement and transfers that are abound with the traditional stock
exchanges.
NEW FINANCIAL INSTITUTIONS
A number of institutions of finance have been established to cater to the
credit requirements of various segments of the industry. A brief outline of
these institutions is presented below:
Venture Fund Institutions
An innovative financing scheme of providing funds for high risk and high
reward projects is called ‘Venture capital financing’. It is a form of equity
30 Capi tal Markets

financing designed specially for funding new and innovative project ideas.
Venture capital funds are instrumental in bringing into force the hi-
technology projects by assisting the research and development projects,
which are eventually converted into commercial production ventures. Many
specialized financial institutions have promoted their own venture capital
funds. These include Risk Capital Foundation of IFCI, Venture Fund of
IDBI, SIDBI, Technology Development and Infrastructure Corporation of
India (TDICI), and others.
Mutual Funds
Financial institutions that provide facilities for channeling savings of a
vast number of small investors into avenues of productive investments
are called ‘Mutual Funds’. A mutual fund company invests the funds
pooled from numerous small savers and thus gives them the benefit of
diversified investment portfolio and a reasonable return.
Through institutionalized mechanism, mutual funds offer collective
investment schemes providing benefits of diversified portfolio and expert
investment advice and management to a large number of investors.
Specialized financial institutions like LIC, UTI, etc besides commercial
banks such as SBI, Canara Bank etc are carrying out the business of
mutual funds. A wide range of benefits such as high return, easy liquidity,
safety and tax benefits to the investors are offered by mutual funds.
Factoring Institutions
An arrangement whereby a financial institution provides financial
accommodation on the basis of assignment/sale of accounts receivables
is known as ‘factoring’. Under this arrangement, the factoring institution
undertakes the task of collecting the book debts for and on behalf of its
clients. The concept of rendering financial services through factoring has
gained strong momentum in the advanced countries, like USA, UK etc.
Based on the recommendations of the Vaghul Committee and Shri
Kalyanasundaram Committee, the RBI initiated several measures to develop
factoring service. Accordingly, RBI along with Government of India, has
notified factoring as an eligible banking activity. Some of the factoring
institutions operating in India are SBI Factors and Commercial Services
Private Limited, a subsidiary of State Bank of India and CanBank Factors
Limited, a subsidiary of Canara Bank.
Credit Rating Institutions
There has been a long-felt need in India for such institutions which would
provide services of evaluating the credit-worthiness of traders and
 Ca pi ta l Ma rket 31

securities and issue rating grades indicative of the quality and soundness
of credit. The main purpose of credit rating is to provide guidance to
investors/creditors in determining the credit risk associated with a debt
instrument/credit obligation by an independent, professional and an
impartial institution. The credit rating institutions presently operating in
the country include Credit Rating Information and Services India Limited
(CRISIL), Investment Information and Credit Rating Agency of India
Limited (ICRA), Onida Information and Credit Rating Agency of India
Limited (ONICRA), Credit Analysis and Research Limited (CARE), etc.
Over-The-Counter Exchange of India (OTCEI)
The OTCEI was set up by a premier financial institution to allow the trading
of securities across the electronic counters throughout the country. It
addresses some specific problems of both investors and medium-sized
companies. Some of the greatest strengths of OTCEI are transparency of
transactions, quick deals, faster settlements and better liquidity.
National Stock Exchange of India Limited (NSEI)
NSEI was established under the Companies Act, 1956 on November 27,
1992 to function as a model stock exchange. The Exchange aims at providing
the advantage of nation-wide electronic screen based “scripless” and
“floorless” trading system in securities. The institution is expected to
allow for an efficient and transparent system of securities trading.
National Clearance and Depository System (NCDS)
Under the scripless trading system, settlement of transactions relating to
securities takes place through a book entry as against the physical exchange
of securities under the traditional system. The need for scripless trading
was felt on account of the anticipated unprecedented growth on the stock
market, contributing to a steep rise in the number of investors and the
growth of equity cult among the masses. Moreover, the present system of
physical transfer of securities and the registration is slowly becoming an
out-dated practice. The entire scripless trading system comprises the
following three segments:
a. National Trade Comparison and Reporting System which
prescribes the terms and conditions of contract for the securities
market
b. National Clearing System which aims at determining the net
cash and stock liability of each broker on a settlement date
32 Capi tal Markets

c. National Depository System which arranges to provide for the

transfer of ownership of securities in exchange on payment by
book entry on electronic ledgers without any physical movement
of transfer deed
National Securities Depositories Limited (NSDL)
The NSDL was set up in the year 1996 for achieving a time-bound
dematerialization as well as rematerialization of shares in accordance with
the Depositories Act, 1996. The establishment of NSDL is expected to
alleviate the problems of post-trade transactions in the secondary market.
Stock Holding Corporation of India Limited (SHCIL)
Set up on the basis of the recommendations of the Pherwani Committee,
the corporation aims at serving as a central securities depository in respect
of transactions on stock exchanges. The Corporation also takes up the
administration of clearing functions at a national level.
NEW FINANCIAL INSTRUMENTS
Indian capital market also witnessed a phenomenal growth in launching a
variety of new financial instruments. A brief description of some of the
newly introduced financial instruments is presented below:
Commercial Paper (CP)
A form of usance promissory note, which is negotiable by endorsement
and delivery, is known as Commercial Paper.
Certificate of Deposit (CD)
The CD is a document of title, similar to the deposit receipt issued by a
bank. There is no prescribed interest rate on such funds and therefore
banks have the freedom to issue it at a discount or at face value. Being a
bearer document, it is readily negotiable. It is beneficial both to the banker
and the investor.
Secured Premium Notes (SPN) with Attached Warrant
These are the bonds issued with a detachable warrant and are redeemable
after a notified period, say, 4 to 7 years. In the case of fully paid SPNs, the
warrants attached to them facilitate the holder, the right to apply and get
allotted equity shares.
Nonconvertible Debenture (NCD) with Detachable Equity Warrants
The equity warrants attached to this instrument allows its holder to buy a
specific number of shares from the company at a predetermined price
 Ca pi ta l Ma rket 33

within a definite framework. Warrants are issued where full payment of

NCDs value has been made. Where the option to apply for equities is not
exercised, the company will be at its liberty to dispose off the unapplied
portion of shares.
Zero Coupon Bonds
These are the bonds which bear no interest. In order to compensate the
loss of interest, they are issued at substantial discount from their eventual
maturity values.
Zero Interest Fully Convertible Debentures (FCD)
These instruments carry no interest. They are automatically and
compulsorily converted into shares after the expiry of a specified time
period as may be notified in the terms of issue.
Deep Discount Bonds
The bonds that are issued by corporates at very high discount and matured
at par value are Deep Discount Bonds.
St o c ki n v e s t
An arrangement whereby it is possible for an investor to apply for the
shares without having to pay for them and where the investor could make
payment for shares when allotted to him, through his banker is known as
‘stockinvest’. Under this mechanism, there is only a guarantee of
subscription and a banker makes payment only at the time of making
application for shares.
Equity Shares with Detachable Warrants
The holders of these shares are eligible to apply for a specified number of
shares at a predetermined price in future. Detachable warrants are separately
registered with the stock exchanges and traded separately.
‘Equipref’ Shares
These instruments are issued in two parts, Part A and Part B. Part A is
convertible into equity shares automatically and compulsorily on the date
of allotment without any further act or application by the allottee. Part B
will be redeemed at par/converted into equity shares after a lock-in-period
at the option of the investors.
Preference Shares with Warrants Attached
The holders of these shares are eligible to apply for equity shares for cash
at ‘premium’ at any time in one or more stages between the third and fifth
34 Capi tal Markets

year from the date of allotment.

Euro Issues
The securities that are issued by Indian companies and are traded in
European stock exchange are called ‘Euro Issues’. This has become an
important source of raising finance by Indian companies. Foreign investors
and NRIs are the main subscribers to these securities. The instruments
used as part of Euro Issue include Foreign Currency Convertible Bonds,
European Deposit Receipts, and Global Depository Receipts.
Non-voting Rights Shares
These are the shares that are issued by companies having good track
record, under the relevant provisions of the amended Companies Act.
Other Innovative Instruments
In addition to the above financial instruments that are issued by companies
in India, some of the other major innovative financial instruments floated
by the corporate entities include Money Market Mutual funds, Specialized
Mutual Funds, Nonvoting Shares, Floating Rate and Rating-sensitive
Notes, Commodity Linked bonds, Stripped debt securities, High yield
(junk) bonds, Exchange-traded options, Interest rate futures, Options or
futures contracts, foreign currency futures, Stock index futures, shelf
registration, Discount brokerage, Electronic funds transfer, Leveraged
buyouts, project finance, Secured zero interest Partly Convertible
Debentures (PCDs) with detachable and separately tradable warrants, Fully
Convertible Debentures (FCDs) with interest (optional), etc.
Specialized savings and investment institutions are catering to the
needs of a growing market. The proliferation of financial institutions and
instruments provides the saver with a wider choice of assets depending
upon his perception of risk, liquidity and yield, and has begun to impart a
measure of competition in the field of financial services.
CAPITAL MARKET DOLDRUMS
The developments in the Indian capital market is very typical in the sense
that they were marked by violent fluctuations. For example, amidst market
boom, a crash occurred in the stock market owing to the ‘Securities Scam’
during 1991-92.
The Indian capital market had been quite active during the eighties
and nineties as reflected from the increase in capital issues, the expansion
of the new issues market, the activity in the gilt-edged market and the
 Ca pi ta l Ma rket 35

growth of industrial securities market. However, many scamy developments

took place in the Indian capital market, which led to the current crisis
afflicting the capital market. For instance, during 1987-88, the stock exchange
literally crashed with the crash of Reliance shares. From 1988-89 onwards,
there was upward swing in the stock market, thanks to excellent
performance by market leaders, industry-friendly policies by successive
governments, such as liberalization of licensing procedures, liberal fiscal
measures, liberal and positive export-import policy and greater scope for
the private sector.
Harshad Factor
The Harshad factor played a crucial role in giving a much needed boost to
the stock market activities. In fact the stock market was booming under the
impact of bulls like Harshad Mehta during 1991-92, who flourished with
huge funds, the origin and magnitude not being known at that time. Later
on, it was found that the reason for the market ‘frenzy’ was created by the
Harshad factor through the manipulation of tremendous amount of funds,
which was made available to some brokers like Harshad Mehta and others.
These brokers along with some banks committed frauds through a new
mechanism known as the Bankers Receipts (BR). According to some rough
estimates, as much as Rs. 4,000 crores were placed at the disposal of the
brokers to play in the stock exchange. Unscrupulous brokers in the stock
exchange who colluded with some bank officials, violating the established
rules and guidelines, siphoned off these enormous sums of money. These
funds were diverted for speculative transactions in the stock market. These
irregularities and frauds came to be popularly called “securities scam”.
Measures of Rejuvenation
Time and again, a number of measures have come to be taken by the
government in order to reactivate and rejuvenate the capital market. Some
of the market-friendly measures introduced in the year 1992-93 budget
were the abolition of wealth tax, the reduction of long-term capital gains to
20 percent, free pricing of capital issues, permission to list the shares of
Public Sector Enterprises (PSEs), etc.
Role of SEBI
The regulation of the capital market was aimed at protecting the interest of
the investor against possible risks and frauds. For this purpose, SEBI
formulated a set of prudential guidelines to protect the interests of the
investor. Permission was given to the SEBI to monitor the functioning of
the securities market and the operations of intermediaries like mutual funds
36 Capi tal Markets

and merchant bankers. Efforts were also made by the SEBI to prohibit
insider trading.
MEASURES OF REACTIVATION
In the interest of the investing public and for the healthy development of
the capital market, following measures have been taken by the SEBI to
streamline and reactivate the stock market in India. These steps aimed at
achieving improved practices and greater transparency in the capital
market:
1. Periodical inspection of stock exchanges
2. Registration of intermediaries (registration being based on
certain eligibility norms such as capital adequacy, infrastructure,
etc) such as the stockbrokers and sub-brokers under the
provisions of the Securities and Exchange Board Act, 1992
3 . Guidelines and regulatory measures for capital issues for the
purpose of ensuring a healthy and efficient functioning of the
market
4. Compulsory requirement for companies to make material
disclosures about the risk factors in their offer documents
5. Mandatory rating of debt instruments
6. Vetting of offer documents to ensure due compliance of the
requirements of listing such as, that all disclosures have been
made by the company in the offer document when the application
for listing of securities is made to the stock exchange
7. Advertisement code for public issues so as to ensure fair and
truthful disclosures
8. Regulating registrars to new issues and share transfer agents
on matters concerning capital adequacy requirements, general
obligations and responsibilities, procedures for inspection and
action in case of default
9. Constitution of a panel in 1998 to suggest measures to revive
the secondary market with focus of attention on the need for
strong regulations, surveillance and investor education and
the need to have adequate insurance cover for the members of
the exchange. The committee made many suggestions to revive
the secondary market. For instance, the panel recommended
that Pension and Provident Funds should be allowed to invest
in the secondary market. For this purpose, some of the
institutions such as mutual funds, etc must be permitted to
float dedicated schemes in which the pension funds and
 Ca pi ta l Ma rket 37

provident funds could be invested. It was expected that when

these schemes invested the money in the securities market, it
would pave way for the development in the secondary market.
Moreover, pension funds could derive the benefit of the fund
management expertise and experience of the institutions
10. Expansion of the list of scrips eligible for compulsory
dematerialized trading by institutional investors
11. Implementation of the recommendations by the Government to
allow companies to buyback their shares through an amendment
of the Companies Act, 1956
12. Market-making to help simulate liquidity in a larger number of
scrips on the B2 group on the BSE
13. Granting permission to the stock exchanges to expand their
terminals, allowing for an efficient automated and integrated
system of functioning of stock exchanges throughout India
14. Constituting a Committee on Corporate Governance (CCG under
Kumar Mangalam Birla) with a view to focus attention on
enhancing shareholder value, while ensuring sufficient protection
to stakeholders like creditors and suppliers
15. Introducing a new system of dealing called ‘rolling settlement’
and convincing the institutional investors about the benefits of
moving to this mode of settlement
16. Introduction of new and innovative instruments of trade such as
‘derivatives’

MEASURES OF INVESTOR PROTECTION

The SEBI has initiated a number of measures in order to protect the
investors. These include: computerization of stock exchanges, expanding
the realm of dematerialization of shares, prescribing the capital adequacy
for brokers, application of the circuit breaker in stock exchanges in case of
wide fluctuations in prices, introducing and fine tuning the format of
quarterly results and other stringent measures. These measures are
expected to produce positive results in terms of transaction cost,
transparency, and investor confidence.
Towards enhancing and deepening the transparency of operations in
the capital market, the SEBI has taken a host of measures. These included:
introduction of net trading, implementation of the recommendations of the
Kumar Mangalam Birla report on corporate governance, K.B.Chandrasekhar
report on venture capital funds,etc permitting high net worth foreign
individuals and corporates to invest in stock markets under the FII route,
38 Capi tal Markets

allowing domestic mutual funds to manage foreign portfolios and a new

framework for accounting standards so as to accomplish universal
accounting practices.
SCR A
Stock exchanges are subject to Government supervision and control. The
regulation of the functions and working of stock exchanges in India have
been brought under the purview of the Securities Contracts (Regulation)
Act, which was passed in 1956. The regulations require that only those
stock exchanges which have been recognized by the Central Government,
be permitted to function in any notified State or area.
RECENT INITIATIVES IN THE INDIAN CAPITAL MARKET
During 2001-02, several changes were introduced in the settlement practices
in the capital markets, including extension of the rolling settlement on T+5
basis to all scrips. This is to be changed to T+2 rolling settlement system.
The risk management system for the stock exchanges was strengthened in
the aftermath of the irregularities in the securities market. The year also
witnessed major institutional changes for improving corporate governance
practices. The norms for issuance of shares in the primary market were
eased further in order to encourage companies to come out with public
issues. In the derivatives segment, the range of products was extended
further to include index options, stock options, and stock futures.
Primary Market
The Securities and Exchange Board of India (SEBI) amended the SEBI
(Disclosure and Investor Protection) Guidelines, 2000 to provide for the
inclusion of Foreign Venture Capital Investors (FVCIs) and State Industrial
Development Corporations (SIDCs) as Qualified Institutional Buyers (QIBs)
for participating in the book-building process. It also abolished the lock-in
period for the pre-issue share capital of an unlisted company held by
Venture Capital Funds (VCFs) and FVCIs, and removed the restriction of a
minimum issue size of Rs. 25 crores in case of an Initial Public Offer (IPO)
through book-building. The option to allocate the unsubscribed portion
of the fixed price portion in a book-building issue to any category or lapse
altogether was allowed. Buyback norms were relaxed by the Government
and the cooling-off period for a fresh issue of a security after buyback was
reduced to 6 months from 2 years.
Sec ondar y Mar ket
The SEBI extended compulsory rolling settlement on T+5 basis to 414
scrips w.e.f. July 2, 2001 and advised the stock exchanges to introduce
 Ca pi ta l Ma rket 39

uniform settlement cycle (Monday to Friday) in respect of remaining

securities. Rolling settlement on T+5 basis was extended to all scrips with
effect from January 2, 2002. The settlement cycle was shortened to T+3
effective April 1, 2002. This brings the securities settlement system in
India at par with international standards, in line with the recommendations
of the Report of the Joint Task Force of the Committee on Payments and
Settlement Systems (CPSS) and the International Organization of Securities
Commissions (IOSCO) on securities settlement systems.
Other reforms initiated by the SEBI included banning of all deferral
products, including badla; introduction of a market-wide circuit breaker
system applicable at three stages of the index movements and introduction
of 99 percent value-at-risk (VaR) based margin system for all scrips in the
compulsory rolling settlement with effect from July 2, 2001; and shifting of
the margining system from net basis to gross basis (sales and purchases)
with effect from September 3, 2001. In order to widen the equity derivatives
market, the SEBI permitted introduction of new derivative products. The
stock exchanges, accordingly commenced trading in index options in June
2001, followed by options on select securities in July 2001 and futures on
select securities in November 2001. The FIIs were also permitted to trade
in all exchange-traded derivative contracts subject to position limits
effective February 2002.
Initiatives were also taken to improve standards of corporate
governance, including amendment to listing agreements requiring the
companies to furnish segment-wise details of revenues, results and capital
employed along with quarterly unaudited results, etc. The SEBI issued
norms for speedy redressal of investors’ grievances and prescribed Model
Rules for stock exchanges to be implemented in phases. The SEBI advised
the stock exchanges to amend listing agreements requiring companies to
furnish statements and reports on their Electronic Data Information Filing
and Retrieval (EDIFAR) system.
The disclosure norms for mutual funds were tightened to help investors
take more informed investment decisions. The SEBI decided that mutual
funds should disclose the performance of benchmarks in case of various
types of equity-oriented, debt-oriented and balanced fund schemes while
publishing half-yearly results. Detailed investment and disclosure norms
for employees of Asset Management Companies (AMCs) and Trustee
Companies were laid down in order to avoid any actual or potential conflict
of interests. The SEBI prescribed that all mutual funds should enter into
transactions in Government securities only in dematerialized form. Mutual
funds were allowed to invest in the listed or unlisted securities or units of
40 Capi tal Markets

VCFs within the overall ceiling for such investments. To bring about
uniformity in the calculation of the Net Asset Value (NAV) of mutual fund
schemes, the SEBI issued guidelines for valuation of unlisted equity shares.
With a view to improving the professional standards, certification by the
Association of Mutual Funds of India (AMFI) was made mandatory for
the appointment of agents/ distributors by all mutual funds.

INDIAN CAPITAL MARKET—MAJOR ISSUES

The Indian Capital Market has, over a period of time, undergone rapid
structural transformation. During the last fifty years of 1947 to 1997, it
has evolved itself from a dormant segment of the financial system to a
highly active, dynamic, and volatile segment characterized by institutional
buildup, technological advancement and modernization. With the vast
and varied market reforms unleashed since 1992, primary market has
emerged as a major source of funding for the corporate entities both in
the public and private sectors and the secondary market has modernized
itself through advanced technology and transparent trading practices.
The Development Financial Institutions (DFIs) have also played a crucial
role in meeting long-term credit needs of the industrial sector.
In spite of the fact that the Indian capital market has made a marvellous
dent both in primary as well as secondary markets, there are very many
issues, which require immediate and urgent attention of the authorities
concerned. There are many problems relating to investor protection,
consolidation, integration with other market segments, product innovation
and technology, etc which often come in the way of its efficient functioning.
The major issues confronting the Indian capital market are briefly presented
below:
Investor Protection
Investors constitute the pillars of the capital market. It is imperative that
adequate protection is provided to them. This is of paramount importance.
However, investors have been facing serious problems in view of the
continuing market disturbances arising out of unscrupulous practices
followed by many companies and market intermediaries. Some of the popular
problems that are being faced by investors are as follows:
1. Vanishing companies Certain companies raised funds after taking
advantage of market buoyancy and then desert investors as has happened
in 1985-86. This menace of vanishing companies still haunts investors and
has affected their psyche very much.
2. Lack of commitment The incredibly lack of commitment shown by
 Ca pi ta l Ma rket 41

financial institutions and underwriters regarding the avoidance of project

appraisal during the post-issue period in relation to mega issues in the
eighties has considerably shaken the confidence of the investors. Inability
of many of the corporates to keep up their promises, which are given at the
time of issue, particularly after removal of capital issues control also
contributes to retardation of Indian capital market.
3. Stock scams Series of share market scams arising out of irregularities
in securities transactions in 1992-93, wrongful disclosures as in 1994-95
and share-switching episode of 1995-96 have all exposed the vulnerability
of the Indian capital market.
4. Malaises like share price rigging and insider trading continue to
afflict the Indian capital market, affecting the investors adversely.
5. L a c k o f n e c e s s a r y p r o f e s s i o n a l e x p e r ti s e and integrity
on the part of merchant bankers and other market intermediaries. In many
cases merchant bankers act hand-in-glove with companies to attract the
gullible investors.
6. Th e de fa ul ts c om mi tted b y so me b ro ke rs in different stock
exchanges have also adversely affected the confidence of investors
causing occasional suspension of trading.
7. M ul ti p l i c i ty o f th e n um b er o f i n v e s to r c o m p l a i n ts with
the SEBI, the Department of Company Affairs (DCA) and the stock
exchange authorities.
As a step towards overcoming many of the woes of investors, it is
essential to pay attention to the following:
a. Coordinated approach to attend to investor complaints
b. Introduction of complete transparency in transactions. Such a
step, under the changed environment, would enable companies
to raise resources from the capital market easily, besides inspiring
the confidence of the investors
c. Evolving a system of dissemination of information to a large
number of investors as possible that influences the valuation of
securities at the earliest. For this purpose, stock exchanges have
to upgrade themselves to play their self-regulatory role more
effectively; the members of stock exchanges should conform to
the just and equitable principles of conduct embodied in
exchanges’ rules
Integration of Stock Exchanges
The sheer size of the Indian capital market in terms of number of stock
exchanges (24) etc requires the immediate attention of the policy
42 Capi tal Markets

formulators. This is essential in the light of the massive expansion of

capital market activities particularly during the eighties and nineties. An
answer for this problem could be found in the issue of consolidation.
Efforts must be made to reduce the number and provide interconnectivity
between all stock exchanges in the country. In this connection, the steps
taken by the NSE are laudable. More than 100 cities and other major stock
exchanges are in the process of extending their trading terminals outside
their places of operation under the umbrella of NSE. Although the vast
size of the country, the regional loyalty of companies, etc might warrant
the size of such a magnitude, it is incumbent on the part of the planners to
stem the stock market of many ailments faced by it.
Efforts must be made on a continuous basis to consolidate and merge
the existing stock exchanges rather than to set up new ones as has
happened in the UK. For example, in the late sixties there were about 20
stock exchanges that got reduced to about half a dozen in 1972 and further
down to a single entity, viz. The London Stock Exchange in 1986. Although,
many new stock markets are being set up in Europe for small fast-growing
companies, such attempts in India in the form of OTCEI have not, however,
been successful.
National Stock Market System
An important issue that needs to be addressed when it comes to tackling
the issue of size and the number of stock exchanges is to have an ‘integrated
stock exchange system’. Accordingly, all the existing stock exchanges in
India will have to be federated to a single entity at the national level. It is
a matter of great satisfaction that recently the Federation of Indian Stock
Exchanges (FISE) has been formed by 12 regional stock exchanges. A
body known as ‘Indian Stock Exchanges Services Corporation’ (ISESC)
has been set up as a central trading system to provide the facility of
interconnectivity. If the efforts of constituting FISE succeed, there will be
three entities with a national stature, viz. NSE, BSE, and ISESC. Such an
arrangement of nation-wide integrated stock marketing would help
enhancing liquidity, improving market efficiency besides reducing
transaction costs.
Efforts must also be made to develop a uniform settlement cycle and
a common clearing system across the bourses. Such a measure will bring
an end to unnecessary speculation at the bourses based on arbitrage
opportunities. Further, there is a pressing need for drawing up a uniform
framework for rules, regulations and byelaws for stock exchanges. In this
connection, SEBI has constituted a Committee under the Chairmanship of
 Ca pi ta l Ma rket 43

Mr. M.R. Mayya to work out a blueprint in the matter.

Science and Technology
The developments that are taking place in the realm of science and
technology have totally revolutionized the way trading used to be taking
place in stock markets. The availability and the power of computers have
probably made more impact on the securities business than in any other
industry. Adoption of the state-of-art technology by the stock exchanges
in the developed markets has not only changed the functioning of the
stock exchanges but also enabled product innovation in terms of
introduction of trading of options/futures. Technological innovations have
helped bring about the speed in the execution of orders and also to the
efficiency of prudential control. The information technology has facilitated
prudent use of the investment tool. Besides, information technology and
its sophisticated application have come to make all the difference when it
comes to the question of managing risks in the market place.
Derivative Instruments
Derivative instruments help in deepening of the capital markets by
providing for risk hedging and guarded speculation. With a larger size of
market, India commands the advantage of clearing houses/corporations
and depository system, which are essential conditions for introducing
derivatives. Although derivatives trading is considerably more complex to
understand because of the fact that the pay offs and the risks that buyers
and sellers face, and the economic theory that is used for pricing derivatives
are difficult to comprehend than the cash market, it offers an excellent
opportunity for an efficient, profitable, and sound stock trading.
In order to put in place a speedy, efficient and safe payments system
as part of the technological revolution in stock markets, RBI has introduced
the Electronic Fund Transfer System and connect all the important
institutions of the financial sector through VSAT system to improve the
payment arrangements and systems.
With the kind and the quality of human skills possessed by India’s
financial industry, it is quite imperative that there is a need to provide
sound capital foundation for the derivatives market. However, the derivative
trading is not a panacea for all that ails the Indian stock market if the recent
experience of some of corporates and banks abroad is of any indication. It
is to be noted with happiness that the Government of India has successfully
introduced the derivative trading in the stock exchanges.
Integration of Capital Market
44 Capi tal Markets

In order that the capital market thrives well, it is important that it gets itself
integrated with other segments of the financial system. Such an integration
would lead to reduction of speculative movements of funds that may
occur due to arbitrage that market segmentation offers. This in turn will
ensure efficient financial intermediation and optimal resource allocation.
The borderlines between different market segments are fast getting
obliterated in view of the rapid and varied developments taking place in
the realm of capital market. With banks being allowed greater flexibility so
far as their investment activities are concerned, the traditional wall between
banks and securities market is getting eliminated. Moreover, as banks are
increasingly providing long-term loans, they enter capital market to raise
resources through equity capital and subordinated debts. Similarly, the
development financial institutions (DFIs) are also allowed to lend in money
market and borrow in the notice money market segment. The distinction
between the banks and DFIs is getting thinner and the DFIs are facing
increasing competition from the banks so far as long-term funding is
concerned. Banks have also been permitted to diversify into capital market
activities by setting up of mutual funds.
REBOUND IN INDIAN CAPITAL MARKET
Although Indian capital market suffered bruises in the last part of the
nineties owing to the manipulative trade practices of unscrupulous brokers
and other participants, it has been witnessing fine times in the recent past,
thanks to many favorable conditions contributing to it. Some of the factors
that are responsible for this phenomenon are as follows:
1. Strong macroeconomic aggregates
2. Active participation of retail investors with renewed vigor
3. Active FII buying
4. Active Indian Institutional Investor (III) buying
5. Favorable corporate and sovereign ratings by leading credit rating
agencies like S & P, Moody’s, etc
6. Strong foreign exchange reserve position
7. Strong fundamentals of basic and other industrial segments such as
steel, FMCGs, IT, etc
8. Favorable monsoons fuelling adequate demand for goods and
services in the economy
9. Favorable political conditions
10. Forecasts of better prospects in future
 Ca pi ta l Ma rket 45

REVIEW QUESTIONS

Section A
1. Define the term ‘capital market’?
2. What is a money market?
3. Mention the characteristics of a money market
4. Who are the participants of in a capital market?
5. Where is a capital market located?
6. What are ‘working groups’ associated with the Indian capital
market?
7. What is a ‘Gilt-edged market’?
8. What is industrial securities market?
9. State the components of industrial securities market
10. What is a primary market?
11. What are the different modes by funds are raised in a primary
market?
12. What is a secondary market?
13. State the importance of a secondary market
14. What is a stock exchange?
15. What are venture capital institutions?
16. What are mutual funds?
17. What are factoring institutions?
18. What are credit rating institutions?
19. What is an ‘OTCEI’?
20. Write a note on the National Clearance and depository System
21. What is NSDL?
22. What is a ‘Certificate of Deposit’ (CD)?
23. What are ‘zero coupon bonds’?
24. What are ‘deep discount bonds’?
25. What is a stockinvest?
26. What are ‘equipref’ shares?
27. What are ‘Euro issues’?
28. Write a note on the ‘Harshad Factor’
Section B
1. What are the functions of a capital market?
2. Identify some of the important forces that were responsible for
the structural transformation of the Indian capital market
3. Mention the new financial institutions that have come up in the
Indian capital market.
4. Bring out the measures of rejuvenation and reactivation
46 Capi tal Markets

undertaken by the SEBI in recent times

5. Identify the factors that have caused rebound in the Indian capital
market in the recent past
Secti on C
1. Trace the development and the growth of the Indian capital market
2. Discuss the constituents of the Indian capital market
3. Give an account of the various types of financial instruments
that are used in the Indian capital market
4. What are the recent initiatives taken by the SEBI as part of
revamping the Indian capital market?
5. What are the major issues confronting the Indian capital market?
Discuss
 Chapter 3

Capital Market Instruments

The changes that are sweeping across the Indian capital market especially
in the recent past are something phenomenal. It has been experiencing
metamorphic changes in the last decade, thanks to a host of measures of
liberalization, globalization, and privatization that have been initiated by
the Government. Pronounced changes have occurred in the realm of
industrial policy, licensing policy, financial services industry, interest rates,
etc. The competition has become very intense and real in both industrial
sector and financial services industry.
As a result of these changes, the financial services industry has come
to introduce a number of instruments with a view to facilitate borrowing
and lending of money in the capital market.
MEANING
Financial instruments that are used for raising capital resources in the
capital market are known as ‘Capital Market Instruments’.
TYPES
The various capital market instruments used by corporate entities for
raising resources are as follows:
1. Preference shares
2. Equity shares
3. Non-voting equity shares
4. Cumulative convertible preference shares
5. Company fixed deposits
6. Warrants
7. Debentures and Bonds
PREFERENCE SHARES

Meaning
Shares that carry preferential rights in comparison with ordinary shares
are called ‘Preference Shares’. The preferential rights are the rights
48 Capi tal Markets

regarding payment of dividend and the distribution of the assets of the

company in the event of its winding up, in preference to equity shares.
Types
1. Cumulative preference shares Shares where the arrears of dividends
in times of no and/or lean profits can be accumulated and paid in the year
in which the company earns good profits.
2. Non-cumulative preference shares Shares where the carry forward
of the arrears of dividends is not possible.
3. Participating preference shares Shares that enjoy the right to
participate in surplus profits or surplus assets on the liquidation of a
company or in both, if the Articles of Association provides for it.
4. Redeemable preference shares Shares that are to be repaid at
the end of the term of issue, the maximum period of a redemption being 20
years with effect from 1.3.1997 under the Companies Amendment Act,
1996. Since they are repayable, they are similar to debentures. Only fully
paid shares are redeemed. Where redemption is made out of profits, a
Capital Redemption Reserve Account is opened to which a sum equal to
the nominal value of the shares redeemed is transferred. It is treated as
paid-up share capital of the company.
5 . F ul l y c o n v e r ti b l e c um ul a ti v e p r e f e r e n c e s h a r e s Shares
comprise two parts viz., Part A and B. Part A is convertible into equity
shares automatically and compulsorily on the date of allotment. Part B will
be redeemed at par/converted into equity shares after a lock-in period at
the option of the investor, conversion into equity shares taking place after
the lock-in period, at a price, which would be 30 percent lower than the
average market price. The average market price shall be the average of the
monthly high and low price of the shares in a stock exchange over a period
of 6 months including the month in which the conversion takes place.
6 . P r e f e r e n c e s h a r e s wi th w a r r a n ts a tta c h e d The attached
warrants entitle the holder to apply for equity shares for cash, at a
‘premium’, at any time, in one or more stages between the third and fifth
year from the date of allotment. If the warrant holder fails to exercise his
option, the unsubscribed portion will lapse. The holders of warrants would
be entitled to all rights/bonus shares that may be issued by the company.
The preference shares with warrants attached would not be transferred/
sold for a period of 3 years from the date of allotment.
 Capi t al Market Instruments 49

