Capital Markets [2 ed.] 0070153302, 9780070153301

Table of contents :
Cover
Contents
Chapter 1 Financial Markets
Definition
Location
Role
Functions
Constituents
Financial Instruments
Indian Financial Market
Global Financial Markets
Review Questions
Chapter 2 Capital Market Money Market
Indian Capital Market—Evolution and Growth
Constituents of Indian Capital Market
New Financial Institutions
New Financial Instruments
Capital Market Doldrums
Measures of Reactivation
Measures of Investor Protection
Recent Initiatives in the Indian Capital Market
Indian Capital Market—Major Issues
Rebound in Indian Capital Market
Review Questions
Chapter 3 Capital Market Instruments Meaning
Types
Preference Shares
Equity Shares
Non-Voting Equity Shares
Convertible Cumulative Preference Shares (CCPS)
Company Fixed Deposits
Warrants
Debentures and Bonds
Global Debt Instruments
Review Questions
Chapter 4 Regulation of Indian Capital Market Genesis
The Factors
The Regulatory Framework
Committees on Regulatory Framework
Review Questions
Chapter 5 Derivatives Market
Meaning of Derivatives
Growth of Derivatives Market—Factors
Limitations of Derivatives Market
Functions of Derivatives Market
Categories of Derivatives
Forward Contract Vs. Futures Contract
Option Based Derivatives
Futures and Options—Participants
Benefits of Derivatives
Risks in Derivatives Market
Capital Standards for Derivatives
Regulating Derivatives Market
Advent of Derivatives Market in India
Review Questions
Chapter 6 SEBI—Functions and Working
Genesis
Features of the SEBI Bill
Objectives
Management
Powers and Functions
Regulatory Role
Role and Relevance
Review Questions
Chapter 7 Investor Protection
Loss of Confidence of Small Investor—Causes
Rights of Investors
Facilities by BSE
Ombudsman
Review Questions
Chapter 8 Insider Trading
Nationale
Insiders—Categories
Insider Information
Connected Persons
Need for Control
Prohibition of Insider Trading
Investigation by SEBI
Action by Corporates
Review Questions
Chapter 9 Stock Exchange
History of Stock Exchanges
Meaning
Definition
Functions/ Services/ Features/ Role
Stock Exchange and Commodity Exchange Distinguished
World’s Stock Exchanges
Organization Structure
Mode of Organization
Stock Exchange Traders
Jobbers and Brokers
Jobbers Vs. Brokers
Weaknesses
Regulation of Stock Exchanges
Steps in Stock Trading
Mechanics of Settlement
Systems of Stock Trading
Specialists
Recent Developments
Interconnected Stock Exchange of India (ISE)
Indonext
Review Questions
Chapter 10 Indian Stock Exchange
The Bombay Stock Exchange (BSE)
For New Companies
For Companies Listed on Other Stock Exchanges
For Companies Delisted Already and Seeking Relisting of this Exchange
Safety of market
Opportunities for Foreign Investors
Shortages and Objections
Derivatives Trading
Calcutta Stock Exchange
The National Stock Exchange of India Limited (NSE)
Review Questions
Chapter 11 Primary Market
NIM and Secondary Markets—An Interface
Services of NIM
NIM Vs. Secondary Market
Review Questions
Chapter 12 Methods of New Issue
Methods of Marketing Securities
Stock Option or Employees Stock Option Scheme (ESOP)
Bought-out Deals Vs. Private Placements
Review Questions
Chapter 13 Intermediaries in New Issues Market
Intermediaries in NIM
Merchant Bankers/Lead Managers
Underwriters
Bankers to An Issue
Brokers to an Issue
Registrars to an Issue and Share Transfer Agents
Debenture Trustees
Review Questions
Chapter 14 SEBI Guidelines on Primary Market
SEBI Guidelines for Listed and Unlisted Companies
Review Questions
Chapter 15 Listing
Security Listing
Security
Stock Exchange
Recognized Stock Exchange
Legal Provisions
Steps
Legal Significance
Refusal of Listing
SEBI Powers
Listing and Corporate Governance
Particulars to be Furnished
Listing Agreement
Stock Exchange Powers
Listing—Benefits
Consequences of Non-listing
New Entry Norms for Unlisted Companies
Listing—Suspension / Withdrawal
Review Questions
Chapter 16 Underwriting
Definition
Types
Mechanics of Underwriting
Benefits/Functions
Indian Scenario
Underwriting Agencies
Obstacles
Underwriter
Underwriting Agreement
SEBI Guidelines
Variants of Underwriting
Grey Market
Review Questions
Chapter 17 Book-Building
Concept
Characteristics
The Process
Allocation Procedure
Case I—Initial Public Offer (IPO) Issue
Illustration
Case II—Additional Issue by Listed Company
Illustration
Case III—Offer by Unlisted Company
Illustration
Reverse Book-building
Review Questions
Chapter 18 Over the Counter Exchange of India (OTCEI)*
Genesis
OTCEI Vs. Other Stock Exchanges
Over-the-Counter
Need and Objectives
Features
Benefits
Securities Traded
Players
Members and Dealers
Sponsorship
Admission of Members—Conditions
Admission of Dealers—Conditions
Registrars and Custodians
Central Clearing Bank
Monitoring Agencies
Trading Mechanism
Settlement Procedure
Slow Growth of OTCEI—Causes
Revamping OTCEI
Working of NASDAQ
Changing Role of OTCEI
Major Changes in OTCEI Functioning
New Norms
Utility of OTCEI’s New Listing Norms to Entrepreneurs
OTCEI MOU with NASSCOM
Revision in Composite Index
Clearing and Settlement
Technology
Review Questions
Chapter 19 Stock Market Index Meaning
Features
BSE INDEX
BSE-SENSEX
2. BSE-TECk Index
3. BSE-PSU Index
4. BSE-100 Index
5. BL-250 Stock Index
6. BSE BANKEX
7. S&P CNX Nifty
S&P CNX Nifty Vs. BSE Sensitive Index
Dow Jones Indices
NASDAQ Stock Market Indices
NASDAQ Index Calculation Description
Other Index Descriptions
S & P 500 Index
1. S&P Global 1200
2. S&P Global 1200 Sector Indices
Hang Seng Index
DAX Index
Straits Times Index
KOSPI
FTSE
MSCI (Morgan Stanley Capital International Inc) Index
India Index Services Ltd (IISL)
Review Questions
Chapter 20 Stock Market Trading Mechanism
Jobbers and Brokers
Jobbers Vs Brokers
Stock Exchange Dealings
Speculative Dealings
Share Prices—Factors
Regulating Speculation
The Securities Contracts (Regulation) Act
Magin Trading
Trading of Securities—Steps
Margins
Badla System
Current Trading System—Problems and Palliatives
Review Questions
Chapter 21 Depository Services
Depository
Bank and Depository—Comparison
Depository Participant (DP)
Depository (Demat) Services
Services/Functions
Demat (Beneficiary) Account
Dematerialization
Electronic Settlement of Trade—Procedure
Demat of Debt Instruments
Safety System for Demat
Shortcomings of Demat System
Indian Depository
Role of CDSL
Constitution
Major Tasks
Benefits
Role of NSDL
Depository Stock Exchanges
Legal Framework
Review Questions
Chapter 22 Speculation
Speculation Vs. Gambling
Investors Vs. Speculators
Types of Speculators
Review Questions
Chapter 23 On-line Stock Trading
Meaning
Features
Current Scenario
Internet Trading—Alternatives
Internet Trading—Some Issues
Regulating Internet Stock Trading
IPOs on the Internet—Indian Experience
E-IPO Prospectus
E-Commerce Act and Internet Stock Trading
Review Questions
Chapter 24 Debt Market
Advantages
Risks on Debt
Issuers Profile
Types
Role of Bond Market
Price Determination—Factors
Yield of Bond
Yield and Price
Secondary Debt Market
Repos and Normal Buy or Sell
Broken Period Interest
Guidelines for Issue of Debt Instruments
Review Questions
Index

Citation preview

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 NEW DELHI McGraw-Hill Offices New Delhi New York St Louis San Francisco Auckland Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal San Juan Santiago Singapore Sydney Tokyo Toronto

PUBLISHED BY THE TATA M CGRAW HILL EDUCATION PRIVATE LIMITED, 7 WEST PATEL NAGAR, NEW DELHI 110 008.

Capital Markets, 2/e Copyright © 2009, by Vijay Nicole Imprints Private Limited. No part of this publication may be reproduced or distributed in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise or stored in a database or retrieval system without the prior written permission of the publishers and copyright holders. The program listings (if any) may be entered, stored and executed in a computer system, but they may not be reproduced for publication. First reprint 2010 RXLQCRCZRCQRR

This edition can be exported from india by the publishers, Tata McGraw Hill Education Private Limited.

ISBN(13): 978-0-07-015330-1 ISBN(10): 0-07-015330-2 Information contained in this work has been obtained by publishers, from sources believed to be reliable. However, neither publishers nor copyright holders guarantee the accuracy or completeness of any information published herein, and neither publishers nor copyright holders shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that publishers and copyright holders are supplying information but are not attempting to render engineering or other professional services. If such services are required, the assistance of an appropriate professional should be sought. Laser Typeset at: Vijay Nicole Imprints Private Limited, Chennai - 600 091 Printed at: Novena Offset Printing Co., Chennai - 600 005

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

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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

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. 1. Short-term financing

6 Capi tal Markets

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. 4. Central bank

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 longterm 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

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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 shareholders 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 insurance to the company issuing the new stock and bear the risk associated 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 adjustablerate 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

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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.

b.

c.

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. 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. 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), Nonresident 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

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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 nonbanking 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

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b.

c.

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. 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. 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.

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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. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

State the meaning of a financial market How is a financial market defined? Where does a financial market exist? State the financial functions of a financial market What are the constituents of a financial market? What is a capital market? What is a money market? What is a debt market? What is a Eurobond market? What are equity markets? What is a financial services market? What is a depository market? What are pension funds? What are insurance companies? What are financial instruments? What is a commercial paper? What are certificates of deposits? What are repos? What are Eurodollars? What are bankers’ acceptances? What is a corporate equity? What are corporate bonds?

20 Capi tal Markets

23. What are mortgages? 24. What are global financial markets? Section B

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Explain the role of a financial market What are the functions of a financial market? State the features of a capital market State the features of a money market What are the various constituents of a non-depository market? Describe briefly the money market instruments Describe briefly the various capital instruments Write a note on the organized money market in India What are the features of Indian capital market? How is a ‘third market’ different from a ‘fourth market’? 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. 2.

Make a detailed discussion on the financial instruments Discuss the contours of Indian financial market

Chapter

2

Capital Market Capital market may be defined as a market for borrowing and lending longterm 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. 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: Security prices

1. 2.

Yield on securities Extent of funds available from public savings

22 Capi tal Markets

3. 4. 5. 6.

Level of demand for funds Flow of funds from the banking system Price situation in general Attitude towards liquidity on the part of investors

There are many players in the capital market. The participants 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: Participants

1.

2. 3.

Financial intermediaries like insurance companies, investment companies, pension funds, etc Non-financial business enterprises 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: Capital market allows for the channelization of the savings of innumerable investors into various productive avenues of investments. 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. Allocation function

Capital market provides a means whereby buyers and sellers can exchange securities at mutually satisfactory prices. This allows better liquidity for the securities that are traded. Liquidity function

In addition to the functions of funds allocation and liquidity, capital market also renders the following functions: Other 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.

5.

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 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 wellmanaged 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

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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

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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. Corporate enterprises, which are desirous of raising capital funds through the issue of securities, approach the primary market. Issuers exchange financial securities for long-term funds. The primary market allows for the formation of capital in the country and the accelerated industrial and economic development. Following are the popular ways by which capital funds are raised in the primary market: M odes of r ai s in g c ap ita l

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.

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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. 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. Importance

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

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financing designed specially for funding new and innovative project ideas. Venture capital funds are instrumental in bringing into force the hitechnology 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

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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

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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

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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

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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

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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

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10. 11.

12. 13.

14.

15.

16.

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 Expansion of the list of scrips eligible for compulsory dematerialized trading by institutional investors Implementation of the recommendations by the Government to allow companies to buyback their shares through an amendment of the Companies Act, 1956 Market-making to help simulate liquidity in a larger number of scrips on the B2 group on the BSE 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 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 Introducing a new system of dealing called ‘rolling settlement’ and convincing the institutional investors about the benefits of moving to this mode of settlement 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,

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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

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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

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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

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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

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45

REVIEW QUESTIONS Section A

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28.

Define the term ‘capital market’? What is a money market? Mention the characteristics of a money market Who are the participants of in a capital market? Where is a capital market located? What are ‘working groups’ associated with the Indian capital market? What is a ‘Gilt-edged market’? What is industrial securities market? State the components of industrial securities market What is a primary market? What are the different modes by funds are raised in a primary market? What is a secondary market? State the importance of a secondary market What is a stock exchange? What are venture capital institutions? What are mutual funds? What are factoring institutions? What are credit rating institutions? What is an ‘OTCEI’? Write a note on the National Clearance and depository System What is NSDL? What is a ‘Certificate of Deposit’ (CD)? What are ‘zero coupon bonds’? What are ‘deep discount bonds’? What is a stockinvest? What are ‘equipref’ shares? What are ‘Euro issues’? Write a note on the ‘Harshad Factor’

Section B

1. 2. 3. 4.

What are the functions of a capital market? Identify some of the important forces that were responsible for the structural transformation of the Indian capital market Mention the new financial institutions that have come up in the Indian capital market. Bring out the measures of rejuvenation and reactivation

46 Capi tal Markets

5.

undertaken by the SEBI in recent times Identify the factors that have caused rebound in the Indian capital market in the recent past

Secti on C

1. 2. 3. 4. 5.

Trace the development and the growth of the Indian capital market Discuss the constituents of the Indian capital market Give an account of the various types of financial instruments that are used in the Indian capital market What are the recent initiatives taken by the SEBI as part of revamping the Indian capital market? 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

e.

f.

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. 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. 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.

2.

3.

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. 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. 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

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 6.

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 antiinflationary 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 steppingstone 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 halfyearly. The bonds provided an annualized yield equivalent to 16.64 percent. 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 retirement. 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 maturity value of the bond. IFCI’s Bonds, 1996

a. b.

c.

d.

e.

These bonds include: Deep Discount Bonds—Issued for a face value of Rs.1 lakh each. Regular Income and Retirement Bonds—They had a fiveyear tenure, a semi-annual yield of 16 percent and a frontend discount of 4 percent. The bonds had three-year put option and an early bird incentive of 0.75 percent. 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. 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. 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 contributing 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. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

What are capital market instruments? State the various types of market instruments. What are preference shares? What are equity shares? How is cash dividend different from stock dividend? What are non-voting shares? What are convertible cumulative preference shares? What are company fixed deposits? What are warrants? What is a debenture? What are participating debentures? 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. 2. 3.

Explain briefly the various types of preference shares. State the features of equity shares. 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. 2. 3.

Explain the features of various capital market instruments. Discuss the relevance of global debt instruments bringing out their features. 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.

2.

3.

4.

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. 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. 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. 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

5.

6.

7.

8.

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. 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. 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. 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. 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

9.

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. 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

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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 has identified the following areas for focusing its attention for the overall growth and the development of the stock market in India: SEBI activities

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

The 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 Registration of brokers

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

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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

2. 3.

4.

5.

6.

7.

8.

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. Draft prospectus A draft prospectus containing the disclosures will have to be vetted by SEBI, before a public issue is made. 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. 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. 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. 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. 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. 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

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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 screenbased 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. 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. Clearing house

The parallel to SEBI in USA, is the Securities and Exchange Commission (SEC), created under Securities Exchange Act, 1934. The SEC

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has been given the following wide-ranging powers for the purpose of protecting the investors’ interests: 1. 2. 3. 4.

5. 6. 7.

To monitor the working of stock exchanges To insist on the companies for the supply of extensive information on a regular basis To penalize members of stock exchanges who were found to violate securities laws To debar the wrong-doers from any activity in the stock market and impose on them civil penalties and initiate criminal proceedings To make rules about the manipulative practices To move court for checking insider trading, and 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

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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

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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

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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.

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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.

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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 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 Recognition of stock exchange

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 Annual report

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4. 5. 6.

Admissions, readmissions, deaths or resignation of members Disciplinary action against members 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 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 Submission of return

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. Enquiry

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

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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

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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.

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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

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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 wideranging 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

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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. 2.

State the objectives of regulating the Indian capital market. State the objectives of the Capital issues Control Act, 1947.

Section B

1. 2. 3.

Trace the genesis of the regulation of Indian capital market. State the functions of SEBI. State the role of Securities Exchange Commission (SEC) of the US.

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4. 5. 6. 7. 8. 9.

What are the powers vested with the Government under the Securities Contracts Regulation (SCR) Act, of 1956? What do the rules of the Securities Contracts Regulation (SCR), 1957 prescribe for the safe trading at stock exchanges? How is Indian capital market regulated under the provisions of the Indian Companies Act, 1956? What were the major recommendations of the G.S. Patel Committee. State the key recommendations of the M.J. Pherwani Committee? What were the recommendations of the Malegam Committee on the regulation of Indian capital market?

Secti on C

1. 2. 3.

Discuss the factors responsible for the introduction of measures of regulation and control of the Indian capital market. How is Indian capital market regulated? Bring out clearly the regulatory framework that has been put in place for this purpose. 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 offbalance 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

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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.

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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

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2. 3. 4. 5.

6.

Fortunes are made and lost very quickly Lack of awareness and suspicion about the efficiency of the tools used in the derivatives market There is a fear of great and insurmountable risks 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 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

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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.

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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

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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.

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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

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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).

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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

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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.

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FORWARD CONTRACT Vs. FUTURES CONTRACT

The distinguishing characteristics between forward contract and futures contract are presented below: Sl. No.

Characteristics

Forward Contract

1.

Contract Terms

Decided by buyers and sellers

Standardized contract

2.

Contract Price

Remains constant till maturity

Changes every day

3.

Marking to Market

Cannot be done

Done every day

4.

Margin Requirements

Not needed

Margin is to be paid by both buyers and sellers

5.

Risk of Counter Party

Exists

Does not exist

6.

Number of Contracts

No limit on the number of contracts in a year

Number of contracts limited between 4 and 12 a year

7.

Hedging

Tailor-made contracts makes possible perfect hedging

Since contract period is limited to a month, hedging not perfect

8.

Liquidity

No liquidity

Highly liquid

9.

Operational Mechanism

Not traded on exchange but traded over the counter

It is exchange-traded

10.

Delivery

Delivery is specifically decided; contracts usually result in delivery

Standardized and cash delivery of contracts

Futures Contract

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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’. Underlying 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’.

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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-themoney 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-themoney 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 optionbased 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 floatingrate 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.

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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

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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. 2. 3.

The exchanges play an important part in providing an infrastructure required for carrying out the dealings on assets There can be a separate exchange for financial assets and nonfinancial assets 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. 2. 3.

4.

A clearing house acts as a nerve center of contract execution and completion It helps clear transactions that are executed in derivatives market 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 Ensures performance of contracts even in volatile market conditions by means of a good system

Cus tod i an s 1. 2.

Custodians require the participants to deposit their securities before starting trade Custodians ensure a smooth and standardized delivery mechanism which is an essential prerequisite for the efficient functioning of the market

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Custodians help ensure that the prices of assets traded reflect an equilibrium price

Banks 1. 2. 3.

Banks handle large volume of fund movements that take place between members and the clearing house Banks facilitate daily settlements by carrying out accounting entries of the members of the exchange and the clearing house Banks help reduce the possibility of misappropriations in dealings

The Regulator 1. 2. 3. 4.

5.

The regulator creates confidence among the transacting members of the exchange The regulator provides a level playing field to the participants by making rules and regulations The regulator ensures the protection of investors In India, SEBI and the RBI provide the much needed protection to the members by regulating the working of the different constituents The approach and the outlook of the regulator, very much affects the strength and the volume of the market

Market Makers 1.

2.

3. 4. 5. 6.

Jobbers are called ‘market makers,’ as they decide the market price depending upon the demand and supply of the underlying asset In the case of an out-cry system, jobbing counters are useful, as they provide information about the price quotations for executing deals In the case of screen-based trading, they help display on the screen the best buy and sell rates They are members of the exchange who take part in purchase and sale transactions by regularly quoting bid-ask rates The difference between bid and ask is known as bid-ask spread, with spread increasing with the volatility in prices Jobbers provide much needed liquidity to the market

Brokers 1. 2.

Brokers perform the task of bringing together the buyers and the sellers Brokers help all those persons who are not members of the exchange to conduct the transactions

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3. 4.

5.

Brokers are responsible for final settlement and delivery 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 Brokers play an important role in the options and futures contracts

Arbitrageurs 1. 2.

3. 4. 5.

Arbitrageurs are risk-averse players who enter into such contracts that can earn riskless profits through the process called ‘arbitrage’ Arbitrageurs indulge in buying in one market and simultaneously selling in another market to earn the riskless profits under the conditions of imperfect market Arbitrageurs always look for price imperfections in the market Spot and future prices provide opportunities for arbitrage Prevalence of different prices at different contracts provide opportunities of arbitrage

Spe c ulators 1. 2.

3. 4. 5.

Speculators indulgement in the market is shaped by the expected future prices of the underlying asset 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 Speculators assume the role of either the bull or the bear depending upon their perceptions about the price movements Speculators help provide the much needed liquidity and the volume to the market which helps reducing the costs Speculators provide the wherewithal to hedgers to manage their risks

He dge rs 1. 2. 3. 4.

Hedgers with futures and option contracts provide for locking in of the future expected price at which to buy or sell Hedgers can enter into futures or option contracts by means of which price risk exposure is covered Hedgers are traders and exporters who enter into futures contracts to safeguard their position from falling rates and prices Traders and producers could benefit from a favorable price movements and hedge their price risk by entering into an option

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contract that gives them the right but not the obligation to buy or sell the asset at specified price 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

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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

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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.

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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:

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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 optionbased 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

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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

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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.

b.

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. 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.

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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 onesided. 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-tomarket 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

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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

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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 shortdated 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

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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

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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).

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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. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

What are ‘derivatives’? What are ‘forward contracts’? What are ‘swaps’? What is a financial swap? What is meant by ‘parallel loan’? What are ‘currency swaps’? What is ‘swap spread’? How is a swap valued? What are ‘futures contract’? What are ‘Forward Rate Agreements’? Name some of the option based derivatives What are ‘options’? What are its types? What is ‘a call option’?

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14. 15. 16. 17. 18. 19. 20. Section 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

What is ‘a put option’? What are ‘structured options’? What is ‘bundling an option’? What are ‘swaptions’? Identify the various participants in the derivatives market What is ‘liquidity risk’? What is ‘credit risk’? B What are the shortcomings of the derivatives market? What are the features of ‘forward contracts’? What are the features of ‘swaps’? How are swaps beneficial? Explain the modus operandi of swaps. How does the ‘interest rate swaps’ work? What are the features of ‘futures contracts’? State the features of ‘Forward Rate Agreements’? How is a forward contract different from a futures contract? Bring out the features of ‘options’? Explain clearly the role of dealers in the derivatives market. How are derivatives useful for corpoarates? How are derivatives beneficial to institutional investors? What is ‘market risk’? Identify the different kinds of market risk? How could a ‘credit risk’ managed? What is the ‘settlement risk’ attached to the use of derivatives? How is operational risk caused while handling derivatives? State the nature of ‘legal risk’ attached to the use of derivatives? How are derivatives important in the financial system of a country?

Section C 1. 2. 3. 4. 5. 6.

7.

Trace the factors that have caused tremendous growth of derivatives market around the globe in the recent times. Discuss the various functions of a derivatives market. How are derivatives categorized? Explain. Explain the role of various participants in the derivatives market. Discuss the various advantages of derivatives. 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. 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

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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 conducive 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 endeavoring 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.

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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 investment. 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 facilitating 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. investors 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

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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 takeover 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

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4.

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Where the SEBI persistently defaults in complying with any direction issued by the Central Government under the Act 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 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

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o. p. q.

than between members of a recognized stock exchange or through or with such members would be illegal Regulation and control of the business of dealing in spot delivery contracts Hearing appeals submitted by companies against refusal of a stock exchange to list their securities and 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

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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

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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.

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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.

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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

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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

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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.

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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

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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

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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. 2. 3. 4.

Name the committee that recommended the setting up of the SEBI. State the features of the SEBI bill. How is SEBI managed? State the purpose of regulatory role played by the SEBI.

Section B 1. 2. 3. 4. 5. 6. 7. 8.

State the need for setting up the SEBI. What are the objectives of SEBI? Explain. What are the powers vested with the SEBI to regulate stock exchanges in India? State the powers of the SEBI with regard to action initiated against. the erring market intermediaries. How is SEBI empowered of adjudication? What are the steps taken by the SEBI to build investor confidence? Evaluate the role of SEBI on improving the operational efficiency of the Indian capital market. Identify the measures initiated by the SEBI to promote screen based trading in India.

Section C 1. 2.

What are the powers and functions of SEBI? Discuss elaborately. 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

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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

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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. 2. 3. 4. 5. 6.

To receive all benefits/material information declared for the investors’ by the company To obtain prompt services from the company such as transfers, subdivisions and consolidation of holdings in the company To subscribe to further issue of capital by the company in the case of existing equity shareholders To pay a maximum brokerage of 2.5 percent of the contract price To receive the contract note from the broker in the specified format showing transaction price and brokerage separately 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

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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

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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 subbrokers 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/subbroker. 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.

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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. 2. 3. 4. 5. 6. 7. 8.

Not to deal with unregistered intermediaries which might expose to counter party risk To give clear and unambiguous instructions to broker/sub-broker To keep a record of all instructions issued to the broker/ sub-broker To confirm with the broker/sub-broker whether delivery is in physical or demat form before selling shares Not to fall prey to promises of unrealistic high returns Not to indulge in speculative trading but to go by the fundamentals only To trade within the predetermined limits To use the Investors’ Grievance Redressal system of the exchanges to redress grievances, if any

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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:

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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)

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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

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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.

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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

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3. 4.

Not below the age of 45 years of age, and 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:

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To receive complaints specified in regulation 13 against any intermediary or a listed company or both To consider such complaints and facilitate resolution thereof by amicable settlement To approve a friendly or amicable settlement of the dispute between the parties To adjudicate such complaints in the event of failure of settlement thereof by friendly or amicable settlement powers and functions The Ombudsman shall 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 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 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

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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

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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 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

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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

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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

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disclose the grievance redressal mechanism through Ombudsman under sub-regulation (2) or any failure to display the particulars as per subregulation (1) shall attract the penal provisions contained in section 15A of the Act. REVIEW QUESTIONS Section A

1. 2. 3. 4. 5.

What does ‘investor protection’ constitute? State the rights of an investor. Write a note on the ‘investor protection fund’ constituted by the BSE. What do you know of ‘trade guarantee fund’? What do you know of the ‘investor awareness program’ organized by the BSE?

Section B

1. 2. 3. 4. 5.

Analyze the causes for the loss of confidence of small investors. in the Indian capital market witnessed in the late nineties. What are the facilities offered by the BSE for the protection of investor interest? State the some of the general do’s and don’ts for investors. Explain the process of solving the grievances of investors as adopted by the BSE. Explain the working of the ‘ombudsman’ set up by the SEBI for the protection of investors.

Se ctio n C

1. 2. 3.

What are the safeguards offered by the BSE to investors as regards trading of securities? What are the powers and functions of ombudsman’ set up by the SEBI for the protection of investors. 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.

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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.

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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.

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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:

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Criminal prosecution against the insider, and/ or 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:

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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.

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REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6.

Define the term ‘insider trading’ Why do corporates often indulge in insider trading practices? Who are ‘primary insiders’? Who are ‘secondary insiders’? Who are ‘connected persons’? Who is a ‘deemed connected person’?

Section B 1. 2. 3. 4. 5.

How are insiders categorized? Explain. State the some insider information. Why do you think there is an obvious need for controlling insider treading? State the obligations of insiders while an investigation is ordered by the SEBI. Mention the ‘internal code’ introduced by the SEBI for controlling insider trading.

Section C 1. 2.

What are the steps initiated by the SEBI to prevent and control insider trading? 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.

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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

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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.

2.

3.

4.

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. 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”. 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. 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.

2.

3.

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” According to Husband and Dockeray, “Securities or stock exchanges are privately organized markets which are used to facilitate trading in securities” 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”

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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.

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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.

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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

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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

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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

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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.

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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 1.

Function

2.

Object

Stock Exchange

Commodity Exchange

Providing easy

Offering hedging or marketability price insurance services and liquidity to securities

Object is facilitating capital formation and making best use of capital resources Participants Investors and speculators

Object is facilitating goods flow through risk reduction

4.

Period of Dealings

Cash, ready delivery and dealings for account for a fortnight

Instant cash dealings and a settlement period of 2 or 3 months for Futures Market dealings

5.

Articles

Industrial securities

Only durable, graded and

3.

Producers, dealers, traders and a body of speculators

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Traded

6.

7.

8.

9.

such as stocks and bonds, and Government securities such as public debt etc. Speculation Speculation ensures saleability of securities affording a broad, ready, liquid and continuous market of securities Forward Forward dealings are Contract simplified as securities are fully standardized Cornering As seller has to deliver the agreed securities, cornering is easy PriceQuotation

As regards forward dealings, only one quotation is possible

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goods having large volume of trade, price uncertainty and uncontrolled supply Speculation ensures assumption and absorption of price risk

Standards are to be fixed for deliverable grades to facilitate futures contract Cornering is difficult as the seller has option to deliver standard or other deliverable goods For futures dealings, multiple quotations are 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

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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-todealer 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.

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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

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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 activity 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

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(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; onethird 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.

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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-President 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 consecutive 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 conditions 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 guidelines and Board’s decisions are implemented effectively. Besides, a number of Committees and Subcommittees assist the Governing Body in discharging 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

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5. 6. 7. 8.

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Appointment of authorized clerks and attorneys Enforce attendance and information, adjudicate disputes and impose penalties Determining the mode and conditions of stock exchange business and regulating stock exchange trading; and 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.

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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

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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 clientshareholders, 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

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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.

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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 brokermembers.

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JOBBERS Vs BROKERS

Sl. No.

Feature

Jobber Jobber is an independent dealer or a merchant willing to buy and sell securities

Broker

1.

Agent

Broker is merely an agent to buy or sell on behalf of his clients

2.

Specialization Jobber is a specialist

Broker is a generalist

3.

Dealing with Public

Jobber deals only with brokers and not with public. No direct sale or purchase in the market

Broker deals with a jobber on behalf of his clients. He is a middleman between the jobber and the real buyer/seller

4.

Price Quotation

Jobber quotes two prices to the broker, one for buying and one for selling. Sale quotation is higher than the purchase quotation

Broker has to negotiate terms and conditions of sale or purchase and safeguard his client’s interest. He lives on commission paid by his client which is fixed by the Exchange

5.

Margin

Jobber’s profit margin is fixed by competition among themselves as dealers. It is narrow when there is keen competition

Lower brokerage rate is fixed by rules; the higher rate by competition. In practice minimum becomes maximum 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

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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.

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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.

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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 volumes of trading. For instance, the level of computerization across stock exchanges has been inadequate resulting in the absence of computer linkages between stock exchanges and its members. This has hampered the effective inter-market operations, monitoring of trading and post-trading operations, as well as the free flow of information on an intra and inter-exchange basis. The inadequate infrastructure and ineffective trading settlements/pratices have also resulted in a lack of NRI confidence in the Indian capital markets. REGULATION OF STOCK EXCHANGES

All stock exchanges were subject to self-regulation till 1956, whereby the regulation emanated from their own management bodies, i.e. Board of Governors. Now, Indian stock exchanges are subject to three-tier regulation. The first level constitutes the authority exercised by the Central Government under the Indian Constitution and through its Ministry of Finance (Stock Exchange Division) over the functioning of the stock exchanges. The authority, however, is regulated primarily through the Securities Contract (Regulation) Act, 1956 (SCRA). Further, the Securities and Exchange Board of India (SEBI) also regulates the stock exchanges in order to protect the interest of investors and to promote the development of security markets in India. This constitutes the second-level authority.

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The third-level of authority constitutes self-regulation whereby all stock exchanges have their own separate rules, byelaws and regulations that are exercised through their Governing Board. Regulatory Structure

The stock exchange division The Stock Exchange Division of Ministry of Finance has its Head Office at Delhi and Branch offices at Bombay and Calcutta. The essential functions of the Division are as follows: a. Providing linkage between government and stock exchanges b. Monitoring the operations of the stock exchanges c. Providing advice to overcome the untoward developments and crises d. Ensuring the compliance of listing provisions e. Ensuring smooth functioning of the stock exchanges and f. Issuing licenses to brokers and dealers in securities and also in areas beyond the jurisdiction of recognized stock exchanges SEBI An apex body called the Securities and Exchange Board of India (SEBI) has also been constituted besides the above. A Chairman heads the SEBI. The first chairman of this Board was Dr. S.A. Dave, former Executive Director of IDBI. Besides, the Central Government is also empowered to nominate four members that comprise the top management team of the SEBI. The SEBI issues from time to time various rules, regulations and guidelines for promoting the development and stabilization of the securities market in India. A few important among them are as follows: a. SEBI (Portfolio Managers) Rules and Regulations, 1992 b. SEBI (Stock Brokers and Sub-brokers) Rules and Regulations, 1992 c. SEBI (Insider Trading) Regulations, 1992 d. SEBI (Merchant Bankers) Rules and Regulations, 1992 e. SEBI (Mutual Fund) Regulations, 1993 f. SEBI (Underwriters) Rules and Regulations, 1993 g. SEBI (Registrars to Issue and Share Transfer Agents) Rules and Regulations, 1993 h. SEBI (Debenture Trustee) Rules and Regulations, 1993 i. SEBI (Bankers to an Issue) Rules and Regulations, 1993 Besides the above, SEBI has also issued guidelines regarding the following: 1. Free pricing of shares 2. Disclosures and Investors’ protection

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3. Registration of Foreign Institutional Investors (FII) 4. Allotment of shares 5. New financial instruments 6. Credit rating of fixed return bearing securities Departments The major departments of a typical stock exchange in India are as follows: a. Listing Department b. Operations Department c. Computer and EDP Department d. Inspection and Audit Department e. Monitoring Department f. Investor Service Department 1. Listing department It is an important department of a stock exchange. Its main function is to list the securities of companies for trading purposes at the stock exchange. The task of this department is to examine the prospectus and project of the company to ensure whether the company fulfills all their requirements as per existing byelaws of the stock exchange and guidelines of the government. It also ensures whether the company has made fair and equitable allotment of shares 2. Operations department The basic objective of this department is to keep watch on the daily trading and other operations of the stock exchange. It collects quotations and makes them available to members by publishing in the evening every day. This department also looks after the auction of shares and related matters connected with settlements 3. Computer and EDP department The basic function of this department is to collect and compile the various data relating to corporates, quotations of scrips and member-wise and scrip-wise turnover. Financial results of companies like their net profits, dividends, bonus, balance sheets, etc are all recorded on the computer. Further, it builds up a sound management information system, which is useful to members and investors for making their investment decisions 4. Inspection and audit department This department is concerned with carrying out routine audit of the stock exchanges for checking the accuracy and validity of the accounting records, balance sheet item, receipts and payments items, and other relevant registers. The department ensures that all the registers and records

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5.

6.

are duly maintained by the stock exchanges as per guidelines of the SEBI and the Government Monitoring department This department aims at supervising the activities of the members in the trading ring. Besides, it also watches the price movements and the trading volume of the members. The department initiates necessary measures to check excessive trading and speculative transactions by imposing ad hoc margin, suspending trading and enquiring into any specific development Investor service department The basic objective of this department is to safeguard the interests of investors by rendering expeditious service to them and by attending to their complaints against broker-members and their authorized clerks and the listed companies. The department takes necessary follow-up action with the members and the companies concerned

STEPS IN STOCK TRADING

Following are the typical steps involved in trading on the National Stock Exchange: Client Registration The buyer approaches the broker and executes a client registration form wherein all details about the buyer are furnished. This forms the basis for trading in the exchange through the broker. Agre e me n t An agreement between the buyer and the broker as specified by the exchange concerned is entered into. This agreement is called the client member agreement. Order Placing Buyer places the order in writing with the broker for the purchase of certain number of scrips at a certain specified price. Order Confirmation After collecting the order from the client ,the broker places the order in his computer system, which is in turn transmitted to the computer system of the NSE at Mumbai. The order confirmation slip is obtained by the broker from the exchange. Trade Confirmation A trade confirmation slip is generated as soon as the order is matched by the computer against the price generated by the matching algorithm

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(price-time priority). The trade confirmation slip gives details of the trade executed. The buyer makes payment of necessary margin money to the broker. Contract Note The broker issues a contract note to the buyer in respect of all the orders that are executed during the day. Such a note spells out the obligations of the parties concerned, for the buyer to make payment and the broker to make delivery of scrips. Accordingly, the payment is made and the scrips are taken delivery by the buyer, which thus concludes the contract. The steps in stock trading are depicted in Exhibit 4. Exhibit 4

Steps i n Stock Tradi ng

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MECHANICS OF SETTLEMENT

The process of fulfillment of the obligations of the trade by the parties to the transactions is known as ‘settlement’. This implies payment of funds to the seller and delivery of securities to the buyer. Although in a traditional commodity market, a trade is negotiated and settled instantaneously, i.e. payment is made and goods are taken delivery immediately, settlement of trade is in a stock market, not instantaneous. For instance, payment for the purchase and the delivery of shares takes a certain cycle. T ype s There are two types of settlement of trade in vogue. They are Rolling Settlement and Account Period Settlement. Rolling settlement Under this system of settlement, the trades executed on a certain day have to be settled after a certain number of days depending on the nature of settlement cycle practised by the exchange concerned. Accordingly, where a settlement cycle specified is T+3, it implies the trades executed on the first day (say a Monday) have to be settled on the fourth day (on Thursday), i.e. after a gap of 3 days. Account period system Under this system of settlement, trading is allowed to continue for a certain agreed period and it is possible for the investor to buy or sell for a certain number of days, and thereby accumulate a certain position during the period. At the end of this period, his obligation in terms of shares purchased or sold and the amount to be paid by him is worked out and communicated to him. The obligations of a broker are worked out after netting the trades. The working of the above system of settlement as practised in the NSE for its equity segment is illustrated below: Settlement Cycle at NSE Day 1 Day 7 Day 8

Wednesday Tuesday Wednesday

Day 13

Monday

Day 14

Tuesday

Day 15

Wednesday

Trade cycle commences Trade cycle ends Obligations worked out and communicated to brokers Sellers deliver shares sold to the clearing house Purchasers pay amounts for purchases made Sellers get amounts due and buyers get their shares

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As shown above, it is possible for an investor to freely trade in any pattern that he chooses during a period between a Wednesday and a Tuesday. After the expiry of this period, the obligation of each broker in terms of the shares sold/purchased and the money to be paid/received is worked out and duly communicated to the broker. The broker is expected to deliver the shares that he has sold on Monday next and pay the amounts due on Tuesday next. Counter Party Default The default committed by either or both the parties to the trading transaction namely buyer and the seller in honoring their respective commitments at the end of the settlement period, in a bilateral settlement process is referred to as ‘counter party default’. In a situation like this, the buying broker might default in making payment although the seller is ready to deliver the shares. Similarly, the selling broker might default to deliver the shares although the buying broker is ready to pay the money. In such a situation because of the default of one party, the other party suffers. The counter party default is deleterious in that it would cause destabilization of the functioning of the stock exchanges thus threatening the safety and integrity of the market. It is therefore imperative to have a safety system in place to deal with such situations. Settlement Guarantee Mechanism The system, which is devised to eliminate counter party risks, is known as ‘settlement guarantee mechanism’. The National Stock Exchange of India first introduced the system, which is popular in the developed markets. This is being adopted in other exchanges as well. According to the system, settlement of trade is undertaken by a separate legal agency called the ‘Clearing Corporation’. Stock exchanges may set up separate Clearing Corporation either singularly or jointly. The NSE has a separate fully owned subsidiary which undertakes this function. The working of the settlement guarantee mechanism is described below: The clearing corporation acts as a counter party in respect of every trade. It ensures and verifies that the deliveries of money and shares are made and passes them on to the respective brokers. If one of the brokers defaults, the Clearing Corporation ensures that the trade is carried out unhindered by making payment or making delivery of scrips on behalf of the defaulting broker, who is thereafter dealt with by the Corporation separately. The mechanism thus, helps both the brokers and thereby their investors who are assured of prompt settlement irrespective of the

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fulfillment of obligations by the other party. Such a function helps minimize the market risk and thus helps save the integrity and safety of the stock exchange. The guarantee also covers transactions involving bad deliveries. In order to perform this function satisfactorily, the clearing corporation resorts to a variety of risk management techniques like margining, exposure limits, etc. Prerequisites For the successful working of the settlement guarantee system, the following essential requirements are called for: a. Automated trading and settlement processes b. Established risk management procedures c. Well defined settlement schedule d. All securities to be cleared through the clearing house e. Multilateral netting (netting across locations, etc.) f. Funds settlement through clearing banks g. Clear procedures for post-settlement issues SYSTEMS OF STOCK TRADING

Trading on a stock exchange takes place either on the basis of the auction system on a trading floor or a broker-dealer market (which is quote-driven or dealer-driven). Every one of the worlds stock markets uses one of the two trading systems or a hybrid of both. Auction Trading System This is an order-driven or a custom-driven trading system where customers’ buy and sell orders are matched at a central point. The New York Stock Exchange (NYSE) is an order-driven auction market. This system allows the buyer and the seller to find a mutually agreeable price, with no intervention from the broker-dealers. The buy and sell orders are automatically matched and in case of any imbalances, the specialists take up the job of filling in. The specialist is a single designated market-maker who stands in the market at all times, adding effectiveness and efficiency into the trading mechanism. 90 percent of the trading in the NYSE is done this way. In Indian stock markets other than the BSE, the trading is mainly order-driven with the buyers and sellers transacting directly with one another. Although this does have the advantage of giving the investors a better price, growth of the markets has been hampered by a relatively high-degree of volatility and liquidity. SEBI has proposed a system of market-makers on the exchanges at Bombay, Calcutta, Delhi and Chennai.

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Any member of these stock exchanges can, with prior approval of SEBI, take up the charge of becoming a market-maker. Market-makers can make markets for 500 scrips, which are not included under the BSE National Index. Each market-maker will be required to acquire at least 30,000 shares in each of the scrips. According to Reserve Bank of India guidelines, market- makers would be in a position to impart liquidity to scrips and reduce volatile movements in share prices by permitting banks to finance their operations. Banks have been authorized to determine the amount of working capital requirements, the margin (existing 50 percent margin on loans to individuals against shares is not applicable) and credit limits for margin making requirements. The rate of interest depends on the amount and banks can stipulate an interest rate subject to a minimum of 16 percent on amount over Rs. 2 lakhs. Scrips, other than those for which market making is undertaken may be accepted as collateral. Dealer Trading System This is a quote-driven or dealer-driven trading system where dealers compete to give the customers the best price. This type of trading takes place through an electronic media with the help of well-networked computer system. The system runs the trading by trying to find the customer for the best price available. The National Association of Security Dealers Automated Quotation System (NASDAQ) is quote-driven, as it is a computerized network, which serves over the counter. Dealers who buy and sell a particular security regularly make a market in that security. The market-makers quote both ‘bid and ask’ prices for the two sides of the market, both buy and sell continuously. There are no restrictions on the number of market-makers in a given share. Competing market-makers are obliged to quote the best and competitive prices through the system. Market-makers offering the best price are assigned orders on a rotating basis. The market-makers for most of the active shares transmit their quotations electronically. Hybrid Trading Hybrid trading system is an auction type of trading with bids and offers being made by open out-cry and at the same time it is a quote-driven system too. This type of trading system is prevalent in the Bombay Stock Exchange (BSE). A jobber, unlike the NYSE specialist, does not have to maintain an orderly and continuous market. Acting on their own behalf and never as agents, their income was mostly derived from the spread

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between the bid and the offer prices by assuming a position in a particular share. Bombay Stock Exchange has an informal system of jobbers. Margin Trading A method of trading on a stock exchange whereby an investor is allowed to buy securities on credit by making a deposit of a certain amount in the concerned stock exchange is known as ‘margin trading’. Margin account or margin trading is much in vogue in the USA. An investor can open a cash account or a margin account with a member firm. Whereas in the case of cash account, securities are purchased against cash, the margin account investors have to apply for permission to buy securities on credit besides furnishing more information regarding the financial standing. Margin trading provides a customer with added leverage through the use of borrowed funds. Such accounts can also be used to procure quick and easy loans, for short sales, naked call writing and spreads. When investors buy securities on margin, they buy some shares against cash payments and borrow from the brokers to pay for additional shares, using the paid shares as collateral. The margin customer has to sign a margin agreement, pledging securities as loan collaterals. Before they lend the clients margined securities, the brokers also ask the customers to sign a stock-loan consent form. Margins are regulated by the Federal Reserve, which stipulates 55 percent of margin. SPECIALISTS

Specialists are market-makers who focus their attention on the maintenance of prices for the investors to find an appropriate price for their bids. Specialists contribute for the effective functioning of the stock exchange. The Specialists firms are mostly the members of the exchange who act as dealers/brokers in shares. Specialists on the floor of exchange carry out the dual function of representing the customers on the one hand and trading on their own account on the other. They buy and sell shares of one or more companies and thereby, help in maintaining a free and continuous market in the shares of companies for which they act as specialists. The specialists are expected to maintain a fair and orderly market for the securities. In their capacity as brokers, they execute orders on behalf of other brokers for a commission and as dealers, they trade on their own accounts, profits and risks. They buy from the public, when other public bids for purchase are not available and execute the market orders in the absence of other public offers to sell at or near the last price prior to their order. Their customers constitute the other members of the exchange. As specialists they do not transact business directly with the public.

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Functions of Specialists Specialists operating on a stock exchange make a continuous market in shares assigned to them. Following are the functions of specialists: 1. Acting as brokers on the acceptance of orders for execution from other members of the exchange 2. Providing a conduit of information for electronically quoting and recording current bid and ask prices for the shares of companies assigned to them 3. Acting as dealers and trade on their own accounts when faced with a liquidity imbalance in the market 4. Providing the two-sided market, by quoting a bid indicating the price at which shares will be purchased from a seller and an offer the ask price at which shares will be sold to a buyer Market-makers Dealers who are responsible for creating and maintaining a market in a security are called “market-makers”. In order to carry out the function of market-making, it is essential that the market-making dealers continuously engage themselves in the purchase and sale of a particular security on their own account, and at their own risk and at prices equivalent to the security’s trading unit. The quotations that are used for this purpose by the dealers are of two types. They are ‘bid price’ and ‘ask price’. A bid price is the price at which the dealer will buy a security and an ask price is that at which a dealer is willing to sell a security. The difference between bid and ask prices in any quotation is the ‘spread’. The market-makers are obliged to offer a continuous two-way market in all their registered securities. Transactions are reported within 90 seconds of execution. A dealer may take a position in a security by buying for inventory (long position) or by selling securities that he has not yet purchased. A quotation, at all times, must include both sides of the market even though one side may be non-existent. The Broker-dealer He is the dealer in the New York Stock Exchange (NSE). The broker-dealers are registered with SEC. They may buy and sell securities on their own risk/account, or as an agent, trade on behalf of others. A broker-dealer can also handle purchase orders and perform the following functions: 1. To sell out of his inventory if he makes a market in a particular share which a customer wants to buy

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2.

3.

To act as an agent where he gets the order for a share in which he does not make a market and buy the same from another marketmaker or from someone else who owns the securities To buy shares on his own account and resell them

The main advantages of the broker-dealer markets are as follows: a. Provision of instance information to the market-makers regarding the bid and ask quotations in a particular share b. Assurance to investors about the best possible execution of their orders as the traders check with all the market concerned c. Possibility for traders to gauge market quickly d. Stimulating market competition e. Facilitating easy and convenient trading f. Providing an easy access to the information on the volume, the indexes of OTC shares, and individual trades RECENT DEVELOPMENTS

The structure of stock market in India has undergone a vast change due to the liberalization process initiated by the Government. A number of new structures have come to be added to the existing structure of the Indian stock exchange. A brief description of these structures in the Indian stock market system is presented below: Over-the-counter Market System Basically this market is meant for small size companies. The primary objective of this market was to enable the small start-up companies or companies in green field ventures to obtain their capital requirements at the minimum cost. On the basis of the recommendations of the High Powered Committee on Stock Exchange Reforms (G.S. Patel) and Committee (Abid Hussain) on Capital Market Reforms, the Over-The-Counter Exchange of India (OTCEI) was incorporated in October 1990 under the Companies Act, 1956. Granted recognition under section 4 of the Securities Contract (Regulation) Act 1956, the OTCEI was promoted by various public financial institutions like Unit Trust of India (UTI), Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI), Life Insurance Corporation of India (LIC), General Insurance Corporation of India (GIC), SBI Capital Market, CanBank Financial Services, etc. Commencing its operations on September 29, 1992 at Bombay, the OTCEI introduced screen-based automatic singular trading system. Although companies enjoy the same

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status as listed on the other stock exchanges, it is not possible that a company listed at OTCEI can be listed on other stock exchanges. National Stock Market System (NSMS) National stock market system was advocated by the “High Powered Group on the Establishment of New Stock Exchanges” headed by Shri.M.J.Pherwani (popularly known as Pherwani Committee). The committee recommended in June 1991, the following three tier-stock market structure: • Principal Stock exchanges comprising 5 major stock exchanges at Bombay, Calcutta, Madras, Delhi and Ahmedabad • Regional stock exchanges like those in major state capitals • Additional Trading Floors (ATFs) sponsored or managed by Principal or Regional stock exchanges At present the National Stock Market in India comprises the following: 1. National Stock Exchange of India Limited (NSE) 2. Stock Holding Corporation of India Limited (SHCIL) 3. National Clearing and Depository System (NCDS) 4. Securities Trading Corporation of India (STCI) National Stock Exchange (NSE) The National Stock Exchange (NSE) was set up for the purpose of providing a nationwide stock trading facility to investors so as to bring the Indian financial market in line with international financial market. It started its operations by the end of 1993. The NSE uses the electronic trading system and computerized settlement system aimed at extending the facility of electronic trading to every corner of the country. The exchange has two separate segments, viz. capital market segment and money market segment. While the capital market segment is concerned with trading in equity shares, convertible debentures and debt instruments as nonconvertible debentures, the money market segment facilitates high value trading in debts, public sector bonds, mutual fund units, treasury bills, government securities, call money instruments, etc. The main participants, in this market are usually banks, financial institutions, and other financial agencies. Stock Holding Corporation of India Limited (SHCIL) This Corporation was set up in October 1987, under the Companies Act, by 7 All India financial institutions viz. IDBI, IFCI, ICICI, LIC, GIC, UTI and RBI. The range of services that are made available by this institution includes quick transfer of shares among its member institutions, clearing services, depository services, support services, management information

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services, and development services. This is a board-managed company and has a whole time Managing Director in charge of the day-to-day management of the corporation. It has set up regional centers at New Delhi, Calcutta and Madras. It is providing facilities in the major market centers in India. National Clearance and Depository System (NCDS) This system was created chiefly to help overcome the problem of settlement and clearance of transactions consequent to enormous workload on the clearing agencies and share transfer agencies. The problems mainly arose out of systematic risk like counter party risk, credit risk, bad deliveries, long delayed delivery, counterfeit scrips, and forged scrips. Securities Trading Corporation of India (STCI) The Reserve Bank of India set up Securities Trading Corporation of India Limited (STCI) in May 1994, under the provisions of the Indian Companies Act, 1956, jointly with public sector banks and All-India financial institutions. The main objective of establishing the Corporation was to foster the development of an active secondary market for Government securities and bonds issued by public sector undertakings. It had an authorized and paid-up capital of Rs. 500 crores of which, RBI contributed 50.18 percent. The RBI in December 1997 divested part of its equity in STCI in favor of the Bank of India, an existing shareholder of the Company. Corporitization and Demutualization Of late, efforts are on by the SEBI to corporatize and demutulize the Indian stock exchanges. For this purpose a Study Group under the Chairmanship of Justice M.H. Kania has been constituted. The object is to put in place a common structural model for the Indian stock market system. Accordingly, stock exchange will have to undergo changes in organizational structure. Corporitization and Demutualization refer to the process of conversion of a stock exchange from a not-for-profit entity to a for-profit company. The process of transition from ‘mutually-owned’ association to a company ‘owned by shareholders’ is called ‘demutualization’. Demutualization involves the segregation of members’ right into distinct segments, viz. ownership rights and trading rights. It changes the relationship between members and the stock exchange. Members, while retaining their trading rights, acquire ownership rights in the stock exchange, which have a market value, and they also acquire the benefits of limited liability.

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INTERCONNECTED STOCK EXCHANGE OF INDIA (ISE)

Ge n e s i s Interconnected Stock Exchange of India Limited (ISE) has been promoted by 15 Regional Stock Exchanges to provide cost-effective trade linkage/ connectivity to all the members of the Participating Exchanges, with the objective of widening the market for the securities listed on these exchanges.  ISE is a national-level stock exchange which provides trading, clearing, settlement, risk management and surveillance support to its traders and dealers. ISE aims to address the needs of small companies and retail investors, with the guiding principle of optimizing the existing infrastructure and harnessing the potential of regional markets, so as to transform them into a liquid and vibrant market, through the use of state-of-the-art technology and networking. The Participating Exchanges of ISE have in all, about 4,500 stock-brokers, out of which, more than 200 have been currently registered as ‘traders’ on ISE.  In order to leverage its infrastructure and to expand its nationwide reach, ISE has also appointed around 450 ‘dealers’ across 70 cities other than the Participating Exchange centers. These dealers are administratively supported by the regional offices of ISE at Delhi (north), Kolkata (east), Coimbatore (south) and Nagpur (central), besides Mumbai (west). ISE has also floated a wholly-owned subsidiary, ISE Securities and Services Limited (ISS), which has taken up corporate membership of the National Stock Exchange of India Ltd. (NSE) in the Capital Market Futures and Options segments and the Stock Exchange, Mumbai, in the Equities segment, so that the traders and dealers of ISE can access other markets, in addition to the ISE market and their local markets. ISE thus provides the investors in smaller cities, a one-stop solution for cost-effective and efficient trading, and settlement in securities. With the objective of broadbasing the range of its services, ISE has started offering the full suite of DP facilities to its traders, dealers and their clients. ISE endeavors to consolidate the small, fragmented and less liquid markets into a national-level, liquid market by using state-of-the-art infrastructure and support systems. Objectives /Fe atures The Interconnected Stock Exchange of India Limited was constituted to realize the following objectives:

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1.

2. 3. 4.

5. 6. 7.

Create a single integrated national-level solution with access to multiple markets for providing high cost-effective service to millions of investors across the country Create a liquid and vibrant national-level market for all listed companies in general and small capital companies in particular Optimally utilize the existing infrastructure and other resources of participating stock exchanges, which are under-utilized now Provide a level playing field to small traders and dealers, by offering an opportunity to participate in a national-market having investment-oriented business Reduce transaction cost Provide clearing and settlement facilities to the traders and dealers across the country at their doorstep in a decentralized mode Spread demat trading across the Country

INDONEXT

Indonext is the proposed common trading platform for regional stock exchanges. It is planned to be introduced, by the SEBI on the basis of recommendations by the, ‘Justice Kania Committee on Corporatization and Demutalization of Stock Exchanges. Indonext is to be set up as the third National Stock Exchange, on the lines of ‘Euronext’. Indonext is to be established by merging regional stock exchanges with, the Over-TheCounter Stock Exchange (OTCEI). The scheme aims at giving a new lease of life for the regional stock exchanges in India. Ne e d The need for setting up Indonext arose, owing to the rapid expansion of the national and Bombay stock exchanges, into small centers and cities, and the struggle of regional exchanges to survive of all the national exchanges, seven of them do not conduct any business at all. Further, the capital market regulator, SEBI, has permitted companies to cut down their multiple listings and to eventually delist from the regional bourses. Good quality stocks started vanishing from the bourses and new stocks are not being listed, due to lack of initial public offerings. The idea behind Indonext is, to have a single trading segment. Features Indonext seeks to be different from the ISE in the following respects: 1. Exclusive trading Indonext aims at offering exclusive trading in the case of companies with paid-up capital of Rs 20 lakhs, very small and medium capital companies.

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2. Liquidity Indonext proposes to generate liquidity in the thinly traded stocks so as to ensure survival of small stock exchanges. 3. Wide trading Trading on Indonext will be open to all members including NSE, BSE, ISEI, OTCEI and regional exchanges. 4. Trading model Trading segment of all regional exchanges and OTCEI will be modeled along lines of Euronext, Paris or Amsterdam. 5. Eliminating conflict of interest Indonext seeks to eliminate a conflict of interest among regional stockbrokers by disallowing participating exchanges to retain a separate trading platform. Members will be permitted to trade only on the Indonext platform. ‘S Group’ Companies The Federation of Indian Stock Exchanges (FISE) representing the regional stock exchanges, gave the idea of ‘S Group’ Companies. Corporates such as Alfa Laval, Tata Coffee, Tata Honeywell, Tata Infomedia, Texmaco, Jindal Strips, Crisil, Godfrey Phillips and Forbes Gokak are among the 2,260 scrips that BSE has agreed to be traded on the Indonext. For this purpose, agreement is to be worked out between FISE and BSE, to create a single order book for companies with a paid-up capital of upto Rs. 20 crores. These companies with small capital bases will be called ‘S Group’ companies. Scrips that are traded on BSE ‘A Group,’ would not be included even if they have a small capital base. Similarly, all ‘Z Group’ scrips at BSE that have not paid listing fee at the regional stock exchanges, would be excluded from this group. Once a company is admitted, it cannot come out of the ‘S Group,’ even if its paid-up capital increases beyond Rs. 20 crores. Benefits Indonext offers the advantage of sharing common trading platform, whereby all the shares listed exclusively in the regional stock exchanges are placed on a common order book. This would facilitate trading of shares in all participating exchanges. This would in turn, entail increase of shares traded and also increase the number of players in this segment. Members of NSE and BSE would be permitted to trade in Indonext through limited trading rights, which could be formed at a low entry price. This would activate the segment with the increase in the number of players, too. Some of the regional stock exchanges that are set to form a common trading platform, are the stock exchanges of Madras, Bangalore, Cochin, Coimbatore, Mangalore and Hyderabad.

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REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

What is a stock exchange? How is a stock exchange defined? Who are ‘remisiers’ on a stock exchange? Who are ‘authorized clerks’ on a stock exchange? Who are ‘brokers’ on a stock exchange? Who are ‘jobbers’ on a stock exchange? Who are ‘tarawaniwalas’ on a stock exchange? Who are ‘dealers’ on a stock exchange? What is ‘settlement cycle’? What is ‘counter party default’? Who is a depository? What is ‘hybrid trading’? What is ‘margin trading’? Who are market makers on a stock exchange? What is allocative efficiency of a stock exchange? What is operational efficiency of a stock exchange? What is ‘NSMS’? What is ‘over-the-counter market system’? What do you know of ‘NSE’? What is ‘corporitization of a stock exchange? What is a ‘demutualized stock exchange? State the objectives of Interconnected Stock Exchange of India What is ‘INDONEXT’?

Section B 1. 2. 3.

How is a stock exchange different from a commodity exchange? How are stock exchanges organized in India? Explain. Explain the mode of organization adopted for the Indian stock exchanges. 4. Who are the traders in a stock exchange? 5. What is the special role played by the SEBI in regulating of stock exchanges in India? 6. Identify the steps involved in trading on a stock exchange. 7. How does settlement take place on a stock exchange? Explain. 8. State the need for a depository. 9. Analyze the various systems of trading on a stock exchange. 10. How is ‘auction trading system’ different from ‘dealer trading system’?

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11. Who are specialists on a stock exchange? What are their functions? 12. How does the ‘National Clearance and depository System’ (NCDS) function? 13. Explain the special role of ‘Interconnected Stock Exchange of India’. 14. Write a note on the trading methodology adopted at the Interconnected Stock Exchange of India. 15. Write a note on the Indian Public Offering Distribution System 16. State the features of INDONEXT. 17. How is INDONEXT advantageous? Section C 1. 2. 3. 4. 5. 6. 7. 8. 9.

Trace the history of stock exchanges around the world. Give a detailed account of the functions and the role played by stock exchanges to the general economic development of a nation. Discuss the features of some of the world’s stock exchanges. Trace the history of stock exchanges in India. Analyze the principal weaknesses with which Indian stock exchanges suffer from? How are Indian stock exchanges regulated? Discuss. Discuss the various forms of measuring the efficiency of a stock exchange. Capture the recent developments that have taken place in the realm of Indian stock exchanges. Examine the achievements of Interconnected Stock Exchange of India.

Chapter

10

Indian Stock Exchange

There are 24 stock exchanges in the country, with 21 of them being regional in nature. Three others that have been set up in the reforms era, viz., National Stock Exchange (NSE), the Over the Counter Exchange of India Limited (OTCEI), and Interconnected Stock Exchange of India Limited (ISE) have mandate to nationwide trading network. The ISE has been promoted by 15 regional stock exchanges in the country and is based at Mumbai. The ISE provides a member-broker of any of these stock exchanges an access into the national market segment, which would be in addition to the local trading segment available at present. The NSE, OTCEI, ISE, and majority of the regional stock exchanges have adopted the Screen Based Trading System (SBTS) to provide automated and modern facilities for trading in a transparent, fair and open manner with access to investors across the country. Following are the names of the various stock exchanges in India: 1. The Bombay Stock Exchange 2. The Ahmedabad Stock Exchange Association Ltd 3. Bangalore Stock Exchange Ltd 4. Bhubaneshwar Stock Exchange 5. The Calcutta Stock Exchange Association Ltd 6. The Cochin Stock Exchange Ltd 7. The Delhi Stock Exchange Association Ltd 8. The Guwahati Stock Exchange Ltd 9. The Hyderabad Stock Exchange Ltd 10. The Jaipur Stock Exchange Ltd 11. The Kanara Stock Exchange Ltd 12. The Ludhiana Stock Exchange Association Ltd 13. The Madras stock Exchange Ltd 14. The Madhya Pradesh Stock Exchange Ltd 15. The Magadh Stock Exchange Ltd 16. The Mangalore Stock Exchange Ltd

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17. 18. 19. 20. 21. 22. 23. 24.

The Pune Stock Exchange Ltd The Saurashtra Kutch Stock Exchange Ltd The Vadodara Stock Exchange Ltd The Coimbatore Stock Exchange The Meerut Stock Exchange Ltd The Over The Counter Exchange of India (OTCEI) The National Stock Exchange of India (NSE) The Interconnected stock Exchange of India Ltd

TH E BOMBAY STOCK EX CHANGE ( BSE)

Genesis The Bombay Stock Exchange, Mumbai, was originally established in 1875 under the name of “The Native Share and Stockbrokers Association” as a voluntary non-profit organisation. It is acclaimed as a premier stock exchange in the country. It is the oldest stock exchange in Asia, much older than the Tokyo Stock Exchange, which was founded in 1878. The Exchange while providing an efficient market mechanism also upholds the interests of the investors and ensures redressal of their grievances, whether against the companies or its own member-brokers. It also strives to educate and enlighten the investors by making available necessary informative inputs. Management A Governing Board, comprising of 9 elected directors (one third of them retire every year by rotation), an Executive Director, 3 Government nominees, a Reserve Bank of India nominee and 5 public representatives, is the apex body, which regulates the Exchange and decides its policies. A President, Vice-President and Honorary Treasurer are annually elected from among the elected directors by the Governing Board following the election of directors. However, as per SEBI Orders issued in March 2001, the elected directors have been restrained from acting as directors and the Governing Board presently comprises of only 10 directors, viz., 3 government nominees, a RBI nominee, 5 public representatives and an Executive Director. The Executive Director, as the Chief Executive Officer, is responsible for the day-to-day administration of the Exchange. BOLT (BSE-ON-LINE-TRADING) BSE has obtained permission from Securities and Exchange Board of India (SEBI) for expansion of its BSE-On-Line-Trading (BOLT) network to

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locations outside Mumbai. According to the new arrangements, the members of the BSE are free to install their own trading terminals at any place in the country. In order to expand the BOLT network to centers outside Mumbai and support the smaller regional stock exchanges, the BSE has admitted subsidiary companies formed by 13 regional stock exchanges as its members as on November 30, 2001. The members of these regional stock exchanges work as sub-brokers. The objective is to reach out to investors in these centers via the members of these Exchanges, and thus provide them access to the trading facilities in all scrips listed on the BSE. Listing of Securities Listing means admission of securities for the purpose of dealings on a recognized stock exchange. The securities may be of any public limited company, Central or State Government, quasi-government and other financial institutions/corporations, municipalities, etc. The objectives of listing are: • Providing liquidity to securities • Mobilizing savings for economic development • Protecting interest of investors by ensuring full disclosures The BSE has a separate Listing Department to grant approval for listing of securities of companies, in accordance with the provisions of the Securities Contracts (Regulation) Act, 1956, Securities Contracts (Regulation) Rules, 1957, Companies Act, 1956, Guidelines issued by SEBI, and Rules, Bye-laws and Regulations of the Exchange. A company intending to have its securities listed on the Exchange has to comply with the listing requirements prescribed by the Exchange. Some of the requirements are as under: FOR NEW COMPANI ES

Minimum Capital New companies can be listed on the Exchange, if their issued and subscribed equity capital after the public issue is Rs.10 crores. In addition, the issuer company should have a post-issue net worth (equity capital + free reserves excluding revaluation reserve) of Rs.20 crores. For new companies in high technology, (i.e. information technology, internet, e-commerce, telecommunication, media including advertisement, entertainment etc.) the following criteria will be applicable regarding the threshold limit: 1. The minimum amount of total income/sales from the main activity, i.e. the field of information technology, internet, e-commerce,

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2. 3.

