Concept of Financial Market

A business needs finance from the time an entrepreneur makes the decision to start it. A business is part of an economic system that consists of two main sectors: households, which are typically net savers of funds, and business firms, which are typically net investors of these funds. A financial market is a market for the creation and exchange of financial assets (like shares, debentures, bonds, etc.). It acts as a crucial link or an intermediary between the savers and the investors by mobilising funds between them.

In doing so, a financial market performs what is known as an allocative function. It allocates or directs the funds available for investment into their most productive investment opportunities. When this allocative function is performed well, it leads to two positive consequences for the economy:

• The rate of return offered to households (savers) is higher, which encourages more savings.

• Scarce financial resources are allocated to those firms and projects that have the highest productivity for the economy, leading to economic growth.

The process by which this allocation of funds is done is called financial intermediation. There are two major alternative mechanisms through which this can happen: via banks or via financial markets.

• Via Banks: Households can deposit their surplus funds with banks, who in turn can lend these funds to business firms.

• Via Financial Markets: Households can directly buy the shares and debentures offered by a business, using the financial markets as a platform.

Banks and financial markets are thus competing intermediaries in the financial system, and they provide households with a choice of where they want to place their savings.

Functions of Financial Market

Financial markets play an important and indispensable role in the allocation of scarce resources in an economy. They do so by performing the following four important functions:

1. Mobilisation of Savings and Channeling them into the most Productive Uses

A financial market facilitates the transfer of savings from savers (like households) to investors (like business firms). It offers savers a variety of different investment options where they can park their surplus funds. By providing these avenues, it helps to mobilise the savings of the country and channelise these surplus funds into their most productive use, which is investment in business and industry. This process is the foundation of capital formation and economic growth.

2. Facilitating Price Discovery

In any market, the price of a commodity or service is established by the forces of demand and supply. Similarly, in the financial market, the price of a financial asset (like a share or a debenture) is determined by the interaction of the demand and supply for that asset. In the financial market, households are the suppliers of funds and business firms represent the demand for these funds. The interaction between them helps to establish a price for the financial asset which is being traded in that particular market. This process is known as price discovery.

3. Providing Liquidity to Financial Assets

Financial markets facilitate the easy purchase and sale of financial assets. In doing so, they provide liquidity to these assets. Liquidity is the ability to convert an asset into cash quickly and without a significant loss in its value. Holders of financial assets can readily sell them through the mechanism of the financial market whenever they need cash. This feature of liquidity is a key attraction for investors.

4. Reducing the Cost of Transactions

Financial markets provide valuable information about the securities being traded in the market. They bring together a large number of buyers and sellers. This helps to save the time, effort, and money that both buyers and sellers of a financial asset would otherwise have to spend to try and find each other. The financial market, thus, acts as a common platform where buyers and sellers can meet for the fulfillment of their individual needs, which significantly reduces the cost of transactions.

Classification of Financial Markets

Financial markets can be classified in several ways, but a broad and fundamental classification is done on the basis of the maturity of the financial instruments that are traded in them. Based on this, financial markets are of two types:

• Money Market: In this market, financial instruments with a maturity of less than one year are traded.

• Capital Market: In this market, financial instruments with a longer maturity (more than one year) are traded.

The capital market is further classified into the primary market and the secondary market.

Money Market

The money market is a market for short-term funds. It deals in monetary assets and debt instruments whose period of maturity is up to one year. These assets are very close substitutes for money. It is a market where low-risk, unsecured, and highly liquid short-term debt instruments are issued and actively traded every day.

The money market has no physical or geographical location; it is an activity that is conducted over the telephone and through the internet among various participants. It serves two main purposes: it enables the raising of short-term funds for meeting the temporary shortages of cash and other obligations, and it provides an avenue for the temporary deployment of excess funds for earning returns.

The major participants in the money market are the Reserve Bank of India (RBI), Commercial Banks, Non-Banking Finance Companies (NBFCs), State Governments, Large Corporate Houses, and Mutual Funds.

Money Market Instruments

The main financial instruments of the money market are:

1. Treasury Bill (T-Bill): A Treasury bill is a short-term instrument of borrowing by the Government of India, with a maturity of less than one year. They are also known as Zero Coupon Bonds. They are issued by the RBI on behalf of the Central Government at a price that is lower than their face value (at a discount) and are repaid at their face value (at par) on maturity. The difference between the issue price and the redemption value represents the interest earned by the investor.