EQUITY SHARES

Meaning
Equity shares, also known as ‘ordinary shares’ are the shares held by the
owners of a corporate entity.
F e a tu r e s
Since equity shareholders face greater risks and have no specific preferential
rights, they are given larger share in profits through higher dividends than
those given to preference shareholders, provided the company’s
performance is excellent. Directors declare no dividends in case there are
no profits or the profits do not justify dividend for previous years even
when the company makes substantial profits in subsequent years. Equity
shareholders also enjoy the benefit of ploughing back of undistributed
profits kept as reserves and surplus for the purposes of business expansion.
Often, part of these is distributed to them as bonus shares. Such bonus
shares are entitled to a proportionate or full dividend in the succeeding
year.
A strikingly noteworthy feature of equity shares is that holders of
these shares enjoy substantial rights in the corporate democracy, namely
the rights to approve the company’s annual accounts, declaration of
dividend, enhancement of managerial remuneration in excess of specified
limits and fixing the terms of appointment and election of directors,
appointment of auditors and fixing of their remuneration, amendments to
the Articles and Memorandum of Association, increase of share capital
and issue of further shares or debentures, proposals for mergers and
reconstruction, and any other important proposal on which member’s
approval is required under the Companies Act.
Equity shares in the hands of shareholders are mainly reckoned for
determining the management’s control over the company. Where
shareholders are widely disbursed, it is possible for the management to
retain the control, as it is not possible for all the shareholders to attend the
company’s meeting in full strength. Furthermore, the management group
can bolster its controlling power by acquiring further shares in the open
market or otherwise. Equity shares may also be offered to financial
institutions as part of the private placement exercise. Such a method,
however, is fraught with the danger of takeover attempt by financial
institutions.
Equity shareholders represent proportionate ownership in a company.
They have residual claims on the assets and profits of the company. They
50 Capi tal Markets

have unlimited potential for dividend payments and price appreciation in

comparison to the owners of debentures and preference shares who enjoy
just a fixed assured return in the form of interest and dividend. Higher the
risk, higher the return and vice-versa.
Share certificates either in physical form or in the demat (with the
introduction of depository system in 1996) form are issued as a proof of
ownership of the shares in a company. Demat facilitates electronic trading.
Fully paid equity shares with detachable warrants entitle the warrant holder
to apply for a specified number of shares at a determined price. Detachable
warrants are separately registered with stock exchanges and traded
separately. The company would determine the terms and conditions
relating to the issue of equity against warrants.
Voting rights are granted under the Companies Act (Sections 87 to 89)
wherein each shareholder is eligible for votes proportionate to the number
of shares held or the amount of stock owned. A company cannot issue
shares carrying disproportionate voting rights. Similarly, voting right
cannot be exercised in respect of shares on which the shareholder owes
some money to the company.
Capital
Equity shares are of different types. The maximum value of shares as
specified in the Memorandum of Association of the company is called the
authorized or registered or nominal capital. Issued capital is the nominal
value of shares offered for public subscription. In case shares offered for
public subscription are not taken up, the portion of capital subscribed is
called subscribed capital. This is less than the issued capital. Paid-up
capital is the share capital paid-up by shareowners which is credited as
paid-up on the shares.
Par Value and Book Value
The face value of a share is called its Par value. Although shares can be
sold below the par value, it is possible that shares can be issued below the
par value. The financial institutions that convert their unpaid principal
and interest into equity in sick companies are compelled to do it at a
minimum of Rs.10 because of the par value concept even though the
market price might be much less than Rs.10. Par value can also lead to
unhealthy practices like price rigging by promoters of sick companies to
take market prices above Rs.10 to get their new offers subscribed.
Par value is of use to the regulatory agency and the stock exchange.
It can be used to control the number of shares that can be issued by the
 Capi t al Market Instruments 51

company. The par value of Rs.10 per share serves as a floor price for issue
of shares.
Book value is the intrinsic value of a share that is calculated to reflect
the networth of the shareholders of a corporate entity.
Cash Divid ends
These are dividends paid in cash. A stable payment of cash dividend is
the hallmark of stability of share prices.
Stock Dividends
These are the dividends distributed as shares and issued by capitalizing
reserves. While networth remains the same in the balance sheet, its
distribution between shares and surplus is altered.
NON-VOTING EQUITY SHARES
Consequent to the recommendations of the ‘Abid Hussain Committee’
and subsequent to the amendment to the Companies Act, corporate
managements are permitted to mobilize additional capital without diluting
the interest of existing shareholders with the help of a new instrument
called ‘non-voting equity shares’. Such shares will be entitled to all the
benefits except the right to vote in general meetings. Such non-voting
equity share is being considered as a possible addition to the two classes
of share capital currently in vogue. This class of shares has been included
by an amendment to the Companies Act as a third category of shares.
Corporates will be permitted to issue such shares upto a certain percentage
of the total share capital.
Non-voting equity shares will be entitled to rights and bonus issues
and preferential offer of shares on the same lines as that of ordinary shares.
The objective will be to compensate the sacrifice made for the voting
rights. For this purpose, these shares will carry higher dividend rate than
that of voting shares. If a company fails to pay dividend, non-voting
shareholders will automatically be entitled to voting rights on a prorata
basis until the company resumes paying dividend.
The mechanism of issue of non-voting shares is expected to overcome
such problems as are associated with the voting shares as that the ordinary
investors are more inclined towards high return on capital through sizeable
dividends and capital appreciation through the issue of bonus shares and
the inability of corporates to respond to the investors’ just aspiration for
reasonable dividends. Moreover, there is every need for corporates to
spend huge sums of money on a variety of not-so-useful items including
colorful and costly annual reports. For all these above-mentioned reasons,
52 Capi tal Markets

non-voting equity shares are expected to have a ready and popular market.
In effect, this kind of share is similar to preference shares with regard to
non-voting rights but may get the advantage of higher dividends as well
as appreciation in share values through entitlement to bonus shares which
is not available to preference shares.
CONVERTIBLE CUMULATIVE PREFERENCE SHARES (CCPS)
These are the shares that have the twin advantage of accumulation of
arrears of dividends and the conversion into equity shares. Such shares
would have to be of the face value of Rs.100 each. The shares have to be
listed on one or more stock exchanges in the country. The object of the
issue of CCP shares is to allow for the setting up of new projects, expansion
or diversification of existing projects, normal capital expenditure for
modernization and for meeting working capital requirements.
Following are some of the terms and conditions of the issue of CCP
shares:
• Debt-equity ratio For the purpose of calculation of debt-equity
ratio as may be applicable CCPS are be deemed to be an equity
issue.
• Compulsory conversion The conversion into equity shares
must be for the entire issue of CCP shares and shall be done
between the periods at the end of three years and five years as
may be decided by the company. This implies that the conversion
of the CCP into equity shares would be compulsory at the end of
five years and the aforesaid preference shares would not be
redeemable at any stage.
• Fresh issue The conversion of CCP shares into equity would
be deemed as being one resulting from the process of redemption
of the preference shares out of the proceeds of a fresh issue of
shares made for the purposes of redemption.
• Preference dividend The rate of preference dividend payable
on CCP shares would be 10 percent.
• Guideline ratio The guideline ratio of 1:3 as between preference
shares and equity shares would not be applicable to these shares.
• Arrears of dividend The right to receive arrears of dividend
up to the date of conversion, if any, shall devolve on the holder
of the equity shares on such conversion. The holder of the equity
shares shall be entitled to receive the arrears of dividend as and
when the company makes profit and is able to declare such
dividend.
 Capi t al Market Instruments 53

• Voting right CCPS would have voting rights as applicable to

preference shares under the Companies Act, 1956.
• Quantum The amount of the issue of CCP shares would be to
the extent the company would be offering equity shares to the
public for subscription.

COMPANY FIXED DEPOSITS

Fixed deposits are the attractive source of short-term capital both for the
companies and investors as well. Corporates favor fixed deposits as an ideal
form of working capital mobilization without going through the process of
mortgaging assets and the associated rigmaroles of documentation, etc.
Investors find fixed deposits a simple avenue for investment in popular
companies at attractively reasonable and safe interest rates. Moreover,
investors are relieved of the problem of the hassles of market value fluctuation
to which instruments such as shares and debentures are exposed. There are
no transfer formalities either. In addition, it is quite possible for investors to
have the option of premature repayment after 6 months, although such an
option entails some interest loss.
Re gu latio ns
Since these instruments are unsecured, there is a lot of uncertainty about
the repayment of deposits and regular payment of interest. The issue of
fixed deposits is subject to the provisions of the Companies Act and the
Companies (Acceptance of Deposits) Rules introduced in February 1975.
Some of the important regulations in this regard as follows:
a. Advertisement Issue of an advertisement (with the prescribed
information) as approved by the Board of Directors in dailies
circulating in the state of incorporation.
b. Liquid assets Maintenance of liquid assets equal to 15 percent
(substituted for 10% by Amendment Rules, 1992) of deposits
(maturing during the year ending March 31) in the form of bank
deposits, unencumbered securities of State and Central
Governments or unencumbered approved securities.
c. Disclosure Disclosure in the newspaper advertisement the
quantum of deposits remaining unpaid after maturity. This would
help highlight the defaults, if any, by the company and caution
the depositors.
d. Deemed public company Private company would become a
deemed public company (From June 1998, Section 43A of the
Act) where such a private company, after inviting public deposits
54 Capi tal Markets

through a statutory advertisement, accepts or renews deposits

from the public other than its members, directors or their relatives.
This provision, to a certain extent, enjoins better accountability
on the part of the management and auditors.
e. Default Penalty under the law for default by companies in
repaying deposits as and when they mature for payment where
deposits were accepted in accordance with the Reserve Bank
directions.
f. CLB Empowerment to the Company Law Board to direct
companies to repay deposits, which have not been repaid as per
the terms and conditions governing such deposits, within a time
frame and according to the terms and conditions of the order.

WARRANTS
An option issued by a company whereby the buyer is granted the right to
purchase a number of shares (usually one) of its equity share capital at a
given exercise price during a given period is called a ‘warrant’. Although
trading in warrants are in vogue in the U.S. Stock markets for more than 6
to 7 decades, they are being issued to meet a range of financial requirements
by the Indian corporates.
A security issued by a company, granting its holder the right to
purchase a specified number of shares, at a specified price, any time prior
to an expirable date is known as a ‘warrant’. Warrants may be issued with
either debentures or equity shares. They clearly specify the number of
shares entitled, the expiration date, along with the stated/exercise price.
The expiration date of warrants in USA is generally 5 to 10 years from the
date of issue and the exercise price is 10 to 30 percent above the prevailing
market price. Warrants have a secondary market. The exchange value
between the share at its current price and the shares to be purchased at
the exercise price represents the minimum value of a warrant. They have
no floatation costs and when they are exercised, the firm receives additional
funds at a price lower than the current market, yet higher than those
prevailing at the time of issue. Warrants are issued by new/growing firms
and venture capitalists. They are also issued during mergers and
acquisitions. Warrants in the Indian context are called ‘sweeteners’ and
were issued by a few Indian companies since 1993.
Both warrants and rights entitle a buyer to acquire equity shares of
the issuing company. However, they are different in the sense that warrants
have a life span of three to five years whereas, rights have a life span of
only four to twelve weeks (duration between the opening and closing date
 Capi t al Market Instruments 55

of subscription list). Moreover, rights are normally issued to effect current

financing, and warrants are sold to facilitate future financing. Similarly, the
exercise price of warrant, i.e. the price at which it can be exchanged for
share, is usually above the market price of the share so as to encourage
existing shareholders to purchase it. On the other hand, one warrant buys
one equity share generally, whereas more than one rights may be needed
to buy one share. The detachable warrant attached to each share provides
a right to the warrant holder to apply for additional equity share against
each warrant.
DEBENTURES AND BONDS
A document that either creates a debt or acknowledges it is known as a
debenture. Accordingly, any document that fulfills either of these
conditions is a debenture. A debenture, issued under the common seal of
the company, usually takes the form of a certificate that acknowledges
indebtedness of the company.
A document that shows on the face of it that a company has borrowed
a sum of money from the holder thereof upon certain terms and conditions
is called a debenture. Debentures may be secured by way of fixed or
floating charges on the assets of the company. These are the instruments
that are generally used for raising long-term debt capital.
F e a tu r e s
Following are the features of a debenture:
1. Issue In India, debentures of various kinds are issued by the corporate
bodies, Government, and others as per the provisions of the Companies
Act, 1956 and under the regulations of the SEBI. Section 117 of the
Companies Act prohibits issue of debentures with voting rights. Generally,
they are issued against a charge on the assets of the company but at times
may be issued without any such charge also. Debentures can be issued at
a discount in which case, the relevant particulars are to be filed with the
Registrar of Companies.
2. Negotiability In the case of bearer debentures the terminal value is
payable to its bearer. Such instruments are negotiable and are transferable
by delivery. Registered debentures are payable to the registered holder
whose name appears both on the debenture and in the register of debenture
holders maintained by the company. Further, transfer of such debentures
should be registered. They are not negotiable instruments and contain a
commitment to pay the principal and interest.
56 Capi tal Markets

3. Security Secured debentures create a charge on the assets of the

company. Such a charge may be either fixed or floating. Debentures that
are issued without any charge on assets of the company are called
‘unsecured or naked debentures’.
4. Duration Debentures, which could be redeemed after a certain period
of time are called Redeemable Debentures. There are debentures that are
not to be returned except at the time of winding up of the company. Such
debentures are called Irredeemable Debentures.
5. Convertibility Where the debenture issue gives the option of
conversion into equity shares after the expiry of a certain period of time,
such debentures are called Convertible Debentures. Non-convertible
Debentures, on the other hand, do not have such an exchange facility.
6. Return Debentures have a great advantage in them in that they carry
a regular and reasonable income for the holders. There is a legal obligation
for the company to make payment of interest on debentures whether or
not any profits are earned by it.
7. Claims Debenture holders command a preferential treatment in the
matters of distribution of the final proceeds of the company at the time of
its winding up. Their claims rank prior to the claims of preference and
equity shareholders.
Kinds
Innovative debt instruments that are issued by the public limited companies
in India are described below:
1. Participating debentures
2. Convertible debentures
3. Debt-equity swaps
4. Zero-coupon convertible notes
5. Secured premium notes (SNP) with detachable warrants
6. Non-convertible debentures (NCDs) with detachable equity
warrant
7. Zero-interest fully convertible debentures (FCDs)
8. Secured zero-interest partly convertible debentures (PCDs) with
detachable and separately tradable warrants
9. Fully convertible debentures (FCDs) with interest (optional)
10. Floating rate bonds (FRB)
 Capi t al Market Instruments 57

1. Participating debentures Debentures that are issued by a body

corporate which entitle the holders to participate in its profits are
called ‘Participating Debentures’. These are the unsecured corporate
debt securities. They are popular among existing dividend paying
corporates.
2. Convertible debentures
a. Convertible debentures with options are a derivative of
convertible debentures that give an option to both the issuer, as
well as the investor, to exit from the terms of the issue. The coupon
rate is specified at the time of issue.
b. Third party convertible debentures are debts with a warrant
that allow the investor to subscribe to the equity of a third firm at
a preferential price vis-à-vis market price, the interest rate on the
third party convertible debentures being lower than pure debt on
account of the conversion option.
c. Convertible debentures redeemable at a premium are issued
at face value with a put option entitling investors to sell the bond
to the issuer, at a premium later on. They are basically similar to
convertible debentures but have less risk.
3. Debt-equity swaps They are offered from an issuer of debt to swap
it for equity. The instrument is quite risky for the investor because the
anticipated capital appreciation may not materialize.
4. Zero-coupon convertible note These are debentures that can be
converted into shares and on its conversion the investor forgoes all
accrued and unpaid interest. The zero-coupon convertible notes are
quite sensitive to changes in the interest rates.
5. SPN with detachable warrants These are the Secured Premium
Notes (SPN) with detachable warrants. These are the redeemable
debentures that are issued along with a detachable warrant. The warrant
entitles the holder to apply and get equity shares allotted, provided
the SPN is fully paid. The warrants attached to it assure the holder
such a right. No interest will be paid during the lock-in period for SPN.
The SPN holder has an option to sell back the SPN to the company
at par value after the lock-in period. If this option is exercised by the
holder, no interest/premium will be paid on redemption. The holder
will be repaid the principal and the additional interest/premium amount
in instalments as may be decided by the company. The conversion of
detachable warrant into equity shares will have to be done within the
time limit notified by the company.
58 Capi tal Markets

6. NCDs with detachable equity warrants These are Non-convertible

debentures (NCDs) with detachable equity warrants. These entitle
the holder to buy a specific number of shares from the company at a
pre-determined price within a definite time frame. The warrants
attached to NCDs are issued subject to full payment of the NCDs’
value. The option can be exercised after the specific lock-in period.
The company is at liberty to dispose off the unapplied portion of
shares if the option to apply for equities is not exercised.
7. Zero interest FCDs These are Zero-interest Fully Convertible
Debentures on which no interest will be paid by the issuer during the
lock-in period. However, there is a notified period after which fully
paid FCDs will be automatically and compulsorily converted into
shares. In the event of a company going in for rights issue prior to the
allotment of equity (resulting from the conversion of equity shares
into FCDs), it shall do so only after the FCD holders are offered
securities.
8. Secured zero interest PCDs with detachable and separately tradable
warrants These are Secured Zero Interest Partly Convertible
Debentures with detachable and separately tradable warrants. They
are issued in two parts. Part A is a convertible portion that allows
equity shares to be exchanged for debentures at a fixed amount on
the date of allotment. Part B is a non-convertible portion to be redeemed
at par at the end of a specific period from the date of allotment. Part B
which carries a detachable and separately tradable warrant provides
the warrant holder an option to receive equity shares for every warrant
held, at a price worked out by the company.
9. Fully convertible debentures (FCDs) with interest (Optional) These
are the debentures that will not yield any interest for an initial short
period after which the holder is given an option to apply for equities
at a premium. No additional amount needs to be paid for this. The
option has to be indicated in the application form itself. Interest on
FCDs is payable at a determined rate from the date of first conversion
to the date of second/final conversion and in lieu of it, equity shares
will be issued.
10. Floating rate bonds (FRBs) These are the bonds where the yield
is linked to a benchmark interest rate like the prime rate in USA or
LIBOR in the Euro currency market. For instance, the State Bank of
India’s floating rate bond, issue was linked to the maximum interest
on term deposits that was 10 percent at that time. The floating rate is
quoted in terms of a margin above or below the benchmark rate.
Interest rates linked to the benchmark ensure that neither the borrower
 Capi t al Market Instruments 59

nor the lender suffer from the changes in interest rates. Where interest
rates are fixed, they are likely to be inequitable to the borrower when
interest rates fall and inequitable to the lender when interest rates rise
subsequently.
Shares Vs. Debentures
Shares are different from debentures in the following manner:
1. Shareholder has a proprietary interest in the company, and
debenture holder is only a creditor of the company.
2. Debenture holder is entitled to fixed interest whereas the
shareholder is entitled to dividends depending on and varying
with profits.
3. Shareholders have voting rights whereas debenture holders do
not have voting rights.
4. Debentures may be redeemable whereas shares except preference
shares are not redeemable.
5. Debenture holders get priority over shareholders when assets
are distributed upon winding up.

GLOBAL DEBT INSTRUMENTS

Following are some of the debt instruments that are popular in the
international financial markets:
Income Bonds
Interest income on such bonds is paid only where the corporate
commands adequate cash flows. They resemble cumulative preference
shares in respect of which fixed dividend is paid only if there is profit
earned in a year, but carried forward and paid in the following year. There
is no default on income bonds if interest is not paid. Unlike the dividend
on cumulative preference shares, the interest on income bond is tax
deductible. These bonds are issued by corporates that undergo financial
restructuring.
As se t Bac ked Sec uri ti es
These are a category of marketable securities that are collateralized by
financial assets such as instalment loan contracts. Asset backed
financing involves a disintermediating process called securitization,
whereby credit from financial intermediaries in the form of debentures
are sold to third parties to finance the pool. Repos are the oldest asset
backed security in our country. In USA, securitisation has been
undertaken for the following:
60 Capi tal Markets

• Insured mortgages
• Mortgage backed bonds
• Student loans
• Trade credit receivable backed bonds
• Equipments leasing backed bonds
• Certificates of automobile receivable securities
• Small business administration loans
• Credit and receivable securities
Junk Bonds
Junk bond is a high risk, high yield bond which finances either a Leveraged
Buyout (LBO) or a merger of a company in financial distress. Junk bonds
are popular in the USA and are used primarily for financing takeovers. The
coupon rates range from 16 to 25 percent. Attractive deals were put together
establishing their feasibility in terms of adequacy of cash flows to meet
interest payments. Michael Milken (the junk bond king) of Drexel Burnham
Lambert was the real developer of the market.
Indexed Bonds
These are the bonds whose interest payment and redemption value are
indexed with movements in prices. Indexed bonds protect the investor
from the eroding purchasing power of money because of inflation. For
instance, an inflation-indexed bond implies that the payment of the coupon
and/or the redemption value increases or decreases according to
movements in prices. The bonds are likely to hedge the principal amount
against inflation. Such bonds are designed to provide investors an
effective edge against inflation so as to enhance the credibility of the anti-
inflationary policies of the Government. The yields of an inflation-indexed
bond provide vital information on the expected rate of inflation.
United Kingdom, Australia, and Canada have introduced index linked
government securities as a segmented internal debt management operation
with a view to increase the range of assets available in the system, provide
an inflation hedge to investors, reduce interest costs and pick up direct
signals, and the expected inflation and real rate of interest from the market.
Zero Coupon Bonds (ZCBs)/ Zero Coupon Convertible Debentures
Zero Coupon Bonds first came to be introduced in the U.S. securities
market. Initially, such bonds were issued for high denominations. These
bonds were purchased by large security brokers in large chunks, who
resold them to individual investors, at a slightly higher price in affordable
lots. Such bonds were called ‘Treasury Investment Growth Receipts’
(TIGRs) or ‘Certificate of Accruals on Treasury Securities’ (CATSs) or
 Capi t al Market Instruments 61

ZEROs as their coupon rate is Zero. Moreover, these certificates were sold
to investors at a hefty discount and the difference between the face value
of the certificate and the acquisition cost was the gain. The holders are not
entitled for any interest except the principal sum on maturity.
Advantages Zero Coupon Bonds offer a number of advantages as
shown below:
a. No botheration of periodical interest payment for the issuers.
b. The attraction of conversion of bonds into equity shares at a
premium or at par, the investors usually being rewarded by way
of a low premium on conversion.
c. There is only capital gains tax on the price differential and there
is no tax on accrued income.
d. Possibility of efficient servicing of equity as there is no obligation
to pay interest till maturity and its eventual conversion.
Mahindra & Mahindra came out with the scheme of Zero Coupon
Bonds for the first time in India along with 12.5 percent convertible bonds
for part financing of its modernization and diversification scheme. Similarly,
Deep Discount Bonds were issued by IDBI at Rs.2,000 for a maturity of
Rs.1 lakh after 25 years. These are negotiable instruments transferable by
endorsement and delivery by the transferor. IDBI also offered Option
Bonds which may be either cumulative or non-cumulative bonds where
interest is payable either on maturity or periodically. Redemption is also
offered to attract investors.
Floating Rate Bonds (FRBs)
Bonds that carry the provision for payment of interest at different rates for
different time periods are known as ‘Floating Rate Bonds’. The first floating
rate bond was issued by the SBI in the Indian capital market. The SBI,
while issuing such bonds, adopted a reference rate of highest rate of
interest on fixed deposit of the Bank, provided a minimum floor rate payable
at 12 percent p.a. and attached a call option to the Bank after 5 years to
redeem the bonds earlier than the maturity period of 10 years at a certain
premium. A major highlight of the bonds was the provision to reduce
interest risk and assurance of minimum interest on the investment provided
by the Bank.
Secured Premium Notes (SPNs)
Secured debentures that are redeemable at a premium over the issue price
or face value are called secured premium notes. Such bonds have a lock-in
period during which period no interest will be paid. It entitles the holder to
sell back the bonds to the issuing company at par after the lock-in period.
62 Capi tal Markets

A case in point was the issue made by the TISCO in the year 1992,
where the company wanted to raise money for its modernization program
without expanding its equity excessively in the next few years. The
company made the issue to the existing shareholders on a rights basis
along with the rights issue. The salient features of the TISCO issue were
as follows:
• Face value of each SPN was Rs.300
• No interest was payable during the first three years after allotment
• The redemption started at the end of the fourth year of issue
• Each of the SPN of Rs.300 was repaid in four equal annual
instalments of Rs.75, which comprised of the principal, the interest
and the relevant premium. (Low interest and high premium or
high interest and low premium, at the option to be exercised by
the SPN holder at the end of the third year)
• Warrant attached to each SPN entitled the holder the right to
apply for or seek allotment of one equity share for cash payment
of Rs.80 per share. Such a right was exercisable between first
year and one-and-a-half year after allotment by which time the
SPN would be fully paid up
This instrument tremendously benefited TISCO, as there was no
interest outgo. This helped TISCO to meet the difficulties associated with
the cash generation. In addition, the company was able to borrow at a
cheap rate of 13.65 percent as against 17 to 18 percent offered by most
companies. This enabled the company to start redemption earlier through
the generation of cash flow by the company’s projects. The investors had
the flexibility of tax planning while investing in SPNs. The company was
also equally benefited as it gave more flexibility.
Euro Convertible Bonds
Bonds that give the holders of euro bonds to have the instruments
converted into a wide variety of options such as the call option for the
issuer and the put option for the investor, which makes redemption easy
are called ‘Euro-convertible bonds’. A euro-convertible bond essentially
resembles the Indian convertible debenture but comes with numerous
options attached. Similarly, a euro-convertible bond is an easier instrument
to market than equity. This is because it gives the investor an option to
retain his investment as a pure debt instrument in the event of the price of
the equity share falling below the conversion price or where the investor
is not too sure about the prospects of the company.
P o p ul a r i ty o f c o n v e r ti b l e e ur o b o n ds A convertible bond
 Capi t al Market Instruments 63

issue allows an Indian company far greater flexibility to tap the Euro market
and ensures that the issue has a better market reception than would be
possible for a direct equity issue. Moreover, newly industrialized countries
such as Korea have chosen the convertible bond market as a stepping-
stone to familiarity and acceptance of their industrial companies in the
international market. The convertible bonds offer the following advantages:
a. Protection Euro convertible bonds are favored by international
investors as it offers them the advantage of protection of their
wealth from erosion. This is possible because the conversion is
only an option, which the investors may choose to exercise only
if it works to their benefit. This facility is not available for equity
issues.
b. Liquidity Convertible bond market offers the benefit of the most
liquid secondary market for new issues. Fixed income funds as
well as equity investment managers purchase convertible bonds.
c. Flexibility The feature of flexibility in structuring convertible
bonds allows the company to include some of the best possible
clauses of investors’ protection by incorporating the unusual
features of equity investments. A case in point is the issues made
by the Korean corporate sector, which contained a provision in
the issue of convertible euro bonds. The provision entitled the
holders to ensure the due compliance of the liberalization
measures that had already been announced within a specified
period of time. Such a provision enabled the investor to opt for a
‘put’ option.
d. Attractive investment The issue of convertible debentures
facilitates removal of many of the unattractive features of equity
investment. For investors, convertible bond market makers are
the principal sources of liquidity in their securities.
Bond Issue—Indian Experience
In recent times, all-India financial institutions have come to design and
introduce special and innovative bond instruments exclusively structured
on the investors’ preferences and funds requirement of the issuers. The
emphasis from the issuer’s viewpoint is the resource mobilization and not
risk exposure. Several financial institutions such as the IDBI, the ICICI, etc
are engaged in the sale of such bonds. A brief description of some these
bonds is presented below:
IDBI’s Zero Coupon Bonds, 1996 These bonds are sold at a discount
64 Capi tal Markets

and are paid no interest. It is of great advantage to issuers as it is not

required for them to make periodic interest payment.
IDBI’s Regular Income Bonds, 1996 These were the bonds issued by
the IDBI as 10-year bonds carrying a coupon of 16 percent, payable half-
yearly. The bonds provided an annualized yield equivalent to 16.64 per-
cent. The bonds, which were priced at Rs.5,000 can be redeemed at the end
of every year, after the third year allotment. There was also a call option
that entitled the IDBI to redeem the bonds five years from the date of
allotment.
Retirement Bonds, 1996 The IDBI Retirements Bonds were issued
at a discount. The issue targeted investors who are planning for retire-
ment. Under the scheme, investors get a monthly income for 10 years after
the expiry of a wait period, the wait period being chosen by the investor.
Thereafter, the investors also get a lump sum amount, which is the matu-
rity value of the bond.
IFCI’s Bonds, 1996 These bonds include:
a. Deep Discount Bonds—Issued for a face value of Rs.1 lakh
each.
b. Regular Income and Retirement Bonds—They had a five-
year tenure, a semi-annual yield of 16 percent and a front-
end discount of 4 percent. The bonds had three-year put
option and an early bird incentive of 0.75 percent.
c. Step-up Liquid Bond—The five-year bonds with a put option
every year with a return of 16 percent, 16.25 percent, 16.5
percent, 16.75 percent, and 17 percent at the end of every
year.
d. Growth Bond—An investment of Rs.20,000 per bond under
this scheme entitles investors to a Rs.1 lakh face-value bond
maturing after 10 years. Put options can be exercised at the
end of 5 and 7 years respectively. If exercised, the investor
gets Rs.43,500 after 5 years and Rs.60,000 after a 7 year period.
e. Lakhpati Bond—The maturity period of these bonds varried
from 5 to 10 years, after which the investor gets Rs.1 lakh.
The initial investment required was Rs.20,000 for 10 years
maturity, Rs.23,700 for 9 years, Rs.28,000 for 8 years, Rs.33,000
for 7 years, Rs.39,000 for 6 years and Rs.46,000 for 5 years
maturity.
ICICI’s Bonds, 1997 ICICI came out with as many as five bonds in
 Capi t al Market Instruments 65

March 1997. These are encash bonds, index bonds, regular income bonds,
deep discount bonds, and capital gain bonds. The bonds were aimed at
meeting the diverse needs of all categories of investors, besides contrib-
uting to the widening of the bond market so as to bring the benefits of
these securities to even the smallest investors.
a. Capital gains bond Also called infrastructure bonds
incorporated the capital gains tax relaxations under Section 54EA
of the Income Tax Act announced in the Union Budget for 1997-98.
They are issued for 3 and 7 years maturity. 20 percent rebate was
available under Section 88 of the I.T. Act for investors on the
amount invested in the capital gains bonds upto a maximum of
Rs.70,000. They can avail benefit under Section 88. The annual
interest rate worked out to 13.4 percent while the annual yield
came to 20.7 percent. However, investment through stock-invest
will not qualify for the rebate.
b. Encash bond The five-year encash bonds were issued at a face
value of Rs.2,000 and can be redeemed at par across the country in
200 cities during 8 months in a year after 12 months. The bond had
a step-up interest every year from 12 to 18.5 percent and the
annualized yield at maturity for the bond works out to 15.8 percent.
The encashing facility, however, is available only to the original
bondholders. The bonds not only offer higher return but also help
widen the banking facilities to investors. The secondary market
price of the bonds is likely to be favourably influenced by the
step-up interest that results in an improved YTM every year.
c. Index bond Which gives the investor both the security of the
debt instrument and the potential of the appreciation in the return
on the stock market. Priced at Rs.6,000 the index bond has two
parts:
Part A is a deep discount bond of the face value of Rs. 22,000
issued for a 12 year period. Its calculated yield was 15.26 percent.
It also has a call and a put option attached to it assuring the
investor a return of Rs.9,300 after 6 years option is exercised. Part
B is a detachable index warrant issued for 12 years and priced at
Rs. 2,000. The yield was linked to the BSE SENSEX. The face value
of the bond will appreciate the number of times the SENSEX has
appreciated. The investors’ returns will be treated as capital gains.
Tax Free Bonds The salient features of the tax-free Government of India
66 Capi tal Markets

bonds to be issued from October 1, 2002 are as follows:

a. Interest rate The bonds will carry an interest rate of 7 percent.
b. Tax exemption The bonds will be exempt from Income-tax and
Wealth-tax.
c. Maturity The bonds will have a maturity period of six years.
d. Ceiling The bonds investment will have no ceiling.
e. Tradability The bonds will not be traded in the secondary market.
f. Investors The eligible investors include individuals and Hindu
Undivided families (HUFs). NRIs are not eligible for investing in
these bonds.
g. Issue price Bonds will be issued for a minimum amount of Rs.
1,000 and its multiples.
h. Maturity value The cumulative maturity value of the bond will
be Rs.1,511 at the end of six years.
i. Form of issue The bonds will be both in demat form as well as in
the traditional form of stock certificates. Option once chosen
cannot be changed.
j. Transferability Bonds will not be transferable except by way of
gift to relatives as defined in the Companies Act.
k. Collaterals The bonds cannot be used as collaterals for
obtaining loans from banks, financial institutions and non-banking
financial companies.
l. Nomination A sole holder or a sole surviving holder of the
bond being an individual can make a nomination.
REVIEW QUESTIONS

Section A
1. What are capital market instruments?
2. State the various types of market instruments.
3. What are preference shares?
4. What are equity shares?
5. How is cash dividend different from stock dividend?
6. What are non-voting shares?
7. What are convertible cumulative preference shares?
8. What are company fixed deposits?
9. What are warrants?
10. What is a debenture?
11. What are participating debentures?
12. What are floating rate bonds?
 Capi t al Market Instruments 67

13. What are asset backed securities?

14. What are junk bonds?
15. What are indexed bonds?
Section B
1. Explain briefly the various types of preference shares.
2. State the features of equity shares.
3. State the conditions with regard to the issue of convertible
cumulative preference shares.
4. State the regulations governing the company fixed deposits.
5. What are the features of debentures?
6. Explain briefly the different kinds of debentures
7. How shares different from debentures?
8. How are zero coupon bonds useful?
9. State the features of secured premium notes.
10. What are the various kinds of bonds issued by corporates in
India? Explain.
Secti on C
1. Explain the features of various capital market instruments.
2. Discuss the relevance of global debt instruments bringing out
their features.
3. What are euro convertible bonds? Why are they popular?
 Chapter 4