4.

telecommunication, media including advertisement, entertainment, etc should be less than 75 percent of the total income during the two immediately preceding years, as certified by the auditors of the company The minimum post-issue paid-up equity capital should be Rs.5 crores The minimum market capitalization should be Rs.50 crores. (The capitalization will be calculated by multiplying the post-issue subscribed number of equity shares with the issue price) Post-issue net worth (equity capital + free reserves excluding revaluation reserve) of Rs.20 crores

Minimum Public offer As per Rule 19(2) (b) of the Securities Contracts (Regulation) Rules, 1957, securities of a company can be listed on a stock exchange only when at least 25 percent of each class or kind of securities is offered to the public for subscription. In case of IPOs by unlisted companies in the IT and entertainment sector, at least 10 percent of the securities issued by the company may be offered to the public subject to the following: 1. Minimum 20 lakh securities are offered to the public (excluding reservation, firm allotment, and promoters contribution) 2. The minimum size of the offer to the public is 50 crores For this purpose, the term “offered to the public” means only the portion offered to the public and does not include reservation of securities on firm or competitive basis. SEBI may, however, relax this condition on the basis of recommendations of stock exchange(s), only in respect of a Government Company defined under Section 617 of the Companies Act, 1956. FOR COMPANI ES LI STED ON OTHER STOCK EXCHANGES

The companies listed on other stock exchanges and seeking listing on the BSE are required to fulfill the following criteria: 1. Minimum issued equity capital of Rs. 3 crores 2. Profit track record for at least last three years 3. Minimum net worth of Rs. 20 crores (net worth includes equity capital and free reserves excluding revaluation reserves) 4. Minimum market capitalization of Rs. 20 crores, based on average price of last six months

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7.

8.

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Trading for a minimum 50 percent of the total trading days during the same six months on any stock exchange Minimum average volume traded per day during the last three complete months should be 1,000 shares and minimum 5 trades per day 25 percent of the issued capital should be with public (including body corporates) and minimum 15 shareholders per Rs. 1 lakh of capital in the public category The company should be agreeable to sign an agreement with CDSL and NSDL for DEMAT Trading

FOR COMPANI ES DELI STED ALREADY AND SEEKI NG RELI STI NG OF THI S EX CHANGE

The companies delisted by this Exchange and seeking relisting are required to make a fresh public offer and comply with the prevailing SEBI’s and BSE’s guidelines regarding initial public offerings. Permission to use the Name of the Exchange The Exchange follows a procedure in terms of which companies desiring to list their securities offered through public issues, are required to obtain its prior permission to use the name of the Exchange in their prospectus or offer for sale documents before filing the same with the concerned office of the registrar of companies. The Exchange has since last three years formed a “Listing Committee” to analyze draft prospectus/offer documents of the companies in respect of their forthcoming public issues of securities and decide upon the matter of granting them permission to use the name of “The Stock Exchange, Mumbai” in their prospectus/offer documents. The committee evaluates the promoters, company, project and several other factors before taking a decision in this regard. Submission of Letter of Application As per Section 73 of the Companies Act, 1956, a company seeking listing of its securities on the Exchange is required to submit a letter of application, to all the stock exchanges where it proposes to have its securities listed, before filing the prospectus with the registrar of companies. Allotment of Securities As per listing agreement, a company is required to complete allotment of securities offered to the public within 30 days of the date of closure of the subscription list and approach the regional stock exchange, i.e. stock exchange nearest to its registered office for approval of the basis of

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allotment. In case of Book-building issue, allotment shall be made not later than 15 days from the closure of the issue, failing which, interest at the rate of 15 percent shall be paid to the investors. Trading Permission As per the SEBI guidelines, the issuer company should complete the formalities for trading at all the stock exchanges where the securities are to be listed within 7 working days of finalization of basis of allotment. A company should scrupulously adhere to the time limit for allotment of all securities and dispatch of allotment letters/share certificates and refund orders, and for obtaining the listing permissions of all the exchanges whose names are stated in its prospectus or offer documents. In the event of listing permission to a company being denied by any stock exchange, where it had applied for listing of its securities, it cannot proceed with the allotment of shares. However, the company may file an appeal before the SEBI under Section 22 of the Securities Contracts (Regulation) Act, 1956. Security Deposit The companies making public/rights issues are required to deposit 1 percent of issue amount with the regional stock exchange before the issue opens. This amount is liable to be forfeited in the event of the company not resolving the complaints of investors regarding delay in sending refund orders/share certificates, non-payment of commission to underwriters, brokers, etc. Listing Fees All companies listed on the Exchange have to pay annual listing fees by the 30th April of every financial year, to the exchange as per the schedule of listing fees prescribed from time to time. Listing Agreement The companies desirous of getting their securities listed are required to enter into an agreement with the Exchange called the ‘listing agreement’ and they are required to make certain disclosures and perform certain acts. As such, the agreement is of great importance and is executed under the common seal of a company. Under the listing agreement, a company undertakes, amongst other things, to provide facilities for prompt transfer, registration, sub-division and consolidation of securities; to give proper notice of closure of transfer books and record dates, to forward copies of unabridged Annual Reports and Balance Sheets to the shareholders, to file distribution schedule with the Exchange annually; to furnish financial

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results on a quarterly basis; intimate promptly to the Exchange the happenings which are likely to materially affect the financial performance of the company and its stock prices, to comply with the conditions of Corporate Governance, etc. The listing department of the Exchange monitors the compliance of the companies with the provisions of the listing agreement, especially with regard to timely payment of annual listing fees, submission of quarterly results, requirement of minimum number of shareholders, etc and takes penal action against the defaulting companies. ‘Z ’Group The Exchange has introduced a new category called ‘Z Group’ from July 1999, for companies which have not complied with and are in breach of provisions of the listing agreement. The BSE has the highest number of companies under this category among the Stock Exchanges in the country and in the world. SAFETY OF MARKET

The BSE has initiated the following measures towards making the trading, both on-floors and off-floors safer: Surveillance Department One of the objectives of the Exchange is to promote and inculcate honourable and just practices of trade in securities, and to discourage malpractices. The surveillance function at the Exchange has assumed greater importance in recent times. The Exchange has accordingly set up a separate surveillance department to keep a close watch on price movement of scrips, detect market manipulations like price rigging, etc monitor abnormal prices and volumes which are not consistent with normal trading pattern. Besides, the department also monitors the member-brokers’ position to ensure that defaults do not occur. A general manager, who reports directly to the Executive Director, heads the department. The surveillance department monitors exposure of the members on a daily basis. It also scrutinizes the prices and volumes of the scrips on a daily basis. Circuit Filters The limit imposed by a stock exchange for the price of a security to move within a prescribed band is called ‘circuit filters’. The imposition of circuit filters on scrips ensures that the price of scrip cannot move upward or downward beyond the limit set for a day and a settlement. The objective is to prevent price manipulation. Under this dispensation, the large variation

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in the prices as well as the volumes of the scrips is scrutinized and appropriate actions taken. The scrips, which reach new high or new low, and companies which have high turnover, are watched. Similarly, the prices and volumes in the newly listed scrips are monitored. In case, certain abnormalities are noticed, then circuit filters are reduced to make it difficult for the price manipulators to increase or push down the prices of scrip within a short period of time. The Exchange imposes special margin on the scrips where it is suspected that there is an attempt to ramp up the prices by creating artificial volumes. In cases where the abnormal movements continue despite the aforesaid measures, trading in the scrip is suspended. As per the guidelines issued by SEBI, the stock exchanges are required to apply daily circuit filter of 8 percent on scrips quoting above Rs. 20. However, in respect of scrips quoting below Rs. 20, the exchanges are free to set their own circuit filters. The Exchange has accordingly prescribed 8 circuit filters for scrips quoting above Rs. 10 but below Rs. 20, and for scrips quoting upto Rs. 10, daily and weekly circuit filters are 25 percent and 50 percent respectively. As directed by SEBI, the circuit filter limit is 200 scrips, which are commonly traded and jointly identified by BSE and NSE scrips, which are under the compulsory rolling settlement, has been relaxed to 16 percent with effect from July 3, 2000. In this connection, it has been decided that if scrip touches 8 percent circuit filter band in either direction, the circuit filter would be relaxed by another 8 percent in that same direction. Detailed investigations are conducted in cases where price manipulation is suspected and disciplinary action is taken against the members concerned, if warranted. Where any scrip has been suspended for more than three days, a detailed investigation report is prepared and sent to SEBI for further investigation/action, if any. OLRT With effect from July 15, 1999 the Exchange is using an On-line Real Time (OLRT) Surveillance System. Under this system, alerts are generated by the system on-line, in real time, based on certain preset parameters like the price and volume variation in scrips, members taking unduly large positions not commensurate with their financial position or having concentrated position(s) in one or a few scrips, etc. This system includes databases such as company profile, members’ profile and historical database of turnover and price movement in scrips, members’ turnover, their pay-in obligations, etc. The system generates

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alerts on the basis of preset parameters during the trading hours, and corrective action based on further investigations is taken in such cases. Transfer of Ownership Transfer of ownership of securities, if the same is not delivered in demat form by the seller, is effected through a date-stamped transfer deed, which is signed by the buyer and the seller. The duly executed transfer deed along with the share certificate has to be lodged with the company for change in the ownership. A nominal duty is payable in the form of stamps to be affixed on the transfer-deeds. Transfer-deed remains valid for twelve months or the next book closure following the stamped date whichever occurs later for transfer of shares in the name of the buyer. However, for delivery of shares in the market, transfer deed is valid till book closure date of the company. Brokerage and Transaction Costs Brokerage is negotiable. The Exchange has not prescribed any minimum brokerage. The maximum brokerage is subject to a ceiling of 2.5 percent of the contract value. However, the average brokerage charged by the members to the clients is much lower. Typically there are different scales of brokerages for delivery transaction, trading transaction, etc. The stamp duty on transfer of securities in physical form is to be paid by the seller but in practice the buyer while registering the shares in his name pays it. In case of transfer of shares, the rate is 50 paise for every Rs.100/- or part thereof on the basis of the amount of consideration, and that for transfer of debentures the rate of stamp duty varies from state to state, where the registered office of a company issuing the debentures is located. OPPORTUNI TI ES FOR FOREI GN I NVESTORS

Following are the opportunities available for foreign investors: 1. Direct investment Foreign companies are now permitted to have a majority stake in their Indian affiliates except in a few restricted industries. In certain specific industries, foreigners can even have holding up to 100 percent. 2. Investment through stock exchanges Foreign Institutional Investors (FIIs) upon registration with the SEBI and the Reserve Bank of India are allowed to operate on the Indian stock exchanges subject to the guidelines issued for the purpose by SEBI. Important guidelines in this regard are as follows: Portfolio investment in primary or secondary market of a company by all registered FIIs, NRIs and OCBs is subject to a ceiling of 30/40

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3.

percent of issued share capital. Holding by a single FII, NRI or OCB in any one company is subject to a ceiling of 10 percent of the total issued capital. However, in applying the ceiling of 30/40 percent the following are excluded: a. Foreign investment under a financial collaboration, which is permitted up to 51 percent in all priority areas b. Investment by FII’s through offshore single/regional funds, GDR’s and euro convertibles Disinvestment is allowed through a member broker of a stock exchange. A registered FII is required to buy or sell securities on the stock exchanges only for delivery. It is not allowed to offset a deal in the same settlement. It is also not allowed to sell short i.e., sell a security without having the stock in its portfolio. Investment in euro issues/mutual funds floated overseas Foreign investors can invest in Euro issues of Indian companies and in Indiaspecific funds floated abroad.

Broking Business Foreign brokers upon registration with the SEBI are now allowed to route the business of their registered FIIs clients through the members of Stock Exchanges. Guidelines for the purpose have been issued by SEBI. Asset management compani es/ merchant banki ng Foreign participation in Asset Management Companies and Merchant Banking Companies is also permitted. Trading and Settlement 1.T rading— BOLT The Exchange, which had an open outcry trading system, had switched over to a fully automated computerized mode of trading known as BOLT (BSE-On-Line-Trading) system with effect from March 14, 1995. Through the BOLT system the members can now enter orders from Trader Work Stations (TWSs) installed in their offices instead of assembling in the trading ring. This system, which was initially both order and quote driven, was commissioned on March 14, 1995. However, the facility of placing of quotes has been removed w.e.f. August 13, 2001 in view of lack of market interest and to improve system-matching efficiency. The system, which is now only order driven, facilitates more efficient processing, automatic order matching and faster execution of orders in a transparent manner. 2. Scrips group Trading on the BOLT System is conducted from Monday to Friday between 9:55 a.m. and 3:30 p.m. The scrips traded on

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the Exchange have been classified into ‘A’, ‘B1’, ‘B2’, ‘F’ and ‘Z’ groups. The ‘F’ group represents the debt market (fixed-income securities). The ‘Z’ group was introduced by the Exchange in July 1999 and covers the companies which have failed to comply with listing requirements and/or failed to resolve investor complaints or have not made the required arrangements with both the Depositories, viz., Central Depository Services (I) Ltd. (CDSL) and National Security Depository Ltd. (NSDL) for dematerialization of their securities by the specified date, i.e. September 30, 2001. 3. ‘C’ group scrip The Exchange has also the facility to trade in ‘C’ group which covers the odd lot securities in ‘A’, ‘B1’, ‘B2’ and ‘Z’ groups and Rights renunciations in all the groups of scrips in the equity segment. The Exchange, thus, provides a facility to market participants of on-line trading in odd lots of securities and Rights renunciations. The facility not only offers an exit route to investors to dispose of their odd lots, but also provides them an opportunity to consolidate their securities into market lots. 4. Exit route scheme The ‘C’ group can also be used by investors for selling up to 500 shares in physical form in respect of scrips of companies where trades are to be compulsorily settled by all investors in demat mode. This scheme of selling physical shares in compulsory demat scrips is called as Exit Route Scheme. With effect from December 31, 2001, trading in all securities listed in equity segment of the Exchange takes place in one market segment, viz., Compulsory Rolling Settlement Segment. 5. P ermi tted securi ti es The Exchange permits trading in the securities of the companies listed on other stock exchanges under “Permitted Securities” category, which meet the relevant norms specified by the Exchange. Accordingly, to begin with the Exchange has permitted trading in scrips of five companies listed on other Stock Exchanges w.e.f. April 22, 2002. 6. Closi ng pri ce The closing prices of scrips are computed on the basis of weighted average price of all trades in the last 15 minutes of the continuous trading session. However, if there is no trade during the last 15 minutes, then the last-traded price in the continuous trading session is taken as the official closing price. Compulsory Rolling Settlement ( CRS) Segment With a view to introduce the best international trading practices and to achieve higher settlement efficiency, as mandated by SEBI, trades in all the equity shares listed on the Exchange in CRS Segment were to be

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settled on T+5 basis w.e.f. December 31, 2001. SEBI has further directed the Stock Exchanges that trades in all scrips w.e.f. April 1, 2002 should be settled on T+3 basis. Accordingly, all transactions in all groups of securities in the equity segment and fixed-income securities listed on the Exchange are settled on T+3 basis w.e.f. April 1, 2002. Under a rolling settlement environment, the trades done on a particular day are settled after a given number of business days, rather than settling all trades done during a period at the end of an ‘account period.’ A T+3 settlement cycle means that the final settlement of transactions done on a trade day by exchange of monies and securities occurs on the fifth business day after the trade day. The transactions in securities of companies which have made arrangements for dematerialization of their securities by the stipulated date are settled only in Demat mode on T+3 on net basis, i.e. buy and sale positions in the same scrip are netted and the net quantity is to be settled. However, transactions in securities of companies, which have failed to make arrangements for dematerialization of their securities (‘Z’ group) are settled only on trade to trade basis on T+3, i.e. the transactions are settled on a gross basis and the facility of netting of buy and sale transactions in a scrip is not available. I llustration If one buys and sells 100 shares of a company on the same day, which is on trade to trade basis, the two positions will not be netted and he will have to first deliver 100 shares at the time of pay-in of securities and then receive 100 shares at the time of pay-out of securities on the same day. Thus, if one fails to deliver the securities sold at the time of pay-in, it will be treated as a shortage and the position will be auctioned/closed-out. In other words, the transactions in scrips of companies which are in compulsory demat are settled in demat mode on T+3 netting basis and the transactions in scrips of companies, which have not made arrangements for dematerialization of their securities by the stipulated date or are in ‘Z’ group for other reasons, are settled on trade to trade basis on T+3 either in demat mode or in physical mode. The settlement of transactions in ‘F’ group securities representing Fixed Income Securities is also on Rolling Settlement Cycle of T+3 basis. The Information Systems Department (ISD) of the Exchange generates the following statements, which can be downloaded by the members in their back offices on a daily basis:

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a.

Statement giving details of the daily transactions entered into by the members b. Statements giving details of margins payable by the members in respect of the trades executed by them The settlement of the trades (money and securities) done by a member on his own account or on behalf of his individual, corporate or institutional clients may be either through the member himself or through a SEBI registered Custodian appointed by him or the respective client. In case the delivery/payment is to be given or taken by a registered custodian, he has to confirm the trade done by a member on the BOLT System through 6A7A entry. For this purpose, the custodians have been given connectivity to BOLT System and have also been admitted as members of the clearing house. In case a registered Custodian does not confirm a transaction, the liability for pay-in of funds or securities in respect the same devolves on the concerned member. The introduction of settlement on T+3 basis has resulted in reduction in settlement risk, besides providing early receipt of securities and monies to buyers and sellers respectively, and brought Indian Capital Markets at the international standard of settlements. Settlement The trades done by members in all the securities in CRS are now settled by payment of money and delivery of securities on T+3 basis. All deliveries of securities are required to be routed through the clearing house, except for certain off-market transactions, which, although are required to be reported to the Exchange, may be settled directly between the members concerned. The scheme of operations in this regard is outlined below: 1. Clearing house The clearing house is an independent company promoted jointly by Bank of India and the BSE for handling the clearing and settlement operations of funds and securities on behalf of the Exchange. For this purpose, the Clearing and Settlement Department of the Exchange liaises with the clearing house on a day-to-day basis. The Information Systems Department of the Exchange generates ‘delivery and receive orders’ for transactions done by the members in A, B1, B2 and F group scrips after netting purchase and sale transactions in each scrip whereas delivery and receive orders for ‘C’ and ‘Z’ group scrips are generated on trade to trade basis, i.e. without netting of purchase and sale transactions in a scrip. 2. Delivery orders The delivery orders provide information like scrip, quantity and the name of the receiving member to whom the securities are to be delivered through the clearing house. The money statement

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provides scrip wise/item wise details of payments/receipts for the settlement. The members in their back offices can download the delivery/ receive orders and money statements. The bank accounts of members maintained with the eight clearing banks, viz., Bank of India, HDFC Bank Ltd., Global Trust Bank Ltd., Standard Chartered Bank, Centurion Bank Ltd., UTI Bank Ltd., ICICI Bank Ltd., and Indusind Bank Ltd., are directly debited through computerized posting for their settlement and margin obligations, and credited with receivables on accounts of pay-out dues and refund of margins. The securities, as per the delivery orders issued by the Exchange, are required to be delivered by the members in the clearing house on the day designated for securities pay-in i.e., on T+3 day. In case of the physical securities, the members have to deliver the securities in special closed pouches (supplied by the Exchange) along with the relevant details (distinctive numbers, scrip code, quantity, and receiving member) on a floppy. The data submitted by the members on floppies is matched against the master file data on the clearing house computer systems. If there are no discrepancies, then the clearing house generates a scroll number and a scroll slip is issued. The members can then submit the securities at the receiving counter in the clearing house. 3. Auto D .O. faci li ty Instead of issuing Delivery-Out (D.O) instructions for their delivery obligations in a settlement/auction, a facility has been made available to the members by automatically generating Delivery-Out instructions on their behalf from their CM (Clearing Member) pool a/cs by the clearing house w.e.f. August 10, 2000. This Auto D.O. facility is available for CRS (normal & auction) and for trade-to-trade settlements. This facility is, however, not available for delivery of non-pari passu shares and shares having multiple ISINs. The members wishing to avail of this facility have to submit an authority letter to the clearing house. This Auto D.O. facility is currently available only for clearing member pool accounts/principal accounts maintained by the members with National Securities Depository Ltd. (NSDL) and Central Depositories Services Ltd. (CDSL). 4. D emat pay- i n The members can effect demat pay-in either through CDSL or the NSDL. In case of NSDL, the members are required to give instructions to their Depository Participant (DP) specifying settlement number, settlement type, effective pay-in date, quantity, etc. The securities are transferred to the pool account. The members are required to give delivery-out instructions so that the securities are considered for pay-in. As regards CDSL, the members give pay-in instructions to their DP. The securities are transferred by the DPs to the Clearing Member (CM)

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Principal Account. The members are required to give confirmation to their DP, so that securities are processed towards pay-in obligations. Alternatively, the members may also effect pay-in from the clients’ beneficiary accounts for which they are required to do break-up on the front-end software to generate obligations and settlement IDs. 5. Securi ties buy-i n The clearing house arranges and tallies the securities received against the receiving member-wise report generated on the pay-in day. This process is called ‘securities pay-in’. Once this reconciliation is complete, the bank accounts of members with eight clearing banks having pay-in obligations are debited on the scheduled pay-in day. This procedure is called ‘pay-in of funds’. Once the pay-in of securities and funds is complete, the clearing house arranges for payout of securities and funds. As regards payout of securities, in case of demat securities, the same are credited in the Pool Account of the members or the client accounts as per the client details submitted by the members. In case of physical securities, the receiving members are required to collect the same from the clearing house on the payout day. The clearing house with the clearing banks credits the bank accounts of the members having payout of funds. This process is referred to as payout of funds. In case of rolling settlements, pay-in and payout of both funds and securities is completed on the same day. The settlement schedules are drawn by the Exchange in advance on a quarterly basis and circulated to the market participants. The settlement schedules have been strictly adhered to by the Exchange and there has been generally no case of clubbing of settlements or postponement of pay-in and payout during the last over six years. Database on Bad Paper The Exchange is also maintaining a database of fake/forged, stolen, lost and duplicate securities in physical form with the clearing house, so that distinctive numbers submitted by members in case of physical securities on delivery may be matched against the database to weed out bad paper from circulation at the time of introduction of such securities in the market. This database has also been made available to the members so that delivering and receiving members can check the entry of fake, forged and stolen shares in the market. SH ORTAGES AND OBJECTI ONS

Shortages and Consequent Actions The members download delivery/receive orders based on their netted positions for transactions entered into by them, during a settlement in ‘A’,

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‘B1’, ‘B2’, and ‘F’ group scrips and on trade-to-trade basis i.e., without netting buy and sell transactions in scrips in ‘C’ & ‘Z’ groups and scrips in B1 and B2 groups which have been put on trade-to-trade basis as a surveillance measure. The seller-members have to deliver the shares in the clearing house as per the delivery orders downloaded. If a seller-member is unable to deliver the shares on the pay-in day for any reason, his bank account is debited at the standard rate (which is equal to the closing price of the scrip on the day of trading) fixed by the Exchange for the quantity of shares short-delivered. The clearing house arrives at the shortages in delivery of various scrips by members on the basis of their delivery obligations and actual delivery. The members can download the statement of shortages on T+3 in rolling settlements. After downloading the shortage details, the members are expected to verify the same and report discrepancy, if any, to the clearing House by 1:00 p.m. If no discrepancy is reported within the stipulated time, the clearing house assumes that the shortage of a member is in order and proceeds to auction the same. However, in ‘C’ group, i.e. Odd Lot segment the members are themselves required to report the shortages to the clearing house. The Exchange issues an ‘Auction Tender Notice’ to the members informing them about the names of the scrips, quantity slated for auction and the date and time of the auction session on the BOLT. The auction for the undelivered quantities is conducted on T+4 for all the scrips under compulsory rolling settlements. The auction offers received in batch mode which are electronically matched with the auction quantities so as to award the ‘best price’. The members who participate in the auction session can download the delivery orders on the same day, if their offers are accepted. The members are required to deliver the shares in the clearing house on the auction pay-in day, i.e. T+5. Payout of auction shares and funds is also done on the same day, i.e. T+5. The various auction sessions relating to shortages, and bad deliveries are conducted during normal trading hours on BOLT. Thus, it is possible to schedule multiple auction sessions on a single trading day. In auction, the highest offer price is allowed up to the close-out rate and the lowest offer price can be 20 percent below the closing price on a day prior to day of auction. A member who has failed to deliver the securities of a particular company on the pay-in day is not allowed to offer the same, in auction. He can, however, participate in auction of other scrips.

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In case no offers are received in auction for a particular scrip, the sale transaction is closed-out at a close-out price, determined by higher of the highest price recorded in the scrip from the settlement, in which the transaction took place up to a day prior to the day of the auction or 20 percent above the closing price on a day prior to the day of auction. However, in case of the closeout of the shares under objection and shortages in ‘C’ or ‘Z’ group, 10 percent above the closing prices of the scrips on the payout day of the respective settlement are considered instead of 20 percent. Further, if the auction price/close-out price of scrip is higher than the standard price of the scrip in the settlement in which the transaction was done, the difference is recovered from the seller who failed to deliver the scrip. However, in case, auction/closeout price is lower than standard price, the difference is not given to the seller but is credited by the Exchange to the Customers Protection Fund. This is to ensure that the seller does not benefit from his failure to meet his delivery obligation. Further, if the offeror-member fails to deliver the shares offered in auction, then the transaction is closed-out as per the normal procedure and the original selling member pays the difference below the standard rate and offer rate and the offeror-member pays the difference between the offer rate and close-out rate. Self-auction The ‘Delivery and Receive Orders’ are issued to the members after netting off their purchase and sale transactions in scrips, where netting of purchase and sale positions is permitted. It is likely in some circumstances that a selling client of a member has failed to deliver the shares to him. However, this did not result in a member’s failure to deliver the shares to the clearing house, as there was a purchase transaction of some other buying client of the member in the same scrip, and the same was netted off for the purpose of settlement. In such a case, the member would require shares so that he can deliver the same to his buying client, which otherwise would have taken place from the delivery of shares by the seller. To provide shares to the members, so that they are in a position to deliver them to their buying clients in case of internal shortages, the members have been given an option to submit floppies for conducting self-auction, (i.e. as if they have defaulted in delivery of shares to the Clearing House). Such floppies are to be given to the clearing house on the pay-in day. The internal shortages reported by the members are clubbed with the normal shortages in a settlement and the clearing house for the combined shortages conducts the auction. A member after getting delivery of shares from the clearing house in self-auction credits the shares to the beneficiary

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account of his client or hand over the same to him, in case securities received are in physical form and debits his seller-client with the amount of difference, if any, between the auction price and original sale price. Obj ections When receiving members collect the physical securities from the Clearing House on the Payout day, the same are required to be checked by them for good delivery as per the norms prescribed by the SEBI in this regard. If the receiving member does not consider the securities good delivery, he has to obtain an arbitration award from the arbitrators and submit the securities in the Clearing House on the following day of the receipt. The clearing house returns these securities to the delivering members on the same day, i.e. (T+4). If a delivering member feels that arbitration award obtained against him is incorrect, he is required to obtain arbitration award for invalid objection from the members of the Arbitration Review Committee. The delivering members are required to rectify/replace the objections and return the shares to the clearing house on the next day (T+5) to have the entry against them removed. The Clearing House delivers the rectified securities to the buyer-members on the same day (T+5). The buyer-members, if they are not satisfied with the rectification, are required to obtain arbitration awards for invalid rectification from the Bad Delivery Cell on T+6 day and submit the shares to the clearing house on the same day. If a member fails to rectify/replace the objections then the same are closed-out. This is known as “Objection Cycle” and the entire process takes 3 days. The un-rectified and invalid rectification of securities are directly closed-out by the clearing house instead of first inviting the auction offers for the same. The shares in physical form returned under objection to the clearing house are required to be accompanied by an arbitration award (Chukada) except in certain cases where the receiving members are permitted to submit securities to the clearing house without ‘Chukada.’ These cases are as follows: • Transfer Deed is out of date • Cheques for the dividend adjustment for new shares where distinctive numbers are given in the Exchange Notice is not enclosed • Stamp of the Registrar of Companies is missing • Details like Distinctive Numbers, Transferors’ Names, etc are not filled, in the Transfer Deeds

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Delivering broker’s stamp on the reverse of the Transfer Deed is missing • Witness stamp or signature on Transfer Deed is missing • Signature of the transferor is missing • Death Certificate (in cases where one or more of the transferors are deceased) is missing A penalty at the rate of Rs.100/- per Delivery Order is levied on the delivering member for delivering shares, which are not in order. In the event of a receiving member misusing the facility of submitting shares under objection without ‘Chukada,’ a penalty of Rs.500/- per case is charged and the penalty of Rs.100/- per Delivery Order levied on the delivering member is refunded to him by debiting the receiving member’s account. •

Book-building Book-building is basically a capital issuance process used in Initial Public Offer (IPO), which aids price and demand discovery. It is a process used for marketing a public offer of equity shares of a company. It is a mechanism where, during the period for which the book for the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The process aims at tapping both wholesale and retail investors. The offer/issue price is then determined after the bid closing date, based on certain evaluation criteria. The Process The process of book-building as followed at the BSE is described below: • Book runner The Issuer who is planning an IPO nominates a lead merchant banker as a ‘book runner’ • Price band The Issuer specifies the number of securities to be issued and the price band for orders • Syndicate The Issuer also appoints syndicate members with whom orders can be placed by the investors • Placing orders Investors place their order with a syndicate member who inputs the orders into the ‘electronic book’. This process is called ‘bidding’ and is similar to open auction. The book should remain open for a minimum of 5 days. Bids cannot be entered less than the floor price. The bidder can revise bids before the issue closes • Evaluation On the close of the book-building period the ‘book runner’ evaluates the bids on the basis of the evaluation criteria which may include Price Aggression, Investor quality of bids, etc.

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Final Price The book runner and the company conclude the final price at which it is willing to issue the stock Quantum The number of shares are fixed, the issue size gets frozen based on the price per share discovered through the bookbuilding process. Allocation of securities is made to the successful bidders

BSE’s Book- building System The book-building process that is in vogue is explained below: • BSE offers the book-building services through the book-building Software that runs on the BSE private network • This system is one of the largest electronic book-building networks anywhere spanning over 350 Indian cities through over 7000 Trader Work Stations via leased lines, VSATs and Campus LANS • The syndicate member-brokers operate the software through book-runners of the issue. Through this book, the syndicate member-brokers on behalf of themselves or their clients’ place orders • Bids are placed electronically through syndicate members and the information is collected on-line real time until the bid date ends In order to maintain transparency, the software gives visual graphs displaying price v/s quantity on the terminals. I nitial Public Offerings Corporates may raise capital in the primary market by way of an initial public offer, rights issue or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book-building method or a combination of both. In case the issuer chooses to issue securities through the bookbuilding route then as per SEBI guidelines, an issuer company can issue securities in the following manner: • 100 percent of the net offer to the public through the book-building route • 75 percent of the net offer to the public through the book-building process and 25 percent through the fixed price portion Under the 90 percent scheme, this percentage would be 90 and 10 respectively.

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DERI VATI VESTRADI NG

The Stock Exchange, Mumbai created history by launching the first Exchange traded financial derivatives product in India, the Sensex Futures. Sensex I ndex An index is an indicator of the broad market. For instance, tracking the changes in the Sensex enables one to effectively gauge stock market movements. The BSE 30 Sensex, first compiled in 1986, is a market capitalization weighted index of 30 scrips. It represents 30 large wellestablished and financially sound companies. The Sensex also has the largest social recall attached with it. It was the first index to be launched by any Stock Exchange in India and has acquired a unique place in the collective memory of investors. It facilitates investors to relate to the market. The most important advantage is that, as one of the oldest and reliable barometers of the Indian Stock Market, it provides time series data over a fairly long period of time. The primary consideration in minimizing changes in the composition of the BSE 30 has been for historical purposes. However, the structural and market driven changes are taken into consideration. While an index must represent the current state of an evolving market, it should concurrently maintain the track record of changes in the Indian capital markets. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups, which are large enough to be used for effective hedging. Trading in Sensex Futures Given the lower cost structure and the overwhelming popularity of the Sensex, Sensex futures are expected to garner large volumes. The Sensex futures are expected to become the most liquid contract in the country. This is because institutional investors in India and abroad, money managers and small investors use the Sensex, when it comes to describing the mood of the Indian Stock Markets. Thus is has been observed that the Sensex is an effective proxy for the Indian stock markets. Higher liquidity in the product essentially translates to lower impact cost of trading in Sensex futures. The arbitrage between the futures and the equity market is further expected to reduce impact cost. Trading in stock index futures is likely to be pre-dominantly retail driven. Internationally, stock index futures are an institutional product with 60 percent of the volumes generated from hedging needs. Immense retail participation to the extent of 80–90 percent is expected in India based on the following factors:

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1.

2. 3. 4.

Stock index futures will require lower capital adequacy and margin requirements as compared to margins on carry forward of individual scrips. The brokerage costs on index futures will be much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are traded in packaged forms. The impact cost will be much lower in case of stock index futures as opposed to dealing in individual scrips.

The market is conditioned to think in terms of the index and therefore, would prefer to trade in stock index futures. Further, the chances of manipulation are much lesser. The stock index futures are expected to be extremely liquid given the speculative nature of our markets and the overwhelming retail participation expected to be fairly high. It is poised to become the most liquid contract in the world in terms of number of contracts traded, if not in terms of notional value. The advantage to the equity or cash market is in the fact that they would become less volatile as most of the speculative activity would shift to stock index futures. The stock index futures market should ideally have more depth, volumes, and act as a stabilizing factor for the cash market. However, it is too early to base any conclusions on the volume or to form any firm trend. Operators in the Derivatives Market Operators in a derivatives market include the following: 1. Hedgers Operators, who want to transfer a risk component of their portfolio. 2. Speculators Operators, who intentionally take the risk from hedgers in pursuit of profit. 3. Arbitrageurs Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing. CALCUTTA STOCK EX CH ANGE

Genesis The origin of stock broking in India goes back to a time, when shares, debentures and bonds representing titles to property were first issued on the condition of transfer from one person to another. The earliest record of dealings in securities in India is the East India Company’s loan securities. By 1836, there was a perceptible increase in the volume of business in Calcutta. The then widely circulated newspaper from Calcutta ‘The English

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Man’ contained quotations of 4 percent, 5 percent and 6 percent loans of the East India Company, with the shares of the Bank of Bengal being quoted at a considerably high premium over the par value of Rs. 100/-. Three years later, in 1839, quotations were also found in newspapers published from Calcutta, of shares of the Union Bank, the Agra Bank and certain other commercial undertakings like Bengal Bonded Warehouse Docking Company and Steam Tug Company. The advent of the Companies Act 1850, and subsequent introduction of the principle of limited liability, made investments in stocks and shares popular. In May 1908, an association was formed under the name and style of the Calcutta Stock Exchange Association at 2, China Bazar Street. On June 7, 1923 the Association was registered as a limited liability concern, with an authorized capital of Rs. 3 lakhs divided into 300 shares of Rs. 1,000/each. The shares were subdivided into 4 shares of Rs. 250/- each in 1959. The Golden Jubilee of the Association was celebrated in 1938. The Diamond Jubilee in 1968, and The Platinum Jubilee in 1983. At the time of incorporation in 1908, the Stock Exchange had 150 members. Today the total membership has risen to more than 900, which consist of several corporate and institutional members. The Calcutta Stock Exchange has been granted permanent recognition by the Central Government with effect from April 14, 1980 under the relevant provisions of the Securities Contracts (Regulation) Act, 1956, with a view to render useful service to investors. In the year 1997, the Calcutta Stock Exchange ushered in a new era by replacing the old manual trading system with completely computerized on-line trading and reporting system known as C-STAR (CSE Screen Based Trading And Reporting). The computerized trading started initially with 101 ‘B’ Group scrips. Subsequently with effect from 7.3.1997 remaining ‘B’ Group and all ‘Permitted Group’ scrips (approx. 3,500) were transferred on to the C-STAR systems. The exchange finally shifted the entire ‘A’ Group scrips to the computerized system with effect from April 4, 1997. Governing Body The Calcutta Stock Exchange is managed by a Governing Body which consists of a President, a Vice-President, both elected from the members of the CSE. From among the 8 elected members of the CSE, 3 are Government nominees (appointed by SEBI) and 6 are public representatives. The Executive Director, appointed by the Exchange with SEBI’s approval, discharges the executive functions. The Governing body is responsible for policy formulation and for ensuring smooth functioning of the exchange.

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Trading, Clearing and Settlement CSE has an auction type of trading with bids and offers being made by open outcry. There is no compulsory market-making at CSE but it has an informal system of jobbers. Communication in the trading ring is either verbal or through hand signals. Traders within the ring can communicate with their offices on intercoms provided by the CSE within the trading ring. The jobbers stand at specific locations in the trading ring called trading posts. They continuously announce the two-way quotes for the scrips traded at the post. As there is no prohibition on a jobber acting as a broker or a broker as a jobber, members are free to do jobbing on any day. However, an identifiable group emerges which confines its activities to jobbing alone. The Reuter rare display board and the PTI stocks is used for the dissemination of information, for showing the current prices of the important shares in other exchanges and the CSE from time to time. They also publish scrip-wise volume of trades in the official line. On striking a deal, traders enter abbreviated details in small ‘souda books’. At the end of the trading all deal details are transferred to a Souda sheet and is handed over to the CSE computer division. The clearing system was introduced in 1944. I nvestor Protection The CSE was the pioneer in the forming of an Investor Service Cell in 1986. Today the cell handles more than 5,000 complaint letters from investors, on an average per year. The stock exchange has the practice of subjecting the members to various forms of disciplinary action like warning, reprimand, censure, fine, withdrawal of all or any of the membership rights. It can suspend the dealings in securities of errant listed companies or even delist them, if required. However, such an action is taken only in extreme cases as it has repercussions on investor’s interest. During 1994-95, 13 companies were delisted. Members can be suspended if they involve themselves in illegal practices like price rigging, or if they do not submit adequate information (like financial statements, audit reports, etc.) or if they are unable to meet the daily margin requirements, etc. Defaults could arise out of excessive speculation, entering into commitments beyond one’s financial capacity or a combination of both. Or it could be a case of intentional evasion of commitment. Margins Daily margins are collected in respect of every contract outstanding at the end of the day. Daily margins are applicable on the gross position of the

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member. It is always made on a cash basis. The rate is 20 percent for specified shares and 5 percent for non-specified shares. There is no carryover margin at CSE. The third type of margin is the ad hoc margin, which is collected from individual members who overtrade. Market I nformation The availability of prompt and accurate market information is very important when it comes to removing ‘imperfections’ in the market. Various programmes aim at making the market related information available to the investing public through reuter rare display. PTI Stockscan Publication of scrip-wise volume of trades in the official line. M atching transactions The trading period is restricted from 11:00 a.m. to 2:00 p.m. due to the limitations of the existing infrastructure. CSE has initiated a screen-based trading system. The current settlement period is 14 days beginning on a Friday and ending two weeks later on Thursday for the specified group. The settlement period for non-specified shares is 7 days beginning on a Tuesday and ending on Monday the next week. THE NATI ONAL STOCK EX CHANGE OF I NDI A LI MI TED ( NSE)

Genesis The National Stock Exchange of India Limited was set up on the basis of the recommendations of the High Powered Study Group on Establishment of New Stock Exchanges. On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000. The National Stock Exchange (NSE) was incorporated in November 1992 with an equity capital of Rs. 25 crores. It was promoted by the International Securities Consultancy (ISC) of Hong Kong in association with financial institutions, insurance companies, banks, SBI Capital Markets Ltd., Infrastructure Leasing and Financial Services Ltd., and Stock Holding Corporation Ltd. ISC has prepared the detailed business plan, including the installation of hardware and software systems. It aims at promoting professionalism in the capital market and providing better securities trading facilities to investors nationwide. NSE transcends geographical barriers and overcomes fragmentation by providing a screenbased trading system instead of the conventional trading ring. This results

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in greater depth and liquidity of the market and reduces the transaction costs. The NSE is not an exchange in the traditional sense of the term, where brokers own and manage the exchange. Its two tier administrative set up involves a company board and a governing board of the exchange. NSE is a professionally managed national market for shares, PSU bonds, debenture and government securities with all the necessary infrastructure and trading facilities. The Mission NSE was set up to realize the following objectives: 1. Establishing a nationwide trading facility for equities, debt instruments and hybrids 2. Ensuring equal access to investors all over the country through an appropriate communication network 3. Providing a fair, efficient and transparent securities market to investors using electronic trading systems 4. Enabling shorter settlement cycles and book entry settlements systems, and 5. Meeting the current international standards of securities markets The standards set by NSE in terms of market practices and technology has become industry benchmarks and is being emulated by other market participants as well. NSE is more than a mere market facilitator. It guides the industry towards new horizons and greater opportunities. Trading Mechanism In order to encourage an institutional market where large volume trades come up for settlement in jumbo lots, two exclusive additional market segments, the institutional lot segment and trade-for-trade segment have been setup. NSE has an order driven system, which allows members to undertake jobbing in securities of their choice. Several members undertake jobbing on account of the cease of entry and exit, and narrow margins which results in improved liquidity and reduced transaction costs. Settlement The settlement cycle is completed within eight days from the last day of the trading cycle. The trading period is a week (Wednesday to Tuesday) and the settlement of trades takes place in the ensuing week.

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Counter Guarantee NSE’s Clearing Corporation stands guarantee to all trades done in the cash market on the exchange. The counter guarantee of the Clearing Corporation ensures that no default, either in payment or delivery takes place for trades done on NSE. Price Bands The price bands are based on the liquidity of a company’s shares as well as its volatility. The chances for price manipulation are more in the case of liquid securities. The factors, which determine the measure of liquidity of a security, are: 1. Frequency of trading 2. Average daily volume of trading 3. Average daily value of trading 4. Average daily number of trades Listing Requirement The exchange has also modified two of its listing clauses. The minimum paid-up capital requirement for initial public offerings has been increased from Rs.10 crores to Rs. 20 crores. With regard to companies whose shares are already listed on another exchange, there will now be a requirement of a minimum market capitalization of Rs. 20 crores (for companies with a paid-up capital of atleast Rs. 10 crores) or of Rs. 40 crores (for companies with a paid-up capital of less than Rs. 10 crores). Companies, which have not paid dividend for at least two of the last three years, will not be required to have a net worth of at least Rs. 50 crores for seeking listing on the house. Trading The National Stock Exchange of India started its trading operations in debt market segment from June 30, 1994. The NSE has adopted a fully automated screen-based trading system, which allows trading members to trade from their offices through a communications network. Price, time and volume conditions are quite flexible. Securities like the government bonds, treasury bills, PSU bonds, CPS, floating rate bonds and Unit 64 of UTI are traded on the exchange. The capital market segment covers the trading done in convertible/non-convertible debentures and hybrids, both in equities and retail trade. W holesale Debt Market Two distinctive segments representing Wholesale Debt Market (WDM) and Capital Market have started operations in 1994-95, providing secondary

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market trading facilities. WDM is a facility for institutions and corporate bodies to enter into high value transactions in instruments such as government securities, treasury bills, PSU bonds, Unit 64 of UTI, CPS and CDs. Few large investors and a high average trade volume characterize the segment. The principal participants are banks, corporates and mutual funds. There are two types of entities on WDM, Trading Members and Participants. Trading members are the recognized members of NSE. They can either trade on their own account or on behalf of their clients, including participants. In the WDM segment of the exchange more than nine categories of instruments are allowed for trading. The capital market segment of NSE commenced operations on November 3, 1994 to provide trading facilities for institutions and retail investors. The exchange has allowed for trading 1,300 securities of medium and large companies with nationwide investor bases. Because of the nationwide equal access, such securities can be traded anywhere in country at the same price. Electronic Trade Monitoring System The Stock-Watch system is a computer system designed and programmed to monitor market activity and identify aberrations from historical patterns. The algorithm for the NSE system is similar to the one prevalent at NASDAQ in the United States. However, the trading systems at NASDAQ and NSE are totally different. The algorithm of NASDAQ has been adapted to NSE’s trading conditions. The system enables NSE to electronically monitor the trading patterns, which would lead to a more effective surveillance. Currently, NSE officials have to manually screen the trading patterns to ascertain any strange price fluctuations. The electronic track monitoring system will automatically kick off alerts. It will make the task of surveillance easier and more effective. There is a great need to enhance information flow and this will go hand-in-hand with better monitoring of trading patterns to reduce cases of price manipulation. SEBI will define the kind of information the stock exchanges need to furnish so as to make their enforcement job more effective. Corporate Structure NSE is one of the first demutualized stock exchanges in the country, where the ownership and management of the Exchange is completely divorced from the right to trade on it. Though the impetus for its establishment came from policy makers in the country, it has been set up as a public limited company, owned by the leading institutional investors in the country.

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The ownership, management and trading is in the hands of three different sets of people. NSE is owned by a set of leading financial institutions, banks, insurance companies and other financial intermediaries and is managed by professionals, who do not directly or indirectly trade on the Exchange. This has completely eliminated any conflict of interest and helped NSE in aggressively pursuing policies and practices within a public interest framework. Board The Board of NSE comprises of senior executives from promoter institutions, eminent professionals in the fields of law, economics, accountancy, finance, taxation, etc public representatives, three nominees of SEBI including a senior official of SEBI and one full time executive of the Exchange. Executive Committee While the Board deals with broad policy issues, decisions relating to market operations are delegated by the Board to an Executive Committee (EC) formed under the Articles of Association and Rules. The EC includes representatives from trading members, the public and the management. The EC has four broker-members who are nominated by the Board of NSEI based on their experience in stock market and represent different regions. The day-to-day management of the Exchange is delegated to the Managing Director who is supported by a team of professional staff. Promoters NSE was promoted by leading financial institutions, banks, insurance companies and other financial intermediaries such as the following: • Industrial Development Bank of India • Industrial Finance Corporation of India Limited • Life Insurance Corporation of India • State Bank of India • ICICI Bank Limited • Infrastructure Leasing and Financial Services Limited • Stock Holding Corporation of India Limited • SBI Capital Markets Limited • Unit Trust of India • Bank of Baroda • Canara Bank • General Insurance Corporation of India

238 Capi tal Markets • • • • • • • • •

National Insurance Company Limited The New India Assurance Company Limited The Oriental Insurance Company Limited United India Insurance Company Limited Punjab National Bank Oriental Bank of Commerce Corporation Bank Indian Bank Union Bank of India

Committees The Exchange has constituted various committees to advise it on areas such as good market practices, settlement procedures, risk containment systems, etc. Industry professionals, These committees, are manned by industry trading members, exchange staff as also representatives from the market regulator. • Executive Committee • Committee on Settlement Issues (COSI) • Dispute Resolution Committee (DRC) • Committee On Trade Related Issues (COTI) • Advisory Committee—Listing of securities Products NSE has played a catalystic role in bringing about a favorable transformation in the securities market in terms of microstructure, market practices and trading volumes. The market has witnessed several innovations in products and services. NSE offers a wide range of products and services in the equities, debt and derivative segments of the market as shown below: • Indices: Major Indices/Other Indices • Derivatives—Futures/Options • Computer to Computer Link (CTCL) facility: Equities/Derivatives • Internet-based Trading: Equities/Derivatives • Initial Public Offering (IPO) • Mutual Funds • Mutual Fund Service System (MFSS) • Exchange Traded Funds (ETFs) • Index Funds • Working Capital Funding • Direct Payout to Investors

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Debt Market • • • •

References Rates (MIBID/MIBOR) Zero-coupon Yield Curve (ZCYC) Var for Government Securities Constituent SGL Account

Maj or I ndices The NSE deals with the following major indices: • S & P CNX Nifty • CNX Nifty Junior • S & P CNX 500 • S & P CNX Defty • CNX Midcap 200 • Other IISL Indices • CNX IT Sector Index • CNX FMCG Index • CNX Millennium Index • CNX Segment Indices: CNX PSE Index/CNX MNC Index/CNX IBG Index • S & P CNX Industry Indices • Customized Indices Derivatives The derivatives that are dealt in include: • S & P CNX Nifty Futures • S & P CNX Nifty Options • Futures on Individual Securities • Options on Individual Securities Computer-to-Computer Link ( CTCL) Facility NSE offers a facility to its trading members by which members can use their own trading front-end software in order to trade on the NSE trading system. This facility called Computer-to-Computer Link (CTCL) facility is available only to trading members of NSE. Trading Members can use their own software running on any suitable hardware/software platform of their choice. This software would be a replacement of the NEAT front-end software that is currently used by members to trade on the NSE trading system. Members can use software customized to meet their specialized needs like provision of on-line trade analysis, risk management tools, integration of back-office operations,

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etc. The dealers of the member may trade using the software remotely through the member’s own private networks, subject to approvals from Department of Telecommunication, etc as may be required in this regard. I nternet Based Trading The Securities and Exchange Board of India (SEBI) approved the report on Internet Trading brought out by the SEBI Committee on Internet Based Trading and Services. Internet trading can take place through order routing systems, which will route client orders to exchange trading systems for execution. Thus a client sitting in any part of the country would be able to trade using the internet as a medium through brokers’ internet trading systems. SEBI-registered brokers can introduce Internet based trading after obtaining permission from respective stock exchanges. SEBI has stipulated the minimum conditions to be fulfilled by trading members to start internet based trading and services. NSE became the first exchange to grant approval to its members for providing internet based trading services. In line with SEBI directives, NSE has issued circulars detailing the requirements and procedures to be complied with by members desirous of providing internet based trading and services. Members can procure the internet trading software from software vendors who are empanelled with NSE or they may develop the software through their own in-house development team or may procure the software from other non-empanelled vendors. Members can also avail of services provided by Application Service Providers(ASP) (which may inter-alia include providing/maintaining software/hardware/other infrastructure etc) for providing Internet based trading services subject to the Application Service Provider being empanelled with the exchange for providing such services. Mutual Fund Service System Mutual Fund Service System (MFSS) is a facility provided by NSE/NSCCL to the investors for transacting in the dematerialized units of open-ended schemes of mutual funds. The objective is to provide the investor with a one-stop shop for transacting in financial products. While a good number of closed-ended schemes are traded on the Exchanges, the facilities for transacting in open-ended schemes of the Mutual Funds are very limited. The entire process of buying and redeeming open-ended mutual fund scheme units takes place directly between the individual investor and the Asset Management Company (AMC). The AMC appoints a number of agents/representatives for the purpose. In

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spite of these arrangements, the Mutual Funds have not been able to effectively cater to the millions of small investors spread across the length and breadth of the country.The Mutual Funds Services System addresses the need for a common platform for sale and repurchase of units of schemes managed by different Funds. The Exchange with its extensive network covering around 400 cities and towns across the country offers a mechanism for electronic on-line collection of orders from the market and the Clearing Corporation acts as a central agency for the clearing and settlement of all the orders. Sal i ent features of M F SS a. Orders for purchase and sale (redemption) of units from investors are collected using the on-line order collection system of NSE b. Orders are settled using the Clearing and Settlement system of NSCCL c. Orders are settled on order-to-order basis d. Settlement on rolling basis with orders entered on T-day settled on T+3 (working days) e. Settlement to the extent of securities/funds pay-in made by the participants f. Securities settlement in dematerialized mode only g. Transactions are not covered by settlement guarantee Exchange Traded Funds An Exchange Traded Fund (ETF) is a mutual fund scheme, which combines the best features of open-ended and close-ended funds. It usually tracks an index and trades like a single stock on the stock exchange. It is priced continually and can be bought or sold throughout the trading day. Buying/ Selling ETFs is as simple as buying/selling any other stock on the exchange allowing investors to take advantage of intra-day price movements. Thus, with ETFs, one can benefit, both from, the flexibility of a stock as well as the diversification and cost efficiency of an index fund. Globally, since their introduction in the U.S., in 1993, ETFs have grown rapidly with around U.S. $ 100 Billion in assets as on December 2001. Today, over 60 percent of trading volumes on the American Stock Exchange (AMEX) are from ETFs. Currently, more than 120 ETFs are available in US, Europe, Singapore, Hong Kong, Japan and other countries. Among the popular ones are SPDRs (Spiders) based on the S&P 500 Index, QQQs (Cubes) based on the NASDAQ-100 Index, iSHARES based on MSCI Indices and TRAHK (Tracks) based on the Hang-Seng Index.

242 Capi tal Markets

I ndex Funds Index funds today are a source of investment for investors looking at a long-term, less risky form of investment. The success of index funds depends on their low volatility and therefore the choice of the index. S&P CNX Nifty is used by a number of well-known mutual funds in India for promoting Index Funds. These funds are: 1. India Access Fund Ltd., by UTI, Warburg Dillon Read and Morley Fund Management. It was launched in November 1997, and is listed on the London Stock Exchange. 2. UTI Nifty Fund, by Unit Trust of India, is a domestic fund launched in March 2000 and IDBI Index I-Nit ’99, by IDBI - Principal Mutual Fund, a domestic fund launched in July 1999. 3. Franklin India Index Fund, by Templeton Mutual Fund , a domestic fund launched in June 2000. 4. Franklin India Tax Index Fund, a domestic fund launched in February 2001 and Pioneer ITI Index Fund, a domestic fund launched in August 2001. 5. NIFTY BEES, an Exchange Traded Fund on the Nifty, by Benchmark Mutual Fund, launched in December 2001. 6. Magnum Index Fund, a domestic fund by SBI Mutual Fund, launched in December 2001. 7. IL&FS Index Fund, a domestic index fund, launched in February 2002. 8. Prudential ICICI Index Fund, a domestic index fund, launched in February 2002. Working Capital Funding This is a facility provided to clearing members in association with the clearing banks to meet their working capital requirements. Any clearing bank interested in utilizing this facility has to enter into an agreement with NSCCL and with the clearing member. The bank is also required to open clearing accounts with depositories. Clearing member interested in availing the facility would approach its bank to meet its funding requirements for a particular settlement. The bank in consultation with NSCCL would extend the funding to meet its funds pay-in obligation for that settlement against the securities payout of the member for the same settlement. Funding amount is determined after applying appropriate haircut to the values of its securities payout. The securities payout to the extent determined for funding is given to the bank.

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Direct Payout to I nvestors According to the SEBI directives NSCCL has introduced the facility of direct payout to clients’ account on both the depositories. It ascertains from each clearing member, the beneficiary account details of their respective clients who are due to receive payout of securities. NSCCL has provided its members with a front-end for creating the file through which the information is provided to NSCCL. Based on the information received from members, the Clearing Corporation sends payout instructions to the depositories, so that the client receives the payout of securities directly to their accounts on the payout day. The client receives payout to the extent of instructions received from the respective clearing members. To the extent of instruction not received, the securities are credited to the CM pool account of the member. Reference Rates—FI MMDA-NSE MI BI D MI BOR A reference rate is an accurate measure of the market price. In the fixedincome market, it is an interest rate that the market respects and closely watches. It plays a useful role in a variety of situations. In particular, a call money reference rate can find the following applications: 1. Traders can make many decisions as offsets compared with the prevailing reference rate. 2. Derivatives require a clearly defined reference rate as a foundation, of which the pay-off from the derivative is defined. 3. A variety of contracts can be structured as offsets from the future levels of a reference rate. The simplest example may be a floating rate bond that uses an interest rate, which is a given ‘n’ offsets above a given reference rate. Apart from its accuracy, such a reference rate needs to have other qualities. The methodology of collation and computation should be scientific, should eliminate noise, and resist manipulation. It should form an unbiased source, be representative of the market, transparent, reliable and continuously available. Moreover, it should find applicability across a wide range of products. A reference rate, which embodies all these qualities, would be widely acceptable to the market as the benchmark rate. NSE Z ero-coupon Yield Curve ( Z CYC) With NSE’s strong focus on debt market segment and the long felt need to create standardized market practices, NSE has embarked upon developing products that will be used by the market participants to address themselves to issues relating to this market segment.

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In its continuing effort to innovate, the Exchange has developed a ‘Zero-coupon Yield Curve’ (ZCYC) that will help in valuation of sovereign securities across all maturities irrespective of its liquidity. It aims at creating uniform valuation standards in the market. The product has been developed keeping in mind the requirements of the banking industry, financial institutions, mutual funds, insurance companies, etc that have substantial investment in sovereign papers. NSE ZCYC aims at improving the Asset Liability Management of institutions with realistic valuations of portfolio of sovereign papers. It has been developed keeping in mind the emergence of a scientific forward curve for the market that will be useful in developing derivative products and STRIPS in the emerging scenario. NSE VaR for Government Securities ‘Value-at-Risk (VaR)’ has been widely promoted by regulatory authorities as a way of monitoring and managing market risk and as a basis for setting regulatory minimum capital standards. The revised Basle Accord, implemented in January 1998, makes it mandatory for banks to use VaR as a basis for determining the amount of regulatory capital, adequate for covering market risk beyond that required for credit risk. Within the realm of the fixed-income portfolios of financial sector players, market related risk has become more relevant and important on account of their trading activities and market positions. For players in the Indian financial sector, the need to develop risk measurement models would prove critical, as regulation progressively moves from uniform prudential standards to entity-specific risk coverage requirements. Specifically, the guidelines call for linking of each entity’s market risk capital charge to the riskiness of its assets as measured by the chosen VaR model. Accuracy of measurement would prove critical as regulation would not specify ‘a’ single model for measurement of risk; the choice of model would be left to market participants who would also be required to furnish details of back-testing for the chosen VaR model. While a conservative estimate of risk would lead to very large capital holdings, a liberal estimate would result in inadequate coverage of loss and excessive number of model failures historically, which would in turn attract penalties from the regulator. It would therefore be in the interest of market participants to develop models that accurately measure the riskiness of their portfolios and furnish estimates of capital charge that would provide adequate cover. An important consideration in this context is that setting up of risk measurement systems by each individual participant for estimating portfolio risk under alternative models and scenarios would involve significant costs.

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In line with its endeavor to develop market infrastructure, NSE has taken initiative in developing a VaR system for measuring the market risk inherent in Government of India (GoI) securities. The NSE-VaR system builds on the NSE database of daily yield curves—the NSEZCYC is now well accepted in terms of its conceptual soundness and empirical performance, and is increasingly being used by market participants as a basis for valuation of fixed-income instruments. The NSEVaR system provides measures of VaR using 5 alternative methods—variancecovariance (normal) and historical simulation methods, together with weighted normal, weighted historical simulation and the recently developed extreme value method. Constituent SGL Account SGL stands for ‘Subsidiary General Ledger’ account. It is a facility provided by RBI to large banks and financial institutions to hold their investments in Government securities and Treasury bills in the electronic book-entry form. Such institutions can settle their trades for securities held in SGL through a ‘Delivery-versus-Payments’ (DVP) mechanism, which ensures movement of funds and securities simultaneously. As all investors in Government securities do not have an access to the SGL accounting system, RBI has permitted such investors to hold their securities in physical stock certificate form. They may also open a Constituent SGL account with any entity authorized by RBI for this purpose, and thus avail of the DVP settlement. Such client accounts are referred to as Constituent SGL accounts. Due to the wholesale nature of the market, retail investors usually lose their competitive strength due to their physical holdings. Further, absence of a common settlement agency makes it difficult for the retail investors to settle these transactions on a bilateral basis. To redress the problems faced by retail participants in the market, NSCCL offers Constituent SGL facility to such participants. RBI has allowed NSCCL to open SGL and current accounts for this purpose. RBI has also permitted PFs/Trusts to open their accounts with NSCCL in the year 1998. Book-building at NSE The NSE has set up nation-wide network for trading whereby members can trade remotely from their offices located all over the country. The NSE trading network spans around 400 cities and towns across India. NSE offers this infrastructure for conducting on-line IPOs through the Bookbuilding process. NSE operates a fully automated screen-based bidding system called NEAT IPO that enables trading members to enter bids directly

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from their offices through a sophisticated telecommunication network.Bookbuilding through the NSE system offers several advantages: • Nationwide bidding facility in securities • Fair, efficient and transparent method for collecting bids using latest electronic trading systems • Costs involved in the issue are far less than those in a normal IPO REVI EW QUESTI ONS

Section A 1. 2. 3. 4. 5.

How many stock exchanges are there in India? Name them. When was the Bombay Stock Exchange (BSE) set up? How is BSE managed? What are ‘circuit filters’? What do you know of the ‘OLRT surveillance system adopted by the BSE in order to ensure the safety of securities trading? 6. When was the National Stock Exchange (NSE) established? 7. Who are the promoters of the NSE? 8. State the products offered by the NSE. 9. What do you know of the ‘Mutual Fund Service System’ (MFSS) of the NSE? 10. What are exchange-traded funds? 11. What is a ‘reference rate’? State its applications. Section B 1. 2.

Explain the concept of ‘BOLT’ as practiced at the BSE What are the opportunities offered by the BSE for foreign investors? 3. How are scrips grouped in the BSE? 4. What are ‘permitted securities’? 5. Illustrate the working of the ‘rolling settlement system’ followed by the BSE. 6. Explain the working of the settlement of trades in the BSE. 7. Explain the working of the ‘self-auction’ at the BSE. 8. Write a note on the ‘derivatives trading’ happening at the BSE. 9. State the objectives for which NSE was set up? 10. Explain the trading mechanism adopted by the NSE. 11. How does the ‘electronic trade monitoring system’ of the NSE work? 12. How does the NSE work for the ‘internet trading’?

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13. Explain the ‘direct payout facility’ extended by the NSE to its clients 14. Write notes on: a. NSE’s ZCYC b. NSC’s VaR Section C 1. 2. 3. 4. 5. 6.

Detail the various requirements to be followed by companies who want to list themselves in the BSE. Discuss the measures adopted by the BSE to ensure safe trading of securities . What are the guidelines prescribed by the BSE for the foreign brokers? Explain the mechanism of book building adopted at the BSE. Discuss the working of the Calcutta Stock Exchange. Critically examine the working of the NSE.

Chapter

11

Primary Market NIM also known as ‘primary market’ is a market, which is characterized by the presence of a set of all institutions, structures, people, procedures, services, and practices involved in raising of fresh capital funds by both new and existing companies. NIM AND SECONDARY MARKETS—AN INTERFACE

Both the primary and secondary markets are closely interrelated. This is clear from the following: Trading For the purpose of securities to be traded in the secondary market, it is important that they are first issued in the primary market. Listing In order that a corporate entity makes a successful issue of security in the primary market, it is incumbent that the terms of such an issue carry a stipulation that the issues are to be listed in a recognized stock exchange and that an application for this purpose has been made already to the stock exchange concerned. Regulation The activities in the primary market such as the new issues, etc are greatly influenced by the regulatory norms prescribed by the SEBI and stock exchanges. The object is to bring about orderliness in the new issues market. Marketability The advantage of marketability provided by the secondary market greatly helps the subscribers in the primary market. For instance, the positive trends prevailing in the secondary market immensely help the investors to off-load their existing holdings so as to subscribe for fresh issues in the NIM. This liquidity advantage helps in expansion of the NIM.