2. Commercial Paper (CP): Commercial paper is a short-term, unsecured promissory note, which is negotiable and transferable. It is issued by large and highly creditworthy companies to raise short-term funds at interest rates that are often lower than the prevailing market rates. It usually has a maturity period of 15 days to one year. It is also sold at a discount and redeemed at par.

3. Call Money: Call money is a form of very short-term finance that is repayable on demand, with a maturity period ranging from one day to fifteen days. It is a method by which banks borrow from each other to be able to maintain their mandatory Cash Reserve Ratio (CRR). The interest rate paid on call money loans is known as the call rate, which is a highly volatile rate.

4. Certificate of Deposit (CD): A Certificate of Deposit is an unsecured, negotiable, short-term instrument in bearer form, which is issued by commercial banks and development financial institutions. They can be issued to individuals, corporations, and companies. They are typically issued during periods of tight liquidity when the deposit growth of banks is slow but the demand for credit is high.

5. Commercial Bill: A commercial bill is a bill of exchange that is used to finance the working capital requirements of business firms. It is a short-term, negotiable, and self-liquidating instrument used to finance the credit sales of firms. When a trade bill (which is drawn by a seller of goods on the buyer) is accepted by a commercial bank, it is known as a commercial bill.

Capital Market

The capital market refers to the facilities and institutional arrangements through which long-term funds (both debt and equity) are raised and invested. It consists of a series of channels through which the savings of the community are made available for industrial and commercial enterprises and for the public in general. It directs these savings into their most productive use, which leads to the growth and development of the economy. The main components of the capital market are development banks, commercial banks, and stock exchanges.

An ideal capital market is one where finance is available at a reasonable cost. The process of economic development is greatly facilitated by the existence of a well-functioning capital market. The Capital Market can be divided into two main parts: the primary market and the secondary market.

Distinction between Capital Market and Money Market

The capital market and the money market are the two main segments of the financial market. The major points of distinction between them are as follows:

Primary Market

The primary market is also known as the new issues market. It is the part of the capital market that deals with the issuance of new securities. When a company wants to raise funds by issuing shares or debentures for the first time, it approaches the primary market. The essential function of a primary market is to facilitate the transfer of investible funds from savers (investors) to entrepreneurs and companies seeking to establish new enterprises or to expand and modernise existing ones. The investors in this market are banks, financial institutions, insurance companies, mutual funds, and individuals.

In the primary market, the flow of funds is directly from the savers to the company. Therefore, it directly promotes capital formation in the economy.

Methods of Floatation (Issuing Securities)

There are various methods through which a company can offer its new securities to investors in the primary market. These are known as methods of floatation.

1. Offer through Prospectus: This is the most popular and common method of raising funds by public companies. It involves inviting subscriptions from the public through the issue of a prospectus. A prospectus is a formal legal document that contains all the relevant information about the company, its promoters, its financial performance, the purpose of the issue, and the risks involved. It makes a direct appeal to investors to raise capital. The issues are often underwritten to ensure success and must be listed on at least one stock exchange.

2. Offer for Sale: Under this method, securities are not issued directly to the public by the company. Instead, the company sells its securities in a block at an agreed price to intermediaries like issuing houses or stockbrokers. These intermediaries, in turn, resell the securities to the investing public at a higher price. The main advantage of this method is that the company is saved from the complexities of a direct public issue.

3. Private Placement: This is the allotment of securities by a company to a select group of institutional investors (like banks, insurance companies, mutual funds) and some selected wealthy individuals. This method is preferred by companies as it helps to raise capital more quickly and at a lower cost than a public issue, as many of the mandatory and non-mandatory expenses of a public issue are avoided.

4. Rights Issue: This is a special privilege given to the existing shareholders of a company. They are offered the ‘right’ to subscribe to a new issue of shares in proportion to the number of shares they already possess. The company has to send a letter of offer to all existing shareholders, and if a shareholder does not wish to exercise their right, they can sell or transfer it to another person.

5. e-IPOs (Electronic Initial Public Offer): This refers to the method of issuing capital to the public through the on-line system of the stock exchange. A company proposing to issue capital in this manner has to enter into an agreement with the stock exchange. SEBI-registered brokers have to be appointed for the purpose of accepting applications and placing orders with the company. This method makes the process of issuing shares more efficient, transparent, and accessible to a larger number of investors.