Regulation of
Indian Capital Market

GENESIS
A sound and an efficient capital market provides investors and issuers of
capital an opportunity to spread investment risk and access to various
source of capital. The main advantage of a securities market is that it
enables liquid trading and provides a mechanism for price determination
for a wide range of financial instruments. A well-developed securities
market brings down cost of capital to enterprises in the long run, leading
to economic growth. However, there seems to be no proven path to follow.
The road to the positive outcome of accelerated economic growth is long,
costly, and faltering.
The Indian capital market is relatively young as compared to its western
counterparts, and has grown through the phases of disruptive shocks,
repression and times of prosperity and growth. This uneven path that
securities markets have to traverse is the outcome of the inherent nature
of the market and weakness of its participants’ behavior. The history of
the Indian capital market, beginning with the establishment of Bombay
Stock Exchange is no different, in terms of the shocks, crashes and scams
experienced by other capital markets and the hesitant steps by regulators
to stabilize it. Throughout its existence, the market has witnessed phases
of depression and unbridled competition. Since independence in 1947, the
market was under repressive policies until 1991 when the new economic
policy was unveiled.
THE FACTORS
Many factors were responsible for the introduction of measures of
regulations and control especially after initiation of reform process. Many
of these factors relate to the deficiencies in the Indian capital market.
Following are the kind of problems faced in the capital market in India,
which eventually led to the introduction of regulatory mechanism:
70 Capi tal Markets

1. Lack of adequate instruments Financial instrument are the media

through which trading and investment activities take place. One of
the biggest problems faced by the participants and investors in the
Indian capital market, was the non-availability of sufficient number of
different variety of financial instruments as compared to the capital
markets in advanced countries. The market was predominated by
traditional securities such as equity and preference sharers. Innovative
instruments such as participation certificates, certificates of deposit,
etc were not to be seen so popular.
2. Inadequate financial disclosure Information about market is an
edifice on which a sound capital market structure is built. Further, the
efficiency of capital market is greatly determined by the free flow of
unbiased and reliable market information. The Companies Act 1956,
had a number of norms requiring information disclosure about
companies. However, unfortunately, there was not only a dearth of
adequate market information but also quality and reliable information
for the investors to make right and timely decisions. The offer
documents of issuers hardly contained any useful information for the
investors. Companies often indulged in ‘window dressing’ with bad
accounting practices.
3. Lack of developed secondary market For a capital market to grow,
it is important that there must be available a strong and an agile
secondary market for scrips. Unfortunately, facilities were not
available for active trading of the securities in the secondary market.
Consequently, there was lack of liquidity for the scrips traded. This
greatly hampered the development of the capital market in India.
Moreover, the activities of speculators resulted in volatile share price
movements, jeopardizing the interest of the investors. Many a time,
no market existed for certain newly issued scrips.
4. Insider trading menace The menace of insider trading haunts the
Indian stock market. Insiders are those who have access to confidential
information of a company by virtue of the positions occupied by
them in the said company and thereby, are in a position to manipulate
the share prices to their advantage, with a view to make windfall
profits. They take away substantial business of the exchange stealthily,
thus making huge profits. Their actions cause wide fluctuations in
the prices of the securities, besides undermining the trust of the
investors in the capital market. When the investors find that the stock
market activity is rigged, they simply shy away from the market.
The provisions of the Companies Act (Sections 307 & 308)
 Regul ati on of Indi a n Capi tal Market 71

requiring full disclosure by the Board of Directors of the company,

regarding the purchase or sale of securities by any director, statutory
auditor, cost auditor, financial accountant, cost accountant, tax and
management consultant, adviser, solicitors and others prove to be
totally ineffective in controlling such trading. Even the publication of
half-yearly results by listed companies, as required by Clause 41 of
the listing agreement in operation from the beginning of 1987, has not
helped minimize such a practice.
5. Price manipulation A typical characteristic of the Indian capital
market has been the price manipulation of new securities at the time of
fresh issue. Stock market operators indulge in price manipulations in
order to obtain higher premium so as to lure gullible investors to
subscribe to the issues.
6. Abolition of CCI The lifting of the several restrictions and controls
over the capital issues and the abolition of the office of CCI, turned
the conditions completely favorable to the manipulators. Further, the
set of liberalized procedures that came to be introduced thereafter
including the free market pricing of securities by the issuers led to the
practice of price rigging. The stock market quotations nose-dived
even before the subscription lists are closed for the issue, thus leaving
the prospective investors in lurch.
7. Unofficial trading Indian stock market faced the peculiar problem
of unofficial trading in shares prior to listing of new companies. Because
of the stipulation that the shares of new companies are required to be
issued at par; in case of prospective companies having bright future,
the issues are over-subscribed by many times. This gave an
opportunity to the management, underwriters and merchant bankers
to entice the investors. A case in point was the incredible stock market
activity witnessed during the boom, just prior to the unearthing of the
Scam in May 1992.
8. Uncontrolled share broking Yet another significant factor was the
deficiency of the Indian capital market and the resultant lack of control
over the activities of brokers and jobbers. The stock exchanges, instead
of being in a position to exercise their control over the affairs of the
share brokers, allowed themselves to be dictated by the whims of the
unscrupulous brokers who reined in their supremacy on the stock
exchange. This gave rise to a situation of uncontrolled and volatile
fluctuations in the security prices, which besides greatly affecting
the investors’ psychology, further precipitated the share prices. In
fact, there were cases of wiled threats from the broking community of
72 Capi tal Markets

non-cooperation and boycott. In addition, there were unofficial brokers

who commandeered the stock market operations. All these affected
the investors’ confidence thus debilitating the stock market ambience.
9. Lack of institutional support The presence and the active
participation of financial institutions like the UTI, IDBI, and LIC etc in
the stock market contribute in a large measure to the development
and the growth of a stock market. Unfortunately, in India, although
financial institutions were present in large number, there were found
to be highly inadequate in as far as their reach and support was
concerned. They failed to provide their ‘supportive and stabilizing
role’ for the cause of the stock exchange in India. This made the
capital market highly susceptible for many insurmountable problems.

THE REGULATORY FRAMEWORK

Under the SEBI Act

The provisions of the CIC (Capital Issues Control) Act were found to be
inadequate as to allow for the better control over the issues of capital
taking place in the realm of Indian capital market. Further factors such as
the changing industrial environment, spurt in the growth of joint stock
companies, enactment of the Companies Act of 1956, disclosure
requirements of accounting and financial information, listing of securities
for the purpose of their trading in the stock exchanges etc gave rise to a
situation where the existing legislation was found to be grossly inadequate.
Under the circumstances where the Indian stock market faced several
insurmountable problems outlined above, the need for a larger body which
could act as a unifying force in bringing together the scattered legislation
so as to offer better protection to the Indian stock investor was greatly
felt. It was for this purpose, the Securities and Exchange Board of India
(SEBI) was set up on April 12, 1988 as a non-statutory body with the chief
objective of protecting the interest of investors in securities, and for
promoting the development and the regulation of the securities market in
India.
SEBI functions SEBI was constituted to render the following functions:
1. Regulating the business in stock exchanges and any other
securities markets
2. Registering and regulating the working of stockbrokers,
sub-brokers, share transfer agents, bankers to an issue, trustees
of trust deeds, registrars to an issue, merchant bankers,
underwriters, portfolio managers, investment advisers and such
 Regul ati on of Indi a n Capi tal Market 73

other intermediaries who may be associated with securities

markets in any manner
3. Registering and regulating the working of collective investment
schemes including mutual funds
4. Promoting and regulating self regulatory organizations
5. Prohibiting fraudulent and unfair trade practices relating to
securities market
6. Promoting investors’ education and training of intermediaries of
securities market
7. Prohibiting insider trading in securities
8. Regulating substantial acquisition of shares and take over of
companies
9. Calling for information from undertaking inspection, conducting
inquiries and audits of the stock exchanges and intermediaries,
and self regulatory organizations in the securities market
10. Performing such functions and exercising such powers under
the provisions of Capital Issues Control Act and Securities
Contracts Regulation Act, as may be delegated to it by the Central
Government
11. Levying fees or other charges for carrying out the purposes of
regulation
12. Conducting research for the above purposes
SEBI activities SEBI has identified the following areas for focusing its
attention for the overall growth and the development of the stock market
in India:
1. Registration of brokers
2. Authorization of merchant bankers
3. Control over mutual funds
4. Issue of insider trading regulations
5. Issue of portfolio managers regulations
6. Issue of guidelines for disclosure and investor protection
7. Suveillance
8. Clearing house
Registration of brokersThe foremost activity that was initiated by the
SEBI towards stock exchange reforms was the registration of brokers and
sub-brokers operating on the stock exchange. For this purpose, SEBI
74 Capi tal Markets

issues regulations requiring every stockbroker to make an application for

the grant of a certificate of registration. In order to be eligible to obtain the
certificate of registration, it is incumbent on the part of the prospective
broker that he/she has all the necessary facilities and infrastructure at
his/her command for conducting the trading for the investors.
The broker holding the certificate of registration should abide by the
code of conduct envisaged under the rules of the exchange. Brokers and
sub-brokers are required to make payment of requisite fees on the annual
turnover to the stock exchange concerned.
Authorization of merchant bankers Under section 30, SEBI has the
power to grant authorization to any institution engaged in the business of
merchant banking activity. For this purpose, SEBI issues guidelines and
regulations for merchant bankers for registration with the SEBI. The
intending merchant bankers are expected to fulfill such conditions as the
availability of the necessary infrastructure like adequate office space,
equipment, manpower, etc to discharge their activities, fulfillment of the
capital adequacy norms, professional qualifications as recognized by the
Government, in finance, law or business management, promotion of investor
interest, etc.
The regulations also deal with the matters relating to restriction of
appointment of lead managers depending on the size of the issue,
obligations of lead managers, and code of conduct for merchant bankers.
The regulations require a merchant banker to observe high standards of
integrity and fairness in all his dealings with his clients and other merchant
bankers.
Control over mutual funds With the mushrooming growth of mutual
funds business especially with the entry of commercial banks, other
financial institutions and agencies in a big way, SEBI came out with
guidelines for their regulation. The SEBI’s action was aimed at instilling a
sense of competition, transparency and fair play, and thereby spurs mutual
funds to a greater level of efficiency and investor-friendliness. The
regulations related to investment by mutual funds in both primary and
secondary markets.
Many mutual funds are permitted to operate by separately establishing
Asset Management Companies (AMCs). For this purpose, the AMCs
were required to fulfill such conditions as sound track record, general
reputation and fairness in all their business transactions, the directors to
be persons of high repute and standing having at least 10 years of
professional experience in the relevant fields such as portfolio management,
investment analysis and financial administration, etc, with at least
 Regul ati on of Indi a n Capi tal Market 75

50 percent of the board of AMC to be independent directors not connected

with the sponsoring organization, and the AMC to have a minimum net
worth of Rs.5 crores.
Regulations also related to the limitations on the investment of funds
by mutual funds. Accordingly, mutual funds are allowed to invest only in
transferable securities and are prohibited from giving term loans for any
purpose. Separate limits are prescribed for investment in any single
company. As a step towards overseeing the working of these funds, SEBI
was given the right to call for any information regarding the operations of
the fund, lay down accounting policies and impose penalties for violating
the guidelines as may be necessary, with the concurrence of the RBI and
the central government.
Insider trading regulations In view of the fact that the actions
of insiders leave a debilitating effect on the functioning of stock exchanges,
SEBI has issued requisite regulations so as to curb such practices. These
provide for various measures including the SEBI’s right to investigate and
inspect the books of account of any insider, and render the act a criminal
offence punishable with fine or imprisonment up to one year. Trading by
insiders is considered harmful because they attempt to deal in the securities
of a company listed on a stock exchange on the basis of any unpublished
price sensitive information. The insiders communicate any unpublished
price sensitive information to any person, with or without his request for
such information, except as required in the ordinary course of business or
they counsel or procure any other person to deal in securities of any
company on the basis of unpublished price sensitive information.
Regulating portfolio managers SEBI seeks to regulate the activities
of portfolio managers too, by means of issuing guidelines thereto. Any
person, who pursuant to a contract or arrangement with a client, advises
or directs or undertakes on behalf of the client, the management or
administration of a portfolio of securities or the funds of the client is called
a ‘portfolio manager’. For the purposes of fair play towards investors,
portfolio managers are required to register themselves with the SEBI. The
capital adequacy limit is fixed at Rs.50 lakhs.
Dis closures a nd in vesto r pro tecti on Guidelines relating to the
issue of shares, debentures, new financial instruments, and bonus shares
are issued to ensure sound disclosure practices and investor protection.
Salient among them are:
1. Par issue All the new companies are permitted to issue shares
to public only at par and where the new company was set up by
an existing company with a five year track record of consistent
76 Capi tal Markets

profitability, it will be free to price its issue, provided the promoter’s

contribution is not less than 50 percent of the equity of the new
company.
2. Draft prospectus A draft prospectus containing the disclosures
will have to be vetted by SEBI, before a public issue is made.
3. Free pricing Existing listed-companies are allowed to raise fresh
capital by freely pricing their further issues, the draft prospectus
being vetted by the SEBI.
4. FCDs As regards the issue of fully convertible debentures
(FCDs), no conversion shall take place beyond 36 months, unless
conversion is made optional with ‘put’ and ‘call’ option.
5. Credit rating Credit rating is made mandatory for FCDs
converting after 18 months. Premium amount on conversion, time
of conversion are predetermined and stated in the prospectus.
These guidelines are also applicable to partially convertible
debentures (PCD) and non-convertible debentures (NCD). In
addition, the non-convertible portions of PCD/NCD are to be
rolled over with or without change in the interest rate.
6. Debenture disclosures Disclosures relating to raising of capital
through debentures should contain, inter alia, the existing and
future equity and long-term debt ratio, servicing behavior on
existing debentures, payment of interest on due dates on term
loans and debentures, certificate from a financial institution or
banker about their no objection to a second or pari passu charge
being created in favor of the trustees to the proposed debenture
issue, etc.
7. Reservation The guidelines provide for reservation in issues
of capital to various categories of persons like employees,
non-resident Indians, financial institutions, mutual funds,
shareholders of group companies and promoter companies.
However, not less than 20 percent of the capital should be offered
to public.
8. Compulsory subscription The guidelines also provide for
compulsory subscription by the promoters of companies. In the
case of new companies established by individual promoter and
entrepreneur, the promoter’s contribution should be at least 25 or
20 percent of the total issued capital, as the case may be,
depending on the size of the issue. In the case of new companies
set up by existing companies with a 5-year track record of
 Regul ati on of Indi a n Capi tal Market 77

consistent profitability, the promoters should contribute a

minimum of 50 percent of total issued capital.
Surveillance In order that the efficiency and integrity of stock exchanges
is maintained, an effective monitoring and surveillance mechanism must
be put in place. The automation process initiated at the BSE, NSE, OTCEI
and other exchanges has made it possible to put such a monitoring
mechanism in place. There has been a significant increase in the process
of automation contributing to the best reach of the capital market.
SEBI has allowed the expansion of the trading terminals of screen-
based trading systems of stock exchanges to cities with no stock exchanges.
Expansion to cities with stock exchanges has also been permitted, provided
there is an understanding with the local exchange for allowing the
installation of outside terminals within its jurisdiction. The participating
exchange would keep its membership open to the brokers of the other
local exchanges. It will ensure an adequate arrangement for resolving
investor grievances and for timely settlement of arbitration cases arising
out of trades executed on the extended terminals.
The expansion of Bombay On Line Trading (BOLT) system of the
stock exchange, Mumbai, to the trading systems of other exchanges was
subject to such general conditions as ensuring adequate monitoring and
surveillance mechanism, stipulation of usual margins, capital adequacy,
intra-day trading limits fixed for the broker stock exchange, and the
introduction of trade guarantees. The expansion of trading networks will
lead to healthy competition between various stock exchanges with
increased efficiency.
Clearing house SEBI has directed all stock exchanges to set up clearing
house or clearing corporations to provide trade guarantees. This aimed at
reducing counter party risks and thus enabling investors trading through
the exchanges to settle their transactions through a depository. The
National Securities Clearing Corporation Limited (NSCCL) is entrusted
with the task of guaranteeing settlement of trades in the capital market
segment of the NSE. It has made considerable progress in the enhancement
of clearing facilities in other regions by establishing regional clearing
facilities. The setting up of Delhi Regional Clearing House and other
regional clearing facilities of the NSCCL enables the regional relocation of
the settlement facilities. This is bound to increase the efficiency of the
system, thus helping timely settlement of transactions on the NSE.
The parallel to SEBI in USA, is the Securities and Exchange
Commission (SEC), created under Securities Exchange Act, 1934. The SEC
78 Capi tal Markets

has been given the following wide-ranging powers for the purpose of
protecting the investors’ interests:
1. To monitor the working of stock exchanges
2. To insist on the companies for the supply of extensive information
on a regular basis
3. To penalize members of stock exchanges who were found to
violate securities laws
4. To debar the wrong-doers from any activity in the stock market
and impose on them civil penalties and initiate criminal
proceedings
5. To make rules about the manipulative practices
6. To move court for checking insider trading, and
7. To prosecute the company and its directors on its own, even
without receiving complaints by an aggrieved investors in respect
of supplying inadequate, incomplete and incorrect information.
Under the BSCC Act
In January 1926, the Bombay Securities Control (BSCC) Act 1926 was
enacted. The Act provided the government, power to grant recognition to
a stock exchange and/or withdraw recognition as it thought fit. Moreover
the recognized stock exchanges could make rules or any amendment thereof
only after prior approval of the government. Ahmedabad Stock Exchange
got recognition under this Act in 1939.
The BSCC Act 1926, remained in force until the Securities Contract
Regulation Act was promulgated in 1957, but it had no significant effect
on securities trading. One of the major shortcomings of this Act was its
definition of ‘ready delivery contract’. The ambiguity arose due to the lack
of a specified time frame for deliveries. The forward market with its strong
speculative tone thrived on this lacunae. In 1947, the Bombay Forward
Contracts Control Act applying to commodities, mainly cotton and bullion,
was passed. Shares and stock remained outside its purview, due to
objections raised by the stock exchanges. Eventually appropriate Central
legislation; based on the original principles of the Bombay Forward
Contracts Control Act 1947 was enacted in 1952, for commodity markets
and stock exchanges in 1956.
Under the Defence of India Rule
The Defence of India Rule 94-C was promulgated in 1943. It aimed at
countering speculative operations during World War II. The Rule prohibited
stock exchanges from offering facilities for carry-over transactions and
 Regul ati on of Indi a n Capi tal Market 79

other than ready delivery transactions. It proved to be counter-productive,

since it drove the stock and share business away from regular exchanges
to the street kerbs. The Defence of India Rule 94-C lapsed in September
1946. The government recognized the need to take a wider consensus
before legislating Acts for regulating stock markets. This ended the Central
Government’s first phase of experiments with legislation of the financial
market.
Under the Capital Issues Control Act, 1947
Originally the Control of Capital Issues began in the legistative framework
during the World War II. In 1943, Rule 94-A under the Defence of India
(DOI) Rules was promulgated. It was designated to prevent establishment
of industries, which did not assist in the production of war goods and
mushrooming of small companies, which would not survive in normal
times. It continued to be in force up to 1947 as Capital Issues (Control)
Act.
Its objectives were as follows:
1. To channelize the balanced investment of resources in accordance
with objectives of the Five Year Plan
2. To further the growth of companies with sound capital structure
and to promote a rational and healthy expansion of the corporate
sector in general public interest
3. To direct and distribute public issues of capital in a balanced
manner
4. To regulate bonus issues and to control pricing of issues
5. To regulate the capital organization plans of companies including
mergers and amalgamations necessitating issue of capital
In order to effect the national economic policy in the corporate sector,
various factors like state of the capital market, the volume and nature of
applications coming up for consent, the technical and financial
collaboration required, the criteria for industrial licensing and provisions,
and objectives of company law and stock exchange guidelines were
considered essential. In other words, almost every aspect of the firm’s
activities in the real and financial sector came under its purview, thus
reflecting the repressive policy measures pursued by the government.
Capital issues control was administered by the Controller of Capital Issues
according to Central Government Guidelines, in consultation with the
Capital Issues Advisory Committee.
CIC applied to all companies whether incorporated in India or outside
India, which made an issue of capital, or which offered securities for sale
80 Capi tal Markets

in India. It also applied to companies incorporated in India, which made

an issue outside India. No non-government, i.e. private enterprise could
raise capital in the market without prior consent of the CCI. Consent was
granted usually after complying with time consuming procedures and
rules, it involved detailed scrutiny of documents. There was no incentive
structure to make a trade-off and issue consent letters quickly and
prevent hold ups. Delays often led to cost escalation and consequent
inefficiencies.
The Act covered a wide range of guidelines as pertaining to new
share capital issue, bonus issue, employees stock option, debentures by
public limited companies, rights debentures, cumulative convertible
preference shares, over subscription retention, and a myriad of related
activities.
Pricing o f issues The most important area on which the CCI
influenced the capital market was in determining the level of premium if
any that could be charged, in a public issue. This factor significantly
contributed to under-pricing of the issue and a highly conservative view
of a firm’s future profit earning potential led to issues being made at par
and issues at a premium being an exception rule during the CCI era.
Consequently, the under-pricing influenced public investors to
clamour for allotment, which led to over subscription of issues. CCI used
the parameters of fair value, which were determined by the Net Asset
Value (NAV), the Profit Earning Capacity Value (PECV), and the Market
Value (MV). The NAV was calculated by using the true ‘net worth’ (NW)
of a company after deducting all possible liabilities like contingency
liability, etc.
Since May 29 1992, when the CIC Act was repealed, premium charged
on public issues became market-determined. Though the overall format
described above is maintained, firms today have the freedom to decide
the level of premium it can charge, in consultation with their merchant
bankers and underwriters. This is the free-pricing of issue policy. The
CCI acted as a final check post to ensure that a company obtained all
clearance required from the government, industrial license, letter of intent
under the Industries Development Regulation (IDR) Act 1951, registration
under the Director General of Technical Development, appraisal of project
by financial institution etc before raising capital from the market. Further
over the years, capital issues control was used for regulation of bonus
share issue, capital reorganization plans, including mergers and
acquisitions, capital structure, terms and conditions of capital issue,
fixation of premia on issues of capital by existing companies and foreign
 Regul ati on of Indi a n Capi tal Market 81

investment in India. It was an all-pervading umbrella institution. The

repeal of the CIC Act changed the nature of the capital market by ushering
in market orientation, a clear departure from the socialistic ideals of the
post-independence era.
Under the Securities Contracts (Regulation) Act, 1956
After independence, the new Constitution of India became effective in
1950. Futures markets and stock exchanges became an exclusive Union
subject under item 48 of the Union list. In 1951, the Gorwala Committee,
with representatives from Bombay, Calcutta and Madras Stock Exchanges,
submitted a report on which a draft bill was prepared. In 1956, the Securities
Contracts (Regulation) Act was enacted.
The Act was passed ‘to prevent undesirable transactions in securities
by regulating the business of dealing therein, by prohibiting options and
by providing for certain other matters connected therewith’. It permitted
only those stock exchanges recognized by the Central Government. The
recognized stock exchanges enjoyed a privileged position, but at the same
time it vested the government with wide ranging powers of supervision
and control over them. The Act provided the following powers:
1. Granting recognition of stock exchanges after application is
made by stock exchanges within the prescribed norms
2. Withdrawal of recognition to a stock in the interest of public
and trade
3. Calling for periodical return or direct enquiries to be made by
every recognized stock exchange
4. Furnishing periodical returns and maintaining records and
books of accounts, and other documents, which they had to
submit to the Central Government. The latter could make enquiries,
if it thought fit in the interest of the public and trade
5. Power to call for Annual Reports by stock exchanges to the
Central Government
6. Power of recognized stock exchanges to make rules restricting
voting right
7. Power of Central Government to direct rules to be made or to
make rules
8. Power of recognized stock exchanges to make byelaws. This
involved the overriding function of trading in securities for the
regulation and control of contracts to listing and trading practices,
hours and settlement of contracts, etc.
82 Capi tal Markets

9. Power of the government to make or amend byelaws of

recognized stock exchanges (this relates to the previous section)
10. Power of the government to supersede governing bodies of
recognized stock exchanges.
11. Power to suspend business of recognized stock exchanges, these
are known as circuit breakers to prevent excess speculation in
any specified scrip
12. Power to deem contracts in notified areas illegal in certain
circumstances
13. Power to declare contracts in notified areas to be void in certain
circumstances
14. Power to prohibit members to acts as principal in certain
circumstances
15. Power to prohibit contracts in certain cases—if the Central
Government is of the opinion that it is necessary to prevent
undesirable speculation in specified securities in any State or
area, it has the power to declare by notification that no person
can enter into contract for the sale or purchase of any security
specified in the notification
16. The Act provided license to dealers in securities in certain areas,
the lack of this license render contracts undertaken by them void
17. Only recognized stock exchanges were permitted to organize or
assist in the activity of entering into or performing contracts in
securities
18. Power to compel listing by public companies. This section
included a right of appeal against refusal by stock exchange to
list securities of public companies
There are altogether 29 sections in the Act, which includes provisions
for penalty and procedures, offences by companies, jurisdictions for trying
the offences, title of dividend and other miscellaneous factors. The rules
among other things provided for recognition of stock exchanges,
submission of periodical returns, annual report by stock exchanges, inquiry
into their activities, their members and requirements for listing of securities.
The rules are statutory and constitute a code of standardized regulations,
which are uniformly applicable for all stock exchanges. In 1985, several
amendments were made to liberalize its impact following the Patel Committee
Report recommendations.
 Regul ati on of Indi a n Capi tal Market 83

Under the Securities Contracts (Regulation) Rules, 1957

These were the rules framed for facilitating efficient and safe trading at the
stock exchanges. The rules pertain to the following:
1. Procedures to be followed for the recognition of stock exchanges
2. Submission of periodical returns and annual returns by recognized
stock exchanges
3. Inquiry into the affairs of recognized stock exchanges and their
members
4. Requirements for listing of securities
Recognition of stock exchange Stock exchanges, for the purpose of
obtaining recognition, must make an application under Section 3 of the
SCR Act along with a fee of Rs.500. Four copies of rules, including the
Memorandum and Articles of Association, and where the applicant stock
exchange is an incorporated body, byelaws, should also accompany the
application. The government may make enquiries and may seek further
clarifications before granting recognition. Application for renewal should
be made 3 months before the expiry date along with a fee of Rs.200.
Records Every stock exchange should maintain and preserve the
following books of account and documents for a period of 5 years:
1. Minute books of the meetings of members, governing body, any
standing committee of the governing body or general body of
members
2. Register of members
3. Register of authorized clerks
4. Register of authorized remisiers or authorized assistants
5. Record of security deposits
6. Margin deposits books
7. Ledgers
8. Journals
9. Cash book
10. Bank pass books
Annual report Every recognized stock exchange has to furnish the
Central Government/SEBI annually with a report about its activities during
the preceding year which shall, inter alia, contain details of information on
the following matters:
1. Changes in rules and byelaws, if any
2. Change in the composition of governing body
3. Any new committee set up and changes in the composition of
the existing one
84 Capi tal Markets

4. Admissions, readmissions, deaths or resignation of members

5. Disciplinary action against members
6. Nature and number of disputes for arbitration between members
and non-members
7. Defaults
8. Action taken to combat any emergency in trade
9. Securities listed and delisted
10. Securities brought or removed from the forward list
11. Audited balance sheet, and profit and loss account for the
preceding year
Submission of return Periodical returns have to be submitted by the
stock exchange to Central Government/SEBI relating to the following:
1. Official rates for the securities listed thereon
2. Number of shares delivered through the clearing house
3. Making up prices
4. Clearing house programs
5. Number of securities listed and delisted during the previous 3
months
6. Number of securities brought on or removed from the forward list
during the previous 3 months, and
7. Any other matter as may be specified by Central Government/
SEBI
Enquiry The Central Government/SEBI can appoint two or more persons
to enquire into the affairs of the governing body of a recognized stock
exchange or any of its member. The inquiring authority hands over a
statement of issues to the governing body/member who is then given
adequate opportunity to state their case. The inquiring body has to submit
its report to Central Government/SEBI.
Under the Companies Act, 1956
One of the most important laws in the Indian corporate legislation is the
Companies Act 1956, which has far-reaching and all-pervading effect on
the Indian industry. The Companies Act is voluminous and was enacted
with the explicit objective of controlling and regulating every conceivable
facet of the corporate sector. Its inception was in the 19th century in 1850,
when the Act was first promulgated and initiated joint stock company
business in India. The 1850 Act was changed and amended several times
in 1857, 1866, 1882, 1913, 1938, 1942 and in 1949. It was earlier known as the
Indian Companies Act. These amendments were made as and when the
 Regul ati on of Indi a n Capi tal Market 85

need arose. The 1956 Act was drafted retaining certain sections of the
earlier Act and incorporating a whole new spectrum of legislation that
would correspond to independent India’s socialistic ideals and policies.
The Companies Act of 1956 consists of thirteen parts and fourteen
schedules; part VI has eight chapters while part VII has five chapters.
Important provisions The important provisions as pertaining to the
Indian capital market are detailed below:
1. Part I contains the preliminaries, mostly definition as it relates
to the constitution of the Company Law Board (CLB) consisting
of nine members and its mandate.
2. Part II relates to the incorporation of the companies, its Articles
of Association, and memorandum of association, registration of
companies, etc.
3. Part III is relevant to the capital market as it relates to the
firm’s issue of capital activity, i.e. regarding prospectus allotment,
and other matters relating to issue of shares and debentures.
4. Section 55 to 68 relate to prospectus issue and material
information. Section 62 stipulates that misstatements in
prospectus are subject to civil liabilities in terms of compensation
to persons (aggrieved), who subscribe to an issue in good faith
and sustain any loss. It must be noted that there are sufficient
number of provisons to enable the unscrupulous promoter’s or
officers of the company to evade any indictment. Again Section
63 relates to criminal liability for mis-statements on prospectus.
This phenomenon of entice unwary investors into purchasing
securities of unprofitable firms with dubious credentials is the
driving force behind most financial regulation, since information
asymmetry is ubiquitous in financial markets. Section 68 relates
to penalty for fraudulently inducing persons to invest money.
This section deals with speculation in share and debenture price
in the secondary market.
5. Section 77 relates to purchase by a company of its own shares—
the buy-back provision. While some experts believe in repealing
this clause permitting buy-back, others are in the opinion that
the market is not mature and transparent enough, and this could
lead to further price rigging and manipulations. Buy-back of shares
is legal and a common practice in USA. It is done to reward the
shareholder. The price paid is usually higher than the market rate
86 Capi tal Markets

which is given as an incentive to the shareholders. If firms want

to bring down the paid-up capital to reduce dividend servicing
out flow, this method is undertaken.
6. Part IV relates to share capital and debentures with regard to
type, numbering, certificate of share, share capital, etc. Section
116 in this part provides for penalty for impersonation of
shareholders.
7. Part V refers to registration of charges including mortgages,
etc.
8. Part VI is long and consists of eight chapters. Chapter I is
concerned with general provisions of the company such as
annual returns, meetings, proceedings, proxies, voting at
meetings, accounts with audits, managerial remuneration,
payment of interest and dividends, etc as well as investigation of
the affairs of the company. Chapter II relates to the directors of
the company, constitution of the board of directors, managing
directors, prohibition of contribution to political parties, (this
clause is causing considerable controversy and a lively debate is
in progress presently), remuneration of directors, their powers
and qualification, etc.
9. Part VII relates to winding up and consists of five chapters.
The Companies Bill 1993 intends to make certain significant
changes to ensure transparency, so that firms with poor financial
health and inadequate assets are not passed off as going
concerns. Next Part XIII concerns general matters such as
collection of information and statistics from companies (this needs
higher priority to check the ubiquitous information asymmetry
present in the Indian corporate sector). There are as many as
fourteen schedules.
The Companies Act 1956 is so exhaustive that there are several areas
where the jurisdiction of the Act overlaps with other Act like the SC(R)
Act and even the I(DR) Act. However in 1991, when the structural
adjustment programme was launched, it was realized by political leaders
and policy decision makers of India that Companies Act of 1956 could not
fulfill the functions appropriately under the new policy regime of
liberalization and market orientation. Hence in 1993, the Companies Bill
was drafted to replace the 1956 Act. The bill was amended again in the
year 2000.
 Regul ati on of Indi a n Capi tal Market 87

COMMITTEES ON REGULATORY FRAMEWORK

A number of committees came to be set up to review the control and
regulatory mechanisms that are in place already and suggest necessary
measures to overhaul the functioning of the stock exchanges, so as to
usher in a strong capital market in India. The salient features of these
committees are presented below:
The G.S. Patel Committee
This was the high-powered committee constituted in May 1984, under the
chairmanship of G.S. Patel. The terms of reference of the G.S. Patel Committee
(GSPC) were:
a. Organizational structure and management of stock exchanges
b. Threshold level of quality for membership of brokers
c. Market mechanism of trading and settlement
d. New issues and listing requirement
e. Investor protection and services
Important recommendations of the Committee were as follows:
1. All stock exchanges to follow a standard model of management
by registering under the Companies Act Section 25, company
limited by guarantee
2. Infusing professionalism into the organizational system through
the non-brokers representation in the stock exchange managing
committee, and the Executive Director and President to have no
direct link with trading activity so as to prevent insider trading
3. Establishing an independent supervisory body modeled on the
SEC of USA to monitor the market. This was the genesis of the
SEBI, which is the regulatory authority today
4. Prescription of minimum educational qualification of XII standard
and certain diploma courses for members
5. Raising the training and qualifying levels for new members and
assistants
6. Members to take insurance cover for loss of documents and acts
of fraud committed by their employees
7. Introducing odd-lot dealing, prohibiting non-bank finance for
‘badia’ dealers and banning all option contracts
8. Checking overtrading, up front margin payment
9. Introduction of provisional listing of new issues to check the
clandestine market and high premium charges caused by the
inordinate delay in listing procedures
10. Cut in underwriters’ commission from 3 percent to 2.5 percent to
reduce issuers cost
88 Capi tal Markets