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Prevailing Conditions The conditions prevailing in the secondary market affect to a very great extent the successfulness or otherwise of the issue being made in the NIM. Accordingly, where the conditions are so favorable in the secondary market that high market prices prevail, the issues made in the primary market will turn out to be encouraging and successful. Issues would fetch good premiums. Survival The existence and the survival of the secondary market are dependent upon the efficacy of the NIM as an avenue for fund raising. There could be no stock exchanges if there is no NIM, in the same manner that there will be no NIM in the absence of an efficiently functioning stock exchange. An efficient secondary market is therefore, a sine-qua-non for a growing primary market. SERVICES OF NIM

A brief description of the various services rendered by the new issues market is made below: The Transfer An important function rendered by NIM is to allow the transfer of resources from savers to entrepreneurs who establish new companies. It is also called the function of ‘origination’. The transfer function is facilitated by specialist agencies that are engaged in the provision of investigative and advisory services as specified below: Investigative services The merchant bankers and other agencies provide the investigative services. These include technical analysis, economic analysis, financial analysis and analysis of legal and environmental aspects of the proposed business. Merchant bankers provide the above information to investors so as to enable the investors in making a choice as to the type, quality and quantity of the issue.

Advisory services Various advisory services are made available with a view to improving the quality of capital issues. The relevant services include determining the type, the mix, the price, the timing, the size, the selling strategies, the methods of floatation, and the terms and conditions of issue of securities.

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The Guarantee It is the function of ‘underwriting’. Underwriting aims at guaranteeing the subscription of public issue. Underwriters ensure successful subscription of the issue by undertaking to take up the securities in the event of the public failing to subscribe the same. It benefits the issuing company, the investing public and capital market in general. The function of underwriting is undertaken for a fee. The Distribution The function that facilitates the sale of securities to ultimate investors is called ‘distribution’. The function of distribution is rendered by the specialized agencies like brokers and dealers in securities. They maintain a constant and a close link with the issuers and the ultimate investors on the one hand, and issuers and other agencies of capital market on the other. NIM Vs. SECONDARY MARKET

NIM is different from the secondary market in the following respects: Sl. No.

Feature

NIM

Secondary Market

1.

Issues of securities

NIM deals only with new or fresh issue of securities. Issues are considered fresh or new provided such issues are made for the first time either by the existing company or by the new company

Deals in existing securities

2.

Location

No fixed geographical location needed

Needs a fixed place to house the secondary market activities, viz. trading

3.

Transfer of securities

4.

Entry

Securities are created and transferred from corporates to investors for the first time All companies can enter NIM and make fresh issue of securities

Securities are transferred from one investor to another through the stock exchange mechanism For the securities to enter the portals of stock exchanges for the purpose of trading, listing is mandatory

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Sl. No.

Feature

NIM

Secondary Market

5.

Administration

Has no tangible form of administrative set-up

6.

Regulation

7.

Aim

8.

Price Movement

9.

Depth

Subject to regulations mostly from outside the company—SEBI, Stock Exchanges, Companies Act, etc Creating long-term instruments for borrowings Stock price movement in secondary market influences pricing of new issues Depends on number and the volume of issue

Has a definite administrative set-up that facilitates trading in securities Subject to regulation both from within and outside the stock exchange framework Providing liquidity through marketability of those instruments. Both macro and micro factors influence the stock price movement

Depth depends upon the activities of the primary market as it brings into the fore more corporate entities and more instruments to raise funds

REVIEW QUESTIONS

Section A 1.

What is a primary market?

Section B 1. 2. 3.

Bring out the interface between the primary market and the secondary market. What are the various services offered by the NIM (New Issues Market)? How is NIM different from secondary market?

Chapter

12

Methods of New Issue METHODS OF MARKETING SECURITIES#

Following are the various methods being adopted by corporate entities for marketing the securities in the New Issues Market: Pure Prospectus Method

Meaning The method whereby a corporate enterprise mops up capital funds from the general public by means of an issue of a prospectus, is called ‘Pure Prospectus Method’. It is the most popular method of making public issue of securities by corporate enterprises. Features 1. Exclusive subscription Under this method, the new issues of a company are offered for exclusive subscription of the general public. According to the SEBI norms, a minimum of 49 percent of the total issue at a time is to be offered to public. 2. Issue price Direct offer is made by the issuing company to the general public to subscribe to the securities at a stated price. The securities may be issued either at par, of at a discount or at a premium. 3. Underwriting Public issue through the ‘pure prospectus method’ is usually underwritten. This is to safeguard the interest of the issuer in the event of an unsatisfactory response from the public. 4. Prospectus A document that contains information relating to the various aspects of the issuing company, besides other details of the issue is called a ‘Prospectus’. The document is circulated to the public. The general details include the company’s name and address of its registered office, the names and addresses of the company’s promoters, manager, managing director, directors, company secretary, legal adviser, auditors, bankers, brokers, etc the date of opening and closing of subscription list, contents of Articles, the names and addresses of #

Information sourced from the official website of SEBI, http://www.sebi.gov.in/

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underwriters, the amount underwritten and the underwriting commission, material details regarding the project, i.e. location, plant and machinery, technology, collaboration, performance guarantee, infrastructure facilities, etc nature of products, marketing set-up, export potentials and obligations, past performance and future prospects, management’s perception regarding risk factor, credit rating obtained from any other recognized rating agency, a statement regarding the fact that the company will make an application to specified stock exchange(s) for listing its securities and so on.

Advantages The pure prospectus method offers the following advantages to the issuer and the investors alike: Benefits to investors The pure prospectus method of marketing the securities serves as an excellent mode of disclosure of all the information pertaining to the issue. Besides, it also facilitates satisfactory compliance with the legal requirements of transparency, etc. It also allows for good publicity for the issue. The method promotes confidence of investors through transparency and non discriminatory basis of allotment. It prevents artificial jacking up of prices as the issue is made public. Benefits to issuers The pure prospectus method is the most popular method among the large issuers. In addition, it provides for wide diffusion of ownership of securities contributing to reduction in the concentration of economic and social power.

Drawbacks The raising of capital through the pure prospectus method is fraught with a number of drawbacks as specified below: High issue costs A major drawback of this method is that it is an expensive mode of raising funds from the capital market. Costs of various hues are incurred in mobilizing capital. Such costs as underwriting expenses, brokerage, administrative costs, publicity costs, legal costs and other costs are incurred for raising funds. Due to the high cost structure, this type of marketing of securities is followed only for large issues. Time consuming The issue of securities through prospectus takes more time, as it requires the due compliance with various formalities before an issue could take place. For instance, a lot of work such as underwriting, etc should be formalized before the printing and the issue of a prospectus. Offer for Sale Method

Meaning Where the marketing of securities takes place through intermediaries, such as issue houses, stockbrokers and others, it is a case of ‘Offer for Sale Method’.

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Features Under this method, the sale of securities takes place in two stages. Accordingly, in the first stage, the issuer company makes an enblock sale of securities to intermediaries such as the issue houses and share brokers at an agreed price. Under the second stage, the securities are re-sold to ultimate investors at a market-related price. The difference between the purchase price and the issue price constitutes ‘profit’ for the intermediaries. The intermediaries are responsible for meeting various expenses such as underwriting commission, prospectus cost, advertisement expenses, etc. The issue is also underwritten to ensure total subscription of the issue. The biggest advantage of this method is that it saves the issuing company the hassles involved in selling the shares to the public directly through prospectus. This method is, however, expensive for the investor as it involves the offer of securities by issue houses at very high prices. Private Placement Method

Meaning A method of marketing of securities whereby the issuer makes the offer of sale to individuals and institutions privately without the issue of a prospectus is known as ‘Private Placement Method’. This is the most popular method gaining momentum in recent times among the corporate enterprises. Features Under this method, securities are offered directly to large buyers with the help of share brokers. This method works in a manner similar to the ‘Offer for Sale Method’ whereby securities are first sold to intermediaries such as issues houses, etc. They are in turn placed at higher prices to individuals and institutions. Institutional investors play a significant role in the realm of private placing. The expenses relating to placement are borne by such investors. Advantages Private placement of securities offers the following advantages: 1. Less expensive as various types of costs associated with the issue are borne by the issue houses and other intermediaries 2. Less troublesome for the issuer as there is not much of stock exchange requirements concerning contents of prospectus and its publicity, etc to be complied with 3. Placement of securities suits the requirements of small companies 4. The method is also resorted to when the stock market is dull and the public response to the issue is doubtful

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Disadvantages The major weaknesses of the private placement of securities are as follows: 1. 2. 3.

Concentration of securities in a few hands Creating artificial scarcity for the securities thus jacking up the prices temporarily and misleading general public Depriving the common investors of an opportunity to subscribe to the issue, thus affecting their confidence levels

Initial Public Offer (IPO) Method The public issue made by a corporate entity for the first time in its life is called ‘Initial Public Offer’ (IPO). Under this method of marketing, securities are issued to successful applicants on the basis of the orders placed by them, through their brokers. When a company whose stock is not publicly traded wants to offer that stock to the general public, it takes the form of ‘Initial Public Offer’. The job of selling the stock is entrusted to a popular intermediary, the underwriter. An underwriter is invariably an investment banking company. He agrees to pay the issuer a certain price for a minimum number of shares, and then resells those shares to buyers, who are often the clients of the underwriting firm. The underwriters charge a fee for their services. Stocks are issued to the underwriter after the issue of prospectus which provides details of financial and business information as regards the issuer. Stocks are then released to the underwriter and the underwriter releases the stock to the public. The issuer and the underwriting syndicate jointly determine the price of a new issue. The approximate price listed in the red herring (the preliminary prospectus—often with words in red letters which say this is preliminary and the price is not yet set) may or may not be close to the final issue price. IPO stock at the release price is usually not available to most of the public. Good relationship between the broker and the investor is a pre requisite for the stock being acquired. Full disclosure of all material information in connection with the offering of new securities must be made as part of the new offerings. A statement and preliminary prospectus (also known as a red herring) containing the following information is to be filed with the Registrar of Companies: 1. A description of the issuer’s business 2. The names and addresses of the key company officers, with salary and a 5 year business history on each

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257

The amount of ownership of the key officers The company’s capitalization and description of how the proceeds from the offering will be used and Any legal proceedings that the company is involved in

Applications are made by the investors on the advice of their brokers who are intimated of the share allocation by the issuer. The amount becomes payable to the issuer through the broker only on final allocation. The allotment is credited and share certificates delivered to the depository account of the successful investor. The essential steps involved in this method of marketing of securities are as follows: 1. Order Broker receives order from the client and places orders on behalf of the client with the issuer. 2. Share allocation The issuer finalizes share allocation and informs the broker regarding the same. 3. The client The broker advises the successful clients of the share allocation. Clients then submit the application forms for shares and make payment to the issuer through the broker. 4. Primary issue account The issuer opens a separate escrow account (primary issue account) for the primary market issue. The clearing house of the exchange debits the primary issue account of the broker and credits the issuer’s account. 5. Certificates Certificates are then delivered to investors. Otherwise depository account may be credited. The biggest advantage of this method of marketing of securities is that there is no need for the investors to part with the money even before the shares are allotted in his favor. Further, the method allows for elimination of unnecessary hassles involved in making a public issue. Under the regulations of the SEBI, IPOs can be carried out through the secondary market and the existing infrastructure of stock exchanges can be used for this purpose. Rights Issue Method Where the shares of an existing company are offered to its existing shareholders, it takes the form of ‘rights issue’. Under this method, the existing company issues shares to its existing shareholders in proportion to the number of shares already held by them.

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The relevant guidelines issued by the SEBI in this regard are as follows: 1. Shall be issued only by listed companies 2. Announcement regarding rights issue once made, shall not be withdrawn and where withdrawn, no security shall be eligible for listing upto 12 months 3. Underwriting as to rights issue is optional and appointment of Registrar is compulsory 4. Appointment of category I Merchant Bankers holding a certificate of registration issued by SEBI shall be compulsory 5. Rights shares shall be issued only in respect of fully paid shares 6. Letter of Offer shall contain disclosures as per SEBI requirements 7. Agreement shall be entered into with the depository for materialization of securities to be issued 8. Issue shall be kept open for a minimum period of 30 days and for a maximum period of 60 days 9. A minimum subscription of 90 percent of the issue shall be received 10. No reservation is allowed for rights issue as regards FCDs and PCDs 11. A ‘No Complaints Certificate’ is to be filed by the ‘Lead Merchant Banker’ with the SEBI after 21 days from the date of issue of offer document 12. Obligatory for a company where increase in subscribed capital is necessary after two years of its formation or after one year of its first issue of shares, whichever is earlier (this requirement may be dispensed with by a special resolution)

Advantages

Rights issue offers the following advantages:

Economy Rights issue constitutes the most economical method of raising fresh capital, as it involves no underwriting and brokerage costs. Further, the expenses by way of advertisement and administration, etc are less. Easy The issue management procedures connected with the rights issue are easier as only a limited number of applications are to be handled. Advantage shareholders Issue of rights shares does not involve any dilution of ownership of existing shareholders. Further, it offers freedom to shareholders to subscribe or not to subscribe the issue.

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Drawbacks

259

The method suffers from the following limitations:

Restrictive The facility of rights issue is available only to existing companies and not to new companies. Against society The issue of rights shares runs counter to the overall societal considerations of diffusion of share ownership for promoting dispersal of wealth and economic power. Bonus Issues Method Where the accumulated reserves and surplus of profits of a company are converted into paid up capital, it takes the form of issue of ‘bonus shares’. It merely implies capitalization of existing reserves and surplus of a company. The issue of bonus shares is subject to certain rules and regulations. The issue does not in any way affect the resources base of the enterprise. It saves the company enormously of the hassles of capital issue. Issued under Section 205 (3) of the Companies Act, such shares are governed by the guidelines issued by the SEBI (applicable to listed companies only) as follows: SEBI Guidelines Following are the guidelines pertaining to the issue of bonus shares by a listed corporate enterprise: 1. Reservation In respect of FCDs and PCDs, bonus shares must be reserved in proportion to such convertible part of FCDs and PCDs. The shares so reserved may be issued at the time of conversion(s) of such debentures on the same terms on which the bonus issues were made. 2. Reserves The bonus issue shall be made out of free reserves built out of the genuine profits or share premium collected in cash only. Reserves created by revaluation of fixed assets are not capitalized. 3. Dividend mode The declaration of bonus issue, in lieu of dividend, is not made. 4. Fully paid The bonus issue is not made unless the partly paid shares, if any are made fully paid-up. 5. No default The company has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof and has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity, bonus, etc.

260 Capi tal Markets

6. Implementation A company that announces its bonus issue after the approval of the Board of Directors must implement the proposal within a period of 6 months from the date of such approval and shall not have the option of changing the decision. 7. The articles The Articles of Association of the company shall contain a provision for capitalization of reserves, etc. If there is no such provision in the Articles, the company shall pass a resolution at its general body meeting making provisions in the Articles of Associations for capitalization. 8. Resolution Consequent to the issue of bonus shares if the subscribed and paid-up capital exceeds the authorized share capital, the company at its general body meeting for increasing the authorized capital shall pass a resolution. Rights Issue Vs. Bonus Issue Bonus issue is different from rights issue in the following respects: Sl. No.

Feature

Rights Issue

Bonus Issue

1.

Payment

The issue is to be paid for

The issue is free

2.

Privilege

Confers a privilege on the existing members

Not a privilege issue

3.

Paid-up shares

Shares may be partly paid-up also

Shares are necessarily to be fully-paid

4.

Minimum Subscription

Minimum subscription is required

Minimum subscription is not required

5.

Separate Account

Money is to be kept in a separate bank account

No such requirement

6.

Right to Renounce

Rights issue may be renounced by a member in favour of a nominee

No such facility is available

7.

Regulation

Regulated by the provisions of the Companies Act and SEBI guidelines

Regulated by the provisions of the company’s Articles and SEBI guidelines

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261

Book-building Method A method of marketing the shares of a company whereby the quantum and the price of the securities to be issued will be decided on the basis of the ‘bids’ received from the prospective shareholders by the lead merchant bankers is known as ‘book-building method’. Under the book-building method, share prices are determined on the basis of real demand for the shares at various price levels in the market. For discovering the price at which issue should be made, bids are invited from prospective investors from which the demand at various price levels is noted. The merchant bankers undertake full responsibility for the issue. The option of book-building is available to all body corporates, which are otherwise eligible to make an issue of capital to the public. The initial minimum size of issue through book-building route was fixed at Rs. 100 crores. However, beginning from December 9, 1996 issues of any size will be allowed through the book-building route. Book-building facility is available as an alternative to firm allotment. Accordingly, a company can opt for book-building route for the sale of shares to the extent of the percentage of the issue that can be reserved for firm allotment as per the prevailing SEBI guidelines. It is therefore possible either to reserve securities for firm allotment or issue them through the book-building process. The book-building process involves the following steps: 1. Appointment of book-runners The first step in the bookbuilding process is the appointment by the issuer company, of the bookrunner, chosen from one of the lead merchant bankers. The book-runner in turn forms a syndicate for the book building. A syndicate member should be a member of National Stock Exchange (NSE) or Over-The-Counter Exchange of India (OTCEI). Offers of ‘bids’ are to be made by investors to the syndicate members, who register the demands of investors. The bid indicates the number of shares demanded and the prices offered. This information, which is stored in the computer, is accessible to the company management or to the book-runner. The name of the book-runner is to be mentioned in the draft prospectus submitted to SEBI. 2. Draftin g prospec tus The draft prospectus containing all the information except the information regarding the price at which the securities are offered is to be filed with SEBI as per the prevailing SEBI guidelines. The offer of securities through this process must separately be disclosed in the prospectus, under the caption ‘placement portion category’. Similarly, the extent of shares offered to the pubic shall be

262 Capi tal Markets

separately shown under the caption ‘net offer to the public’. According to the latest SEBI guidelines issued in October 1999, the earlier stipulation that at least 25 percent of the securities were to be issued to the public has been done away with. This is aimed at enabling companies to offer the entire public issue through the book-building route. 3. Ci rc ul atin g d r aft pros pec t us A copy of the draft prospectus filed with SEBI is to be circulated by the book-runner to the prospective institutional buyers who are eligible for firm allotment and also to the intermediaries who are eligible to act as underwriters. The objective is to invite offers for subscribing to the securities. The draft prospectus to be circulated must indicate the price-band within which the securities are being offered for subscription. 4. Main tain in g offer record s The book-runner maintains a record of the offers received. Details such as the name and the number of securities ordered together with the price at which each institutional buyer or underwriter is willing to subscribe to securities under the placement portion must find place in the record. SEBI has the right to inspect such records. 5. In tima tion abo ut ag greg ate ord e rs The underwriters and the institutional investors shall give intimation on the aggregate of the offers received to the book-runner. 6. Bid analysis The bid analysis is carried out by the bookrunner immediately after the closure of the bid offer date. An appropriate final price is arrived at after a careful evaluation of demands at various prices and the quantity. The final price is generally fixed reasonably lower than the possible offer price. This way, the success of the issue is ensured. The issuer company announces the pay-in-date at the expiry of which shares are allotted. 7. Man d at ory un d erwr itin g Where it has been decided to make offer of shares to public under the category of ‘Net Offer to the Public’, it is incumbent that the entire portion offered to the public is fully underwritten. In case an issue is made through book-building route, it is mandatory that the portion of the issue offered to the public be underwritten. For this purpose, an agreement has to be entered into with the underwriter by the issuer. The agreement shall specify the number of securities as well as the price at which the underwriter would subscribe to the securities. The book-runner may require the underwriter of the net offer to the public to pay in advance all moneys required to be paid in respect of their underwriting commitment.

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8. Filing with ROC A copy of the prospectus as certified by the SEBI shall be filed with the Registrar of Companies within two days of the receipt of the acknowledgement card from the SEBI. 9. Bank accounts The issuer company has to open two separate accounts for collection of application money, one for the private placement portion and the other for the public subscription. 10. Collection of completed applications The book-runner collects from the institutional buyers and the underwriters the application forms alongwith the application money to the extent of the securities proposed to be allotted to them or subscribed by them. This is to be done one day before the opening of the issue to the public. 11. Allotment of securities Allotment for the private placement portion may be made on the second day from the closure of the issue. The issuer company, however, has the option to choose one date for both the placement portion and the public portion. The said date shall be considered to be the date of allotment for the issue of securities through the bookbuilding process. The issuer company is permitted to pay interest on the application moneys till the date of allotment or the deemed date of allotment provided that payment of interest is uniformly given to all the applicants. 12. Payment schedule and listing The book-runner may require the underwriters to the ‘net offer to the public’ to pay in advance all moneys required to be paid in respect of their underwriting commitment by the eleventh day of the closure of the issue. In that case, the shares allotted as per the private placement category will become eligible for being listed. Allotment of securities under the public category is to be made as per the prevailing statutory requirements. 13. Under-subscription In the case of under-subscription in the ‘net offer to the public’ category, any spillover to the extent of undersubscription is to be permitted from the ‘placement portion’ category subject to the condition that preference is given to the individual investors. In the case of under-subscription in the placement portion, spillover is to be permitted from the net offer to the public to the placement portion. Advantages of Book-building Book-building process is of immense use in the following ways: 1. Reduction in the duration between allotment and listing 2. Reliable allotment procedure 3. Quick listing in stock exchanges possible 4. No price manipulation as the price is determined on the basis of the bids received

264 Capi tal Markets

STOCK OPTION OR EMPLOYEES STOCK OPTION SCHEME (ESOP)

A method of marketing the securities of a company whereby its employees are encouraged to take up shares and subscribe to it is known as ‘stock option’. It is a voluntary scheme on the part of the company to encourage employees’ participation in the company. The scheme also offers an incentive to the employees to stay in the company. The scheme is particularly useful in the case of companies whose business activity is dominantly based on the talent of the employees, as in the case of software industry. The scheme helps retain their most productive employees in an industry, which is known for its constant churning of personnel. SEBI Guidelines Company whose securities are listed on any stock exchange can introduce the scheme of employees’ stock option. The offer can be made subject to the conditions specified below: 1. Issue at discount Issue of stock options at a discount to the market price would be regarded as another form of employee compensation and would be treated as such in the financial statements of the company regardless the quantum of discount on the exercise price of the options. 2. Approval The issue of ESOPs is subject to the approval by the shareholders through a special resolution. 3. Maximum limit There would be no restriction on the maximum number of shares to be issued to a single employee. However, in cases of employees being offered more than 1 percent shares, a specific disclosure and approval would be necessary in the AGM. 4. Minimum period A minimum period of one year between grant of options and its vesting has been prescribed. After one year, the company would determine the period during which the option can be excercised. 5. Superintendence The operation of the ESOP Scheme would have to be under the superintendence and direction of a Compensation Committee of the Board of Directors in which there would be a majority of independent directors. 6. Eligibility ESOP scheme is open to all permanent employees and to the directors of the company but not to promoters and large shareholders. The scheme would be applicable to the employees of the subsidiary or a holding company with the express approval of the shareholders. 7. Director’s report the following:

The Director’s report shall make a disclosure of

Methods of New Issue

265

a. b. c.

Total number of shares as approved by the shareholders The pricing formula adopted Details as to options granted, options vested, options exercised and options forfeited, extinguishments or modification of options, money realized by exercise of options, total number of options in force, employee-wise details of options granted to senior managerial personnel and to any other employee who receive a grant in any one year of options amounting to 5 percent or more of options granted during that year d. Fully diluted EPS computed in accordance with the IAS 8. IPO SEBI’s stipulations prohibiting initial public offerings by companies having outstanding options should not apply to ESOP. If any ESOPs are outstanding at the time of an IPO issue by an unlisted company, the promoters’ contribution shall be calculated with reference to the enlarged capital that would arise if all vested options were exercised. Stock Option Norms for Software Companies The relevant guidelines issued by the SEBI as regards ‘employees stock option’ for software companies are as follows: 1. Minimum issue A minimum issue of 10 percent of its paid-up capital can be made by a software company which has already floated American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) or a company which is proposing to float these is entitled to issue ADR/GDRlinked stock options to its employees. For this purpose, prior permission from the Department of Economic Affairs is to be obtained. 2. Mode of issue Listed stock options can be issued in foreign currency convertible bonds and ordinary shares (through depository receipt mechanism) to the employees of subsidiaries of infotech companies. 3. Permanent employees Indian IT companies can issue ADR/GDR linked stock options to permanent employees, including Indian and overseas directors, of their subsidiary companies incorporated in India or outside. 4. Pricing The pricing provisions of SEBI’s preferential allotment guidelines would not cover the scheme. The purpose is to enable the companies to issue stock options to its employees at a discount to the market price which serves as another form of compensation. 5. Approval Shareholders’ approval through a special resolution is necessary for issuing the ESOPs. A minimum period of one year between grant of option and its vesting has been prescribed. After one year, the company would determine the period in which option can be exercised.

266 Capi tal Markets

Bought-out Deals Meaning A method of marketing of securities of a body corporate whereby the promoters of an unlisted company make an outright sale of a chunk of equity shares to a single sponsor or the lead sponsor is known as ‘boughtout deals’. Features 1. Parties There are three parties involved in the bought-out deals. They are promoters of the company, sponsors and co-sponsors who are generally merchant bankers and investors. 2. Outright sale Under this arrangement, there is an outright sale of a chunk of equity shares to a single sponsor or the lead sponsor. 3. Syndicate Sponsor forms a syndicate with other merchant bankers for meeting the resource requirements and for distributing the risk. 4. Sale price The sale price is finalized through negotiations between the issuing company and the purchaser, the sale being influenced by such factors as project evaluation, promoters image and reputation, current market sentiments, prospects of off-loading these shares at a future date, etc. 5. Fund-based Bought-out deals are in the nature of fund-based activity where the funds of the merchant bankers get locked in for at least the prescribed minimum period. 6. Listing The investor-sponsors make a profit, when at a future date, the shares get listed and higher prices prevail. Listing generally takes place at a time when the company is performing well in terms of higher profits and larger cash generations from projects. 7. OTCEI Sale of these shares at Over-the-Counter Exchange of India (OTCEI) or at a recognized stock exchanges, the time of listing these securities and off-loading them simultaneously are being generally decided in advance. BOUGHT-OUT DEALS VS. PRIVATE PLACEMENTS

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267

Following are the differences between bought-out deals and private placements: Sl. No.

Feature

Private Placement

Bought-out Deal

1.

Trading Scrips

Listed securities

Unlisted securities

2.

Creating Securities

Results in the creation of additional securities for the buying institutions

Securities are simply transferred from promoters to sponsors who in turn off-load them to the public

3.

Lock-in Period

Five Years

18 months

Benefits Bought-out deals provide the following benefits: Speedy sale Bought-out deals offer a mechanism for a speedier sale of securities at lower costs relating to the issue. Freedom Bought-out deals offer freedom for promoters to set a realistic price and convince the sponsor about the same. Investor protection Bought-out deals facilitate better investor protection as sponsors are rigorously evaluated and appraised by the promoters before off-loading the issue. Quality offer Bought-out deals help enhance the quality of capital floatation and primary market offerings. Limitations Bought-out deals pose the following difficulties for the promoters, sponsors and investors: 1. Loss of control The apprehensions in the minds of promoters, particularly of the private or the closely held companies that the sponsors may usurp control of the company as they own large chunk of the shares of the company. 2. Loss of sales Bought-out deals pose considerable difficulties in off-loading the shares in times of unfavorable market conditions. This results in locking up of investments and entailing losses to sponsors. 3. Wrong appraisal Bought-out deals cause loss to sponsors on account of wrong appraisal of the project and overestimation of the potential price of the share. 4. Manipulation Bought-out deals give great scope for manipulation

268 Capi tal Markets

at the hands of the sponsor through insider trading and rigging. 5. No accountability Bought-out deals pose difficulty of penalizing the sponsor as there are no SEBI guidelines to regulate offerings by sponsors. 6. Windfall profits Bought-out deals offer the advantage of windfall profits by sponsors at the cost of small investors. 7. Loss to investors Where the shares taken up by issue brokers and a coterie of select clients are being bought back by the promoters at a pre-fixed higher price after allotment causing loss to investors of the company. The different methods used for marketing securities in a new issues market is shown in Exhibit 5. Exhibit 5

NIM— Methods of Marketi ng Securi ti es

OTCEI Guidelines The OTCEI allows for the off-loading of the shares acquired by sponsors in bought-out deals. The following conditions have been prescribed in this regard: 1. Minimum post-issue holding of promoters shall be 25 percent with a

Methods of New Issue

2.

3. 4.

5.

6.

269

lock-in period of five years Sponsor to act as a market-maker for 18 months who has to identify an additional market maker for such compulsory market-making. The two market-markers should, between them, hold upto 5 percent of the equity offered to the public Sponsors to offer two-way quotes based on minimum and maximum trading prices Freedom to members and dealers to decide the ratio of holdings between the members, and dealers and the non-members/non-dealers in a bought-out deal where the members and dealers participate in the bought-out deal by taking up a minimum 10 percent of the total value of securities for which the deal is done Initial offer of the bought-out deals should be made on the OTCEI members and dealers and where the participation from them is not forthcoming, only then it may be offered to nonmembers/non-dealers Offer of a minimum 25 percent of the post-issue paid-up capital of the company to the public. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8.

What is a prospectus? What do you mean by ‘pure prospectus method’ of marketing of securities? What is ‘offer for sale method’ of marketing of securities? What is an IPO? What is a rights issue? What is a bonus issue? What is ‘ESOP’? How is a bought-out deal different from a private placement?

Section B 1. 2. 3. 4. 5.

Mention the features of ‘pure prospectus method’ of marketing of securities. Specify the advantages and drawbacks of ‘pure prospectus method’ of marketing of securities? What are the features of ‘private placement’ as a method of marketing of securities? Bring out the essential steps involved in an IPO. Mention the SEBI guidelines pertaining to making of rights issue.

270 Capi tal Markets

6. 7. 8. 9. 10. 11. 12. 13.

How is rights-issue beneficial? What are the SEBI guidelines pertaining to making of bonus issue? How is a rights-issue different from a bonus issue? How is book building method of marketing of securities beneficial? State the SEBI guidelines regarding the ESOP. What are ‘bought-out deals’? What are its features? State the limitations of private placement of securities. What are the OTCEI guidelines as regards the bought-out deals?

Section C 1. 2.

Discuss the different methods of marketing of securities. Explain the process of book building as an efficient method of marketing of securities by a corporate enterprise.

Chapter

13

Intermediaries in New Issues Market

INTERMEDIARIES IN NIM*

Several intermediaries carry out activities of different nature in the new issues market. The intermediaries include Merchant Bankers/Lead Managers, Underwriters, Bankers to the issue, Brokers to the issue, Registrars, Share Transfer Agents, and Debenture Trustees. The legal framework of operations of these intermediaries as prescribed by the SEBI, is presented below: MERCHANT BANKERS/LEAD MANAGERS

Meaning The intermediaries in the stock market who are responsible for public issues management are known as ‘merchant bankers or lead managers’. Category Merchant bankers are categorized as follows: Category I These are the merchant bankers who carry out such functions as relating to new issues as determination of security-mix to be issued, drafting of prospectus, application forms, allotment letters and a host of other documents, appointment of registrars for handling share applications and transfers, making arrangements for underwriting, placement of shares, selection and appointment of brokers and bankers to the issue, publicity of the issue, etc. Only these merchant bankers are permitted to act as ‘Lead Managers’ to an issue. Category II These merchant bankers act as consultants, advisers, portfolio managers and co-managers. Category III These merchant bankers act as underwriters, advisers and consultants. Category IV These merchant bankers act only as advisers or consultants to an issue.

272 Capi tal Markets

As per the SEBI guidelines introduced on September 5, 1997, all categories of merchant bankers below category I would stand abolished. The guidelines required those merchant bankers who are functioning below the category I to upgrade themselves to category I. Merchant bankers currently carrying out underwriting and portfolio management, besides issue management, would be required to get separate registrations as portfolio managers, while underwriting could be done without any additional registration. Further, only body corporates with a net worth of Rs. 5 crores would be allowed as category I merchant bankers. Registration—Conditions Merchant bankers shall compulsorily register with the SEBI in the interest of investors. Following are the conditions to be satisfied by them before registration is done by the SEBI: 1. Capital adequacy Merchant bankers have to fulfill the prescribed minimum capital adequacy norm in terms of its net worth, i.e. paid-up capital and free reserves. 2. Infrastructure Merchant bankers should have adequate and necessary infrastructure, such as adequate office space, equipment and manpower for effective discharge of their duties and responsibilities. 3. Expertise Merchant bankers should employ experts having professional qualifications in finance, law or business management competent to handle merchant banking business and who are not involved in any litigation connected with securities market. 4. Fees Merchant bankers should make a payment of fee as prescribed by the SEBI. 5. Undertaking Merchant bankers shall undertake to fulfill their obligations and responsibilities as may be prescribed by the SEBI from time to time. Further, they should also undertake to adhere to the prescribed code of conduct. Role and Responsibilities SEBI has laid down the following responsibilities for a merchant banker: 1. Contract A merchant banker shall enter into a contract with the issuing company. The contract invariably specifies their mutual rights, obligations and liabilities relating to the issue, particularly relating to disclosures, allotment and refund. A copy of the above contract is to be submitted to the SEBI at least one month before the opening of the issue for subscription. The merchant banker has the right not to accept the appointment as lead manager, if the issuing company is its associate.

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2. Registration A registration certificate has to be obtained by the merchant banker from the SEBI. 3. Minimum underwriting The merchant banker is duty-bound to accept on his own or through its associate, a minimum underwriting obligation of 5 percent of total underwriting commitment or Rs. 25 lakhs, whichever is less. 4. ‘Due diligence certificate’ The merchant banker has to submit ‘Due Diligence Certificate’ to SEBI at least two weeks before the opening of the issue for subscription. The certificate has to be given on the basis of the verification of the contents of the prospectus/letter of offer regarding the issue and reasonableness of the views expressed therein. For this purpose, the merchant banker should reasonably be satisfied: a. That the document contains all details relevant to the issue; b. That all legal requirements relating to the issue have been fully complied with; and c. That all disclosures are true, fair and adequate to enable the investing public to make a well-informed decision regarding investment in the proposed issue. 5. Documents submission The merchant banker shall submit to SEBI various documents containing details such as issue, draft prospectus/ letter of offer and other literature to be circulated to the investors/ shareholders, etc at least two weeks before the date of filing them with the Registrar of Companies and regional stock exchanges. It has to ensure that all the modifications and suggestions made by SEBI regarding the above documents have been duly incorporated. 6. Disclosure to SEBI The merchant banker shall make a disclosure of the following to the SEBI: a. Its responsibilities regarding the management of the issue b. Any change in the information/particulars previously furnished with SEBI having a bearing on certificate of registration granted to it c. Details relating to the breach of capital adequacy norms d. Names and addresses of the companies whose issues it has managed or has been associated with, and e. Information regarding its activities as manager, underwriter, consultant or adviser to the issue 7. Other duties In addition to the above, the merchant banker has to fulfill the following obligations too: a. Continuing to remain fully associated with the issue till the subscribers have received share/debenture certificates or the refund of excess application money

274 Capi tal Markets

b.

c.

Not to acquire securities of any company on the basis of unpublished price sensitive information obtained in the course of discharge of his professional assignment, whether obtained from the client or any other person Submit complete particulars with SEBI within 15 days of the acquisition of securities of the company whose issue the merchant banker is managing

Code of Conduct Every merchant banker has to abide by the code of conduct in the course of performance of his duties. The codes include observance of high standards of integrity and fairness in its dealings with the client and other merchant bankers; disclosure to the clients possible sources of conflict of duties and interest, if any, while accepting the assignment and while providing the services; provision of all professional services to the client in a prompt, efficient and cost-effective manner; making available to the investors true and adequate information relating to the issue without making any misguided or exaggerated claims, attendant risks relating to the issue before any investment decisions are taken by them, and copies of prospectus, memorandum and related documents uncomplete; taking adequate steps for fair allotment of securities and refund of application money without delay; adequately dealing with complaints from the investors; not to practise unfair competition, i.e. not making any statement or become party to an act which is likely to harm the interest of other merchant bankers; not divulging to other clients, press or any other party any confidential information about his client, which has come to his knowledge; not to be a party to creation of false market, or price rigging or manipulations, etc. SEBI’s Role SEBI is empowered to carry out the inspection of the working of any merchant banker with a view to protecting the interest of investors and to ensure better ambience of the capital market. The merchant banker is duty-bound to extend all assistance and support to the SEBI for carrying out the inspection. In respect of any merchant banker who fails to comply with any of the conditions subject to which certificate of registration has been granted by SEBI, and/or acts in violation of any of the provisions of the SEBI Act, rules or regulations, the SEBI may suspend the registration or cancellation of registration.

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SEBI may order suspension of Registration under such circumstances as violation of the provisions of the SEBI Act, rules or regulations, violation of the conditions of registration, failure to furnish to SEBI the required information relating to its activities as merchant banker, furnishing wrong, false or misleading information, failure to submit periodical returns required by SEBI, defying cooperation in any enquiry/inspection conducted by SEBI, failure to resolve the complaints of the investors and/or fails to give a satisfactory reply to SEBI in this regard, indulging in manipulating prices of securities, or price rigging or cornering activities, etc. UNDERWRITERS

Meaning A set of all institutions and agencies that provide a commitment to take up the issue of securities in the event of a failure of the issue to get full subscription from the public, are known as ‘underwriters’. They are compensated for their services by a payment of commission as agreed upon between the issuing company and the underwriter, and subject to the ceiling under the Companies Act. Brokers, investment companies, commercial banks and term lending institutions provide underwriting services. Although underwriting of issues is not obligatory, underwriters play a significant role in the development of the primary market. The issuing company in consultation with the merchant bankers/lead managers appoints underwriters. A statement to this effect is also to be incorporated in the prospectus. Role and Responsibilities Under the SEBI guidelines, underwriters have the following duties and responsibilities as regards the public issue: 1. Registration A certificate of registration has to be obtained by the agencies that wish to carry out underwriting activities from the SEBI. SEBI grants the certificate of registration on the fulfillment of the following conditions: a. Availability of adequate and necessary infrastructure like sufficient office space, equipment and manpower to effectively function and discharge his duties b. Previous experience in underwriting or having a minimum of two persons with experience in underwriting c. Meeting capital adequacy requirement of a minimum net worth of Rs. 20 lakhs

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d.

That the applicant (director, principal officer or partner) has not been convicted of any offence involving moral turpitude or found guilty of any economic offence e. Undertaking to fulfill obligations under the SEBI Act, rules and regulations f. Undertaking to abide by the prescribed code of conduct and g. Payment of the prescribed fee for grant of registration certificate and for its renewal, which is Rs. 2 lakhs for the first and the second years from the initial grant of certificate and Rs. 20,000 per annum subsequently for keeping the certificate in force or for its renewal. The Certificate of Registration can be suspended by SEBI in case of failure to pay the fee. Thereupon, the underwriter ceases to act as underwriter 2. Agreement In order that the issues are taken up by the underwriters, an agreement has to be entered into between the underwriter and the issuing company. The agreement should, among others, contain such details as the period during which the agreement will remain in force, the amount of underwriting obligation, the maximum period within which the underwriter will have to subscribe to the offer, after being intimated by or on behalf of the issuing company, the rate and amount of commission/ brokerage chargeable by the underwriter, within the limits imposed by the Companies Act, and any other details regarding the arrangements made by the underwriter for fulfilling the underwriting obligations. 3. Code of conduct An underwriting agency shall follow the necessary codes of conduct as framed by the SEBI. These include duty not to derive any other direct or indirect benefit from underwriting the issue except receiving the underwriting commission at the agreed rate, the ceiling for which is 5 percent in case of underwriting of shares and 2.5 percent in case of debentures, duty not to take up total underwriting obligation, at any point of time under all underwriting agreements, exceeding 20 times his net worth, and duty to subscribe for securities under the agreement within 45 days of the receipt of intimation from the issuing company. 4. Compliance Underwriters are required to comply with all the formalities regarding registration with SEBI, agreement with the client company and general responsibilities. These include ensuring that all terms and conditions regarding disclosure in the prospectus and its filing with ROC have been complied with before signing the underwriting agreement with the issuing company, ensuring that the prospectus is delivered to ROC within 30 days of the underwriting agreement or within

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such an extended time as approved by the underwriter in writing, subject to the limits within the law, complying with any additional disclosures that may be made in the interest of investors as stipulated by SEBI/lead managers, and such disclosure requirements shall not give any right to the underwriter to avoid or reduce his obligations, unless certified by SEBI as material in nature and essential for underwriting agreement, arranging for sub-underwriting but continues to be responsible for any failure or default on the part of such sub-underwriters, etc. 5. Termination of agreement An underwriter is entitled to terminate an underwriting agreement at any time before the opening of the issue as notified in the prospectus under such circumstances as where the issuing company has made any incorrect representation or statement to the underwriter, in the application form, in negotiations and correspondence, and in the prospectus, where a complete breakdown or dislocation of business has occurred in major financial markets in Mumbai, Calcutta, New Delhi and Chennai and where any other major disturbance-such as declaration of war, open and wide insurgency, civil upheaval has taken place which has adversely affected the major financial markets. BANKERS TO AN ISSUE

Meaning Bankers who are engaged in the function of acceptance of applications for shares and debentures alongwith application money from investors in respect of issue of securities and also refund of application money to the applicants to whom securities could not be allotted, are called ‘bankers to an issue’. They play an important role in the working of the primary market. Role and Responsibilities The intermediary to act as a banker has the following responsibilities as ordained by the SEBI: 1. Registration Bankers who are desirous of acting as bankers to an issue are required to obtain the necessary certificate of registration from the SEBI. For this purpose, the conditions to be fulfilled include adequacy of the necessary infrastructure such as office space, equipment, communication facilities, data processing facilities and manpower to effectively perform activities relating to the issue, and a stipulation that the banker or any of its directors is not involved in any litigation connected with securities market nor they are convicted for any economic offence. If the applicant is a scheduled bank, the grant of certificate of registration

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would serve the interest of investors and the applicant pays the registration fee. 2. Fees to SEBI Annual registration fee of Rs. 2.5 lakhs for the first two years is payable to the SEBI by the intending banker and Rs. 1 lakh is to be paid for the third year. An application for the renewal of the registration can be made three months before the expiry of registration certificate. The renewal fees are Rs. 1 lakh annually for the first two years and Rs. 20,000 for the third year. 3. Contract The issuer company has to enter into a contract with the banker to an issue. The contract shall include detailed information about the number and addresses of collection centres at which applications and application money are to be received, the fee for the services and other terms and conditions of the appointment. 4. Daily statement A daily statement giving the details regarding the number of applications and the amount of money received from the investors shall be submitted by the banker to the issuing company/registrar to an issue. 5. Information to SEBI Information pertaining to such details as to the profile of the issue, the number of applications and the details of application money received, the date-wise details of application money collected and refunds, if any, to the SEBI. Similarly information about any disciplinary action initiated by the RBI entailing the suspension or cancellation of the banker is also to be sent to the SEBI. 6. Books and records Books of accounts, records and documents pertaining to all matters regarding which the banker may be required to submit details to SEBI shall be maintained by the banker. This is to be done for a minimum period of three years from the completion of the issue. 7. Code of conduct In addition to the code of conduct prescribed for the merchant bankers and underwriters, a banker to an issue has to adhere to the following code of conduct: a. Not to keep blank application forms bearing broker’s stamp at the bank premises or at the entrance of the bank b. Not to accept applications after office hours, or on bank holidays, or after the date of the closure of the issue c. Not to act at any time in collusion with other agents in a manner detrimental to the interest of small investors, and d. Abide by all acts, rules, regulations, notifications, directions, circulars, instructions and guidelines issued by the Government, RBI, Indian Banks Association and SEBI that are relevant to his operations as banker to an issue.

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RBI’s Role RBI is empowered to carry out the inspection of the bankers to the issue with a view to protecting the investors’ interest and also promoting compliance with SEBI Act, rules and regulations. SEBI may order the suspension of the registration of the banker in such circumstances as the violation of the provisions of SEBI Act, rules and regulations, failure to submit the required information, submission of wrong or false information, failure to resolve investors’ complaints or give satisfactory reply to SEBI, guilty of misconduct or unprofessional conduct, etc. BROKERS TO AN ISSUE

Intermediaries that are responsible for procuring the subscription to the issue from the prospective investors are called ‘brokers to the issue’. They provide a vital connecting link between the prospective investors and the issuer. They assist in the speedy subscription of issue by the public. Appointment of brokers is however not compulsory. Unless permitted by the stock exchange, the issuing company abides by the prescribed listing requirements and also undertakes to get its securities listed on a recognized stock exchange. Moreover, its members can neither act as managers or brokers to an issue, nor can they make any preliminary arrangement for floatation of an issue. The brokers to the issue must have an expert knowledge, professional competence and integrity in order to be able to carry out the various functions of an issue. They help the investors make a right choice of the company for making investments. Consent must be obtained from the stock exchange broker to act as the brokers to the issuer company. For this purpose, the approval of stock exchanges is required. Copies of consent letters of brokers are to be filed with ROC alongwith the copy of prospectus. The names and addresses of the brokers to the issue are to be disclosed in the prospectus. Brokerage has to be paid by the issuer company according to the provisions in the Companies Act and rules and regulations, the agreement between the broker and the company, and guidelines prescribed by SEBI. Maximum brokerage rate, applicable to all types of industrial securities, whether underwritten or not, is 1.5 percent. The brokers have to meet all mailing costs, canvassing expenses and all other out-of-pocket expenses relating to the subscription of the issue out of their brokerage. The maximum rate of brokerage payable by listed companies on private placement of capital is 0.5 percent.

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REGISTRARS TO AN ISSUE AND SHARE TRANSFER AGENTS

Registrars and transfer agents are of two categories such as category I which carry on activities of both registrars to an issue and also of share transfer agents and category II which carry on activities either of a registrar to an issue or as a share transfer agent. Functions Registrars to an issue carry out such functions as keeping a proper record of applications and moneys received from investors, assisting issuing companies in determining the basis of allotment of securities as per stock exchange guidelines and in consultation with stock exchanges, assisting in the finalization of allotment of securities, and processing and dispatching of allotment letters, assisting in processing and dispatching refund orders, share and debenture certificates and other documents related to the capital issue, functioning as Depository Participants (DPs), etc. Share Transfer Agents perform such functions as maintaining records of holders of securities of the company for and on behalf of the company, handling all matters related to transfer and redemption of securities of the company and functioning as Depository Participants (DPs). Role and Responsibilities The role and responsibilities of registrars and share transfer agents are as follows: Registration A certificate of registration is to be obtained from the SEBI. For this purpose, the SEBI considers such factors as their ability to discharge their duties with efficiency and integrity, the adequacy of infrastructure and past experience in this line of activity and capital adequacy. Capital adequacy requirement is net worth of Rs. 6 lakhs for category I and Rs. 3 lakhs for category II registrars and share transfer agents. They have to pay an annual fee of Rs. 15,000 and Rs. 10, 000 respectively for initial registration and annual renewal. Maintenance of records Registrars and share transfer agents shall show such details as applications received from investors relating to the issue, rejected applications together with the reasons for rejection, basis of allotment of securities in consultation with the stock exchanges, terms and conditions of purchase of securities, allotment of securities, list of allottees and non-allottees, refund orders, etc and names of transferors and transferees, and the dates of transfer of securities. Such records and books are to be preserved for three years from the date of issue. SEBI can also ask them to file these books and records with it whenever required.

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Absorbing code of conduct Registrars and share transfer agents should adopt those codes of conduct prescribed for merchant bankers and underwriters. Besides, they should ensure that enquiries from investors are adequately dealt with and adequate steps are taken for proper allotment of securities and refund of excess application money as per law and without delay. SEBI’s Role SEBI is empowered to undertake inspection of books of accounts, records and documents of registrars and share transfer agents. The certificate of registration issued to registrars and share transfer agents will be suspended of their registration by the SEBI under such circumstances as violation of SEBI Act, rules and regulations, violation of SCRA rules and regulations, and stock exchange bye-laws, rules and regulations, failure to furnish information to SEBI, furnishing wrong and false information, noncooperation in an inspection, investigation or an enquiry, failure to resolve investor complaints, failure to give satisfactory reply to SEBI regarding investor complaints, involvement in manipulation, price rigging and cornering activities, guilty of misconduct, failure to maintain capital adequacy requirement, etc. The registration of the registrars and transfer agents will be cancelled by the SEBI under such circumstances as repeated defaults leading to suspension of registration certificate, deliberate manipulation, price rigging and cornering activities adversely affecting the securities market and the investor interest, violating provisions relating to insider trading and take over regulations, guilty of fraud, conviction for a criminal offence, and violating SEBI Act, rules and regulations. DEBENTURE TRUSTEES

Meaning Trustees who are appointed to safeguard the interests of debenture holders are called ‘debenture trustees’. They are to be appointed before issue of debentures by a company. No person can act as debenture trustee unless a certificate of registration has been obtained from SEBI for the purpose. Eligibility To be appointed as a debenture trustee, the following are eligible: 1. A scheduled bank carrying on commercial activity; or 2. A public financial institution within the meaning of Section 4-A of the Companies Act, 1956; or

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3. 4.

An insurance company; or A body corporate

Role and Responsibilities 1. Registration An institution shall be registered with the SEBI to be in a position to function as a debenture trustee. For this purpose, the institution concerned shall have an adequate and necessary infrastructure like adequate office space, equipments and manpower to effectively discharge his activities, relevant experience of a debenture trustee, professional qualification for a debenture trustee from an institution recognized by the government in finance, accountancy, law or business management and the applicant or any of its director or principal officers has not at any time been convicted for any offence involving moral turpitude or has been found guilty of any economic offence. 2. Consent Consent in writing must be given to the body corporate to act as debenture trustee before the debenture issue. 3. Inspection Debenture trustee shall carry out the inspection of books of accounts, records, registers of the body corporate and the trust property to the extent necessary for discharging his obligations. 4. Possession A debenture trustee shall take possession of trust property in accordance with the provisions of the trust deed and enforce security in the interest of the debenture holders. 5. Protection of interest A debenture trustee shall carry out any act as would be necessary for the protection of the interest of and the resolution of grievances of the debenture holders. He must also ensure that debenture certificates have been dispatched to the debenture holders in accordance with the provisions of the Companies Act. Besides, he must also ensure that interest warrants for interest due on the debentures have been dispatched to the debenture holders on or before the due dates. 6. Due diligence A debenture trustee should exercise due diligence to ascertain whether or not the assets of the body corporate which are available by way of security or otherwise are sufficient or are likely to be or become sufficient to discharge the claims of debenture holders as and when they become due. It must also inform the Board immediately of any breach of trust deed or provision of any law. 7. Meeting A debenture trustee shall call, or cause to be called by the body corporate, a meeting of the entire debenture holders where a

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requisition for the meeting has been made at least one-tenth of the debenture holders or the happening of any event, which constitutes a default or which in the opinion of the debenture trustees affects the interest of the debenture holders. 8. Code of conduct Every debenture trustee shall abide by the prescribed code of conduct. 9. Maintenance of books of accounts, etc. Subject to the provisions of any law, every debenture trustee has to keep and maintain proper books of accounts, records and documents relating to the trusteeship functions for a period of not less than 5 financial years preceding the current financial year. Every debenture trustee has to intimate to SEBI, the place where the books of accounts, records and documents are maintained. 10. Information to SEBI Every debenture trustee shall furnish information relating to the following to the SEBI: a. Number and nature of the grievances of debenture holders received and resolved b. Copies of the trust deed c. Non-payment or delayed payment of interest to debenture holders, if any, in respect of each issue of debentures of a body corporate d. Details of dispatch and transfer of debenture certificates giving therein the dates, mode, etc e. Inspection and Disciplinary Proceedings and f. Any other particulars or documents that are relevant to debenture trustee SEBI’s Role SEBI is empowered to carry out the inspection of the books of accounts, other records and documents of the debenture trustee for the purpose of ensuring that the records and documents which are relevant to debenture trustees are being maintained in the manner required by the Board, that the provisions of the Companies Act, 1956, rules and regulations are being complied with, that there exists any circumstances, which would render the debenture trustee ineligible for grant of registration or continuance thereof, that the complaints received from investors, other debenture trustees are investigated into, and that the interest of the investors is protected. SEBI can suspend the certificate of registration granted to a debenture trustee under the following circumstances: 1. Violation of the provisions of the SEBI Act, rules or regulations 2. Not following the prescribed code of conduct.

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3.

Failure to furnish information relating to his business as debenture trustee as required by the Board . 4. Furnishing wrong or false information. 5. Not submitting reports as required by SEBI. 6. Non-cooperation in any enquiry conducted by SEBI. 7. Indulging in manipulating or price rigging or cornering activities. 8. Guilty of misconduct or improper or unbusinesslike or unprofessional conduct. 9. Failure to pay the fees. 10. Violation of the conditions subject to which the certificate has been granted and. 11. Failure to fulfill the obligations under the trust deed. Under the following circumstances, SEBI can cancel the certificate of registration granted to debenture trustees: 1. Repeated defaults of the type leading to suspension of certificate 2. Indulging in deliberate manipulation or price rigging or cornering activities affecting the securities market and the investors’ interests. 3. Guilty of fraud, or is convicted of a criminal offence. 4. Violation of any provision of insider trading regulations. 5. Violation of the provisions of Companies Act and the rules made thereunder, and. 6. Trustee being removed by the debenture holders by a resolution passed by not less than 75 percent of the debenture holders. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7.

Who are the intermediaries of the NIM? Who is a merchant banker? Who is a ‘category I merchant banker’? Who are underwriters? Who is a ‘banker to an issue’? Who is a ‘broker to an issue’? Who are debenture trustees?

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Section B 1. 2. 3. 4. 5. 6. 7.

How are merchant bankers categorized by the SEBI? What are the conditions prescribed by the SEBI for the registration of merchant bankers? How does the SEBI influence the working of the merchant bankers? What is the code of conduct prescribed for the merchant bankers? Bring out the role and responsibilities of bankers to the issue? What are the functions of registrars and share transfer agents? What is the role played by the SEBI in governing the working of debenture trustees?

Section C 1. 2. 3.

Discuss the various types of intermediaries working for the NIM. Enumerate and explain the role and responsibilities of merchant bankers. Write a note on: a. Role and responsibilities of registrars and share transfer agents. b. Role and responsibilities of debenture trustees.

Chapter

14

SEBI Guidelines on Primary Market

SEBI GUIDELINES FOR LISTED AND UNLISTED COMPANIES

For Companies Issuing New securities Following are the conditions to be satisfied by the companies that issue securities offered through an offer document: As Regards Unlisted Companies

Track record No unlisted company shall make a public issue of any equity share or any security convertible at a later date into equity share, unless the company has a track record of distributable profits in terms of section 205 of Companies Act, for at least three out of the immediately preceding five years and a pre-issue net worth of not less than Rupees One crore in three out of preceding five years, with the minimum net worth to be met during immediately preceding two years. For the purpose of determining the minimum track record of three years, at least three audited accounts shall be available comprising not less than thirty-six months. In case of companies in the information technology sector, the track record of distributable profits shall be considered for the purpose of eligibility requirements only if the profits are emanating from the information technology business or activities. In the case of partnership firms which have since been converted into companies, the track record of distributable profits of the firm shall be considered for the purpose of eligibility requirements if the financial statements for the respective years pertaining to partnership business conform to and are revised in a format identical to that required for companies, and also comply with the following that adequate disclosures are made in the financial statements similar to that of companies as specified in Schedule VI of the Companies Act, 1956, and the financial statements shall be duly certified by a Chartered Accountant stating unequivocally that the accounts as revised or otherwise and disclosures made are in line

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with the provision of Schedule VI of the Companies Act, 1956 and that the accounting standards of the Institute of Chartered Accountants of India (ICAI) have been followed, that the financial statements present a true and fair picture of the firm’s accounts and that the lead merchant banker shall also confirm that the financial statements furnished on behalf of the partnership firms are in accordance with accounting standards prescribed by the ICAI. In the case of an unlisted company formed out of a division of an exiting company, the track record of distributable profits of the division spun off shall be considered for the purpose of eligibility criteria if the requirements regarding financial statements as specified above for partnership firms. Project appraisal An unlisted company which does not satisfy the above requirement can make a public issue of equity share capital or any security convertible at a later date into equity share capital, provided a public financial institution or a scheduled commercial bank has appraised the project to be financed through the proposed offer to the public and not less than 10 percent of the project cost is financed by the said appraising bank or institution by way of loan, equity, participation in the issue of security in the proposed issue or combination of any of them. The appraising bank or institution shall bring in the minimum specified contribution at least one day before the opening of the public issue. As Regards Listed Companies 1. Filing of offer document No company shall make any public issue of securities, unless a draft prospectus has been filed with the Board, through an eligible Merchant Banker, at least 21 days prior to the filing of prospectus with the Registrar of Companies (ROC). Where the Board makes any changes within 21 days from the date of submission of draft Prospectus, the issuer or the Lead Merchant banker shall carry out such changes in the draft prospectus before filing the prospectus with ROCs. 2. Letter of offer No listed company shall make any issue of security through a rights issue where the aggregate value of securities, including premium, if any, exceeds Rs. 50 lakhs, unless the letter of offer is filed with the Board, through an eligible Merchant Banker, at least 21 days prior to the filing of the Letter of Offer with Regional Stock Exchange (RSE). Where the Board makes any changes within 21 days from the date of submission of the draft Letter of Offer, the issuer or the Lead Merchant banker shall carry out such changes in the draft offer letter before filing the prospectus with ROCs.

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3. Companies barred No company shall make an issue of securities if the company has been prohibited from accessing the capital market under any order or direction passed by the Board. 4. Application for listing No company shall make any public issue of securities unless it has made an application for listing of those securities in the stock exchange(s). 5. Issue of securities in dematerialized form No company shall make public or rights issue or an offer for sale of securities, unless the company enters into an agreement with a depository [registered with the Board under the Securities and Exchange Board of India (Depositories and Participants) Regulations, 1996] for dematerialization of securities already issued or proposed to be issued to the public or existing shareholders; and the company gives an option to subscribers/ shareholders/investors to receive the security certificates or hold securities in a dematerialized form with a depository. A listed company shall be eligible to make a public issue of equity shares or any security convertible at a later date into equity share where as a result of the proposed issue, the net worth of the company becomes more than five times the net worth [Aggregate of value of the paid-up equity capital and free reserves (excluding reserves created out of revaluation) reduced by the aggregate value of accumulated losses and deferred expenditure not written off including miscellaneous expenses not written off ] prior to the issue, the company shall satisfy the relevant provisions as specified above. Public issue by listed companies which has changed its name to indicate as if it was engaged in the business/activities in information technology sector during a period of three years prior to filing of offer document with the Board, shall be eligible to make a public issue of equity share or securities convertible at a later date into equity share, if it has a track record of distributable profits in terms of Section 205 of Companies Act, for at least three out of immediately preceding five years from the information technology business/activities, and it has a pre-issue net worth of not less than One Crore in three out of preceding five years, with the minimum net worth to be met during, the immediately preceding two years. Exemption from Eligibility Norms The above provisions of track record and project appraisal shall not be applicable: 1. In case of a banking company including a Local Area Bank (hereinafter referred to as Private Sector Banks) set up under sub-section (c) of

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2.

3.

4.

Section 5 of the Banking Regulation Act, 1949 and which has received a licence from the Reserve Bank of India To a corresponding new bank set up under the Banking Companies (Acquisition and Transfer of Undertaking) Act, 1970 Banking Companies (Acquisition and Transfer of Undertaking) Act, 1980, State Bank of India Act 1955, and State Bank of India (Subsidiary Banks) Act, 1959 (hereinafter referred to as “public sector banks”) To an infrastructure company whose project has been appraised by a Public Financial Institution or Infrastructure Development Finance Corporation (IDFC) or Infrastructure Leasing and Financing Services Ltd. (IL&FS) and not less than 5% of the project cost is financed by any of the institutions referred to in sub-clause (a), jointly or severally, irrespective of whether they appraise the project or not, by way of loan or subscription to equity or a combination of both To rights issue by a listed company

Credit Rating for Debt Instruments 1.

2.

3.

4.

No public or rights issue of debt instrument (including convertible instruments) irrespective of their maturity or conversion period shall be made unless credit a rating from a credit rating agency is obtained and disclosed in the offer document Where credit rating is obtained from more than one credit rating agencies, all the credit rating/s, including the unaccepted credit ratings, shall be disclosed For a public and rights issue of debt-securities of issue size greater than or equal to Rs. 100 crores, two ratings from two different credit rating agencies shall be obtained All the credit ratings obtained during the three years, preceding the public or rights issue of debt instrument (including convertible instruments) for any listed security of the issuer company shall be disclosed in the offer document

Outstanding Warrants or Financial Instruments No unlisted company shall make a public issue of equity share or any security convertible at later date into equity share, if there are any outstanding financial instruments or any other right, which would entitle the existing promoters or shareholders any option to receive equity share capital after the initial public offering.

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Partly Paid-up Shares No company shall make a public or rights issue of equity share or any security convertible at a later date into equity share, unless all the existing partly paid-up shares have been fully paid or forfeited in a manner specified above. On Pricing Issues The companies eligible to make public issue can freely price their equity shares or any security convertible at a later date into equity shares in the following cases: 1. Public/rights issue by listed companies A listed company whose equity shares are listed on a stock exchange, may freely price its equity shares and any security convertible into equity at a later date, offered through a public or rights issue. 2. Public issue by unlisted companies An unlisted company eligible to make a public issue and desirous of getting its securities listed on a recognized stock exchange pursuant to a public issue, may freely price its equity shares or any securities convertible at a later date into equity shares. 3. Infrastructure company An eligible infrastructure company shall be free to price its equity shares subject to the compliance with the disclosure norms as specified by SEBI from time to time. 4. Initial public issue by banks Banks (whether public sector or private sector) may freely price their issue of equity shares or any securities convertible at a later date into equity share subject to approval by the Reserve Bank of India. 5. Differential pricing Any unlisted company or a listed company making a public issue of equity shares or securities convertible at a later date into equity shares, may issue such securities to applicants in the firm allotment category at a price different from the price at which the net offer to the public (the offer made to the Indian public and does not include firm allotments or reservations or promoters’ contributions) is made provided that the price at which the security is being offered to the applicants in firm allotment category is higher than the price at which securities are offered to public. A listed company making a composite issue of capital may issue securities at differential prices in its public and rights issue. In the public issue, which is a part of a composite issue, differential pricing is also permissible.

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6. Price band Issuer company can mention a price band of 20 percent (cap in the price band should not be more than 20 percent of the floor price) in the offer documents filed with the Board and actual price can be determined at a later date before filing of the offer document with ROCs. If the Board of Directors has been authorized to determine the offer price within a specified price band, such a price shall be determined by a Resolution to be passed by the Board of Directors. The Lead Merchant Bankers shall ensure that in case of the listed companies, a 48 hours notice of the meeting of the Board of Directors for passing resolution for determination of price is given to the regional Stock Exchange. The final offer document, shall contain only one price and one set of financial projections, if applicable. 7. Payment of discounts/commissions etc. No payment, direct or indirect in the nature of a discount, commission, allowance or otherwise shall be made either by the issuer company or the promoters in any public issue, to the persons who have received firm allotment in such public issues. 8. Denomination of shares  An  eligible  company  shall  be  free  to make public or rights issue of equity shares in any denomination determined by it, in accordance with sub-section (4) of section 13 of the Companies Act, 1956 and in compliance with the norms as specified by SEBI through its circular. Companies, which have already issued shares in the denomination of Rs. 10/- or Rs.100/-, may change the standard denomination of the shares by splitting or consolidating the existing shares. The companies proposing to issue shares in any denomination or changing the standard denomination shall comply with the following: a. b. c. d.

e.

The shares shall not be issued in the denomination of decimal of a rupee The denomination of the existing shares shall not be altered to a denomination of decimal of a rupee At any given time, There shall be only one denomination for the shares of the company The companies seeking to change the standard denomination may do so after amending the Memorandum and Articles of Association, if required The company shall adhere to the disclosure and accounting norms specified by SEBI from time to time

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On Promoter’s Contribution and Lock-in Requirements Promoter’s Contribution The relevant provisions regarding the promoter’s contribution are as follows: 1. Pubic issue by unlisted companies In a public issue by an unlisted company, the promoters shall contribute not less than 20 percent of the post issue capital. 2. Offers for sale The promoter’s shareholding after offer for sale shall not be less than 20 percent of the post issue capital. 3. Public issues by listed companies In case of public issues by listed companies, the promoters shall participate either to the extent of 20 percent of the proposed issue or ensure post-issue shareholding to the extent of 20 percent of the post-issue capital. 4. Composite issues In case of composite issues of a listed company, the promoter’s contribution shall at the option of the promoter(s) be either 20 percent of the proposed public issue or 20 percent of the post-issue capital. Rights issue component of the composite issue shall be excluded while calculating the post-issue capital. 5. Computation of promoters’ contribution a.