Secondary Market (Stock Exchange)

The secondary market is also known as the stock market or stock exchange. It is a market for the purchase and sale of existing, previously issued securities. In this market, the securities are not issued directly by the company but are traded among investors. The secondary market helps existing investors to disinvest (sell their securities) and fresh investors to enter the market. The transaction in the secondary market involves a transfer of ownership from one investor to another. It provides crucial liquidity and marketability to existing securities.

By providing liquidity to long-term securities, the secondary market indirectly promotes capital formation. Investors are more willing to invest in the primary market if they know there is a ready market where they can sell their securities later if needed.

Meaning of Stock Exchange

According to the Securities Contracts (Regulation) Act 1956, a stock exchange is 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."

Functions of a Stock Exchange

1. Providing Liquidity and Marketability to Existing Securities: The basic and most important function of a stock exchange is the creation of a continuous market where securities are bought and sold. It gives investors the chance to disinvest and reinvest their funds easily. This provides both liquidity and easy marketability to the already existing securities in the market.

2. Pricing of Securities: The share prices on a stock exchange are determined by the free and fair interplay of the forces of demand and supply. A stock exchange is a mechanism of constant valuation through which the prices of securities are determined. This valuation provides important and instant information to both buyers and sellers in the market.

3. Safety of Transaction: The membership of a stock exchange is well-regulated, and its dealings are well-defined according to the existing legal framework (SEBI regulations). This ensures that the investing public gets a safe and fair deal on the market, protecting them from fraud and manipulation.

4. Contributes to Economic Growth: A stock exchange is a market in which existing securities are resold or traded. Through this process of disinvestment and reinvestment, the savings of the community get channelised into their most productive investment avenues. This process leads to capital formation and, consequently, economic growth.

5. Spreading of Equity Cult: The stock exchange plays a vital role in ensuring wider share ownership by regulating new issues, ensuring better trading practices, and taking effective steps in educating the public about the benefits and risks of investments in the stock market.

6. Providing Scope for Speculation: The stock exchange provides sufficient scope for speculative activity, but in a restricted and controlled manner. It is generally accepted that a certain degree of healthy speculation is necessary to ensure liquidity and price continuity in the stock market, as speculators are willing to take on the risk that other investors may want to avoid.

Trading and Settlement Procedure

In the past, trading on stock exchanges was done through an open outcry system on the floor of the exchange. However, now, all trading in securities is executed through an on-line, screen-based electronic trading system. This system offers greater transparency, efficiency, and reach. The steps involved in this screen-based trading are:

1. Selection of a Broker: If an investor wishes to buy or sell any security, they first have to approach a registered broker or sub-broker and enter into an agreement. The investor has to sign a broker-client agreement and a client registration form.

2. Opening a Demat Account: The investor also has to open a ‘demat’ account with a depository participant (DP) for the purpose of holding and transferring securities in electronic (dematerialised) form.

3. Placing the Order: The investor then places an order with the broker to buy or sell shares. Clear instructions have to be given about the number of shares and the price at which the shares should be bought or sold.

4. Executing the Order: The broker then goes on-line and connects to the main stock exchange computer. They match the investor's order with the best available price. When the shares can be bought or sold at the price mentioned, the order is executed electronically.

5. Issuance of Contract Note: After the trade has been executed, within 24 hours the broker issues a Contract Note. This note contains all the details of the transaction, such as the number of shares bought or sold, the price, the date and time of the deal, and the brokerage charges. This is a legally enforceable document.

6. Settlement of the Trade: Now, the investor has to deliver the shares sold or pay cash for the shares bought. This is called the pay-in day. The settlement of all trades is done on a T+2 basis on a rolling settlement system, which means the trade is settled on the second business day after the trade day (T).

7. On the T+2 day, the exchange will deliver the share or make the payment to the other broker. This is called the pay-out day.

8. The broker then has to make the payment to the investor (if shares were sold) or deliver the shares in demat form directly to the investor’s demat account (if shares were bought) within 24 hours of the pay-out day.

Dematerialisation and Depositories

Dematerialisation is the process where securities held by an investor in physical form (paper share certificates) are cancelled, and the investor is given an electronic entry or number so that they can hold the securities as an electronic balance in an account. This process is done to eliminate the problems associated with physical certificates, such as theft, fake/forged transfers, transfer delays, and excessive paperwork.

To hold securities in this dematerialised (demat) form, an investor has to open a demat account with an organisation called a depository participant (DP). The DP is an intermediary between the investor and the depository and can be a bank, a broker, or a financial services company.