11. Publication of half yearly unaudited accounts in the media to

keep shareholders and prospective investors informed as a means
of an efficient disclosure practice
The Narasimham Committee
In 1991, pursuing liberalized policies and structural adjustment programme,
the government constituted a high-powered committee on financial sector
reforms with M. Narasimham as chairman. The committee made wide-
ranging recommendations on banking reforms and restructuring of capital
market regulation.
In the capital market, the committee advised greater market orientation
by permitting free pricing of public issues, which until then, was under the
purview of the CCI. To make the primary market independent of government
control, and vest the private sector with the responsibility of primary
market activity, it recommended that merchant bankers be allowed to take
deposits from the public. It became imperative for the lead managers,
underwriters and registrars of the issue to apply due diligence in
consultation with the company concerned in pricing the issue. This was a
step for establishing an incentive structure for allocational efficiency in
the capital market.
The M.J. Pherwani Committee (1991)
This committee was set up to initiate orderly growth of the stock market
and promote investor’s interests. The most important recommendation
was establishing of a National Stock Exchange System, which was
established in 1995, in greater Bombay (much against the objections
forwarded by the BSE). The NSE was created to offer competition to BSE,
which is too gigantic and monolithic, handling almost two thirds of the
country’s primary and secondary market business. Other key
recommendations were:
1. Establishing Central Depository Trust, and evolving electronic
hook-up with regional depositories, upgrading the Stock Holding
Corporation of India
2. Establishing National Clearing and Settlement Corporation for
settlement between regional stock exchanges and Central
Depositories
3. Creating a three-tier stock market system with more floors added
to existing exchanges
4. Active promotion on jobbing or market-making in debt
instruments, or providing separate trading hours
 Regul ati on of Indi a n Capi tal Market 89

The Malegam Committee (1995)

Important recommendations of the committee were as follows:
1. Disclosing in prospectus the actual project expenditure, sources
of finance expenditure, year-wise break up, residual expenditure,
and details of bridge loans
2. Transparent accounting procedures by making clear statement
in the prospectus on failure to make provisions, for losses in
previous years, and change in accounting policy, financial
disclosures must include accounting ratios such as earnings per
share, return on net worth, and net asset value per share
3. Mandatory disclosure of technology, market, competition, and
managerial competence
4. Disclosures in prospectus to include appraising agency’s report;
forecasts of profit should be supported by an auditor’s certificate
5. The terms ‘promoter’ and ‘promoter’s group’ needs to be defined
precisely
6. Disclosure needs to be of aggregate holding of the promoter’s
group and a list of the persons who constitute the promoter’s
group, and information regarding other venture promoted by the
promoter
7. Other recommendations include disclosure of such information
as stock market data, litigation, defaults and adverse events,
justification for price, technical and financial collaboration
agreements, management’s analysis, capitalization statement,
buy-back and stand-by arrangements, specialized industry
groups, major shareholders, abridged prospectus, advertisement,
rights issue, responsibility for adequacy and authenticity of
disclosure (due diligence), monitoring of use of funds, small
issues, pricing of issues, news items on mergers, etc.
REVIEW QUESTIONS

Section A
1. State the objectives of regulating the Indian capital market.
2. State the objectives of the Capital issues Control Act, 1947.
Section B
1. Trace the genesis of the regulation of Indian capital market.
2. State the functions of SEBI.
3. State the role of Securities Exchange Commission (SEC) of the
US.
90 Capi tal Markets

4. What are the powers vested with the Government under the
Securities Contracts Regulation (SCR) Act, of 1956?
5. What do the rules of the Securities Contracts Regulation (SCR),
1957 prescribe for the safe trading at stock exchanges?
6. How is Indian capital market regulated under the provisions of
the Indian Companies Act, 1956?
7. What were the major recommendations of the G.S. Patel
Committee.
8. State the key recommendations of the M.J. Pherwani Committee?
9. What were the recommendations of the Malegam Committee on
the regulation of Indian capital market?
Secti on C
1. Discuss the factors responsible for the introduction of measures
of regulation and control of the Indian capital market.
2. How is Indian capital market regulated? Bring out clearly the
regulatory framework that has been put in place for this purpose.
3. Give an account of the various committees set up to review the
control and regulatory mechanism of the Indian capital market.
 Chapter 5

Derivatives Market

The field of finance has undergone a sweeping change in modern times

thanks to the creation and the widespread use of the ‘derivatives’. Presently,
most major institutional borrowers and investors use derivatives. Similarly,
many act as intermediaries dealing in derivative transactions. Derivatives
are responsible for not only increasing the range of financial products
available but also fostering more precise ways of understanding,
quantifying, and managing financial risk.
Among the several factors that have been responsible for the
development of derivatives, search for higher yields, lower funding costs
and a demand for tools to manage risk are important. Other factors that
have caused broad demand for derivatives include diverse and changing
financial needs of a wide array of users, need for hedging current or future
risks, taking market risk positions, inefficiencies between markets, etc.
Derivatives are financial investments that derive their value from the
underlying financial assets. Derivative contracts are used to unbundle the
price risks embodied in assets and liabilities. Derivatives do not eliminate
risks. They simply divert risks from investors who are risk averse to those
who are risk-neutral. The use of derivative instruments is part of the
growing trend among financial intermediaries like banks to substitute off-
balance sheet activity for traditional lines of business. The exposure to
derivatives by banks have implications not only from the point of capital
adequacy, but also from the point of view of establishing trading norms,
business rules and settlement process. Trading in derivatives differ from
that in equities as most of the derivatives are marked-to-the-market. History
is replete with instances of dangers posed to the financial system on
account of derivatives trading. But it is to be noted that most of the
episodes of losses in derivative markets have arisen due to lack of
transparency and weak internal controls.
An important function of derivatives is the efficient allocation of risks
in the economy. But the ability of derivative instruments to transform risks
can be misused as well. Reportedly, some people have used derivatives to
92 Capi tal Markets

evade investment guidelines, conceal risks from principals, evade taxes,

circumvent regulations, etc. The effect of these misuses on the financial
ability of the system is substantial as evident from recent episodes of Barings
Bank in UK, Daiwa Bank, Sumitomo Corporation in Japan. It is in this context
that the regulatory issues assume much importance. A common viewpoint
among bank regulators is that the presence of derivatives creates a potential
for systematic risk that could wipe out a large portion of capital of banks.

MEANING OF DERIVATIVES
A bilateral contract or payments exchange agreement whose value is
derived from the value of an underlying asset or underlying reference rate
or index is known as ‘derivative’. The scope of derivatives has widened
and includes derivatives transactions covering a broad range of underlying
assets such as interest rates, exchange rates, commodities, equities, and
other indices.
Every derivative transaction can be built up from two simple and
fundamental financial blocks namely forwards and options. Forward-based
transactions include forward contract, swap contract and exchange-traded
futures. Option-based transactions include privately negotiated OTC
options such as caps, floors, collars and options on forward and swap
contracts, and exchange-traded options on futures. It is interesting to
note that many diverse type of derivatives can be created by combining
the building blocks in different ways and by applying these structures to
a wide range of underlying assets, rates, or indices.
In addition to privately negotiated global transactions, derivatives
also include standardized futures and options on futures that are actively
traded on organized exchanges, and securities such as call warrants.
GROWTH OF DERIVATIVES MARKET—FACTORS
The explosive growth in recent times of the derivates market is on account
of the following factors:
Volatility in3 Prices
An important reason for the emergence of derivatives market in the world
has been the sharp volatility noticed in the movement of prices of assets—
securities, currencies, commodities, etc. The forces of demand and supply
determine the market prices. The changes in these forces cause price
volatility. Price changes bring about market adjustments. The imminent
risks that result from such price changes are to be well protected through
a host of instruments and techniques available in the derivatives market.
 Deri v ati ves Mar ket 93

Price volatility, for example, was caused by the currency meltdown

experienced in the Southeast Asian countries in 1997. Similarly, the rapid
developments taking place in the realm of telecommunications have also
caused the prices of corporate securities to fluctuate.
Globalization of Markets
The size, the reach, the magnitude and the volume of business operations
have increased manifold thanks to the globalization of markets. Financial
markets came to be affected by the global happenings. Global investors,
global exchanges, global financial institutions started appearing in the
financial markets. Further, globalization has also steadily increased the
competition in operations, thus necessitating different tools to handle.
Technological Advancements
The growth witnessed in the derivatives tools could also be attributed to
the kind and the magnitude of technological breakthroughs in the
communications industry. Advancement achieved in the computer and
satellite technology has helped storage and rapid transmission of
information that provides the right architecture. Such scientific and
technological advancements have impacted in a great way the market
prices to volatility. Derivative instruments help manage the risks arising
from price volatility.
Developments in Financial Theories
The advancements made in the theories of financial management in the
recent past have mainly contributed to the innovation of derivative
products. The theories developed were designed to give the advantage of
better and efficient management of risks arising from asset trading in
markets. Some of the theories of financial management that are worth
noting include option pricing models propounded by Fischer Black and
Martin Scholes in 1973, which are used to determined the value of call and
put options. Similarly, the theory developed by Lewis Edeington on ways
of hedging financial risks with financial futures contributed to the growth
of instruments in the financial market.
LIMITATIONS OF DERIVATIVES MARKET
The derivatives market mechanism is generally fraught with the following
drawbacks:
1. Worldwide, the instruments used in the derivatives such as
options and futures have become more controversial in as far as
its efficacy in handling speculative situation is concerned
94 Capi tal Markets

2. Fortunes are made and lost very quickly

3. Lack of awareness and suspicion about the efficiency of the
tools used in the derivatives market
4. There is a fear of great and insurmountable risks
5. Derivative trading takes place with traders and speculators
indulging in selling what they do not own and buying what they
do not intend to hold, with the only requirement being the ability
to make payment of margin money
6. Potential dangers of defaults by traders who could not keep up
their commitments, thereby creating a situation of loss of
confidence
FUNCTIONS OF DERIVATIVES MARKET
Despite fears of and pitfalls about the efficacy the working of the system
in the derivatives market, there are a number of functions that are
beneficially rendered by the use of derivative instruments as mentioned
below:
Price Discovery
The tools used in a derivatives market such as options, futures, etc are
capable of making a reasonable estimate of a relevant future price that is
expected to continue to prevail for a certain period. Such a mechanism
results from open and competitive trading on the floor of the exchange,
thus reflecting the supply and demand position. This is expected to prevail
in the certain specified future period. The price that is set in this manner is
carried throughout the market by a well-authenticated price reporting
system supported by advancement in telecommunications technology.
This process of establishing equilibrium in the future price of an asset is
known as ‘price discovery function’. A derivatives market is essentially
concerned with anticipating a future price for the asset dealt with. Such a
price discovery mechanism is an important part of an efficient financial
system. Such a price would truly reflect the relative costs of production
and the consumption utilities. The tools help in bringing about equilibrium
between present and future price.
Risk Management
Another important function of a derivatives market is that of managing the
risk exposure resulting from the volatile movements in the price of traded
asset. New instruments such as options and futures are known to be very
effective in minimizing the risk through the arbitrage process arising from
the price movements. Counter party risk is reduced or sometimes
 Deri v ati ves Mar ket 95

non-existent. Liquidity is added to the market through standardized futures

contracts. To guarantee the due performance of contracts in future, clearing
houses are available which take care of the solvency of the members of
trading. Easy entry and competition provide for low costs and efficient
trading.
Speculative Advantage
The success of derivatives market is built on the edifice of assumed
minimum level of speculative activity of estimating the kind of price to
prevail in future. In fact, speculation is considered a boon to the activities
in a derivatives market. The activities of speculators such as expecting
future prices to go up and indulging in selling spree in order to buy the
asset in the future when prices fall and thus to make a profit, all bring
about speculative advantage. The increased speculative activity therefore,
would bring about better functioning of futures market by allowing for
price discovery and hedging.
CATEGORIES OF DERIVATIVES
The different categories of derivatives that are available to investors and
traders are described below:
Forward-based Derivatives
Forward Contracts

Meaning A contract that obligates one counter party to buy and the
other to sell a specific underlying asset at a specific price, amount and
date in the future is known as a ‘forward contract’. Forward contracts are
the important type of forward-based derivatives. Forward contracts are
the simplest derivatives.
Characteristics Following are the characteristics of forward con-
tract:
1. Uniqueness Separate forward markets exist for a multitude of
underlyings, including the traditional agricultural or physical commodities,
as well as currencies (referred to as foreign exchange forwards) and interest
rates (referred to as forward rate agreements or “FRAs”).
2. Value The change in the value of a forward contract is roughly
proportional to the change in the value of its underlying asset. This
distinguishes forward-based derivatives from option-based derivatives,
which have a different payoff profile.
96 Capi tal Markets

3. Custom-designed Forward contracts are customized with terms and

conditions tailored to fit the particular business, financial, or risk
management objectives of the counter parties.
4. Negotiations Negotiations often take place with respect to contract
size, delivery grade, delivery locations, delivery dates, and credit terms.
Forwards, in other words, are not standardized.
5. Risks Forward contracts create credit exposures. Since the value of
the contract is conveyed only at maturity, the parties are exposed to the
risk of default during the life of the contract. The credit risk is two-sided.
Only the party for whom the contract has a positive mark-to-market value
can suffer a loss; but, since either party can ultimately end up in this
situation, each party must evaluate the credit worthiness of its counter
party. Since these contracts are typically large and the potential credit risk
may be significant, the counter parties to forward contracts are usually
corporations, financial institutions, institutional investors, or government
entities.
Swaps
Meaning

Swaps are transaction that obligates the two parties to the contract to
exchange a series of cash flows at specified intervals known as payment
or settlement dates. A contract whereby two parties agree to exchange
(swap) payments, based on some notional principal amount is known as
‘swap’. Only the payment flows are exchanged and not the principal amount.

Financial Swaps
Financial swaps constitute a funding technique, which permit a borrower
to access one market and then exchange the liability for another type of
liability. Under this arrangement, it is possible for investors to exchange
one type of asset for another type of asset with a preferred income stream.
Parallel Loan
According to the concept of parallel loans, parties based in two different
countries, borrow funds denominated in their respective currencies. The
two parties would lend each other the funds denominated in their own
currencies. This process does not involve any intermediary such as a
bank, etc. This type of loans were not popular as they had many drawbacks;
for example, the default of one party does not automatically release the
other party from his obligations and the two loans were very much
considered as balance sheet items requiring disclosure as per the law, and
 Deri v ati ves Mar ket 97

that such loans were difficult to arrange as it was difficult to find two
parties with reciprocal needs.
Benefits
SWAPS offer the following benefits:
1. Off-balance sheet transactions
2. No initial exchange of principal but only the future cash flow
payments
3. Lower transaction costs
4. Help borrowers and investors overcome the difficulties posed
by market access
5. Providing opportunities for arbitraging some market imperfections
6. Hedging of interest rate and exchange rate risks
7. Provides for profitable access of markets
Mod e
Swap transactions are normally carried out by telephone, the moment
parties agree on the terms such as the coupon rate, floating rate basis, day
basis, maturity date, rollover dates, the governing law, and documents.
Banks, individuals and financial institutions may carry out trading in swaps.
Characteristics
1. Cash flows The cash flows of a swap are either fixed, or calculated for
each settlement date by multiplying the quantity of the underlying
(notional) principal by specified reference rates or prices. The cash flows
from a swap can be decomposed into equivalent cash flows from a bundle
of simpler forward contracts.
2. Types Depending upon the type of the underlying asset, swaps are
classified into interest rate, currency, commodity, or equity swaps. Except
for currency swaps, the notional principal is used to calculate the payment
stream but not exchanged. Interim payments are generally netted, with the
difference being paid by one party to the other. Interest rate and currency
swaps can also be analyzed in economic terms as back-to-back or parallel
loans. Both of this decomposition has important implications for pricing
and hedging.
3. Bilateral agreement Swaps, like forwards, are bilateral agreements
between sophisticated, institutional participants. Swap agreements are
entered into through private negotiations, which give rise to credit
exposures.
98 Capi tal Markets

4. Risk management Swaps are tailored, like forwards, to meet the specific
risk management needs of the counter parties.
5. Implication Swaps imply pricing relationships and related arbitrage
opportunities among swaps, forwards, and futures contracts and between
derivatives in general, and various cash market instruments.
6. Hedge Swaps also suggest the many ways in which the market risk of
swaps can be hedged. For example, combinations of long and short
positions in Government or corporate securities, exchange-traded interest
rate futures, or forward rate agreements can be used to hedge swap
exposure—and vice versa.
Interest Rate Swaps
Under this arrangement, one party called ‘fixed rate payer’ agrees to
exchange his series of fixed rate interest payments to a party called ‘floating
rate payer’ in exchange for his variable rate interest payments. The fixed
rate payer takes a short position in the forward contract whereas, the
floating rate payer takes a long position in the forward contract.
Accordingly, a fixed rate payer will benefit in a situation where the interest
rate rises or the price of debt instrument falls. Conversely, the floating rate
payer will benefit in a situation where interest rate is higher and the cash
flows are declining because of decline in variable interest rates.
There are three types of interest rate swaps. They are: coupon swaps,
basis swaps, and cross currency swaps.
1. Coupon swaps offer the condition where parties exchange each
other’s fixed and floating interest payments
2. Basis swaps offer the condition where one benchmark is
exchanged for another benchmark under floating rates. This is
very popular for rates like LIBOR, T-bill rate, etc.
3. Cross currency swaps offer the condition where fixed rate flows
in one currency is exchanged for floating rate flows in another
currency
Curre ncy Swaps
Under this arrangement, both the principal amount and the interest on a
loan in one currency are swapped for the principal and the interest payments
on a loan in another currency. The parties to the swap contract generally
hail from two different countries. This allows the counter parties to borrow
easily and cheaply in their home currency. Where both the parties are
interested to borrow the foreign currency at the foreign interest rate, both
the parties would benefit from swaps. This is because, it will not be possible
 Deri v ati ves Mar ket 99

for a foreign firm to borrow in the foreign currency at rates of interest that
are available to local resident/company.
Under a currency swap, cash flows to be exchanged are determined at
the spot rate at a time when swap is done. Such cash flows are supposed
to remain unaffected by subsequent changes in the exchange rates.
However, failure of the counter party may change the ruling interest rates
for the two currencies on account of change in exchange rate. The net
present value of the net amount to be exchanged determined at ruling
exchange and an interest rate constitutes the amount of risk.
Using Hedge
Hedge technique can be used in a swap. Accordingly, a ‘pay fixed and
receive floating swap,’ may be hedged by making borrowing at the floating
rate and investing in a bond. Similarly, ‘the pay fixed rate sterling interest
and principal, and receive floating price’ can be hedged by borrowing
floating rate dollars, buying pound, investing in pound bond and paying
dollar interest and principal.
Swap Spread
The profit arising from a swap transaction is called ‘swap spread’. Several
factors determine the swap spreads. Such factors include: cost of carry of
the hedging instrument, demand and supply, credit arbitrage, the shape of
yield curve and movement in the treasury market.
A swap spread may be calculated as follows:
[LIBOR + (Treasury coupon rate – Repo rate)] – Treasury yield
Valuing a Swap
A swap is equivalent to a borrowing plus an investment. The value of a
swap is therefore, the difference between the present values of all inflows
and all outflows. A comprehensive discount rate, which encompasses
both the risk-free interest rate and a risk premium, is used for the purpose
of market valuation of a series of cash flows. The need for the valuation of
swaps arises in circumstances where it is necessary to report to
shareholders and also where the contract is terminated prematurely.
The problem of pricing a swap is closely related to swap valuation.
The problem of pricing involves determining the type of rate to be quoted
for the swap, whether fixed rate of interest or floating rate of interest
(LIBOR).
100 Capi tal Markets

Futures Contracts

Meaning A transaction that obligates its owner to buy a specified un-

derlying at a specified price on the contract maturity date or settle the
value for cash is known as ‘futures contract’. The basic form of a futures
contract is similar to that of a forward contract. The payoff, or market risk
profile facing the owner of a futures contract is also similar to that of a
forward contract.

Features Although both forward and futures contracts are similar in

many respects, futures contract has many distinguishing characteristics
as stated below:

1. Standardized The terms and conditions governing futures contract

are well standardized. The contract, besides describing the quantity and
quality of the underlying, specifies the time and place of delivery and the
method of payment. Price is the only variable left to be determined. This
standardization extends to the credit risk of futures.
Credit risk is greatly reduced by marking the contract to market with
frequent settling up of changes in value and by requiring buyers and
sellers alike to post margin as collateral for these settlement payments.
This way contracts of the same maturity act as perfect substitutes. This
process of full standardization results in fungibility, whereby it facilitates
anonymous trading in an active and liquid exchange market.
2. Contractual obligations Contractual obligations under futures
contract are entered into directly with the exchange clearing house and are
generally satisfied through offset—the cancellation of an existing futures
position through the acquisition of an equal but opposite position that
leaves the clearing-house with zero net exposure. The right to offset allows
futures participants to readily cut their losses or take their profits, without
negotiating with counter parties
3. Easy access The anonymous nature of futures trading and the
relatively small contract size make futures contracts accessible to members
of the general public, including retail speculators, who are unable to transact
business in forwards and swaps.
Forward Rate Agreements (FRAs)
Definition According to Apte, “A Forward Rate Agreement (FRA) is
an agreement between two parties in which one of them (the seller of the
FRA) contracts to lend to the other (the buyer), a specified amount of
 Deri vati ves Market 101

funds, in a specific currency, for a specified period starting at a specified

future date, at an interest rate fixed at the time of agreement.”
Meaning A forward contract on interest rates is known as a forward
rate agreement. It signifies an agreement between two parties, normally a
bank and a depositor whereby the banker guarantees the
borrower-depositor a fixed rate of interest for a term. Accordingly, the
difference between the agreed rate and the actual rate will be made good
by one party to another.
Characteristics
1. Exchange No principal is exchanged. Only the difference between
fixed interest rate and reference rate on a future date is exchanged.
2. Locking up costs Provides an ideal mechanism for locking up costs
of funds or future stream of income.
3. Interest rate Interest rate is quoted from a certain future date.
4. Principal The principal amount being the reference money is the
basis of the agreement.
5. Buyer The buyer of FRA has to borrow from the cash market, where
the exchange of money is absent.
6. Settlement On the specified future date, the reference rate (MIBOR/
LIBOR) is compared with FRA and settlement is made only for the
difference between the two rates.

Benefits
Interest lock-up Useful device for locking up effective interest costs
where new debt securities are issued and high interest rates are forecasted.
Protection Protection is available against a reduction in the market
value of securities due to rising interest rates. Further, it also protects
against a loss in the market value of fixed rate securities due to rising
interest rates. Similarly, protection is also available for spreads between
fixed rate assets and floating rate liabilities during a period of rising and
falling interest rates. Interest rates decline on future money market
investments is also protected.
102 Capi tal Markets

FORWARD CONTRACT Vs. FUTURES CONTRACT

The distinguishing characteristics between forward contract and futures
contract are presented below:

Sl. Forward
Characteristics Futures Contract
No. Contract
1. Contract Terms Decided by Standardized contract
buyers and
sellers
2. Contract Price Remains Changes every day
constant till
maturity
3. Marking to Cannot be done Done every day
Market
4. Margin Not needed Margin is to be paid by
Requirements both buyers and sellers
5. Risk of Counter Exists Does not exist
Party
6. Number of No limit on the Number of contracts
Contracts number of limited between 4 and
contracts in a 12 a year
year
7. Hedging Tailor-made Since contract period is
contracts makes limited to a month,
possible perfect hedging not perfect
hedging
8. Liquidity No liquidity Highly liquid
9. Operational Not traded on It is exchange-traded
Mechanism exchange but
traded over the
counter
10. Delivery Delivery is Standardized and cash
specifically delivery of contracts
decided;
contracts usually
result in delivery
 Deri vati ves Market 103

OPTION-BASED DERIVATIVES

O ption s
Meaning A derivative transaction that gives the option holder the right
but not the obligation to buy or sell (or settle the value for cash) the
underlying at a price, called the strike price, during a period or on a specific
date in exchange for payment of a premium is known as ‘option’. Underly-
ing refers to any asset that is traded. The price at which the underlying is
traded is called the ‘strike price’ or ‘exercise price’. It is one of the building
blocks of the option contract.
T ype s
Options are basically of two types as described below:
1. Call Option
2. Put Option
Call option A contract that gives its owner the right but not the
obligation to buy an underlying asset-stock or any financial asset, at a
specified price on or before a specified date is known as ‘call option
contract’. The owner makes a profit provided he sells at a higher current
price and buys at a lower future price.
Put option A contract that gives its owner the right but not the
obligation to sell an underlying asset-stock or any financial asset, at a
specified price on or before a specified date is known as ‘put option
contract’. The owner makes a profit provided he buys at a lower current
price and sells at a higher future price. Hence, no option will be exercised
if the future price does not increase.
Characteristics
Options have the following features:
1. The right Both call and put options give the owner the right to buy or
sell some underlying asset without the obligation to perform the contract
on maturity. The buyer’s right exists only up to the time of expiry of the
contract. The owner of the option can choose not to exercise the option
and let it expire.
2. Trading Options are both exchange and counter traded.
3. Position Option buyer assumes ‘long position’ and the option seller
(writer) assumes ‘short position’.
104 Capi tal Markets

4. Premiums Option premium is payable on the option contract.

5. Types Options may be European option where the option can be
exercised only on maturity date and in the case of American option the
option can be exercised any time before the maturity date. Where the
option is advantageous to exercise, such an option is known as in-the-
money option and where the option is not advantageous to exercise, such
an option is known as out-of-the-money option. Where there is no gain or
loss on the exercise of the option such an option is known as at-the-
money option.
6. Benefits The buyer benefits from favorable movements in the price of
the underlying asset, but is not exposed to corresponding losses.
7. Private options Privately negotiated options exist on a multitude of
underlyings, such as bonds, equities, currencies and commodities, and
even swaps.
8. Structured options Options also can be structured as securities such
as warrants or can be embedded in securities such as certain commodity
or equity-linked bonds with option-like characteristics.
9. Bundling options Options can be bundled to create other option-
based contracts called caps, floors, and collars. Like interest rate swaps,
caps, floors, and collars are generally medium-to long-term transactions.
A notional principal is used to calculate periodic cash flows. The buyer
of the cap pays a premium, normally at inception. At each payment date, the
seller must pay the buyer an amount based on the difference, if positive,
between the reference and strike rate (cap). A cap therefore protects a floating-
rate borrower against a rise in interest rates. A floor contract is the opposite
of a cap in that payment is made only if the difference is negative. A floor
therefore protects a floating-rate investor against a decline in interest rates.
Buying a collar is equivalent to buying a cap and selling a floor.
Swa ptio n s
A swaption (or swap option) is an option on a swap. It gives the buyer the
right, but not the obligation, to enter into a specified swap contract at a
future date. In this case, the asset underlying the option contract is another
derivatives transaction, (i.e. a swap). A borrower can buy protection against
the effect of a general rise in interest rates through the purchase of an
option to enter into an interest rate swap. Swaptions now play an important
role in the management of corporate debt, especially callable debt.
 Deri vati ves Market 105

Options on Futures Contracts

Options on futures contracts have similar payoff profiles but differ from
OTC options in that they are fully standardized (including credit terms),
can be cancelled through offset and can be traded by the general public.
The category of derivations is depicted in Exhibit 3.
Exhibit 3 Deri vati ves-Categori es

FUTURES AND OPTIONS—PARTICIPANTS

There are many players in the derivatives market, each one performing a
role depending on the respective goal. For instance, when a trader transacts
in the market for price risk management he is called a hedger, when he
takes an open position in the futures market or if he sells naked options
contracts, he is called speculator and when he enters into simultaneous
contracts to take advantage of mispricing, he is called the arbitrager. Market
makers create liquidity in the market while brokers provide services to
other participants. Fund managers, stockists of goods, processors,
investors, traders and others play an active part in the derivatives market.
The participants in derivatives activity can be divided into two groups,
the end-users and dealers. End-users consist of corporations, government
entities, institutional investors, and financial institutions. Dealers consist
mainly of banks and securities firms with a few insurance companies, and
highly rated corporations having recently joined the ranks. An institution
may participate in derivatives activity both as an end-user and a dealer.
For example, a money-center bank acts as an end-user when it uses
derivatives to take positions as part of its proprietary trading or for hedging
as part of its asset and liability management. It acts as a dealer when it
106 Capi tal Markets

quotes bids and offers, and commits capital to satisfying customers’

demands for derivatives. Derivatives are used by end-users to lower
funding costs, enhance yields, diversify sources of funding, hedge, and
express market views through position taking.
Derivatives permit end-users and dealers to identify, isolate, and
manage separately the fundamental risks and other characteristics that are
bound together in traditional financial instruments. Desired combinations
of cash flow, interest rate, currency, liquidity, and market source
characteristics can be achieved largely by separable choices, each
independent of the underlying cash market instruments. As a result,
management is able to think and act in terms of fundamental risks. The
place and the role of each of the several participants are discussed below:
Exc han g e s
1. The exchanges play an important part in providing an
infrastructure required for carrying out the dealings on assets
2. There can be a separate exchange for financial assets and non-
financial assets
3. Where trading is based on out-cry system, members of the
exchange come together and transact business during a fixed
trading period and where trading is on-line, exchange provides
the real-time access to information and trading
Clearing House
1. A clearing house acts as a nerve center of contract execution and
completion
2. It helps clear transactions that are executed in derivatives market
3. Besides guaranteeing the due performance of contracts, it also
acts as a counter party to each contract. It ensures the solvency
of members by enforcing strict rules of entry and conduct on
their part
4. Ensures performance of contracts even in volatile market
conditions by means of a good system
Cus tod i an s
1. Custodians require the participants to deposit their securities
before starting trade
2. Custodians ensure a smooth and standardized delivery mechanism
which is an essential prerequisite for the efficient functioning of
the market
 Deri vati ves Market 107

3. Custodians help ensure that the prices of assets traded reflect an

equilibrium price
Banks
1. Banks handle large volume of fund movements that take place
between members and the clearing house
2. Banks facilitate daily settlements by carrying out accounting
entries of the members of the exchange and the clearing house
3. Banks help reduce the possibility of misappropriations in dealings
The Regulator
1. The regulator creates confidence among the transacting members
of the exchange
2. The regulator provides a level playing field to the participants by
making rules and regulations
3. The regulator ensures the protection of investors
4. In India, SEBI and the RBI provide the much needed protection
to the members by regulating the working of the different
constituents
5. The approach and the outlook of the regulator, very much affects
the strength and the volume of the market
Market Makers
1. Jobbers are called ‘market makers,’ as they decide the market
price depending upon the demand and supply of the underlying
asset
2. In the case of an out-cry system, jobbing counters are useful, as
they provide information about the price quotations for executing
deals
3. In the case of screen-based trading, they help display on the
screen the best buy and sell rates
4. They are members of the exchange who take part in purchase and
sale transactions by regularly quoting bid-ask rates
5. The difference between bid and ask is known as bid-ask spread,
with spread increasing with the volatility in prices
6. Jobbers provide much needed liquidity to the market
Brokers
1. Brokers perform the task of bringing together the buyers and the
sellers
2. Brokers help all those persons who are not members of the
exchange to conduct the transactions
108 Capi tal Markets