Nonconvertible security Where the promoters of any company making an issue of securities have acquired equity during the preceding three years, before filing the offer documents with the Board, such equity shall not be considered for computation of promoter’s contribution. This is to be taken note of where the securities have been acquired for consideration other than cash and revaluation of assets or capitalization of intangible assets is involved in such transaction(s) or resulting from a bonus issue, out of revaluation reserves or reserves without accrual of cash resources. In case of public issue by unlisted companies, securities which have been issued to the promoters during the preceding one year, at a price lower than the price at which equity is being offered to public, shall not be eligible for computation of promoter’s contribution. The shares for which the difference between the offer price and the issue price for these shares is brought in by the promoters shall be considered eligible subject to issuer company complying with the applicable provisions of the Companies Act, 1956 (such as passing of revised resolution by shareholders or issuer’s Board, filing of revised return of allotment with RoC, etc.)

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b.

In respect of companies formed by conversion of partnership firms, where the partners of the erstwhile partnership firm and the promoters of the converted company are the same and there is no change in management, the shares allotted to the promoters during previous one year out of the funds brought in during that period shall not be considered eligible for computation of promoters’ contribution unless such shares have been issued at the same price at which the public offer is made. If the partners’ capital existed in the firm for a period of more than one year on a continuous basis, the shares allotted to promoters against such capital shall be considered eligible. Such ineligible shares acquired in pursuance to a scheme of merger or amalgamation approved by a High Court shall be eligible for computation of promoters’ contribution. For the purposes of computing the promoters’ contribution, a minimum contribution of Rs. 25,000 per application from each individual and a minimum contribution of Rs.1 lakh from firms and companies (not being business associates like dealers and distributors), shall be eligible to be considered towards promoters’ contribution. No securities forming part of promoters’ contribution shall consist of any private placement made by solicitation of subscription from unrelated persons either directly or through any intermediary. The securities for which a specific written consent has not been obtained from the respective shareholders for inclusion of their subscription in the minimum promoters’ contribution subject to lock-in shall not be eligible for promoters’ contribution. Convertible security In case of any issue of convertible security by a company, the promoters shall have an option to bring in their subscription by way of equity or by way of subscription to the convertible security being offered through the proposed issue so that the total promoters’ contribution shall not be less than the required minimum contribution as required. However, where the conversion price of emerging equity is not predetermined and the same has not been specified in the offer document (instead a formula for conversion price is indicated), the promoters shall not have the said option and shall contribute by subscribing to the same instrument. In case of any issue of security convertible in stages either at par or premium (conversion price being predetermined), the promoters’ contribution in terms of equity share capital shall not be at a price lower than the weighted average price of the share capital arising out

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of conversion. (‘Weights’ means the number of equity shares arising out of conversion of security into equity at various stages and ‘price’ means the price of equity shares on conversion arrived at after taking into account predetermined conversion price at various stages). The promoters’ contribution shall be computed on the basis of post-issue capital assuming full-proposed conversion of such convertible security into equity. Where the promoter is contributing through the same optional convertible security as is being offered to the public, such contribution shall be eligible as promoters’ contribution only if the promoter(s) undertake in writing to accept full conversion. 6. Preferential allotment In the case of a listed company, participation by promoters in the proposed public issue in excess of the required minimum percentage as required shall attract the pricing provisions of guidelines on preferential allotment, if the issue price is lower than the price as determined on the basis of the said preferential allotment guidelines. 7. Promoters’ contribution Promoters shall bring in the full amount of the promoters’ contribution including premium at least one day prior to the issue opening date. Where the promoters’ minimum contribution exceeds Rs. 100 crores, they shall bring in Rs.100 crores before the opening of the issue and the remaining contribution shall be brought in by the promoters in advance on pro-rata basis before the calls are made on public. The company’s board shall pass a resolution allotting the shares or convertible instruments to promoters against the moneys received. A copy of the resolution along with a Chartered Accountants’ Certificate certifying that the promoters’ contribution has been brought in shall be filed with the Board before opening of the issue. The certificate of the Chartered Accountants shall also be accompanied by a list of names and addresses of friends, relatives and associates who have contributed to the promoters’ quota along with the amount of subscription made by each of them. 8. Exemption The requirement of Promoters’ Contribution is exempt under the following circumstances: a. In case of public issue of securities by a company which has been listed on a stock exchange for at least 3 years and has a track record of dividend payment for at least 3 immediately preceding years b. Where the promoters’ participate in the proposed issue to the extent higher than of the two options available as specified above, the subscription in excess of such percentage shall attract pricing guidelines on preferential issue, if the issue price is lower than

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c. d.

the price as determined on the basis of said guidelines on preferential issue In case of companies where no identifiable promoter or promoter group exists In case of rights issues promoters shall disclose their existing shareholding and the extent to which they are participating in the proposed issue in the offer document

Lock-in Requirements 1. Lock-in of minimum specified promoters’ contribution In case of any issue of capital to the public the minimum promoters’ contribution shall be locked in for a period of 3 years. The lock-in shall start from the date of allotment in the proposed public issue and the last date of the lock-in shall be reckoned as 3 years from the date of commencement of commercial production. (The last date of the month in which commercial production in a manufacturing company is expected to commence as stated in the offer document) or the date of allotment in the public issue whichever is later. 2. Lock-in of excess promoters’ contribution In case of a public issue by unlisted company, if the promoters’ contribution in the proposed issue exceeds the required minimum contribution, such excess contribution shall also be locked in for a period of 3 years. In case of a public issue by a listed company, participation by promoters in the proposed public issue in excess of the required minimum percentage shall also be locked-in for a period of 3 years as per the lock-in provisions as specified in guidelines on preferential issue. The excess promoters’ contribution shall not be subject to lock-in. In case the shortfall in the firm allotment category is met by the promoter as specified, such subscription shall be locked in for a period of 3 years. 3. Last-in-first The securities that form part of promoters’ contribution, as specified and issued last to the promoters shall be locked in first for the specified period. The securities issued to the financial institutions appearing as promoters, if issued last, shall not be locked-in before the shares allotted to the other promoters. 4. Ineligibility of lock-in of shares Any security issued to promoters or other shareholders, out of revaluation of assets or capitalization of intangible assets, within a period of 3 preceding years from the date of filing of offer documents with the Board, shall be locked-in for a period of 3 years from the date of allotment of the proposed issue of capital. Any security to promoters or other shareholders, issued by way of bonus out

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of revaluation reserves, within a period of 3 preceding years, shall be locked-in for a period of 3 years from the date of allotment of the proposed issue of capital. In case of unlisted companies, any security issued to promoter or to any other shareholder, during the preceding one year, at a price lower than the price at which equity is being offered to public, shall be locked-in for a period of 3 years from the date of allotment of the proposed issue of capital. 5. Lock-in of pre-issues of an unlisted company Where an unlisted company eligible to make a public issue and desirous of getting its securities listed on a recognized stock exchange pursuant to a public issue has issued shares to any person within six months prior to the date of opening of the public issue at a price lower than the price at which equity is being offered/issued to public, the entire share capital (except shares issued to venture capitalists and employees of the company) existing prior to public issue shall be locked in for a period of six months from the date of trading of the shares on the regional stock exchange. The lock-in would not apply to the shares (other than shares issued to promoters, friends, relatives and associates) if the same were issued more than 6 months prior to the date of opening of the public issue and are offered under “offer for sale.” Other Lock-in Requirements

Pledge of securities Locked-in securities held by promoters may be pledged only with banks or financial institutions as collateral security for loans granted by such banks or financial institutions, provided the pledge of shares is one of the terms of sanction of loan. Inter-se transfer of securities Transfer of locked-in securities amongst promoters as named in the offer document, can be made subject to the lock-in being applicable to the transferees for the remaining period of lock in. Inscription of nontransferability The securities which are subject to lock-in shall carry inscription ‘nontransferable’ along with duration of specified nontransferable period mentioned on the face of the security certificate.

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REVIEW QUESTIONS

Section A 1. 2.

What is meant by ‘differential pricing’? What is ‘price band’ with reference to a primary issue?

Section B 1.

2. 3. 4. 5. 6. 7. 8.

What are companies that have been granted exemption under Section 205 of the Companies Act with regard to new issue of securities? Explain as to how credit rating is made compulsory for companies issuing debt instruments. Enumerate the relevant SEBI guidelines with regard to pricing of public issues. State the SEBI guidelines with regard to issue of shares on different denominations. Bring out the SEBI guidelines with regard to promoters’ contribution with regard to issue of shares. Explain the mode of computation of promoters’ contribution State the circumstances under which requirements of promoters’ contribution is exempt. What are the lock-in requirements with regard to promoters’ contribution?

Section C 1. 2. 3.

What are the guidelines issued by the SEBI with regard to the issue of securities in the primary market? What are the conditions to be satisfied by unlisted companies that issue securities through an offer document? What are the conditions to be satisfied by listed companies that issue securities through an offer document?

Chapter

15

Listing The term ‘listing’ refers to a process or steps or exercise involved in listing something with some one. Listing means permission to quote shares and debentures officially on the trading floor of the stock exchange. The listed shares appear on the official list of securities for the purposes of trading. SECURITY LISTING

Security listing refers to the steps that are required to register and to place on record the securities of a corporate entity with the appropriate authority, the appropriate authority being the recognized stock exchange. Securities are required to be listed under section 9 of Securities Contract (Regulation) Act, 1956, hereinafter referred to as SCRA. Listing simply means the inclusion of any security for the purpose of trading in a recognized stock exchange. SECURITY

Securities are those financial instruments that are defined under section 2(h) of SCRA, 1956. Stock exchanges through their byelaws, are authorized under section 9(m) of SCRA, 1956, to make a provision for listing of securities on the stock exchange. STOCK EXCHANGE

According to section 2(i) of the SCRA, ‘Stock Exchange’ means 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. Only a recognized stock exchange has been conferred the authority to list the securities of a corporate entity. RECOGNIZED STOCK EXCHANGE

Stock exchanges that are given recognition under section 4 of SCRA, 1956, in response to application made to Central Government under section 3 of the said Act are known as ‘recognized stock exchanges’.

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Characteristics Following are the characteristic features of listing: Agreement Listing of securities with the stock exchanges is made possible by means of a ‘Listing Agreement’ between the respective Stock Exchanges where the securities are to be listed on the one hand and the corporate entity which offers or issues the securities to the public through the issue of offer document like prospectus/letter of offer, on the other hand. Purpose The purposes that are served by listing with a Stock exchange are ensuring free transferability of securities so as to facilitate clear transparency and open disclosure of information relating to the affairs of the company whose securities are listed. In addition, official quotation and liquidity in the trading of listed securities is also ensured. Listing allows for official trading in the Stock Exchange by the registered member/ broker of the stock exchange, which provides an ideal marketplace for securities. Restriction A corporate entity is free to have its securities listed in any number of stock exchanges. It is however, important that the securities are listed at least on the regional stock exchange. A stock exchange is considered to be a regional stock exchange provided it is located in the place where the registered office of the company is situated. In the event of more than one stock exchange being located in the place or state where the corporate’s registered office is situated, the stock exchange which is nearer to the company would be considered as the ‘recognized stock exchange.’ In case of conflict, as to the regional stock exchange, the decision of Stock Exchange Division, Ministry of Finance shall be final. Investor protection Listing is a barometer of performance and continued good performance of the company. This offers a measure of protection to the investors. LEGAL PROVISIONS

The legal provisions relating to the listing of securities are enshrined in the Securities Contracts (Regulation) Act, 1956 read with the rules made there under, SEBI Act, 1992 and the Companies Act, 1956. The various legal and legislative provisions of listing are summarized below: Section 21 of SCRA This section prescribes necessary conditions that are required to be satisfied by the public companies for the purpose of having their securities listed in the Stock Exchanges.

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Section 11 B of SEBI Act This section empowers SEBI to formulate regulations governing the working of the listing mechanism. It aims at protecting the interest of investors in securities, thereby contributing to the development and the regulation of the securities market. Section 11 B of the SEBI Act This section empowers the SEBI to issue directions to intermediaries who are associated with securities market. This may include stock exchanges as a regulatory organization for the purpose of protection of interest of investor and orderly development of securities market. The section also empowers the SEBI to frame rules for the regulation of listing of securities. Section 73 of Companies Act This section requires corporate enterprises to make an application to one or more recognized stock exchanges seeking permission for dealing with the securities offered to the public before issue of prospectus. STEPS

Listing of corporate securities involves the following steps: Initial Listing This involves making a simple application by the payment of initial listing fee as prescribed by the respective stock exchanges. This is done before the offer of securities to the public and registration of prospectus with the Registrar of Companies, as required under section 60 of the Companies Act, 1956. Final Listing This involves getting the approval of the recognized stock exchange for the listing by means of an agreement with the stock exchange. Registration and Recording This involves registering and placing on record the corporate securities openly. This is done for the purpose of trading by the registered members of the Stock Exchange and for the official quotation/announcement of the security price, for the benefit of the public who intend dealing with such securities. Continued Listing This step involves making efforts by the corporate enterprise for the purpose of continuing to remain listed on the stock exchange until it is

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delisted from the records of the exchange, either at the option of the company or at the option of the stock exchange concerned. Listing as regards further issue of securities will take place as long as the existing securities remain listed on the stock exchanges. LEGAL SIGNIFICANCE

Listing is mandatory for a public company, which intends offering its securities to the public by issue of prospectus and which wishes to provide trading facilities to the securities being offered to the public. This mandatory provision is also enforced indirectly by stipulating that any allotment of securities made in the absence of listing or refusal of listing is held to be void. Besides, any failure to comply with the section 21 of SCRA attracts penalty as prescribed under section 23 of the SCRA. REFUSAL OF LISTING

It is quite possible that the securities of a corporate enterprise are refused listing by the authorities of the stock exchange. In the event of the decision of the authorities to refuse listing, it is incumbent on their part to intimate the company concerned within 15 days, the reasons for refusal. This is required under section 22 of SCRA. The aggrieved corporate enterprise may appeal to the Central Government within a prescribed period under section 73 of the Companies Act, 1956. It is prerogative of the Central Government either to grant or refuse to grant the permission for listing and the decision of the Central Government would be informed to the Stock Exchange concerned, who shall act in conformity with such a decision. SEBI POWERS

Under section 11 read with section 11B of SEBI Act, SEBI is empowered to direct the Stock Exchanges from time to time to amend the provisions of the listing agreement. This may be required for the purpose of regulating the business in the Stock Exchanges and securities market in the interest of investors and for promoting orderly development of securities market. Rule 19 of Securities Contracts (Regulation) Rules, 1957 also prescribes documents and particulars to be submitted/furnished by a corporate enterprise to the Stock Exchange for the purpose of listing its securities on the Stock Exchange. LISTING AND CORPORATE GOVERNANCE

Listing assumes special significance in the light of the measures that have been initiated to revamp the functioning and thus shape the culture of

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corporate management. The Birla Committee of Corporate Governance has recommended that SEBI shall issue frequent directions to the Stock Exchanges, to introduce new listing provisions aimed at securing the healthy corporate governance of the affairs of the Company, in larger interest of the stakeholders. PARTICULARS TO BE FURNISHED

A public company desirous of getting its securities listed on a recognized stock exchange has to apply for that purpose to the stock exchange and forward along with its application the following documents and particulars: 1.

Copies of Memorandum and Articles of Association and in the case of a debenture issue, a copy of the trust deed

2.

Copies of all prospectuses or statements in lieu of prospectuses issued by the company at any time

3.

Copies of offers for sale and circulars or advertisements offering any securities for subscription or sale during the last five years

4.

Copies of balance sheets and audited accounts for the last five years, or in the case of new companies, for such shorter period for which accounts have been made up

5.

Statement showing dividends and cash bonuses, if any, paid during the last ten years (or such shorter period as the company has been in existence, whether as a private or public company) and dividends or interest in arrears, if any

6.

Certified copies of: a.

Agreements or other documents relating to arrangements with or between vendors and/or promoters, underwriters and sub-underwriters, and brokers and sub-workers

b.

Agreements with managing agents and secretaries and treasurers, selling agents, managing directors and technical directors, and general manager, sales manager, manager or secretary

c.

Every letter, report, balance sheet, valuation contract, court order or other document, part of which is reproduced or referred to in any prospectus, offer for sale, circular or advertisement offering securities for subscription or sale, during the last five years

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d.

Letters of consent of the Controller of Capital Issues (now not required because the office of CCI has been abolished); and agreements, if any, with the Industrial Finance Corporation, Industrial Credit and Investment Corporation and similar bodies

7.

Statement containing particulars of the dates of, and parties to all materials contracts, agreements (including agreements for technical advice and collaboration), concessions and similar other documents (except those entered into in the ordinary course of business carried on or intended to be carried on by the company) together with a brief description of the terms, subject-matter and general nature of the documents 8. Statement of brief history of the company since its incorporation, giving details of its activities including any reorganization, reconstruction or amalgamation, changes in its capital structure (authorized, issued and subscribed), and debenture borrowings, if any 9. Particulars of shares and debentures issued for consideration other than cash, whether in whole or part, at a premium or discount, or in pursuance of an option 10. Statement containing particulars of any commission, brokerage, discount or other special terms including an option for the issue of any kind of the securities granted to any person 11. Particulars of shares forfeited 12. A list of highest ten holders of each class or kind of securities of the company as on the date of application along with particulars as to the number of shares or debentures held by and the address of each such holder 13. Particulars of shares or debentures for which permission to deal is applied for, provided that a recognized stock exchange may, either generally by its byelaws or in any particular case, call for such further particulars or documents as it deems proper. Listing agreement will be executed with the company concerned on the satisfactory fulfillment of the above requirements. LISTING AGREEMENT

An agreement entered into between a stock exchange and a company, whereby security listing is proposed is called a ‘listing agreement.’

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Features Following are the features of a listing agreement:

SCRA provisions The agreement contains provisions in accordance with the rule 19(3) of SCR Rules (SCRR), 1957; the provisions can be modified, amended or altered from time to time in consonance with the conditions prevailing in the securities market and the general economy. SED direction The Stock Exchange Division (SED) of the Ministry of Finance periodically issues directions to SEBI, to amend the listing agreement provisions so as to make the listing agreement more compatible and adaptable to the changing capital market environment. SEBI powers SEBI is authorized to issue guidelines, orders and directions to all the recognized stock exchanges, to amend the listing agreement more in particular reference to the recommendations of Malegam and Birla Committee. The purpose is to achieve the cherished objectives of better investor protection and disclosure of more information in the most transparent manner to the public at large, who are directly or indirectly associated with the affairs of the company. SEBI is empowered under rule 19 (7) of SCRR, 1957 to waive or relax the enforcement of all or any of the listing provisions either on its own motion or on recommendation of stock exchanges. Applicability The provisions contained in the listing agreement will be applicable to the body corporate constituted by an Act of Parliament or any State Legislature with equal force, besides being applicable to a body corporate under the Companies Act. STOCK EXCHANGE POWERS

The stock exchange is empowered under the rule 19(5) of SCRR, 1957, to suspend or withdraw an admission to dealing in securities of company or body corporate, for breach or non-compliance with the listing provision on giving an opportunity of being heard in writing. In an eventuality where any such withdrawal or suspension exceeds 3 months the corporate may appeal to the SEBI. The SEBI may either vary or set aside the decision of the stock exchange. The decision upon being communicated to the stock exchange shall have to be implemented by the stock exchange accordingly.

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LISTING—BENEFITS

Listed securities command the following advantages: 1. Easy marketability and liquidity that ensures easy raising of capital 2. High collateral value for bank loans 3. Easy evaluation of the real worth of securities 4. Safeguarding general public interest by ensuring equitable allotment, easy transfer, disclosure of proper information, etc 5. Availability of tax advantages to listed securities 6. Provision of selling forum for companies to mop up additional capital in future 7. Higher status and reputation for the company by enjoying the confidence of the investing public 8. Assurance of genuineness of securities as listing is made after thorough analysis of a company’s capital structure, the management pattern and business prospects 9. Provides an assurance of an existence of good faith or an absence of fraud with regard to the issue of securities 10. Providing activities of quick transfer registration and corporate information CONSEQUENCES OF NON-LISTING

Following consequences are to be faced by companies that have not had their securities listed on one or more recognized stock exchanges: 1. Any allotment of shares or debentures on an application shall be void 2. Any application money collected is to be refunded without interest, within eight days after the company becomes liable to repay it 3. Joint and several liability to every director of the company after the expiry of the aforesaid eighth day to repay the amount with interest at prescribed rate NEW ENTRY NORMS FOR UNLISTED COMPANIES

With reference to the SEBI’s Disclosure and Investor Protection Guidelines, August 12, 1997 following are the tightened entry norms for unlisted companies:

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3. 4. 5.

6.

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Dividends should have been paid immediately preceding three years before public issue Fee pricing of securities possible where the company has shown net profits in the immediately preceding three years subject to its fulfilling the existing disclosure requirements Compliance with the entry norms only if the post-issue net worth becomes more than five times the pre-issue net worth Conversion of partly paid-up shares into fully paid-up or forfeit the same, before making a public/ rights issue Promoters’ contribution for public issues by unlisted as well as listed companies will be at 20 percent irrespective of the issue size Only such securities that provide for lock-in facility can be offered for promoters contribution for which a specific written consent has been obtained from the shareholders. Mandatory appointment of a ‘Registrar to an Issue’ for rights issue. A provision has been made regarding disclosure of the shareholding of the promoters whose name figure in the paragraph on ‘Promoters and their Background’

LISTING—SUSPENSION / WITHDRAWAL

The dealings in the securities of a company or body corporate may be suspended or withdrawn admission to a recognized stock exchange either for a breach of or non-compliance, with any of the conditions of admission to dealings or for any other reasons, to be recorded in writing, which in the opinion of the stock exchange justifies such action. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6.

What does the term ‘listing’ mean? What is meant by ‘security listing’? How is security defined? How is a stock exchange defined? What are recognized stock exchanges? What is a listing agreement?

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Section B 1. 2. 3. 4. 5. 6.

What are the characteristic features of listing. State the legal provisions as to listing of securities. What is the legal significance of listing? Specify the powers of the SEBI as to listing of securities. When can listing be refused by a stock exchange? Bring out the association between listing and corporate governance. 7. State the features of a listing agreement. 8. How is a stock exchange empowered on securities listing? 9. How is listing beneficial? 10. What are the consequences of non-listing? 11. What are the new-entry norms brought out by the SEBI for unlisted companies? 12. When can listing be suspended or withdrawn? Section C 1. 2.

Outline the steps involved in the listing of securities of a corporate enterprise. What are the particulars to be furnished to the stock exchange while making an application for listing of securities by a corporate enterprise?

Chapter

16

Underwriting

DEFINITION

Underwriting is a guarantee given by the underwriters to take up whole or part of the issue of securities not subscribed by the public. It is a marketing technique whereby corporate enterprises are able to sell their securities to the public and thereby achieve success in the public issue. The service is utilized by corporates in order to procure the necessary funds. The agreement between the issuing company and the financial intermediary, called the underwriter, whereby sale of a certain quantum of securities is guaranteed for the issuing company, is known as underwriting agreement. The underwriter works for a commission called ‘underwriting commission’. According to Gerstenberg, “Underwriting is an agreement entered into before the shares are brought before the public that in the event of the public not taking up the whole of them the underwriter will take an allotment of such part of the shares as the public has not applied for.” TYPES

A brief description of different types of underwriting is outlined below: Firm Underwriting It is an underwriting agreement whereby, the underwriter agrees to take up a specified number of securities, irrespective of the securities being offered to the public. It is an agreement for outright purchase of securities, the underwriter being given a preference in allotment over the general public in respect of the commitment given by the company issuing the securities. This is in addition to the shares not taken up by the public. Such an agreement is designed to create confidence in the minds of investing public.

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Sub-underwriting When a large issue of securities is made and the underwriting of securities is contracted out by the main underwriter to other underwriting intermediaries for a commission, it is known as ‘sub-underwriting’. This type of underwriting helps the main underwriter minimize the risk of loss of investment in the event of the issue being unpopular. Joint Underwriting When an issue of securities by a company is underwritten by two or more underwriting intermediaries jointly, it is called ‘joint underwriting’. The objective is to minimize the risk and share the benefit arising from the capital issue. Besides, this also helps underwriters with limited resources to pool them and successfully take up the issue. Syndicate Underwriting When a syndicate of underwriters, by means of an agreement, underwrites the issue of securities collectively, it is known as ‘syndicate underwriting’. Such an arrangement is worked out in the case of issues that are considered potentially risky. There will be two types of agreements which will form part of the syndicate underwriting. They are: agreement between the issuing company and underwriter, and agreement among the underwriters themselves stating the terms and conditions.

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MECHANICS OF UNDERWRITING

The working mechanism connected with the underwriting of securities is depicted in Exhibit 6. Exhibit 6

Mechani cs of Underwri ti ng

BENEFITS/FUNCTIONS

The financial service of ‘underwriting’ is found advantageous for the issuers and the public alike. The function and the role of underwriting firms is given below: Adequate Funds Underwriting, being a kind of a guarantee for subscription of a public issue of securities enables a company to raise the necessary capital funds. By undertaking to take up the whole issue, or the remaining shares not subscribed by the public, it helps a company to undertake project

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investments with the assurance of adequate capital funds. Underwriting agreement assures the company of the required funds within a reasonable or agreed time. Expert Advice Underwriters of repute often help the company by providing advice on matters pertaining to the soundness of the proposed plan etc thus enabling the company to avoid certain pitfalls. It is therefore, possible for an issuing company to obtain the benefit of expert advice through underwriting before entering into an agreement. Further, underwriters supply important information to the issuing company with regard to investor’s attitude, market conditions etc and suggest changes in their financial plans too, wherever necessary. Enhanced Goodwill The fact that the issues of securities of a firm are underwritten, would help the firm achieve a successful subscription of securities by the public. This is because, intermediaries, of financial integrity and established reputation usually do the underwriting. Such an activity, therefore, helps enhance the goodwill of the issuing company. By purchasing securities, either directly from the company or from the market, they vouchsafe the financial soundness of the company. Assurance to Investors Underwriters, before underwriting the issue, satisfy themselves with the financial integrity of the issuer-company and viability of the plan. The underwriting firms assure this way, the soundness of the company. The investors are, therefore, assured of having low risk when they buy shares or debentures which have been underwritten by them. Their firm commitment towards fulfilling their underwriting obligations helps create confidence in the minds of the investing public about the company. Better Marketing Underwriters ensure efficient and successful marketing of the securities of a firm through their network arrangements with other underwriters and brokers at national and global level. This promotes a wide geographical dispersion of securities and facilitates tapping of financial resources for the company. Benefits to Buyers Underwriters are very useful to the buyers of securities due to their ability to give expert advice regarding the safety of the investment and the soundness of companies. The information and the expert opinion published by them in various newspapers and journals are also helpful.

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Price Stability Underwriters provide stability to the price of securities by purchasing and selling various securities. This ultimately benefits the stock market. INDIAN SCENARIO

Underwriting, as an important type of financial service, became popular in the Indian capital market only recently. It made its beginning in 1912 when M/s.Batliwala and Karni underwrote the shares of the Central India Spinning and Weaving Co. Ltd. Underwriting, on a substantial scale, started in the Indian capital market only after World War I. The Tatas started the first underwriting business in India in 1937, with the setting up of the ‘Investment Corporation of India Ltd’. Not only were there few underwriting firms operating in India, but also the quantum of underwriting done was also less. Underwriting gained momentum and popularity after January 1955, with the setting up of the Industrial Credit and Investment Corporation of India (ICICI). Later, other development financial institutions such as the Life Insurance Corporation of India, Industrial Development Bank of India (IDBI) and Unit Trust of India (UTI) started taking an active part in the underwriting of new issues, with IDBI being one of the largest. UNDERWRITING AGENCIES

The Indian capital market is dominated by several underwriting agencies such as private firms, banks, financial institutions, etc. Private Agencies Some of the important private firms that are involved in underwriting business are M/s.Place, Siddons and Gough, M/s.Baltiwala and Karni, M/ s.Dalal and Co., M/s.Kothari and Co. and M/s.Wright and Co. Investment Companies In addition to private agencies, a number of investment companies and trusts are also engaged in the underwriting business. These include Industrial Investment Trusts of Bombay, Birds Investment Ltd., Calcutta, Devkaran Nanji Investment Co., and Investment Trust of India Ltd. Commercial Banks After the nationalization of commercial banks, and with the initiation of reform measures in the beginning of the nineties, banks started taking a active part in the underwriting business.

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Development Finance Institutions (DFIs) A number of development finance institutions were established all over the country in order to spur development and growth in the industrial, export and agricultural sectors. These institutions provide both direct and indirect, financial and other type of assistance. Among the indirect assistance of finance, underwriting constitutes an important segment. These institutions include the Life Insurance Corporations (LIC), the Industrial Finance Corporation of India (IFCI), the Industrial Credit and Investment Corporation (ICICI), the Industrial Development Bank of India (IDBI), the Unit Trust of India (UTI) and State Financial Corporations (SFCs). These institutions account for a major share of the underwriting business in India. OBSTACLES

Underwriters in India face several debilitating conditions that constitute obstacle to their progress. Some of the hardships faced by them are as follows: Chaotic Capital Market An essential prerequisite for the development and the promotion of underwriting is the existence of a well-developed capital market. Unfortunately, the capital market in India is of recent origin. With the progress taking place very slowly, even after the implementation of economic reforms in the beginning of the nineties, a lot of uncertainties persist. Moreover, the kind of equity culture existing in the capital market is sluggish, dormant and chaotic. All these factors resulted in the slow progress of underwriting. Slow Industrialization Thanks to many obstacles in the Indian economy, industrial development has been relatively slow and tardy. There were many legislative and other measures of control and regulation that were so archaic that they caused heavy hardship to industrial development. On account of these reasons, the Indian capital market remained under-developed especially with regard to underwriting agencies for a long time. Managing Agency System The managing agency system, prevalent in the corporate world, was responsible for the slow growth of the underwriting business in India.

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Managing agents who performed the underwriting activity indulged in the sale of securities of managed companies to their friends. Bashful Investors The bashful nature of Indian investors is responsible for the slow progress of underwriting. Indian investors lack the inclination to make smart investment in securities. The backward nature of the Indian industry is responsible for not contributing anything towards the development of underwriting business. Lack of Specialized Institutions For the underwriting service to take place and flourish, it requires the presence of specialized financial institutions similar to the investment bankers of USA, or the issue houses of UK. Such specialized institutions were not available in the Indian capital market, although the banks and institutions started the underwriting business in a big way very late. Uns uccess ful Corporates The inability of the Indian corporates to emerge successful after the public issue of securities made potential investors lose faith in the activities of the capital market in India. This also resulted in inadequate capital formation. The underwriting business thus, did not take off well, since this made the investments more risky. UNDERWRITER

The financial services intermediary who arranges for the subscription of the issue of securities, in the event of the issue not being taken up by the public, or who firmly guarantees a capital issue, is called ‘the underwriter’. National financial institutions, commercial banks, merchant bankers, and members of stock exchanges function as underwriters. The lead manager, in consultation with the company, arranges the underwriting service. Several factors are taken into consideration while making the selection of an underwriter for an issue. The factors include financial strength, experience in the primary market, past underwriting performance and defaults, if any, underlying underwriting commitments, the network of investor clientele of the underwriter and overall reputation of the underwriter. If any part of the issue is underwritten, the prospectus shall contain a statement that the underwriters have sufficient resources to discharge their obligations. Before accepting the underwriting obligation, the underwriter takes into consideration factors such as the company’s standing and record,

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competence of the management, objectives of the issue, project details, offer price, other terms of the issue, and off-balance sheet liabilities. UNDERWRITING AGREEMENT

A contract between an underwriter and the company issuing capital with regard to the commitment for subscription of securities is known as ‘underwriting agreement’. The underwriter agrees to subscribe or procure subscription to a portion of the capital to be issued, in case the issue is not fully subscribed, the maximum liability of the underwriter being restricted to the amount underwritten. The underwriters usually include merchant bankers or financial institutions such as UTI, and other mutual funds, LIC or ICICI. In finalizing underwriting arrangements, both the resources of the underwriters and the marketing aspects of the issue are kept in mind. The participation of brokers in underwriting helps in marketing the issue to the individual investor. Financial institutions consider underwriting proposals on the basis of the viability of the project for which public issue is being made. SEBI GUIDELINES

SEBI has issued detailed guidelines regulating underwriting as a financial service. Following are the important guidelines: Optional Underwriting has been made optional by the SEBI, for issues since October 1994. Accordingly, if an issue has not been underwritten and the firm is not able to collect 90 percent of the amount offered to the public, the entire amount collected would be refunded to the investors. However, the requirement of a minimum of 90 percent subscription will not be applicable to the exclusive debt issues, provided the issuer makes adequate disclosures about the alternative sources of finance that have been tiedup. Number of Underwriters The issuers will decide the number of underwriters. For this purpose, the lead managers must satisfy themselves about the net worth of the underwriters, and the outstanding commitments, and disclose the same to SEBI. The underwriting arrangement should be filed with the stock exchange.

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Registration An important regulation announced by SEBI was the requirement for underwriting firms to get themselves registered with SEBI. The registration requires the underwriters to have a minimum net worth of Rs. 20 lakhs. Obligations Underwriters are obligated to follow scrupulously the general obligations and responsibilities, procedures for inspection and disciplinary proceedings in case of default. The underwriting obligations, at any point of time, should not exceed 20 times an underwriters net worth. Sub-underwriting As a step towards diversifying the risk, the underwriter can off-load a portion of the obligations to other underwriters. For this purpose, underwriters can arrange for sub-underwriting on their own. In order to ensure transparency in the operations of underwriters, an agreement is entered into with each body corporate on whose behalf the underwriting is undertaken. The agreement stipulates details such as the period within which the underwriter shall subscribe to the issue after being asked, the precise commission payable and details of arrangements made by the underwriter for fulfilling the underwriting obligations. Underwriting Commission The payment of underwriting commission depends on the amount of obligation devolving on the underwriter. Underwriting commission is payable by the issuer-corporation on the basis of the commission rates prescribed by SEBI. They are the maximum ceiling rates and are negotiable. No underwriting commission is payable on amounts taken up by promoters, employees, directors and their friends, and business associates. Underwriting commission is to be paid within 15 days of finalization of allotment. However, it is payable only when the entire portion has been subscribed. The relevant rates of underwriting commission are as follows: 1. In respect of equity shares, the commission is 2.5 percent on both the amount devolving on underwriter, and on the amount subscribed by the public 2 . In respect of preference, convertible and non-convertible debentures • For underwriting upto Rs. 5 lakhs, the commission is 2.5 percent for the amount devolving on underwriter and 1.5 percent on the amount subscribed by the public

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•

For underwriting exceeding Rs. 5 lakhs, the commission is 2 percent for the amount devolving on underwriter and 1 percent on the amount subscribed by the public

VARIANTS OF UNDERWRITING

There are variants of the underwriting business, which have evolved owing to the series of changes that have taken place in the control and regulatory ambience of the capital market in India. Offer for Sale Offer for sale takes place when a company arranges to obtain money from private sources, by making the issue of securities fully to them. The private sources include issue houses and merchant bankers. Issue is generally made below the par value, which is then sold to the public. In such an eventuality, the company issues a ‘statement in lieu of prospectus’ instead of a regular prospectus. A statement in lieu of prospectus with information to be disclosed according to Schedule III of the Companies Act (Sec. 70(1)) should be filed with ROC three days before allotment of shares or debentures. Bought-out Deals (BODs)

Meaning An arrangement, whereby the entire equity or related security is bought in full or in lots, with the intention of off-loading it later in the market is called ‘bought-out deal’. Features a.

b.

c. d.

e.

Arrangement The arrangement takes place between the merchant banker/sponsor and the company, the shares being held by the sponsor until they are ready for public participation No retailing BODs eliminate retailing, thereby saving time and cost. They are the cheapest and quickest source of finance for small and medium companies Fund-based activity BODs convert a fee-based activity into a fund-based activity for merchant bankers Wholesale activity The capital raised from public, which is a retail activity, is rendered into a wholesale activity by the guidelines issued by SEBI in 1994, for reservation of issues without lock-in periods Reserved portions From the reserved category for institutional investors, lead managers can take a stake upto 5 percent of the

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post-issue equity. The reserved portion of the issue need not be underwritten. The public offer is 25 percent of the issue and underwriting is optional

Ad vantages a. b. c. d. e. f. g.

Efficient appraisal of the project by the merchant bankers before the funds are invested Appropriate avenue to price the securities of companies Helpful in raising funds upfront and thus saving the cost of raising funds through a public issue Helpful to entrepreneurs who are not confident enough of tapping the capital market directly Measure of assurance and safety to the investor since the project is appraised by a merchant banker Benefits of larger participation of FIs, merchant bankers and FIIs and consequent higher credibility Handsome gains for the merchant banker if proper issue and prices are selected

Private Placement

Definition The direct sale of securities by a company to institutional investors is called private placement. It is another variant of underwriting. Private placement assumes that the offerees are limited and few, and have sufficient knowledge and experience to evaluate the merits and risk of investment. Private placement facility is available for both listed and unlisted companies with a good track record of sales and profit. In the case of listed companies, private placements take into account their trading volumes, the level of floating stock and the purpose for which additional funds are being raised.

Features a. b. c. d.

No prospectus In private placement no prospectus is issued Instrument covered Private placement covers shares, preference shares and debentures Issuers The issuers could be public limited companies or private limited companies Investors Investors include Unit Trust of India, Life Insurance Corporation, General Insurance Corporation, State Finance

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Corporations, and Pension and Insurance Funds. Investors have sufficient knowledge and experience to be capable of evaluating the merits and risks of the investment e. Intermediaries The intermediaries are credit rating agencies, trustees (e.g. ICICI) and financial advisors such as merchant banks. The financial intermediary plays a vital role in preparing an offer memorandum, and negotiating with investors f. Negotiation By dealing with a limited number of institutional investors, the credit rating agents or trustees like ICICI can negotiate a loan directly tailored to suit the issuer’s needs g. Popular instrument The most widely used instrument in private placement is nonconvertible debenture, which is preferred by institutional investors because it gives stable and assured yield. The debentures are generally held until maturity h. Market size The private placement market is as big as the market for public issue through prospectus and rights combined Rationale Many factors contributed to the need for the development of opportunities for privately placing the securities. Some of these factors are as follows: a.

b.

c.

Capital market conditions The conditions that were prevailing in the Indian capital market with regard to pricing, listing and trading conditions made it difficult for corporates to raise capital for new projects. The cost of raising capital in terms of publicity and brokerage, which has always been prohibitive, along with uncertainties, has prompted companies to look for private placement opportunities for public subscription. Activity in the institutionalized private placement market has been quite intense, with most public sector enterprises, financial institutions and corporations meeting their requirement through private equity funding FIs resources A huge pool of savings with Financial Institutions (FIs) such as banks, including rural banks, insurance companies, provident funds, trusts and foreign private equity funds, made it possible for the growth of private placements Preferences The preferences of institutional investors, details of the company, promoters, management, project to be undertaken, pricing norms, and projections also played an important part in the development of the private placement market

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Ad vantages a.

b. c.

d.

Popular mode Private placement has obvious advantages of speed, low cost, confidentiality, and accommodates smaller debt financing than is possible in a public issue Quick access Private placement offers access to capital more quickly than the public issue Secrecy Confidentiality is ensured in private placement, especially for private limited companies and closely held public limited companies, which do not want to make public issues for fear of takeover, wealth tax hassles and institutional interference Influence Private placement is not influenced by the prevailing bull or bear phases in the stock markets

GREY MARKET

When securities are not sold through prospectus, it is a case of ‘grey market placement’. In the grey market, trading takes place in securities much before official listing. The modus operandi in grey market is soliciting through post or print media, or door-to-door, and interested parties to purchase shares in private placement. While shares of new companies are sold at par or at nominal premium, in the case of shares of existing and profit making companies, premium could be very high. The brochure that normally accompanies the application presents a rosy picture and does not convey the gestation period or risks involved. The grey market exists with the active connivance of promoters. They sell shares out of their quota and profit from any premium collected. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8. 9.

Define the term ‘underwriting’ What is meant by ‘firm underwriting’? What is ‘sub-underwriting’? What is ‘joint underwriting’? How is it different from ‘syndicate underwriting’? Who is an underwriter? What is an underwriting agreement? What is ‘offer for sale’? What are ‘bought-out deals’? What is ‘private placement’?

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Section B 1. 2.

How is underwriting classified? Explain. Explain the mechanics of underwriting of securities of a corporate enterprise. 3. State the advantages of underwriting of securities. 4. State the underwriting agencies operating in India. 5. What are the obstacles to the business of underwriting in India? 6. State the relevant rates of underwriting commission as applicable to underwriting firms in India. 7. What are the features of ‘bought-out deals’? 8. State the benefits of ‘bought-out deals’ 9. Bring out the features of private placement. 10. What is the rationale for the development of private placement in India? 11. What is ‘grey market’? How is it significant? Section C 1. 2. 3.

Examine the business underwriting in the Indian scenario. What are the SEBI guidelines relating to the business of underwriting in India? Discuss the variants of underwriting.

Chapter

17

Book-Building

C ON C E P T

Book-building is a process by which corporates determine the demand and the price of a proposed issue of securities through public bidding. The objective is to determine the quantum of the issue on the basis of the price book-built. Once the price and the quantum of issue has been determined by the issuer, the issue may either be offered under the private placement or the public offer category, or both, as per the requirement of the SEBI regulations. CHARACTERISTICS

Tendering Process Book-building involves inviting subscriptions to a public offer of securities, essentially through a tendering process. Eligible investors are required to place their bids for the number of shares to be issued and the price at which they are willing to invest, with the lead manager running the book. At the end of the cut-off period, the lead manager determines the response to the issue in terms of the quantum of shares and the highest price at which demand is sufficient to match the size of the issue. Floor Price Floor price is the minimum price set by the lead manager in consultation with the issuer. This is the price at which the issue is open for subscription. Investors are free to place a bid at any price higher than the floor price. Price Band The range of price (the highest and the lowest price) at which offer for the subscription of securities is made is known as ‘price band’. Investors are free to bid any price within the price band.

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Bid The investor can place a bid with the authorized lead manager-merchant banker. In the case of equity shares, usually several brokers in the stock exchange are also authorized by the lead manager. The investor fills up a bid-cum-application form, which gives a choice to bid for upto three optional prices. The price and demand options submitted by the bidder are treated as optional demands and are not cumulated. Allotment The lead manager, in consultation with the issuer, decides the price at which the issue will be subscribed and proceeds to allot shares to investors who have bid at or above the fixed price. All investors are allotted shares at the same fixed price. For any allottee, therefore, the price would be equal to or less than the price bid. Participants Generally, all investors, including individuals, eligible to invest in a particular issue of securities can participate in the book-building process. However, if the issue is restricted to qualified institutional investors, as in the case of government securities, then, only those eligible can participate.

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THE PROCESS

The process of book-building is depicted in Exhibit 7. Exhibit 7

Process of Book-bui ldi ng

The procedures relating to the book-building process depend on the level at which it is to be taken up by a corporate entity. According to the SEBI, there are two options available to a company, either 75 percent or 100 percent book-building process. Each of these methods is discussed briefly below:

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75 Percent Book-building The 75 percent book-building option of securities is offered on a ‘firm basis’, where a minimum of 25 percent of the securities is offered to the public. The following steps are involved in this process: 1. Eligibility All corporates eligible for public shares are also eligible for raising capital through the book-building process. 2. Earmarking securities Where a decision is taken by a corporate to issue shares through the book-building process, the securities to be used should be separately earmarked as the ‘placement portion category’ in the prospectus. The balance securities must be stated as ‘net offer to the public’ category. 3. Draft prospectus A draft prospectus containing all the information except price of the issue must be filed with the SEBI. Although no precise mention is made, a ‘price band’ indicating the price range within which securities are being offered for subscription should be indicated. The prospectus is to be filed with the ROC within two days of the issue price being finalized. 4. Appointment of book runner The issuing company appoints a merchant banker as the book runner, which should be mentioned in the prospectus. The book runner circulates a copy of the draft prospectus among the institutional buyers who are eligible for firm allotment and to the intermediaries who are eligible to act as underwriters, inviting them to subscribe to the issue of securities. The book runner maintains a record of the names and number of securities ordered by intermediary buyers and the price at which they are willing to subscribe the issue under the placement portion. The book runner collects information about the subscriptions received from underwriters and other intermediaries. After a stipulated time period, the book runner aggregates the subscriptions so received. The underwriters are required to make a payment of the total amount for the subscription of issues. The book runner collects payments from underwriters and institutional buyers a day prior to opening of the issue to the public, which includes application money for all the applications through which securities were subscribed by them. 5. Price setting Based on the data collected from intermediaries relating to the total orders received, the issuing company and the book runner set an appropriate price of the issue for offer to the public. The issue price is determined on the basis of ‘bids’ received through members

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of the syndicate formed under the lead book runner. This would be the issue price for both the private placement and the public category. The number of securities to be issued is decided on the basis of amount and the issue price. This can be expressed as: Number of securities = Amount of issue ÷ Price per security 6. Underwriting The members of the syndicate fully underwrite the offer to the extent that it is not offered to promoters, permanent employees and shareholders. For this purpose, the syndicate members enter into an underwriting agreement. The agreement specifies the quantum and price of shares that would be underwritten for book-building. Underwriting is mandatory for issues that are earmarked as ‘net offer to the public’. The underwriters maintain a record of the subscriptions received by them for the issue in the placement portion and forward these records to the book runner. In the event of the underwriters not being in a position to take up the shares as committed, the book runners have to subscribe to the issue committed for by the underwriters. 7. Bank account The issuer company opens two accounts, one for collection of the application money towards the private placement portion, and the other for the offer of the 25 percent of the total issue made to the public. 8. Allotment All those intermediaries who have offered their bid price at and above the now determined issue price, will become eligible for allotment of securities. Once the eligibility is decided, intimation has to be sent to them for the subscription and payment. Although the allotment in the private placement category has to be made two days prior to the date of closure of the issue, the issuer may choose to allot securities under the book-building process for both private placement and public offer category on the same day. The allotment of securities under the public offer category should be made in accordance with the relevant guidelines. In the event of under-subscription to the public offer category, orders in the private placement category can be utilized to fill public subscription. While doing so, preference should be given to individual investors. Similarly, when there is deficient subscription to the private placement category, a spillover is allowed from the public offer category. Interest is payable by the issuer for the period between the date of closure of the issue and date of allotment. 9. Listing When all the committed money has been collected from the underwriters by the 11th day of issue closure, the shares allotted in the

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private placement category become eligible for listing. The securities issued under the public offer category are also eligible for listing. However, securities offered on-line over the internet are not listed. 10. Inspection SEBI serves as the chief regulator supervising the bookbuilding process. It has the powers to carry out inspection of books and records maintained by intermediaries such as the book runner, the underwriter and others. 100 Percent Book-building It is an option of book-building process whereby 100 percent of the securities is offered on a ‘firm basis’ or is reserved for promoters, permanent employees of the issuer company. It may also be offered to shareholders either on a competitive basis or on a firm allotment basis. The required minimum issue of capital is Rs. 25 crores. Following are the procedures connected with the 100 percent book-building process: 1. Conditions It is possible for an issuer to make a public issue through the 100 percent book-building process by fulfilling the following conditions: a. The minimum capital to be raised must be Rs. 25 crores b.

Reservation or firm allotment to promoters can be made only according to the guidelines of the SEBI, i.e. to permanent employees of the issuer company, and in the case of new companies, to the permanent employees of the promoting company

c.

Allotment can also be made either on a competitive basis or on firm allotment basis to the shareholders of the promoting companies in the case of a new company, or to the shareholders of group companies in the case of existing companies

d.

Eligible merchant bankers shall be appointed as the lead book runners and their names shall be mentioned in the draft prospectus to be filed with the SEBI

2. Lead book runner An essential requirement for a 100 percent bookbuilding process is the appointment of a lead book runner by the issuer. The book runner is primarily responsible for book-building in order to determine the appropriate price and quantum of issue. For this purpose, a syndicate is formed. SEBI-registered underwriters and other eligible merchant bankers are appointed by the book runner as members of the syndicate. In the event of any undersubscription of issue, the lead merchant bankers have to fill the shortfall. The book runners are responsible for incorporating any changes in the draft prospectus that might be suggested by SEBI.

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In addition, they are also responsible for maintenance of records relating to the book-building process, which may be inspected by SEBI to examine the modalities of book-building adopted by the company. 3. Draft prospectus The lead book runner files a draft prospectus with SEBI. This document contains all the required disclosures, such as the total size of the issue etc in accordance with SEBI norms. The information about the issue price and the quantum issue need not be mentioned. Any modifications are intimated to the company by SEBI within a period of 21 days after the receipt of the draft prospectus. 4. Essential disclosures The following information should be disclosed in the draft prospectus before being filed with SEBI: a. Details of the members of the ‘syndicate’ formed by the lead book runner for the purpose of bidding for the issue b.

Details of registrars and bankers to the issue

c.

Details of basis of ascertainment of issue price by the issuer and the book runners

d.

Details of accounting ratios, such as preissue EPS, P/E, average return on net worth etc for three years including a comparison with industry average. The ratios have to be computed after giving due effect to the consequent increase of capital on account of compulsory outstanding conversions

e.

Details of NAV per share based on the last balance sheet

5. Advertisement The issuer, after obtaining the revised prospectus from SEBI, advertises in leading newspapers. The advertisement contains all the requisite features of the final offer document as specified under the provisions (Section 2A) of the Companies Act. It is incumbent on the part of the issuing company to offer at least 10 percent of the total issue to the public. 6. Stockbrokers SEBI-registered stockbrokers are appointed for placing orders with the company by the stock exchange that would act as collection centers for the applications. These brokers must be capable of taking up the issue in the event of failure on the part of their clients to honor their commitment. The issuer pays commission for their services. 7. Bidding process The members of the syndicate bid for the securities to be issued by the issuer. Following are the procedures connected with the bidding: a. Advertisement regarding the bidding, containing information about the date of opening and closing of the bidding (minimum 5

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b. c. d. e.

f. g.

days of opening), names and addresses of the syndicate members, bidding terminals and the method of bidding are given Bidding takes place on-line electronically by members present at the designated centers The number of collection centers and bidding centers shall be according to the guidelines of SEBI Individuals and institutions who are not members of the syndicate can bid through the syndicate memberse Bidding shall be done in the prescribed form wherein information about the investor, price and quantum of securities etc are to be furnished The serial number of the bidding form shall be system generated and stamped automatically The bidding form shall be made out in duplicate, signed by the investor and countersigned by the book runner/syndicate member

8. Allotment process Following are the procedures for the allotment of securities: a. A minimum of 15 percent of the issue shall be reserved for allotment to individual investors to a maximum of 10 tradeable lots through the syndicate member b.

A minimum of 10 percent of the issue shall be reserved for allotment to individual investors who have not participated in the book-building process

c.

Allotment to individual investors shall be on the basis of a proportionate allotment system

d.

In the event of under-subscription of issues reserved for individual investors, the issuer company may make allotment in any manner as it deems fit

e.

Allotment to other categories of investors shall be decided by the book runner on the basis of prior commitment, investor quality, price quoted, etc

f.

Allotment shall be made within a period of 15 days from the date of final closure of the issue. Failure to do so will entail the company to pay interest @ 15 percent p.a. to the investors (issue must be open for a period of at least 21 days)

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9. Refund The broker shall refund the amounts received from unsuccessful applicants within 3 days of the receipt of the allocation. The details of the amount received from successful applicants shall be furnished to the stock exchange in electronic medium. 10. Certificate Once all the formalities for subscription and allotment are completed, the registrars to the issue post the share certificate to the applicants, or arrange to have the shares demated by a depository. ALLOCATION PROCEDURE

The allocation procedure relating to an issue of a firm that wishes to follow the ‘book-building’ route is as follows: CASE I—INITIAL PUBLIC OFFER (IPO) ISSUE

In the case of a company going in for an IPO and availing the book-building facility, the allocation to individual investors applying through the syndicate members shall be with reference to the post-issue capital. The allocation to individual investors not applying through the syndicate members shall be with reference to the issue size offered to the public through the prospectus. The allocation procedure in the case of an IPO is as follows: 1. Calculate initial promoters’ contribution: = Initial post-issue capital × 20% (Minimum) 2.

Calculate the quantum of book-building: = Initial post-issue capital – Initial promoters’ contribution

3.

Calculate allocation to individual investors applying through syndicate (fixed): = Initial post-issue capital × 15% (Minimum)

4.

Calculate allocation to institutional investors (fixed): = Initial post-issue capital – [Initial promoters’ contribution + Allocation to individual investors pplying through syndicate]

5.

Calculate allocation to individual investors NOT applying through syndicate (fixed): = Initial post-issue capital × 8% (Minimum)

6.

Calculate new post-issue size: = Initial post-issue capital + Allocation to individual investors NOT applying through syndicate

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7.

Calculate New allocation to individual investors applying through syndicate (fixed): = New post-issue capital × 15% (Minimum)

8.

Find the excess contribution to be brought in by the promoter: = New allocation to individual investors applying through syndicate (fixed) – Old allocation to individual investors applying through syndicate

9.

Find new allocation to institutional investors (fixed): = Initial post-issue capital – [Initial promoters’ contribution + New allocation to individual investors applying through syndicate]

10. Find the deficiency contribution to be brought in by the promoter: = Fixed allocation – New allocation 11. Calculate total promoters’ contribution: = Initial contribution + Excess of individual investors + Deficiency of institutional investors 12. Calculate individual investors allocation: = Minimum allocation to individual investors applying through syndicate + Minimum allocation to individual investors applying through syndicate 13. Calculate total issue size: = Total promoters’ contribution + Total allocation to individual investors + Allocation to institutional investors ILLUSTRATION

From the following information, set out the calculations to show the quantum of book-building, the total promoters’ contribution and the total allocation to individual investors: • Initial post-issue capital Rs. 100 Crores •

Minimum promoters’ contribution 20%

•

Minimum allocation to individual investors applying through syndicate 15%

•

Minimum allocation to individual investors not applying through syndicate 8%

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Solution Quantum of book-building, promoters’ contribution and individual investors contribution 1. Initial post-issue size = Rs. 100 Crores 2. Initial promoters’ contribution = Rs. 100 Crores × 20% = Rs. 20 Crores 3. Calculate the quantum of book-building = Rs. 100 Crores – Rs. 20 Crores = Rs. 80 Crores 4. Fixed allocation to individual investors applying through syndicate = Rs. 100 Crores × 15% = Rs. 15 Crores 5. Fixed allocation to institutional investors = Rs. 100 Crores – [Rs. 20 Crores + Rs. 15 Crores] = Rs. 65 Crores 6. Fixed allocation to individual investors applying NOT through syndicate = Rs. 100 Crores × 8% = Rs. 8 Crores 7. New post-issue size = Rs. 100 Crores + Rs. 8 Crores = Rs. 108 Crores 8. New (fixed) allocation to individual investors applying through syndicate = Rs. 108 Crores × 15% (Minimum) = Rs. 16.2 Crores 9. Excess contribution to be brought in by the promoter = Rs. 16.2 Crores – Rs. 15 Crores = Rs. 1.2 Crores 10. NEW (fixed) allocation to institutional investors = Rs. 100 Crores – [Rs. 20 Crores + Rs. 16.2 Crores] = Rs. 63.8 Crores 11. Deficiency contribution to be brought in by the promoter Rs. 65 Crores – Rs. 63.8 Crores = Rs. 1.2 Crores 12. Total promoters’ contribution = Rs. 20 Crores + Rs. 1.2 Crores + Rs. 1.2 Crores = Rs. 22.4 Crores 13. Total individual investors allocation = Rs. 15 Crores + Rs. 8 Crores = Rs. 23 Crores 14. New total issue size = Rs. 22.4 Crores + Rs. 23 Crores + Rs. 65 Crores = Rs. 110.4 Crores CASE II—ADDITIONAL ISSUE BY LISTED COMPANY

In the case of a listed company going in for an additional issue of capital, and availing the book-building facility, the allocation to individual investors applying through the syndicate members shall be with reference to the proposed issue. The allocation to individual investors not applying through syndicate members shall be with reference to the issue size offered to the public through the prospectus. The allocation procedure in case of an additional issue by a listed company is as follows:

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1.

Calculate promoters’ contribution: = Proposed issue × 20% (Minimum)

2.

Calculate the quantum of book-building: = Proposed issue – Promoters’ contribution

3.

Calculate allocation to individual investors applying through syndicate (fixed): = Proposed issue × 15% (Minimum)

4.

Calculate allocation to institutional investors (fixed): = Proposed issue – [Promoters’ contribution + Allocation to individual investors applying through syndicate]

5.

Calculate allocation to individual investors NOT applying through syndicate (fixed): = Quantum of book-building × 10% (Minimum)

6.

Calculate New additional issue size: = Proposed issue + Allocation to individual investors applying NOT through syndicate

7.

Calculate New (fixed) allocation to individual investors applying through syndicate: = New additional issue size × 15% (Minimum)

8.

Find the excess contribution to be brought in by the promoter: = New allocation to individual investors applying through syndicate (fixed) – Old allocation to individual investors applying through syndicate

9.

Find New allocation to institutional investors (fixed): = Proposed issue – [Promoters’ contribution + New allocation to individual investors applying through syndicate]

10. Find the deficiency contribution to be brought in by the promoter: = Fixed allocation – New allocation 11. Calculate Total promoters’ contribution: = First contribution + Excess of individual investors + Deficiency of institutional investors 12. Calculate total individual investors allocation: = Minimum allocation to individual investors applying through syndicate + Minimum allocation to individual investors applying through syndicate

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13. Calculate total additional issue size: = Total promoters’ contribution + Total allocation to individual investors + Allocation to institutional investors ILLUSTRATION

From the following information, set out the calculations to show the quantum of book-building, the total promoters’ contribution and the total allocation to individual investors: • Additional issue proposed Rs. 100 Crores • Minimum promoters’ contribution 20% • Minimum allocation to individual investors applying through syndicate 15% • Minimum allocation to individual investors not applying through syndicate 10% Solution Quantum of book-building, promoters’ contribution and individual investors contribution 1. Proposed issue = Rs. 50 Crores 2.

Promoters’ contribution = Rs. 50 Crores × 20% (Minimum) = Rs. 10 Crores

3.

Quantum of book-building = Rs. 50 Crores – Rs. 10 Crores = Rs. 40 Crores

4.

Allocation to individual investors applying through syndicate (fixed) = Rs. 50 Crores × 15% (Minimum) = Rs. 7.5 Crores 5. Allocation to institutional investors (fixed) = Rs. 50 Crores – [10 Crores + Rs. 7.5 Crores] = Rs. 32.5 Crores 6. Allocation to individual investors NOT applying through syndicate (fixed) = Rs. 40 Crores × 10% (Minimum) = Rs. 4 Crores 7. New additional issue size = Rs. 50 Crores + Rs. 4 Crores = Rs. 54 Crores 8. New allocation to individual investors applying through syndicate (fixed) = Rs. 54 Crores × 15% (Minimum) = Rs. 8.1Crores 9. Find the excess contribution to be brought in by the promoter = Rs. 8.1Crores – Rs. 7.5 Crores = Rs. 0.6 Crores 10. New allocation to institutional investors (fixed) = Rs. 50 Crores – [Rs. 10 Crores + Rs. 8.1 Crores] = Rs. 31.9 Crores

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11. Find the deficiency contribution to be brought in by the promoter = Rs. 32.5 Crores – Rs. 31.9 Crores = Rs. 0.6 Crores 12. Total promoters’ contribution = Rs. 10 Crores + Rs. 0.6 Crores + Rs. 0.6 Crores = Rs. 11.2 Crores 13. Total individual investors allocation = Rs. 7.5 Crores + Rs. 4.0 Crores = Rs. 11.5 Crores 14. Total additional issue size = Rs. 11.2 Crores + Rs. 11.5 Crores + Rs. 32.5 Crores = Rs. 55.2 Crores CASE III—OFFER BY UNLISTED COMPANY

In the case of an unlisted company going in for an offer of sale, and availing the book-building facility, the allocation to individual investors applying through the syndicate members shall be with reference to the post-issue capital. The allocation to individual investors not applying through syndicate members shall be with reference to the issue size offered to the public through the prospectus. The allocation procedure in the case of an offer for sale by an unlisted company is as follows: 1. Calculate Total promoters’ contribution: = Proposed issue × 20% (Minimum) 2.

Calculate the quantum of book-building: = Proposed issue – Promoters’ contribution

3.

Calculate allocation to individual investors applying through syndicate (fixed): = Proposed issue × 15% (Minimum)

4.

Calculate allocation to individual investors NOT applying through syndicate (fixed): = Quantum of book-building × 10% (Minimum)

5.

Calculate allocation to institutional investors (fixed): = Proposed issue – [Promoters’ contribution + Allocation to individual investors applying through syndicate + Allocation to individual investors NOT applying through syndicate]

6.

Calculate total individual investors allocation: = Minimum allocation to individual investors applying through syndicate + Minimum allocation to individual investors applying through syndicate

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7.

337

Calculate total issue size: = Total promoters’ contribution + Total allocation to individual investors + Allocation to institutional investors

ILLUSTRATION

From the following information, set out the calculations to show the quantum of book-building, total promoters’ contribution and the total allocation to individual investors: • Issue proposed Rs. 100 Crores • Minimum promoters’ contribution 20% • Minimum allocation to individual investors applying through syndicate 15% • Minimum allocation to individual investors not applying through syndicate 10% Solution Quantum of book-building, promoter’s contribution & individual investors contribution 1. Proposed issue size = Rs. 100 Crores 2. Total promoters’ contribution = Rs. 100 Crores × 20% (Minimum) = Rs. 20 Crores 3. Quantum of book-building = Rs. 100 Crores – Rs. 20 Crores = Rs. 80 Crores 4. Allocation to individual investors applying through syndicate (fixed) = Rs. 100 Crores × 15% (Minimum) = Rs. 15 Crores 5. Allocation to individual investors NOT applying through syndicate (fixed) = Rs. 80 Crores × 10% (Minimum) = Rs. 8 Crores 6. Allocation to institutional investors (fixed) = Rs. 100 Crores – [Rs. 20 Crores + Rs. 15 Crores + Rs. 8 Crores] = Rs. 57 Crores 7. Total individual investors allocation = Rs. 15 Crores + Rs. 8 Crores = Rs. 23 Crores 8. Total issue size = Rs. 20 Crores + Rs. 57 Crores + Rs. 23 Crores = Rs. 100 Crores Normal Public Issue Vs. Book-Building Process Issue of securities through book-building process differs from the public issue in the following respects:

338 Capi tal Markets

Feature

Normal Public Issue

Book-building Process

Pricing

The investor knows in advance the price at which the securities are offered.

The investor does not know in advance the price at which securities will be offered. Only an indicative price range is known.

Demand

Demand for the securities offered is known only after the closure of the issue.

Demand for the securities offered can be known everyday as the book is built.

Payment

Payment is made at the time of subscription wherein refund is given after allocation.

Payment only after allocation.

REVERSE BOOK-BUILDING

Meaning The process, By which the exit price of the shares of a corporate entity is determined, is called, ‘reverse book-building’. This happens where a firm exits from the stock market through the delisting process. Reverse book-building allows shareholders to tender their shares at a price of their choice and the acquirer the freedom to accept or reject the offer. Recently there was a move by the Hewlett Packard (HP) to get its Indian subsidiary ‘Digital Globalsoft’ delisted through reverse bookbuilding. Features/Benefits 1. Offer from shareholders Reverse book-building essentially involves generating offers from the seller (shareholders) who have no indication of the buyer’s intention on the price that the buyer is willing to pay for the strategic value of the company. 2. Exit price Reverse book-building is used as a method of arriving at the exit price for delisting of shares. The exit price will be determined on the basis of the average of weekly highs and lows of either 26 weeks or 52 weeks. Such a price will be the minimum offer price.