A depository is an institution that is like a bank; it keeps securities (like shares and debentures) in electronic form on behalf of the investor. It facilitates the transfer of ownership of securities without the physical movement of share certificates. In India, there are two main depositories:

• National Securities Depositories Limited (NSDL): This was the first and is the largest depository currently operational in India.

• Central Depository Services Limited (CDSL): This was the second depository to commence operations and was promoted by the Bombay Stock Exchange (BSE).

National Stock Exchange of India (NSE)

The National Stock Exchange (NSE) is India's leading stock exchange. Incorporated in 1992, it started operations in 1994 and has since been a pioneer in technology and innovation in the Indian capital market. It was set up by a consortium of leading financial institutions, banks, and insurance companies with the objective of creating a nationwide, transparent, and efficient securities market.

The NSE introduced a fully automated, screen-based trading system that allows trading members to trade from their offices across the country. This system provides equal access to investors irrespective of their geographical location and has been a key change agent in transforming the Indian capital market. Its benchmark index is the NIFTY 50.

BSE (Bombay Stock Exchange Ltd.)

The BSE Ltd (formerly known as the Bombay Stock Exchange Ltd) was established in 1875 and holds the distinction of being Asia’s first stock exchange. It has played a pivotal role in the development and growth of the Indian corporate sector by providing a reliable and efficient platform for raising capital. Originally established as 'The Native Share & Stock Brokers' Association', it is now a corporate entity with a broad shareholder base.

The BSE has a nationwide presence and a global reach. Its benchmark index is the S&P BSE SENSEX, which is a widely tracked indicator of the Indian stock market. As mentioned in the opening case, if the SENSEX rises, it indicates that the market is doing well and investors expect better earnings from Indian companies.

Securities and Exchange Board of India (SEBI)

The Securities and Exchange Board of India (SEBI) is the principal regulator of the securities and commodity market in India. It was established by the Government of India on 12 April 1988 as an interim administrative body. It was given statutory status and powers on 30 January 1992 through the SEBI Act, 1992. SEBI was established to address the various malpractices that were prevalent in the capital market in the 1980s, such as the rigging of prices, unofficial private placements, non-adherence to the provisions of the Companies Act, and long delays in the delivery of shares, all of which had eroded investor confidence.

Purpose and Role of SEBI

The basic purpose of SEBI is to create a conducive environment that facilitates the efficient mobilisation and allocation of resources through the securities markets. It aims to meet the needs of the three main groups that constitute the market:

• For the Issuers of securities (Companies): To provide a marketplace where they can raise finance in an easy, fair, and efficient manner.

• For the Investors: To provide strong protection for their rights and interests by ensuring that they receive adequate, accurate, and authentic information on a continuous basis.

• For the Intermediaries: To offer a competitive and professionalised market with an efficient infrastructure so that they can render better and more responsible service to investors and issuers.

Objectives of SEBI

The overall objective of SEBI is to protect the interests of investors and to promote the development of, and regulate, the securities market. This can be elaborated as follows:

1. To regulate the stock exchanges and the entire securities industry to promote their orderly and healthy functioning.

2. To protect the rights and interests of investors, particularly individual investors, and to guide and educate them on the market.

3. To prevent trading malpractices (like price rigging and insider trading) and to achieve a balance between self-regulation by the securities industry and its statutory regulation.

4. To regulate and develop a code of conduct and fair practices for all intermediaries like brokers, merchant bankers, and underwriters, with a view to making them more competitive and professional.

Functions of SEBI

Keeping in mind the emerging nature of the securities market in India, SEBI was entrusted with the twin task of both the regulation and the development of the market. Its functions can be classified into three categories:

1. Regulatory Functions: These functions are performed to regulate the business in the stock exchanges. They include the registration of brokers, sub-brokers, and other players in the market; the registration of collective investment schemes and Mutual Funds; the regulation of stockbrokers, portfolio exchanges, and merchant bankers; and the regulation of takeover bids by companies.

2. Development Functions: These functions are performed by SEBI to develop the securities market. They include the training of intermediaries of the securities market; conducting research and publishing information that is useful to all market participants; and undertaking measures to develop the capital markets by adopting a flexible approach.

3. Protective Functions: These functions are performed by SEBI to protect the interests of investors. They include the prohibition of fraudulent and unfair trade practices like making misleading statements and price rigging; controlling insider trading and imposing penalties for such practices; undertaking steps for investor protection; and the promotion of fair practices and a code of conduct in the securities market.

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