3. Brokers are responsible for final settlement and delivery

4. Brokers ensure greater participation by non-members which in
turn increases the volume of their trade in the market and provides
the benefits of liquidity and depth to the market
5. Brokers play an important role in the options and futures contracts
Arbitrageurs
1. Arbitrageurs are risk-averse players who enter into such contracts
that can earn riskless profits through the process called ‘arbitrage’
2. Arbitrageurs indulge in buying in one market and simultaneously
selling in another market to earn the riskless profits under the
conditions of imperfect market
3. Arbitrageurs always look for price imperfections in the market
4. Spot and future prices provide opportunities for arbitrage
5. Prevalence of different prices at different contracts provide
opportunities of arbitrage
Spe c ulators
1. Speculators indulgement in the market is shaped by the expected
future prices of the underlying asset
2. Speculators trading is determined by several factors such as
demand and supply, market positions, economic fundamentals,
international events, monsoon behavior, credit policies
enunciated by the central monetary authority of the country, the
fiscal and other policy announcements made by the Government
3. Speculators assume the role of either the bull or the bear
depending upon their perceptions about the price movements
4. Speculators help provide the much needed liquidity and the
volume to the market which helps reducing the costs
5. Speculators provide the wherewithal to hedgers to manage their
risks
He dge rs
1. Hedgers with futures and option contracts provide for locking in
of the future expected price at which to buy or sell
2. Hedgers can enter into futures or option contracts by means of
which price risk exposure is covered
3. Hedgers are traders and exporters who enter into futures contracts
to safeguard their position from falling rates and prices
4. Traders and producers could benefit from a favorable price
movements and hedge their price risk by entering into an option
 Deri vati ves Market 109

contract that gives them the right but not the obligation to buy or
sell the asset at specified price
5. Hedgers provide a cost-effective tool in managing price risks
BENEFITS OF DERIVATIVES
The different uses of derivatives for corporate enterprises are discussed
below:
Benefits to Companies
1. Lowering funding costs Derivatives allow corporations to lower
funding costs by taking advantage of differences that exist between capital
markets through arbitrage opportunities or issuance of customized
instruments. Derivatives allow the principle of comparative advantage to
be applied to financing. Where financial markets are segmented nationally
or internationally due to market or regulatory barriers or different
perceptions of credit qualities in various markets, the use of derivatives
has delivered unambiguous cost savings for borrowers and higher yields
for investors.
For instance, it is possible for a borrower to issue debt where it has a
comparative advantage and use a currency swap to obtain funding in its
desired currency at a lower funding cost than a direct financing. Similarly,
a borrower who generates savings in this way is, in effect, using a swap to
exploit an arbitrage between the financial markets involved. Further,
borrowers are able to achieve savings by issuing structured securities
tailored to meet specific investor requirements. Borrowers use swaps to
obtain the borrowing currency and structure they need.
2. D i vers ifyi n g f un d i n g s ourc es By obtaining financing
from one market and then swapping all or part of the cash flows into the
desired currency denominations and rate indices, issuers can diversify
their funding activities across global markets. Placing debt with new
investors may increase liquidity and reduce funding costs for the issuer.
3. In tern atio n al oper atio n s In the case of transnational
corporations, borrowing needs of a particular country or countries may be
too small to be funded cost effectively through the local capital markets.
Such corporations would find the whole task of borrowing in the domestic
market cheaper and then swaping them into the currencies of needed
countries.
4. Hedging the cost It is obvious that volatile interest rates
create uncertainty about the future cost of issuing fixed-rate debt. Delayed
start swaps, or forward swaps, can be used to “lock-in” the general level
110 Capi tal Markets

of interest rates that exists at the time the funding decision is made. Such
hedging eliminates general market risk. It does not eliminate, however,
specific risk—the risk that an issuer’s funding cost may move out of line
with the funding cost of other borrowers, due to factors related primarily
to the issuer.
5. Managing existing debt or asset portfolios Where a company
wants to change the characteristics of its existing debt portfolio—either
the mix of fixed and floating rate debt or the mix of currency
denominations, interest rate swaps can be used to adjust the ratio of
fixed to floating rate debt, while currency swaps can be used to transform
an obligation in one currency into an obligation in another currency,
thus changing the currency mix of the debt portfolio. Volatile interest
rates may affect the value of a firm’s assets as well as its liabilities. To
protect the firm’s net worth from the interest rate risk, corporate treasuries
increasingly take account of the interest rate sensitivity of both assets
and liabilities in designing hedges. Interest rate swaps can be used to
adjust the average maturity or interest rate sensitivity of a company’s
debt portfolio so that it more closely matches the interest rate sensitivity
of the asset side of the balance sheet, reducing the exposure of the
company’s net worth or market value to interest rate risk.
6. Managing foreign exchange exposures Both importers and
exporters are exposed to exchange rate risk. As a result of this transactional
exposure, an importer’s profit margin can, and often does evaporate, if its
domestic currency weakens sharply before purchases have been paid for.
International firms with overseas operations also face translation exposure
as the value of their overseas assets and liabilities are translated into
domestic currency for accounting purposes. The competitive position of
many domestic producers also is subject to change with major movements
in foreign exchange rates. Currency swaps, and foreign exchange forwards
and options can be used to create hedges of those future cash flows and
reduce the risk.
7. Managing commodity price exposures Volatility in commodity
prices, such as oil or copper, creates significant risk exposures for producers
or firms using these or closely related commodities as inputs. These
exposures can be hedged using commodity forwards, swaps, caps, or
collars.
8. Benefits to government entities Government entities, including
national governments, local governments, state-owned or sponsored
entities, and supranationals such as the World Bank use derivatives for
much the same reasons as non-financial corporations. They use derivatives
 Deri vati ves Market 111

in financing activities to diversify their sources of funds and achieve cost

savings through arbitrage of international and national capital market and
issuance of hedged structured securities. Derivatives are also used for
debt management purposes, especially by those governments borrowing
in different currencies. Recently, some government entities have turned to
commodity derivatives to manage oil price risk.
Benefits to Institutional Investors
1. Enhancing yields The earliest use of swaps by institutional
investors involved asset swaps, in which the cash flows from a particular
asset are swapped for other cash flows, possibly denominated in another
currency or based on a different interest rate. Institutional investors use
derivatives to create investments with a higher yield than corresponding
traditional investments. They might do this when securities trade poorly
because of some unattractive feature. In such a case, an investor may
purchase the securities, neutralize the undesirable feature with a suitable
derivatives transaction, and create, for example, a synthetic fixed-rate
investment with a higher yield than comparable fixed-rate instruments of
the same credit quality.
2. Managing exposures Institutional investors have recently begun
to use derivatives, especially interest rate and equity swaps, to manage
their exposure to debt and equity markets, both domestic and international.
The immediate appeal is the ability to quickly and effectively adjust
exposures—between debt and equity or among different equity classes—
without incurring substantial transaction and custodial costs. There is
also potential to enhance yields. The availability of equity swaps on the
major international equity indices allows investors to diversify globally
and adjust their portfolios in a cost-effective manner.
3. Eliminating currency risk Some institutional investors wish to
benefit from investment in or exposure to foreign debt or equity markets
without necessarily incurring foreign exchange risk. A family of swaps
called “quanto” swaps has been designed to meet the growing demands
of investors for investment diversification without currency risk.
4. Managing risk exposures Institutional investors have benefited
from the creation of customized structured securities in which the principal
redemption, coupons, or both are indexed to an underlying. These
structured securities are equivalent to combinations of derivatives and
traditional credit extension instruments, such as bonds, loans, or
deposits. They meet the particular investment needs of the institutional
investors and allow corporations to raise funds at a lower all-in cost.
112 Capi tal Markets

Corporations, Banks, and Government borrowers that issue these

instruments typically use derivatives to hedge the unwanted risk and
create attractively priced synthetic fixed or floating rate liabilities in the
currency of their choice.

RISKS IN DERIVATIVES MARKET

The risks to end-users and dealers involved in derivatives can be broadly
categorized as market, credit, operational, and legal. These risks are of
the same types that banks and securities firms have to face in their
traditional lines of business, taking deposits and making loans, or
purchasing and financing securities positions. However, sophisticated
risk management system has been developed for managing the derivatives
risks. Some other banking products, such as residential mortgages with
prepayment options, require a similarly sophisticated approach to risk
management.
The assessment and management of the risks associated with
derivatives activities is discussed below:
Market Risk
Meaning
Market risk of derivatives arises from price behavior when market conditions
undergo changes. The dealer or the end-user can manage the risk by
identifying the components of market risk and understanding their
interaction too. The assessment of market risk relies on a mark-to-market
valuation of derivatives and the underlying instruments, which may serve
as hedges. Dealers now typically manage the market risks of their
derivatives activity on the basis of the net or residual exposure of the
overall portfolio. A dealer’s portfolio generally will contain many offsetting
positions, which substantially reduce the overall risk of the portfolio,
leaving a much smaller residual risk to be hedged.

Managing Market Risks

While managing market risk, a dealer must first of all determine properly
the net position of the portfolio. Dealers look beyond the particular
contracts and focus instead, on identifying the fundamental risks they
contain, so that the overall portfolio can be decomposed into underlying
risk factors that can be quantified and managed. The fundamental risks
that must be identified are as follows:
 Deri vati ves Market 113

1. Absolute price or rate (or delta) risk This is the exposure to a

change in the value of a transaction or portfolio corresponding to a given
change in the price of an underlying.
2. Convexity (or gamma) risk This is the risk that arises when the
relationship between the price of an underlying and the value of a transaction
or portfolio is not linear. The greater the non-linearity greater the risk.
3. Volatility (or vega) risk This is typically associated with options
and is the exposure to a change in the value of a transaction or portfolio
resulting from a given change in the expected volatility of the price of an
underlying.
4. Time decay (or theta) risk This is typically associated with options
and is the exposure to a change in the value of a transaction or portfolio
arising from the passage of time.
5. Basis (or correlation) risk This is the exposure of a transaction or
portfolio to differences in the price performance of the derivatives it contains
and their hedges.
6. Discount rate (or rho) risk This is the exposure to a change in the
value of a transaction or portfolio corresponding to a change in the rate
used for discounting future cash flows.
Analysis of Market Risks
The market risks of derivative portfolios are best analyzed in terms of the
fundamental risks associated with the two basic types of derivatives. It
may contain: forward-based and option-based derivatives. The market
risks of forward-based derivatives are relatively straightforward since the
dominant risk is absolute price or rate risk. Changes in the price of the
underlying result in proportional changes in the value of the derivative.
Forward-based derivatives generally do not have significant exposure to
convexity (gamma) risk. The simplicity of the market risk profile of these
derivatives makes hedging and monitoring risk easier than for option-
based derivatives. A hedge will consist of a proportional amount of the
underlying (or another forward-based derivative) and this hedge is, for all
intents and purposes, relatively static.
The relationship between the price of an option and the price of its
underlying is not constant, as is the case with forward-based derivatives.
The price sensitivity of an option’s value changes with changes in the
price of the underlying, so that options create exposures to risk of gaps in
prices of the underlying as well as directional movements. Options also
create exposure to volatility risk. Changes in the expected volatility of the
underlying will affect the value of the option, even if the price of the
underlying remains constant. The passage of time also affects the value of
114 Capi tal Markets

an option because of time decay—the reduction in the likelihood that the

option will end-up in-the-money (or further in-the-money) as the time to
expiration is reduced.
The risks inherent in option-based derivatives are more complex. The
valuation of options is based upon a set of theories and mathematical
models built on foundation first developed in the 1970s. One of the key
contributions was the option valuation model developed by Fisher Black
and Myron Scholes. The Black-Scholes model identifies five factors that
determine the value of many options such as the price of the underlying,
the exercise price of the option, the time of expiration of the option, the
volatility of the price of the underlying, and the discount rate over the life
of the option. These risk factors are considered below:
Market Liquidity Risk
This is typically associated with the possibility that a large transaction in
a particular instrument could have a discernible effect on the price of the
instrument. This market impact increases the cost of hedging. In illiquid
markets, moreover, bid-ask spreads are likely to be larger, further increasing
the cost. A related phenomenon is the risk of an unexpected and sudden
erosion of liquidity, possibly as a result of a sharp price move or jump in
volatility.
By breaking the market risk of a particular product down into its
fundamental elements, however, dealers are able to move beyond product
liquidity to risk liquidity. For example, the interest rate risk of a complicated
U.S. Dollar interest rate swap can be hedged with other swaps, FRAs,
Eurodollar futures contracts, treasury notes, or even bank loans and
deposits. The customized swap may appear to be illiquid, but, if its
component risks are not, then other dealers can effectively acquire the
transaction and hedge it.

Basis or Correlation Risk

When a derivatives transaction is used to hedge another position, changes
in the market value of the combined position result from basis risk. With a
perfect hedge, the value of the combined position remains unchanged for
a change in the price of the underlying. With an imperfect hedge, the
values of the instrument and its hedge are not perfectly correlated. For
example, when similar asset classes are aggregated, so that the risk can be
managed on a portfolio basis, there may be maturity mismatches among
deals or variation in price movements between the net derivatives position
and the corresponding hedge. Correlation risk is an additional element of
 Deri vati ves Market 115

market risk that must be measured and managed.

Investing and Funding Risk
Dealers and other participants who manage a portfolio of derivatives
must meet the investing and funding requirements arising from cash
flow mismatches. In addition, participants may be exposed to additional
investing and funding requirements if the agreements they use to
document transactions contain collateral provisions that protect cash
and securities receipts or payments. The magnitude and direction of net
cash positions can be forecast, but will fluctuate with changes in the
market and activity in the portfolios. Transactions can be undertaken in
derivatives and the cash markets to manage investing and funding risks.
Credit Risk
Credit risk is the risk that a loss will be incurred if counter party defaults on
a derivatives contract. The loss due to a default is the cost of replacing the
contract with a new one. The replacement cost at the time of default is
equal to the present value of the expected future cash flows.
1. Credit risk of individual derivatives The credit risk of a derivatives
transaction fluctuates over time with the underlying variables that determine
the value of the contract. In assessing credit risk, the current exposure and
the potential exposure must be considered.
a. Current exposure It simply asks for the current market value of
the derivatives at a given point in time— the cost of replacing the
remaining cash flows at the prices and market interest rates
prevailing when the event of termination occurs. The replacement
cost could be positive or negative, depending on the evolution of
the underlying, since the inception of the transaction. Whenever
the replacement cost is negative, the remaining party incurs no
loss on its counter party defaults.
b. Potential exposure It explains the replacement cost of the
derivatives transaction in the future if the underlying variables
that determine the value of the contract move adversely. Dealers
use Monte Carlo or historical simulation studies or option valuation
models to assess potential exposure. These analysis generally
involve modeling the volatility of the underlying and the effect of
its movements on the value of the derivatives transaction. These
techniques are often used to generate two measures of potential
exposure: “expected” exposure and maximum or “worst case”
exposure.
116 Capi tal Markets

Expected exposure at any point during the life of the swap is the mean
of all possible replacement costs, where the replacement cost in any
outcome is equal to the market value, if positive, and zero, if negative.
Expected exposure is the best estimate of the present value of the positive
exposure, or credit risk, that is likely to materialize. Hence, expected
exposure is an important measure in derivatives dealer’s capital allocation
and pricing decisions.
It is important to appreciate that counter party defaults in a forward or
swap transaction may not cause a loss. For a credit loss to occur on a
forward or swap transaction, two conditions must coexist—that the counter
party defaults and that the replacement cost of the transaction, (i.e. the
exposure) is positive.
Unlike forwards and swaps, counter party risk in options is one-
sided. The buyer of the option typically pays in full for the option at
contract initiation. The seller, however, is not required to perform until the
option is exercised. This exposes the buyer to credit risk in that the seller
may default prior to fulfilling the commitment under the option.
2. Credit risk of a portfolio In calculating the current replacement
costs for a portfolio of transactions with a counter party, it is important to
know whether netting applies and is enforceable. Master agreements used
for documenting swaps typically provide for netting of close-out values
across all transactions under the contract in the event of default. If a
counter party defaults, application of close-out netting will result in all the
outstanding transactions being terminated and marked to market; the net
(not gross) amount owed under all the transactions would be the
replacement cost for that counter party. If netting applies, the current
credit exposure is simply the sum of the positive and negative mark-to-
market values of the transactions in the portfolio. If netting does not
apply, only the positive mark-to-market transactions should be added in
calculating current exposure because the positive mark-to-market could
not be offset against negative mark to market positions in the event of
default.
The potential exposure for a portfolio of transactions is more difficult
to calculate. While the simplest method is to add the potential exposure of
each transaction in the portfolio, this procedure dramatically overstates,
in most cases, the actual potential exposure. It does not take into account
transactions in the portfolio with offsetting exposures or transactions that
have peak maximum potential exposures that occur at different times. The
potential exposure of a portfolio of transactions with a given counter
party can be analyzed more thoroughly by portfolio-level simulation that
 Deri vati ves Market 117

accounts for portfolio effects and provides more accurate measures of

expected and maximum potential exposure than would be obtained by
aggregating exposures on individual transactions.
The overall credit risk of a derivatives portfolio also depends upon
the extent of diversification across specific counter parties and types of
counter parties. For large diversified derivatives portfolios, “worst case”
exposure becomes a less useful measure since it is highly unlikely that all
worst-case outcomes will occur simultaneously. Concentration of the
portfolio with one counter party (or type of counter party) increases credit
risk. This is as true for a derivatives portfolio as it is for a loan book.
3. Managin g credit ris k Dealers adopt various policies and
procedures to manage counter party credit risk. These include internal
controls that ensure that credit risk is assessed prior to entering into
transactions with a given counter party and that credit risk is monitored
over the life of the transaction. Besides, documentation provisions also
help mitigate credit risk and thereby ensure transaction enforceability.
Similarly, credit enhancement structures are also put in place to reduce or
limit the credit exposure of dealing with particular counter parties.
4. Cred it evaluation The credit risk in these derivatives is
addressed generally through counter party credit evaluation and by the
use of risk limits for counter parties. The credit quality of the users of
global derivatives is typically high. For less creditworthy counter parties,
credit enhancement methods such as collateral are often employed.
5. Cre d it expo s ure s Although the measurement of credit
exposures for derivatives transactions is more complicated than the
measurement of exposure for more traditional banking products, the
principles of assuming credit risk and managing these risks remain the
same. For this reason, major dealers typically manage credit exposure on a
consistent and integrated basis across the organization. Specifically, the
evaluation of the credit exposures of derivatives transactions is made on
a comparable basis with those exposures for on-balance-sheet activities,
allowing the dealer to consistently integrate the two activities in the credit
allocation and review process.
Settlement Risk
One aspect of settlement risk results from the fact that few financial
transactions are settled on a same-day basis, or simultaneously. In the
U.S. equity markets, for example, the difference between the trade date and
settlement is at present five days. As a result, one party could suffer a loss
if the price moved in his favor and the counter party refused to exchange
118 Capi tal Markets

on the settlement date. The largest settlement exposures, however, typically

occur on the settlement day itself when the full value of the security can
be at risk if delivery of the security and delivery of the payment are not
synchronized.
Settlement risk in derivatives is reduced greatly by the widespread
use of the payment netting provisions of master agreements. This reduces
the settlement risk of payments made in the same currency. In addition, for
many derivative transactions (e.g. interest rate swaps), principal amounts
are not exchanged on the maturity date.
Payment netting, however, does not address cross currency settlement
risk. The largest source of settlement risk in payment systems is the
settlement exposure created by foreign currency trades—spot and short-
dated forwards (called “Herstatt” risk after the 1974 failure of the Bankhaus
Herstatt). While derivatives activity would benefit from a reduction of
Herstatt risk, it must be noted that the amounts involved in derivatives are
very small relative to the amounts involved in traditional foreign exchange
activities.
Operational Risk
Operational risk is the risk of losses occurring as a result of inadequate
systems and control, human error, of management failure. Such risks also
exist in securities and credit businesses. The complexity of derivatives,
however, requires special emphasis on maintaining adequate human and
systems controls to validate and monitor the transactions and positions
of dealers. The main types of internal controls, depending upon the level
of derivatives and the sophistication of the institution, may include the
following:
1. Oversight of informed and involved senior management
2. Documentation of policies and procedures, listing approved
activities and establishing limits and exceptions, credit controls
and management reports
3. Independent risk management function (analogues to credit
review and asset/liability committees) that provides senior
management validation of results and utilizations of limits
4. Independent internal audits which verify adherence to the firm’s
policies and procedures
5. A back office with the technology and systems for handling
confirmations, documentation, payments, and accounting
 Deri vati ves Market 119

6. A system of independent checks and balances throughout the

transaction process, from front-office initiation of a trade to final
payment settlement

Legal Risk
Legal risk is the risk of loss because a contract cannot be enforced. This
includes risks arising from insufficient documentation, insufficient capacity
or authority of a counter party (ultra vires), uncertain legality and
unenforceability in bankruptcy or insolvency.
Although financial institutions have encountered these legal risks in
their traditional lending and trading businesses, the risk comes in new
forms with derivatives. Legal analysis of derivatives-related disputes,
moreover, often turns on form as well as substance. In the early days of
global derivatives activity, lawyers were presented with a host of issues—
corporate, constitutional, tax, and regulatory that grew out of the fact that
existing laws and regulations had been written before these new
transactions were developed.
Enforceability risk results from the possibility that a derivative contract
with a positive replacement cost might be found to be unenforceable. This
might result from one’s counter party being legally incapable of entering
into the contract, (i.e. ultra vires) or from an entire class of contracts being
declared illegal or unenforceable. Similarly, provisions for netting of
exposures on transactions documented under master agreements offer
obvious benefits to end-users and dealers.
Derivatives and Financial System
Derivatives cause the systemic risk. Such a risk is caused by the following
factors:
1. The size and complexity of derivatives activity
2. The concentration of activity among a relatively small number of
institutions
3. The lack of transparency of risk management activities including
derivatives
4. The apparent illiquidity of customized derivatives interactions
5. Increased settlement risk because of growth of derivatives
6. The credit exposures undertaken by dealers
7. The presence, among large dealers, of unregulated activities
8. The interconnection risk arising from the role played by
derivatives in increasing links among capital markets
120 Capi tal Markets

CAPITAL STANDARDS FOR DERIVATIVES

The Basle Committee on Banking Supervision published standards for
capital adequacy in 1988. The standards sought to establish a system in
which minimum capital requirements were set for banking firms based on
the risk of bank assets. Many countries including India have adopted the
risk-based capital standards specified in the Basle Accord. The
assignments of minimum capital primarily reflected an assessment of credit
risk or the risk of loss due to counter party default. Consideration of other
types of risk was left to national regulatory authorities or to future
deliberations of the Basle Committee and its subgroups.
REGULATING DERIVATIVES MARKET
The regulatory and supervisory response has so far focused on improving
supervisory oversight and on increasing disclosure. In April 1993, the
Basle Committee sought comments on a consultative paper describing
proposals for incorporating additional types of risks into the original
framework. The G30 report (July 1993) on derivatives was the first attempt
to set out principles for the management of a derivatives trading operation.
In March 1995, the Derivatives Policy Group (DPG), drawn from six U.S.
securities firms produced Framework for Voluntary Oversight, a code for
better disclosure of their Over-The-Counter (OTC) derivatives activities.
In July 1995, a tripartite group of banks, securities and regulators
recommended setting up of a nine-person joint forum representing the
Basle Committee on Banking Supervision, the International Organization
of Securities Commissions (IOSCO) and International Association of
Insurance Supervisors (IAIS) to examine different aspects relating to
derivatives. But an agreement on the financial regulation of derivatives
market has eluded so far.
ADVENT OF DERIVATIVES MARKET IN INDIA
Although India has started the innovations in financial markets very late,
some of the recent measures initiated by the regulatory authorities are
worth mentioning as follows:
Pe rmis sion
Futures trading has been permitted in certain commodity exchanges.
Mumbai Stock Exchange has started futures trading in cottonseed and
cotton under the BOOE and under the East India Cotton Association
(EICA).
 Deri vati ves Market 121

Infrastructure
Necessary infrastructure has been created by the National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE) for trading in stock index
futures, and the commencement of operations in selected scrips.
LERMS
Introduction of the Liberalized Exchange Rate Management System
(LERMS) in the year 1992 for regulating the flow of foreign exchange.
Tarapore Committee
Constitution of a committee by the RBI headed by S.S. Tarapore to go into
the merits of full convertibility on capital accounts.
Interest Rate
RBI has initiated measures for freeing the interest rate structure. Further,
the RBI has envisioned ‘MIBOR’ (Mumbai Inter Bank Offer rate) on the
line of LIBOR as a step towards introducing futures trading in interest
rates and forex.
Badla
Banning of ‘Badla’ transactions in all 23 stock exchanges including the
NSE, DSE and the BSE from July 2001.
Nifty
NSE’s efforts to start trading in index options based on the Nifty (NSE 50)
and certain stocks.
REVIEW QUESTIONS
Section A
1. What are ‘derivatives’?
2. What are ‘forward contracts’?
3. What are ‘swaps’?
4. What is a financial swap?
5. What is meant by ‘parallel loan’?
6. What are ‘currency swaps’?
7. What is ‘swap spread’?
8. How is a swap valued?
9. What are ‘futures contract’?
10. What are ‘Forward Rate Agreements’?
11. Name some of the option based derivatives
12. What are ‘options’? What are its types?
13. What is ‘a call option’?
122 Capi tal Markets

14. What is ‘a put option’?

15. What are ‘structured options’?
16. What is ‘bundling an option’?
17. What are ‘swaptions’?
18. Identify the various participants in the derivatives market
19. What is ‘liquidity risk’?
20. What is ‘credit risk’?
Section B
1. What are the shortcomings of the derivatives market?
2. What are the features of ‘forward contracts’?
3. What are the features of ‘swaps’?
4. How are swaps beneficial?
5. Explain the modus operandi of swaps.
6. How does the ‘interest rate swaps’ work?
7. What are the features of ‘futures contracts’?
8. State the features of ‘Forward Rate Agreements’?
9. How is a forward contract different from a futures contract?
10. Bring out the features of ‘options’?
11. Explain clearly the role of dealers in the derivatives market.
12. How are derivatives useful for corpoarates?
13. How are derivatives beneficial to institutional investors?
14. What is ‘market risk’? Identify the different kinds of market risk?
15. How could a ‘credit risk’ managed?
16. What is the ‘settlement risk’ attached to the use of derivatives?
17. How is operational risk caused while handling derivatives?
18. State the nature of ‘legal risk’ attached to the use of derivatives?
19. How are derivatives important in the financial system of a
country?
Section C
1. Trace the factors that have caused tremendous growth of
derivatives market around the globe in the recent times.
2. Discuss the various functions of a derivatives market.
3. How are derivatives categorized? Explain.
4. Explain the role of various participants in the derivatives market.
5. Discuss the various advantages of derivatives.
6. Derivatives need to be handled carefully; else they would entail
a huge loss – Elucidate the statement clearly bringing out the
various risks attached to the use of derivative instruments.
7. How is the derivatives market regulated in India? Explain in the
light of the measures initiated by the Government .
 Chapter 6

SEBI—Functions and Working

Presence of an efficient securities market is an important requirement for a

country’s march towards industrialization. For, the market offers a
mechanism for efficient mobilization and channeling of savings of the
household sector into productive enterprises. By offering attractive
rewards in the form of returns and capital appreciation, the securities
market encourages thrift and risk taking. It also helps enterprises to raise
money in a cost-effective manner. The emergence of securities market in
India dates back to the eighteenth century, when the Bombay Stock
Exchange was set up in 1887. It was a vital segment of the Indian financial
system.
The securities market came in for a spectacular growth, both in terms
of its ability to mobilize resources and to allocate it with some efficiency in
the nineteenth century. The market came to provide all the support needed
for the growth and development of the corporate sector by facilitating the
raising of long-term capital funds. In fact, the Indian financial system
witnessed an unprecedented growth in terms of the number and the variety
of players. The number of active investors, institutions and intermediaries
increased manifold. The stock exchanges also grew in number. All these
factors necessitated the need for creating an awareness and interest among
the common investors. Moreover, the burgeoning growth of corporate
enterprises ushered in excellent investment opportunities available in the
securities market among the lay savers.
The need for setting up a statutory apex body was felt by the
government to promote an orderly and healthy growth of the securities
market and for investor protection. The body was expected to help sustain
the growth momentum and thereby, crystallize the awareness and interest
into a committed, discerning and growing pool of investors. This was
aimed at protecting investors’ rights and curbing trading malpractices and
structural inadequacies of the market. In countries like the USA and UK,
National Securities Exchange Commission monitors the capital market
124 Capi tal Markets

operations and safeguards the investors’ interest. Such an agency helped

the healthy growth of the securities market there.
GENESIS
Government of India set up the Securities and Exchange Board of India
(SEBI) on April 12, 1988 on the basis of the recommendations of the high
powered Committee on Stock Exchange Reforms headed by G.S. Patel.
SEBI was given a legal status by the Securities and Exchange Board of
India Ordinance, 1992. The members of the Board of Management of the
SEBI comprised those drawn from professional brokers, financial
consultants, merchant bankers, investors, stock exchange authorities,
finance ministry, etc.
FEATURES OF THE SEBI BILL
The SEBI has been entrusted with a wide range of responsibilities in
regulating the activities of almost all the players in the capital market.
After the abolition of the controller of capital issues, the issuer of capital,
which is the promoter, has come under SEBI’s jurisdiction. The SEBI laid
down certain guidelines for the issuers to ensure investor protection. The
SEBI was expected to regulate mutual funds, merchant bankers, registrars
to issue, share transfer agents, portfolio managers, underwriters, investment
advisors, brokers and sub-brokers. SEBI has also been given certain powers
to regulate the functioning of stock exchanges in India.
OBJECTIVES
SEBI was set up with the following objectives of assisting and facilitating
the mobilization of adequate resources through the securities market and
its efficient allocation, keeping in mind the interests of issuers, investors
and the intermediaries:
Conducive environment SEBI aims at creating a proper and con-
ducive environment required for raising money from the capital market
through the rules, regulations, trade practices, customs and relations among
institutions, brokers, investors and companies. It also aims at endeavor-
ing to restore and safeguard the trust of investors, especially the interest
of the small investors. This is to be achieved by meeting the needs of the
players connected with the securities market such as the investors, the
corporate sector and the intermediaries. SEBI works for creating proper
investment climate to enable corporate sector to float industrial securities
easily, efficiently and at affordable minimum cost.
 SEBI— Functi ons and Worki ng 125

Investor education SEBI aims at educating investors so as to make

them aware of their rights in clear and specific terms by providing them
with information. This way, SEBI aims at maintaining liquidity, safety and
profitability of the securities in the market that are crucial for any invest-
ment. A high degree of protection of investor rights and interests is made
possible by providing adequate, accurate and authentic information on a
continuous basis. This way, the market efficiency is also ensured.
Infrastructure SEBI aims at developing a proper infrastructure for fa-
cilitating automatic expansion and growth of business of middlemen like
brokers, jobbers, commercial banks, merchant bankers, mutual funds, etc.
This is aimed at providing efficient service to their constituents, viz. in-
vestors and corporate sector at competitive prices.
Others In addition to the above mentioned objectives, SEBI would
also make efforts to bring about necessary enactments for regulating
business of intermediaries such as mutual funds, NBFCs and chit funds,
etc. SEBI would also work towards creating a framework for more open,
orderly and unprejudiced conduct in relation to takeover and mergers in
the corporate sector so as to ensure fair and equal treatment to all the
security holders.