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3. Fair price Reverse book-building process is expected to provide a transparent, fair, and reasonable mechanism for pricing of shares and ensure investor participation in the whole process of delisting. 4. Reasonable pricing Reverse book-building process is expected to provide a transparent, fair, and reasonable mechanism for pricing of shares and ensure investor participation in the whole process of delisting. 5. Viable solutions It focuses on viable solutions for determining “fair price” to the shareholders in the case of outright acquisition of 100 percent equity stake by multinational or domestic promoters/persons in control of the company to gain full control over the Indian companies. Mec han is m The reverse book-building process as required under the SEBI guidelines will utilize the trading system network of the stock exchanges now being used in the Initial Public Offerings (IPOs). The acquirer determines the floor price of the offer based on the average prices for 26 weeks proceeding the date of public announcement. Shareholders are then allowed to tender their shares at or above the floor price. Once the reverse book-building process is completed the final price will be determined as the price at which the maximum shares are tendered. While this provides the shareholder an opportunity to determine the price, the acquirer has the right to accept or reject the price so discovered. In case, the acquirer accepts the price, all shareholders who bid at or below the discovered price, will receive the discovered price for their holdings. Criticisms Despite many advantages claimed by the reverse book-building process, it is criticized on the following grounds: 1. Manipulations The process of reverse book-buildings is prone to manipulation, as it would operate on a restricted audience, as against an IPO, which is open to the general public. The possibility of getting a fair price for shareholders in the reverse book-building process is limited, as this process is subject to manipulation in the hands of more experienced and savvy shareholders. 2. Low participation Moreover, the participation of the small shareholders (or the public) will be extremely low as their understanding of the process is imperfect. 3. Price indication Any open offer delisting should indicate the price that the buyer is willing to pay.

340 Capi tal Markets

4. No fair price Under the rising market conditions, the floor exit price, which is based on the 26-week average, may not truly be reflective of the current market price. Hence, such a price will not serve as a useful benchmark for the investor. 5. Non-acceptance Although the shareholders command the flexibility of tendering their shares at any price, they also run the risk of their shares not getting accepted if the acquirer finds the price unattractive. 6. False price There is a bigger risk of speculators spreading false information in the market and thereby increasing the share price to unrealistic levels and selling the stock back to small investors. This would prove highly detrimental to the interest of the investors especially when share prices come down after the delisting is over. Sugges tions Only a combination of “independent investment valuation” and “stock price” can serve to improve the valuation in a voluntary open offer transaction. In a voluntary open offer, one criterion for evaluating the fair price can be the market price (based on the average of 52-week highs and lows, instead of the 26 weeks now being considered) of the company To avoid the vagaries of the market the company can appoint an ‘independent valuer’ to arrive at fair price for the stock (just as in acquisition deal) impounding the premium for control. Further, the valuation report must be available for inspection to the non-promoter shareholders. The fair exit price can be arrived at on basis of the higher of these two criteria. In order to avoid the risk non-acceptance of the shares by the acquirer, it is essential that the shareholder gets some indication about the level at which the acquirer is willing to buy out the shares. This is to avoid making the process a fruitless exercise. Although this is still imperfect mechanism for arriving at the fair price, there is a possibility that the shareholders may have less reason to complain. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6.

What do you mean by ‘book-building’? What is ‘floor piece’? What is ‘price band’? Who is a ‘book-runner’ in a book-building process? What is a ‘draft prospectus’? What is ‘reverse book-building’?

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Section B 1. 2. 3. 4. 5. 6. 7. 8. 9.

Explain briefly the features of ‘book-building’. How is price discovered in a book-building process?. What are the conditions to be satisfied for the 100 % bookbuilding process?. Explain the bidding process involved in book-building of securities. Explain the allotment process pertaining to book-building of securities. How is a book-building issue different from a normal issue? Explain the mechanism of reverse book-building. State the benefits of reverse book-building. State the criticisms leveled against the reverse book-building.

Section C 1. 2. 3. 4.

Explain and illustrate the entire book-building process. Illustrate as to how the shares are allocated to the bidders in the case of an IPO. Illustrate as to how the shares are allocated to the bidders in the case of an additional issue by an existing company . How are shares allocated under a book-building process in respect of shares offered by an unlisted company?

Chapter

18

Over the Counter Exchange of India (OTCEI)*

GENESIS

OTCEI was incorporated in October 1990 under the Companies Act, 1956 and is recognized as a stock exchange under Section 4 of the Securities Contracts (Regulation) Act, 1956. A consortium of premier financial institutions including UTI, ICICI, IDBI, IFCI, LIC, SBI Capital Markets Ltd, GIC and its subsidiaries and Canbank Financial Services Ltd promoted it. OTCEI is a recognized stock exchange under the Securities Contract (Regulation) Act and became operational in 1992. It is the first stock exchange in India which introduced state-of-the-art screen-based automated ringless trading system. Companies listed on OTCEI enjoy the same listing status as available to companies listed on any other recognized stock exchange in the country. However, the companies listed on OTCEI cannot be listed/traded on any other stock exchange in India. The Exchange was set up to aid enterprising promoters in raising finance for new projects in a cost-effective manner and to provide investors with a transparent and efficient mode of trading. Modeled along the lines of the NASDAQ market of USA, OTCEI introduced many novel concepts to the Indian capital markets such as screen-based nationwide trading, sponsorship of companies, market making, scripless trading, etc. Over-the-counter Exchange of India is primarily meant for small size companies and small investors. The exchange has the merits of transparency, fast settlements and potential to reach the nook and corner of the country that could make it as the premier niche exchange in India. Investors benefit due to cleaner deals and easier reach and small companies have a safer route to the stock market. The Dave Committee on Over-the-counter Exchange of India (OTCEI) recommended relaxation of the maximum size of the issues that may be *

Discussed with reference to stock exchanges other than BSE and NSE.

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listed on OTCEI, relaxation in listing criteria and a shift from a rolling (T+3) settlement to five-day account period settlement being followed by other stock exchanges. These and most of the other recommendations of the Committee for making OTCEI more effective and viable have been accepted by SEBI and are being implemented. OTCEI Vs. OTHER STOCK EXCHANGES

OTCEI is different from the regular stock exchange in the following ways: Sl. No.

Feature

OTCEI

Traditional Stock Exchanges

1

Formation

Organization promoted by financial institutions

Association formed by brokers of the exchange

2

Number

Only one stock exchange called the OTCEI exists with a nationwide reach

Twenty-two stock exchanges exist independently in the country (including NSE)

3

Listing

Companies with equity share capital between Rs.30 lakhs and Rs.25 crores are allowed to be listed

Companies with equity share capital of Rs.3 crores and above are allowed listing

4

Coverage

Decentralized exchange with a nation-wide network

Centralized exchange with members operating at a single location (except BSE)

5

Transferable Document

Share certificate is not a transferable document. Counter Receipt (CR) was the transferable document earlier which has since been discontinued

Ordinarily share certificate acts as a transferable document

6

Computer Usage

Screen-based trading with computer network

Trading is done in a trading hall/ring by public outcry (except BSE)

7

Transfer Mode

Securities are transferred through ‘counter receipts’

Securities are transferred by transferring share certificates through demating

Over the Counter Exchange of Indi a (OTCEI) 345

Sl. No.

Feature

OTCEI

Traditional Stock Exchanges

8

Transparency

Spot deals with full transparency

Speculative activities obstruct transparency

9

Settlement

Daily settlement system

Weekly or fortnightly settlement

10

Price Quotes

Market-makers are obliged to offer twoway quotes

Jobbers may or may not offer two-way quotes

11

Transfer

Automatic transfer upto 0.5 percent of equity capital of the company

Transfer takes place with the permission of the company

to Capital

12

Spreads

OTCEI has laid down that market spreads would not exceed a specified percentage

There is no restriction on spreads volatile

13

Free Pricing

SEBI guidelines permit free pricing of issues without a track record also under certain conditions

As per SEBI guidelines, free pricing of Equity of new company shares is not permitted

‘OVER-THE-COUNTER’

The term over-the-counter is a way of trading securities otherwise than on an organized stock exchange. Trading of securities is carried out by the brokers, dealers scattered over different locations and regions, with the help of a communication network including telephone, telegraphs, teletypewriters, telex, fax and computers. Communication network links every dealer-broker, helps arrive at the prices and allows investors to select among the competing market-makers. A market-maker is one who offers two-way prices (a buy rate and a sell rate) at which the member-dealer is willing to buy or sell a standard quantity of scrips that will be continuously quoted for a specified period. Thus, over-the-counter (OTC) market is envisaged as a floorless securities trading system equipped with electronic or computer network through which nationally and internationally scattered buyers and sellers can conduct business more efficiently and economically.

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NEED AND OBJECTIVES

The setting up of the OTCEI was conceived as a method by which the ailments facing the working of the traditional stock exchanges at present could be overcome. Stock exchanges function as a single door market in which the securities of companies engaged in different industries and trades of varied sizes are listed with identical qualifying criteria, and are traded simultaneously in the same trading hall. This creates a situation where only the big and important companies receive all the attention, with the large bulk of companies, particularly the new and small companies remaining unnoticed. This creates a situation of unlisted/non-traded companies that greatly jeopardizes liquidity of small scrips. Small investors all over the country are faced with the problems of access, liquidity, delays in payment and delivery, and uncertainty regarding prices at which their shares are bought or sold. Prohibitive issue costs, restricted access to the markets and administered pricing of their shares are the main problems faced by companies. This meant India lacked a stock market option for small and medium companies given the BSE and NSE entry threshold of Rs.10 crores-equity base. Similarly small, start-up companies in India had the problems of raising capital through a public issue at exorbitant costs and delays in realization of proceeds. Moreover, many companies, which are doing well, were unable to grow to their potential because of their inhibition to go public to raise adequate capital. All such mid-cap companies have benefited from the establishment of OTCEI. The OTC Exchange has been set up as an answer to these problems of companies and investors, the two critical players in the capital markets. The OTCEI aims at creating a stock exchange that will: 1. Facilitate small companies to raise funds from the capital market in a cost-effective manner, as it does not involve any flotation costs 2. Provide a convenient and an efficient avenue of capital market investments for small investors 3. Strengthen investors’ confidence in the financial market by offering them the two-way best prices to the investors 4. Ensure transparency, redress investors’ complaints and unify the country’s securities market to cover even those places which do not have a stock exchange 5. Provide liquidity advantage to the securities traded 6. Promote organized trading in Unlisted Securities 7. Broad base the existing informal market in order to make it more liquid

Over the Counter Exchange of Indi a (OTCEI) 347

8. 9.

Provide a source of valuation for securities traded and Act as a launch pad to an IPO

FEATURES

The salient features of OTCEI are as follows: Nation-wide Trading OTCEI has a nation-wide network. By listing on the OTCEI, securities of a company can be traded across the country through centers that are located in different cities. Counters opened at different locations are interlinked by computer-based communication system. A public notice is given as to the availability of counters where trading takes place. Facilities for trading will be available at the counters of the sponsors and the market-makers who are notified by the OTCEI. Companies have an unique benefit of nationwide listing and trading of the scrips by simply listing at only one exchange, the OTC Exchange. Compulsory Investor Registration Every investor is expected to obtain ‘Invest OTC Card’ for buying and selling securities on OTCEI by making an application at any of the counters of OTCEI. In fact, the share application form includes the necessary details to be filled in for obtaining ‘Invest OTC Card’. The purpose of the investor registration is to facilitate computerized trading. It also provides greater safety of operations to the investors. Ringless Trading Trading does not take place on any specific floor of an exchange. The members and dealers open counters at various places, which offer investors to connect locations for the purchase and sale of the listed securities. OTCEI does not have any trading ring/hall. Dealers quote, query and transact business through a central OTC computer connected with computers that are located at different centers/counters spread across the country. The network of on-line computers allows market participants to execute trades from their offices and provides all relevant information on their screens, creating a fair market. Trading takes places through a network of computers (screen based) of OTC dealers located at several places within the same city and even across cities. These computers allow dealers to quote, query and transact through a central OTC computer using telecommunication links. Investors can walk into any of the counters of members and dealers, and see the quote display on the screen, decide to deal and conclude the transaction.

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Transparent Computerized Trading The entire trading at OTCEI is done in a transparent and speedy manner through computers. This makes the market more disciplined. The confirmation that the investor receives through the computer, gives the exact date, time, price of the deal and brokerage charged. The system also ensures that transactions are done at the best prevailing quotes in the market. The investors’ interest is fully protected in this regard. Exclusive Listing Companies listed at OTCEI are not listed on other stock exchanges. However, of late, following the liberalized approach of the RBI, companies that have been already listed in other stock exchanges are also allowed trading on the OTCEI. The companies sponsored by members of OTCEI are listed. Closeness to Investors There are a large number of inter-connected counters throughout the country. Facility for trading is available at the counters of the sponsors. The addresses of Additional Market-makers and dealers are provided in the application attached to the offer for sale. This way, OTCEI is considered to be closer to investors. Authorized Dealers Only those members and dealers who are authorized and approved by the OTCEI can deal on it. Price Display In a traditional stock exchange, the investor has no means of verifying the price at which the broker effected the transaction. Conversely, the OTCEI continuously displays current security prices on the screens installed at each of the OTC Exchange counters. This enables investors to make onthe-spot decisions on purchase or sale of securities. Greater Liquidity Since the sponsor and the Additional Market-maker offer two-way quotes, (i.e. buy and sell quotes) within specified margin, securities can be purchased and sold at any time. The compulsory market-making by the sponsor for every security ensures that buy and sell quotes are available everyday for a period of 3 years after which another market-maker takes over the price quotation. Unlike other stock exchanges, the OTC Exchange, through its nationwide reach, facilitates widely dispersed trading across the country, thus enabling greater liquidity.

Over the Counter Exchange of Indi a (OTCEI) 349

Trading for Unlisted Companies In pursuance of the recommendations of the Dave Committee, the SEBI has allowed trading of equity shares of all unlisted companies on the OTCEI to boost the business volume of OTCEI. Such trading provides an opportunity to make the stocks liquid and tradable. In addition, it also provides a source of valuation of mutual funds, facilitates inter-institutional trades and enables placement of these shares with foreign institutional investors (FIIs) who can now subscribe to the shares of unlisted companies. Trading in Derivatives Based on Dave Committee recommendations, instruments like futures and options, forward contracts on stocks, other forms of forward transactions and stock lending are allowed to be traded on OTCEI. This aims at improving OTCEI’s liquidity by providing greater depth. Instant Execution of Orders The investors’ orders are executed immediately. If there are no buyers or sellers on the OTC Exchange, the market-maker deals with the investor. Ready Information The compulsory market-maker carries out research on the scrip sponsored by him and, hence, all vital information pertaining to the company is readily available. MoU with NASDAQ OTCEI has signed a Memorandum of Understanding with NASDAQ, USA, the second largest stock exchange in the world. The MoU entails mutual exchange of information, training in various aspects of the capital market, access to the global market, etc. Multiproduct Exchange A lot of innovation has gone into the working of the OTCEI. For instance, OTCEI introduces new products from time to time for the benefit of the investors, issuers and intermediaries in the capital market and the nation at large. OTCEI has also created a national market in its listed segment to facilitate large corporates to have simultaneous listing on the exchange. It is pertinent to note that OTCEI currently offers trading in the following category of securities viz., Listed Equity, Listed Debentures, GOI Securities, Permitted Equity, Permitted Debentures, Mutual Funds and Bonds of public sector units.

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T ec hnology OTCEI uses computers, telecommunications and other technologies of the modern information age in order to bring members/dealers together electronically, so as to enable them to trade with one another electronically, rather than on a trading floor in a single location. All the information needed for trading is available on the OTCEI’s computer screen. To enhance connectivity for its trading systems, OTCEI has shifted to VSATs (Very Small Aperture Terminals). The use of modern technology ensures a more transparent, quick and disciplined trading. Faster Transfers The investor have to submit counter receipt at any of the OTCEI counters for transfer of shares. Shares are automatically transferred in the name of the investor, if the consolidated holding of the shares is within the limit of 0.5 percent of the issued capital of the company. OTC trading provides for transfer of shares by Registrars upto a certain percentage per folio. This results in faster transfers. The concept of immediate settlement makes it better for the investors. Investors will trade, not with share certificates but with a different tradable document called Counter Receipt (CR). However, an investor can always exercise his right of having the share certificate by surrendering the CR and again exchanging the share certificate for CR when he wants to trade. A custodian provides this facility alongwith a settler who will do the signature verification and CR validation (The Counter Receipt is no longer a tradable document from 1st March, 1999). Trading Services An investor can buy and sell any listed scrip at any of the OTC exchange counter. The investor can also make an application for services like transfer of shares, splitting and consolidation of shares, nomination and revocation of nomination, registering power of attorney, transmission of shares and change of holder’s name, etc. The parties involved in trading on OTC are Investor, Counter, Settler, Registrar/Custodian, Company and Bank. The trading documents mainly involved in OTC exchange transactions are: Temporary Counter Receipt (TCR), Permanent Counter Receipt (PCR), Sales Confirmation Slip (SCS), Transfer Deed (TD), Service Application Form (SAF), Application Acknowledgement Slip (AAS), and Deal Form (DF).

Over the Counter Exchange of Indi a (OTCEI) 351

BENEFITS

The OTCEI offers the following benefits: Benefits to Listed Companies The benefits that are offered to companies listed with OTCEI are as follows: 1. Negotiability The company can negotiate the issue price with the sponsors who have to market the issue. It provides an opportunity for fair pricing of an issue through negotiation with the sponsors. 2. Fixation of premium In consultation with the sponsors, the company can fix an optimum level of premium on issue with minimum risk of non-subscription of the issue. 3. Savings in costs Lots of costs associated with public issue of capital are saved through this mode. It provides an opportunity to companies to raise funds through capital market instruments at an extremely low cost as compared to a public issue. The method of sponsors placing the scrips with members who in turn will offload the scrips to public will obviate the need for a public issue and its associated costs. 4. No take-over threat OTCEI lists scrips even with 40 percent of the capital offered for public trading. This limit has now been brought down to 20 percent in the case of closely held companies and new companies. As a result, the present management of the companies are saved of threats of takeover if they restrict public offer. 5. Large access Accessing a large pool of captive investor base through the OTCEI’s computerized network is made possible for companies. Through nationwide network for servicing of investors, companies listed on OTC Exchange can have a larger investor base. 6. Other benefits a. Helpful to small companies b. Shares of all unlisted companies can now be traded on OTCEI c. Platform for issuers and first-level investors like financial institutions, state level financial corporations, Foreign Institutional Investors, etc. d. System for defining benchmark for securities e. Increasing business for the market constituents f. Easier launch pad for an IPO Benefits to Investors The OTCEI offers the following benefits that are otherwise not available for investors dealing in other stock exchanges. These are as follows:

352 Capi tal Markets

1. Safety OTCEI’s ringless and scripless electronic trading ensures safety of transactions of the investor. For instance, every investor in a OTCEI is given an ‘Invest-OTC-Card’ free. This code is allotted on a permanent basis and should be used in all OTC transactions and applications of OTC issues. This card provides for the safety and security of the investors’ investments. The mechanism offers greater security to investors as the sponsors investigate into the company and the projects, before accepting sponsorship thus building up much-needed greater investor confidence. 2. Transparency OTC screens at every OTC counter display the best buy/sell prices. The exact trading prices are printed in the trading documents for confirmations. This protects the investor interest and thereby minimizes disputes. 3. Liquidity A great advantage of the OTC is that the scrips traded are liquid. This is because there are at least two market-makers who indulge in continuous buying and selling. This enables investors to buy and sell the scrips any time. 4. Appraisal OTC members sponsor each scrip listed in an OTC counter. The sponsor makes an appraisal of the scrips for investor worthiness. This ensures quality of investments. 5. Access Every OTC counter serves as a single window to the entire OTC exchange throughout the country and throughout the world too. Therefore, buying and selling may be resorted to from any part of the world. It offers the facility of faster deal settlement for investors across the counters spread over the entire country. 6. Transfer It is important that OTC shares are transferable within 7 days, where the consolidated holdings of the scrips do not exceed 0.5 percent of the issued capital of the company. 7. Allotment There is not much waiting for the investors when it comes to allotment of scrips. Allotment is completed in all respects within a matter of 35 days and trading begins immediately thereafter. 8. Other benefits a. Derivatives such as futures and options, forward contracts on stocks, and other forms of forward transactions and stock lending are allowed on OTCEI b. Scripless trading makes dealings simpler and easier c. Market-making system in OTC Exchange gives sufficient opportunities for the investor to exit d. Acts as a benchmark to value securities

Over the Counter Exchange of Indi a (OTCEI) 353

e. f. g.

Creating an exit option for illiquid stocks/venture capitalists Shuffling portfolios for the investors Organizing and broad-basing trading in the existing market

Benefits to Financial System The OTCEI’s role has been laudable in as far as it helps contribute improving the financial system of India in the following ways: 1. National network of OTCEI operations facilitates the integration of capital market in the country 2. Boon to closely-held companies as they are encouraged to go public because scrips can be listed even if only 40 percent of capital (now a minimum of 20 percent in case of closely held and new companies) is offered for public trading 3. Facilitates wider dispersal of economic activities by encouraging small companies and small investors 4. Promoting savings and investments by offering easier avenues for raising capital 5. Providing over-all stimulation to venture capital activities thereby promoting entrepreneurship 6. Market-making assistance by the sponsors on the OTCEI that helps in making an appraised future projections in the issue documents which in turn helps prospective investors in determining the usefulness of the issues for investment purposes, promoting investment environment in general 7. Those members of the OTCEI who did not have multiple memberships can now have an opportunity to trade in some of the large capital index stocks 8. Encourage venture capital activities and boost entrepreneurship 9. Spread of stock exchange operations geographically all over India SECURITIES TRADED

Following are the securities that are traded on the OTCEI: 1. Listed equity (exclusive) These are equity shares of the companies listed exclusively on the OTCEI. The shares can be bought or sold at any of the member/dealer’s office all over India. The securities, which are listed exclusively on the OTCEI, cannot be traded on other stock exchanges. 2. Listed debt These are the debentures/bonds that are issued through a public issue or a private placement and are listed on OTCEI. Any entity holding the entire series of a particular debt instrument can also

354 Capi tal Markets

3.

4.

5.

offer them for trading on the OTCEI, by appointing an OTCEI member/ dealer to carry out compulsory market-making in those securities. Gilts The securities issued by the Central and State Governments are called ‘gilts’. Government of India Dated Securities, Treasury Bills and special securities are traded in this segment. Banks, Foreign Investors, Foreign Institutional Investors, NBFCs and Provident Funds can trade in these securities through OTCEI designated members/dealers. PSU Bonds, Commercial Paper, and Certificates of Deposit will also be traded in this segment. Permitted securities These are the securities listed on other exchanges, which are permitted for trading on OTCEI. Securities of Blue Chip companies like ACC, Reliance Industries Ltd., State Bank of India, ITC, etc are traded in this segment. Listed mutual funds Listed mutual funds are units of mutual funds that are listed on OTCEI. Mutual fund units like units of Unit–64, Monthly Income Plan, and IISFUS ’97 are also listed under this category.

PLAYERS

Trading in OTCEI, which brings together investors and companies, is facilitated by members/dealers, registrars and custodians, clearing bank, settler and the entire set of regulatory and monitoring mechanism. Main players in the OTC market are as follows: Investor Investors constitute the most important players in the OTCEI. They indulge in purchase and sale of shares. All other players simply support the investors’ operations to take place in a smooth, efficient and fault-free manner. For the purpose of trading in the OTCEI, an investor needs ‘Invest OTC Card’. The card helps buying and selling of shares on OTCEI. Application for the card can be made either before purchase and sale, at any of the counters of OTCEI or at the time of applying for new issues on the OTCEI. The requirements for obtaining Invest OTC Card are mentioned in the share application form of the listed companies. Iss uer The companies that make issue of securities through the mechanism of OTCEI are the issuers. The securities that are issued through the OTCEI are categorized as under: 1 . Listed securities These are the shares and debentures of companies that have been listed on OTCEI and can be bought or sold

Over the Counter Exchange of Indi a (OTCEI) 355

2.

3.

4.

at any of the counters of OTCEI anywhere in the country. These securities cannot be traded on any other stock exchange. Permitted securities These are securities of companies listed with other stock exchanges but are allowed to be traded as permitted securities on the counters of OTCEI. Equity shares of unlisted companies Equity shares of all unlisted companies can be traded on the OTCEI, thus creating a market for unlisted companies within a proper regulatory framework. Initiated debentures Debentures that are held by an entity holding a minimum of one lakh debentures of a particular company that wants trading to take place for these debentures through a member or a dealer appointed by the entity as a compulsory market-maker in these debentures.

MEMBERS AND DEALERS

Members and dealers together extend all the support services that are required by the investors in the OTCEI, whereas members can engage in sponsorship, dealers cannot. Functions The activities that are engaged in by both members and dealers at OTCEI are as follows: 1. Acting as brokers for buying and selling securities according to the instructions of the client investor 2. Engaging in trading in securities on their own account at prices quoted by the market-maker, and 3. Market-making in scrips, i.e. quote two-way prices at which he commits himself to buy and sell a declared number of securities Market-Making The process of offering two-way quotes, i.e. buy as well as sell quotes for particular scrip, is known as ‘market-making’. Each quote must mention the value or the quantity of scrip for which the quote is valid. The three types of market-making in OTCEI are as follows: 1. Compulsory market-making This is to be undertaken by the sponsor of scrip for a period of 18 months from the date of commencement of public trading in the specific scrip. Sponsor can assign compulsory market-making to a member/dealer but in that case, the sponsor would continue to be responsible in all respects for the satisfactory discharge of this function.

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2. Additional market-making Additional market-making is undertaken by a dealer/member appointed by the sponsor for a period of at least three months from the date of commencement of public trading or commencement of market-making, whichever is applicable. Additional market-maker and compulsory market maker must hold between themselves upto 5 percent of the public offer. 3. Voluntary market-making Any counter other than compulsory and additional market-makers in scrip can do voluntary market-making. The market-making can be done for a period of at least three months from the commencement of voluntary market-making. Voluntary market-makers offer two-way quotes for the same scrip, but if they do not have adequate saleable stock of at least one market lot or any other quantity specified by OTCEI, then they may abstain from offering sale quote for the time being. Whereas members can perform any of the above three roles of marketmaking, dealers cannot, however, be compelled to do market-making unless this function has been assigned to them by the sponsor in that scrip, and due prior notice in writing has been given to OTCEI in this regard. 4. Graded s ys tem of market-making The Dave Committee recommended the graded system of market making. According to the system, the market-making inventory between the compulsory marketmaker and additional market-maker has now been graded. The inventory is 5 percent for companies with market capitalization of less than Rs.5 crores, 2 percent for capitalization between Rs.5 crores and Rs.10 crores, and 1 percent for market capitalization of above Rs.10 crores. More flexibility is allowed by the OTCEI in the quotes offered by the market-makers whereby the quotes could be ‘two-way’, increased or decreased within a specific range ‘band width’, depending on the price of the security. SPONSORSHIP

The process of screening the companies and their projects before listing of scrips at OTCEI is known as Sponsorship of scrips. As per the Nonbanking Financial Companies (Reserve Bank) Directions, 1977, institutions with a minimum net worth of Rs.2.5 crores, and which can carry out the sponsorship functions are eligible for carrying out the sponsorship function. Accordingly, institutions such as public financial institutions, scheduled banks and mutual banks, banking subsidiaries, venture capital funds, SEBI approved merchant bankers and other non-banking financial companies are eligible to render this service.

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These institutions qualify as members of OTCEI. Finance and leasing companies were not eligible to become members of OTCEI, but some relaxations are under consideration regarding their membership. The idea is to get investors better scrips, besides allowing for better liquidity for investors by offering them guaranteed exit. Functions Following are the functions performed by the sponsors: 1. Appraising the company and its projects for ensuring that the company’s projects are technologically and financially viable and that all government regulations have been satisfied, and the company has adequately arranged for raw materials, infrastructural inputs, marketing and financial inputs 2. Ascertaining the value of the shares of the company 3. Giving a certificate to OTCEI regarding the investment worthiness of the company and its projects 4. Ensuring compliance with SEBI guidelines for the issue of securities 5. Performing compulsory market-making in the issued scrips for at least eighteen months from the date of commencement of trading in the scrip 6. Appointing one member or dealer as additional market-maker. ADMISSION OF MEMBERS—CONDITIONS

According to the SEBI, following are the conditions that should be satisfied for admission to membership of OTCEI: 1. Institutions eligible for the sponsorship function as mentioned above are also eligible and can be admitted to membership of OTCEI 2. Members to have a standing and status to carry the confidence of other members and dealers while recommending the scrips for investment 3. Members to possess the skill, resources and the capability necessary for appraising projects, establishing their viability, analyzing company’s financial position and income earning potential, evaluating the company’s management, determining marketability of the company’s products and ensuring that the company/project meets various governmental regulations 4. Members to be financially sound, having adequate financial resources to perform the activities of sponsorship and trading 5. Members to have the capacity to invest in scrips and hold on to them for sufficient period depending on the market requirement, provide

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market-making in the scrips for the desired period and to have an adequate office space to set OTCEI counter for dealings with the investors 6. Members to have adequate organizational infrastructure to perform such functions as handling of investments, project appraisal, OTCEI counter management, and market-making and other trading activities The OTCEI committee on its part verifies whether the applicants for membership satisfy all the above conditions or not. On being satisfied, fresh membership is accepted. All existing members should continue to meet all the above requirements. On their failure to meet these requirements, OTCEI committee may cancel their membership after following the due procedure. Admission of Members—Fees Members have to pay one-time non-refundable admission fee of Rs.20 lakhs. In addition, an annual subscription of Rs.1 lakh is also payable. OTCEI Committee can change the fee structure. ADMISSION OF DEALERS—CONDITIONS

OTCEI admits an entity as dealer subject to satisfying the following conditions: 1. Any corporate body, partnership firm or an individual having a net worth of Rs.5 lakhs is eligible to become a dealer. In case of a corporate dealer, at least 40 percent of the share capital of such corporate body should be held by promoters and in case of individuals, proof of having tangible liquid assets of Rs.5 lakhs, two independent references and a reference from a bank regarding the financing standing of the applicant should be submitted. The individual should at least be a graduate 2. Dealers to have adequate financial resources to carry on the activities of trading and market-making 3. Dealers to have adequate knowledge of stock market trading, stock valuation, share transfer rules and laws governing these activities 4. Dealers to have adequate office space 5. Dealers to have adequate organizational infrastructure to perform such functions as handling of investments, OTCEI counter management, and market-making and other trading activities 6. Dealers to have passed the test/interview conducted by OTCEI Committee for admission.

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OTCEI Committee advertises in newspapers inviting applications for dealership from time to time. Duly filled applications with required certificates/documents/references, etc are scrutinized. Short listed candidates are required to appear for computer based test and are interviewed by the selection panel. Partnership firms and corporate bodies have to nominate an authorized signatory for test and interview. The dealership is restricted to the city for which it is granted. Moreover, dealership is not transferable. Admission of Dealers—Fees The fee for dealership is to be paid as specified in the advertisement inviting applications. A one-time non-refundable admission fee of Rs.6 lakhs is to be paid by the dealers. In addition, an annual subscription of Rs.5,000 is also to be paid by them. They may also be required to deposit an additional security with OTCEI. Rules regarding fee and deposit can change from time to time. REGISTRARS AND CUSTODIANS

The registrars and custodians appointed by the OTCEI are required to carry out the following functions: • Transferring of shares not exceeding 0.5 percent of equity per folio • Maintaining a register of members • Keeping in custody share certificates of the company • Maintaining a record of signatures and checking them at the time of receiving Counter Receipt (CR) and Transfer Deed (TD) for transferring securities • Updating the list of members • Registering power of attorney, transmission and transposition of shares, and • Registering nominations, etc. CENTRAL CLEARING BANK

Central clearing banks are the intermediaries through whom all the counter deals and settlements are done. These intermediaries perform the following functions: • Record keeping of documents generated by counters • Monitoring the movement of documents • Keeping a record of signatures of all investors at the counters • Verification of signatures on counter receipts (CR)

360 Capi tal Markets • • • •

Checking genuineness of CRs Sending confirmations to the counters regarding receipts of CRs and their validity, etc within the prescribed time limits Exchange of CRs for shares before sending them to the Registrar Checking applications for splitting, etc.

MONITORING AGENCIES

Monitoring is done by the OTCEI through its own committee, which monitors the activities of sponsors, members/dealers and overall trading at OTCEI. In addition, SEBI also frames rules and regulations, and does monitoring of activities at OTCEI. The Ministry of Finance, Government of India, also intervenes as and when required. TRADING MECHANISM

The trading mechanism at OTCEI is entirely different from that of recognized stock exchanges. It is a ringless security exchange equipped with computers and electronic equipments instead of a trading hall of conventional stock exchanges. The dealings will be carried on through counters scattered all over the country and linked with communication network. The investors, for the purpose of trading, can choose the price quoted by the marketmakers scattered all over the country. The prices quoted can be viewed on the computer screens with the push of a button. Every counter at OTCEI displays these quoted prices continuously at every working day. Having decided about the price and the market-maker, the investor may proceed further with the purchase or sale of scrips. The mechanism of trading followed at OTCEI is different for listed securities and permitted securities. The trading procedure in respect of these securities is described below: For Listed Securities Trading in listed securities commences three days after the listing and after due notice to the public and OTCEI counters, i.e. members and dealers. Trading commences with the compulsory market-maker, additional marketmaker and/or voluntary market-maker offering quotes for the minimum depth depending on the issue price of the security. In case the issue price is Rs.50, the market-makers have to give quotes for at least 10 market lots. In other cases the minimum depth is five market lots. Counter receipts Shares certificates of listed securities are not traded on OTCEI. The entire trading takes place through counter receipt (CR), which creates a tradable document. An investor holding share

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certificates has to first convert them into counter receipts before trading in them. Counter receipts are of three types as shown below: 1. Initial Counter Receipt (ICR) which is issued initially at the time of primary issues. Sale of ICR is to be accompanied by a transfer deed properly executed by the seller/transferor so as to avoid bad delivery 2. Permanent Counter Receipt (PCR) which is issued at the time of secondary market sale. It is non-transferable though it carries the investor’s name. This is because it is not entered in the register of members of the company. A Transfer deed (TD) need not accompany a sale of PCR 3. Transferred Permanent Counter Receipt (TR-PCR) which is issued after investor’s service request for transfer of holdings in his name in the books of the company, has been carried out. A CR generated after completing the request for transfer of holdings is a transferred PCR. Sale of transferred PCR should be accompanied by a transfer deed (TD) Documents used Following are the main documents that are used in the course of trading for listed securities on OTCEI: 1. Transfer Deed (TD) Separate TDs are to be executed by both the transferor and transferee. The seller of transferred PCR signs the TD as transferor. At the time of service request, the investor signs TD as transferee. The registrar and the transfer agent of the company execute the transfer request after matching the two TDs 2. Sale Confirmation Slip (SCS) Is a receipt issued by the counter to the seller of CR confirming that the transaction of sale of securities has been completed 3. Application Acknowledgement Slip (AAS) Is issued by the concerned counter to the investor requesting for such services as transfer of shares to his own name, transposition of securities, recombination i.e., splitting and consolidation of shares etc conversion of ICR or transferred PCR into share certificate and converting share certificate back to transferred PCR. Each of the above service request generates an AAS for the investor. Steps in Trading Following are the steps involved in the trading of listed securities on OTCEI: 1. Issue of CRs Counter Receipt (CR) is issued in lieu of share certificate. CR is issued at the time of initial public issue or when scrip is purchased at

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OTCEI counter. Each CR shall contain such details as the name of the investor, i.e. buyer, name of the company whose shares have been sold by the counter, number of shares and the price at which shares are bought, name, address and telephone number of custodian/settler holding shares, time and date of transaction, total value of transaction, brokerage charged, investor’s signature, transaction code—there is a separate code for each transaction, name and code of issuing counter, name, signature and stamp of the authorized signatory of the counter. There is also certification that the transaction is a valid one. The details and signatures of the buyer are also obtained before issuing CR. The counter fills up the seller’s details and obtains his signature. CR is prepared in triplicate—the original for the buyer, one copy for the counter and the other for the custodian/ settler.

2. Transfer In case of a request of transfer of security in the name of the investor, Application Acknowledgement Slip (AAS) is also generated. AAS is also prepared in triplicate—the original for the buyer, one copy for counter and the other for the custodian/registrar. In addition, the investor gives to the counter a duly stamped and attested Transfer Deed (TD). At the end of each day, all TDs with relevant CRs and AASs are sent to the custodian/settler. The registrar/custodian affects the transfers and issue the actual share certificate, if required by the investor, in exchange for the CR. Share certificates are not accepted at the counters, but the seller surrenders them to custodian/settler in exchange for the CR. 3. Compilation OTCEI compiles and up-dates a manual of all OTCEI counters alongwith the name, address, signature of the representative authorized to deal on OTCEI and counter code. A copy of the manual is sent to all members/dealers. 4. Sellin g s ecurities An investor wanting to sell securities submits the CR at the counter. After verification of the particulars on the CR and settlement of price, the deal is put through and the investor is given Sale Confirmation Slip (SCS). In case the shares have been transferred in the seller’s name, then he will have to complete and submit a TD before he gets SCS and a cheque. SCS shall contain such particulars as the name of the investor/buyer, name of the company whose shares have been bought by the counter, number of shares and the price at which shares have been bought by the counter, commission charged, stamp duty, total value of transaction, name, address and code number of the counter, date and time of transaction, corresponding CR number, name and signature of authorized signatory of the counter.

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SCS is prepared in triplicate—original for the investor/buyer, a copy each to the counter and the custodian/settler. At the end of each day, all CRs, SCSs and relevant TDs are sent to the custodian/settler for updation. 5. Counter details At the end of each day, each counter sends to OTCEI the details of CRs and SCSs issued by it, and a consolidated statement showing companywise transactions. Sponsors/companies periodically send an updated list of shareholders to the registrar. The counters send to the registrar TDs filled by the sellers. They may not transfer the scrip in their own name. When those scrips are sold back, the buyer’s particulars are directly filled up on a separate Transfer Deed and sent to the custodian/settler who matches the seller’s TD and buyer’s TD and completes the transaction. Each CR is for the full number of shares (upto 1,000 shares per CR) purchased by the investor. In case the investor wants to sell only a part of the holding in a CR, he has first to get the old CR split and get new CRs and then proceed to transact.

6. Automatic transfer An automatic transfer in favor of transferor’s name within seven days takes place for transactions involving less than a certain specified size of holding, which may be 0.5 percent of the company’s equity or such other limit specified by OTCEI. In case the holding of the investor exceeds this limit, the counters send the TDs to the companies for endorsement. Any transaction involving more than 900 shares is reported to the company on the same day. 7. Consolidated statement After checking its records of CRs issued by various counters, the custodian/settler issues a consolidated statement to each counter once in a week to confirm that the CRs accepted by the counters are valid. The entire process of compilation and matching is computerized so that daily compilation and quick matching is done without any difficulty. For Permitted Securities In respect of the securities that are listed on other stock exchanges, permission is granted for the purpose of being traded on OTCEI under permitted category. This way the benefit of transparent computerized trading is made available. The trading mechanism is outlined below: 1. Share certificate with a valid TD is the trading document 2. The counters doing market-making in these scrips give two-way quotes voluntarily, the depth quantity being in multiples of the market lot for the scrip

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3.

Counters can give quotes even without having inventory of the scrip who can also modify or withdraw their quotes strictly before the deal is struck 4. Selling investors are issued Purchase Confirmation Slips (PCSs) and the purchasing investors are given Sale Confirmation Slips (SCSs) by the counters at the time of finalization of the transaction 5. While accepting share certificates, the counter has to ensure that it is in market lots 6. The counters have to ensure that the share certificates are accompanied by valid TDs with dates later than the previous book closure date, the signature of the transferor is genuine, it is in good condition and meets all the requirements of a good delivery 7. All delivering brokers have to affix on the reverse of the TD a rubber stamp giving such details as broker’s name and code number, name of the exchange, SEBI registration of the delivering broker and the amount of the transaction The counter has also to certify that any person other than the final transferee does not fill the TD. Bad Delivery The counters are responsible for defective share certificates and TDs accepted and introduced by them into the OTCEI system. In case the shares and TDs are subsequently found defective by the company or its registrar, the counter originally accepting and introducing the defective share certificate and/or TD has the responsibility of rectifying the defective delivery. If an investor suffers a loss due to their negligence, the counters are liable to compensate the investor. SETTLEMENT PROCEDURE

A separate system of settlement is adopted for the listed securities and permitted securities. The procedure is outlined below: For Listed Securities OTCEI does not permit short selling or forward buying in listed securities. All deals get completed after the CRs, SCSs and AASs are confirmed, matched and issued. The settlement process is based on a rolling T+3 settlement system as explained below: 1. Where transfer of security is not intended, only a list of CR holders is periodically sent to the company

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2.

Where transfer of security is intended to take place and the investor wants that the security to be transferred in his name, and his name should appear in the list of members in the register of the company, the un-transferred PCR and duly filled TD is sent to the custodian/settler who makes a record of signatures. On T+3 day, the counter prepares a pay-in for the securities purchased and sends to the registrar with relevant documents. On T+4 day after confirming the signatures of the seller, a payout is made for the securities sold. Based on Dave Committee recommendations, SEBI allowed shifting the settlement system from the T-3 system to the T-5 system where the pay-in takes place on the fifth day and the payout on the sixth day.

For Permitted Securities The salient features of settlement of deals in permitted securities are as follows: 1. Settlement mechanism has a five-day trading cycle 2. Short-selling and squaring up by the counters is to be completed within the trading cycle 3. Delivery and payment is on net basis, not on trade basis 4. A transaction generates a single confirmation slip for any value of transaction 5. Certificates must be delivered to the investors within a fortnight from the date of purchase of the security Day-wise Settlement Procedure The procedure for physical settlement, i.e. delivery and receipt of share certificate, and payment and receipt of cash procedure is as follows: 1. For T-day (Friday) At the end of five-day trading period each week, (i.e. Monday to Friday) on Friday, each counter gets a scrip-wise net position report. Report on net pay-in and net pay-out is prepared. 2. T+d day (Monday) Each counter delivers the share certificates to transfer agent by Monday of the week following the week in which transaction has taken place. 3. T+4 day (Tuesday) Transfer agent sends scrip wise and counterwise default report to OTCEI. It is a pay-in day. 4. T+5 day (Wednesday) Auction trading session is held for squaring up the short-sales by the counters. Cash settlement report is prepared after the auction session is over. Pay-out day, i.e. the sellers are paid for the securities sold.

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5. T+6 day (Thursday) Defaulting counters deliver the share certificates. 6. T+7 day (Friday) Transfer agent delivers share certificates and cash clearing status from OTCEI to all receiving counters. The OTCEI is permitted by the SEBI to undertake weekly netting of trades in permitted securities segment as in the case of other stock exchanges. This is expected to remove administrative bottlenecks and facilitate physical settlement of scrips on a nationwide basis. SLOW GROWTH OF OTCEI—CAUSES

Despite technical superiority of OTCEI in terms of computerization, speed, transparency and integrated functioning, the growth of OTCEI operations has been found to be highly unsatisfactory. Following are some of the factors that have contributed for the slow growth of business on OTCEI: 1. Crash of BoDs market The primary reason for the slow growth of the business of the OTCEI was the crash of the Bought-out-Deal (BoD) market. Large amounts of money stuck in bought-outs contributed to the liquidity problem on the exchange. Many OTCEI sponsors are responsible for making a fast buck by listing boughtouts six to nine months after the deal at very high premium and then failing to support the scrip. 2. Lack of commitment Only a few sponsors are willing to commit time, staff and funds for OTCEI operations. Most members and dealers operate only as brokers and only a limited number takes up the marketmaking function. Further, there was a lack of support from the founder institutions too. SEBI’s insistence for de-linking OTCEI business to companies with no fund-based activities also contributed to the shrinkage in the OTCEI operations. 3. Poor settlement system The T+3 trading cycle that was in operation earlier limits broking operations as it takes a minimum of three days for the client’s cheque to get encashed, whereas the payment has to be made on the third day after the trade takes place. Institutional clients take even seven to eight days to make payment. Market operators have to commit funds for the intervening period. However, with the introduction of T+5 trading cycle this problem has been taken care of to a great extent. 4. Other causes 1. Lack of depth which makes the market susceptible to large swings on small deals 2. Inadequate funds for market-making

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3. 4. 5. 6. 7. 8.

Existence of only spot market and lack of short selling and forward trading has kept many operators away from OTCEI Inefficient software Delay in transfer of shares by registrars Lack of aggressiveness on the part of OTCEI board Limited representation of members and dealers on the policy making committees of OTCEI Limited awareness about the merits of operations on OTCEI due to inadequate marketing of the exchange.

REVAMPING OTCEI

A number of measures have been initiated in order to revamp the functioning of the trading and settlement mechanisms at the OTCEI. Following are some of these measures: 1. Membership in the National Stock Exchange (NSE) through a wholly owned subsidiary wherein all those existing brokers who have cleared their dues with OTCEI will be permitted to act as sub-brokers with the subsidiary to trade on the NSE order book 2. Total revamp of its market-making mechanism aimed at providing greater liquidity and an easy exit for investors at all stages whereby market-makers need to have a minimum net worth of Rs.1 crore 3. Introduction of the concept of an inventory bandwidth, whereby a market-maker does not get a stock dumped on him during adverse market conditions. Accordingly, when once a marketmaker’s net inventory reaches 5 percent of the net offer to the pubic for the scrip, the ‘bid’ side gets disabled and when it falls to 3 percent, it gets reactivated automatically 4. SEBI allowing the OTCEI to have a ‘free hand’ in increasing the number of companies under the permitted securities and debentures category 5. RBI with effect from November, 1997 permitting many market players to undertake transactions in government securities through the members of the OTCEI which resulted in an increasing number of brokers opting to trade through the OTCEI. The OTCEI trading screens provide for online calculation of yield on government securities and display the accrued interest portion of the security price. The trading software allows brokers to negotiate deals directly on the trading screen. The introduction of this segment on OTCEI increases both the volume of business as well as the spread of OTCEI activities

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WORKING OF NASDAQ

NASDAQ is the over-the-counter market of USA. Securities that are traded over the counter are listed on the National Association of Security Dealers Automatic Quote system (NASDAQ). The quote system of NASDAQ enables the potential trader to ascertain the person interested in trading at a certain price. The NASDAQ quote system also serves as an information source and not as an electronic trading system. Brokers trading for a customer will take note of the brokers who are interested and at what prices, and then will directly contact the broker to negotiate a trade. Three levels of service are available from NASDAQ. Level III subscribers are given terminals with which to enter bids and asks. These dealers must be prepared to execute at least a minimum amount (usually 1,000 shares) at these prices. Level II subscribers are usually traders who have access to all bids and ask, as well as the name of the firm making the quote. This allows the traders to determine where to obtain the best price. Bid quotations are displayed in the descending order and offer quotations in the ascending order. Level I subscribers simply obtain the best bid and ask for any stock; these subscribers are normally salespersons (registered representatives) dealing with customers. NASDAQ classifies some of the stocks as part of the National market system (primarily on the basis of trading volume). Stocks designated as part of the National market system are eligible for short sales and margin purchases. OTC stocks not listed on the NASDAQ quote system have bids and offers recorded on paper available once a day; these are called “pink sheets”. These quotes are not binding and simply give the trader an idea of who is potentially interested in the stock. CHANGING ROLE OF OTCEI

By insisting on uniform settlement, OTCEI has realized that brokers will avoid OTCEI transactions in the absence of business. Speculation is very important to drive the share prices. An important ingredient of any stock market is the facility for investors to speculate and also possess the ability to close out and shift position from one exchange to another so as to take advantage of price differential at different exchanges. If this facility is absent, price discovery and price formation will be hampered leading to low investor interest in capital markets. In view of the emerging trends in the capital market, a major need has been felt to improve the working of OTCEI. The Over-the-counter Exchange of India is currently being revived with help from the National Stock Exchange (NSE).

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MAJOR CHANGES IN OTCEI FUNCTIONING

OTCEI has named itself as “The Contemporary and Competitive Exchange” in its brochures thereby emphasizing its new role in the following spheres: 1. Weekly Settlement 2. Revamping the Trading System 3. Technology Weekly Settlement OTCEI had introduced weekly settlement for the listed segment. This is an Arbitrage Opportunity involving Saturday-Friday trading. This introduces a weekly settlement cycle instead of the current rolling settlement on a T+5 basis (transaction day and five days thereafter). Brokers on the exchange have long argued that the rolling settlement does not provide any leeway for speculation and thereafter, the exchange lacks much needed liquidity. The trading time in operation is Monday-Friday 10–4 p.m., Saturday, 1st day of trading 10–1 p.m. All weekly settlements under new system are successfully completed without default/crisis. Revamping the Trading System OTCEI has decided to revamp its trading activity by switching over to share certificate to attract investor interest. Counter Receipt, as a trading document, would cease to be a valid trading document. In its place, the physical shares will be allotted to the logical holders. This move by OTCEI to shift from CR to share certificate or dematerialization is a fresh initiative to improve liquidity and bring about price discovery and price formation. Similarly, a change from the earlier system of Counter Receipts (CR) (tradable document on the exchange) commenced from March 1, 1999, when all the counter-receipts ceased to be valid trading documents. OTCEI has informed all the listed companies to move from CR to share certificates mode or dematerialization. Companies that choose to dematerialize will give the option to their shareholders to retain their share certificates. Changes in the Listed Segment Major changes have been proposed in the listed segment. The exclusive quote driven system (market making) will be replaced by the hybrid system. This would result in a situation where the investor benefits by placing order directly on the system through any of the broker terminals and not necessarily through the market-maker.

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Changes in the Permitted Segment In the permitted segment, OTCEI introduced trading in the demat form and added actively traded and fancied scrips from the regional exchanges. Around 485 scrips in the permitted segment are being dealt with in the permitted segment. Also the permitted debt segments with corporate debt and PSU bonds have been launched. Trading in Unlisted Segment Equity shares of companies that have not made a public offering but are held by promoters and/or venture capital funds would come under the definition of unlisted securities. At present, there is no organized market for unlisted securities. Hence, it is difficult for an investor in an unlisted company to sell the shares as is done in the case of companies that are listed on the stock exchanges. Hence, the OTCEI is now planning to provide a segment that will permit trading in such securities. The objective of launching trading in the unlisted securities segment is to provide an exit route for investments made by venture capital and private equity funds. Further it is expected to broad-base the existing informal market to make it more liquid and promote organized trading in unlisted securities. It is also expected to act as a preparatory ground for an initial public offering (IPO) that may be planned for the future. Salient Features of this Segment By definition, only qualified participants (QPs) can trade in this segment. Corporates, including scheduled banks, venture capital funds, private equity funds or mutual funds, Unit Trust of India (UTI), State level institutions and companies wishing to make strategic investments and high net worth individuals can participate in this segment. All QPs need to have a minimum net worth of Rs.2.5 crores. The unlisted securities market can act as an ideal launch pad to complement the IPO market in the country because it helps companies not having a track record to access the stock market platform to raise funds. It also provides an ideal exit route for private equity and venture capital funds, thereby attracting fresh capital and at the same time preventing flight of capital. NEW NORMS

1. 2.

New threshold listing requirements for IPO’s seeking listing on the OTCEI An arrangement with the NSE for parallel trading of OTCEI listed securities

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3.

4. 5.

The appointment of a panel of chartered accountant/audit firms to undertake a due diligent exercise of companies seeking listing on the Exchange The constitution of a separate committee for screening companies prior to listing A complete revamp of the Exchange’s market-making rules to create greater liquidity for stocks listed on the Exchange to provide better exit opportunities for the investors at all stages. The new marketmaking system has become operational from the second week of November 1999 and is being integrated with the existing OASIS system

UTILITY OF OTCEI’S NEW LISTING NORMS TO ENTREPRENEURS

Any entrepreneur who needs funds for a project has three options. He can either approach a venture capital fund, or go to a bank or financial institution (FI) or raise money through the IPO route. Banks and financial institutions normally hesitate in financing projects if entrepreneurs lack experience. In the absence of a healthy track record, listing norms of large stock exchanges prohibit entrepreneurs from raising money using the IPO route. The listing norms require that any company planning to raise money through an IPO needs to have a three-year profitability record. The OTCEI has done away with the three-year track record requirement for companies planning an IPO. This would mean that even inexperienced entrepreneurs could raise money using the IPO route by approaching OTCEI. However, OTCEI has laid down stringent norms to ensure that only genuine entrepreneurs raise money from the market. The exchange will set up a high-powered panel of chartered accountants, which will do due diligence of such companies and their projects. Also, marketmaking will be mandatory for a period of 18 months at these counters. Such companies without a track record have to be introduced through a sponsor. According to SEBI norms, all companies that have a paid-up capital of less than Rs.3 crores (excluding premium) have to be listed on the OTCEI. OTCEI MOU WITH NASSCOM

To provide for exchange of ideas and concepts for developing a vibrant and active market for hi-tech companies in India, NASSCOM and the OTC Exchange of India have decided to enter into a memorandum of understanding. According to the MOU, NASSCOM will nominate a representative on the Screening Committee for listing IT companies on OTCEI; develop models and methodology for rating promoters and projects of software companies planning to raise capital through the OTCEI route.

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The NASSCOM will arrange and conduct investor education programmes to generate awareness on investment opportunities and risks associated with software companies and provide for research and analysis of the software industry/OTCEI listed software companies for market information and business development. The OTCEI has also put in place mechanisms to handhold new IT entrepreneurs through the entire stock exchange listing and market creation process. The NASSCOM alongwith OTCEI will from time to time plan and organize seminars and conferences on topics related to the role and scope of capital market in the software industry. The NASSCOM will assist start-up companies listed on the OTCEI by registering them for NASSCOM membership and providing them with software industry updates, getting recognition for companies in the international markets through its ongoing process. It will also hold training programs for the entrepreneurs on process/quality controls. REVISION IN COMPOSITE INDEX

OTCEI revised its Composite Index to Market Capitalization with effect from 23rd July 1997. The earlier OTCEI Composite Index was an unweighted, simple price index, which comprises all the listed scrips on the exchange. The new index comprises a basket of 25 scrips having the highest market capitalization on the exchange. These scrips contribute more than 75 percent of the total market capitalization of the exchange (as of 15th July 1997) and represent 17 broad industry groups. The base date for the new index is 10th December 1996 and the base index value is Rs. 100. The index is expected to reflect the true market sentiments as it gives weightage to market capitalization. Twenty-five scrips constitute the index. These include, amongst others, IIS Infotech Ltd., Aryan Pesticides Ltd., Renewable Energy Systems Ltd., Maxwell Apparel Ltd., Valecha Engineering Ltd., Elcot Power Controls Ltd., Bio-chem Synergy Ltd. and Tribology India Ltd. CLEARING AND SETTLEMENT

The clearing has been arranged through National Securities Clearing Corporation Limited (NSCCI). OTCEI has tied up with National Securities Depositories Limited (NSDL) for demat option. It has also provided for custodial participation in settlements. Risk containment measures have also been taken up.

Over the Counter Exchange of Indi a (OTCEI) 373

TECHNOLOGY

OTCEI has introduced the latest trading platform Hardware—Fully Fault Tolerant Stratus Machine. The latest trading software adopted is the OASIS. The OTCEI plans to update and change its trading software. For this purpose, it will adopt a modified version of the NSE’s trading software, for which negotiations have already started with the software vendor. Facilities support is to be provided by experts like TCS, HCL, Comment, CMS and CMC. Other measures include trading through VSATs, Modems and Lease Line. Y2K compliance has been achieved and continuous upgradation of software is taking place. Reach OTCEI has facilities whereby brokers across the country provide ‘at-yourdoor’ trading convenience and nationwise quotes. Safety The safety measures provided by OTCEI are Settlement Guarantee Fund (SGF), insurance cover for SGF, capital adequacy norms and margins in place, insurance cover for members and the establishment of a Contingency Fund. Support OTCEI provides training to brokers. It has Helpdesk and Information dissemination and the Press. OTCEI Bulletin is being circulated on a regular basis. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5.

What is an OTCEI? What do you mean by the term ‘over-the-counter’? What do you mean by the term ‘ringless trading’? Who are the members and dealers at the OTCEI? What is ‘market-making’? What are its kinds?

Section B 1. 2. 3. 4. 5. 6.

What are the objectives of OTCEI? State the need for setting up of OTCEI. State the explain the various features of OTCEI. What are the benefits offered by OTCEI trading mechanism? How is the OTCEI beneficial to investors? In what way the OTCEI is beneficial to the financial system of a country?

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7. 8. 9. 10. 11. 12. 13. 14. 15. 16.

What are the types of securities that are traded at the OTCEI? What are the functions performed by sponsors of the OITCE? What are the functions carried out by the registrars and custodians of the OITCE? What are the functions of the central clearing bank of the OITCE? What are the obligations cast on the companies that seek admission for OTCEI trading? Explain the trading mechanism at the OTCEI. Explain the procedure relating to the settlement at the OTCEI. Outline the steps initiated to revamp the working of the OTCEI Write a note on the working of NASDAQ. How do you see the changing role of the OTCEI?

Section C 1. 2. 3. 4. 5. 6. 7. 8. 9.

Trace the origin and the growth of Over-the-counter Exchange of India. How an OTCEI different from other stock exchanges? Discuss the role played various participants at the OTCEI. Set out the conditions to be satisfied for admission of members to the OTCEI trading. State the conditions to be satisfied for admission of dealers to the OTCEI trading. Examine the SEBI guidelines on the registration and the listing requirements for OTCEI trading. Discuss the various methods of offering securities in the OTCEI ambience. Analyze the factors that have caused slow growth of the OTCEI. What are the new changes introduced in the realm of OTCEI trading?

Chapter

19

Stock Market Index

MEANING

An indicator of the trend in the movement of prices of securities that are dealt with on a stock market on a specified day is called a ‘stock market index’. The function of a stock market index is to provide a benchmark or price trend for the investment community. A stock market index captures the behaviour of the overall equity market. A stock market index is defined as a statistical indicator that provides a representation of the value of the securities constituted by it. Indices often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured. FEATURES

The following are the features of a stock market index: 1. Index of quality data A stock market index is an independent, full-service index provider, supplying accurate, reliable and transparent index data. Indices underlie a variety of financial products in today’s marketplace such as exchange-traded funds, futures and options contracts, mutual funds, variable annuity and equity-indexed annuities, and structured products such as OTC options, swaps, warrants, equity-linked notes and public/private debt. 2. Index of transparency Stock market indices are maintained according to a clear, transparent and systematic methodology that is fully integrated across all types of indices of an index family. This methodology, together with historical data is open for review and is made available at no cost to the professional investment community. 3. Index delivery Stock market indices are delivered through a variety of real-time and end-of-day market data vendors. For instance, the major indices in the world are published daily in The Wall Street Journal’s “Money & Investing” section and weekly in the “Market Week” section of Barron’s, and are disseminated via radio and television. The Dow Jones Global Indices and the Dow Jones Global

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4.

5.

6.

7.

Titans Indices are also published daily in The Wall Street Journal Europe’s “Global Finance Diary” section. In India, stock market indices are published in dailies, both financial and non-financial, journals on money markets and capital markets, etc. Index of future perspectives The ups and downs of an index mean the changing expectations of the stock market about future dividends of India’s corporate sector. When the index goes up, it is because the stock market thinks that the prospective dividends in the future will be better than previously thought. When the prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant-to-instant readings about how the stock market perceives the future of trade and industry. Index of averaging Every stock price moves for two possible reasons: a. news about the company (e.g. a product launch, or the closure of a factory, etc.) or, b. news about the country (e.g. nuclear bombs, or a budget announcement, etc.). The job of an index is to purely capture the second part, the movements of the stock market as a whole (i.e. news about the country). This is achieved by averaging. Each stock contains a mixture of these two elements, stock news and index news. When an average of returns on many stocks is taken, the individual stock news tends to cancel out. On any given day, there would be good stock-specific news for a few companies and bad stockspecific news for others. In a good index, these will cancel out, and the only thing left will be news that is common to all stocks. This is what the index will capture. Index of portfolio interpretation A typical stock market index gives an idea of portfolio construction. For instance, it is easy to create a portfolio which will reliably get the same returns as the index. For example, if the index goes up by 4 per cent, this portfolio will also go up by 4 per cent. A stock market index is hence just like other price index in showing what is happening on the overall indices. The wholesale price index is a comparable example within context. In addition, the stock market index is also attainable as a portfolio. Index Types The most important type of market index is the broad-market index. Generally, a single major index dominates benchmarking index funds, index derivatives and research applications. In addition, more specialized indices often find interesting

Stock Market Index

8.

377

applications. In India, there are many type of stock indices, where a dedicated industry fund uses an industry index as a benchmark. Index of diversification The averaging that takes place in an index is equivalent to diversification. Diversification cancels out individual stock fluctuations. From an investment perspective, diversification reduces risk. From an information perspective, diversification cancels out stock noise, the bad news about the macro economy. Although it is possible that a larger number of stocks in an index will give more diversification, it is not advisable. This is because, there are diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying, beyond a certain point. The more serious problem lies in the stocks that we take into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsens an index.

Importance Stock market indices are significant in the following respects: 1. Leading indicator Traditionally, indices have been used as information sources. By looking at an index, it is possible to know how the market is faring. This information aspect also figures in myraid applications of stock market indices in economic research. This is particularly valuable when an index reflects on highly up-to-date information and the portfolio of an investor contains illiquid securities. In this case, the index is a lead indicator of how the overall portfolio will fare. 2. Application advantage In recent years, indices have come to the fore owing to direct applications in finance, in the form of index funds and index derivatives. Index funds are funds which passively ‘invest in the index’. Index derivatives allow people to cheaply alter their risk exposure to an index (called hedging), and to implement forecasts about index movements (called speculation). Hedging using index derivatives has become a central part of risk management in the modern economy and has now became a multi-trillion dollar industry worldwide, being critically linked up to market indices. 3. Benchmarks Stock market indices serve as a benchmark for measuring the performance of fund managers. An all-equity fund should obtain returns like the overall stock market index. A 50:50 debt-equity fund should obtain returns close to those obtained by an

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investment of 50 per cent in the index and 50 per cent in fixed income. A well-specified relationship between an investor and a fund manager should explicitly define the benchmark against which the fund manager will be compared, and the exact manner in which the comparison would be done. BSE INDEX

BSE Index refers to the Bombay Stock Exchange (BSE) Index. It was launched by the BSE, the premier Stock Exchange of India. BSE was founded in the year 1857. BSE occupies a place of prominence in the annals of Indian stock market. The growth of equity markets in India has been phenomenal in the part decade. From the early nineties, the stock market witnessed a heightened activity in terms of various bull-and-bear runs. The BSE-SENSEX capture all these happenings in the most judicial manner. One can identify the booms and bust of the Indian equity market through BSE-SENSEX. Till the eighties, there was no measure or scale that could precisely measure the various ups and downs in the Indian stock market. The Stock Exchange, Mumbai (BSE) in 1986 came out with a Stock Index that subsequently became the barometer of the Indian Stock Market. The launch of BSE-SENSEX in 1986 was later followed up in January 1989 by the introduction of BSE National Index (Base: 1983-84 = 100). It comprised of 100 stocks listed at five major stock exchanges in India at Mumbai, Kolkatta, Delhi, Ahmedabad and Chennai. The BSE National Index was renamed as BSE-100 Index from October 14, 1996 and since then, it is calculated taking into consideration only the prices of stocks listed at BSE. With a view to provide a better representation of the increased number of companies listed, increased market capitalization and the new industry groups, the Exchange constructed and launched on 27th May, 1994, two new index series viz., the ‘BSE-200’ and the ‘DOLLEX-200’ indices. Since then, BSE has come a long way in tuning itself to the varied needs of investors and market participants. In order to fulfill the need of market participants for still broader, segment-specific and sector-specific indices, the Exchange has continuously been increasing the range of its indices. The launch of BSE-200 Index in 1994 was followed by the launch of BSE-500 Index and 5 sectoral indices in 1999. In 2001, BSE launched the BSE-PSU Index, DOLLEX-30 and the country’s first free-float based index - the BSE-TECk Index taking the family of BSE Indices to thirteen.

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379

The Exchange also disseminates the Price-Earnings Ratio, the Price to Book Value Ratio and the Dividend Yield Percentage on day-to-day basis for all its major indices. The values of all BSE indices (except the Dollar version of indices) are updated every 15 seconds during the market hours and displayed through the BOLT system, BSE website and news wire agencies. All BSE-Indices are reviewed periodically by the “Index Committee” of the Exchange. The committee frames the broad policy guidelines for the development and maintenance of all BSE indices. The Index Cell of the Exchange carries out the day-to-day maintenance of all indices and conducts research on development of new indices. Following are the important types of BSE Indices: 1. BSE-SENSEX The Stock Exchange, Mumbai, started compiling and publishing the BSE-SENSEX index number of equity prices from 2nd January, 1986. The base period of BSE-SENSEX is 1978-79. The base value of BSE-SENSEX is 100 points. The purpose is to provide the tread of the equity market as reflected in the equity share price movement of the basket of shares. a. Method of Compilation BSE-SENSEX is a “Market CapitalizationWeighted” index of 30 stocks representing a sample of large, well-established and financially sound companies. BSE-SENSEX is calculated using a “Market Capitalization-Weighted” methodology. As per this methodology, the level of index at any point of time reflects the total market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. Statisticians call an index of a set of combined variables (such as price and number of shares) as composite index. A single indexed number is used to represent the results of this calculation in order to make the value easier to work with and track over time. It is much easier to graph a chart based on indexed values, than one based on actual values. The actual total market value of the stocks in the Index during the base period has been set equal to an indexed value of 100. This is often indicated by the notation 1978-79=100. The formula used to calculate the Index is fairly straightforward. However, the calculation of the adjustments to the Index (commonly called Index maintenance) is more complex.

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b.

c.

d.

The calculation of BSE-SENSEX involves dividing the total market capitalization of 30 companies in the Index by a number called the Index Divisor. The Divisor is the only link to the original base period value of the BSE-SENSEX. It keeps the Index comparable over time and is the adjustment point for all Index maintenance activities. During market hours, prices of the index scrips, at which latest trades are executed, are used by the trading system to calculate BSE-SENSEX every 15 seconds and disseminated, all-over the country through BOLT terminals in real time. Maintenance of the Index One of the important aspects of maintaining continuity with the past is to update the base year average. The base year value adjustment ensures that additional issue of capital and other corporate announcements like bonus etc. do not destroy the value of the index. The beauty of maintenance lies in the fact that adjustments for corporate actions in the Index should not per se affect the index values. The Index Cell of the Exchange does the day-to-day maintenance of the index within the broad index policy framework set by the Index Committee. The Index Cell takes special care to ensure that BSESENSEX and all the other BSE indices maintain their benchmark properties by striking a delicate balance between high turnover in Index scrips and its representative character. The Index Committee of the Exchange has experts from different field of finance related to the capital markets. They include Academicians, Fund-managers from leading Mutual Funds, Finance - Journalists, Market Participants, Independent Governing Board members, and Exchange administrators. On-line Computation During market hours, prices of the index scrips, at which trades are executed, are automatically used by the trading computer to calculate the BSE-SENSEX every 15 seconds and continuously updated on all trading workstations connected to the BSE trading computer in real time. Adjustment The arithmetic calculation involved in calculating BSESENSEX is simple, but problem arises when one of the component stocks pays a bonus or issues rights shares. If no adjustments were made, a discontinuity would arise between the current value of the index and its previous value despite the non-occurrence of any economic activity of substance. At the Index Cell of the Exchange, the base value is adjusted, which is used to deflate market capitalization of the component stocks to arrive at the BSE-SENSEX value. The Index Cell of the Exchange keeps a close watch on the events

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381

that might affect the index on a regular basis and carries out daily maintenance of all the thirteen Indices. Adjustments for Rights Issues When a company, included in the compilation of the index, issues right shares, the market capitalization of that company is increased by the number of additional shares issued based on the theoretical (ex-right) price. An offsetting or proportionate adjustment is then made to the Base Market Capitalization (see ‘ Base Market Capitalization Adjustment’ below). Adjustments for Bonus Issue When a company, included in the compilation of the index, issues bonus shares, the market capitalization of that company does not undergo any change. Therefore, there is no change in the Base Market Capitalization, only the ‘number of shares’ in the formula is updated.

e.

Other Issues Base Market Capitalization Adjustment is required when new shares are issued by way of conversion of debentures, mergers, spin-offs etc or when equity is reduced by way of buy-back of shares, corporate restructuring etc. Base Market Capitalization Adjustment The formula for adjusting the Base Market Capitalization is as follows: New Base Market Capitalization = Old Base Market Capitalization × [New Market Capitalization ÷ Old Market Capitalization] To illustrate, suppose a company issues right shares which increases the market capitalization of the shares of that company by say, Rs.100 crores. The existing Base Market Capitalization (Old Base Market Capitalization), say, is Rs. 2450 crores and the aggregate market capitalization of all the shares included in the index before the right issue is made is, say Rs.4781 crores. The “New Base Market Capitalization” will then be Rs. 2501.24 crores. This figure of 2501.24 will be used as the Base Market Capitalization for calculating the index number from then onwards till the next base change becomes necessary.

Criteria for Selection and Review

Index Review Frequency The Index Committee meets every quarter to review the BSE indices. In case of any revision in the Index constituents, the announcement of the incoming and outgoing scrips is made six weeks in advance of the actual implementation of change in the index. Qualification Criteria The general guidelines for selection of constituent scrips in SENSEX are as follows.

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Quantitative Criteria 1.

2.

3.

4.

5.

Market capitalization The scrip should figure in the top 100 companies listed by market capitalization. Also market capitalization of each scrip should be more than 0.5 per cent of the total market capitalization of the Index i.e. the minimum weight should be 0.5 per cent. Since the SENSEX is a Market Capitalization-weighted index, this is one of the primary criteria for scrip selection. (Market Capitalization would be averaged for the previous six months) Liquidity  As regards trading frequency, the scrip should have been traded on each and every trading day for the last one year.Exceptions can be made for extreme reasons like scrip suspension etc·  As regards number of trades, the scrip should be among the top 150 companies listed by average number of trades per day for the last one year  As regards value of shares traded, the scrip should be among the top 150 companies listed by the average value of shares traded per day for the last one year. Continuity Whenever the composition of the index is changed, the continuity of historical series of index values is re-established by correlating the value of the revised index to the old index (index before revision). The back calculation over the last one-year period is carried out and correlation of the revised index to the old index should not be less than 0.98. This ensures that the historical continuity of the index is maintained. Industry representation Scrip selection would take into account a balanced representation of the listed companies in the universe of BSE. The index companies should be leaders in their industry group. Listed History The scrip should have a listing history of at least one year on BSE.

Qualitative Criteria In the opinion of the Committee, the company should have an acceptable track record. The constituents of BSE-SENSEX are as follows: 1. ACC 2. Bajaj Auto 3. BHEL 4. BSES Ltd 5. Castrol 6. Cipla 7. Colgate 8. Dr. Reddy Labs 9. Glaxo 10. Grasim

Stock Market Index

11. 13. 15. 17. 19. 21. 23. 25. 27. 29.

Gujarath Ambuja cements Hero Honda HLL ICICI bank ITC MTNL Ranbaxy Satyam Computers TCS TISCO

12. 14. 16. 18. 20. 22. 24. 26. 28. 30.

383

HDFC HINDALCO HPC Infosys Larson & Tubro Nestle Reliance SBI TELCO RCVL

2. BSE-TECk INDEX

The BSE-TECk is a stock index constituted of companies in the Information Technology, Media and Telecom sectors. It would track the performance of TMT sectors through a basket of 21 quality stocks. The BSE-TECk Index would provide a quality benchmark for the investment community in the knowledge-based sectors. ‘TECk’ stands for the following:  ‘T’ - Technology (BSE Sector: Information Technology)  ‘E’ - Entertainment(BSE Sector: Media & Publishing)  ‘C’ - Communication (BSE Sector:Telecom)  ‘k’ - Other Knowledge-based companies not falling in any of the above three sectors. The Base Date for BSE TECk Index is 2nd April, 2001. The Base Value for BSE TECk Index is 1000 points. In other words, the BSE TECk Index was equal to 1000 on 2nd April 2001. The technology orientation of the current economy has primarily marked a paradigm shift from manufacturing-based activities to knowledgebased activities. In the present economic scenario, tangible assets like land, plant & machinery are losing their significance to intangibles like intellectual property, knowledge-base and technology. This has resulted in the dominance of emerging sectors like Information Technology, Media and Telecom. The Need The TMT sectors have seen heightened activity in the last couple of years and the stock valuations of the companies in these sectors have witnessed unprecedented volatility. This led to a strong bull run in the TMT stocks in 1999 and early 2000. The market subsequently witnessed

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the most unexpected sell-off in the stocks of the TMT sectors which led to huge market capitalization erosion on the bourses and scared away genuine investors. It was felt that in the absence of a proper benchmark, the performance of the TMT sectors remained inadequately tracked. In order to fill this void, the BSE-TECk index was launched as a reliable index for benchmarking the performance of the TMT sectors. The launch of BSE-TECk index was justified on rational grounds which include inter-alia: a. Globally a lot of investment is being committed to the TMT sectors. Even in India, the last 2 years have seen a lot of international and local money flowing into the TMT sectors. b. The TMT sectors are currently dominating the trading pattern on the bourses worldwide. In India, the TMT sectors account for around 68% of the total daily turnover. c. With a lot of domestic retail money committed to the TMT sectors and existence of many mutual funds dedicated to one or more of the TMT sectors in India, a need for a quality benchmark to track the performance of such funds has been long felt. d. The global and domestic investment community monitors eagerly. the performance of the TMT sectors to discern typical trends in the economy. e. To provide a ready basket of quality TMT stocks for passive investors. f. Reference for Index futures, options and other derivative products in the times to come. Me thod ology Modified Market Capitalization-Weighted (MMCW) method is used for calculating the BSE TECk Index. It is also called the free-float adjustment method because it takes into consideration only the free-float (nonpromoter) capital of the company for the purpose of calculation of the index. It may be noted that currently all other stock market indices in India take into consideration the entire market capitalization. Free-float of a company consists of shares readily available in the market for trading. These are shares held by non-promoters of the company. The market capitalization of a company is adjusted to reflect the free-float portion. For e.g. if a company has 35 per cent non-promoter-holding, then only 35 per cent of the total market capitalization of the company would be considered for the purpose of calculating the index. SEBI has mandated submission of shareholding pattern to the exchanges (on a quarterly basis) by all listed companies in a standardized format.

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Free-float for a company Free-float for a company is determined as per format relating to shareholding pattern stipulated by SEBI and incorporated in clause 35 of the Listing Agreement. The format is as follows: a) Promoters  Indian  Foreign  Persons acting in concert b) Non-promoters  Institutions (FI/FII’s)  Corporate Bodies  Public For the purpose of BSE TECk Index calculation, Part B i.e. ‘Non-Promoters’ is taken as Free-Float of the company. Illustration Company XYZ Promoters: Indian Foreign Persons acting in concert Non-promoters: Institutions Corporate bodies Public Free-float = B = 45%

30% 10% 15% 15% 0% 30%

BSE-TECk Index Vs. Other BSE Indices The BSE-TECk Index is the first free-float adjusted index in the country. Globally most of the index providers have switched to free-float adjusted indices to better reflect the true buying and selling opportunity in the market. The free-float adjusted index ignores the locked portion of a company’s equity and takes into consideration only the freely tradable portion for the purpose of calculating the index. All other BSE Indices presently consider the full equity of a company for the purpose of index calculation irrespective of whether the equity is held by promoters or non-promoters. Constructing BSE-TEC k index The BSE-TECk Index is constructed and maintained as per a laid down

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policy detailed in the “Guide to BSE-TECk Index”. The Guide has laid down a scientific and comprehensive construction and revision methodology for the TECk Index in order to minimize subjectivity in index calculation and maintenance. Determining Weights The constituent companies in the BSE-TECk index are weighted by their free-float adjusted market capitalization. For e.g. an Index of two constituent stocks A and B will have the following weightages in the Index given their market capitalization and free-float factors as below: Company

Mkt. Cap. (Rs. Crs.)

Free-float Adj. Factor

Free-float Adj. Factor

Weightage (%)

A

10000

0.25

2500

41.67

B

7000

0.50

3500

58.33

Review of BSE-TEC k Index The BSE-TECk index would be reviewed in a routine Index Committee meeting which meets on a quarterly basis. Global Benchmarks on TMT Sectors The NASDAQ (US) and TECk MARK (UK) are markets specifically for technology companies. The NASDAQ composite index is the most widely tracked technology stock index in the world. The London Stock Exchange launched in November 1999 a separate market called TECk MARK, to meet the unique requirements of technology companies. TECk MARK comprises companies from the main market that share a common attribute, in this case a commitment to technological innovation. Prediction Since the BSE-TECk index represents around 90 per cent of the market capitalization of the TMT sector universe and includes the sector leaders as its constituents, this index is expected to act as a trendsetter for the remaining TMT sector scrips. 3. BSE-PSU INDEX

The Stock Exchange, Mumbai launched “BSE-PSU Index” on Monday, 4th June 2001. The index consists of 34 major Public Sector Undertakings listed on the Exchange. The BSE-PSU Index is displayed on-line on the BOLT trading terminals nationwide. The BSE - Public Sector Undertaking

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(PSU) Index is a stock index that will track the performance of the listed PSU stocks on the Exchange. The index is being launched with 34 constituents which are currently part of the BSE-500 Index. Objec tive It is an index tracking the performance of listed equity of PSU companies. It is a suitable benchmark for the Central Government to monitor its wealth on the bourses. Index Specifications The Base Date for the BSE-PSU Index is set as 1st February 1999 when the BSE-500 was launched. Being a subset of BSE-500, the BSE-PSU Index is aimed at ensuring a reasonable history of how the Central Government wealth fluctuates on the bourses. The base value for the BSE-PSU Index has been set at 1000 to ensure adequacy in terms of Daily Index movement. The BSE-PSU index has been constituted of listed companies/ institutions/ corporations owned or controlled by the Central Government within the meaning of Section 619-B of the Companies Act, 1956. 4. BSE-100 INDEX

The BSE-100 Index is also known as ‘BSE National Index’. A need was felt for a more broad-based index, which can also reflect the movement of stock prices on a national scale because the BSE Sensitive Index has only 30 scrips. The BSE started compilation and publication of an index series called “BSE National Index” on 3rd January, 1989. C ov e r ag e The equity shares of 100 companies from the “Specified” and the “Non-specified” list of the five major stock exchanges, viz., Mumbai, Calcutta, Delhi, Ahmedabad and Madras were selected for the purpose of compiling the BSE National Index. The criteria for selection were market activity, due representation to various industry-groups and representation of trading activity on major stock exchanges. Base-Year The financial year 1983-84 was chosen as the base-year. The price stability during that year and proximity to the index series were the main consideration for choice of 1983-84 as the base-year. Method of Compilation The basic method of compilation is the same as the one used in the case of the BSE Sensitive Index. However, in the case of BSE National Index, a

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distinction is made between “local scrips” for which prices were taken from only one exchange and “Inter-Exchange scrips” for which an average of the prices quoted on two or more exchanges were considered for index compilation. Redesignation of the BSE-100 National Index The BSE-100 National Index took prices of certain scrips from other exchanges or weighed average of some scrips which were popular on other exchanges in order to reflect market movements at the national level. However, changes in trading technology, longer trading period and almost instantaneous availability of information across the country have ensured that there is little or no difference in prices of the index scrips. Therefore, the Exchange administration has decided to redesignate the BSE-100 National index as the ‘BSE-100’ index. Since October 14, 1996, the prices of the BSE are taken to calculate the index. 5. BL-250 STOCK INDEX

BL-250 index is a portfolio of 250 stocks from 48 industry groups, one diversified group and one miscellaneous group. It has been designed comprehensively to capture and disseminate the underlying spirit of the Indian economy. The BL-250 index is formulated and maintained by Business Line. It is broad-based and includes stocks of companies in which the public have a significant stake. The public is defined as both consumers and investors. Companies tracked by this index are those that have a significant share in the markets in which they operate and individual and institutional investors who hold a significant part of equity. Features The significant features of the index are as follows: Weight The index is weighted by market capitalization. Accordingly, a big price spurt in a stock that has small market capitalization will have only a small impact on the index. Wealth index The index is adjusted for dividends, buy-back of equity, offerings of equity, convertible debt and issue and exercise of warrants. It is therefore both a full-fledged wealth index and a price index. Composition It is a composite index of 50 groups of stocks and the performance of individual industry groups is captured by the composite. The individual indices are tracked and reported.

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Flexibility The index is designed to facilitate the deletion and addition of stocks. It is therefore immunized against fossilization. The deletion of a stock of a certain industry is usually followed by the addition of a stock in the same industry. Accordingly, a cement stock will not be replaced by sugar stock and vice-versa. 6. BSE BANKEX

BANKEX, is the new entrant in BSE’s current portfolio of 13 indices, and adds value to BSE’s ability in reflecting both the broad market and specific sector movements in the Indian equity market. Indian banking is riding on a major recovery both in terms of strength and soundness. In the year 2002, return on assets in Indian banking was higher as compared to many emerging economies and the Moody’s Bank Financial Strength Index (2002) placed India at 27.5, which is much better than 16.7 of Korea, 15.8 of Thailand or 12.5 of Japan. India is making sizeable gains in expanding into consumer credit by tightening credit administration procedures similar to other rapidly growing countries. Major policy actions that led to a sharp fall in interest rates have enabled banks to post a significant rise in operational profits. The enactment of Securitization Bill offered great opportunities to step up loan recoveries that could further enhance the scope of greater profitability. These developments impacted the performance of bank stocks significantly. Since bank stocks are emerging as a major segment in the equity markets, BSE considered it important to design an index exclusively for bank stocks. The index is computed on the basis of the globally accepted free-float methodology. Features A few important features of the BANKEX are given below: 1. 2. 3. 4. 5. 6.

7.

BANKEX will track the performance of the leading banking sector stocks listed on the BSE. BANKEX is based on the free float methodology of index construction. The base date for BANKEX is 1st January 2002. The base value for BANKEX is 1000 points. BSE has calculated the historical index values of BANKEX since 1st January 2002. 12 stocks which represent 90 per cent of the total market capitalization of all banking sector stocks listed on BSE are included in the Index. The Index will be disseminated on a real-time basis through BSE Online Trading (BOLT) terminals from 23rd June, 2003.

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Constitutents of BANKEX Index Stocks forming part of the BANKEX along with the particulars of their free-float adjusted market capitalization are listed below. Andhra Bank Bank of Baroda Bank of India Canara Bank Corporation Bank HDFC Bank ICICI Bank ING Vysya Bank Oriental Bank of Commerce Punjab National Bank State Bank of India Union Bank of India 7. S&P CNX NIFTY

S&P CNX Nifty is a stock index diversified into fifty and accounting for twenty-three sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. S&P stands for ‘Standard & Poor’ and CNX stands for CRISIL NSE Index. Features S&P CNX Nifty index of NSE is characterized by the following: 1.

Launch Equities trading at NSE began in November 1994. In late 1995, NSE became India’s largest equity market platform and was looking for a market index to utilize this unique information source. NSE also wanted to have a vehicle for the futures and options market. NSE approached the economists Dr. Ajay Shah and Dr. Susan Thomas, who were at CMIE, to do research on methods in index construction. This work was funded by the USAID FIRE project. This led to the formation of S&P CNX Nifty.

2.

Ownership S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint venture between NSE and CRISIL. IISL has India’s first specialized company focused upon the index as a core product. IISL have a consulting and licensing agreement with Standard & Poor’s (S&P), who are world leaders in the index services. The total traded value of all Nifty stocks is approximately 70 per cent of the traded value of all stocks on the NSE. Nifty stocks represent about 59 per cent of the total market capitalization.

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S&P owns the most important index in the world, the S&P 500 index, which is the foundation of the largest index funds and the most liquid index futures markets in the world. When S&P came to India to look at market indices, they focused upon the S&P CNX Nifty as opposed to alternative indices. They now stand behind the S&P CNX Nifty, as is evidenced by the name “S&P CNX Nifty”. This is a unique situation; S&P has never endorsed a market index before. 3. Types a.

S&P CNX Defty S&P CNX Defty is S&P CNX Nifty, measured in dollars. If the S&P CNX Nifty rises by 2% it means that the Indian stock market rose by 2%, measured in rupees. If the S&P CNX Defty rises by 2%, it means that the Indian stock market rose by 2%, measured in dollars. The S&P CNX Defty is calculated in real time. Data for the S&P CNX Nifty and the dollar—rupee is absorbed in real time, and used to calculate the S&P CNX Defty in real time. Realtime currency data is obtained from Knight Ridder. When there is currency volatility, the S&P CNX Defty is an ideal device for a foreign investor to know where he stands, even intraday.

b.

CNX Nifty Junior S&P CNX Nifty is the first rung of the largest, highly liquid stocks in India. CNX Nifty Junior is an index built out of the next fifty large, liquid stocks in India. It is not as liquid as the S&P CNX Nifty, which implies that the information in the CNX Nifty Junior is not as noise-free as that of the S&P CNX Nifty. It may be useful to think of the S&P CNX Nifty and the CNX Nifty Junior as making up the hundred most liquid stocks in India. S&P CNX Nifty is the front line blue-chips, large and highly liquid stocks. The CNX Nifty Junior is the second rung of growth stocks which are not as established as those in the S&P CNX Nifty. Stocks like Infosys and NIIT, which recently graduated into the S&P CNX Nifty, were in the CNX Nifty Junior for a long time prior to this. CNX Nifty Junior can be viewed as an incubator where young growth stocks are found. As with the S&P CNX Nifty, stocks in the CNX Nifty Junior are filtered for liquidity, so they are the most liquid of the stocks excluded from the S&P CNX Nifty. Buying or selling of the entire CNX Nifty Junior as a portfolio is feasible.

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The maintenance of the S&P CNX Nifty and the CNX Nifty Junior are synchronized so that the two indices will always be disjoint sets; i.e. a stock will never appear in both indices at the same time. Hence, it is always meaningful to pool the S&P CNX Nifty and the CNX Nifty Junior into a composite hundred stock indices or portfolio.

4.

5.

6.

7.

S&P CNX Nifty is professionally maintained and is ideal for derivatives trading. Mechanism S&P CNX Nifty is based upon solid economic research. A trillion calculations were expended to evolve the rules inside the S&P CNX Nifty index. The results of this work are remarkably simple: (a) the correct size to use is fifty, (b) stocks considered for the S&P CNX Nifty must be liquid by the ‘impact cost’ criterion, (c) the largest 50 stocks that meet the criterion go into the index. S&P CNX Nifty is a contrast to the ad hoc methods that have gone into index construction in the preceding years, where indices were made out of intuition and lacked a scientific basis. The research that led up to S&P CNX Nifty is well-respected internationally as a pioneering effort in better understanding how to make a stock market index. ‘Impact cost’ Market impact cost is the best measure of the liquidity of a stock. It accurately reflects the costs faced when actually trading an index. For a stock to qualify for possible inclusion into the S&P CNX Nifty, it has to reliably have market impact cost of below 1.5 per cent when doing S&P CNX Nifty trades of half a crore rupees. The impact cost is not something fixed. It changes, depending upon the liquidity of the market. Indeed, the time-series of the S&P CNX Nifty impact cost is one of the best measures of changes in market liquidity over the years. S&P CNX Nifty trade The index assigns weightages to index components, and the weight of a stock is proportional to its market capitalization. This idea can be applied to buying the S&P CNX Nifty. If one buys all 50 stocks in the S&P CNX Nifty, in correct proportions, that would be called “an index trade”. Minimum market lot Each purchase would have to be rounded off to the nearest round lot. Hence, one can’t buy 74 shares of Reliance; you have to choose either 50 or 100. For example, on 26 October 1998, the weightage of Reliance in S&P CNX Nifty was 5.91 per cent. This means that buying Rs.5 million of S&P CNX Nifty involves buying Rs.2,95,500 of Reliance. The price of Reliance was Rs.115.25 so one

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would need 2564 shares of Reliance. However, the market lot of Reliance is 50, so 2564 is rounded off to 2550. Therefore, if one has bought Rs.4 million of the S&P CNX Nifty, with rounding off to the nearest market lot, then the portfolio would have a 99.99 per cent correlation with the true S&P CNX Nifty. Larger trade sizes would have an even higher correlation, and smaller trade sizes would have a lower correlation. This number (99.99) is adequate for even the most risk averse people; a trade size of Rs.4 million all but eliminates ‘tracking error’ between the portfolio being traded and the true S&P CNX Nifty. 8. Index variations A liquid stock, when considered as a good thermometer, gives accurate data about the true price of the stock, because it trades actively with a tight spread. The prices observed for an illiquid stock are like readings from a low quality thermometer, which reports noisy data about the phenomenon of interest (the true price of the security). S&P CNX Nifty is constructed by using ‘fifty best thermometers’ in the country and averages their values. As time passes, better thermometers become available (in the form of large, liquid stocks that are not in the S&P CNX Nifty), and it is always be ensured that S&P CNX Nifty uses the best thermometers possible. Hence, the weakest thermometer from inside the S&P CNX Nifty is removed and the new stock into it is accepted. 9. Data used S&P CNX Nifty uses clear, publicly documented rules for index revision. These rules are applied regularly, to obtain changes to the index set. For instance, IDBI was once not listed; SBI was once illiquid; Infosys was once an obscure software startup. The world changes, and one by one, these stocks have come into the S&P CNX Nifty. Each change in the S&P CNX Nifty is small, so the continuity of the index is maintained. Yet, at all times, S&P CNX Nifty represents the 50 most important liquid stocks in the country the best thermometers to build an index out of. 10. Composition There are mathematical formulas which ensure that yesterday’s value and today’s are comparable, even if a change in composition takes place in-between. Think of an index as a portfolio. The composition of the portfolio changes, but it is still meaningful to keep measuring the overnight returns on the portfolio from day to day. These returns, cumulated up, are the index level. It is part of the Scientific Index Revision Mechanism. The revision of index is thus perfectly managed. Further, there are objective, publicly defined rules

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which determine when stocks come in and go out of the index. There isn’t much room for personal judgment here. 11. Closing price The best closing prices of the country are used for the purpose of calculating the closing price of Nifty. These, in turn, come from a “call auction” in the last ten minutes. The call auction yields a single, sharp price out of millions of shares of supply and demand. NSE has the best surveillance procedures in India. This ensures that the extent of market manipulation is minimum. For instance, in NSE, the professional staff of the surveillance department have no positions on the market. This elimination of conflicts of interest generates a more honest focus upon eliminating market manipulation. From the date November 18, 1998 onwards, the NSE ‘official closing price’ was determined by a call auction, a remarkable market procedure where a single, sharply defined closing price arises out of supply and demand of millions of shares. Due to the liquidity and order flow from numerous market players, manipulation of the closing price becomes very hard. NSE is the most liquid exchange in India. Hence, the prices observed there are the most reliable. NSE has the highest trading intensity (reducing stale prices) and their bid-ask spreads are the tightest (reducing bid-ask bounce). This is assisted by the fact that the NSE tick size is Rs.0.05 for all stocks, which encourages tight bid-ask spreads. 12. Change in weights When corporate actions take place, the market capitalization changes and weights are adjusted. Rights issues, public issues and mergers, all present such problems. Of course, when indexset changes take place, the portfolio is adjusted and the weights are modified. This requires elaborate, and consistently- applied policies. 13. Depository All stocks can be dematerialized and traded for electronic settlement. Of the 50 stocks in the S&P CNX Nifty, institutions are required (by SEBI) to settle through NSDL for 49 stocks. As of today, 82 per cent of the NSE settlement volume for S&P CNX Nifty stocks is done through NSDL. Problems of S&P CNX Nifty The problem for a S&P CNX Nifty essentially arises in respect of illiquid stocks. Illiquid stocks do not generally consider the price information as anything of significance for index compilation. This is because of the three problems that are associated with it, ‘stale prices’, ‘bid-ask bounce’ and vulnerability to manipulation. Through these problems, an index is actually worsened when illiquid stocks are put into it. Further, it is quite

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possible that a stock may be liquid on one exchange and illiquid on another. In such an eventuality, it would be difficult to arrive at a workable index. Illiquid stocks yield bad price data; so the best quality data will come from the most liquid exchange. In India, the most liquid exchange is the NSE. The S&P CNX Nifty uses price data from NSE for calculations. a. Stale prices When one looks at the closing price of an index, it is supposed to reflect the state of the stock market at a specified time, say 3.50 P.M. If an illiquid stock is in the index, the last traded price (LTP) of the stock might be an hour, or a day, or a week old. The index is supposed to show how the stock market perceives the future of the corporate sector at the time specified, say 3.50 P.M. When an illiquid stock injects these ‘stale prices’ into the calculation of an index, it makes the index staler. It reduces the accuracy with which the index reflects information. b. bid-ask bounce Similarly, there is also a problem of ‘bid-ask bounce’. For instance, a stock trades at bid 1440, ask 1490. If no news appears for ten minutes and if a buy order first comes in (at Rs.1490) followed by a sell order (at Rs. 1440), this sequence of events makes it seem that the stock price has dropped by Rs.50. This is a totally spurious price movement. Hence, even when no news is breaking, when a stock price is not changing, the ‘bid-ask bounce’ is about prices bouncing up and down between bid and ask. These changes are spurious. This problem is the greatest with illiquid stocks where the bid-ask spread is wide. When an index component shows such price changes, it contaminates the index. c. Market manipulation The index is a large entity and is intrinsically harder to manipulate when compared with individual stocks. Obviously, larger indices are harder to manipulate than smaller indices. The weak links in an index are the large, illiquid stocks. These are the ‘Achilles’ Heel’ where a manipulator obtains maximum impact upon the index at minimum cost. Optimal index manipulation consists of attacking these stocks. This is one more reason why illiquid stocks should be excluded from a market index; indeed this aspect requires that the liquidity of a stock in an index should be proportional to its market capitalization.

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S&P CNX NIFTY Vs. BSE SENSITIVE INDEX

Sl.

Feature

S&P CNX Nifty

BSE-SENSEX

50

30

1

Number of stocks

2

Diversification

More diversified index, accurately reflecting overall market conditions

More vulnerable to movements of individual stocks

3

Risk

Less risk

Higher risk

4

Liquidity

More liquid

Less liquid

5

Impact cost

Suffers lower market impact cost

Suffer higher market impact cost

6

Price base

NSE prices

BSE prices

7

Safety

Since calculated form a more liquid market featuring the safety of novation at the clearing corporation, high safety

There is a settlement risk because of trading on a less liquid exchange due to lack of novation and lack of a clearing corporation

8

Index rule

Has fully articulated and professionally implemented rules governing index revision, corporate actions, etc; rules are carefully thought out to dovetail with operational problems of index funds and index arbitrageurs.

Procedures are ad hoc and undocumented, and do not reflect an awareness of modern applications of an index

9

Hedging effectiveness

Better for randomly selected portfolios in India.

Not so

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Sl.

Feature

S&P CNX Nifty

BSE-SENSEX

10

Manipulations

Relatively free of manipulation, because the index levels are calculated from the more liquid exchange with better surveillance procedures, S&P CNX Nifty has a larger market capitalization so the consequence of a given move in an individual stock price is smaller and S&P CNX Nifty calculation intrinsically requires liquidity in proportion to market capitalization, thus avoiding weak links which a manipulator can attack.

It is easier for a manipulator to move prices at BSE.

11

Research

Benefit from research is possible owing to the long time-series available.

Owing to the large changes in the `BSE sensitive index' in 1996, the comparable series available is only for a limited period.

12

Backing

Backed by solid economic research and three most respected institutions: NSE, CRISIL and S&P.

Not so

DOW JONES INDICES

‘Dow Jones’ develops, maintains and licenses market indices for investment products. The Dow Jones Industrial Average and the leading pan-European indices, are among the more than 3,000 indices which are recognized as the world’s best known stock indicators. Dow Jones Index is part of Dow Jones & Company which publishes The Wall Street Journal and its international and interactive editions, Barron’s and SmartMoney magazines and other periodicals, the Dow Jones Newswires, dowjones.com and the Ottaway group of community newspapers. Dow Jones is a co-owner with Reuters Group of Factiva, and

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NBC of the CNBC television operations in Europe and Asia. Dow Jones also provides news content to CNBC in the U.S. NASDAQ STOCK MARKET INDICES

Eligible Securities The following common type securities are eligible for index inclusion in the NASDAQ. There is no distinction between either the NASDAQ National Market and The NASDAQ SmallCap Market, and the domestic US and Non-US securities.  American Depositary Receipts (ADRs)  Common Ordinary Shares  Real Estate Investment Trusts (REITs)  Shares of Beneficial Interest (SBIs)  Tracking Stocks Ineligible Securities The following issue types are not eligible for inclusion in the indices:  Convertible debentures  Preferred stocks  Rights, warrants, units and other derivative securities 1. NASDAQ-100 Index Launched in January 1985, the NASDAQ-100 Index represents the largest non-financial domestic and international issues listed on the NASDAQ Stock Market based on market capitalization. The NASDAQ-100 Index is calculated under a modified capitalization-weighted methodology. The methodology retains in general, the economic attributes of capitalizationweighting while providing enhanced diversification. NASDAQ reviews the composition of the NASDAQ-100 Index on a quarterly basis and adjusts the weightings of Index components using a proprietary algorithm, if certain pre-established weight distribution requirements are not met. The NASDAQ-100 Index includes 100 of the largest domestic and international non-financial companies listed on the NASDAQ Stock Market based on market capitalization. The Index reflects companies across major industry groups including computer hardware and software, telecommunications, retail/wholesale trade and biotechnology. It does not contain financial companies including investment companies. Initial Eligibility Criteria To be eligible for initial inclusion in the NASDAQ-100 Index, a security must be listed on the NASDAQ Stock Market and meet the following criteria:

Stock Market Index   





 





·

399

The security must be listed on the NASDAQ National Market. The security must be of a non-financial company. The security may not be issued by an issuer currently in bankruptcy proceedings. The security must have average daily trading volume on NASDAQ of at least 2,00,000 shares. If the security is of a foreign issuer, it must have listed options or be eligible for listed-options trading. Only one class of security per issuer is allowed. The issuer of the security shall not have entered into a definitive agreement or other arrangement which would result in the security no longer being listed on NASDAQ within the next six months The issuer of the security shall not have annual financial statements with an audit opinion which the auditor or the company has indicated as cannot be currently relied upon The security must have “seasoned” on NASDAQ or any other recognized market (generally, a company is considered to be seasoned if it has been listed on a market for at least two years; in the case of spin-offs, the operating history of the spin-off will be considered); and If the security would otherwise qualify to be in the top 25 per cent of the securities included in the Index by market capitalization for the six prior consecutive month ends, then one-year “seasoning” criteria would apply.

Continued Eligibility Criteria In addition, to be eligible for continued inclusion in the Index the following criteria apply:  The security must be listed on the NASDAQ National Market  The security must be of a non-financial company  The security may not be issued by an issuer currently in bankruptcy proceedings  The security must have average daily trading volume of at least 2,00,000 shares  If the security is of a foreign issuer (a foreign issuer is determined based on its country of incorporation), it must have listed options or be eligible for listed-options trading  The security must have an adjusted market capitalization equal to or exceeding 0.10 per cent of the aggregate adjusted market capitalization of the Index at each month end. In the event of a

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company not meeting this criterion for two consecutive monthends, it will be removed from the Index effective after the close of trade on the third Friday of the following month; and  The issuer of the security shall not have annual financial statements with an audit opinion which the auditor or the company has indicated cannot be currently relied upon. Securities listed on the NASDAQ Stock Market which meets the above eligibility criteria are ranked by the market value using closing prices as of the end of October, and the publicly available total shares outstanding as of the end of November. Index-eligible securities which are already in the Index, and which are in the top 150 eligible securities (based on market value) are retained in the Index provided that such security was ranked in the top 100 eligible securities as of the previous ranking review. Securities not meeting such criteria are replaced. The replacement securities chosen are those Index-eligible securities not currently in the Index which have the largest market capitalization. Generally, the list of annual additions and deletions is publicly announced via a press release in the early part of December. Replacements are made effective after the close of trade on the third Friday of December. Moreover, if at any time during the year an Index Security is not traded on the NASDAQ Stock Market, or is otherwise determined by NASDAQ to become ineligible for continued inclusion in the Index, the security will be replaced with the largest market capitalization security not currently in the Index and meeting the Index eligibility criteria listed above. 2. NASDAQ FINANCIAL-100 Index The NASDAQ Financial-100 Index includes 100 of the largest domestic and international financial organizations listed the NASDAQ Stock Market based on market capitalization. The Index contains bank and savings institutions and related holding companies, insurance companies, broker dealers, investment companies and financial services. 3. NASDAQ Composite Index The NASDAQ Composite Index measures all NASDAQ domestic and international-based common-type stocks listed on the NASDAQ Stock Market. Today the NASDAQ Composite includes over 4,000 companies, more than most other stock market indices. Because it is so broad-based, the Composite is one of the most widely followed and quoted major market indices. 4. NASDAQ National Market Composite Index The NASDAQ National Market Composite Index is a sub-set of the

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NASDAQ Composite Index, and consists of all companies included in the NASDAQ Composite Index which are listed on the NASDAQ National Market tier of the NASDAQ Stock Market. 5. NASDAQ Bank Index The NASDAQ Bank Index contains all types of banks and savings institutions, and related holding companies such as establishments performing functions closely related to banking, for example, check, encashing agencies, currency exchanges, safe deposit companies and corporations for banking abroad. 6. NASDAQ Biotechnology Index The NASDAQ Biotechnology Index contains companies primarily engaged in using biomedical research for the discovery or development of novel treatments or cures for human disease, which also meet other eligibility criteria. The NASDAQ Biotechnology Index is calculated under a modified capitalization-weighted methodology. 7. NASDAQ Computer Index The NASDAQ Computer Index contains computer hardware and software companies that furnish computer programming and data processing services and firms that produce computers, office equipment, and electronic components/accessories. 8. NASDAQ Industrial Index The NASDAQ Industrial Index contains companies not classified in any of the other sub-indices, and includes agricultural, mining, construction, manufacturing, retail/wholesale trade, services, public administration enterprises, health maintenance organizations and companies that do not meet the NASDAQ Biotechnology Index criteria. 9. NASDAQ National Market Industrial Index The NASDAQ National Market Industrial Index is a sub-set of the NASDAQ Industrial Index, and consists of all companies included in the NASDAQ Industrial Index which are listed on the NASDAQ National Market tier of the NASDAQ Stock Market. 10. NASDAQ Insurance Index The NASDAQ Insurance Index contains all types of insurance companies including life, health, property, casualty, and brokers, agents, and related services.

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11. NASDAQ Other Finance Index The NASDAQ Other Finance Index includes credit agencies (except banks and savings institutions and related holding companies), security and commodity brokers, exchanges and dealers, real estate, and holding investments companies. 12. NASDAQ Telecommunications Index The NASDAQ Telecommunications Index contains all types of telecommunications companies, including point-to-point communication services and radio and television broadcast, and companies that manufacture communication equipment and accessories. On November 1, 1993, the NASDAQ Utility Index was renamed the NASDAQ Telecommunications Index. The former NASDAQ Utility Index was reset to a base of 200.00, using a factor of 5.74805. 13. NASDAQ Transportation Index The NASDAQ Transportation Index contains all types of transportation companies, including railroads, trucking companies, airlines, pipelines (except natural gas), and services incidental to transportation, such as warehousing, travel arrangements, and packing. 14. The KLD-NASDAQ® Social Index SM The KLD-NASDAQ Social Index is a market-value weighted index reflecting the performance of the largest NASDAQ listed US corporations in major sectors of the market, including technology, financial, and telecommunications. All constituents of the KLD-NASDAQ Social Index pass KLD Research & Analytics proprietary social and environmental screens. NASDAQ INDEX CALCULATION DESCRIPTION

All NASDAQ Indices are market value weighted except the NASDAQ-100 Index which is weighted using a modified market capitalization method. The representation of each security in the Index is proportional to its last sale price times the total number of shares outstanding, relative to the total market value of the respective index. The formula used for determining the Index values is as follows: a. Index Level = [Current Market Value ÷ Adjusted Base Period Market Value] × Base Value

Stock Market Index

403

b.

Adjusted Base Period Market Value = [Current Market Value After Adjustments × Previous Base Period Market Value] ÷ Current Market Value Before Adjustments The level of an Index will only change as a result of price changes occurring between the opening and closing of the market. Adjustments for securities being added to or deleted from the NASDAQ Stock Market, Inc., or capitalization Changes, are adjustments which take place during the system maintenance process after the market has closed. These adjustments will result in value changes to the Current Market Value and Adjusted Base Period Market Value, but will not in and of themselves after the level of an Index. Stock splits and stock dividends are likewise adjusted for, during the system maintenance process. However, the system makes a price adjustment to account for the increased number of shares with the result being that the current market value does not change. In the case of cash dividends, no system adjustment is made. Neither the Current Market Value nor the Adjusted Base Period Market Value is adjusted to reflect cash dividends. The index formula relies on market forces to determine the level of the Index. OTHER INDEX DESCRIPTIONS

1. AMEX Composite The Amex Composite Index reflects the aggregate market value of all its components relative to their aggregate value on December 29, 1995. The index was developed with a base of 550 as of Dec. 29, 1995. Components of the index include the common stocks or ADRs of all Amex-listed companies, REITs, master limited partnerships, and closed-end investment vehicles. Each component’s market value is determined by multiplying its price by the number of shares outstanding. The day-to-day price change in each issue is weighted by its market value (as at the start of the day) as a percentage of the total market value for all components. Thus, the daily price change for each company influences that day’s change in the index in proportion to the company’s market value. The level of the Composite Index is not altered by stock splits, stock dividends or trading halts, nor is it affected by new listings, additional issuances, de-listings, or suspensions. 2. Dow Jones Average - 30 Industrial Prepared and published by Dow Jones & Co. this is one of the oldest and most widely quoted of all the market indicators. The Dow Jones Industrial

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Average is comprised of 30 stocks that are major factors in their respective industries, and widely held by individuals and institutional investors. These 30 stocks represent about a fifth of the market value of all U.S. stocks and about a fourth of the value of stocks listed on the New York Stock Exchange. 3. Dow Jones Average - 20 Transportation Prepared and published by Dow Jones & Co., the Dow Jones Transportation Average represents 20 stocks of the airline, trucking, railroad, and shipping business. 4. Dow Jones Average - 15 Utilities Prepared and published by Dow Jones & Co., the Dow Jones Utility index is geographically representative of the gas and electric utilities industries. 5. FORTUNE 500 Index Developed by the editors of FORTUNE, this Market CapitalizationWeighted Index is based on FORTUNE’s 45-year-old list of America’s 500 biggest companies domiciled in the U.S. In addition, the Index is restricted to publicly listed companies in the FORTUNE 500 List whose shares are actively traded. Index was set to a base level of 1000.00 at the end of trading on December 31, 1999 and is being calculated real-time at 15-second intervals during the trading day. 6. FORTUNE e-50 Index First published in the Dec. 6, 1999 issue of FORTUNE Magazine, it is based on a list of the 50 companies that FORTUNE has determined best capture the scope of the Internet sector. 7. Frank Russell - 3000 Index Measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98 per cent of the investable U.S. equity market. 8. Frank Russell - 2000 Index Measures the performance of the 2,000 smallest companies in the Russell- 3000 Index, which represents approximately 8 per cent of the total market capitalization of the Russell 3000 Index. 9. Frank Russell - 1000 Index Measures the performance of the 1,000 largest companies in the Russell-3000 Index, which represents approximately 92 per cent of the total market capitalization of the Russell 3000 Index.

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10. Frank Russell - Midcap Index Measuring the performance of the 800 smallest companies in the Russell-1000 Index, which represent approximately 35 per cent of the total market capitalization of the Russell-1000 Index. 11. NYSE Composite Index In 1966, the NYSE established the NYSE Composite Index to provide a comprehensive measure of market trends. The indices consist of a Composite Index of all common stocks listed on the NYSE and four subgroup indices, Industrial, Transportation, Utility, and Finance. The indices are basically a measure of the changes in aggregate market value of NYSE common stocks, adjusted to eliminate the effects of capitalization changes, new listings and delistings. 12. Philadelphia Semiconductor Index Created in December 1993, the Philadelphia Semiconductor Index is a priceweighted index composed of 16 U.S. semiconductor companies primarily involved in the design, distribution, manufacture, and sale of semiconductors. 13. S&P 500 Index Widely regarded as the standard for measuring large-cap U.S. stock market performance, this popular index includes a representative sample of leading companies in leading industries. The S&P 500 is used by 97 per cent of U.S. money managers and pension plan sponsors. 14. S&P Midcap 400 Index Measuring the performance of the mid-size company segment of the U.S. market, this index is used by over 95 per cent of U.S. managers and pension plan sponsors. $20 billion is indexed to the S&P Midcap 400. 15. S&P 100 Index The Standard & Poor’s 100 Stock Index, known by its ticker symbol OEX, measures large company U.S. stock market performance. This market capitalization-weighted index is made up of 100 major, blue chip stocks across diverse industry groups. 16. Wilshire 5000 Equity Index The Wilshire 5000 Equity Index measures the performance of all U.S. headquartered equity securities with readily available price data. Over 7,000 capitalization weighted security returns are used to adjust the index.

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S & P 500 INDEX

Standard & Poor’s is a leader in providing highly valued financial data, analytical research and investment and credit opinions to the global capital markets. Among the company’s many products are the S&P Global 1200, the first real time, global equity index, the S&P 500, the premier U.S. portfolio index, and credit ratings on more than 2,20,000 securities and funds. With more than 5,000 employees located in 19 countries, Standard & Poor’s is an integral part of the world’s financial architecture. The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value. The “500” is one of the most widely used benchmarks of U.S. equity performance. Standard & Poor’s, the independent financial research, ratings and indices leader, has announced the introduction of the S&P Equal Weight Index (S&P EWI), a new index co-developed with Maryland-based Rydex Global Advisors. The S&P EWI will have the same constituents as the S&P 500 and is designed to offer investors an opportunity to invest in the 500 leading U.S. companies represented by the S&P 500 in equal measure. Standard & Poor’s will begin calculating the index later this month and daily index values will be published on. The S&P 500 is designed to reflect the investable US equity universe, which it achieves through its market capitalization weights and sectorbalanced approach. Standard & Poor’s recognizes that many in the financial community have been calculating an equal-weighted version of the S&P 500 for both investing and benchmarking for some time. A key reason for introducing an S&P-calculated equal weight index based on the S&P 500 is to provide these investors with accurate information and tools that will enable them to make size, style, and sector decisions relative to the S&P 500. 1. S&P GLOBAL 1200 The S&P Global 1200 sets a new standard for global equity benchmarks. The S&P Global 1200 combines the features of a broad global portfolio with sufficient liquidity in the underlying equities, making the index ideally suited for index-related investment products. The S&P Global 1200 is the world’s first real-time, free-float weighted index. The S&P Global 1200 covers approximately 70 per cent of global market capitalization. Building on the success of the S&P 500, the S&P Global 1200 provides investors with an equivalent global index built and maintained to the same

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high standard. With index constituents selected on a global basis, it supports both regional and sectoral views of asset allocation. The S&P Global 1200 is comprised of six regional indices: S&P 500, S&P/TSX 60 (Canada), S&P Latin America 40, S&P/TOPIX 150 (Japan), S&P Asia Pacific 100, and S&P Europe 350. Constituents for each index are selected to ensure sectoral and, where applicable, country balance. Constituent weights are determined by a company’s free-float market capitalization. Free-float implies removal of corporate cross-holdings, government ownership, strategic holders, and foreign investment restrictions. The component indices are maintained by an index committee made up of Standard & Poor’s staff worldwide. In the case of two indices, Canada and Japan, Standard & Poor’s collaborates with two of the World’s leading exchanges, the Toronto Stock Exchange and the Tokyo Stock Exchange. Index governance and maintenance for all component indices follow the same principles that have been successful for the S&P 500. This ensures high quality constituents with strong fundamentals and liquidity, and low index turnover. Defining the S&P Global 1200 The S&P Global 1200 Index is comprised of six distinct, regional, component indices: US - S&P 500, Canada - S&P/TSX 60, S&P Latin America 40, Japan - S&P/TOPIX 150, S&P Asia Pacific 100, and the S&P Europe 350. The S&P Global 1200 represents the opportunity set of investable equities around the globe. Each regional benchmark is constructed in a manner similar to the S&P 500 with the addition of a float-adjustment factor. The size of each region corresponds to its relative size in the global equity market based on adjusted market value. The S&P Global 1200 is the first global index to be calculated in real time. Index Construction and Eligibility Eligibility Stocks are eligible for the S&P Global 1200 if they meet criteria for size, liquidity, and sector representation on a regional basis. Each of the component indices are balanced across country and sector weights in the region. Float-Adjusted Market value When calculating index weights, individual constituents’ shares held by governments, corporations, strategic partners, or other control groups are excluded from the company’s shares outstanding. Shares owned by other companies are also excluded regardless of whether they are index constituents.

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In countries with regulated environments, where a foreign investment limit exists at the sector or company level, the constituent’s weight will reflect either the foreign investment limit or the percentage float, whichever is more restrictive. Liquidity Stocks are ranked according to liquidity measured by dollar value traded. Value traded and float turnover are also analyzed on a monthly basis to ensure ample liquidity. Sector Classification Standard & Poor’s has mapped stocks to the Global Industry Classification Standard (GICS). The S&P Global 1200 index provides geographic and economic balance over the 10 GICS market sectors. These sectors, consistent throughout all the S&P indices, include Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services and Utilities. Standard & Poor’s classifies a stock according to the source of its largest revenue share. Fundamental Analysis The financial and operating condition of a company are rigorously analyzed. Keeping in mind the goal of minimizing index turnover, the financial stability of index constituents is a major consideration. Additions An index addition generally is made only if an index vacancy is created by an index deletion. Index additions will be made according to their market size and liquidity, with a view to preserving regional, country, and sector representation in the index. An Initial Public Offering (IPO) will be added to the index only when an appropriate vacancy occurs, and subject to proven liquidity for at least six months. An exception may be made for extraordinary large global offerings where expected trading volume justifies inclusion (i.e. privatizations). Deletions A guiding principle of S&P’s index management is the minimization of turnover among index constituents. Deletions may occur due to delistings, bankruptcy, spin-offs or a failure to meet previously defined criteria for the S&P Global 1200. The most common reason for deleting a stock from an S&P index is its acquisition by another company. Revisions to the Float Adjustments Once a year, the float adjustments will be reviewed. Each company’s financial statements will be used to update the major shareholders’ ownership.

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Quarterly Index Rebalancing Changes in the number of shares outstanding, driven by corporate events such as stock dividends, splits, and rights issues will be adjusted on the ex-date. Share changes of 5 per cent or greater are implemented when they occur. All share changes of less than 5 per cent are updated on a quarterly basis (the third Friday of March, June, September, and December or at the close of the expiry of future contracts). Implementation of new additions, deletions, and changes to the float adjustment, due to corporate actions, will be made available at the close of the third Friday in March, June, September, and December. Generally, index changes, due to rebalancing, are announced 10 days before the effective date by way of a news release posted on www.spglobal.com. Real Time Calculation The S&P Global 1200 calculation begins as soon as the first quote for any index constituent is received. The index is calculated until 5:15p.m. EST to allow for last minute revisions by regional stock exchanges that are the last to close (U.S., Canada, and Mexico). At the country level, the opening price is the first trade of any stock, and in the event of a stock not opening the previous closing price or adjusted price in the region will be used. The closing index value is calculated using the closing price of each stock in its primary market. Exchange Rates and Pricing WM/Reuters spot rates provided real time by the WM Company. Equity pricing source is a Reuters real time feed. Base Date The S&P Global 1200 was based at December 31, 1997. Base value = 1000. 2. S&P GLOBAL 1200 SECTOR INDICES

Standard & Poor’s offers Sector Indices on the S&P Global 1200 based upon the Global Industry Classification Standard (GICS). This standard is jointly maintained by Standard & Poor’s and MSCI. Each stock is classified into one of 10 sectors, 23 industry groups, 59 industries, and 122 sub-industries according to their largest source of revenue. Standard & Poor’s and MSCI jointly determine all classifications. The ten sectors are Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services, and Utilities. These indices are calculated using the same guiding principles that apply to all Standard & Poor’s Indices.

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HANG SENG INDEX

The Hang Seng is the leading index for shares traded on the Hong Kong Stock Exchange. Started in 1969, the index consists of the 33 largest companies that trade on the exchange. The index is maintained by a subsidiary of Hang Seng Bank. It is a capitalization-weighted index, meaning that the largest firms (based on market value) carry the greatest weight in the Hang Seng. The index represents approximately 70% of the value of all stocks traded on the Hong Kong Stock Exchange. The index can be further divided into four sub-indices: Commerce, Finance, Property, and Utilities. DAX INDEX

The DAX Index is the most commonly cited benchmark for measuring the returns posted by stocks on the Frankfurt Stock Exchange. Started in 1984 with a value of 1000, the index is comprised of the 30 largest and most liquid issues traded on the exchange. It is a performance-based index, which means that any dividends and other events are rolled into the index’s final calculation. STRAITS TIMES INDEX

The Straits Times Index, which is compiled by the newspaper of the same name, is Singapore’s premier equity index. Started in August of 1998, this index is comprised of 55 of the exchange’s most valuable firms. It is a modified value-weighted index, which is complicated in calculation, but ensures that the largest firms have the greatest impact on the index’s value. When taken together, the index’s 55 components represent about 60% of the total market value of all issues traded on the Singapore Stock Exchange. KOSPI

In South Korea, the main tracking index is the Korean Composite Stock Price Index or KOSPI for short. Originally started in 1964, the index has been modified numerous times over the years, taking its current form in 1994. The KOSPI Index is comprised of 200 of the largest and most liquid issues traded on the Korean Stock Exchange. The index is market capitalization weighted, meaning that firms with the largest market value have the greatest influence on the KOSPI’s returns. FTSE

The Financial Times 100 Index, or FTSE, is the most widely used benchmark for the performance of equities traded on the London Stock Exchange. Started in January 1984 with an initial value of 1000, the index contains the

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100 largest companies traded on the London Stock Exchange (based on market capitalization). These stocks represent about 80% of the value of all issues traded on the exchange. Because it is weighted by market capitalization, the index’s largest component stocks have the greatest influence on the FTSE’s value. The index is quite unusual in that it reweights its component stocks daily to represent the actual state of the market. Meanwhile, the index is fully rebalanced (additions and subtractions) on a quarterly basis. MSCI (MORGAN STANLEY CAPITAL INTERNATIONAL INC) INDEX

MSCI is the leading international benchmark provider. The information is provided for informational purposes only, and is not a recommendation to participate in any particular trading strategy. MSCI is a leading provider of global indices and benchmark related products and services to investors worldwide. Morgan Stanley, a global financial services firm and a market leader in securities, asset management, and credit services, is the majority shareholder of MSCI, and the Capital Group Companies, Inc., a global investment management group, is the minority shareholder. MSCI Equity Indices MSCI provides global equity indices, which, over the last 30 years, have become the most widely used international equity benchmarks by institutional investors. MSCI constructs global equity benchmark indices that contribute to the investment process by serving as relevant and accurate performance benchmarks and effective research tools, and as the basis for various investment vehicles. As such, the MSCI Equity Indices are designed to fulfill the investment needs of a wide variety of global institutional market participants. In constructing these indices, MSCI consistently applies its index construction and maintenance methodology across 23 developed and 27 emerging markets. This consistent approach makes it possible to aggregate individual country and industry indices to create meaningful composite, regional, sector, and industry benchmarks. Around 2000 organizations worldwide currently use the MSCI international equity benchmarks. MSCI estimates that over USD 3 trillion are currently benchmarked to these indices on a worldwide basis. International Equity Indices Products include under this category include global, regional and country equity indices, sector industry group and industry indices, value and growth indices, small cap equity indices, hedged and GDP-weighted indices, custom equity indices, and real time equity indices. MSCI Equity

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Indices are available in local currency and USD, and with or without dividends reinvested. US Equity Indices In 2003, MSCI launched a new family of US equity indices to provide a much broader and deeper coverage of the US equity market. The new index series reflects the full breadth of investment opportunities within the US equity markets by capitalization size, value and growth investment styles and sector groups. By design, the MSCI US Equity Indices offer:  More accurate representation of the US equity market and segments  More frequent index reviews  Robust value and growth style methodology  Two dimensional, multi-factor  Float weighted  Transparent methodology  More accurate representation of the investment process of size and style managers via unique buffer rules Fixed Income Indices MSCI provides a wide range of fixed income indices for the investment community, including indices for Sovereign, Investment Grade and High Yield debt markets, as well as the Interest Rate Swaps market. The MSCI Fixed Income Indices are unique in their emphasis on trader quotes as the basis for security pricing, as well as on their use of an industry classification system based on the Global Industry Classification Standard (GICS ®). The GICS was developed by MSCI in conjunction with Standard & Poor’s and is used by MSCI to classify securities in its equity indices. The use of GICS in the MSCI Fixed Income Indices facilitates analysis across asset classes. Hedge Fund Indices and Data Base Leveraging its unique understanding of the institutional asset management environment and its expertise in creating and managing global benchmarks, MSCI has developed a family of hedge fund indices based on a comprehensive classification system and a growing fund database. Hedge Invest Index Launched in 2003, the MSCI® Hedge Invest Index consists of a diverse sample of hedge funds that represent a broad range of hedge fund strategies and have weekly liquidity. The index may be licensed for the creation of index linked financial products.

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INDIA INDEX SERVICES LTD (IISL)

India Index Services & Products Ltd. (IISL) is a joint venture between the National Stock Exchange of India Ltd. (NSE) and the Credit Rating Information Services of India Limited (CRISIL). IISL has been formed with the objective of providing a variety of indices and index related services and products for the capital markets. IISL has a consulting and licensing agreement with Standard and Poor’s (S&P), the world’s leading provider of investable equity indices, for co-branding IISL’s equity indices. India Index Services and Products Ltd (IISL), a joint venture of CRISIL and NSE has launched the CNX BANK index which will represent the capital market performance of banking stocks in the country. CNX Bank Index is an index comprising the most liquid and largest capitalized banking stocks. It provides investors and market intermediaries with a benchmark that captures the capital market performance of Indian banks. The index is a market capitalization weighted index with base date of January 1, 2000, indexed to a base value of 1000. The index, with 12 stocks from the banking sector, which trade on the National Stock Exchange, will initially be calculated at the end of the trading day. The banks in the index are among the most liquid in terms of trading turnover and trading frequency on the NSE. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

What is a ‘stock market index’? How is a ‘stock market index’ defined? What is ‘SENSEX’? What is ‘BSE-BANKEX’? What is ‘BSE-TECk index’? What does ‘TECk’ stand for? What is ‘BSE-100 National index’? What is ‘BL-250 Stock index’? What do you know of ‘market capitalization-weighted index’? State the constituents of SENSEX. What is ‘S&P CNX Nifty’? What is ‘AMEX Composite’ index? What do you know of ‘FORTUNE-500’ index?

Section B

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1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

What are the features of a stock market index? How is a stock market index important? Explain how the SENSEX constructed and maintained How is ‘BSE-TECk Index’ constructed? Explain What do you know of the ‘BSE-PSU Index’? How is ‘BSE-100 Index’ constructed? Explain Bring out the features of ‘BSE-BANKEX’? How is ‘S&P CNX Nifty’ compiled and maintained? How is ‘NASDAQ-100’ index constructed? What are the conditions to be fulfilled for inclusion in the NASDAQ-100 index? Explain how the NASDAQ index is calculated Write a note on the ‘S&P 500’ index What are the services rendered by the IISL (India Index Services Limited)? Write short notes on: a. Hang Seng Index b. KOSPI c. DAX index d. Straight Times index e. FTSE

Section C 1. 2. 3. 4.

Give an account of various indices of the Bombay Stock Exchange (BSE). Explain the broad features of ‘S&P CNX Nifty’? How is ‘S&P CNX Nifty’ different from ‘BSE-SENSEX’? Discuss the various indices constructed and maintained by the NASDAQ.

Chapter

20

Stock Market Trading Mechanism The act of buying and selling of securities on a stock exchange is known as stock market trading. 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 brokermembers.

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JOBBERS Vs BROKERS

Sl. No.

Feature

Jobber

Broker

Jobber is an independent dealer or a merchant willing to buy and sell securities

Broker is merely an agent to buy or sell on behalf of his clients

1.

Agent

2.

Specialization Jobber is a specialist

Broker is a generalist

3.

Dealing with Public

Jobber deals only with brokers and not with public. No direct sale or purchase in the market

Broker deals with a jobber on behalf of his clients. He is a middleman between the jobber and the real buyer/seller

4.

Price Quotation

Jobber quotes two prices to the broker, one for buying and one for selling. Sale quotation is higher than the purchase quotation

Broker has to negotiate terms and conditions of sale or purchase and safeguard his client’s interest. He lives on commission paid by his client which is fixed by the Exchange

5.

Margin

Jobber’s profit margin is fixed by competition among themselves as dealers. It is narrow when there is keen competition

Lower brokerage rate is fixed by rules; the higher rate by competition. In practice minimum becomes maximum under keen competition

STOCK EXCHANGE DEALINGS Type The type and the nature of dealings on an Indian stock exchange are of three different categories. They are described as follows: Spot delivery contract Where in a contract the payment and delivery of securities take place on the spot, on the same day or on the next day, it is a case of ‘spot delivery contract’. The sale is said to be complete on the day of contract. These are essentially cash dealings and are primarily meant for investors. All listed securities are allowed trading in the spot market.

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Ready delivery contract Where settlement—payment and delivery takes place within a fixed time period of not exceeding 7 days from the date of contract, it is a case of ‘ready delivery contract’. There is usually handdelivery against full payment. All listed securities are allowed trading in the spot market. Forward delivery contract Where the settlement—payment and delivery of securities take place once at the end of every fortnight through clearing house only, it is case of ‘forward delivery contract’. Such a contract has carry-over facilities also. Speculators are the main interested parties in these dealings. SPECULATIVE DEALINGS

Following are the dealings that are carried out as part of speculative activity: Option Dealings The right to buy or sell a certain security within a certain time and at a certain price is known as ‘option dealing’. An option to buy a security is known as ‘call option’ and an option to sell a security is known as ‘put option’. Where in an option, both the right to buy and sell is acquired by an investor it is a case of ‘double option’ or ‘put and call option’. A person acquires call option where the price of a security is expected to rise in future and in such a case, the person will buy the security at a lower price and sell it at a higher price, thereby making a profit by way of the difference in price. A person acquires put option where the price of a security is expected to fall in future and in such a case, the person will sell the security at a higher price and buy it at a lower price, thereby making a profit by way of the difference in price. As the speculator will either buy or sell, or not exercise the right at all, he will be interested in taking advantage of the price variations. Option, therefore, is in the nature of a gamble. Hedging A mechanism through which loss on a transaction can be minimized is known as ‘hedging’. It is possible for a bull speculator to hedge himself by buying a put option (right to sell) where he agrees to purchase the security from somebody. This would help him offset any loss that he may suffer on the exercise of the call option. In the similar fashion, a speculator intending to exercise right to sell (put option) can hedge himself against loss through a call option.