MANAGEMENT
Under Section 4 of the SEBI Act, the management of SEBI is entrusted
with the Board of Members. The Board consists of a Chairman, two
members from amongst the officials of the Ministries of the Central
Government dealing with Finance and Law, one member from amongst
the officials of the Reserve Bank of India constituted under Section 3 of
the Reserve Bank of India Act, 1934 and two other members appointed
by the Central Government who are professionals having experience or
special knowledge relating to securities market. The Chairman and the
other members of the Board are chosen from amongst the persons of
ability, integrity and standing who have shown capacity in dealing with
problems relating to securities market or have special knowledge or
experience of law, finance, economics, accountancy, administration or in
any other discipline which, in the opinion of the Central Government,
shall be useful to the Board.
POWERS AND FUNCTIONS
Under the SEBI Act
Under Section 11 (1) of the SEBI Act, following are the powers and the
126 Capi tal Markets

functions of the SEBI, designed to protect and promote the interests of

investors in securities, and thereby allow for the promotion and the
development of the securities market in a regulated manner:
1. Stock exchange regulation SEBI is empowered to regulate the
business in stock exchanges and any other securities market. It works to
prohibit fraudulent and unfair trade practices in securities market. SEBI
performs functions like calling for information, undertaking inspection,
conducting enquiries and audits of the stock exchanges, intermediaries,
and self-regulatory organizations in the securities market.
2. Stock brokers regulation SEBI is empowered to register and
regulate the working of stockbrokers, sub-brokers, share transfer agents,
bankers to an issue, trustees of trust deeds, registrars to an issue, merchant
bankers, underwriters, portfolio managers, investment advisers and such
other intermediaries who may be associated with securities market in any
manner.
3. CIS regulation SEBI works to regulate the working of Collective
Investment Schemes (CIS), including mutual funds. For this purpose it
promotes and regulates self-regulatory organizations.
4. Investor protection SEBI is empowered to initiate all the steps for
promoting investor education and training of intermediaries in securities
market. For this purpose it would work towards prohibiting insider trading
in securities, besides regulating substantial acquisition of shares and take-
over of companies.
5. Others
a. Performing such functions and exercising such powers under
the provisions of the capital issues (Control) Act, 1947
(Subsequently repealed) and the Securities Contracts
(Regulations) Act. 1956, as may be delegated to it by the Central
Government
b. Levying fees or other charges for carrying out the purposes of
Section 11 of the Act
c. Conducting research for the above purpose
d. Performing such other functions as may be prescribed by the
government
Section 17 of the Act empowers the Central Government to supersede
SEBI and exercise all of the above powers under the following
circumstances:
1. Where on account of grave emergency SEBI is unable to
discharge the functions and duties under any provisions of the
Act
 SEBI— Functi ons and Worki ng 127

2. Where the SEBI persistently defaults in complying with any

direction issued by the Central Government under the Act
3. Where in the discharge of its functions and duties under the Act
and as a result of such default the financial position of SEBI or its
administration has deteriorated
4. Where the public interest is to be served
Under the SCRA
In addition to the powers that have been granted to be exercised by the
SEBI under its own law, following are the powers granted to it under the
Securities Contracts (Regulation) Act (SCRA):
Information SEBI calls for periodical returns from stock exchanges. It
would also prescribe maintenance of certain documents by the exchanges.
In addition, SEBI calls upon the exchange/any member(s) to furnish
explanation/information relating to the affairs of the exchange/any
member(s) and appoint any person to conduct an inquiry into the affairs
of the governing body of any exchange/any member of the exchange.
Stock exchange regulation SEBI commands the following powers
as relating to the regulation of stock exchanges:
a. Approval of byelaws of the exchange(s) for regulation and control
of contracts
b. Licensing of dealers in securities in certain areas
c. Compel a public company to list its shares
d. Amendment of rules relating to matters specified in Section 3(2)
of the Act
e. Furnishing of annual report by recognized stock exchanges
f. Issuing directions to stock exchanges in general or a stock
exchange in particular to make rules or to amend rules
g. Superseding the governing body of a recognized stock exchange
h. Suspension of business of a recognized stock exchange
i. Prohibit contracts in certain cases
j. Submission of applications for the recognition of stock
exchanges
k. Grant of recognition to stock exchanges
l. Withdrawal of recognition of a stock exchange
m. Making or amending rules or articles of association of a stock
exchange regarding voting rights of members of a stock exchange
at any meeting
n. Issue of notification declaring Section 13 to apply to an area,
consequent upon which contracts issued in that area, otherwise
128 Capi tal Markets

than between members of a recognized stock exchange or through

or with such members would be illegal
o. Regulation and control of the business of dealing in spot
delivery contracts
p. Hearing appeals submitted by companies against refusal of a
stock exchange to list their securities and
q. Issues of a notification specifying any class of contracts as
contracts to which the SCRA or any provision contained therein
would not apply
Registration of Intermediaries
All intermediaries dealing in securities are compulsorily registered with
the SEBI in accordance with the regulations made under the SEBI Act. The
certificate of registration contains the conditions/rules and regulations
for conduct of business by the security market intermediaries. The SEBI
prescribes regulations for the application form and the manner of making
an application as well as the fee payable. The SEBI can suspend/cancel a
certificate of a registration granted to the intermediaries in accordance
with the regulations made by it in this behalf. An intermediary/person
aggrieved by an order of the SEBI, suspending/canceling registration can
prefer an appeal to the Government. By various regulations notified from
time to time, the SEBI has prescribed the procedure for registration of
various intermediaries associated with the securities market.
Directions from Government
The Government of India can issue directions to the SEBI on questions of
policy in writing from time to time. It is bound to follow and observe such
directions in the exercise of its powers/the performance of its functions.
The Government has absolute discretion to determine whether a question
is one of the policy or not. Its inability to discharge its functions/duties, or
non-compliance to follow and act upon any direction given by the
Government or requirement in the public interest may lead to its
supersession by the Government.
Power to Make Rules
The Government is authorized to make rules for carrying out the purposes
of the SEBI Act. The important matter for which rules may be framed,
include, the additional functions to be performed by it, its constitution,
maintenance of its accounts, manner of inquiry to impose penalty for
defaults, constitution of the Securities Appellate Tribunal (SAT), the forms
of appeal and fee before the SAT, and the form in which reports have to be
 SEBI— Functi ons and Worki ng 129

submitted to the Government. The Government was also empowered to

frame rules regarding the conditions for certificate of registration for
intermediaries. With effect from 1995, this power was withdrawn from the
Government and rests with the SEBI now.
Power to Make Regulations
To carry out its functions, the SEBI is empowered to make regulations.
Every regulation made by it must have the prior approval of the
Government. All such regulations must be published as notification in the
official gazette. The matters for which regulations may be framed include
(a) the conditions for registration certificate, fee for registration,
cancellation/suspension of registration of intermediaries and (b) matters
relating to issue of capital, transfer of securities and so on.
Penalties
With effect from 1995, the SEBI has been empowered to impose penalties
on different intermediaries for defaults such as the following:
1. Failure to furnish information and return The SEBI can impose
penalties as detailed below:
a. For failure to furnish any document, return, report—not exceeding
Rs. 1,50,000 for each such failure
b. For failure to file any return/furnish any information, books or
documents within the specified time—not exceeding Rs. 50,000
for each day
c. Failure to maintain books of accounts/records—not exceeding
Rs. 10,000 for each day
2. Failure to enter into agreement with clients not to exceed Rs. 5
lakh for every failure
3. Failure to red res s in ves tors ’ grievan c es not to exceed
Rs. 10, 000 for each such failure
4. Defaults in case of mutual funds
a. Default in not obtaining certificate of registration—not to exceed
Rs. 10,000 for each day or Rs. 10 lakhs whichever is higher
b. Default in not complying with the terms and conditions of the
certificate of registration—not to exceed Rs. 10,000 for each day
or Rs. 10 lakhs, whichever is higher
c. Default in failing to make an application for listing of schemes—
not to exceed Rs. 5,000 per day or Rs. 5 lakhs, whichever is higher
d. Default in not despatching unit certificates—not to exceed
Rs. 5,000 for each day of default
130 Capi tal Markets

e. Default in failing to refund application money—not to exceed

Rs. 1,000 for each day of default and
f. Default in failing to invest collected money not to exceed
Rs. 5 lakhs for each such default
5. Failure by an AMC not to exceed Rs. 5 lakhs for each such failure
6. Default in case of stock brokers
a. For failure to issue contract notes in the form and manner
prescribed by the stock exchange—not to exceed five times the
amount for which the contract note was required to be issued
b. For failure to deliver any security/payment the amount due to the
investor in the manner and within the period specified in the
regulations—not to exceed Rs. 5,000 for each day of default
c. For charging brokerage in excess of that prescribed by the
regulation not to exceed Rs. 5,000 or five times the excess charge,
whichever is higher
7. Penalty for insider trading If an insider (a) deals in securities on
his behalf or on behalf of others on the basis of an unpublished price
sensitive information or (b) communicates any unpublished price sensitive
information except as required in the course of business or under any law,
or (c) counsels or procures for any person to deal in such securities on the
basis of unpublished price sensitive information, he is liable to a penalty
not exceeding Rs. 5 lakhs.
8. Non-disclosure of acquisition of shares and takeovers Failure
to disclose the aggregate of shareholding in a company before acquiring
any shares of that company, and also to make a public announcement for
acquiring shares at a minimum price is liable to penalty not exceeding
Rs. 5 lakhs.
Power to Adjudicate
The SEBI is empowered since 1995, to appoint any of its officers of the rank
of a division chief as the adjudicating officer, to hold an enquiry in the
prescribed manner for determining the amount of penalty on any intermediary.
The quantum of penalty is to be fixed with due regard to (a) the amount of
disproportionate gain or unfair advantage made as a result of the default,
(b) the amount of loss caused to an investor/group of investors as a result
of the default and (c) the repetitive nature of the default.
 SEBI— Functi ons and Worki ng 131

REGULATORY ROLE
Since its inception in 1992, the SEBI, as a capital market regulator, has been
making tremendous efforts towards achieving its twin objectives of
investor protection and capital market development as mandated by the
SEBI Act. SEBI has initiated a number of policy initiatives. The focus of
attention of SEBI’s activities is as follows:
1. Increasing market transparency through further improvement of
disclosure standards
2. Improving the standards of corporate governance
3. Improving market efficiency by speeding up the process of
dematerialization and introducing rolling settlement in a phased
manner
4. Reduced transaction costs by refining the margin system
5. Enhancing the market safety through an efficient margin system
and stepping up surveillance

ROLE AND RELEVANCE

The role of SEBI in the realm of development and regulation of the securities
market in India is discussed below:
Credible Regulatory Structure
SEBI has been responsible for successfully creating a credible regulatory
structure for the securities market. It acts as a major catalyst for the
development of the securities market in India. For this purpose it brings
about far reaching changes in market practices, introduces the
internationally acclaimed best practices and procedures in the realm of
trading and engages itself in periodical modernization of the market
infrastructure by enforcing regulations taking advantage of technology.
SEBI introduced a package of measures of liberalization, regulation and
development for the healthy promotion of the securities market in India,
keeping in mind the necessity of contributing to the industrial and economic
growth of the country. Some of these measures include the following:
1. Disclosure Introduction of disclosure norms for issuers so as
to ensure the observance of high standards of integrity and fair dealing
thus benefiting the investors.
2. Automation Introduction of automated working procedures
through the computers in all stock exchanges, thus facilitating trading
with the help of terminals of stock exchanges and modernization of market
infrastructure.
132 Capi tal Markets

3. Depository Creation of the facility of depository by the enactment

of the Depositories Act, 1996 thus providing for the establishment of
depositories in securities with the objective of ensuring free transferability
of securities, its speed, accuracy, and security.
4. Trading Introduction of number of systematic measures thus
enforcing reliable trading mechanism and preventing market failures and
the establishment of settlement guarantee funds in the stock exchanges
thus facilitating a smooth and timely settlement of funds.
5. Others Other measures of establishing a credible securities structure
include shortening of settlement cycles of stock exchanges, modernizing
and strengthening of the surveillance systems in stock exchanges and
SEBI, liberalization of FII policy and simplification of the investment
procedures by the FIIs, and strengthening of the regulations for takeover
to encourage take-over in a fair and transparent manner and to protect the
investors.
Market Surveillance
In order to bring about orderliness in the working of the stock exchanges
all over India, market surveillance is an important key used by the SEBI.
This assumes relevance in the context of the growing incidence of scams
taking place in the capital market. SEBI set up a Market Surveillance Division
as early as in July 1995, with a view to keep a pro-active surveillance on the
activities of the stock exchanges. Following are the focus of attention in
this regard:
1. Policy formulation SEBI has the power to formulate relevant policy
for introduction of surveillance systems and risk containment measures at
the stock exchanges to bring integrity, safety and stability in the Indian
securities markets.
2. Surveillance system SEBI commands the power to oversee the
surveillance activities of the stock exchanges including monitoring of
market movements by them. For this purpose, SEBI establishes
independent surveillance cells in stock exchanges. SEBI also assists in
the formation of Inter-Exchange Market Surveillance Group for prompt,
interactive and effective decision-making on surveillance issues and
coordination between stock exchanges. SEBI oversees the implementation
of Stock Watch System, an on-line automated surveillance system at stock
exchanges. Besides, it also involves in alerting and advising investors
through press releases about the need for a cautious trading in scrips in
ICE (Information, Communications and Electronics industry) and directing
 SEBI— Functi ons and Worki ng 133

the stock exchanges to closely monitor the trading and other developments
in respect of shares of such companies.
3. Inspection SEBI is empowered to carry out the inspection of the
surveillance cells of the stock exchanges and initiating investigations. It
also carries out the inspection of intermediaries. Inspection is carried out
to gather evidence of alleged violations of securities market such as price
rigging, creation of artificial market, insider trading, public issue related
irregularities and other misconduct.
4. Information SEBI undertakes the preparation of reports and studies
on market movements, which SEBI circulates periodically to the Ministry
of Finance in the Government of India and to securities markets regulators
from other countries. Reporting by stock exchanges through periodic and
event driven reports is also done by the SEBI.
5. Risk containment Risk containment measures in the form of
elaborate margining system and linking of intra-day trading limits and
exposure limits to capital adequacy are also undertaken by the SEBI.
Suspension of trading in scrips to prevent market manipulation and
tightening entry norms for public/right issues is done by the SEBI.
6. Price bands SEBI arranges for the announcement of daily price
bands to curb abnormal price behavior and volatility.
Disclosure Standards
SEBI appointed an expert committee in 1995, under the Chairmanship of
Y. H. Malegam to suggest measures for improving the disclosure standards.
Another committee was appointed under the chairmanship of C. B. Bhave
to recommend measures for improving the continuing disclosure standards
by corporates and timely dissemination of price sensitive information to
the public. On the basis of the recommendations of the above committees,
SEBI initiated such steps as the imposition of a set of entry barriers on
new issues specifying the minimum issue size requirements for companies
that seek listing. A reinforcing step was initiated by the SEBI by issuing
the compendium of SEBI (Disclosure & Investor Protection) Guidelines,
2000 effective from January 27, 2000. This was the consolidation of all the
earlier guidelines encompassing entry norms, lock-in-period, promoters’
contribution, etc. This was done in order to streamline the current procedure
and smoothen out the aberrations in initial public offerings.
Best Governing Practices
Based on the recommendations of the Kumar Mangalam Birla Report,
SEBI put into vigorous practice, the code of corporate governance in
134 Capi tal Markets

listed companies for the purpose of affording protection to investors

through the mechanism of enhanced standards of corporate management.
To secure corporate governance in companies, the SEBI issued
directives to stock exchanges to amend the listing agreement to include a
new clause (clause 49) on corporate governance to be adhered to, by the
listed companies. The board areas of corporate governance were
composition of board of directors, constitution and functioning of audit
committees, remuneration of directors, disclosure requirements, compliance
report on corporate governance and compliance certificate. Such a measure
was designed to instill investor confidence in the capital market through
better corporate governance.
Building Investor Confidence
SEBI took a number of steps in order to allow for better investor protection
and market development so as to usher in an active primary market. Safety
measures introduced by the SEBI for safeguarding the interests of millions
of investors and also for building their confidence were as follows:
1. Appointment of Compliance Officer
2. Prudent corporate governance norms for all listed companies to
ensure transparency and better disclosure practices
3. Service centers set up by stock exchanges for investors to enable
them to have a forum for recording and counselling their
grievances as well as access to financial and other information of
companies and government policies, rules, regulations, etc
4. Better monitoring and market surveillance systems
5. Directions to stock exchanges to take stern action against
companies not complying with listing agreement
6. Standardization of investor complaints lodged with SEBI against
companies
Global Outlook
Rapid developments in the realm of global financial markets has prompted
the SEBI to initiate steps for the faster integration of the Indian securities
market with the rest of the world. Accordingly, FIIs have been permitted to
invest in all types of securities including government securities. Similarly,
Indian companies have been permitted to raise resources from abroad
through issue of ADRs, GDRs, FCCRs and ECBs. In the same manner,
Indian stock exchanges have been permitted to set up trading terminals
abroad and trading platform of Indian exchanges are now accessed through
internet from anywhere in the world.
 SEBI— Functi ons and Worki ng 135

As an active and leading member of the International Organization of

Securities Commission (IOSCO), the SEBI has been making all efforts to
harmonize SEBI regulations and guidelines with IOSCO’s principles of
securities’ regulations. This was designed to conform to global standards.
On the basis of the IOSCO’s 30 principles of securities’ regulations, the
SEBI has devised its own principles aimed at protection of investors,
ensuring that markets are fair, efficient and transparent, and reduction of
systematic risk. The eight categories of principles formulated by the SEBI
are as follows:
1. Principles relating to the regulator
2. Principles of self-regulation
3. Principles for the enforcement of securities regulations
4. Principles for cooperation in regulation
5. Principles of issue
6. Principles for market intermediaries
7. Principles for the secondary market
Improving Operational Efficiency
An important requirement for the efficient functioning of the capital market
is the efficient functioning of the market participants. In this regard, SEBI
has undertaken a number of measures aimed at improving the operational
and informational efficiency in the market. This has helped the participants
to carry out transactions in a cost-effective manner by providing full,
relevant, accurate and timely information.
A number of checks and balances have been built up to ensure the
desired level of investor protection, enhance their confidence and avoid
systematic failure of the market. Allowing contestability of the market and
imposing entry criteria for issuers and intermediaries have ensured stability
of the system as a whole. Prudential controls on intermediaries have
facilitated the financial integrity of the market. For instance, code of conduct
for the intermediaries as prescribed in the regulations, capital adequacy
and other norms, a system of monitoring and inspecting their operations
instituted to enforce compliance and initiating disciplinary actions against
the delinquent intermediaries are some of the measures aimed at improving
the operational efficiency of the market participants in the securities market.
SEBI has been making consistent endeavors to promote a market,
which is both efficient and fair, and also protects the interests of investors.
Dematerialization and the rolling settlements are the major steps taken by
the SEBI for improving and modernizing the markets. The dematerialization
system introduced by the SEBI is one of the far-reaching steps. The
136 Capi tal Markets

process aims at eliminating physical paper and thereby helping in the

reduction of the work on the clearing houses, the registrar to issue and
share transfer agents. It has also helped overcome many of the handicaps
faced under the traditional paper-based system, namely hand delivery
bargains, negotiated trades without price bands, etc.
The system called for elimination or modification of these practices
with a view to improving the market microstructure, provide for increased
transparency, efficient price discovery and curb unhealthy market practices
so as to improve investor confidence. The efforts taken by the players
such as depositories, registrars and share transfer agents in the ‘demat’
system has greatly helped reducing delays and hardships to the investors.
The Rolling Settlement System was introduced by the SEBI in respect
of demat shares in order to enhance the liquidity of the market. This
mechanism has greatly helped integrate Indian markets with the best global
practices and made them more attractive for foreign investors. In fact, the
introduction of rolling settlement proved to be a turning point in the history
of Indian capital market. The system provides many benefits to corporate
entities such as better price realization, decline in speculative activities
leading the share prices to reflect its intrinsic value based on medium-term
and long-term prospects of the company, etc. It has also helped the
exchanges, brokers, fund managers and FIIs in their transactions in
securities.
Screen Based Trading
A landmark development that took place in the history of the SEBI was the
initiative taken by it to constitute the OTCEI (Over The Counter Exchange
of India) in the year 1992 and the National Stock Exchange (NSE) in the
year 1994. The Exchange allowed for transparency in the securities dealings
made possible through the screen-based trading. Under this mechanism,
information regarding quotations for securities, the prices of transactions
and volume of those transactions is made publicly available promptly
after each transaction or quotation.
This electronic form of trading that has gained acceptance
internationally as a highly transparent, cost efficient and faster mode for
executing trades has been greatly contributing to the development of the
Indian securities market. SEBI initiated steps to ensure that all the stock
exchanges in the country introduce electronic trading system and automate
their operations. As a result, the open-outcry system of trading which was
prevalent in the stock exchanges in the country till a few years ago is
being gradually replaced by computerized trading. SEBI has also
 SEBI— Functi ons and Worki ng 137

contributed to further modernization of the trading system by permitting

internet trading under order routing system in a limited way through
registered stockbrokers on behalf of clients for execution of trades on
recognized stock exchanges.
REVIEW QUESTIONS

Section A
1. Name the committee that recommended the setting up of the
SEBI.
2. State the features of the SEBI bill.
3. How is SEBI managed?
4. State the purpose of regulatory role played by the SEBI.
Section B
1. State the need for setting up the SEBI.
2. What are the objectives of SEBI? Explain.
3. What are the powers vested with the SEBI to regulate stock
exchanges in India?
4. State the powers of the SEBI with regard to action initiated
against. the erring market intermediaries.
5. How is SEBI empowered of adjudication?
6. What are the steps taken by the SEBI to build investor confidence?
7. Evaluate the role of SEBI on improving the operational efficiency
of the Indian capital market.
8. Identify the measures initiated by the SEBI to promote screen
based trading in India.
Section C
1. What are the powers and functions of SEBI? Discuss elaborately.
2. Examine the role and the relevance of the SEBI in the context of
regulating the functions and working of the stock exchanges in
India.
 Chapter 7

Investor Protection

The term ‘investor protection’ refers to methods and measures adopted

by a market regulator like the SEBI, SEC, etc. with a view to safeguard the
interest of investor. Investors, especially small investors constitute an
important segment of the Indian stock market. The developments in the
stock market do affect the sentiments of these investors. In turn, the
sentiments of small investors also affect the stock market. Hence, protecting
and promoting their interest is of paramount importance for the efficient
growth of the capital market.
All the stock exchanges in India have put in place adequate measures
of protection for the benefit of small investors. In addition, the government,
regulatory authority, and SEBI have initiated several steps towards
strengthening the position of small investors.

LOSS OF CONFIDENCE OF SMALL INVESTOR—CAUSES

Although small investors (defined by the SEBI, as a person who holds a
small number of shares in different companies, a minimum of hundred
shares of Rs. 10 each for a considerable time, looking for capital appreciation
of his holdings, and disinvests his holdings only when he needs to meet
a huge amount of expenditure for ceremonies like marriage of his children
etc and defined under Section 252 of the Companies Act as a person
holding shares of nominal value of Rs. 20,000 or less in a public company)
are supposed to be protected both by the SEBI and the Companies Act,
keeping in view the need for promoting and developing the regulation of
the securities market, there has been noticed a terrible loss of confidence
in them. This could be attributed to the following factors:
Failing Mutual Funds
Many of the mutual funds in India are in doldrums. The measures of
liberalization and the concerted and conscious efforts of the government
and SEBI to drive the small investor towards mutual funds have met with
little success. Mutual funds have failed to come up to the expectations of
140 Capi tal Markets

the small investors, since the investors never got a consistent return on
their investments. All these have resulted in the diversion of savings to
other avenues such as bank deposits. A major complaint against the mutual
funds is that they are not delivering the goods as advertised by them. The
security and service offered by the mutual funds are far from satisfactory.
Private P lacement
The private placement route often chosen by the corporate sector with
banks, financial institutions and high net worth individuals, has belied
the hopes of innumerable small investors for an affordable capital market
investment. Many corporate enterprises adopt this route because of the
negligible cost involved in raising the money. To the extent the amount is
raised through private placement, the small investor is denied the
opportunity of subscribing to the issues in the capital market. This
handicap is sought to be removed by an amendment to Section 67 of the
Companies (Amendment) Act, 2000 whereby the issuer is expected to
offer to public a minimum of 50 percent of the issue.
Dematerialization
The recent provisions of the Depositories Act and the regulations of the
SEBI require that the securities are demated and kept with the Depository.
This process has contributed to enormous costs of dematerialization and
safekeeping to investors. The compulsory dematerialization by the
investors before selling their securities has caused considerable
consternation among the small investors.
Lack of Corporate Interest
The amount of regulations regarding listing etc clamped on the issuers by
the SEBI has created hurdles in the way of entrepreneurs tapping the
capital market. Some of the demanding regulations include more and more
disclosure requirements insisted upon by SEBI, the tightening of the clauses
of the listing agreements, code of Corporate Governance, etc. Moreover,
financial institutions and banks do not insist on the company to be a listed
one in order to extend long-term finances.
Delisting by MNCs
Small investors are crippled of their ability and deprived of an opportunity
to make investment of funds in the highly profit making MNCs. This is
because many of the foreign companies operating in India are either
incorporated as wholly owned subsidiaries or indulge in buy-back of the
shares from the public. This process reduces the public float in the capital
 Invest or Protect i on 141

market. Further, this has created a roadblock in the development of the

capital market and works against the interest of small investor.
Book-building
The recently introduced ‘book-building’ process is considered to be highly
pernicious for small investors. The mechanism allows for setting the issue
price at unreasonably high levels. This has greatly affected the interest of
common investors. Such a price discovery practice often goes unrealistic
as the market price immediately after the issue nosedives much below the
issue price. Hence, the public is not enamored at all by the fanciful price
fixed by this process.
Takeover and Buy-back
The buy-back mechanism introduced by the Companies Act, 1999, paved
way for promoters acquiring the shares easily and cheaply. This has in
turn reduced the quantum of floating stock in many well-managed
companies in the stock market. The capital market developments are much
in tune with the interest of the promoters than in tune with protecting the
investors’ interests.
RIGHTS OF INVESTORS
1. To receive all benefits/material information declared for the
investors’ by the company
2. To obtain prompt services from the company such as transfers,
subdivisions and consolidation of holdings in the company
3. To subscribe to further issue of capital by the company in the
case of existing equity shareholders
4. To pay a maximum brokerage of 2.5 percent of the contract price
5. To receive the contract note from the broker in the specified
format showing transaction price and brokerage separately
6. To obtain delivery of shares purchased/value of shares sold within
2 days after the payout day
FACILITIES BY BSE
The Bombay Stock Exchange (BSE), Mumbai, is the forerunner and the
pioneer in the realm of providing several facilities for the benefit of investors
as shown below:
Investor’s Service Cell
Protecting the interest of investors dealing in securities is one of the main
objectives of the exchange. In pursuit of this objective, Bombay Stock
142 Capi tal Markets

Exchange (BSE) set up an Investors’ Services Cell (ISC) in 1986. The

grievances of investors against listed companies and members of the
exchange are redressed by the exchange. The exchange also assists in the
arbitration process both between members and investors. The capital market
can grow, only when the investors’ find it safe for them to invest in the
capital market and only if they are assured that the rules governing the
market are fair and just to all the players in the market.
With a view to ensure speedy and effective resolution of claims,
differences, and disputes between non-members, the exchange has laid
down a set of procedures for arbitration thereof. These procedures are
embodied in the rules, bye-laws and regulations of the exchange, which
have been duly approved by the Government of India/Securities and
Exchange Board of India (SEBI).
Safeguards fo r Investors’
Some of the safeguards that need to be adhered to by the investors’
before trading in the securities market are as follows:
1. Selecting the broker/ sub-broker Investors should deal with only
SEBI registered broker/sub-broker after due diligence. Details of list of
brokers can be procured from the member’s list published by the Exchange
and also from the website of the exchange.
2. Formal agreement An investor is expected to enter into a formal
agreement with the broker before transacting business. For this purpose,
he is advised to scrupulously adhere to the following procedures:
a. Registration Fill in a client registration form with
broker/sub-broker
b. Agreement Enter into broker/sub-broker-client agreement. This
agreement is mandatory for all investors for registering as a client
of a BSE trading member. Before entering into agreement, the
client is expected to carefully read and understand the terms and
conditions of the agreement. Similarly, the agreement shall be
executed on a valid stamp paper of the requisite value. The client
and the member or their representative who has the authority to
sign the agreement shall sign the agreement on all the pages.
Agreement has also to be signed by witnesses too, by giving
their name and address
3. Transacting business The following are to be borne in mind by the
investor before transacting business:
a. Specifying exchange Specify to the broker/sub-broker,
exchange through which your trade is to be executed and maintain
separate account per exchange
 Invest or Protect i on 143

b. Contract note Obtain a valid Contract Note (from Broker)/

Confirmation Memo (from sub-broker) within 24 hours of the
execution of the trade. Contract note is a confirmation of trade(s)
done on a particular day for and on behalf of a client in a format
prescribed by the exchange. It establishes a legally enforceable
relationship between the member and client in respect of
settlement of trades executed on the exchange as stated in the
contract note. Contract notes are made in duplicate, and the
member and the client keep one copy each. The client is expected
to sign on the duplicate copy of the contract note for having
received the original
1. Contract Note—Form ‘A’ issued where member is acting
for constituents as brokers and agents
2. Contract Note—Form ‘B’ issued by members dealing with
constituents as principals
3. Confirmation memo—Form ‘C’ issued by registered sub-
brokers acting for clients/constituents as sub-brokers
The investor should ensure that the contract note/confirmation memo
contains such details as SEBI registration number of the member/sub-
broker. Further, such details of trade as, order number, trade number, trade
time, quantity, price, brokerage, settlement number and details of other
levies must also be mentioned. The trade price should be shown separately
from the brokerage charged.
4. Brokerage As stipulated by SEBI, the maximum brokerage that can
be charged is 2.5 percent of the trade value. This maximum brokerage is
inclusive of the brokerage charged by the sub-broker (Sub-brokerage
cannot exceed 1.5 per cent of the trade value). Any additional charges that
the member can charge are service tax @5 percent of the brokerage and
any penalties arising on behalf of the client (investor).
The brokerage and service tax is indicated separately in the contract
note. Signature of authorized representative in the arbitration clause, stating
that the trade is subject to the jurisdiction of Mumbai, must be present on
the face of the contract note.
5. Ensuring settlement Following are the procedures to be followed
by investors for ensuring smooth settlement:
a. Delivery Delivery of securities/payment of money to the broker
is to be ensured immediately upon getting the contract note for
sale/purchase but in any case, before the prescribed pay-in-day.
144 Capi tal Markets

The Member should pay the money or deliver the securities to

the investor within 48 hours of the payout
b. Demat account Open demat account. Preferably opt for buying
and selling demated securities
c. Depository participant (DP) For delivery of shares from Demat
a/c, give the Depository Participant (DP) ‘Delivery out’
instructions to transfer the same from the beneficiary account to
the pool account of broker through whom shares and securities
have been sold. The details such as the pool account of broker to
which the shares are to be transferred, details of scrip, quantity
etc. As per the requirements of depositories the delivery out
instruction should be given at least 48 hours prior to the cut-off
time for the prescribed securities pay-in
For receiving shares in the Demat account, give the
Depository Participant (DP) ‘Delivery in’ instructions to accept
shares in beneficiary account from the pool account of broker
through whom shares have been purchased
6. Delivery If physical deliveries are received, check the deliveries
received as per good/bad delivery guidelines issued by SEBI. Bad delivery
cases should be sorted out through exchange machinery immediately. All
registration of shares for ownership of physical shares should be executed
by a valid, duly completed and stamped transfer deed.
General Do’s and Don’ts for Investors
1. Not to deal with unregistered intermediaries which might expose
to counter party risk
2. To give clear and unambiguous instructions to broker/sub-broker
3. To keep a record of all instructions issued to the broker/
sub-broker
4. To confirm with the broker/sub-broker whether delivery is in
physical or demat form before selling shares
5. Not to fall prey to promises of unrealistic high returns
6. Not to indulge in speculative trading but to go by the fundamentals
only
7. To trade within the predetermined limits
8. To use the Investors’ Grievance Redressal system of the
exchanges to redress grievances, if any
 Invest or Protect i on 145

9. To understand the working of the Investor Service Cell for

complaint against listed companies/brokers, and
10. To preferably trade personally through Internet based trading by
registering with a broker
So lv i n g In v es to r s G r ie v a n ce s —P r o c e s s

BSE has established a full-fledged Investors’ Services Cell (ISC) to redress

investor’s grievances. Since its establishment in 1986, the cell has played
a pivotal role in enhancing and maintaining investors’ faith and confidence
by resolving their grievances either against listed companies or against
Members of the Exchange. The services offered by the ISC are as under:
1. Grievan c es again s t lis ted c ompan ies ISC forwards the
complaints to the respective company and directs them to solve the matter
within 15 days. In spite of the above efforts, if the company fails to resolve
the complaints and the total number of pending complaints against the
company exceeds 25 and are pending for more than 45 days, after issue of
show cause notice for 7 days, the scrip of the company is suspended from
trading till grievances are resolved. ISC also transfers such scrip to ‘Z’
category for non-resolution of investors’ complaints.

Measures ISC takes many other pro-active measures to resolve the

investor’s grievance such as the following:
1. Calling the company representative to the exchange to interact
with investor’s/members to resolve the complaints
2. Calling major registrar and transfer agent to the Exchange to
interact and resolve the grievances of the investor’s and members
of the exchange
3. Issuing monthly press release listing top 25 companies against
whom maximum complaints are pending for resolution. The same
is also released on the website of the exchange
4. Pursuing Mumbai based companies to depute their
representative to the exchange to take the pending list of
complaints and resolve the same immediately
2. Grievances against members
Nature of complaints The nature of complaints received by the exchange
can be broadly classified into the following categories:
146 Capi tal Markets

a. Non-receipt of delivery of shares/Non- removal of objection/

Non-receipt of sale proceeds of shares/ Non-receipt of dividend/
Non-receipt of Rights, Bonus shares
b. Disputes regarding rate difference
c. Disputes relating to non-settlement of accounts
d. Miscellaneous items
Procedures The complaints are forwarded to the concerned members to
reply/settle the complaints within 7 days from the receipt of the letter. If no
reply is received or reply received is not satisfactory, the matter is placed
before the IGRC (Investor’s Grievance Redressal Committee) headed by a
retired high court judge. IGRC is constituted by the governing board to
resolve the complaints of non-members against members through the
process of reconciliation. The parties are heard and the matter is tried to be
solved amicably or it is referred for arbitration under the rules, bye-laws
and regulations of the exchange.
3. Arbitration The investors complaints referred by IGRC can be against
the (i) active members of the exchange as well as the (ii) defaulter-members
of the exchange. The process of solving the investors complaints through
the arbitration procedure is as mentioned below:
a. Arbitration committee For the purpose of resolution of
grievances between investors and member-brokers, the exchange
has constituted an arbitration committee with the approval of
SEBI. The non-member arbitration panel consists of retired High
Court and City Civil Court Judges, Chartered Accountants,
Company Secretaries, Solicitors and other professionals having
in-depth knowledge of the capital market
b. Filing supporting documents On receiving the direction for
arbitration from the IGRC, the complainant (applicant) files
relevant supporting documents for arbitration. A set of the
arbitration documents is sent to the other party (respondent) for
giving his counter reply
c. Hearing After completion of the formalities, the matter is fixed
for hearing before arbitrators. For claims less than Rs. 10 lakhs,
the applicant has to propose the name of three arbitrators and
the respondent(s) has/have to give consent of or the name of
one of the arbitrators. In case the respondent(s) does/do not
give consent on the arbitrator, the exchange appoints the arbitrator
to adjudicate the matter. For claims above Rs. 10 lakhs, a panel of
three arbitrators, one each to be appointed by the applicant(s)
 Invest or Protect i on 147

and respondent(s) and the presiding arbitrator has to be appointed

by the exchange to adjudicate the matter
The date for hearing is fixed and the concerned parties are informed
about the date through notices. After hearing both the parties and taking
the submissions and the documents on record, the arbitrator(s) close the
reference and the award (decision) is given.
4. Appeal If the applicant is not satisfied with the award he can appeal
against the same in the exchange within 15 days of its receipt. The appeal
bench of five arbitrators hears the matter and gives the award. However,
the aggrieved party has to deposit the awarded amount given by the
Arbitral Tribunal with the exchange unless and until the appeal bench
exempts it partly or wholly. If the award is in favor of the applicant, the
active member has to abide by the decision. If he fails to abide by the
award, the Disciplinary Action Committee (DAC) takes necessary action
against him. The award becomes a decree after 3 months from the date on
which it is given and can be executed as a court decree through a competent
court of jurisdiction. The same can be challenged only in the High Court of
Judicature, Mumbai.
5. Arbitration proc ed ure again st defaulter member of the
exchange Any complaint against defaulter-member of the exchange
can directly be filed in arbitration. However, the same has to be filed within
6 months from the date of declaring the member as defaulter by the
exchange. The rest of the process is the same as above.
An award obtained against a defaulter-member is scrutinized by the
Defaulters Committee (DC), a standing committee constituted by the
exchange, to ascertain their genuineness, etc. The awarded amount or
Rs. 10 lakhs whichever is lower is paid from the Customer’s Protection
Fund (CPF). After the approval of the DC and Trustee of CPF, the amount
is distributed to the clients who have obtained the award against
defaulter-member.
Investor’s or Customer’s Protection Fund
BSE is the first exchange to have set up the ‘Stock Exchange Customer’s
Protection Fund’ in the interest of the customers of the defaulter members
of the exchange. This fund was set up on 10th July, 1986 and has been
registered with the Charity Commissioner, Government of Maharashtra as
a Charitable Fund. BSE is the only exchange in India, which offers the
highest compensation of Rs. 10 lakhs in respect of the approved claims of
any investor against the defaulter members of the exchange. The members
148 Capi tal Markets

at present contribute Rs. 1.50 per Rs. 10 lakhs of turnover. The stock
exchange contributes 2.5 percent of the listing fees collected by it. Also
the entire interest earned by the exchange on 1 percent security deposit
kept with it by the companies making public/rights issues is credited to
the Fund.
Trade Guarantee Fund
In order to introduce a system of guaranteeing settlement of trades and
ensuring that market equilibrium is maintained in case of payment default
by the Members, the Trade Guarantee Fund was constituted and it came
into force with effect from May 12, 1997. The main objectives of the fund
are as given below:
Settlement To guarantee settlement of bona fide transactions of
members of the exchange which form part of the stock exchange settlement
system, so as to ensure timely completion of settlements of contracts and
thereby protect the interest of Investors and the members of the exchange.
Confidence To inculcate confidence in the minds of secondary market
participants generally and global investors’ particularly, to attract larger
number of domestic and international players in the capital market.
Protection To protect the interest of investors’ and to promote the
development of and regulation of the secondary market.
The Fund is managed by the Defaulters’ Committee, which is a
standing Committee constituted by the exchange, the constitution of which
is approved by SEBI.
In ves to r A war ene ss Pr ogr am
Investor awareness programs are being regularly conducted by BSE to
educate the investors and to create awareness among them regarding the
working of the capital market and in particular the working of the stock
exchanges. These programs have been conducted in Gujarat, Kerala, Tamil
Nadu, Uttar Pradesh, Rajasthan, Punjab, Haryana and within Maharashtra.
The investor awareness program covers extensive topics like
Instruments of Investment, Portfolio Approach, Mutual Funds, Tax
Provisions, Trading, Clearing and Settlement, Rolling Settlement, Investors’
Protection Fund, Trade Guarantee Fund, Dematerialization of shares,
information on Debt Market, Investors’ Grievance Redressal system
available with SEBI, BSE and Company Law Board, information on Sensex
and other Indices, workshops and Information on Derivatives, Futures
and Options, etc.
 Invest or Protect i on 149

Other Facilities
In addition to the above, the BSE offers the other facilities for the benefit
of the investors:
BSE training institute The institute organizes Investor Education
programs periodically on various subjects like comprehensive program on
Capital Markets, Fundamental Analysis, Technical Analysis, Derivatives,
Index Futures and Options, Debt Market, etc. Further, for the derivatives
market, BSE also conducts the compulsory BCDE certification for members
and their dealers to impart basic minimum knowledge of the derivatives
markets.
BSE’s official website The site serves as the focal point for information
dissemination and updates investors with the latest information on stock
markets on a daily basis through real time updation of statistical data on
market activity, corporate information and results. Educative articles on
various products and processes are also available on the site. BSE regularly
comes out with publication for investor education on various products
and processes like quick reference guide for investors, etc.
OMBUDSMAN
Genesis
The scheme of Ombudsman has been provided for under the SEBI
(Ombudsman) Regulations, 2003 and under subsection 1 of section 11 of
the SEBI Act. The purpose is to redress the grievance of the investors in
securities and for matters connected therewith or incidental thereto.
Definition
According to the SEBI, the term “Ombudsman” means any person
appointed under regulation 3 of the SEBI (Ombudsman) Regulations, 2003
and unless the context otherwise requires, includes Stipendiary
Ombudsman.
“Stipendiary Ombudsman” means a person appointed under
regulation 9 for the purpose of acting as ombudsman in respect of a specific
matter or matters in a specific territorial jurisdiction and for which he may
be paid such expenses, honorarium or sitting fees as may be determined
by the Board from time to time.
Eligibility for Ombudsman
In order to be appointed as an Ombudsman a person shall be:
1. A citizen of India
2. Of high moral integrity
150 Capi tal Markets

3. Not below the age of 45 years of age, and

4. Either
• A retired District Judge or qualified to be appointed a District
Judge, or
• Having at least ten years experience of service in any
regulatory body, or
• Having special knowledge and experience in law, finance,
corporate matters, economics, management or administration
for a period not less than ten years, or
• An office bearer of investors’ association recognized by the
Board having experience in dealing with matters relating to
investor protection for a period not less than 10 years
Disqualification for Ombudsman
A person shall not be qualified to hold the office of the Ombudsman if he:
1. Is an un-discharged insolvent
2. Has been convicted of an offence involving moral turpitude
3. Has been found to be of unsound mind and stands so declared
by a competent court
4. Has been charge sheeted for any offence including economic
offences, or
5. Has been a whole-time director in the office of an intermediary or
a listed company and a period of at least 3 years has not elapsed
Eligibility for Stipendiary Ombudsman
A person shall be eligible to be appointed as Stipendiary Ombudsman
who:
1. Has held a judicial post or an executive office under the Central
or State Government for at least ten years, or
2. Is having experience of at least ten years in matters relating to
consumer or investor protection, or
3. Has been a legal practitioner in corporate matters for at least 10
years, or
4. Has served for a minimum period of 10 years in any public financial
institution within the meaning of section 4A of the Companies
Act, 1956 (1 of 1956) or a regulatory body
Powers and Functions of Ombudsman
General The Ombudsman shall have the following powers and
functions:
 Invest or Protect i on 151

a. To receive complaints specified in regulation 13 against any

intermediary or a listed company or both
b. To consider such complaints and facilitate resolution thereof by
amicable settlement
c. To approve a friendly or amicable settlement of the dispute
between the parties
d. To adjudicate such complaints in the event of failure of settlement
thereof by friendly or amicable settlement
Other powers and functions The Ombudsman shall
a. Draw up an annual budget for his office in consultation with the
Board and shall incur expenditure within and in accordance with
the provisions of the approved budget
b. Submit an annual report to the Board within three months of the
close of each financial year containing general review of activities
of his office, and
c. Furnish from time to time such information to the Board as may
be required by the Board
Procedure for Redressal of Grievance
1. Grounds of complaint A person may lodge a complaint on any
one or more of the following grounds either to the Board or to the
Ombudsman concerned:
a. Non-receipt of refund orders, allotment letters in respect of a
public issue of securities of companies or units of mutual funds
or collective investments schemes
b. Non-receipt of share certificates, unit certificates, debenture
certificates, bonus shares
c. Non-receipt of dividend by shareholders or unit-holders
d. Non-receipt of interest on debentures, redemption amount of
debentures or interest on delayed payment of interest on
debentures
e. Non-receipt of interest on delayed refund of application monies
f. Non-receipt of annual reports or statements pertaining to the
portfolios
g. Non-receipt of redemption amount from a mutual fund or returns
from collective investment scheme
h. Non-transfer of securities by an issuer company, mutual fund,
Collective Investment Management Company or depository
within the stipulated time
152 Capi tal Markets

i. Non-receipt of letter of offer or consideration in takeover or

buy-back offer or delisting
j. Non-receipt of statement of holding corporate benefits or any
grievances in respect of corporate benefits, etc
k. Any grievance in respect of public, rights or bonus issue of a
listed company
l. Any of the matters covered under section 55A of the Companies
Act, 1956
m. Any grievance in respect of issue or dealing in securities against
an intermediary or a listed company
2. Pr oc ed ure of fi lin g c om plai n t Any person who has a
grievance against a listed company or an intermediary, may himself or
through his authorized representative or any investors association
recognized by the Board, shall make a complaint against a listed company
or an intermediary to the Ombudsman within whose jurisdiction the
registered or corporate office of such listed company or intermediary is
located. The complaint shall be in writing, duly signed by the complainant
or his authorized representative.
However, there shall be no complaint made to the Ombudsman:
a. Where the complainant had, before making a complaint to the
Board or the Ombudsman concerned, made a written
representation to the listed company or the intermediary named
in the complaint and the listed company or the intermediary, as
the case may be, had rejected the complaint or the complainant
had not received any reply within a period of one month after the
listed company or intermediary concerned received his
representation or the complainant is not satisfied with the reply
given to him by the listed company or an intermediary
b. Unless the complaint is made within six months from the date of
the receipt of communication of rejection of his complaint by the
complainant or within seven months after the receipt of complaint
by the listed company or intermediary under clause (a) above
c. If the complaint is in respect of the same subject matter which
was settled through the Office of the Board or Ombudsman
concerned in any previous proceedings, whether or not received
from the same complainant or along with any one or more or
other complainants or any one or more of the parties concerned
with the subject matter
d. If the complaint pertains to the same subject matter for which any
proceedings before the Board or any court, tribunal or arbitrator
 Invest or Protect i on 153

or any other forum is pending or a decree or award or a final order

has already been passed by any such competent authority, court,
tribunal, arbitrator or forum
e. If the complaint is in respect of or pertaining to a matter for which
action has been taken by the Board under section 11(4) of the
Act or Chapter VI A of the Act or under subsection (3) of section
12 of the Act or under any other regulations made under the Act
3. Power to call for information For the purpose of carrying out his
duties under these regulations, an Ombudsman may require the listed
company or the intermediary named in the complaint or any other person,
institution or authority to provide any information or furnish certified
copy of any document relating to the subject matter of the complaint
which is or is alleged to be in its or his possession. If the information is not
provided, the ombudsman would draw the inference that the information if
provided or copies if furnished, would be unfavorable to the listed company
or intermediary.
The Ombudsman shall maintain confidentiality of any information or
document coming to his knowledge or possession in the course of
discharging his duties and shall not disclose such information or document
to any person except and as otherwise required by law or with the consent
of the person furnishing such information or document, unless warranted
by compliance with the principles of natural justice and fair play in the
proceedings.
4. Settlement by mutual agreement As soon as it may be practicable
so to do, the Ombudsman shall cause a notice of the receipt of any
complaint along with a copy of the complaint sent to the registered or
corporate office of the listed company or office of the intermediary named
in the complaint, and endeavor to promote a settlement of the complaint
by agreement or mediation between the complainant and the listed company
or intermediary named in the complaint. If any amicable settlement or
friendly agreement is arrived at between the parties, the Ombudsman shall
pass an award in terms of such settlement or agreement within one month
from the date thereof and direct the parties to perform their obligations in
accordance with the terms recorded in the award. For the purpose of
promoting a settlement of the complaint, the Ombudsman may follow such
procedure and take such actions, as he may consider appropriate.
5. Award on adjudication In the event of the matter not being resolved
by mutually acceptable agreement within a period of one month of the
receipt of the complaint or such extended period as may be permitted by
154 Capi tal Markets

the Ombudsman, he shall, based upon the material placed before him and
after giving opportunity of being heard to the parties, give his award in
writing or pass any other directions or orders as he may consider
appropriate. Ombudsman shall make the award on adjudication within a
period of three months from the date of the filing of the complaint. The
Ombudsman shall send his award to the parties to the adjudication to
perform their obligations under the award.
6. Evidence act not to apply In proceedings before the Ombudsman,
strict rules of evidence under the Evidence Act, shall not apply and the
Ombudsman may determine his own procedure in consistent with the
principles of natural justice. Ombudsman shall decide whether to hold oral
hearings for the presentation of evidence or for oral argument or whether
the proceeding shall be conducted on the basis of documents and other
materials. It shall not be necessary for an investor to be present at the oral
hearing of proceedings under these regulations and the Ombudsman may
proceed on the basis of the documentary evidence submitted before him.
No legal practitioner shall be permitted to represent the defendants or
respondents at the proceedings before the Ombudsman except where a
legal practitioner has been permitted to represent the complainants by the
Ombudsman.
7. Finality of award Subject to the provisions of this regulation, an
award shall be final and binding on the parties and persons claiming under
them respectively. Any party aggrieved by the award on adjudication
may, within one month from the receipt of the award, file a petition before
the Board setting out the grounds for review of the award. The Board may
review an award only if there is substantial miscarriage of justice, or there
is an error apparent on the face of the award.
Where a petition for review of the award under sub-regulation (2) is
filed by a party from whom the amount mentioned in the award is to be
paid to the other party in terms of the award, such petition shall not be
entertained by the Board unless the party filing the petition has deposited
with the Board seventy five percent of the amount mentioned in the award.
The Board may review the award and pass such order, as it may deem
appropriate. The Board shall endeavor to dispose of the matter within a
period of forty-five days of the filing of the petition for review.
The award passed by the Ombudsman shall remain suspended till the
expiry of period of one month for filing review petition or till the review the
Board disposes off petition. The party so directed shall implement the
award within 30 days of receipt of the order of the Board on review or
 Invest or Protect i on 155

within such period as may be specified by the Board, in the order disposing
off the review petition. The Board may determine its own procedure
consistent with principles of natural justice in the matter of disposing of
review petition, and may dismiss the petition if it does not satisfy any of
the grounds specified in sub-regulation (3).
8. Cost and interest The Ombudsman or the Board, as the case may
be, shall be entitled to award reasonable compensation along with interest
including future interest till date of satisfaction of the award at a rate,
which may not exceed one percent per month. The Ombudsman in the
case of an award, or the Board in the case of order passed in petition for
review of the award, as the case may be, may determine the cost of the
proceedings in the award and include the same in the award or as the case
may be, in the order. The Ombudsman or the Board may impose cost on
the complainant for filing complaint or any petition for review, which is
frivolous.
9. Non-implementation The award shall be implemented by the party
so directed within one month of receipt of the award from the Ombudsman
or an order of the Board passed in review petition or within such period as
specified in the award or order of the Board. If any person fails to implement
the award or order of the Board passed in the review petition, without
reasonable cause:
a. He shall be deemed to have failed to redress investors’ grievances
and shall be liable to a penalty under section 15C of the Act
b. He shall also be liable for an action under section 11 (4) of the
Act; or suspension or delisting of securities; or being debarred
from accessing the securities market; or being debarred from
dealing in securities; or an action for suspension or cancellation
of certificate of registration; or such other action permissible
which may be deemed appropriate in the facts and circumstances
of the case
Display of the Particulars
Every listed company or intermediary shall display the name and address
of the Ombudsman as specified by the Board, to whom the complaints are
to be made by any aggrieved person in its office premises in such manner
and at such place, so that it is put to notice of the shareholders or investors
or unit holders visiting the office premises of the listed company or
intermediary. The listed company or intermediary in its offer document or
clients agreement shall give full disclosure about the grievance redressal
mechanism through Ombudsman under these regulations. Any failure to
156 Capi tal Markets

disclose the grievance redressal mechanism through Ombudsman under

sub-regulation (2) or any failure to display the particulars as per sub-
regulation (1) shall attract the penal provisions contained in section 15A
of the Act.
REVIEW QUESTIONS

Section A
1. What does ‘investor protection’ constitute?
2. State the rights of an investor.
3. Write a note on the ‘investor protection fund’ constituted by the
BSE.
4. What do you know of ‘trade guarantee fund’?
5. What do you know of the ‘investor awareness program’ organized
by the BSE?
Section B
1. Analyze the causes for the loss of confidence of small investors.
in the Indian capital market witnessed in the late nineties.
2. What are the facilities offered by the BSE for the protection of
investor interest?
3. State the some of the general do’s and don’ts for investors.
4. Explain the process of solving the grievances of investors as
adopted by the BSE.
5. Explain the working of the ‘ombudsman’ set up by the SEBI for
the protection of investors.
Se ctio n C
1. What are the safeguards offered by the BSE to investors as
regards trading of securities?
2. What are the powers and functions of ombudsman’ set up by the
SEBI for the protection of investors.
3. Outline the procedure involved in the redressal of grievances of
investors.
 Chapter 8

Insider Trading

The set of all unhealthy and manipulative dealings and practices indulged
in by persons, who are in better know of internal affairs of the companies
is known as ‘insider trading’. SEBI takes appropriate and necessary steps
to curb and to prohibit such unfair and unethical practices so as to protect
investor interest.
RATIONALE
Although insider trading is the bane of modern stock market trends,
corporates often indulge in them for the following reasons:
1. Benefiting the company through unethical purchase and sale of
the company’s shares by withholding price sensitive information
2. Benefiting the individual indulging in this unethical practice
INSIDERS—CATEGORIES
Insiders are the persons, who have connection with the company in such
a way as to have access to price sensitive information. It includes any
person who is or was connected with the company or is deemed to have
been connected with the company and is reasonably expected to have
access, by virtue of such connection, to unpublished price sensitive
information in respect of securities of the company, or who has received or
has had access to such unpublished price sensitive information.
The various categories of insiders who indulge in manipulative
practices in stock market operations are as follows:
Primary Insiders
These insiders include directors of corporates and stock exchanges,
merchant bankers, registrars, brokers of the company, top executives,
auditors, banks, etc.
Secondary Insiders
These include dealers, agents and other employees having access to price
sensitive information due to their proximity with the company.
158 Capi tal Markets

INSIDER INFORMATION
For the purpose of describing insider trading, the term ‘insider information’
means any unpublished price sensitive information. This implies any
information which is not yet made known, and which, when accessed will
either directly or indirectly is likely to materially affect the price of securities
of that company in the market. The following unpublished information can
be considered as price sensitive:
1. Financial results (both half-yearly and annual) of the company
2. Intended declaration of dividends (both interim and final)
3. Issue of shares by way of public rights, bonus, etc
4. Any major expansion plans or execution of new projects
5. Amalgamation, mergers and takeovers
6. Disposal of the whole or substantially the whole of the
undertaking
7. Any other information as may affect the earnings of the company
8. Any changes in policies, plans or operations of the company

CONNECTED PERSONS
Connected persons mean and include the following:
1. Director of the company
2. Person deemed to be director of the company
3. Person occupying the position as an officer or an employee of
the company
4. Person holding a position involving a professional or business
relationship between himself and the company and who may
reasonably be expected to have an access to unpublished price
sensitive information relating to that company
De emed Con nected Persons
A person is deemed to be a connected person under the following
circumstances:
Same Man agement
Where the said person is a company under the same management or
group or any subsidiary company thereof.
Me mber
Where the said person is an official or a member of a stock exchange or of
a clearing house of that stock exchange, or a dealer in securities or any
employee of such member or dealer of a stock exchange.
 Insi der Tradi ng 159

Merchant Banker
Where the said person is a merchant banker, share transfer agent, registrar
to an issue, debenture trustee, broker, portfolio manager, investment
adviser, sub-broker, investment company or an employee thereof, or is a
member of the Board of Trustees of a Mutual Fund or a member of the
Board of Directors of the Asset Management Company of a Mutual Fund
or is an employee thereof who has a fiduciary relationship with the
company.
BoDs
Where the said person is a member of the Board of Directors or an employee
of a public financial institution.
SR O
Where the said person is an official or an employee of a Self Regulatory
Organization (SRO) recognized or authorized by the board of a regulatory
body.
Relative
Where the said person is a relative of any of the aforementioned persons.
Banker
Where the said person is a banker of the company.
NEED FOR CONTROL
The need for controlling and reining in the insiders arises on account of
the need for protecting the interest of investors. In addition, curbing this
malicious trading practice will help protect and promote the interest and
reputation of the company, besides helping maintenance of confidence in
stock exchange operations and the financial system as a whole.
PROHIBITION OF INSIDER TRADING
SEBI has come out with the following directions regarding the prohibition
of insider trading:
No Dealing
No individual may either on his own behalf or on behalf of any other
person deal in securities of a company listed on any stock exchange on
the basis of any unpublished price sensitive information.
160 Capi tal Markets

No Communication
No individual can communicate any unpublished price sensitive
information to any person, with or without his request for such information,
except as required in the ordinary course of business or under any law.
No Counsel
No individual can counsel or procure any other person to deal in securities
of any company on the basis of unpublished price sensitive information.
Penalty
A penalty upto Rs. 5 lakhs can be imposed on an insider who indulges in
dealing, communicating or counselling on matters relating to insider trading
discussed above.
INVESTIGATION BY SEBI
Where SEBI suspects that some persons who are close to the company
administration are indulging in insider trading, it may order for an
investigation to inspect the books of accounts, and other records and
documents of an insider by an investigating authority. SEBI may order
investigations on the basis of the complaints received from investors,
intermediaries or any other person on any matter having a bearing on the
allegations of insider trading. It may also initiate investigations suo-moto
upon knowledge or information in its possession to protect the interest of
investors in securities against breach of these regulations. Besides, it is
also possible for the SEBI to appoint a qualified auditor to investigate into
the books of accounts or the affairs of the insider.
Obligations of Insiders
Where an investigation by SEBI has been ordered, the insiders are
obligated to:
Documents Produce to the investigating authority such books,
accounts and other documents in his custody or control, and furnish the
statements and information relating to the transactions in securities market.
Access Allow investigating authority access to his premises and books,
records, documents, etc required for such investigation, and otherwise
cooperate with investigating authority.
SEBI’s Action
SEBI may, on the basis of investigative report, initiate the following actions
towards curbing the menacing practice of insider trading:
 Insi der Tradi ng 161

1. Criminal prosecution against the insider, and/ or

2. Giving necessary directions to insiders for protecting the interest
of investors and the securities market, and for due compliance
with the provisions of the SEBI Act, Rules and Regulations, the
directions may prohibit dealing in securities in any particular
manner, may prohibit disposal of any of the securities acquired in
violation of these regulations, and may restrain the insider to
communicate or counsel any person to deal in securities
Internal Code
It is a matter of great satisfaction that SEBI has been making efforts to
prohibit insider trading. Following are some of the measures initiated by
the SEBI in this regard:
Financial institutions Encouraging various financial institutions,
professional bodies and other relevant organizations to develop internal
code of conduct as an effective aid. Such a step would have the effect of
ultimately curbing the menace of insider trading leading to price rigging,
market manipulations and other frauds relating to securities.
Stock exchanges Advising stock exchanges, banks and secondary
market institutions to evolve an ‘internal code of conduct’ which should
lay down internal procedures, and checks and balances for avoiding insider
trading.
Internal control SEBI directly writing to banks, financial institutions,
stock exchanges, mutual funds, merchant bankers and other intermediaries,
and professional bodies, such as, the Institute of Chartered Accountants
of India, Institute of Company Secretaries of India, Institute of Cost and
Works Accountants of India and various Chambers of Commerce and
Industry about the desirability of evolving an internal control for the
purpose. These bodies in turn are expected to formulate procedures and
checks and balances for operations by their members and institutions
which would make a meaningful contribution towards ensuring that their
employees or members, who at times are in possession of unpublished
price sensitive information relating to listed companies, do not use such
information for personal gain through trading in the securities of such
companies.
ACTION BY CORPORATES
SEBI has suggested that companies work out and initiate the following
actions in order to prevent the insiders gaining access to unpublished
information:
162 Capi tal Markets

Type of Information
Corporates shall initiate action to identify the types of information that
could be considered to be price sensitive in relation to the business of the
company and its subsidiaries, and associate companies. The possible
such price sensitive information may include: earnings forecast or material
changes therein, proposals for mergers and acquisitions, significant
changes in investment plans, acquisition or loss of a significant contract,
significant disputes with major suppliers, consumers or sub-contractors,
significant decision affecting the product pricing, profitability, etc.
Type of Employees
Corporates shall initiate action to identify the types of employees and
officers of the company, who are likely to have access to such price sensitive
information.
Type of Controls
Corporates shall initiate action to identify the types of controls that are
put in place in order to handle the price sensitive information specified
above, so as to publish such information wherever possible. This will help
eliminate the non-public character of such information.
Norms
The corporates may prescribe certain norms to be followed by all officers
and employees of the company in dealing with the company’s own shares.
The norms may include: time periods during which time the company
employees and officers are not to deal in the company’s shares, the time
period for the company employees and officers to wait for the price sensitive
information to be made public before dealing in the company’s shares, the
applicability of these norms to representatives of the financial institutions
as well as other directors on the Board of the Company, etc.
Declaration
Corporates may strive to obtain declaration from employees and officers
including transactions done by the relatives of employees and officers as
relating to purchase and sale of the shares of the company.
Handling Information
Corporates may prescribe necessary procedure for handling information
which is likely to affect the price of the securities of other companies in
situations such as mergers, takeovers, etc.
 Insi der Tradi ng 163

REVIEW QUESTIONS

Section A
1. Define the term ‘insider trading’
2. Why do corporates often indulge in insider trading practices?
3. Who are ‘primary insiders’?
4. Who are ‘secondary insiders’?
5. Who are ‘connected persons’?
6. Who is a ‘deemed connected person’?
Section B
1. How are insiders categorized? Explain.
2. State the some insider information.
3. Why do you think there is an obvious need for controlling insider
treading?
4. State the obligations of insiders while an investigation is ordered
by the SEBI.
5. Mention the ‘internal code’ introduced by the SEBI for controlling
insider trading.
Section C
1. What are the steps initiated by the SEBI to prevent and control
insider trading?
2. How are corporates responsible to prevent insider trading?
Elucidate.
 Chapter 9

Stock Exchange

Stock exchanges contribute in a huge measure to the growth and expansion

of national business and to the ultimate benefit and well-being of the
national economy and its people. They provide an ideal conduit through
which enormous amount of capital flows take place through the
interconnected network of financial organizations to all corporate
enterprises in the country. Stock exchanges ensure liquidity and
transferability of financial assets that are dealt with.
Stock exchanges provide an organized marketplace for the investors
to buy and sell securities freely. The market offers perfectly competitive
conditions where a large number of sellers and buyers participate. Further,
stock exchanges provide an auction market in which members of the
exchange participate to ensure continuity of price and liquidity to investors.
The efficient functioning of the stock exchange is responsible for
creating a conducive climate for an active and growing primary market for
new issues. Moreover, an active and a healthy secondary market in existing
securities leads to a better psychology of expectations, thus, considerably
broadening the investment enquiries and thereby, rendering the task of
raising resources by entrepreneurs easier. In fact, good performance and
outlook for equities in the stock exchanges imparts buoyancy to the new
issue market.
HISTORY OF STOCK EXCHANGES
The first organized stock exchange in India is the Bombay Stock Exchange
(BSE), which was established in 1875. But trading in securities used to
take place much earlier in the 18th century, and share quotations were
published in contemporary newspapers. However, dealings were not
regulated by any code of rules, nor any hours of business prescribed nor
was there any committee to supervise the conduct of members of the
exchange. Dealers congregated under some tree in open fields for the
purpose of transacting business.
166 Capi tal Markets

The advent of western styled business practices in India in the early

18th century commenced with the establishment of the East India
Company’s office in India. Towards the close of the 18th century, the East
India Company naturally dominated business in securities and loan
transactions. Evidence of the existence of trading in stocks of banks and
certain companies is available in price quotations in contemporary
newspapers. By the 1830s, there was a perceptible rise in the volume of
business in loans of corporate stocks and shares. In 1836, the “Englishman”
of Calcutta reported quotations of 4 percent, 5 percent and 6 percent loans
of the East India Company as well as shares of Bank of Bengal. Shares of
banks like the “Corporation Bank”, the “Chartered Mercantile Bank”, the
“Chartered Bank”, the “Oriental Bank”, and the old “Bank of Bombay”
were traded. In 1839, the trading list became broader in Calcutta, where
newspapers gave quotations of banks like the “Union Bank”, the “Agra
Bank” and business ventures like “Bengal Bonded Warehouse”, the
“Docking Company” and “Steam Tug Company”. Between 1840 and 1850,
banks recognized about half-a-dozen brokers and merchants in Bombay.
In 1850, the Companies Act introducing limited liability was enacted and
the era of joint stock enterprises thus began in India.
By the mid-19th century, railways were extended, telegraph was
introduced, and hence communication expanded. Consequently, the
country witnessed rapid development of commercial activity. Internal trade
and commerce gradually improved and broadened. This was followed by
a growth in corresponding demand for Indian goods in Europe. Eventually,
the brokers participated in this general progress and prosperity.
The American Civil War of 1860–65 had widespread impact on the
fledging Indian securities market. The supply of cotton to Europe was
totally stopped, and India, especially Bombay, the cotton belt, became the
major supplier. There was an unlimited demand for Indian cotton. Exports
doubled between 1861–65. The price of cotton shot up as the Civil War
progressed. The bulk of these exports was paid in bullion. The largest flow
was in 1864-65, the last year of the war. The flush of gold bullion spawned
numerous ventures in a wave of speculation. Companies were floated for
every imaginable purpose—banks, financial association, land reclamation,
trading, cotton cleaning, pressing, hotels, shipping, and steamer
companies, etc. Every company that was floated commanded a premium.
Brokerage business became attractive, and in 1860 there were 60
brokers. Their acknowledged leader was Premchand Roychand who was
the first broker to read and speak English. He was a genius and a brilliant
financial strategist. He was called the Napoleon of Finance. But the bubble
 St ock Excha ng e 167

burst on 1st of July 1865. Like the South Sea Bubble and Tulip Mania in
Europe, the crash had disastrous effect on Bombay and its environs.
Innumerable companies failed; only a few were left solvent in Bombay.
The share mania left desolation in its wake. Nevertheless, it was responsible
for initiating the process of establishing the Stock Exchange in Bombay.

MEANING
1. A specialized marketplace that facilitates the exchange of
securities that already exist, is known as a Stock Exchange or the
stock market. It is also called a ‘secondary market’ for securities.
It is considered to be sine-quo-non for the primary market.
2. A Stock Exchange represents any body of individuals, whether
incorporated or not, constituted for the purpose of assisting,
regulating or controlling the business of buying, selling or dealing
in securities. It serves as a specialist marketplace for facilitating
transactions in existing corporate securities at prices that are
“fair and equitable”.
3. The stock market is the market place where the corporate and the
government securities are traded and exchanged. It regularly
provides sufficient marketability and price continuity to the listed
scrips.
4. A market where industrial securities are bought and sold under a
code of rules and regulations, is known as a stock exchange. Its
chief aim is to facilitate the provision of capital funds to trade,
industry and commerce.
DEFINITION
1. According to Hastings, “Stock exchange or securities market
comprises all the places where buyers and sellers of stocks and
bonds or their representatives undertake transactions involving
the sale of securities”
2. According to Husband and Dockeray, “Securities or stock
exchanges are privately organized markets which are used to
facilitate trading in securities”
3. According to Derek Honeygold, “Stock exchange can be
described as the place where a marriage of convenience is enacted
between those who wish to raise capital, such as companies,
governments and local authorities, and those who wish to
invest—largely households through the medium of institutions
acting upon their behalf”
168 Capi tal Markets

4. According to Section 2 (3) of the Securities Contract Regulation

Act 1956, “The stock exchange has been defined as any body of
individuals whether incorporated or not, constituted for the
purpose of assisting, regulating or controlling the business of
buying, selling or dealing in securities”
Under the said Act, the following securities can be traded at the
stock exchange:
a. Shares, scrips, stocks, bonds, debentures, debenture stocks
or other marketable securities of a like nature in or of any
incorporated company or other body corporate
b. Government securities; and
c. Rights or interests in securities
The stock exchange provides a marketplace for purchase and sale of
securities as stated above. It ensures the free transferability of securities,
which is the essential basis of corporate system. The private corporate
system cannot function efficiently without the existence of stock exchanges
in an economy. The stock market assures the owners of corporate securities
to sell their holdings at any time and thereby provides liquidity. At the
same time those who wish to invest their surplus funds for long-term
capital appreciation or for speculative gain can also buy scrips of their
choice in this market.
FUNCTIONS/ SERVICES/ FEATURES/ ROLE
Stock exchanges have come to occupy an important place in the economy
of any country. Stock exchanges are very sensitive to the political and
economic changes. They are appropriately called the “barometers of the
state of economy” or “the mart of the world” or “business of business”
and so on.
The growth in the number and size of companies has increased the
significance and the role of stock exchanges. As the citadel of capital
market through which the bulk of investment activities are conducted by
individuals and institutional operators, stock exchanges facilitate the
transfer of existing flow of savings into the profitable channels.
Stock exchanges play an important role in the capital formation of an
economy paving way for the industrial and economic development of the
country. It induces the public to save and invest in the corporate sector
that is profitable to them. Companies depend upon stock exchanges for
raising finance. Stock exchanges render very many important services to
the investors and the corporations alike.
 St ock Excha ng e 169

Following are some of the functions and services rendered by a stock

exchange:
Ideal Meeting Place
A stock exchange provides an ideal and convenient meeting place and a
common platform for sellers and buyers of securities. It is the nerve center
where open offers and bids for purchase and sale are made under free
competition.
Mobilization of Savings
The stock exchanges perform another important function in an economy,
i.e. mobilization of public savings and channelization of the same for
productive purposes. It helps in the mobilization of savings and surplus
funds of individuals, firms and other institutions. In other words, the
stock market provides an ample opportunity to all the investors, both
individuals and institutions to invest their surplus funds (amount saved
after meeting the expenses from the earnings) into various financial
instruments, and thus, directs its flow towards deficit units (which are
short of funds to meet their productive requirements). In this way, stock
markets assist in capital formation process in the economy. Further, in
case of prosperous and growing industries, the stock prices show a rising
trend and more flow of funds will take place and vice versa.
Providing Safety to Investors
One of the fundamental functions of a stock exchange is to provide
adequate safety to the genuine investors from fraud and manipulation
caused due to activities of speculators, members, brokers, etc. For this
purpose, adequate rules and regulations have been laid down under the
Securities Contract (Regulation) Act, 1956. Further, there are well defined
byelaws, rules and regulations given in the SCRA relating to the listing of
securities, admission of the members, trading mechanism, disclosure of
material information, transparency, delivery, penalties, etc. The Securities
and Exchange Board of India (SEBI) also regulates the working of stock
exchanges with a view to provide safety to investors by periodically issuing
guidelines on matters connected with securities trading.
Distribution of New Securities
A stock exchange helps in the distribution of new securities. Already
established companies, which wish to raise additional capital, may sell
their securities through stock exchange.
170 Capi tal Markets