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Margin Trading The level of deposit of cash or securities that is maintained by an investorclient with his broker in an account with the broker may be referred to as ‘margin’. Such an arrangement of margin enables the broker to indulge in buying and selling of securities on behalf of the clients without any difficulty. Margin offers a measure of cushion to the broker in securities. The securities acquired by the broker will be used as a margin for securing prompt collection from the client. At any point in time, it is required that the client maintains the minimum amount with the broker. Margin helps in several ways. For instance, it places a check on excessive speculation by requiring the client to maintain the margin by making a fresh deposit, besides making the broker’s investment safe. The term ‘margin’ is also used with reference to the deposit required to be maintained by the member-brokers with the clearing house of the stock exchange. The level of deposit varies with the value and the volume of security traded by the member. The margin system is prevalent in stock exchanges such as Bombay, Calcutta, Delhi and Ahmedabad. Arbitrage The process whereby a dealer in a security will indulge in buying and selling activity, to take advantage of the price difference prevailing in different markets is known as ‘arbitrage’. Accordingly, the speculator will make purchase of a security in the market where the price is lower and sell it in the market where the price is higher. The arbitrage process will work successfully in a situation where there has not been any quick and easy availability of information relating to conditions prevailing in various markets. Moreover, the process has to be carried out quickly and without loss of time. Otherwise, the prices may get equalized, and the chances of a gain may be eliminated. Arbitrage may be either domestic or foreign. ‘Domestic arbitrage’ is one in which a security is carried from one market to another market and ‘foreign arbitrage’ is one in which the security is carried from one country to another. For foreign arbitrage to take place, it is important that the currencies of the two countries that are involved should be easily convertible. In the same way, the profit should be more than the cost of carrying securities to another country for the purpose of sale. Arbitrage ultimately helps accomplishing equalization in the price of security in different markets. This is because, where a security fetches a higher attractive price in a market, it will be flocked by suppliers/seller of

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that particular security, who will offload a large volume of that particular security. This will ultimately bring down the price of the security and the concomitant price advantage will vanish. This way, the prices will become cheaper and will level off with the prices prevailing in other markets. Wash Sales A kind of fictitious transaction in which a speculator sells a security and then buys it at a higher price through another broker is known as ‘wash sales’. This type of dealing helps a speculator to bring about a misleadingly higher price. This helps him benefit from further rise in the price of the security where at that point in time, the broker-speculator will be able to reap profits by offloading his holdings to the public. The byelaws of a stock exchange envisage a stiff penalty for such sales activity since it is considered to be an undesirable activity. Corn erin g A kind of speculative activity whereby an individual or group of individuals holds the entire supply of a particular security or a commodity is called ‘cornering’. Cornering brings about a situation in which it will not be possible for the bears (short-sellers), who have contracted to sell the security without actually possessing it, to give delivery to the buyers who have cornered the market. This will ultimately lead to a situation of dictating terms to the short-sellers. Such short-sellers are technically known as ‘squeezed-sellers’. This activity is considered to be an undesirable activity. Rigging the Market A kind of speculative activity whereby the price of a particular security is artificially jacked up on account of strong bull movement, causing heavy spurt in the demand for the security is called ‘rigging the market’. Such a speculator with his large holdings of shares is able to make a ‘market’ so as to gradually ‘unload’ his holdings. This is considered to be an undesirable activity as it interferes with the free and fair interplay of demand and supply. Blank Transfers Where a transfer deed is executed by a person, by merely filling the signature without in any way filling the other particulars, especially the name of the transferee, contained in the ‘transfer form’ with a view to facilitate the transfer to an unlimited number of persons, it takes the form of a blank transfer. The execution of a blank transfer gives rise to a speculative activity as it facilitates the carry-over or budla. A budla involves temporary purchase

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and sale of securities without involving any registration of transfer. The transaction enables the parties concerned to evade the payment of stamp duty. The system of blank transfer however facilitates forward dealing. There are many drawbacks associated with the system of ‘blank transfer’. They are as follows: 1. Encourages unhealthy speculation by making securities easily negotiable 2. Encourages evasion of income-tax, payment of stamp duty on transfer of shares, etc 3. Encourages the transferee-shareholders to gain control of management of companies without their name being disclosed 4. Incomplete and misleading nature of the ‘Registers of Members’ of companies which present a false picture of share holdings to prospective investors 5. Danger of the transferor having to pay the calls in respect of the uncalled portion long after he has actually sold them The practice of blank transfer since considered obnoxious and fraught with deleterious consequences was recommended to be abolished by various committees such as the Atlay Committee (1924), the Morison Committee (1937), and the Gorwala Committee (1955). SHARE PRICES—FACTORS

The price of securities that are traded on a stock exchange is influenced by very many factors. It is interesting to note that the movement in share prices is considered to be a broad indicator of the state of affairs of a company. It is highly characteristic that a combination of many factors cause changes in the price levels of securities. The price prevailing in a stock exchange will also affect the yield or return on a security, or the general expectation about the return on shares in an industry. Following are the factors influencing the prices of a security in a stock market: Demand and Supply A natural force that affects the price level of a security is the interplay of its demand and supply. Under the conditions of a perfect market, the forces of supply and demand interact, so as to determine the price of security. Accordingly, where the supply of a security is abundant and with slimming demand, its price goes down and vice versa. The demand and supply position of industrial securities depends on a variety of factors such as the yield and the general expectation about the yield, etc.

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Bank Rate The price of a security is greatly affected by the easiness with which funds are made available in the money market, by banks and financial institutions to investors and brokers to undertake the activities of buying and selling of securities. The availability and the cost are influenced by the rate of interest, which is determined by the Bank rate charged by the central monetary authority of the country, viz. the RBI. Accordingly, where the bank rate is lower, the demand for funds will be more, thus causing a spurt in the demand for securities and vice versa. Market Players The activities of players in a stock exchange such as underwriters, share brokers, banks and financial institutions are responsible for causing fluctuations in share prices, especially of new companies. The market intermediaries through the large scale buying of securities may attempt to create an artificial scarcity for securities of some companies, and thereby jack up the share prices. Similarly, the actions of institutional investors also stimulate the demand for securities. Dividend Policy The extent of price level prevailing for a particular security is greatly determined by the ability of a company to pay dividends to its shareholders. The dividend paying ability is dependent upon the financial capacities of the company. Accordingly, a company that has profitable investment opportunities with excellent cash flows will be in a better position to pay dividends periodically. This in turn, determines higher or lower share prices. It is interesting to note that the dividends act as a signalling device for share price movements. Profile of Management The profile of top management has got a lot to do with the way a company’s policies are formulated and implemented. Similarly, any change that is brought about in the board of management of the company will affect the quality, soundness and the financial stability of the company. Such changes may lead to positive or negative reactions in the investor community. This in turn will cause the price determination to take place in a certain fashion. For instance, the sudden demise of a popular director or the resignation of an important director may cause plunge in the share prices.

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Trade Cycles The ups and downs in the economy called ‘trade cycles’ are also responsible for causing price movements in a particular fashion. Accordingly, in times of prosperity where there is high order of consumer and industrial activism, the market looks up. This shores up heightened activity on the stock exchange leading to higher market prices. The investors will take part in stock market activities in a large number and with a lot of enthusiasm. The converse happens in times of depression with share prices plummeting. Spec ulation The activities of speculators such as the bulls and bears cause upward and downward movement in share prices. They cause fluctuations in security prices. For instance, the action of bull speculators who start buying in the expectation of a profit from the upward movement of prices, causes the price to move upwards naturally. In the same manner, the actions of the bear speculators will lead to selling pressure, with share prices coming down. On the other hand, when bulls liquidate their holdings, they lower the prices on the stock exchange. Similarly, large-scale buying by bears to meet their short sales will force the security prices upwards. Thus, speculative pressures engineer price volatility. Political Factors The changes and the policies of political leaders at the helm of affairs of a country vastly determine the price of a security. The stock exchange will act as a barometer that reflects the changes taking place in the political arena. Accordingly, positive political change will cause a spur in share prices and political disturbances will cause prices to tumble. In fact, political considerations play much greater a role in price movements than any other factor. This is because politics is chiefly responsible for policy formulation and implementation in the economy, governing the industrial development. Other Factors In addition to the abovementioned factors, the following factors are also responsible for causing price variations: 1. The personal health of the head of a Government 2. Weather conditions affecting agricultural production and consequent demand for basic goods 3. Industrial relations

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Competitive market conditions Corporate activism such as mergers and amalgamations Conditions of balance of payments The general price levels General market sentiments

REGULATING SPECULATION

Speculators ensure smooth ride in share prices as they take an informal view of the trends of prices and try to anticipate the future trends on the basis of price fluctuations. However, the harmful consequences of speculative activity make it an imminent necessity to control and regulate it. This is indispensable for the proper and efficient functioning of a stock exchange. This assumes significance in the context of the need for continuity, liquidity and smoothness of working of the stock exchange. It is therefore, essential that the beneficial consequences of speculation must be allowed to be reaped. It is only the gambling nature of unfair practices and undesirable activities of speculators that are required to be curbed. It is for the purpose of ensuring genuine and healthy speculation, and for curbing unhealthy gambling, proper and adequate measures of regulation must be put in place. THE SECURITIES CONTRACTS (REGULATION) ACT

The SCR Act 1956 has given sweeping powers to the Central Government for the purpose of exercising control and regulation on all stock exchanges in India. The important provisions of this Act are as follows: Recognition of Stock Exchanges An important provision of the Act relates to the functioning of only recognized stock exchanges in the country. Unrecognized exchanges are, therefore, illegal. Central Government grants recognition to an exchange on the fulfillment of such conditions as the compliance with rules and byelaws of the exchange to ensure fair dealing to the investors and protect their interests; the exchange is willing to act in accordance with any condition which the Government may impose on it from time to time; and it would be in the interest of the trade and the public at large to recognize the stock exchange. The government has the power either to reject permission or to withdraw recognition in the interests of the trade or the general public.

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Working of Stock Exchanges The Central Government has been vested with the following powers under this Act to require the stock exchanges to: 1. Call for such explanation and information as the Central Government demands 2. Call for periodical returns about their affairs to the Central Government 3. Call for submission of a copy of its annual report to the Central Government 4. Order an enquiry into the affairs of a recognized exchange as and when it thinks necessary 5. Order a recognized stock exchange to adopt or amend a rule relating to their administration or constitution 6. Supersede the governing board of a recognized exchange and order the suspension of business at such an exchange in the event of an emergency, for a maximum period of 7 days, which may be extended in the interests of the trade or public 7. Compel certain public companies to comply with the listing requirements of an exchange and get their securities listed, to license certain individual dealers in securities who are not members of recognized exchange, and to prohibit dealings in certain notified securities with a view to preventing undesirable speculation in any State or area 8. Regulate and control the business of dealing in spot delivery contracts in the interest of trade and the public 9. Insist on the maintenance of accounts of members, and their audit by Chartered Accountants Regulation of Trading The Act empowers the Central Government to regulate the working of the stock exchange as regards the following important matters: 1. Hours of trade at a stock exchange 2. Maintenance of a clearing house for all business transacted at the exchange 3. Regulation, limitation or abolition of blank transfers and carryover facilities 4. Determination and declaration of market rates 5. Regulation of tarawani business 6. Settlement of claims and disputes by arbitration

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Limitation of business done by individual members Fixation of the scale of brokerage, fines, fees, and penalties and the margin requirements and Punishment by way of fine or expulsion or suspension for those members, who contravene these regulations

Curbing Speculative Activity The governing board of the exchange is empowered to discourage the practice of blank transfers. The Act requires the registration of the transfer within 15 days of the date on which dividend becomes due for the transferee to become entitled to receive dividends. All option dealings and ‘kerb trading’ are considered illegal. The business transacted by dealers in securities outside the stock exchanges is known as ‘kerb trading’. Directorate of Stock Exchanges The SCR Act provided for the constitution of the Directorate of Stock Exchanges for the purpose of enforcing and administering the regulatory provisions of the Act. The Government of India set up the Directorate in 1959. Important functions of the Directorate are as follows: 1. Maintaining a close watch on the activities of the stock markets in India and their individual members 2. Advising the exchange concerned in order to curb any unhealthy trends in a recognized stock exchange 3. Taking up matters connected with the control of kerb trading and prevention of option dealings 4. Ensuring the compliance with the listing requirements of recognized stock exchanges by corporates 5. Granting licenses to individual dealers in securities in areas outside the recognized exchanges 6. Acting as an agency of the Government responsible for the administration and implementation of the reforms contained in the Securities Contract (Regulation) Act of 1956 7. Serving as a useful link between Government and the leading stock markets of the country MARGIN TRADING

Meaning Where an investor buys securities by borrowing a portion of the transaction value and using the securities in the portfolio as collateral, it takes the form of ‘Margin Trading’. An investor who purchases securities

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may pay for the securities fully in cash or may borrow a part of the transaction value from the brokerage firm. The term ‘margin’ connotes the amount of money or equivalent value of eligible assets deposited by the investor to borrow money to purchase more securities than he would have otherwise been able to do so with his own money, with the expectation that stock prices will rise enabling him to reap greater profits. In other words, margin implies that part of the transaction value which the investor must deposit with the broker. It is the investor’s initial equity in the account with the broker. The loan from the brokerage firm is secured by the securities that are purchased by the investor. Conversely, one may also enter into a short sale through a margin account, i.e. borrow securities from the brokerage firm in order to sell it, hoping that the price will decline. Features Following are the features of margin trading: 1. Enhanced power Margin trading allows for an increase in the purchasing and selling power of the investor and thereby increases the possibility of a larger gain if the stock market moves on expected lines. At the same time, it magnifies the losses too, in case the stock market behaves contrary to the expectation. 2. Leveraging Margin trading is essentially a form of leverage trading. Leveraging implies borrowing on the strength of the asset purchased and using it as a collateral. Such an asset is considered to be far greater in value than the value of the collateral. The collateral is made up of securities or other financial assets. Leveraging or borrowing money is to amplify the gains. Leveraging leads to a doubling of the purchasing power, offering more flexibility to the investor besides presenting the possibility of multiplying the return on investment. 3. Margin account An account opened by the investor with the brokerage firm, which allows the investor to borrow a certain percentage of the value of his purchases, using his securities as collateral, is known as ‘margin account’. It implies taking loan from the broker like any other borrowing-lending, with the investor owing the principal and the interest to the broker who has lent money through a margin account. 4. Margin value The investor will be entitled for a loan up to 50 percent of the value of purchase. Only certain assets are considered to be marginable securities. Accordingly, securities that cannot be purchased on margin must be purchased in a cash account. These are normally the

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securities that trade below a certain minimum price or are highly volatile in nature with substantial risk to the investor as well as to the broker, if purchased on margin. 5. Commission Trade commissions as applicable in the case of cash dealings are also applicable to margin accounts. However, the brokerage firm charges interest on the margin loans made to the investor. The interest is a fixed rate stipulated by the authorities plus a markup depending upon the exposure (debit balance) in the margin account. The interest rate on the loan varies depending upon the amount borrowed. The cost of margin trading to the investor thus depends on the prevailing rate of interest for margin accounts, the amount of loan and the period for which the money has been borrowed. The broker may charge interest on the outstanding margin debt at the end of say every month. The interest is normally compounded on daily basis. As margin debt increases, the interest charges keep on accumulating. 6. Margin requirements It is essential that the securities purchased on margin have to appreciate enough in value so as to cover the cost of borrowing. Margin requirements aim at limiting trade sizes done in margin accounts. They also prevent the brokerage firm from losing the money lent to investors. While the margin requirements are fixed by the regulatory authorities, the individual brokerage firms are free to set their own margin requirements—often called “house” requirements as long as they are more stringent than those fixed by the regulatory authorities. The brokerage firms fix higher margin requirements if the securities in a margin account are particularly volatile, thinly traded or concentrated in a single security or single industry. This is done to help ensure that there are sufficient funds in the customer’s accounts to cover the large ups and downs in the prices of these securities. Following are the different type of margins that are imposed: a. Minimum margin It is the minimum amount of 100 percent of the purchase price to be deposited by the investor with the brokerage firm before trading on margin. Many firms, however, do not insist on a minimum margin and provide finance based on initial margin. b.

Initial margin It is that portion of the purchase price, which is deposited by the investor with the broker firm. The Federal Reserve Board of U.S. has fixed this at 50 percent. Brokerage firms allow the investors to borrow up to 50 percent of the value of securities. However, some brokerage firms have set the initial margin requirements at as high as 67 percent.

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c.

Maintenance margin It is the minimum level of equity balance that should be maintained in the account at all times. If the equity balance in the margin account falls below this level, then the brokerage firm will insist that the investor deposit. Additional funds or the firm can sell the securities in the account to bring down the margin debt. The maintenance margin requirement varies for different brokerage firms. 7. Margin call When the equity balance in the margin account falls below the floor acceptable to the broker, he can make a “margin call”. The floor at which the broker can make the margin call depends upon what is fixed by the regulatory authorities and the norm followed by the broker. When the broker makes a margin call, the investor is required to deposit more cash or securities into his account. If the margin call is not met, the broker has a right to sell the securities in the margin account to increase the equity level in the account above the minimum margin requirement. If the investor gets a margin call, he will be required to bring in additional funds before a set time/date. If the security prices continue to fall and the equity in the account drops further, the broker may sell the investor out even without waiting till the given time/date. Short sale through a margin account also works in the similar manner. If the investor expects the stock prices to decline, he would borrow securities from the brokerage firm to sell them now and he would purchase the same securities at lower prices in future and repay the broker. In the process, the investor would make profit by selling at high prices and purchasing at lower prices. 8. Margin agreement The margin accounts are governed by a margin agreement signed by the broker and the investor. Accordingly, the brokerage firm is not even required to make a margin call or notify the investor that equity in the account has fallen below the minimum requirement. Securities can simply be sold to meet the shortfall in the account. The investor, therefore, has to remain vigilant about the account balances. This is because when the stock market is declining, the value of the collateral is also declining and so also the value of the securities purchased with the loan. Not meeting the margin call means that the broker can offload these securities in the market to meet the shortfall in the margin account and the proceeds of the sale go directly to meet the repayment of margin debt. The losses can get compounded by the fact that the investor loses control over deciding which stocks should be sold and at what price. The stock prices may rebound later, but the investors still have to pay principal and

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interest for stocks they no longer own. It is therefore better to bring in additional funds much before the investment has gone bad. 9. Caveats The investors venturing into margin trading need to be aware of the several of the following risks associated with it: a. Losing more money In a declining stock market, the losses get amplified in a margin account, with the potential threat of losing more money than one had originally invested. If the value of securities purchased on margin declines, then the investor is required to provide additional funds to the brokerage firm to avoid forced sale of those securities or other securities in the account b. Meeting deficiency For meeting margin deficiency, the brokerage firm can sell the securities in the investor’s account at the current price available in the market. This price may not be the “best” price at which the investor himself would have preferred to sell his securities. Further, the investor continues to remain responsible for any shortfall in the account even after such a sale c. No information Generally, the margin trading rules allow the brokerage firms to liquidate securities in investor accounts without contacting the investor. Most of firms try to intimate their investors of the margin call, but they are not required to do so. This is a source of additional risk. d. No extension of time When the firm makes a margin call, the investor is required to respond to it immediately. Normally, one is not entitled to an extension of time to meet initial margin requirements, while some firms may allow sometime to meet a maintenance margin call. The investors will thus have to keep some extra cash with them, which they can bring in when needed. Similarly, the brokers need to remain alert. Indian Scenario Margin trading is prevalent in most of the markets, which have switched over to rolling settlement. Since rolling settlement has now been introduced for a wider range of securities, the pertinent question is whether Indian markets are ready for margin trading. In margin trading, both the broker and the investor are well aware of the credit element involved before hand and the broker can take adequate precautions, like imposing stricter margin requirements depending upon the type of securities in which the investment is being made and scrutinising the credit-worthiness of the investor before the loan is made. Some kind of

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lending and borrowing mechanism is a must for enthusing investor interest in the market. No market can be vibrant and offer sufficient liquidity without speculators or day traders. The volumes in which day traders operate are not sustainable if they are to operate strictly with own funds. The foremost pre-condition for introducing margin trading in India will be to create widespread investor awareness about margin. Before investing, the investor needs to fully appreciate the costs and risks of investing on margin. The Securities and Exchange Commission, the regulator for securities market in the U.S., has launched an intensive investor education exercise on its website, focusing on risks and costs associated with margin trading and several other new products. TRADING OF SECURITIES—STEPS

Following are the steps involved in the trading of securities at a stock exchange: Order Placing The first and foremost step in the trading of securities is placement of an order by an investor with the broker concerned either to buy or sell certain number of scrips at a certain specified price. An order can be placed by telegram, telephone, letter, fax, etc or in person. There are various kinds of orders. For instance, where in an order, the client places a limit on the price of the security; it is a case of ‘limit order’. Where the order is to be executed by the broker at the best price, such an order takes the name of ‘Best Rate Order’. An ‘Immediate or Cancel Order’ is one that has to be executed immediately and may have to be cancelled if the order is not executed immediately. A Limited Discretionary Order allows the broker to buy and sell within the specified price range and/or within the given time period as per the best judgment of the broker. Where the client orders the broker to sell as soon as the price reaches a particular level, it is a case of ‘Stop Loss Order’. Under the ‘Open Order’, the client does not fix any price limit or time limit on the execution of the order and relies on the judgment of the broker. Order Execution Brokers execute the orders placed by the clients for the purchase or sale of scrips. The execution takes place during the trading hours and during the working days of the exchange. However, the trading after the normal working hours may also take place and this is termed as ‘kerb trading’. Entry to the trading floor of the exchange is restricted only to the

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identified and regular members of the exchange. Such a member is called a ‘single jobber’ or ‘tarawaniwala’ for a particular scrip. In respect of actively traded scrips that involve a huge volume of business, there could be more than one jobber. Jobbers offer two-way quotes for scrips they deal in. This way, jobbers act as market-makers and provide liquidity to the market. The order is executed either by auction or negotiation. Settlement of a transaction takes place by a mutual agreement of the price between the parties concerned. Such prices are published in the newspaper every day. Contract Note Preparation When once an agreement is reached between the parties concerned as regards price, a contract note is made out between the broker and the client. Such a note forms the basis of the transactions recorded in the ‘Pucca Sauda Book’ after the execution of the order. Particulars such as the price, number of scrips, date of transaction, names of parties, brokerage, etc are found in the note. Delivery and Clearing After the preparation of the contract note, delivery of share takes place through the instrument known as ‘transfer deed’. The transfer deed is signed by the transferor (seller) and is authenticated by a witness. It contains the details of the transferee, besides bearing the stamp of the selling broker. There are different kinds of delivery. For instance, in the case of ‘spot delivery,’ the transaction is settled by delivery and payment takes place on the date of the contract or the next day. In the case of ‘hand delivery’, delivery and payment are completed within 14 days from the date of contract. Delivery and payment may be completed after 14 days as specified at the time of the bargain in the case of ‘specified or special delivery’. Delivery and clearing of security takes place through a clearance house. Share Transfer For the purpose of effecting the transfer in the name of the transferee, the share certificate and the transfer deed are lodged with the Company. The parties also pay necessary stamp duty. The company issues the share certificate bearing a new ledger folio number, transfer number, date and buyer’s name at the reverse of the certificate. The appropriate authority of the company endorses these particulars. Settlement

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The procedure adopted for the settlement of transactions varies depending upon the kind of securities. Following are the procedures involved in the settlement of transactions: The steps in stock trading are depicted in Exhibit 8. Exhibit 8

Steps i n Stock Tradi ng

For Specified Securities Specified securities consist of actively traded equity shares of established growth companies commanding a large share of the market capitalization. Following conditions are to be satisfied for inclusion of shares in the category of ‘specified securities’: 1. Listing of shares on a recognized stock exchange for a minimum

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period of 3 years Minimum issued capital of the company must be Rs. 75 crores Market capitalization of the company is 2-3 times Minimum face value of shares held by the public shall be of the order of Rs. 4.50 crores 5. The minimum number of shareholders on the dividend paying list of the company must be 20,000 6. Company should be growth-oriented 7. Company’s shares must have been actively traded during the previous months Following are the procedures followed as regards ‘specified securities’: 2. 3. 4.

Sauda sheets The details of all purchases and sales as recorded in sauda sheets every day, which are then fed into the computer. The details are verified in the computer center where the matched transactions are logged. Unmatched transactions are reverted back to the members for verification. The computer center is informed of all the settlements. Issue of advice After verification, the computer center issues to each member such details as the following: a. Money settlement slips showing the difference between payables and receivables b. The pay slips and receive slips c. Delivery order and receive orders of shares d. Carry over margin settlement in case of badla transactions (since banned) Clearing The above details are accompanied with the cheques/drafts and securities certificates as per the delivery order. The clearing house makes payment and delivers the security certificates to the members on the payout day, which is the subsequent wednesday. Non-specified Securities Securities that are not in the specified list are known as ‘non-specified list’. In respect of ‘Badla’ (since banned), transaction settlement is not permitted in the non-specified group. The clearing house handles the money part. On the pay-in day, members submit only the balance sheet and the cheques/drafts. Members receive only monetary payments from the clearing house and themselves handle the actual physical delivery of securities. Odd-lot Securities

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Odd-lot securities are those, where a single share certificate is of smaller denomination than the minimum denomination required for regular trading. They consist of securities of preference shares and odd-lots of shares and debentures. The members themselves handle both delivery and payment. The job of verification and matching of transactions alone is done by the stock exchange. It also issues to the members a statement of all unmatched transactions entered in the previous settlement period. Members between themselves do the actual settlement of transactions. Rolling Settlement From the year 1998, ‘Rolling Settlement’ is being done in respect of demat shares. Accordingly, trading in demat shares takes place on the basis of T+5 rolling settlement on an optional basis. The system allows for the settlement of each day’s business at the end of the day. The system was introduced in those exchanges, which are connected to a depository. Rolling settlement system was first introduced at Bombay Stock Exchange followed by the National Stock Exchange. New Settlement System SEBI had introduced a new T+5 rolling settlement in equity market from July 2001, and subsequently shortened the settlement cycle to T+3 from April 2002. After having gained experience of T+3 rolling settlement and also taking further steps such as introduction of STP, it is now felt appropriate to further reduce the settlement cycle to T+2, thereby reducing the risk in the market and to protect the interest of investors. The shortening of settlement cycle to T+2 needed cooperation, coordination and active support of various entities and intermediaries in the market such as stock exchanges, clearing corporations/houses, depositories and depository participants, FIIs, custodians, fund managers, brokers, etc. SEBI had held several rounds of consultation with all the market participants and based on the consensus, decided to introduce T+2 rolling settlement in Indian equity market from 1st April 2003. The calendar of events/activities in T+2 rolling settlement would be as follows: 1. Confirmation of the institutional trades by the custodians latest by 11:00 a.m. on T+1. A provision of an exception window would be available for late confirmations. The time limit and the additional charges for the exception window would be decided by the exchanges 2. The exchanges/Clearing House/Clearing Corporation would process and download the obligation files to the brokers’ terminals

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latest by 1:30 p.m. on T+1 DPs shall accept instructions for pay-in of securities by the investors in physical form atleast upto 4:00 p.m. and in electronic form by 6:00 p.m. on T+1 4. The depositories would accept the requests from DPs till 8:00 p.m. for ‘same day processing’ 5. The depository would permit the downloading of the pay-in files of securities and funds till 10:30 a.m. on T+2 from the broker pool accounts 6. The Depository would process the pay-in requests and transfer the consolidated pay-in files to the Clearing House/Clearing Corporation by 11:00 a.m. on T+2 7. The Exchanges/Clearing House/Clearing Corporation would execute the pay-out of securities and funds latest by 1:30 p.m. on T+2 to the Depositories and the Clearing Banks would in turn complete the process by 2:00 p.m. on T+2 The various steps to be initiated by the SEBI to ensure smooth transition into T+2 rolling settlement include: 1. Widening of scope of STP 2. Wider use of electronic fund transfer facility 3. Issue of electronic contract notes 3.

Book Closure Book closure implies cessation of entries after a specified date. Book closure aims at enabling the completion of all transfer of securities before finalization of accounts, so as to determine the beneficiaries of payment of dividends and the interest. Book closure is declared 21 days in advance. In order that the interest of the clients is protected, brokers would require that the claims for transfer is lodged with the company before the book closure date, so that the transfer claim is accepted. Moreover, fresh transfer deeds are required on reopening of books. This way the interest of the buyer will be protected in the case of purchase of securities on the basis of cum-dividends, cum-bonus and cum-right. MARGINS

The brokers who trade in securities on the stock exchange are expected to meet the margin requirements. There are different types of margins. They are as follows: Daily Margins

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Margins that are collected in cash for every transaction of purchase or sale outstanding at the end of the day, for scrips in the specified group are called ‘daily margins’. The margin amount varies depending on the market position and price movement. For instance, daily margins generally vary between 5 to 25 percent and to as high as 50 percent in certain scrips. Carry-over Margin Margins imposed on the carry-over contracts are known as ‘carry-over margin’. In respect of transactions that are carried-over from one settlement period to another, a minimum carry over margin of 3 percent of the makingup price of net aggregate balance of purchases and sales is payable by both parties separately. This is compulsory for all stock exchanges. The margin generally ranges from 5 to 25 percent for purchases in a rising market and for sales in the falling market. Ad hoc Margin Margins that are imposed to ensure that the members do not trade in excess of their financial resources are known as ‘ad hoc margins’. The aim is to curb over-trading. Members of BSE having an outstanding position above Rs. 3 crores have to deposit ad hoc margin at the rate of 10 percent of the excess business on a continuing basis. An additional ad hoc margin would be collected from members in case the market of a particular scrip or securities market in general becomes highly volatile. Automatic Daily Margins Margins that are imposed in respect of shares of the market value exceeding Rs. 50 and in respect of the price rise in scrips taking place by 5 percent in a day or 10 percent over a settlement period are known as ‘automatic daily margin’. Automatic daily margin of 50 percent of the price rise on the scrip is imposed. Overall Margin Margins that are imposed in respect of aggregate outstanding sales and purchase exceeding Rs. 50 lakhs and Rs. 1 crore respectively are called ‘overall margin’. An additional margin of 5 percent and 10 percent is payable. Additional Volatility Margins (AVM) These are the margins that are payable to help curb the effects of volatility in share prices. AVMs came to be prescribed by the SEBI during the first half of 1998. The AVMs allowed for daily price band reduction from 10 percent to 8 percent. The existing weekly price band of 25 percent was

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removed and a graded margin system was put in place in respect of volatile securities. These AVMs are applicable to all positions in the cash and carry-forward markets, and are payable on the outstanding buy or sell positions at the end of each day. BADLA SYSTEM

Meaning A system of stock exchange trading that allows the facility of carry forward of the transaction for the purpose of clearing, from one settlement period to another is known as ‘badla system’. Badla transactions can be carried out only in respect of specified categories only. The system allowed the buyer not to make payment of the entire amount at the time of the purchase against the security of blank transfer deed and share certificates. Badla rates were fixed on fortnightly basis depending on the demand and supply conditions. The greatest advantage of the badla system is that it allows for the expansion in the market size besides providing excellent liquidity to the market. The biggest threat of the system is that it encourages mindless speculation leading to high volatility in stock market prices. The system was banned by the SEBI since December 1993. Mec han is m Badla system involves the following mechanism: 1. Transfer of market position 2. Stock-lending/Short-selling 3. Borrowing/Lending in money market

Transfer of market position In the event of the investor, of the buyer or the seller, not being in a position to settle the transaction at the end of a settlement period either by a payment or a receipt or take delivery or give delivery, it is possible to transfer the position by carrying forward the transaction from one settlement period to another by reversing the transaction. The transfer position varies depending on the type of operator. a. For bull operator In the case of a bull operator, who is supposed to make purchase of securities but not being in a position to do so, he can carry forward his purchase position to the next settlement. This happens by reversing his purchase position in the current settlement, which implies that he has to enter into a sale transaction at the make-up price fixed by the stock exchange. The making-up price is generally the closing quotation of the share in the current settlement. He is thus, allowed to pay or receive the difference between the contract

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b.

price and this brings to an end his earlier commitment and a new contract will thus be born. A fresh purchase position is thus created which will be valid for the next settlement. Such a position is created in the expectation of a rise in price in the next settlement. For availing this facility of carry forward, the bull operator has to pay a charge known as ‘Contango’ to the financiers. For bear operator In the case of bear operator, who is supposed to make sale of securities but not being in a position to do so, it is possible to carry forward the sale position to the next settlement. This happens by reversing the sales position in the current settlement, which implies that a purchase transaction has to be entered into at the make-up price fixed by the stock exchange. The make up price is generally the closing quotation of the share in the current settlement. He is thus allowed to receive or pay the difference between the contract price and this brings to an end his earlier commitment and a new contract will thus be born. A fresh sale position is thus created which will be valid for the next settlement. Such a position is created in the expectation of a fall in price in the next settlement. For availing this facility of carry forward, the bear operator has to pay a charge known as ‘backwardation’ to the financiers.

Stock-lending/short-selling The facility by which it is possible for an operator to sell a security without actually owning it, is called ‘stocklending’ or short-selling. Badla transactions facilitate stock-lending for short-sellers and thus providing for higher investment. In a falling market, the short-sellers have to purchase to cover their sales position. This activity checks a fall in security prices. Similarly in a rising market those who have contracted to purchase, have to sell securities to square their position, thus arresting further rise in share prices. Borrowing/lending in money market Under securities lending, the lenders have to deposit the securities with an approved intermediary under an agreement for a specified period. The agreement will provide for the continuance of the beneficial interest including the corporate benefits with the lender. For this purpose, the SEBI has conditioned that the approved intermediary shall have a minimum net worth of Rs. 50 crores. The stock-lending scheme, also called the ‘Securities Lending Scheme’, was introduced by SEBI in 1997, on the recommendations of B.D. Shah Committee. The benefits accruing to the lender of securities include dividends, rights and bonus. Under the scheme, the borrower and the

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lender of securities have to enter into separate agreements with an approved SEBI intermediary, who shall have a minimum net worth of Rs. 50 crores. The intermediary has to clearly specify the fee payable to the lender and the amount to be collected by the borrowers in their respective agreements. Intermediaries, for this purpose, include stock exchange clearing houses, financial institutions and other similar bodies. The initial registration is for 3 years and the intermediary has to pay a specified fee to SEBI. The scheme of stock lending was first started in India by the Unit Trust of India (UTI) in the year 1997 with 3 SEBI approved intermediaries, such as Stock Holding Corporation of India Ltd. (SHCIL), Deutsche Bank and Reliance Capital and Financial Consultancy. Revised Forward Trading System On account of its large-scale speculation leading to unfettered price volatility, the ‘Badla System’ was banned in December 1993. However, the G.S. Patel Committee, having understood the positive advantages of badla system, came out with an alternative system of trading called ‘Revised Forward Trading System’. The SEBI, on the basis of the recommendations of the above committee, introduced a revised carry forward system with effect from July 28, 1995. Following are the conditions prescribed for the working of the system: 1. Capital adequacy Prescription of capital adequacy norm of 3 percent for individual brokers and 6 percent for corporate/institutional brokers, the calculation being made excludes the membership card of broker and the SEBI being vested with the right to increase capital adequacy norm if the circumstances so warrant. 2. Flat margin Recovery of a flat margin of 15 percent marked to market on weekly basis as against earlier graded margin of 20 to 50 percent of carry forward position, with higher margins to be imposed if the price of the scrip goes up and vice versa. In respect of volatile scrips, the margin requirement can go upto 100 percent. 3. Turnover limit Removal of the limit of 25 percent of the turnover imposed on carry forward deals by brokers due to implementation of capital adequacy norms. 4. Self-certification Introduction of self-certification by the brokers on the status of their settlement. 5. No publication Abolition of the requirement of publishing the carryforward position of each broker, scrip-wise before the commencement of each carry-forward session. 6. Maximum period Allowance of the facility of carry forward of

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transactions for a maximum of 90 days, squaring off being permitted only up to fifth settlement, i.e. 75 days. 7. SEBI permission Stock exchanges to be permitted for carrying out forward trading/carry forward transactions only after obtaining permission from SEBI. 8. Facility Requirement of facilities such as screen-based trading, effective monitoring, surveillance and reporting system, and other infrastructure requirements for stock exchanges. The J.R. Varma Committee was set up by the SEBI for the Review of Revised Carry-forward System, which submitted its recommendations in July 1997. Modified Carry-forward System The Modified Carry-forward System came to be introduced by the SEBI in October 1997, based on the recommendations of the Varma Committee. The crucial condition of twin-track system and 90-days limit for settlement of transactions were retained by the SEBI. Important features of the ‘modified carry-forward system’ are as follows: 1. Withdrawal of the prevailing margin requirement of 7.5 percent on transactions marked for delivery for members doing carry-forward business 2. Withdrawal of the prevailing margin requirement of 7.5 percent on transactions marked for delivery for members doing carry-forward business 3. Continuance of the limit of 90 days for carry-forward transactions 4. Stock exchanges to ensure that no roll-over of transactions takes place beyond 90 days 5. Enhancement of the over-all carry-forward limit to Rs. 20 crores per broker per settlement, up from Rs. 7.5 crores 6. Withdrawal of sub-limits for sale and purchase positions and individual scrips 7. Withdrawal of the limit of Rs. 10 crores for financier, who was operative at the time, with shares received by Vyaj-badla financiers continuing to be deposited with the clearing house CURRENT TRADING SYSTEM—PROBLEMS AND PALLIATIVES

In recent times, the Indian stock market is afflicted with many ailments. It is the most manipulated or rigged market in the world. Its bull session and bear slide are regularly organized. The excessive nature of

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speculative activity has killed the genuine investors’ interest and made them lose by making long-term investments with an expectation of capital appreciation and regular returns. It is a common phenomenon in the Indian stock market that the ordinary investor comes to grief periodically, while a few sharks decamp with the contrived windfall. Proble ms The current trading system in the Indian stock market is polluted with money laundering operations, insider trading and price rigging by certain corporate houses. Following are some of the ailments with which the Indian stock market suffers: 1. Lack of transparency, accountability and fair play resulting in suppressed flow of funds 2. Lack of absolute Government intervention 3. Relatively higher cost of credit (interest rates) resulting in lack of competition 4. Small share of bank credit as a ratio of GDP 5. Lack of limited total capital market exposure of Indian banking system so as to enhance bank lending to stock market operations 6. Unholy nexus between promoter and broker, and politician and broker 7. Lack of viability of stock exchanges in India with too many of them chasing a few of them 8. Lack of adequate efforts at computerization of stock market operations popular In order to overcome the aforesaid ailments, measures of reform such as reorganizing and reducing the number of stock exchanges, providing SEBI with more powers of regulations to pull up the erring exchanges etc should be undertaken. The stock markets should be designed in such a way as to allow for contribution of economic development through orderly growth of investments. Household investors who account for a whooping 85 percent to savings mobilization, must be given due importance and must be afforded all protection for their willing . Palliatives

RBI initiative RBI has introduced guidelines whereby it has fixed the maximum limit on the all forms of exposure of banks on the stock market operations to the extent of 5 percent. Accordingly, the ceiling would cover direct investments by of equity shares, convertible debentures (CDs) and units of equity-oriented mutual funds, advances against shares and

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debentures and guarantees issued on behalf of brokers. These guidelines have been issued in the light of the recommendations made by the technical committee of the SEBI. The 5 percent ceiling would be computed in relation to total advances, including commercial paper (CP) as on March 31, of the previous year as against the total outstanding domestic credit as on March of the previous year under the earlier guidelines. Besides, for the purpose of computing the 5 percent norm, direct investment in equity shares by banks would be calculated at the price paid by banks at the time of acquisition of shares. Wherever exposure to stock market in excess of the 5 percent ceiling has already been made, the concerned banks have to formulate a time bound plan to gradually reduce their exposure to stock markets in line with the amended guidelines. a. Revised norms The Reserve Bank of India has recently issued revised norms for the banks’ exposure in capital market. Accordingly, banks’ investments in shares and also advances against shares and other connected exposures should not exceed 5 percent. The ceiling of 5 percent will also apply to total exposure of a bank to stock market including loans and advances to individuals, corporates, and stockbrokers and debentures. However, this will not be applicable to shares and convertible debentures assigned to banks as collaterals by individuals and corporates for the purpose of availing bank credit for carrying out normal trade, production and investment or other development activities which do not involve stock broking or investment in capital markets. Similarly, the existing instructions with regard to advances to individuals and financing of initial public offerings (IPOs) remain unchanged b. Rationalized margins The norms relating to the margins on such advances have been rationalized. Accordingly, the RBI has proposed an uniform margin of 40 percent against all advances/ guarantees with a minimum cash margin of 20 percent (within the margin of 40 percent) in respect of guarantees issued by banks as against the minimum cash margin of 25 percent for issue of guarantees, 25 percent margin for advances against demat shares, and 50 percent for advances against physical shares c. Simplified operations The RBI has come out with a clear policy on banks’ operations on secondary markets. Accordingly, banks shall not undertake arbitrage operations themselves, or extend credit facilities directly or indirectly to stockbrokers for arbitrage operations in stock exchanges. Similarly, banks shall not undertake

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any sale transaction without the shares in their investment account. The RBI has advised banks to constitute an ‘Investment Committee’ for taking decisions regarding investments in shares and advances against shares, so as to avoid any nexus between banker and stockbrokers. In addition, banks are to constitute a separate and independent ‘Audit Committee’ for surveillance and monitoring of investment and advances against shares. The audit committee will continuously review the total exposure of the bank to capital market, both fund based and non-fund based in all forms. It is the responsibility of the audit committee to ensure that the guidelines issued by the RBI and the Board of the bank are complied with, and adequate risk management and internal control systems are in place Banks have been suitably advised by the RBI to avoid concentration to a few stock broking entities. Banks shall avoid concentration to a few stock broking entities. Banks shall fix within the overall limit of 5 percent, a sub-ceiling for total advances to all stock brokers and market-makers, both fund based and non-fund based and to individual stock broking entities, its associates and interconnected companies. SEBI initiative The Securities and Exchange Board of India decided to ban the age-old carry forward (badla) system and introduce options on individual scrips along with index options, to coincide with the commencement of the rolling system. Accordingly, all deferral products, viz. Automated Lending and Borrowing Mechanism (ALBM), Borrowing and Lending of Securities Scheme (BLESS), Modified Carry Forward System (MCFS) and Continuous Net System (CNS) would be discontinued. This calls for compulsory liquidation of all outstanding deferral positions in the current settlements by September 3, 2001. As many as 414 scrips were brought under the new system and the remaining stocks with effect from January 2, 2002. In the interim period, stocks, which will not be under compulsory rolling settlement, will be traded on the uniform settlement cycle, Monday to Friday. There will not be any price bands (circuit filters) on individual stocks in rolling settlements from July 2, 2001. Market wide index based circuit breakers have been implemented. Similarly, the recommendations of the Group on Insider Trading have also been implemented. In addition to the above measures initiated by the SEBI, the following have also been suggested: a. Constitution of a centralized monitoring mechanism to examine

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b. c. d.

e. f.

g.

h.

the flow of funds from the banking system to the stock markets Formulation of proper norms regarding transactions of overseas corporate bodies in the Indian markets Impounding of at least one-third of the hawala profits by the bourses till their positions are squared up to reduce the risks and leverage under the carry-forward system Evolving a mechanism of sharing information among the surveillance departments of exchanges to have a holistic picture of risk profile and trading by members Review of the system of bank guarantees for meeting capital and margin requirements with a view to reduce leverage in trading Standardization of composition of settlement guarantee funds and trade guarantee funds to work as a cushion for the successful completion of settlements Introduction of unique client identity system to help assess the risk profile of the brokers/clients’ trading in the market across the exchanges in light of the dynamic requirements of the exchanges and particularly in the atmosphere of multiple exchanges and multiple membership Ensuring the efficient application of the risk management mechanism by way of margins, exposure limits and carry forward limits REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

What is ‘stock market trading mechanism’? Who are ‘jobbers’? Who are ‘brokers’? Who are ‘tarawaniwalas’? What is spot delivery contract? What is ready delivery contract? What is forward delivery contract? What are option dealings? What is hedging? What is margin trading? What is arbitrage? What is ‘wash sales’? What is cornering? What is rigging the market? What is a blank transfer?

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16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26.

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What is minimum margin? What is initial margin? What is carry-over margin? What is ad-hoc margin? What are daily margins? What is maintenance margin? What is margin call? What are ‘sauda sheets’? What are ‘odd-lot securities’? What are ‘non-specified securities’? What is ‘rolling settlement’?

Section B 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

13. 14. 15.

In what way the jobbers are different from brokers? How are stock exchange dealings classified? Name the different types of speculative dealings How is a ‘domestic arbitrage’ different from a ‘foreign arbitrage’? State the drawbacks of blank transfers. How the working of a stock exchange regulated? What are the functions of the Directorate of Stock Exchanges? Outline the features of margin trading. Explain the different types of margins imposed by a stock exchange on the stock trading. Specify the type of risks which an investor venturing into margin trading needs to be aware of. Explain the various steps involved in the trading of securities on a stock exchange. What are ‘specified securities’? What are the conditions to be satisfied for inclusion of shares in the category of specified securities? Bring out the features of a new settlement system introduced by the SEBI in July 2001. What are the different types of margin requirements to be met by the brokers on a stock exchange? What are the conditions prescribed for the working of the ‘revised carry forward system’?

Section C

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1. 2.

3. 4.

5.

What are the factors that influence the price of a security traded on a stock exchange? Discuss the various powers granted to the Central Government to control and regulate the stock exchanges in India under the provisions of the Securities Contracts (Regulation) Act, 1956. What is ‘badla system’ of stock trading? Explain its mechanism What are the problems encountered in stock market trading? What are the palliatives announced by the RBI to overcome such problems? Comment on the role of SEBI in the realm of stock market trading.

Chapter 21

Depository Services

Electronic revolution has brought about a number of changes in the functioning of Indian capital market. The most revolutionary change that has been brought into the entire working of the Indian capital market is the introduction of depository (demat) system. The century old Indian capital market has been facing quite a lot of trouble in traditional paperbased settlement of trade causing problems like bad delivery, delayed transfer etc, until the enactment of depositories Act in 1996. Dematerialization and depository services have assumed greater significance consequent to SEBI guidelines which required compulsory demating of share of all listed companies in India. Further, the number of agencies, institutions and persons connected with demat environment has also increased phenomenally. The depository model in India is a competitive multi-depository system. Under the system of dematerialization followed in India, the securities will be cancelled as against the system of immobilization in which the securities are merely kept in custody. DEPOSITORY

A depository is an organization which holds securities in electronic book entries at the request of the shareholder through the medium of a depository participant. A depository can be compared to a bank. To utilize the services offered by a depository, the investor is required to open an account called ‘demat account’ with the depository. The demat account is opened through a depository participant which is very similar to the opening of an account with any of the branches of a bank in order to utilize the services of that bank. The objective is to allow for the faster, convenient and easy mode of affecting the transfer of securities.

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BANK AND DEPOSITORY—COMPARISON

Sl. No. 1.

Feature

Holds funds in an account

Holds securities in an account

Transfer

Transfers funds between accounts on the instruction of the account holder

Transfers securities between accounts on the instruction of the account holder

Handling

Facilitates transfers without having to handle money

Facilitates transfers without having to handle securities

Safekeeping

Facilitates safekeeping of money

Facilitates safekeeping of securities

Customer contract

Direct contact

Contact through depository participant (DP)

3.

5.

Depository

Account

2.

4.

Bank

DEPOSITORY PARTICIPANT (DP)

A Depository Participant (DP) is an agent of the depository through which it interfaces with the investor. A DP can offer depository services only after it gets proper registration from SEBI. A depository can be compared with a bank, like wise a DP may be compared with a branch of a Bank. The financial intermediary who arranges to open and maintain demat account for an investor and who acts as a medium for handling securities through electronic book entries is called a ‘depository participant’. In India, the Depository Participants serve as links between the shareholder, the company and the depository. A Depository Participant is registered with the National Securities Depository Ltd. (NSDL) and also with Central Depository Services Ltd. (CDSL). Intimation like change of address, bank mandate, nomination, request for transmission required to be given to only depository participant (DP) irrespective of the number of companies in which shares are held. DEPOSITORY (DEMAT) SERVICES

Meaning Financial services relating to holding, maintaining and dealing in securities in electronic form by a financial intermediary known as depository participant are called ‘depository or demat services’.

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Securities are demated by transforming their physical form into electronic form. An individual can open as many beneficiary accounts with one or more depository participant as needed. There is no minimum balance of securities required to be maintained in a demat account. One can receive shares allotted in IPOs directly in ones demat account. Bonus/ Rights/ Conversion (of Debentures) shares can also be directly credited to the mat account. Benefits to Investors The benefits accruing to investors in holding shares in the electronic form are manifold. It totally eliminates problems that are normally associated with physical segment. Following are the benefits in this regard: 1. Faster Transfer Transactions take place much faster in electronic trading compared to a 30-60 days settlement cycle that usually takes place in the case of physical transfer of securities; transfer of shares is effected within a few days after payment is made 2. Elimination of bad deliveries and all risks associated with physical certificate such as loss, theft, mutilation, forgery, etc. 3. Easy and enhanced liquidity 4. No stamp duty on transfer 5. No postage/courier charges 6. Faster disbursement of corporate benefits like rights, bonus, etc. 7. Facility for creating charge on dematerialized shares for granting loans and advances against shares. 8. No delay in transfer of securities 9. No follow up with the company regarding the status of the dispatched certificates 10. Lower interest on loans against demat shares 11. Nomination facility at the time of account opening 12. No loss of share certificate(s) in postal transit 13. Much faster payment on sale of shares 14. No scope for theft/forgery/damage of share certificates 15. Minimum handling of paper 16. Low transaction cost for purchase and sale of securities compared to physical mode 17. Reduction in paper work Ne e d SEBI has made compulsory trading of shares of all the companies listed in Stock Exchanges in demat form w.e.f. 2nd January 2002. Hence, if an investor

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wants to trade in respect of the companies which have connectivity with NSDL & CSDL, it would require a demat (beneficiary account) opened with the DP of choice, to hold shares in dematerialised (demat) form and to undertake scripless trading. SERVICES/FUNCTIONS

Important services of a depository participant are transferring securities as per the investor’s instructions without actually handling securities, through electronic mode, maintaining the account balances of securities bought and sold by the investor from time to time, furnishing the investor a statement of holdings similar to a passbook, etc. Depository in a financial services industry provides the following services: Account Opening An investor needs a satisfactory introduction and identification to open a Demat account with a DP. Every account holder in a bank that offers depository and demating services can open a Demat account. An investor has to fill up an Account Opening Form and execute an agreement with the DP for opening a Demat account. The investor (investors are called Beneficial owners in Depository system) intending to hold securities in the electronic form in the Depository system opens an account with a DP of NSDL. The investor fills up an account opening form and signs an Agreement. The investor can also open multiple accounts with same DP as also with different DPs. The DP will provide the investor a statement of holdings and transactions. In case the shares are held in joint names then the account is to be opened in the same order of names. Similarly, separate account needs to be opened for each combination of names. Materialization Holding of securities in physical form is known as ‘materialization’ of securities. Materialization requires securities that are held in paper form whereby buying and selling transaction in securities can take place only in paper mode. In materialization, securities are held by the owner itself and the Depository, can of course, help hold securities in electronic form. Dematerialization The process of transforming paper-form of holding securities into electronic form is known as ‘dematerialization of securities’. A process by which the physical certificates of an investor are taken back by the

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Company/Registrar and actually destroyed and an equivalent number of securities are credited in the depository account of that investor is called dematerialization. Dematerialization allows for easy and faster transaction in securities. Dematerialization is the process by which an investor gets his physical certificates converted into electronic form and reflected in his account with the DP. For this purpose, the investor just fills in Dematerialization Request Form available with his DP and submits the share certificates along with the above form (legend like ‘Surrendered for Dematerialization’ should be written on the face of each certificate before its submission for Dematerialization). The beneficial owner’s account will be credited within 15 days and he will be informed by the DP. If one wishes to convert the electronic shares back to physical shares at a later stage, it can be done by making an application for rematerialization through a Rematerialization Request Form (RRF) available with his DP. The new rematerialized certificates with new range of certificate number may use existing Folio number or a new folio number for the certificates. Rematerialization The reverse of dematerialization is rematerialization. The process of converting securities in electronic form to physical form is known as ‘rematerialization of securities’. The investor must fill up a Remat Request Form (RRF) and give it to the DP. The DP will forward the request to Depository after verifying that the shareholder has the necessary balances. Depository in turn will intimate the RTA/Companies. The RTA/Company will print the certificate and dispatch the same to the investor. Electronic Trading Selling of shares held in electronic form is very similar to selling of the paper form of shares. Instead of signing the transfer deed as seller and delivering it with share certificates to a broker, one gives to the Depository Participant, debit instructions for delivering the shares from the client’s account to the chosen broker’s account. This debit instruction is provided by the client in time to the Depository Participant (DP) at the designated collection centres. This debit instruction is verified for signature and correctness and then acted upon by the DP. The client then receives the money from the share broker in the same manner as is received now. For buying shares in the depository system, the client must inform the broker, the Depository Account Number (Client ID) along with the

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Depository Participant ID (DP ID) so that the shares bought by the client are credited into that account. The payment for the shares in the depository system can be made in the same way as one pays for the purchase of any physical shares. Market Trade and Off Market Trade Trade done and settled through a stock exchange and clearing corporation is called ‘Market Trade’. Trades done in private without the involvement of Stock broker or Stock exchange is called ‘Off Market Trade’. The investor can buy and sell shares only through a Stock broker and not through a Depository Participant. However, DP helps in delivering the shares against a sell transaction or receiving the shares for a buy transaction. There is absolutely no compulsion for the investor to open demats account with the same DP as that of his broker. Corporate Benefit Corporate benefit is a corporate event. It can be cash corporate benefit like dividend, interest, etc. or non-cash corporate benefit like rights, bonus etc. when any corporate event such as rights or bonus or dividend is announced for a particular security, Depository will give the details of the clients having the electronic holdings in that security as one of the record date to the RTA/Company. The RTA/Company will then calculate the corporate benefit due to all the shareholders. The disbursements of cash benefits such as dividend/interest will be done by the RTA/Company directly to the shareholders. Non-cash benefits will be distributed through Depository by crediting the entitled quantity of shares in to shareholder’s demat account. In case of discrepancies in corporate benefits the investor can approach his DP who in turn will contact the RTA/Company for clarifications regarding allotment of securities. Direct Credit of Shares In the case of public/right issue application forms of depository-eligible companies, there will be a provision for the investor to indicate the manner in which the securities need to be allotted. Even in the case of bonus issue the investor is given an option for getting the shares allotted in physical or electronic form. The investor must mention his Client ID number and DP ID Number. SEBI has announced that the shares of all companies going in for public issue will have to be compulsorily settled in demat form by all investors. It is, therefore, advantageous for an investor to prefer the

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allotment in demat form, so that the shares have higher liquidity. Voting Rights Clearing members, clearing corporations and other intermediaries cannot have voting rights in respect of the shares held in pool account. Further, the clearing member or clearing corporation is also responsible for distribution of bonus, rights and other corporate benefits lying in his account to the investor. Pled ging Pleding dematerialized securities is easier and more advantageous as compared to pledging physical securities. The procedure is: 1. Both borrower (Pledger) as well as the lender (Pledgee) must have Depository accounts. 2. The pledger must initiate the pledge by submitting to his DP the details of the securities to be pledged in a standard format. 3. The pledgee should confirm the request through his DP 4. Once this is done, the securities are pledged. All financial transaction between the pledger and the pledgee are handled outside the Depository system. After the borrower has repaid the loan, he can request for a closure of pledge by instructing his DP in a prescribed format. The lender on receiving the repayment will instruct his DP to confirm the closure of the pledge. If the pledgee (lender) agrees, the investor may change the securities offered in a pledge. Transmission In the case of transmission, the claimant will have to fill a Transmission Request Form (TRF), supported by documents like death certificate, succession certificate, etc. The DP, after ensuring that the application is genuine, will transfer securities to the demat account of the claimant. For this purpose the claimant must have a Depository account. The major advantage in transmission of dematerialized holdings is that the transmission formalities for all securities held with a DP can be completed in a single stage, unlike in the case of share certificates, where the claimant will have to interact with each RTA/Company. Transposition Shares sent for transposition can be dematerialized. In case of transposition-cum-dematerialization, the investor can get the securities

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dematerialized in the same account if the names appearing on the certificates match with the names in which the demat account has been opened but are in a different order, by submitting the security certificates along with the Transposition Form and the Dematerialization Request Form (DRF) to the DP. Nomination Like shares held in physical form, shares held in electronic form also can be nominated. Nomination can be made only by individuals holding beneficiary accounts on their own behalf either singly or jointly. Non-individuals including society, trust, body corporate, partnership firm, Karta of Hindu Undivided Family, holder of power of attorney cannot nominate. Nomination is permitted for accounts with joint holders. But, in case of death of any of the joint holders, the securities will be transmitted to the surviving holder(s), only in the event of death of all the joint holders, the securities will be transmitted to the nominee. Only an individual can be a nominee. Hence, a nominee shall not be a society, trust, body corporate, partnership firm, Karta of Hindu Undivided Family or a power-of-attorney holder. A minor cannot nominate either directly or through its guardian. However, a minor can be a nominee. In such a case, the guardian will sign on behalf of the nominee. In addition, the name and photograph of the nominee, the name, address and the photograph of the guardian must also be given. Separate nomination cannot be made for each security. Nomination can be made demat account wise and not security wise. Procedure for nomination The investor must fill in and submit to the DP, the nomination form. The account holder, nominee and two witnesses must sign this form and the name, address and photograph of the nominee must also be submitted. Changing nominee The nomination can be changed anytime by the account holder by filling up the revised nomination form and submitting the same to the DP. The account holder, nominee and two witnesses must sign this form and the name, address and photograph of the nominee must be submitted. In case of joint holders all joint holders must sign. Cu s to d y The act of maintaining the client’s share portfolio in the electronic form (i.e., as a balance in the Depository account) is designated as custody service. The additional services the client gets here is a regular statement

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of account which shows the client’s various share balances, maintenance of details on the account like address, bank account number, nomination etc. Account Freezing An investor can freeze/lock his account for any given period of time if he so desires. During this period no debits can be made to the investor’s account. It is possible for a client to issue instructions requesting for the Depository account to be frozen until any further instructions. No debits will then be allowed to the account. This can be a safe way further ensuring safety of the client investments especially when there are no transactions that are likely to occur for a long time. Single Window Service The DP enjoys the benefits of a broker-cum-DP wherein the client gets the benefit of single window service. The broker-DP interface offers clients the benefit of operating the Depository account at the broker end thus eliminating multiple agencies and contact points. Agency Functions Similar to the brokers who trade on client’s behalf in and outside the stock exchanges, a Depository Participant is the representative (agent) in the Depository System. The Depository Participant maintains the securities account balances and intimation is given to the client on the status of holdings from time to time. The Depository Participant provides the facilities and services related to dealing in the Depository. DEMAT (BENEFICIARY) ACCOUNT

Meaning A beneficiary account is an account opened by the investor or a broker with a DP of his choice, to hold shares in dematerialised (demat) form and undertake scripless trading. The investor must open a demat account with a Depository Participant (DP). Opening a demat account with DP is similar to opening an account with bank. The selection of DP is to be done by the investor based on fee payable, proximity, service levels, etc. An investor cannot open demat account directly with the Depository. Demat account opening procedure will normally take a maximum of 5 days. Features

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A demat account possesses the following features: 1. Documents Following documents are needed for opening a demat account: a. Demat account opening form duly filled b. Address proof c. Photograph 2. Other formalities Once a demat account is opened, the investor must sign an agreement with the DP. The investor will be allotted account number known as Client Identity. This ‘Client identity number’ along with the ‘DP’ identity number forms a unique combination. Both these numbers should be quoted in all future dealings with the Depositories/DP/RTA/ Companies. However, in case of CDSL there is no DP identity and the digital client identity itself is a unique number. The investor must collect forms like Dematerialization Request Form (DRF), Delivery instruction slips etc from the DP. 3. Demat for partnership firm As a partnership firm is not a legal entity, demat account cannot be opened in the name of partnership firms. However, a demat account can be opened in the name of the partners. 4. Demat for Hindu Undivided Family (HUF) Demat account cannot be opened in the name of HUF. It has to be opened in the name of the Karta of the HUF. 5. Demat for minor In the case of minor, the depository account should be opened in the name of minor and the guardian’s name should be mentioned. The guardian will sign as signatory on behalf of the minor. 6. Number of demat account There is no restriction on the number of demat accounts that an investor can open. Investor can open any number of demat accounts with any number of DPs. However, the investor has to incur cost for each of such account. 7. Different demat accounts The investor must open different demat accounts for shares held in different combination of names. Alternatively investor can submit the certificate for demat along with transposition form. 8. Minimum balance There is no minimum balance required to be maintained in the demat account and an investor can maintain nil balance. 9. Informing DP The investor should inform his DP of any change in Address, Bank account, Nomination etc., immediately upon change, thereof.

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10. Charges The Depository does not charge any fee directly from the investors. The Depository charges only the DPs. However the DP is free to charge its client for the services offered. The charges of the DPs to investors vary. Generally, the following charges are levied viz. Account opening, Demat/Remat, Account Maintenance, Custody, Transaction, etc. 11. Account statement The investor is provided with a transaction statement by his DP at regular intervals. Based on this the investor will know his security balances. The DP will send a transaction statement once in a quarter if there are no transactions during the quarter. If there are any transactions DP will send the statement within fifteen days of the transaction. 12. Freezing demat account The Depository system provides the facility to freeze the demat account for any debits or for both debits and credits. In an account which is “freezed for debits”, no debits will be permitted from the account, till the time it is defreezed. This is an additional security feature for the benefit of the investors. 13. Standing instruction The investor can give onetime standing instruction to his DP to receive all the credits coming to his Depository account automatically. However, the investor cannot give standing instruction for any debits in his account. 14. Access to account details A DP cannot access the investor accounts of any other DP. The DP can access only those investor accounts serviced by them. 15. Bank account particulars Details of bank account of the client, including the 9-digit code number of the bank and branch appearing on the MICR cheques issued by the bank have to be given to the DP at the time of account opening. Companies use this information for printing them on dividend/interest warrants, etc. to prevent its misuse. In case client wishes to change this bank account details, he can do so by submitting the changes in writing to the DP. 16. Procedure for Closure An investor can close a demat account by giving an application in the prescribed form. In case there is any balance in the demat account sought to be closed, the following steps are necessary: a. Re-materialisation of all securities standing to the credit of the demat account at the time of making the application for closure or, b. Transferring the balance to the credit of another demat account, with the same participant or with a different participant. Delivery Instruction Slip (DIS)

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To give the delivery instruction to DP one has to fill a form called Delivery Instruction Slip (DIS). DIS may be compared to cheque book of a bank account. The following precautions are to be taken in respect of DIS:1. Ensure and insist with DP to issue DIS book; do not use loose slips 2. Ensure that DIS numbers are pre-printed and DP takes acknowledgement for the DIS booklet issued to investor 3. Ensure that your account number [client id] is pre-stamped 4. If the account is a joint account, all the joint holders have to sign the instruction slips. Instruction cannot be executed if all joint holders have not signed 5. Avoid using loose slips 6. Do not leave signed blank DIS with anyone, viz. broker/subbroker 7. Keep the DIS book under lock and key when not in use. 8. If only one entry is made in the DIS book, strike out remaining space to prevent misuse by any one. 9. Investor should personally fill in target account ID and all details in the DIS. Benefits to Corporates It is possible to get securities allotted to in Public Offerings directly in the electronic form. In the public issue application form there is a provision to indicate the manner in which an investor wants the securities allotted. He has to mention the BO ID, the name and ID of the DP on the application form. Any allotment made will be credited into the BO account. The concerned company obtains the details of beneficiary holders and their holdings as on the data of the book closure/record date from depositories. The payment to the investors will be made by the company through the ECS (Electronic Clearing Service) facility, wherever available. Thus, the dividend/interest will be credited to your bank account directly. Where ECS facility is not available dividend/interest will be given by issuing warrants on which your bank account details are printed. The bank account details will be those which you would had mentioned in your account opening form or changed thereafter. In case of discrepancies in corporate benefits, one can approach his/her DP or the company/its R&T Agents. DEMATERIALIZATION

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Meaning Dematerialization is the process of conversion of shares or other securities held in physical form into electronic form. The investor must approach his DP for dematerialization. The investor can demat the shares of any company that has established connectivity with NSDL or CDSL. Steps in dematerialization 1. Demat Request Form Investor must submit Demat Request Form (DRF) and Share Certificate to DP. 2. Checking securities DP will check whether securities are available for Demat. Investor must deface the Share Certificate by stamping ‘Surrendered for Dematerialisation’ and DP will Punch two holes on the name of the Company and will draw two parallel lines across the face of the Certificate. 3. Entry of request DP Enters the demat requests in their system to be sent to Depository. DP despatches the physical certificates along with the DRF to Registrar and Transfer Agents (RTA)/ Company. 4. Recording details Depository records the details of the Electronic Requests in the system and forwards the request to Registrar and Transfer Agent (RTA) or Issuer (i.e. the Company, whose shares are sought to be dematerialized). 5. Verification RTA/Company on receiving the physical documents and the electronic request verifies and checks them. Once the RTA/Company finds that the documents are in order, dematerialization of the concerned securities is electronically confirmed to the Depository. 6. Account crediting Depository credits the dematerialized securities to the beneficiary account of the Investor and intimates the DP electronically. The DP issues a statement of transaction to the client. 7. Company Identification Once the company is admitted in the depository system, an ISIN (International Securities Identification Number) is allotted by the Depository. This number is unique for each security of the company that is admitted in the Depository. 8. Dematerialization of Shares sent for transfer Shares sent for transfer can be dematerialized if the company is providing “Simultaneous Transfer-cum-Dematerialization Scheme.” Simultaneous Transfer-cum-Dematerialization Scheme On completion of the process of registration of securities sent for transfer,

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the RTA/Company will send an option letter to the investor, providing an option to dematerialize such securities. The investor may exercise this option by submitting demat request form together with the option letter to the DP. Then the company or its RTA would confirm the demat request in the usual manner. SEBI has made it mandatory for all companies whose shares are traded compulsorily in demat form in the Stock Exchanges to offer this facility and has prescribed the procedure therefore. Certificate Number for Dematerialized Shares The dematerialized shares are fungible and they do not have any certificate number or distinctive numbers. Fungible Fungible means the dematerialized securities do not have any distinctive or certificate numbers. It is represented only by the number of securities. This is called fungible. Dematerializing odd lot securities Odd lot share certificates can also be dematerialized. In fact the market lot in demat mode is one share and an investor can even hold one share in a company. Process Time Dematerialization will normally take about 30 days. Holdings in Both Demat Form and Physical Form The investor can dematerialize part of his holdings and hold the balance in physical mode for the same security. Distinguishing Partly Paid-up and Fully Paid-up Shares Partly paid-up shares and fully paid-up shares are identified by separate ISINs (International Securities Identification Number). These are also traded separately at the Stock Exchanges. The company issues call notices to the beneficial holders of partly paid-up securities in the electronic form. The details of such beneficial holders will be provided to the RTA/Company by the Depositories. After the call money realization, RTA/Company will electronically convert the partly paid up shares to fully paid up shares. ELECTRONIC SETTLEMENT OF TRADE—PROCEDURE

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I. For Selling Dematerialized Securities The procedure for selling dematerialized securities in stock exchanges is similar to the procedure for selling physical securities. Instead of delivering physical securities to the broker, the investor must instruct his/her DP to debit his/her demat account with the number of securities sold by him/her and credit broker’s clearing account. Procedure for selling securities is as follows: 1. 2. 3. 4. 5.