Ready Market
An important function of a stock exchange is to provide a continuous,
ready, open and a broad-based market for securities. This way maximum
liquidity, marketability and price uniformity for securities is ensured. It is
possible for the investors to sell their securities at the best-quoted price
and thus, convert their investments into cash, almost immediately and
without much effort.
Liquidity
Liquidity is an important indicator for judging the efficiency of an exchange
as it concerns with sale and purchase of securities, quickly, easily and at
reasonable prices, which is nearer to the previous one. In fact, liquidity is
related with depth, breadth and resiliency of the market. Depth relates to
buy and sell orders around the price at which a share is transacted. Breadth
refers to the adequate volume of orders and response of orders to price
changes in a scrip is called resiliency. The broad indicators of market
liquidity are frequency of sales, narrow spread between bids and offers,
and prompt execution of orders and minimum price changes between
transactions as they occur.
Capital Formation
As an essential adjunct of joint stock enterprise, stock exchange allows
for quick capital formation to take place. This in turn contributes to the
development and promotion of the economy through accelerated industrial
development. Stock exchanges enable people to know the current market
prices of securities. People will invest in those securities that yield higher
returns. Thus, stock exchange facilitates the capital formation in the country
by inducing the public to save and invest.
Speculative Trading
An efficient functioning of stock market motivates investors to save more
and invest in high yielding securities, and thus, promotes those industrial
units that show best productive and financial performance. Speculation
also plays a dominant role in mobilization of savings in an economy. For
instance, healthy speculation on the stock exchanges based on scientific
analysis and expert opinion, not only estimates fair price of the stock but
also provides adequate liquidity. No stock exchange can operate efficiently
merely on the basis of genuine investment, i.e. investment based on actual
(physical) delivery of the scrips. In fact, such investments cannot provide
the requisite volume of business, either to the stock exchange or to the
company. Therefore, the liquidity and the price continuity in the stock
 St ock Excha ng e 171

market are possible only if there is a reasonable opportunity for speculative

trading.
Sound Price Setting
Stock exchange, through a plethora of measures of compliance, allows for
a sound and a fair price setting to take place. The prices usually reflect the
real worth of securities. Many factors such as limitless and free competition
in open market, enlightened scientific trading based on accurate knowledge
of present as well as future prospects of demand and supply, free flow of
information, etc contribute for the better price which benefits the investors
ultimately.
Economic Barometer
Stock exchange serves as a barometer of the economy. The price movement
of securities on a stock exchange indicates the state of health not only of
industrial companies but also of the economy of the nation as a whole. For
instance, any impending trends of the business cycles are correctly reflected
on the stock exchange. Similarly, any deep-rooted malaise afflicting the
economy is also reflected in the stock market operations. In fact, the stock
market indices act as precursors for the entrepreneurs to initiate appropriate
measures governing the management of their corporate enterprises. Thus,
they act as a barometer of the business conditions and progress of the
business in the country.
Dissemination of Market Data
Stock exchanges serve as information hub of trade and industry of an
economy. They disseminate information about share prices, volume of
trade—industry wise, scrip wise, etc. In addition, information is also
provided on the financial aspects of the companies whose shares are
traded widely in the stock market. The signals of impending financial or
business booms or distress are first indicated in advance by stock
exchanges very promptly.
Perfect Market Conditions
Perfect market conditions prevail in the stock exchanges. On account of
these reasons, the transaction and the carrying cost are the least. The
activities are much standardized. They are well regulated by institutions
of government. They facilitate a free and limitless competition among the
dealers and the brokers of securities.
Seasoning of Securities
Stock market players such as underwriters, dealers, brokers and speculators
172 Capi tal Markets

temporarily hold securities issued by new companies. This is called

‘seasoning of securities’. The securities are then released gradually at a
time when the market is prepared to absorb the new issue. This process
ensures a better benchmarking and market for the securities.
Efficient Channeling of Savings
The stock exchange mechanism enables judicious use of national savings
by allowing the flow of savings into the profitable and desirable areas of
investments. It allows corporates to mobilize capital in a free and equitable
manner. For, only those corporate enterprises that satisfy the market tests
of efficiency and profitability could possibly approach the market for capital
funds. Accordingly, a company with good prospects would be able to
raise additional capital, as its share prices would be rising in the market.
Optimal Resource Allocation
Stock exchange serves as an ideal tool of allocating the national savings
to promising issues and thereby, ensures most effective and optimum
allocation and utilization of scarce financial resources in industry and
commerce for maximum social advantage. This is made possible by the
price mechanism under the free competition.
Platform for Public Debt
By serving as an organized market for government securities, stock
exchanges allow for raising huge resources of finance required by the
government for financing its development activities. Stock exchanges act
as platforms for mopping up public debt to execute the schemes of planned
projects. It works as an over-the-counter market, consisting of dealers and
brokers in government securities. Banks, LIC, Provident Fund and Pension
Fund institutions are the chief buyers of government securities.
Clearing House of Business Information
The business information supplied by corporate enterprises is allowed to
be exchanged between investors and the issuers by the stock exchange.
This allows a stock exchange to serve as a clearing house of business
information. Besides, the information provided by corporates by way of
financial statements, annual reports and other reports, etc helps ensure
maximum publicity of corporate operations and working.
Evaluation of Securities
Another important function of the stock exchange is to allow for an
opportunity to determine a reasonable and fair price of various scrips
traded on its floor through the market forces of demand and supply. The
 St ock Excha ng e 173

prices of the scrips quoted on the stock exchange change continuously

on the basis of their real (intrinsic) worth along with fundamental and
technical factors. Whereas, the technical factors are concerned with
demand and supply position, market sentiments, rumours, mood, past
trend, etc fundamental factors include the economy, industry and firm
variables.
True Market Mechanism
The stock exchange provides liquidity and price continuity only to listed
securities. Securities that are listed and allowed to be traded on a particular
stock exchange are called listed securities. It is possible that a security
may be listed at more than one stock exchange for the purpose of trading.
A stock exchange assists in determining the stock prices near to their ‘true
and fair’ market worth and prevents from violent and erratic fluctuations in
such prices. It allows for price continuity to prevail in the market which
leads to stability in the market. A stock exchange, thus facilities free market
mechanism providing for marketability, stability and continuity in prices.
Investor Education
An important function of a stock exchange is to widen the share ownership
base especially in developing countries. Stock exchanges play a significant
role in educating the mass through various communication media by
providing information relating to principles and advantages of investing
in shares, debentures, bonds and other avenues. They also educate the
people in selecting the securities and designing their own portfolio. Stock
exchanges have a potential to play a significant role in the Indian economy
where the saving rate is the highest in the world, and the mass of population
is uneducated and living in rural and semi-urban areas. Educating the
public at large about the investment management has been popular in
developed countries too. For example, the stock exchanges like New York
Stock Exchange, London Stock Exchange, Melbourne Stock Exchange,
Sydney Stock Exchange, Toronto Stock Exchange, etc have initiated various
methods like ‘Own Your Share’ ‘Own Your Share of Australia’ ‘Your Brother
and You’ etc to educate the masses and for widening the share ownership
base.
Fair Price Determination
The prices in the stock market are determined by the interplay of the forces
of supply and demand. The two-way auction trading taking place in the
stock exchange facilitates a fair price determination. There is free trading
and free competition in the stock market, which in turn facilitates better
bargains so as to arrive at a fairly attractive price.
174 Capi tal Markets

Industrial Financing
Stock exchange provides for an ideal ground for the corporate enterprises
to mobilize the capital required for undertaking industrial activities such
as setting up new ventures, expansion and modernization of existing
production units etc at a reasonable cost. If the enterprise happens to be
a company of good standing, then it is possible to obtain an attractive
price for the company’s shares being issued.
Company Regulation
The requirements of ‘listing’ on a stock exchange makes it possible for the
stock exchange to rein in on the corporate enterprises. Listing thus allows
for the quoting and trading of securities of corporate enterprises on the
floor of a stock exchange. Stock exchanges, thus, exercise wholesome
influence on the management and working of companies in public interest.
STOCK EXCHANGE AND COMMODITY EXCHANGE
DISTINGUISHED

The points difference that exist between a stock exchange and a commodity
exchange are furnished below:

Sl.No. Feature Stock Exchange Commodity Exchange

1. Function Providing easy Offering hedging or

marketability price
insurance services and
liquidity to securities

2. Object Object is facilitating Object is facilitating

capital formation goods flow through risk
and making best use reduction
of capital resources
3. Participants Investors and Producers, dealers, traders
speculators and a body of speculators
4. Period of Cash, ready delivery Instant cash dealings
Dealings and dealings for and a settlement period
account for a fortnight of 2 or 3 months for
Futures Market dealings

5. Articles Industrial securities Only durable, graded and

 St ock Excha ng e 175

Traded such as stocks and goods having large

bonds, and Government volume of trade, price
securities such as uncertainty and
public debt etc. uncontrolled supply
6. Speculation Speculation ensures Speculation ensures
saleability of assumption and
securities affording a absorption of price risk
broad, ready, liquid and
continuous market of
securities
7. Forward Forward dealings are Standards are to be fixed
Contract simplified as for deliverable grades
securities are fully to facilitate futures
standardized contract
8. Cornering As seller has to deliver Cornering is difficult as
the agreed securities, the seller has option
cornering is easy to deliver standard or other
deliverable goods
9. Price- As regards forward For futures dealings,
Quotation dealings, only one multiple quotations are
quotation is possible possible

WORLD’S STOCK EXCHANGES

The Continental Europe
The world’s stock exchange has its origin in continental Europe with the
inception of the German and Dutch bourses during the Renaissance. The
first stock exchange was established in Hamburg in 1538, which, however,
was concerned with bills transactions. The first actual stock market began
operating in Amsterdam in 1611. The Amsterdam Stock Exchange was
also the first to trade in the shares of public companies including those of
United East India Company. Dutch investors played a dominant role in the
financing of foreign investments in both the public and private sectors.
Amsterdam stock exchange was ranked the third most important stock
market after New York and the London until the Second World War. Another
oldest stock exchange, the Vienna Stock Exchange was founded in 1771,
during the rein of Empress Maria Theresa as a State institution to provide
a market for the state-issued bonds as well as for exchange transactions.
In Italy, the first formal stock exchange was the ‘Milan Stock
Exchange’, which was created in 1808. The most active and most
176 Capi tal Markets

international of Spanish stock markets, the Bolsa de Madrid, were founded

in 1832. Stock exchanges in the Scandinavia were the Copenhagen Stock
Exchange, the Oslo Stock Exchange founded in 1819, the Stockholm Stock
Exchange founded in 1864 which was internationalized in 1901.
Geneva is the oldest of the 7 stock exchanges in Switzerland that was
founded in 1850, followed by Basle in 1876 and Zurich in 1877.
The London Stock Exchange
The London Stock Exchange is the oldest in the English-speaking world.
The merchant venturers began dealing in stocks and shares during the
17th century, and an informal market dealing in shares in joint venture
trading companies grew up in the coffee houses of Threadneedle Street
during the 18th century as a way of spreading the risk to their backers. The
Council of Associated Stock Exchanges was formed in 1890, with an
amalgam of multifarious stock markets in England. By 1967, they had
grouped themselves into six regional stock exchanges, which finally
became part of the Stock Exchanges of Great Britain and Ireland, with
trading floors in London, Birmingham, Manchester, Liverpool, Glasgow
and Dublin.
North American Stock Exchanges
New York Stock Exchange (NYSE) The New York Stock Exchange
was created in 1817, as an organization of brokers who agreed to meet
regularly at set hours. Trading on the NYSE is conducted on a dealer-to-
dealer basis, without jobbing intermediaries.

American Stock Exchange (AMEX) The American Stock Exchange

was created in 1953, by the second generation of ‘on the curb’ street
traders in stocks and bonds who could not qualify for a listing on the
NYSE. AMEX is based on a central market floor with specialist firms,
which have a commitment to make a market in certain issues.
NASDAQ System
The National Association of Securities Dealers Automated Quotations
System, known as the NASDAQ, is the largest over-the-counter market in
the world. It was started in 1971. It was regarded as the harbinger of the
global stock market of the future. Round-the-clock trading is available to
investors from around the world through a fully computerized system. It is
the third largest trading system in the world after the NYSE and Tokyo
Stock Exchange.
 St ock Excha ng e 177

NASDAQ was first developed as an OTC market to help many smaller

companies which were unable to meet the stringent listing requirements
and high listing costs of the major stock exchanges. The National
Association of Securities Dealers regulate it. Apart from dealing between
major institutions, like pension funds and insurance companies, which
normally hold large blocks of shares, it also provides for the private firms
which make block sales by linking their customers together through
computer terminals. This results in lower commission charges and a greater
speed of transactions.
Canadian Exchanges
In terms of market capitalization, Canada is the world’s fourth largest public
equity market. The three major stock exchanges are the Toronto Stock
Exchange, the Montreal Stock Exchange, and the Vancouver Stock
Exchange.
The Stock Exchanges of Japan and
the Pacific Basin
Japan The Tokyo Stock Exchange (TSE) is the world’s largest stock
exchange both in terms of market capitalization and turnover of having
overtaken the NSE in 1987. TSE was set up in 1878, nearly a hundred years
later than the London and New York stock exchanges. The other stock
exchanges are Osaka, Nagoya, Kyoto, Hiroshima, Fukuoka, Niigaatta and
Sapporo. All Japanese stock exchanges comprise three distinct sections.
The first and the largest section comprises of those that deal in listed
shares, the second section handles the newly quoted or unlisted shares,
which might be traded over-the-counter, and the third section comprises
the over-the-counter market.
Hong Kong Other important markets in Asia are those in Hong Kong
and Singapore. The Hong Kong stock exchange was set up in 1914. This
is the least restricted market in the world, having no exchange controls
and no distinction between resident and nonresident investors.
Australia The first stock exchange was founded in Melbourne in 1865.
Sydney in 1871, Brisbane in 1884, Adelaide in 1887, Hobart and Perth in
1891 followed this. All these exchanges now stand amalgamated under the
‘Australian Stock Exchange Ltd.’ (ASX).
Indian Stock Exchanges

Origin and growth Stock market transactions in India first originated

in the later part of the 18th century with the dealings of the stock
178 Capi tal Markets

transactions of the East India Company. Corporate trading of shares came

into the picture in 1830. The enactment of the Companies Act in 1850,
marked the beginning of the new era in the realm of stock markets in India.
The Act contained many features that were considered significant in as
far as they contributed to the growth and the development of the stock
exchanges across the country. The introduction of limited liability marked
the era of modern joint stock enterprises.
Before World War I
On the eve of the First World War, the Indian Stock Market comprised
three exchanges. During this period, all imports into India ceased and
the Indian manufactures were faced with a boom. As the industrial activ-
ity in Europe centered on producing goods required for the war, the
Indian industries expanded to cater the demand.
Bombay stock exchange The first stock exchange was known as
“The Bombay Stock Exchange” (BSE), which was established in 1887, by
formalizing the deed of association of Native Shares and Stock Brokers
Association. The Association was set up in the year 1875. The Bombay
Stock Exchange made a significant contribution to the growth of the equity
cult and to the development of the Indian capital market.
Ahmedabad stock exchange This was the second stock exchange,
of which came into existence in 1894 under the name of ‘The Ahmedabad
Shares and Stock Brokers Association’. The major factor behind its
establishment was the mushroom growth of cotton textile units in this
region. This exchange was organized practically on the lines of the Bombay
stock exchange.
Calcutta stock exchange This was the third stock exchange to be set
up in India at the beginning of the 19th century. This came into existence
under the name of ‘The Calcutta Stock Exchange Association’ in 1908.
The industries that contributed to its birth were the jute industry of Bengal
and the coal and mining industry of Bihar, Orissa and Bengal.
After World War II
The Second World War also resulted in a sharp boom and mushroom
growth of Indian industries. The boom also resulted in the establishment
of various stock exchanges in the country. During the Second World War,
a few new stock exchanges such as at Hyderabad, Bangalore, Indore, etc
came into existence. Under the provisions of the Securities Contract
 St ock Excha ng e 179

(Regulation) Act, 1956 (SCRA) Central Government granted recognition

to establish stock exchanges at Bombay, Ahmedabad, Calcutta, Madras
and Delhi in 1957, and stock exchanges at Hyderabad and Indore in 1958.
Subsequently, 16 more exchanges were given recognition under the
Securities Contract (Regulation) Act. These were Bangalore Stock Exchange
Ltd. in 1963, Cochin Stock Exchange Ltd. in 1979, Uttar Pradesh Stock
Exchange Association Ltd. (Kanpur) in 1982, Pune Stock Exchange Ltd. in
1982, Ludhiana Stock Exchange Association Ltd. in 1983, Gauhati Stock
Exchange Ltd. in 1984, Kanada Stock Exchange Ltd. (Mangalore) in 1985,
Magadh Stock Exchange Association Ltd. (Patna) in 1986, Jaipur Stock
Exchange Ltd. in 1989, Bhubaneshwar Stock Exchange Association Ltd. in
1989, Saurashtra Kutch Stock Exchange Ltd. (Rajkot) in 1989,
Over-the-counter Exchange of India in 1989, Vadodra Stock Exchange Ltd.
(Baroda) in 1990, Coimbatore Stock Exchange Ltd. in 1991, Meerut Stock
Exchange Ltd. in 1991 and National Stock Exchange (Bombay) in 1993.
ORGANIZATION STRUCTURE
The organizational setup of the stock exchange is chiefly guided by its
objectives which include arrangement for listing of companies, control of
trading in securities, settlement and clearance, regulation of members
activities concerning the disputes among members, members and clients
and others, and other services to members and investors. A brief
description of the common organizational structure of a stock exchange is
discussed below:
Governing Board
The governing board is vested with the over-all management of the affairs
of the stock exchange in India. The governing board is also known as the
Board of Governors or Board of Directors or the Managing Committee.
This body comprises of elected and nominated members, and is headed
by a President. This is the highest body/authority to run the affairs of the
exchange and its members. Various departments implement the decisions
made by the governing body. Sometimes, the committee appointed by the
governing board for specific purposes also takes decisions. The Governing
Body consists of President, Vice-President, Executive Director, Elected
Directors, Public Representatives and Nominees of the Government. The
governing body consists of 13 members as stated below:
Six members elected from the members of the stock exchange; one-
third of the elected members shall retire at each annual general meeting
and one member shall be eligible for re-election subject to a maximum of
two consecutive terms.
180 Capi tal Markets

Three members nominated by the Government or the Board in

accordance with the Act, the government nominees are not subject to
retirement by rotation and they can hold the office till the government
desires.
Three public repres entatives to be nominated by the Board
and one Executive Director to be appointed by the stock exchange. The
public representatives are also appointed for one year and they are also
eligible for re-election. These are nominated by the Board from the various
departments such as Government Departments, Public Financial
Institutions, Investment Institutions, Reserve Bank of India, Educational
Institutions, Industrialists, Professional bodies like Institute of Chartered
Accountants of India, Institute of Cost and Works Accountant and of
India, Institute of Company Secretaries of India, etc. An individual member
is not allowed to be on the governing body of more than one stock exchange.
President and Vice-President The President and Vice-Presi-
dent are elected from amongst the members of the governing body within
10 days after the conclusion of the annual general meeting. No approval is
required for appointment of any person as President or Vice-President
from the Government or Board. The term of these officers is for one year
and they are eligible for re-election but subject to only for two consecu-
tive terms. The President is the Chairman of the Governing Board. He is
responsible for policy aspects and is assisted by the Executive Director in
the implementation of policies. The appointment and other terms and con-
ditions of Executive Director shall be subject to prior approval of the
Board. He would be responsible to implement the directions, guidelines
and orders of the SEBI and will perform his duties as per rules, regulations
and byelaws of that stock exchange. Both the President and Executive
Director have to work in close coordination so that the government guide-
lines and Board’s decisions are implemented effectively. Besides, a num-
ber of Committees and Subcommittees assist the Governing Body in dis-
charging its functions.
The major tasks of the Governing Body are as follows:
1. Making, amending and suspending the operation of the rules,
byelaws and regulations
2. Exercising complete jurisdiction over all members with the power
to admit and expel members
3. Warning, fining and suspending members or their partners,
attorneys, authorized clerks and employees
4. Granting approvals for formation and dissolution of partnership
 St ock Excha ng e 181

5. Appointment of authorized clerks and attorneys

6. Enforce attendance and information, adjudicate disputes and
impose penalties
7. Determining the mode and conditions of stock exchange business
and regulating stock exchange trading; and
8. Supervising, directing and controlling all matters and activities
affecting stock exchange

MODE OF ORGANIZATION
In India, stock exchanges are free to establish themselves in any form of
organization, viz. of public limited company, company limited by guarantee,
an association of individuals, non-profit organization, etc. The Securities
Contract (Regulation) Act usually encourages a stock exchange to be
constituted in a limited company form. A brief description of the way the
stock exchanges in India is organized is presented below:
Voluntary Associations
Some of the recognized stock exchanges in India have been constituted as
voluntary non-profit making associations. Examples include Bombay Stock
Exchange, Ahmedabad Stock Exchange and Indore Stock Exchange. This
form usually suits members as they can frame rules, bye-rules and
regulations that suit them. Moreover, membership can be acquired either
by inheritance or through purchase of a card of another member. The new
card of membership can also be purchased direct from the stock exchange
with the approval of the other members. However, at present this form is
not very much popular and even the Government also discourages it.
Public Limited Companies
Exchanges in Calcutta, Delhi, Chennai, Bangalore, Cochin, Kanpur,
Ludhiana, Mangalore and Jaipur are organized as public limited companies.
In this form, the membership is acquired by purchasing the requisite
qualifying shares. However, these shares are not freely transferable as in
the case of a public limited company. The powers of the members are
derived from the Memorandum of Association and Articles of Association
of the company. Further, the liability of the member is limited. However, the
shares can be forfeited if the Governing Board of the stock exchange
cancels the membership of any persons. The stock exchange being a
service unit normally does not declare dividend for the shareholders.
182 Capi tal Markets

Companies Limited by Guarantee

Stock exchanges in Hyderabad, Magadh, Pune, Bhubaneshwar and
Saurashtra are in the form of companies limited by guarantee. In this form,
there is no share capital. The liability of the members is limited to the extent
of the guaranteed amount mentioned in the Memorandum of Association
and Articles of Association of the company. The membership in this form
can be acquired if the Board of Directors permits the same by passing a
resolution in this respect. Normally each member has one vote in this form
of organization.
Me mbe rship
Only members are allowed to take part in the trading activities of a stock
exchange. Opportunities are usually restricted to persons of high financial
standing with a sufficient knowledge and experience relating to stock
market operations. Members are subject to the rules and regulations of
each of the stock exchanges. Members are also required to make a payment
of cash deposit as margin money. Application for membership has to be
made to the Governing Board of the stock exchange, besides being
recommended by an existing member. Membership of those stock exchanges
that are registered under the Companies Act are governed by the relevant
provisions of the Companies Act.
STOCK EXCHANGE TRADERS
Only the registered members are permitted to carry out trading on the floor
of a stock exchange. However, for reasons of convenience some other
persons are also permitted to enter the premises and transact business on
behalf of the members. They are:
Remis iers
The sub-brokers employed by a member (share-broker) to secure business
are called ‘Remisiers’. As the share brokers are prohibited to get business
by advertisement ,the role of remisiers assumes importance. Remisiers are
not permitted to enter the trading floor for exchange dealings. Remisiers
are those traders who are engaged by the full-fledged members of the BSE
in order to secure business for them. They act as agents of the members.
The members pay them commission on the business procured by them
and for this reason remisiers are best known as “half commission men”.
The remisiers are practically under the same restrictions as their principals.
Authorized Clerks
Authorized clerks are the people who assist a member in transacting
 St ock Excha ng e 183

business, especially at times where the volume is heavy. The employees

of a member of a stock exchange are called ‘authorized clerks’. These
clerks or assistants are authorized to transact business on behalf of their
member-employer, but they cannot make any bargain in their own name.
Such persons can sign on behalf of their employers where they are provided
with the power of attorney. They also assist the member in conducting the
exchange transactions. Besides, they are authorized to enter the trading
floors of the stock exchange for carrying out buying and selling of scrips
on behalf of their employers. They cannot buy or sell on their own account.
The number of authorized clerks permitted for each member varies between
exchanges. For instance, in the Bombay Stock Exchange, five authorized
clerks are permitted per member; the Calcutta Exchange allows eight
authorized clerks or member assistants per member, and the Madras
Exchange provides three authorized clerks for a member.
Brokers and Jobbers
In a stock exchange, the actions of brokers and jobbers are interrelated.
Both the broker and the jobber perform important functions. A broker acts
as an expert agent of the ordinary investors who is hardly competent to
deal with skilled jobbers directly. A jobber renders a useful service by
executing orders without delay. The immediate execution of orders helps
make the price fluctuations smooth. He uses his experience and specialized
knowledge to name the price at which a security should pass from one
investor to another. Although there is a clear-cut distinction between
brokers and jobbers in the London Stock Exchange, no such difference
exists between them in India. For instance, brokers are commission agents
who transact business in securities on behalf of non-members; they work
on a commission basis. A broker’s commission on his business is fixed.
A broker serves as a link between the general public and the jobber.
Since a broker acts for a larger number of his non-member clients, he deals
in a wide variety of securities. Brokers are competent to enter into
transactions in an exchange. Brokerage charges are collected for the services
rendered by them. Brokers place orders on behalf of their client-
shareholders, collect the share certificate from the seller-broker and deliver
the same to the buyer-broker. It is the brokers through whom transactions
are dealt in by a stock exchange. Brokers trade in their own account,
besides placing orders on behalf of their clients. The actions of brokers
infuse liquidity in stock exchanges all over the world. Stock broking
business in India is a traditional family business. With the initiation of
economic reforms, international investors and foreign brokerage houses
184 Capi tal Markets

entered the Indian capital market. A great deal of change has since taken
place in the profile of the market participants. Corporate broking houses
are now common, which is an international norm.
Jobbers are independent dealers in securities. A jobber buys and
sells securities in his own name. He does not deal with non-members
directly, implying that a jobber can either deal with a broker or with another
jobber. He does not work on commission basis, but works for ‘profit’,
which is technically referred to as his ‘turn’. A jobber’s turn on profit is
uncertain. A jobber is a ‘dealer’ in his own right. A jobber is a professional
speculator who usually specializes in a limited number of shares.
A transacting broker approaches a jobber and asks for the price at
which the jobber would be ready to purchase or sell a particular security.
Where the securities are actively traded, the jobber provides a two-way
price, the lower one would be the price at which he would purchase and
the higher one at which he would sell. Otherwise, he offers no quotation.
The difference between the purchase and sale price is his profit or ‘jobber’s
turn’. The broker finalizes/squares up the deal where he is satisfied with
the price.
A jobber does not trade with an inventory of stocks. He merely strikes
a bargain in the expectation that it will be balanced which eventually
involves risk, as sometimes he may not be able to do so for months.
Tarawaniwalas
Tarawaniwalas are dealers in securities in the BSE who transact business
in their own name and on their own behalf as well. Such dealers usually
specialize in one or two securities only. They resemble the jobbers of the
London Exchange in as far as the method of transacting business is
concerned. A typical dealer like the tarawaniwala is not prohibited from
acting as a broker although it might prove objectionable from the point of
view of the public as it gives him a chance to purchase securities from
clients at lower prices or sell his own securities to them at higher prices.
In addition, it is also possible that a tarawaniwala might indulge in a
malpractice of making a false offer and backing out later. In order to prevent
such a practice the Securities Contracts (Regulation) Act of 1956, provides
that a member of a recognized stock exchange can enter into contract in
respect of securities as principal with only a member of a recognized stock
exchange. Where it becomes absolutely essential to have dealings with
any non-member, such dealings can be had only with the express consent
of the authorities of the stock exchange concerned. This is only to afford
a measure of protection to the investors.
 St ock Excha ng e 185

Dealers
Dealers are market-makers. They are important intermediaries in the stock
exchange. Dealers buy and sell inventory of stocks. Through this process,
they absorb excessive buying or selling pressures, thereby providing
liquidity and immediacy in the exchange. Such intermediaries are not very
common in the Indian capital market.
JOBBERS AND BROKERS
Jobbers and Brokers are the two categories of dealers found in the London
Stock Exchange.
J ob b e r s
A Jobber is a dealer in securities, while a broker is an agent of a buyer or
seller of securities. Every year a member has to decide and declare in
advance whether he proposes to act as a jobber or a broker. A jobber gives
two quotations as a dealer in securities, lower quotation for buying and
higher one for selling. The difference between the two prices constitutes
his remuneration. This system enables specialization in the dealings and
each jobber specializes in a certain group of securities. It also ensures
smooth and prompt execution of transactions. The double quotation of a
jobber assures fair-trading to investors.
Brokers
The brokers in the London Stock exchange are known as Tarawaniwalas
on the Bombay Stock Exchange. A Tarawaniwala often performs the task
of both a broker and a dealer in securities although strictly speaking,
Tarawaniwalas must act only as dealers in securities. Frequently,
Tarawaniwalas do perform the functions of brokers in order to be broker-
members.
186 Capi tal Markets

JOBBERS Vs BROKERS

Sl. Feature Jobber Broker

No.
1. Agent Jobber is an independent Broker is merely an
dealer or a merchant agent to buy or sell on
willing to buy and sell behalf of his clients
securities
2. Specialization Jobber is a specialist Broker is a generalist
3. Dealing with Jobber deals only with Broker deals with a
Public brokers and not with jobber on behalf of his
public. No direct sale or clients. He is a
purchase in the market middleman between the
jobber and the real
buyer/seller
4. Price Jobber quotes two prices Broker has to negotiate
Quotation to the broker, one for terms and conditions of
buying and one for sale or purchase and
selling. Sale quotation is safeguard his client’s
higher than the purchase interest. He lives on
quotation commission paid by his
client which is fixed by
the Exchange
5. Margin Jobber’s profit margin is Lower brokerage rate is
fixed by competition fixed by rules; the higher
among themselves as rate by competition. In
dealers. It is narrow practice minimum
when there is keen becomes maximum
competition under keen competition

WEAKNESSES
Although rapid strides have been made in the Indian stock markets, there
are many irritants that continue to afflict the functioning of the stock
exchanges. Following are the principal weaknesses of the Indian stock
exchanges:
Raging Speculation
It is highly characteristic of the Indian stock exchanges that there prevails
a rampant speculative transaction. The continued spell of unprecedented
booms and crashes is a clear testimony for this phenomenon. The Indian
stock market witnesses high volatility taking the unwary investors for a
 St ock Excha ng e 187

ride as they do not reflect a very healthy state of affairs. Over-speculative

character and high volatility have made the Indian stock market crises
prone.
Insider Trading Menace
The possibility that the insiders in a stock exchange have an access to
price-sensitive information about the market movements of certain scrips
breaks the ‘Playing field’. This way, equal opportunity of information
access is denied to all the participants in the market.
Neglect of Small Investors
The Indian stock market is often highly dominated by large financial
institutions, big brokers, and operators. The oligopolistic structure does
not leave any advantage to the small investors. The small investor is often
meted out a raw deal, despite the much-proclaimed safeguards built into
the various regulations issued by the SEBI from time to time.
Restrictions on Forward Trading
The ban imposed on the ‘forward trading’ in India in 1969, had a deleterious
effect on share prices. Further, the restrictions placed on dividend
payments by companies as part of the anti-inflationary measures adopted
by the government aggravated the dealings in share market. The limited
facility allowed for carrying forward the delivery contract beyond 14 days
in an informal manner. Under forward trading, the earlier contract is
concluded and a new contract is entered into without any actual delivery.
Only the balance between the contracted price and market price is paid
between the buyer and the seller. This system of forward trading was
useful for providing liquidity and avoiding payment crisis. However,
rampant speculation gave rise to difficulties in the actual physical transfer
of securities resulting in a virtual and inevitably payment crisis.
Bad Trading Practice
There are many obsolete, inefficient and outdated share-trading practices
that are ruling roost in the Indian stock exchanges. Major problem areas
are settlement periods, margin system and carry forward (badla) system.
The settlement period is 14 days in most of the Indian stock exchanges,
whereas most of the countries are moving towards a rolling 3 days
settlement period. The lengthy settlement period encourages the growth
of trading shops outside the stock exchange system, besides increasing
the risk exposure of market participants due to price movements. Avoidance
of margin payment under the margin system is another problem area.
188 Capi tal Markets

Under the margin system, the members have to maintain with the clearing
house of the stock exchange a deposit, which is a certain percentage of
the value of the security being traded by members. Accordingly, if a member
buys or sells securities marked for margin above the free limit, a specified
amount per share has to be deposited in the clearing house. A major
weakness of the system was that the margin was totally discretionary in
character, with a variation of zero to sometimes 40 percent depending on
nature of shares and timing of trading. This practice often gave rise to
runaway booms. Moreover, under the present settlement and margin system,
there is a strong incentive to collude for the buyer and seller-brokers for
the purpose of avoiding margin payments. Carry forward (or badla) system
was another obnoxious practice followed in the Indian financial system.
The practice caused unprecedented speculation in shares. It allowed a
wholly spurious kind of share trading in which neither the buyer has the
money to pay for the shares at the time of settlement nor the seller has the
shares to deliver, or at least one of the two is spurious. This obviously
constricts the smooth and free functioning of the stock exchanges.
Lack of Integration
In order that the services of a stock market are made use of by a wide
spectrum of investors across the country, close integration among the
various stock exchanges becomes an imperative necessity. Such an
arrangement will also help enhance the cohesive functioning of the stock
exchanges with efficient sharing of information among them. The limited
inter-market operations have resulted in increased costs and risks of
investors in smaller towns. This problem has been further aggravated by
the lack of cohesion among exchanges in terms of legal structure, trading
practices, settlement procedures and jobbing spreads.
Lack of Interface
In India, the kind and the quality of developments taking place in the realm
of new issues market are not adequately matched by the developments in
the secondary markets. For instance, the recent upsurge of the primary
market has created serious problems of interfacing with the secondary
market. The stock exchanges are ill-equipped to handle the great volume
of transactions in the primary market. It therefore, requires that the
secondary market is re-oriented so as to discharge the new responsibilities
efficiently and effectively. This would in turn spur all-round growth in the
capital market, thus making the Indian stock market a real investor-friendly
market.
 St ock Excha ng e 189

Inefficient Banking System

The dilatory and inefficient working of the banking system under which
outstation cheques takes very long to be encashed, the difficulty in making
necessary payments in reply to calls or in connection with the subscription
for issues also affect the system. The restrictions imposed by the FERA
on inflow and outflow of foreign exchange and the time consuming
procedures are irritants not only to foreign but also to nonresident Indian
investors, who have grown substantially in recent years. All this militates
against the efficient functioning of the secondary market.
Inadequacy of Investor Service
As regards investor service, it is found to be much wanting especially
among the small stock exchanges. They make a limited contribution to the
spread of the equity cult in their region.
Inadequate Infrastructure
The extent of facilities that are available in the stock exchanges are far from
satisfactory. This results in lower operational flexibility of stock exchanges
and brokers to handle sudden surges in volu