Investor sells securities in any of the stock exchanges linked to Depository through a broker. Investor gives instruction to DP to debit his account and credit the broker’s (Clearing member pool) account. Before the pay-in day, investor’s broker transfers the securities to clearing corporation. The broker receives payment from the stock exchange (clearing corporation). The investor receives payment from the broker for the sale in the same manner as that is received for a sale in the physical mode.

II. For Buying Dematerialized Securities The Procedure for buying dematerialized securities from stock exchanges is similar to the procedure for buying physical securities. Investor may give a one-time standing instruction to receive credits in to his/her account or may give separate instruction each time in the prescribed format. The transactions relating to purchase of securities are as follows: 1. Investor purchases securities in any of the stock exchanges connected to Depository through a broker. 2. Broker receives payment from Investors. 3. Broker arranges payment to the clearing corporation. 4. Broker receives credit of securities in clearing account and credit client’s account. 5. Investor receives shares in his account. The investor should ensure that the broker transfers the securities purchased to his account, before the book closure. If the securities remain in the clearing account of the broker, the company may give corporate benefit to the broker. Therefore, the investor has to collect benefit from his broker. DEMAT OF DEBT INSTRUMENTS

Debt instruments can also be held in demat form. Instruments like Bonds,

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Debentures, Commercial Paper, Certificate of Deposit, etc. irrespective whether these instruments are listed/unlisted/privately placed or even issued to a single holder can be dematerialised. Commercial paper can also be kept in demat form. As per RBI Monetary and Credit Policy 2001-2002, Banking and Financial Institutions, Primary Dealers and Satellite Dealers are directed to convert their outstanding investment in Commercial Paper in scrip form, into demat form latest by October, 2001. The above entities have also been directed to make fresh investment in Commercial Paper only in demat form w.e.f. June 30, 2001. Bonds and debentures can also be kept in demat form. In its midterm review of the monetary and credit policy RBI has mentioned that Banks and Financial Institutions should make investment in debentures and bonds only in demat form from October 31st, 2001. Allocation Any new instrument can be issued directly in dematerialized form without recourse to printing of either Letter of Allotment or Certificates. Securities will be directly credited into the demat account of the investor by the depositories on receipt of allotment details from RTA/Company. The investor need not open separate demat account for demat of debt instruments. Dematerialization The procedure for dematerialization of debt instrument is the same as applicable for equity shares. In order to dematerialize his/her certificates; an investor will have to first open a debt account with a DP and then request for the dematerialization certificates by filling up a Dematerialization Request Form (DRF) which is available with DP and submitting the same along with the physical certificates. The investor has to ensure that the certificates handed over to the DP for demat, are marked “surrendered for dematerialization” on the face of the certificates. Statement of holdings A regular single statement of holding will reflect all the holdings in a particular demat account, irrespective of type of instrument. SAFETY SYSTEM FOR DEMAT

Demat services in order to be carried out effectively requires the following safety system to be put in place: 1. Strict norms for becoming a depository participant (DP), net

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2. 3. 4. 5. 6.

7. 8.

worth criteria, SEBI approval., etc. are mandatory DP cannot effect any debit or credit in the demat account of the investor without the valid authorization of the investor Regular reconciliation between DP and Depositories Periodic inspection of Depositories of the office of DP and Registrar (RTA) All investors have a right to receive their statement of accounts periodically from the DP In the depository system, the depository holds the investor accounts on trust. Therefore, if the DP goes bankrupt the creditors of the DP will have no access to the holdings in the name of the clients of the DP. These investors can transfer their holdings to an account held with another DP Compulsory internal audit of operations of DP every quarter by practising company secretary or chartered accountant Various procedures for back up and safe keeping of data all levels

SHORTCOMINGS OF DEMAT SYSTEM

Demat system, although greatly facilitates electronic trading of securities in a scripless environment and is considered as highly beneficial to the investing community, suffers from various serious shortcomings as mentioned below: Hazards of a Bank Account The demat account has to be treated virtually like a bank account with the difference being that instead of actual cash there are shares in the account. If one considers the value of these shares, then, they could be far more than the amount that one would carry in their bank accounts. Hazardous Transaction One of the most important items in the operation of the demat accounts is the Delivery Instruction Book. Delivery instruction book refers to the book, which is used to transfer the shares out of the account into some other account when a transaction takes place. When the shares are sold, these have to be transferred into the broker’s account. For this purpose, one needs to sign the delivery instruction book and then give it to the Depository Participant with whom demat account is maintained. The participant will then check whether the shares are in the account and then give approval for the transfer. The process varies slightly when it comes to an online transaction. In this type of transaction, there is no

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need to sign the delivery transaction booklet. Each time when a transaction takes place, the shares are directly taken out by the broker from the depository account, which the shareholder maintains with it. This is possible on account of the fact that the investor has already given the broker, the right to undertake such transactions by signing an agreement when the online account is opened. One can also transfer shares between two demat accounts without there having to be a market transaction. Such a transaction is called an off market deal and there is a separate place in the delivery instruction booklet where such transactions can be put through. It is in this respect there are possibilities of frauds being committed. For instance, if once delivery book falls into the wrong hands, then it is possible for the person to transfer the shares out of the account. This would entail a severe loss to the investor. Such frauds have been experienced by several investors and one therefore needs to exercise extreme caution and care especially at times when the market is booming; as several unscrupulous people are on the prowl to make a quick buck in the entire process. To guard against loss on this front, one needs to know that one must never give blank-signed form in the booklet to anybody. Filling in the details and crossing out the unused portion is a procedure which has to be followed so as to ensure that the signed leaf is not misused. Otherwise, it is tantamount to giving away a blank cheque. More importantly, one must always keep the booklet under lock and key and should under no circumstances leave it signed carelessly. Unauthorized Transactions In addition, one must always be watchful about the transaction that takes place in one’s demat account as that will give an indication of any transaction which might have taken place without the authorization and knowledge of the owner. A close perusal of the transactions that are printed on the statements sent periodically by the DP would reveal any discrepancy. There are two ways in which an unauthorized transaction will be undertaken in a demat account. It might take place by way of forging the signature of the person concerned and also when a signed slip falls into the wrong hands. Hence, extreme care is needed as once the shares have been transferred out of the account it will be very difficult to trace them and even get them back. On the whole, one must be very careful with the demat accounts as one can end up losing quite a bit of money on this front if due diligence is not undertaken.

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DEMAT Costs Another shortcoming of securities demating is demat costs which are very important for an investor, as it has a bearing on his overall portfolio returns. Demat costs, broadly could be segregated as initial and recurring charges. Initial charges are the charges by way of account opening charges and demat charges. Account opening charges typically range between Rs.100 to Rs.200 and many DPs waive these charges. For demating a physical share certificate, the charges are normally Rs.3 per certificate for conversion. In addition, DPs also charge a courier fee Rs.25 to Rs.35 per request. All these are onetime charges. While the initial charges are more or less the same, the recurring charges are more crucial. Recurring charges are Transaction and Custody charges. Transaction charges are levied on a per transaction basis and as a percentage of a trade value, or as a flat amount, whichever is higher. The charge is levied separately for buy and sell transactions with minimum charge riders. Custody Charges Custody charges are flat charges levied by the DP as a cost of maintaining client’s records. Here the DP, in addition to an annual maintenance fee, also charges based on number of companies one holds. In market parlance, the charges are referred as per ISIN (International Security Identification Number) per month. So if the client is a typical small investor with a large portfolio, he or she should ensure that the DP doesn’t have higher custody charges. Dangers in Accounting There can be a case where the shares that one has purchased have not been deposited in the account. In such an eventuality, necessary check has to be held with the broker and the exact transaction date is to be obtained to know whether any such transaction has taken place. At the same time there have been various instances of a transaction of sale of shares being executed twice thus resulting in the investor losing double the shares sold from his account. This is because with a host of open offers, buybacks and mergers from different companies present in the market, the investor has to check whether any inward or outward transactions relate to these deals has taken place. Conversion Delay In case the securities under some different name are deposited into the demat account it could pertain to a merger or amalgamation. In many cases, it’s the time element which is important; for this can result in quite

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a bit of monetary impact. The time element becomes extremely important when shares are to be converted into securities from one company to the other at the time of a merger or an amalgamation or even a takeover. This is because, unless and until one gets the converted shares in the new or separate entity, it will not be possible to transact in them in the secondary market. This delay could mean loss of quite a good opportunity for the investor. At the same time, one has to take extreme care in case of tendering the shares out of the account especially in circumstances where they are substituted by some other securities. Fake Securities Another area for concern is the issue of fake securities. According to reports, there is a probability that some of the companies may have demated shares, which are more than even their issued capital with the end result that there could be quite a bit of such shares floating in the market affecting the investor interest. INDIAN DEPOSITORY

There are two depositories in India. They are National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL). NSDL was formed and registered under the companies Act, 1956. NSDL was promoted by Industrial Development Bank of India (IDBI), Unit Trust of India (UTI), the largest Mutual Fund in India and National Stock Exchange (NSE). Some of the prominent banks in the country also have stake in NSDL. CSDL commenced its operations during February 1999 and is promoted by Stock Exchange, Mumbai in association with Bank of Baroda, Bank of India, and State Bank of India and HDFC Bank. ROLE OF CDSL

A Depository facilitates holding of securities in the electronic form and enables securities transactions to be processed by book entry by a Depository Participant (DP), who as an agent of the depository, offers Depository services to investors. According to SEBI guidelines, financial institutions, banks, custodians, stockbrokers, etc. are eligible to act as DPs. The investor who is known as Beneficial Owner (BO) has to open a demat account through any DP for dematerialization of his holdings and transferring securities.

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The balances in the investors account recorded and maintained with CDSL can be obtained through the DP. The DP is required to provide the investor, at regular intervals, a statement of account which gives the details of the securities holdings and transactions. The Depository system has effectively eliminated paper-based certificates which were prone to be fake, forged, counterfeit resulting in bad deliveries. CDSL offers an efficient and instantaneous transfer of securities. CONSTITUTION

CDSL was promoted by The Stock Exchange, Mumbai (BSE) jointly with leading banks such as State Bank of India, Bank of India, Bank of Baroda, HDFC Bank, Standard Chartered Bank, Union Bank of India and Centurion Bank. CDSL was set up with the objective of providing convenient, dependable and secure depository services at affordable cost to all market participants. MAJOR TASKS

Some of the important milestones of CDSL system are: 1. CDSL received the certificate of commencement of business from SEBI in February, 1999 2. Settlement of trades in the demat mode through BOI Shareholding Limited, the clearing house of BSE, started in July 1999 3. All leading stock exchanges like the National Stock Exchange, Calcutta Stock Exchange, Delhi Stock Exchange, The Stock Exchange, Ahmedabad, etc. have established connectivity with CDSL 4. As at the end of July 2003, over 4600 issuers have admitted their securities (equities, bonds, debentures, and commercial papers), units of mutual funds, certificate of deposits etc. into the CDSL system BENEFITS

Con ve n ie nc e Wide DP Network CDSL has over 200 DPs spread around 114 cities/ towns across the country, offering convenience for an investor to select a DP based on his location. On-line DP Services The branches of a DP can also be directly connected to CDSL thereby providing on-line and efficient Depository service to investors. Wide Spectrum of Securities Available for Demat More than

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4600 companies have admitted their equity into CDSL. Further, CDSL has also admitted an entire gamut of debt instruments viz. bonds, debentures, commercial paper, government securities, certificate of deposits, etc. Thus an investor can hold almost all his securities in one account with CDSL. CDSL has kept its tariffs very competitive to provide affordable Depository services to investors. CDSL also does not collect any custody fees or ISIN fees from its DPs. A DP, which registers itself with CDSL for Internet access, can in turn provide demat account holders with access to their account on the Internet. Dependability CDSL’s system is based on centralised database architecture; DPs can thus provide on-line depository services with to-the-minute status of the investor’s account. The entire database of investors is stored centrally at CDSL. If there is any system-related issues at DPs end, the investor is not affected, as the entire data is available at CDSL. CDSL has made provisions for contingency terminals, which enables a DP to update transactions, in case of any system related problems at the DP’s office. Continuous updation of procedures and processes in tune with evolving market practices is another hallmark of CDSL’s services. ROLE OF NSDL

NSDL is National Securities Depository Limited. For a detailed discussion see Chapter 29 of the book Financial Markets and Institutions. DEPOSITORY STOCK EXCHANGES

At present the following 10 Stock exchanges are connected to the Depositories. 1. National Stock Exchange 2. The Stock Exchange, Mumbai 3. Calcutta Stock Exchange 4. Delhi Stock Exchange 5. Ludihana Stock Exchange 6. Bangalore Stock Exchange 7. Over-the-Counter Exchange of India 8. Madras Stock Exchange 9. Inter Connected Stock Exchange 10. Ahmedabad Stock Exchange

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LEGAL FRAMEWORK

The legal framework for a Depository system has been laid down in the following enactments. 1. Securities & Exchange Board of India Act, 1992 2. The Depositories Act, 1996 3. The SEBI (Depositories & Participants) Regulations, 1996 4. Bye-Laws of Depository 5. Business Rules of Depository 6. The Companies Act, 1956 REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7. 8. 9.

Who is a depository? Who is a depository participant? Who do you mean by demat services? What is ‘dematerialization’? What is ‘rematerialization’? What is ‘electronic trading of securities’? What do you know of the custody service offered by a depository? Can an investor freeze the depository account? If yes, how? What is a demat account?

Section B 1. 2. 3. 4. 5. 6. 7. 8. 9.

How is a depository different from a banker? How are depository services beneficial? State the need for the introduction of depository services in the realm of Indian stock trading What are the functions of a depository participant? How do you distinguish between market trade and off market trade? State the corporate benefits made available under the depository services How are demated shares pledged? Explain How is a demat account opened? Explain What is a ‘Delivery Instruction Slip’ (DIS)? What are the precautions to be taken in respect of the use of DIS?

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10. Outline the steps in rematerialization of securities 11. What do you know of the ‘simultaneous transfer-cumdematerialization scheme’? 12. What are the safety norms that you would put in place to ensure efficient demat services to clients? 13. What are the various costs associated with the demat services? Section C 1. 2. 3. 4.

How is settlement happening under the electronic scenario? Explain the process What are the shortcomings of demat system? Comment on the role of Indian depositories. Discuss the role of NSDL and CDSL in the Indian demat scenario

Chapter

22

Speculation Speculative activity forms an important and an integral part of the working of the stock exchanges the world over. Speculative activity is prevalent in the stock exchanges in India too. Speculation consists of buying and selling commodities or securities or other property, in the hope of a profit from anticipated changes of value. Speculation is therefore, a risky activity and a speculator assumes the risks incidental to change in the price of the commodity under consideration. Speculator is a person who attempts to make a profit merely out of an anticipated change in price. An important prerequisite is that his anticipations must come true. Else, there will be an enormous loss incurred. SPECULATION Vs. GAMBLING

Speculation and gambling, although perceived as similar, are different in many ways as shown below: Feature

Speculation

Gambling

Legitimacy

Involves a legitimate enterprise of buying and selling property, commodities, etc on the basis of an intelligent study and analysis of market trends, and other factors having a bearing on prices

Involves no such intelligent activity, rather it is a reckless and blind betting of future without application of mind and intelligence, and without even possessing resources necessary to meet the commitments

Risks

Speculator merely assumes existing risks arising out of natural or economic forces. A speculator bears the risk of loss on the basis of reason and logic. His activity absorbs an existing risk of price fluctuations

Gambler creates situation out of which risks develop artificially. The gambler’s assumption of risk is based on reckless or blind speculation that creates an artificial risk of loss

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Feature

Speculation

Gambling

Economic Benefits

Speculation, if properly carried out, commands certain economic benefits

Gambling has no such use for the community at large

Orientation & Focus

Speculation focuses its attention on taking up business dealings that carry risks and make profits in a systematic manner. It does not encourage people to engage in a blind and thoughtless search for quick and easy gain

Gambling often focuses its attention on making people run recklessly after easy and quick money

Social Welfare

Speculation is considered useful to the producers and others connected with stock exchanges

Gambling is condemned as anti-social and illegal

Rationality

Speculation is based on knowledge and foresight regarding anticipated price changes

Gambling is based on blind chance without any rational basis

Agreement

Speculators’ agreement is not void but enforceable

The gambler’s agreement is void in law and is not enforceable

Legality

Speculation is a lawful activity and is enforceable in a court of law

Gambling is an unlawful activity

INVESTORS VS . SPECULATORS

Similar to the fact that speculators are different from gamblers, they also differ from investors as shown below: Feature Genuineness

Investors

Speculators

Investors have a genuine intention of buying and selling securities based on the price quotations— selling for the purpose of realizing cash and buying for the purpose of getting an income

Speculators indulge in buying and selling securities for the purpose of making profits arising from future price movements

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Investors

Speculators

Safety

More concerned with the safety of funds invested in securities

More concerned with the appreciation of his capital and quick profits

Delivery

A genuine investor makes an immediate settlement after the conclusion of the trade

A speculator does not make any immediate settlement of the trade, viz. making payment or receiving payment, etc

Type

Investors can be small investors and others

There are different type of speculators such as bulls, bears, etc

In practical terms, there is hardly any difference between a pure speculator and a pure investor. Every speculator is, to a certain extent, an investor too. Similarly, even a pure investor would think in terms of increasing his capital and making quick profits. The difference between the two is, therefore, a matter of degree. TYPES OF SPECULATORS

Speculators in a stock market are of different types. They carry their names depending on their motive of trading in the stock exchange. They are named after animals as their behavior could be compared best with the behavior of animals. Bull A speculator on the stock exchange who expects a rise in the price of a certain security is known as a ‘bull’. He is so called because of the tendency of the bull to throw his victim up in the air. Accordingly, he indulges in buying the security (without taking actual delivery) in order to sell it in future at the expected higher price. He is therefore, a potential seller, as he, having bought a security, must necessarily sell it to reap his profit. In local stock exchange parlance, a bull is known as a ‘tejiwala’. He is considered to be an optimist hoping for an increase in the price of a security and in technical terms he is said to be “on the long side of the market”.

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The share market is said to be ‘bullish’ when it is dominated by an expectation of a rise in price. In a bullish market, the general atmosphere is one of optimism. Sometimes, when the purchases made by the speculators exceed the sales made by them, i.e. there is an over-bought condition in the market and the bulls begin to spread rumors about a rise in the prices. This is known as a ‘bull campaign’. Illustration 1.

2.

3. 4.

5.

A speculator asks his broker to buy for him 1000 shares of a particular company at Rs. 100 each, which he will not have to pay for it at once He would order his broker to immediately sell the shares at Rs. 120 where the price has risen even before the arrival of the day fixed for settlement He would make a profit of Rs. 20 per share and thus make a total profit of Rs. 20,000 Where the price does not rise up above the contracted buying price, then he would incur a loss as he may have to sell much below the bought price and in such an eventuality he has the option of terminating the contract and thereby materialize the loss or carry it forward to the next settlement day by paying ‘contango charge’ Thus, the active involvement of a bull speculator spurs up the stock market activity and a bull pressure is built up, which automatically causes rise in the price of a security

Bear A speculator who expects a fall in the price of the security of a company is known as a ‘bear’. He is called as ‘mandiwala’ in local stock exchange (BSE) parlance. A bear speculator would aim at taking advantage of an expected fall in the price, at which time he would sell (give delivery) on a fixed date, such securities that he may or may not possess. Where the price of the security goes down much before the date of delivery he would buy the security at a lower price and sell at a higher price thus making a profit. Where, however, the price of the security in question rises by the date of delivery, he would have to buy the shares at a higher price from the market to deliver (sell) them at a lower price as per the agreement. In such an eventuality, he would suffer a loss. The market becomes ‘bearish’ when there is a strong expectation of a fall in the share prices. Where, the speculative sales made by the bear

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speculators exceed the purchases made by them, they may spread rumors to bring the price down. This is known as a ‘bear raid’. Illustration 1.

2.

3. 4.

5.

A speculator asks his broker to sell for him 1000 shares of a particular company at Rs. 100 each, which he will not have to deliver at once He would order his broker to immediately buy the shares at Rs. 80 where the price has come down even before the arrival of the day fixed for settlement He would make a profit of Rs. 20 per share and thus make a total profit of Rs. 20,000 Where the price does not go down below the contracted selling price, then he would incur a loss as he may have to buy much above the sold price and in such an eventuality he has the option of terminating the contract and materialize the loss or carry it forward to the next settlement day by paying ‘backwardation charge’ Thus the active involvement of a bear speculator brings down the stock market activity and a bear pressure is built up which automatically causes decrease in the price of a security

Lame Duck Where a speculator finds it difficult to meet his commitments immediately, he is said to be a ‘lame duck’. Accordingly and as stated above, a bear speculator may agree to sell a certain security on a fixed date but may find it difficult to deliver the security as it may not be available in the market at his expected price. Stag A speculator who applies for shares in a new issue like a genuine investor but with the intention of selling the shares at a later date at a premium is known as a ‘stag’. He neither buys nor sells securities, but merely applies for shares of a new company as if he were a genuine investor. He waits for the price of the scrips to go up immediately after the issue of shares and this is why he is popularly called the ‘premium-hunter’. His profit is equal to the difference between the price paid by him and the price at which he sells his allotment. Although the stag operates cautiously, it may turn out that he may also run into the risk of loss where the public response is lukewarm and

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that he is not in a position to offload his holdings at a premium and instead the price rules at a discount. In such a case, the stag may have to sell the shares at a loss. When the stags begin to sell, the price naturally suffers a further decline. REVIEW QUESTIONS

Section A 1. 2. 3.

What is a speculation? Who is a ‘stag’? Who is a ‘lame duck’?

Section B 1. 2. 3. 4.

How does a speculative activity different from gambling? How are investors different from speculators? Who is a ‘bull’? Illustrate the activity of a bull speculator. Who is a ‘bear’? Illustrate the activity of a bear speculator.

Section C 1.

Discuss the different types of speculators on a financial market.

Chapter

23

On-line Stock Trading The Internet has been the sole evolving tool in the present century, that affects almost every aspect of everyday life. The uniting force of the internet, which is changing classic business and economic paradigms, embodies electronic transformation. Commercial interaction is symbolized by newer and better methods used in more ingenious ways, than before to harvest a bumper crop of resultant benefits. The advent of the internet into the trading of securities has heralded the growth in the methods of application of the new mode to develop new models, aimed at encouraging market development in tandem with the rest of the computer literate world. While some countries do seem to have incorporated the American method of recognizing the alternative trading systems on the Internet as additional trading floors and regulating them separately from the other modes of trading, other countries are for creating order routing systems to their existent trading systems and regulating them as another mode of conducting transactions. In India, on-line stock trading facility is offered by capital market intermediaries like ‘Sharekhan’, ‘Kotak Securities’, ‘ICICI Securities’, etc. MEANING

Method of trading in securities whereby information about securities, brokers, dealers, prices, etc are communicated through the official websites of concerned stock exchanges so as to facilitate buying and selling of securities, is known as ‘Internet Stock Trading’. FEATURES

A method of trading in securities whereby, it is possible for the investors to buy and sell scrips through the internet is called ‘Internet Trading’. It is also called ‘On-line Trading’. The trading takes place under the ‘Order Routing System (ORS)’ through registered stockbrokers on behalf of clients for execution of trades on stock exchanges. The buy/sell orders can be executed on the investors’ computers by the brokers filter. The internet trading has been put in place under the auspices of the SEBI.

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All the necessary safety and integrity measures are adhered to in the transactions. For this purpose, the stock exchanges must ensure that the systems used by brokers have provision for security, reliability and confidentiality of data through the use of encryption technology. In this regard, it is incumbent on the part of the brokers to enter into an agreement with clients spelling out all obligations and rights. The exchanges also are required to ensure that the brokers have a system-based control on the trading limits of clients and exposures taken by them. The brokers on the other hand must set predefined limits on the exposure and turnover of each client. CURRENT SCENARIO

At present, conventional securities exchanges are using the internet primarily as a tool for disseminating a variety of information to the public, and for advertising their products and services. In this connection, it is to be noted that stock exchanges in India have already set up their own websites and provide market information. Even in exchanges around the world, information on individual security prices, trading volume, contract terms, trading mechanisms, margin requirements and exchange rules are in some cases dealt with through a general description, and in other cases through comprehensive information. Some exchanges’ websites contain a list of exchange members. Some exchanges provide information on the listed companies, either in total or in specific market segments. Only a few exchanges use the Internet to provide access to information filed with the exchanges by listed companies. In addition to communicating with the public, exchanges and other market infrastructure providers are using the internet for communicating with their members. Exchanges use the Internet as part of their market infrastructure. It is therefore, possible for an exchange to provide links between broker-dealers and the exchange for order transmission, trade execution, and clearance and settlement. INTERNET TRADING—ALTERNATIVES

Worldwide, internet trading is usually one of the two forms: Alternative Trading System (ATS) Alternative Trading System provides investors with additional proprietary electronic trading facilities for securities that are traded principally on stock exchanges or other organized markets. ATSs carry out price discovery functions. In addition, they also serve as order-matching systems, besides serving as crossing systems using prices already established in organized markets such as securities exchanges (e.g. closing price).

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Order Routing System (ORS) An effective Order Routing System takes advantage of cutting edge technology to bring an unprecedented level of efficiency to the order flow process. It involves the utilization of technology to route orders of the investors to the brokers reducing any time lag between their order and its execution on the exchange. INTERNET TRADING—SOME ISSUES

There are many issues that comprise the on-line trading mechanism called the ‘Internet Trading’. They are discussed as under: Examining Alternative Trading System The feasibility of introducing the alternative trading system for the purpose of internet trading is examined as follows: Recognized stock exchanges According to the Securities Contracts (Regulation) Act, 1956 that deals with regulation and control of contracts in securities, a contract in securities can be entered and performed only as per the provisions of SC(R) Act. This implies that the contracts in securities other than spot delivery contracts have to be done under the auspices of a Regional Stock Exchange. Under Section 23 (1) of the SC(R) Act, carrying out the activities of buying and selling of securities in places other than the (RSE) is considered unlawful. Accordingly, the following are considered unlawful which attract punishment: a. Owning or keeping a place other than that of a RSE which is used for the purpose of entering into or performing any contracts in contravention of any of the provisions of this Act; or b. Managing, controlling, or assisting in keeping any place other than that of a RSE which is used for the purpose of entering into or performing any contracts in contravention of any of the provisions of this Act; or c. Joining, gathering or assisting in gathering at any place other than the place of business specified in the byelaws of a RSE, any person or persons for making bids or offers or for entering into or performing any contracts in contravention of any of the provisions of this Act Therefore, the issue here is whether to treat ATS as an exchange or Additional Trading Floor (ATF).

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Stock Exchange or Recognized Stock Exchange Section 2(f) of the SC(R) Act, 1956 defines a stock exchange 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.” Section 2(f) of the SC(R) Act, defines a Regional Stock Exchange (RSE) as “a stock exchange that is recognized by the Central Government or SEBI under Section 4 of the SC(R) Act.” In order that a stock exchange becomes a RSE, an application in the prescribed manner has to be made to the Central Government or SEBI. In addition, a copy of the byelaws of the exchange and the rules by which the constitution of the stock exchange are to be governed, have to be submitted to the Central Government or SEBI. The Central Government or SEBI pursues the application and also the byelaws and rules of the exchange before deciding and granting recognition to the applicant stock exchange. The Central Government or SEBI can require the applicant to satisfy the conditions that it may impose regarding the rules and regulations of the stock exchange in terms of the qualifications of members of the exchange, the manner in which contracts shall be entered into between members of the exchange, the representation of the Government on the Board of the exchange and the maintenance of accounts, by the members of the exchange and the audit of such accounts. SEBI Conditions According to the SEBI’s press release dated December 10, 1996, recognition of new stock exchanges would be allowed subject to the following conditions: 1. That the exchange begins trading only after the introduction of on-line screen based trading 2. That the exchange makes rules, regulations and byelaws with adequate provisions for investor protection, with the approval of SEBI and thereafter strictly follows them 3. That the exchange establishes a clearing house within 6 months from the date of recognition If all the conditions are satisfied, SEBI grants recognition to the exchange subject to such conditions, as it deems appropriate. The Central Government or SEBI has the power to withdraw recognition granted to an exchange in the interest of trade or in public interest. In this regard, Section 8 of the SC(R) Act requires periodical reports to be submitted to SEBI by the RSE.

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Additional Trading Floors Section 13A of the SC(R) Act, 1956, allows a RSE to establish Additional Trading Floors (ATFs) with prior approval from SEBI. The Act defines the term ‘trading floor’ as, “a trading ring or trading facility offered by a RSE outside its area of operation to enable the investors to buy and sell securities through such trading floor under the regulatory framework of that stock exchange.” In terms of Section 13, all contracts in securities within a state where there is a RSE would be void unless the transaction is between members of such RSE. Alternative Trading System ATS provides additional trading facilities to investors in the secondary markets. In this regard, ATS matches orders to buy or sell stock in specific quantities at specific prices in private transactions between customers, who may be brokers, institutions or individuals. ATS are exchange like entities that trade securities. ATS, which assist in dealing in securities through order matching or execution of trades, will fall within the ambit of the definition of “stock exchange” in terms of Section 2(j) of the SC(R) Act. The trading facility of an ATS, which matches the orders and enables the investors to buy and sell securities would come within the definition of a stock exchange or additional trading floor and can be treated as such. Therefore, an ATS has to comply with such requirements as mentioned in the law relating to stock exchanges or additional trading floors. Thus, ATS which provides a mechanism for entering into a contract in securities, assisting in the execution of contracts, order matching, recording contracts, adjusting rights or liabilities arising out of securities contract, will amount to assisting or organizing or entering or the performance of the contract in securities and, will be treated as a stock exchange in the eyes of the law. Therefore, any transaction through an ATS would be within Section 19 and Section 23(1)(e), (f), (i) unless the ATS takes permission from the Central Government for providing trading facilities under Section 19 or seeks and procures recognition as RSE under Section 4 of the SCR Act, in which case all the requirements of being a stock exchange would also have to be satisfied. Alternatively, the ATS can be treated as Additional Trading Floors with the approval of SEBI under Section 13A and brought under the regulatory framework applicable to a stock exchange for which it seeks to act as a trading floor or ring.

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All or None, Cross and Negotiated Deals SEBI has banned all negotiated deals in securities including cross deals and requires that such deals are executed only on the screens of the exchanges in the price and order matching mechanism of the exchanges. Similarly, all or none and negotiated deals are banned at present by SEBI and such transactions could be routed through the ATSs in the guise of regular orders. Thus, the recognition of ATSs as entities separate from the RSE would create a route to by-pass the requirements of these circulars. In the United States, an obligation is cast on the broker to quote a price to his client that is based on the best price in the nation. However, no such requirement is prevalent in Indian law and if the ATS were recognized, the interest of investors would not be safeguarded. In USA there is a restriction on a broker from undertaking proprietary transactions on their own account except in case of dealers on the NASDAQ. However, in India a broker can act as a principal on his own account after fulfilling the requirements of disclosure and confirmation as specified under Section 15 of the SC(R) Act. Without liquidity or depth, the ATS will be unable to discharge its function of price discovery, which is an essential function of a stock exchange. Hence, the investors trading through the ATS may not be able to avail the best price. Further, without any infrastructure or mechanisms for clearing and settlement, the ATS will have no mechanism to enforce the contract. Kerb Deals Kerb deals are transactions in securities between members of stock exchanges carried on after the official close of trading hours on the exchange. Under the byelaws of the RSE in India, trading after official trading hours is prohibited. Such trading can come within the ambit of Section 23(1)(i) of SC(R) Act. In the absence of any regulation, ATS may become a vehicle for such deals. If the ATS is to be permitted as RSE or ATS, it is for consideration whether a similar restriction in respect of trading hours should be imposed. Twenty-four hour trading is prevalent mainly in International exchanges or commodities exchanges. The above issue arises in the context of protecting and providing equality and fairness for all. All the market players should have equal opportunity to hedge, if there is any material information available after the official closing of trading hours. Over-The-Counter Contracts Under section 16(1) of SC(R) Act, no person without permission of Central Government can enter into any contract for sale or purchase of securities

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other than such spot delivery contract or contract for cash or hand delivery or special delivery in any securities as is permissible under the SC(R) Act and the rules, byelaws and regulation of a RSE. Therefore, entering into contracts such as OTC contracts in securities or contracts other than through RSE or spot delivery are prohibited. Clearing Houses / Trade Guarantee Fund All RSEs were required to establish a clearing house or a clearing corporation by June 30, 1996 in terms of the provisions of the circular of SEBI. Further all the exchanges were also advised to settle all their deliveries through the clearing houses. SEBI has also directed all stock exchanges to set up Trade or Settlement Guarantee Funds. ATS that provide on-line trade matching will also have to set up a clearing house and trade guarantee funds. Price In India, securities are required to be listed in such RSE whose name is mentioned in the offer document in terms of Section 73 of the Companies Act, 1956. Further, securities can be traded in other RSE as permitted securities. However, there seems to be no restriction of issuing prices established in main stock exchanges by other stock exchanges. In USA, ATS are permitted to use the price established in securities exchanges. Listing of Securities on ATS Section 73 of the Companies Act, 1956 requires every company intending to offer shares or debentures to the public for subscription by the issue of a prospectus, to make an application to one or more of the RSE for permission for the shares or debentures to be dealt with on that or those stock exchanges. The stock exchanges are required to grant such permission within a period of ten weeks of closing the subscription lists, failing which the company has to repay all the money collected in the issue within eight days. Section 21 of the SC(R) Act states that where securities of a body corporate are listed on a RSE it has to comply with the conditions of the listing agreement. Thus all issues of securities by issue of a prospectus are governed by the listing agreement with the stock exchange. Further Rule 19 of the SC(R), lays down the form of application for listing of securities with a RSE and also lays down the conditions based on which the RSE is to make a decision on listing or refusal to list the said securities. This rule ensures the protection of the right to liquidity of any investor who invests in the securities listed on the stock exchange. One of these

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requirements is the use of a common form of transfer. Besides, it is also required that the company shall issue to its investors letters of allotment and right issue receipts for securities deposited with it for registration, subdivision, exchange or other purposes, issue renewal/consolidation certificates when required. The issue, therefore, is that whether the ATS will be a mechanism only for matching trades and the securities, which are to be traded on the ATS, and which need to be listed by entering into an agreement with such companies. If only a trading facility is to be provided without the listing of those securities being necessary or satisfied, the same may not be in the interest of investors as the company whose securities are to be traded in ATS will be under no obligation to give information to ATS which may affect price of such securities traded in ATS. U.S. Experience ATS have been developing outside conventional securities markets and are now multiplying. They provide investors with additional proprietary electronic trading facilities for securities that are traded principally on securities exchanges or other organized markets. Some ATS have price discovery functions, others serve as matching systems, and still others serve as crossing systems using prices already established in organized markets such as securities exchanges (e.g. closing price). Investors using ATS may be able to lower their transaction costs. The ATS that currently exist in the United States are closed systems. However, they are not generally accessible to the public through the Internet. For emerging ATS, the Internet could be used to increase order flow by providing new participants with easier access to their trading systems. In December 1998, the Securities and Exchange Commission (SEC) introduced a new scheme whereby, it requires an ATS to either (i) register with the SEC as a national securities exchange in accordance with the Securities Exchange Act of 1934, or (ii) register as a brokerdealer and comply with new requirements pursuant to Regulation ATS and related rules. In USA, nine ECNs (Electronic Communication Network) operate as market participants within the NASDAQ network. These alternative trading systems (ATS) display either one or two-sided quotes, which reflect actual orders, and provide institutions and market makers with an anonymous way to enter orders into the marketplace. ECNs foster competition among market makers, further enhancing the market’s liquidity.

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In order to be approved, ECNs must meet three requirements: 1. Each ECN must be a registered broker/dealer and an NASDAQ member 2. Each ECN must be approved by the SEC as an alternative trading member (ATS) 3. Each ECN must agree to NASDAQ contractual terms on how to operate its link into the NASDAQ network Fundamental to the new structure in the United States, is an expanded interpretation of the term “exchange” accompanied by exemptions from the exchange definition that enable ATS to choose their regulatory status either as an exchange or as a broker-dealer with additional requirements that address the market-like functions of the ATS. As adopted, regulation of ATS also includes volume based requirements that provide for increasing levels of regulatory obligations as ATS’s trading volume rise. This incremental approach is intended to promote the regulatory goals of the SEC while preserving the “commercial viability” of the ATS. Necessity of ATS/ ECN In India There are some advantages of ATS/ECN such as efficiency in execution of trade, reduction of costs and execution of trade anytime. Whereas, in USA the ATS/ECN was developed in stages as under, in India the situation is different. All the 24 stock exchanges have become electronic, i.e. they have on-line screen based trading where orders can be matched automatically. The scale of brokerage and the cost of transactions have also come down. With effect from 8.10.1999, SEBI has allowed all the stock exchanges to extend terminals to any place. It is therefore, felt that there is a need to avoid fragmenting the market so as to ensure that all should follow the same rules. A broader, deeper market is good for investors because it increases liquidity and price transparency. The necessity of permitting ATS as RSE in India should be considered in the light of above. It may also be necessary to consider whether ATS is to be allowed for trading only for some limited players such as QIBs. It is also for consideration whether ATS is to be allowed for securities, which are not listed in any RSE. Further, the other issue is whether restriction on trading hours should be removed and the investors should be allowed to transact and hedge their risk all 24 hours in a day, which is necessary in case of international market.

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Concluding Remarks In view of the provisions of the SCR Act, especially, Sections 2(f), 13, 13A, 19 and Section 23, an ATS cannot operate without seeking recognition as a stock exchange or as additional trading floor after satisfying all the legal requirements therefor. Further, permitting an ATS to function, as a stock exchange without proper regulation and safeguards will not be in the interest of general investors or the securities market. The ATS cannot be used for specialized products like OTC and other contracts, in view of the 1969 notification. Thus, permitting ATS to act as stock exchange in Indian scenario would require review of some policies and notifications. Further, in view of the fact that in India all the stock exchanges have electronic online trading facility, the necessity of permitting ATSs/ECNs as RSE should be considered. Examining Order Routing System The feasibility of introducing the Order Routing System (ORS) for Internet Trading is examined below: An order routing system is one that directs orders from a client terminal to the stock exchange terminal or a system which routes matched orders to the stock exchange terminal or to that of a broker. In light of the above, policy decisions need to be taken whether: 1. The system should be such that the order is matched at the stock exchange terminal or at the order routing system 2. The system should merely forward orders received by it to the exchange’s facility 3. The system should forward orders received by it to broker terminals Order to be Routed Through a Member? Section 13 prohibits trading in securities between persons other than the members of the recognized stock exchanges. The only exception to this provision is envisaged in Section 18, which permits any person to enter into transactions in securities on a spot delivery basis, i.e. the delivery of shares and the consideration pursuant to such a transaction has to be completed within 48 hours of the transaction being entered into. According to Section 23(1) the following persons are not eligible for carrying out trading and hence shall be punishable: 1. Person who is not a member of a RSE or his agent authorized as such under the rules or byelaws of such stock exchange or not being a dealer in securities licensed under Section 17 willfully represents to or induces any person to believe that contracts can be entered into or performed under this Act through him; or

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2.

Person who is not a member of a RSE or his agent authorized as such under the rules or bye-laws of such stock exchange or not being a dealer in securities licensed under Section 17, canvasses, advertises or touts in any manner either for himself or on behalf of any other person for any business connected with contracts in contravention of any of the provisions of this Act Further, Section 12 of the SEBI Act, 1992 also bars any person from dealing in securities unless such a person is registered with SEBI as a stockbroker. As per the SC(R) Act, contracts in securities other than trades on a spot-delivery basis have to be entered and performed under the auspices of a RSE through a member of such RSE. Thus, in case of the ORS, the order has to be executed on a RSE and through a member of that RSE. UK Experience Similar to the requirement in Section 12 of the SEBI Act, is the provision of Section 3 of the Financial Services Act 1986, which states that any person who carries on investment business in the United Kingdom must be authorized to do so. The definition of “investment business” includes dealing or arranging deals in, managing or giving advice on investments. “Authorization” generally involves becoming a member of one of the recognized Self Regulating Organizations or Recognized Professional Bodies unless specific exemption is available. In practice, it is unlikely that an access and/or site provider will be conducting investment business if it merely acts as a conduit through which persons or companies gain access to a presence on the internet and where it has no knowledge of, or control over, the information or service being provided. The position under the Act may be less clear if an access and/or site provider is commercially involved with an investment firm for whom they are providing access or a site. Access and/or site providers may need to consider their position under Section 3 of the Act if, for example, they were to: 1. Provide access and/or an off-the-shelf internet site over which they had control of what was placed on the site or the nature of information about investments or investment services provided 2. Have a joint venture arrangement with someone carrying on investment business—such as a firm providing share dealing 3. Services for whom they had provided access and/or a site

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4. 5.

Promote an investment service under their own name; or Promote another person’s investment service or put investment material on the internet

Contract Notes In India, contract notes are required to be issued to the clients by the brokers in terms of the byelaws of the stock exchanges introduced pursuant to the SEBI circular dated 04.02.91. Further, the contract notes to be issued by brokers to clients in terms of the SEBI circular are at present issued in writing and delivery is manual or by post. Further, such contract note should contain price, brokerage, time of execution, provisions regarding arbitration, etc. When orders are to be issued through the ORS, a system for issue and delivery of such contract notes through the same medium may be an issue for consideration while framing the policy. Confirmation in Writing Section 15 of the SC(R) Act prohibits members from entering into contracts as principles with persons other than members unless the consent or authority is secured, in writing. If the consent is secured in a manner other than in writing, the confirmation shall be secured within three days from the date of the contract. Rule 9 of the SC(R) Rules, 1957, states that all contracts in securities between members of the RSE shall be confirmed in writing. Even though the order is routed through the ORS, confirmation in writing would be required. Thus, in case of routing orders through the ORS, all the above legal requirements have to be complied with. Electronic Contract Notes The Stock Exchange of Singapore (SES) has enhanced its Electronic Trade Confirmation (ETC) system to include the provision of Electronic Contract Notes (ECN). Singapore brokers already utilize the ETC system. However, they need to provide hardcopy contract notes to their clients. The introduction of electronic broker confirmations makes the SES trade confirmation system fully automated. As such, brokers no longer have to send out paper contract notes to their institutional clients. Margins The SEBI requires that all members of a RSE have to pay marked to market margins, special margins, additional volatility margins and carry-forward margins as may be applicable to them. The stock exchanges also impose gross exposure margins and net exposure margins. On the introduction of

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the ORS, it will become necessary for increased monitoring of transactions by the RSE for the computation and imposition of these margins. Data Base The stock exchanges require that their members maintain databases of their clients, for which they design client introduction forms and ask the members to get them filled. In case of an ORS, the responsibility of members increases greatly. Further, a record of the time when the client places the order is required to be maintained by the member of the RSE and the same has to be reflected in the contract note alongwith the time of execution of the order. This requirement also affects the implementation of the ORS, in that these requirements would still have to be met by the members. Jurisdiction In case of a dispute in respect of an order routed through an ORS, the question may arise as to which forum will have jurisdiction to resolve the dispute, i.e. the place from where the order was placed or the place where the order is executed. If the forum of arbitration is provided in the place where the order is executed, a client may have to travel a long way. This may not be in the interests of investors. Maintenance of Books Under Rule 15 of the SC(R) Rules, 1957, duplicates of contract notes, written consent of the clients, members contract book, sauda book, etc have to be maintained and preserved for a specified period. Thus under the ORS system, a member has to generate a hard copy of the contract and preserve duplicate copies as prescribed in the SC(R) Rules and the SEBI (Stock Brokers and Sub-Brokers) Regulations, 1993. Security of Information At present the Indian laws do not envisage the security of internet information. However, the draft E-commerce Act focuses on this issue and prescribes the requirements like passwords, net certificates, signatures, etc which will play an important role on the authenticity of such information, gathered from the internet. These requirements will also have to be met by internet traders on the stock exchanges regardless of whether the ORS or the ATS is adopted in the Indian context. The NSE and Internet Stock Trading NSE in one of its brochures states that the exchange plans to introduce trading of stocks on the internet after obtaining all necessary approvals.

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The trading members have to create web pages for retailers to access them. The members will in turn channelise these orders into the NSE trading system for order matching. Thus, NSE only seeks to use internet for order routing, which is permissible subject to the fulfillment of the requirements stated in this note. Concluding Remarks In case of the ORS being adapted to the Indian situation, the possibility within the existing structure would permit the routing of orders through the internet to the broker’s terminal, which would then key in the order in the exchange’s terminal. Thus, the internet can be used as an order routing system through the registered stock broker on behalf of a known client for the execution of trades in RSE. Necessary safeguards such as passwords, etc need to be introduced. However, the laws in respect of physical issue of contract notes and presentation of documents, etc will be required to be reviewed. REGULATING INTERNET STOCK TRADING

Pr os pe c t us Section 56(1) of the Companies Act, 1956 states that the matter specified in Part I of Schedule II of the Companies Act, have to be disclosed in a prospectus to a public issue. Section 56(3) states that no one shall issue any form of application for securities, unless a memorandum containing salient features of a prospectus accompanies such form. Rule 19(2)(b) of the SC(R) Rules provides that at least 25 percent of each class of securities be offered to the public for subscription through advertisement in the newspaper for a period not less than two days and the allotment shall be made fairly and unconditionally. Section 64 states that any company that allots or agrees to allot shares with a view to offering them to the public, “any document by which the offer for sale to the public is made shall, for all purposes, be deemed to be a prospectus of the company and all enactments and rules of law as to the contents of the prospectus shall apply to the ...” In view of this, the disclosures and rules governing prospectuses are applicable to all forms of advertisements for public subscription in companies. Further, under Section 69(3) of the Companies Act, the amount payable on application on each share shall not be less than 5 percent of the nominal value of the share. Under Section 73(3), all monies received from applicants for a share shall be kept in a separate bank account maintained with a scheduled bank.

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Section 72(5) of the Companies Act restricts the revocation of an application till the expiry of five days after the time of opening of subscription lists. Such revocation is also possible if a person responsible for the issue of the prospectus issues a public notice to the effect and in such a situation, the restriction of five days does not apply. Thus, a company seeking to issue its shares through the internet has to comply with the provisions relating to the issue of the prospectus, advertisement, application form accompanying memorandum, minimum application money, minimum period for which issue is to remain open, etc. U.S. Experience The basic rules concerning the registration and issuance of securities is covered by the 1933 Act. The 1933 Act, not only applies to the Initial Public Offering (IPO) but also any further issuance of securities. As a general rule, the 1933 Act requires that any securities must be registered with the SEC prior to offering the securities to the public. This not only applies to stocks but also bonds and any other type of security. A registration statement is to be filed approximately 45 days prior to the date the company intends to begin selling the securities (the effective date). Once the registration statement is filed, the communication with potential investors must be by prospectus only. Between the filing of the registration statement and the effective date, there may be an ongoing dialog between the company and the SEC with the object of making changes in the preliminary prospectus. When the SEC finally approves the registration statement, the company may begin selling the securities. Private placements and Small Corporates Offering Registration (SCOR) offerings are exempt from the filing requirements of the SEC. Although, SCOR offerings must be registered under the Blue Sky laws with each state in which it intends to sell the stock, and one short form does need to be filed with the SEC notifying them of the offering. The 1934 Act provides the framework under which the company may communicate non-offering material with investors. The Act also mandates the filing of periodic reports with the SEC, besides false or misleading statements. It imposes civil liability for those statements. The internet and electronic media have opened up the door for the Internet IPO. In October 1995, the SEC decided that information that can be delivered in paper under the federal securities laws might be delivered in electronic format. In May 1996, the SEC made it clear that electronic distribution of documents would benefit investors and issuers through a faster and cheaper means of communication. According to the SEC, quick and broad access to material information was a fundamental concept of the reporting laws.

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Underwriter’s Role Traditionally, an initial public offering (IPO) is brought out by underwriters. They draft the prospectus and assist with the filings. They solicit interest from investors who might be interested in the IPO. They determine the price at which the shares can be sold. In a true underwriting they purchase the shares of stock from the company at the offering price (less the underwriters’ discount). They then sell the stock to investors. However, with the growing popularity of the internet, many companies are in a position to go public with an IPO without the assistance of an underwriter. A case in point was the ‘Spring Street Brewery IPO’ in which the SEC allowed the offering to proceed as one, which was made solely through electronic documents. Despite this, it is still desirable to use an underwriter or a broker/dealer to help market the IPO securities if you can get one. The Internet IPO issuer faces liability for false or misleading oral or written statements in connection with a solicitation to sell stock. In a traditional IPO the investors purchase their stock from the underwriter and not from the company. The purpose of e-IPO is to enable investors to make informed decisions regarding the purchase of the stock by the full disclosure in the prospectus for the IPO. IPOS ON THE INTERNET—INDIAN EXPERIENCE

Section 11 of the Securities and Exchange Board of India Act, 1992, imposes a duty on the SEBI to protect the interests of investors in securities and to promote the development and to regulate the securities market, by such measures as it thinks fit. In pursuance of this provision and after Ordinance No. 9 of 1992 by which the Capital Issues (Control) Act has been repealed, the Board issued guidelines for disclosure and investor protection regarding the share issues and other matters pertaining to the protection of the rights of investors in securities. The Disclosure and Investor Protection Guidelines and the SEBI (Merchant Bankers) Regulations provide for the filing of offer documents with SEBI. The observation of SEBI if given within 21 days has to be included in offer document. E-IPO PROSPECTUS

The IOSCO has recommended that general antifraud provisions should apply to all offers and advertisements involving securities or financial services, regardless of the medium and whether a regulator or SRO is involved in approving the offer or advertisement.

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In India, the offering of securities other than the private placements has to be done as per SEBI DIP Guidelines. Offering of securities through internet may amount to soliciting to general public and SEBI guidelines pertaining to public issue would be applicable. At present, the Indian laws include within the meaning of the term prospectus; any document by which the offer for sale to the public is made” by a company which allots or agrees to allot any shares or debentures. The mode of making such document public has not been stipulated. Therefore, at present it is possible to include within the meaning of this term, the publishing of the contents of a prospectus through the internet. However, Section 66 of the Companies Act, recognizes newspaper advertisements of a prospectus and states that such advertisements need not specify the contents of the memorandum or the signatories thereto, or the number of shares subscribed for by them. The issue for consideration therefore, is whether the information contained in a website of a company regarding an IPO would be a prospectus. Section 2(36) defines a prospectus as “any document described or issued as a prospectus and includes any notice, circular, advertisement, or other document inviting deposits from the public or inviting offers from the public for the subscription or purchase of any shares or debentures of, a body corporate.” Therefore, the meaning of the term would need to be amended to include the information contained in the website before deeming the same to be a prospectus. Conversely, if the internet is viewed as merely a mode of delivery of the information contained in a prospectus, then the information on the internet could be considered to be an advertisement of the prospectus. If the contents of a website on the internet was to be deemed a prospectus within the meaning of the term in Section 64, then, any material a company puts on its website as promotion of an IPO, would be subject to the provisions of the Companies Act, 1956. The published material could amount to a violation of the provisions governing the contents of the prospectus and if the information posted on the website is in the nature of an advertisement to the prospectus, then the Companies Act, 1956 may be amended to include advertisements being other than newspaper advertisements. Further, if a company and its officers make false or misleading statements in order to fraudulently induce investors to purchase shares then there may be a violation of Section 68 of the Companies Act, 1956. Under SEBI book-building guidelines, it is specified that bidding shall be permitted only if an electronically linked transparent facility is used. Use of internet can be permitted for such bidding subject to safeguards

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such as passwords, etc. In case of an offering through the internet, the question is whether application can be made or entertained through the electronic media. As stated above, the requirement of the Companies Act as mentioned below has to be complied with: 1. An application form should contain abridged prospectus 2. Minimum amount has to be paid with the application 3. Money to be kept in separate account till listing permission is given 4. Investors right to withdraw their application to be protected 5. Collection of money and mandatory collection centers—collection agent cannot collect money in cash, etc Even if the issue is fully subscribed the offering on the internet has to remain open for a minimum of two days as per the provisions of the SC(R) Act. Besides, the above, a company has to comply with disclosure requirements as contained in the Disclosure and Investor Protection Guidelines of SEBI. The merchant banker has to comply with the requirements in the SEBI (Merchant Bankers) Regulations and observe due diligence in respect of the offer documents. E-COMMERCE ACT AND INTERNET STOCK TRADING

The Electronic Commerce Act, 1998 (the Act) seeks to provide legal infrastructure governing electronic contracting, security and integrity of electronic transactions, the use of digital signatures and other related issues. According to Section 3 of the Act, the purposes of the Act are: 1. To facilitate electronic communications, commerce and filing 2. To establish uniform rules and standards regarding the authentication and integrity of electronic records 3. To create legal infrastructure for the use of digital records and signatures Section 4 of the Act provides that Part II (relating to electronic records and signatures) or Part IV (relating to electronic contracting) shall not be applicable to any law requiring writing or signature, inter-alia, in the following circumstances: 1. The execution of negotiable instrument 2. The creation or enforcement of an indenture, declaration of trust or Power of Attorney 3. Documents of title for movable or immovable property

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The Act recognizes that for certain categories of transactions, hand written signatures are more appropriate and therefore the same cannot be dispensed with. Central Government has been authorized to delete or add any class of transactions for which ‘written’ or ‘signature’ requirement will continue. In case of internet trading, the requirement of payment by cheque or other negotiable instrument will continue. Further, under Income Tax Act payment over Rs. 20,000 has to be through crossed cheque. Section 4 further provides that the electronic records shall not be liable to stamp duty. This is on the line of Depository Act. It further provides that it shall be lawful to transmit and receive records electronically. Section 5 of the Act provides that parties involved in generating, receiving, storing or processing electronic records observe the provisions of Part II or Part IV of the Act. In case of internet trading, the stock exchange or SEBI may, if deem fit, specify the model agreement to be entered into by the broker with the client so as to foster uniform practice. Section 6 seeks to give legal recognition or evidentiary weight to electronic records and electronic signatures. It provides that electronic records and signatures shall not be denied legal effect, validity or enforceability solely on the ground that they are in electronic form. Thus, electronic records and signatures are sought to be accorded the same treatment as paper records and signatures. In case of internet trading, this would facilitate issue of electronic contract note, etc. Section 7 provides that where any law requires any matters to be in writing that requirement is met by an electronic record if the matter contained therein is accessible so as to be usable for subsequent reference. This provision seeks to legally recognize the use of electronic ‘writings’ through e-mail, the internet and other electronic records transmitted over networks in electronic contracting. Section 8 provides that where any law requires that the record shall bear a signature that requirement will be met if the identity of the originator and the method indicate the originator’s approval of the information contained in electronic record. This section intends to remove any doubt regarding the enforceability of electronic signatures. Section 9 requires that if the rule of law requires the record to be presented or retained in original form an electronic record meets that requirement if that record is capable of being displayed to the person to whom it is being presented. It provides that an electronic record will constitute an original provided that there exists a reliable assurance as to the integrity of the information.

496 Capi tal Markets

Section 10 provides that the electronic records and electronic signatures shall be admitted as evidence in legal proceedings not withstanding anything contained in the Indian Evidence Act, 1872. It also lays down the standard for determining evidentiary weight of electronic records and electronic signatures. The court cannot refuse to admit any electronic record or electronic signatures into evidence solely on the ground of its electronic format or on the ground that it is not in original. Section 11 provides that if any law provides that certain documents, records or information be retained whether permanently or for a specific period, that requirement is satisfied by retaining them in the form of electronic records, if information in the electronic record remains accessible so as to be usable for subsequent reference, and, is retained in the format in which it was originally generated or which can be demonstrated to represent accurately information originally generated. Sub-clause (d) of Section 11 of the Act provides that nothing in this section shall preclude any department, Ministry or Central Government or State Government or any statutory corporations from specifying additional requirement for the retention of electronic record that are subject to its jurisdiction. In case of internet trading, SEBI or stock exchanges may specify additional requirement in case of electronic record. Sections 12 and 13 deal with ‘secure’ electronic records and ‘Secure’ electronic signatures. It provides that the records that qualify as secure electronic records or signatures are accorded the presumptions set forth in Section 14. An electronic record or signature is to be deemed secure if it is possible to verify the integrity of the record or signature through security procedure. Under Section 14 it is provided that in civil proceedings the secure electronic signatures affixed to an electronic record the signature of the person objectively identified as the signer by application of the applicable qualified security procedures. Section 15 deals with formation and validity of electronic contracts. It recognizes electronic records as a means of forming contract. It provides that offer and acceptance may be accomplished through the use of electronic exchange. It provides that electronic contracts are enforceable agreements formed through the use of electronic agents. Section 16 provides that originator and addressee of the original record shall make a declaration that they shall not deny legal effect, validity or enforceability solely on the ground that agreement is in the form of an electronic record. In case of internet trading, the client or the broker should make declaration that they shall not deny validity of electronic record or enforceability.

On-l i ne Stock Tradi ng

497

Section 17 lays down the circumstances when the electronic record can be deemed to be originated from the originator. This section provides a framework for attributing electronic records to specific persons. Section 18 specifies that many electronic transactions may require acknowledgment of the receipt of electronic records. If an electronic record is conditional on receipt of acknowledgement, transmission shall be treated as if it were never sent if no acknowledgement is received. In case of internet trading such requirement of acknowledgement may be specified. Section 19 deals with the manner of determining the time and place of despatch and receipt of an electronic record. Section 20 deals with the situations in respect of applicable law in case of dispute. It is provided that it may be decided in accordance with the rule of law designated by parties as applicable to the substance of dispute. The above position is similar to Section 28 of the Arbitration and Conciliation Act, 1996. Section 21 provides that an electronic record that is signed with digital signatures shall be treated as a secure electronic record. Part X of the Act deals with acceptance and use of electronic records and electronic signatures by governmental entities. This provision authorizes any department or Ministry to accept electronic filing of documents and to issue permits, licenses or approvals electronically. If the Act were given the shape of the law it would pave the way for reliable electronic contract including the transactions in securities through internet, which can be enforced. The law will make possible the admissibility of electronic records and electronic signatures as evidence in legal proceedings. Under Section 11, sub-section (d) statutory authorities are not precluded from specifying the additional requirement for the retention of electronic records that are subject to its jurisdiction. Therefore, in respect of retention of electronic records the additional requirement can be specified by SEBI or the stock exchanges. Further, under Section 18, by law it can be specified that an electronic record is conditional on receipt of acknowledgement. Thus, electronic transmission of any transaction in respect of any securities requires acknowledgement of receipt of electronic records. Further under section 4, the requirement of certain paper-based transactions has not been dispensed with. In other words, the law applicable such as the execution of negotiated instruments, document for title for movable properties, declaration of trust or Power of Attorney shall be

498 Capi tal Markets

continued to be in writing or should contain the signature. Thus, the enactment of Electronic Commerce Act would pave the way for safe and secure contracts in securities through electronic medium including internet. It will also provide the legal framework for validity and enforceability of electronic documents and signatures. In case of electronic trading generation of physical papers can be dispensed with. This, however, requires that certain provisions of SC(R) Rules and SEBI (Stock Brokers and Sub-Brokers) Regulations, which require retention of certain documents, issue of contract notes, etc are scrupulously. REVIEW QUESTIONS

Section A 1. 2. 3. 4. 5. 6. 7.

What is ‘on-line stock trading’? What is ‘Alternative Trading System’ (ATS)? What is ‘Order Routing System’ (ORS)? What is a trading floor? What are ‘kerb deals’? What are over-the-counter contracts? What are ‘contract notes’?

Section B 1. 2. 3.

What are the features of ‘on-line stock trading’? Explain the working of ‘Alternative Trading System’ (ATS). How is listing of securities done at the ATS?

Section C 1. 2. 3. 4. 5. 6.

Discuss the different forms of internet stock trading. Identify and discuss the major issues concerning the internet stock trading. Bring out the US experience with regard to the working of the ARS. How is internet stock trading regulated? Elaborate. Examine the Indian experience as regards IPOs on the internet. Evaluate the scope of E-commerce Act on the internet stock trading.

Chapter

24

Debt Market A market where fixed income securities of various types and features are issued and traded is known as a ‘debt market’. Fixed income securities include securities issued by central and state governments, municipal corporations, government bodies and commercial bodies such as financial institutions, banks, public sector units, public limited companies, etc. The securities are structured in nature. ADVANTAGES To Investors

Investment in fixed income securities is advantageous to investors in the following manner: Steady income An important advantage of the fixed income securities is that they ensure steady and constant return by way of interest and repayment of principal at the maturity of the instrument. Further, investors are assured of a dependable income. Safety Fixed income securities are issued by eligible entities of standing against the moneys borrowed by them from the investors. This guarantees safety of funds invested on these securities. Moreover, such debt is usually secured against the assets of the company. Risk-free Some of the fixed income securities such as government securities offer a risk-free return on the investors’ moneys. The default on such securities is zero or near zero. Besides, there is a sovereign guarantee on those instruments. To Financial System

Following are the benefits accruing to the Indian financial system on account of the debt market: 1. Reduction in the borrowing costs thus facilitating mobilization of resources at reasonable costs 2. Providing greater funding avenues to public and private sector projects thereby reducing pressure on institutional financing

500 Capi tal Markets

3. 4. 5.

Enhanced resource mobilization by unlocking illiquid retail investments like gold Development of heterogeneity of market participants Assisting in the development of a reliable yield curve

RISKS ON DEBT

Debt instruments are exposed to the following type of risks: Default Risk

Default risk also known as credit risk refers to the risk of inability of the issuer to make prompt payment of the interest and the principal amount. Interest Rate Risk

The risk emerging from an adverse change in the rate of interest prevalent in the market so as to affect the yield on the existing instrument is known as ‘interest rate risk’. An investor would run a risk of having to lose in a situation where there is a sudden upswing in the prevailing interest rate scenario where he has already invested his money. Reinve stment Rate Risk

The risk arising from the probability of a fall in the interest rate resulting in a lack of options to invest the interest received at regular intervals at higher rates or comparable rates in the market is known as ‘reinvestment rate risk’. Counter-p arty Risk

The risk arising from the failure or the inability of the opposite party to the contract to deliver either the promised security or the sale value at the time of settlement is known as ‘counter-party risk’. Price Risk

The risk arising from the possibility of not being able to receive the expected market price of the debt instrument, due to an adverse movement in price is known as ‘price risk’. ISSUERS PROFILE

Fixed income securities can be issued by almost by any legal entity like corporate business houses, banks, financial institutions, municipal corporations, central and state governments, public bodies, statutory corporations, etc.

Deb t Ma rket

501

TYPES

The type of instruments that are traded in the debt market include the following: G ov e rn m en t Sec u ri tie s

Securities of central and state governments include: • Zero coupon bonds • Coupon-bearing bonds • Treasury bills • STRIPS Public Sector Bonds

Bonds that are issued by public sector entities such as government agencies, statutory bodies, public sector bodies, etc include the following: • Government guaranteed bonds • Debentures • PSU bonds • Commercial paper Private Sector Bonds

Bonds that are issued by private sector entities such as corporates, banks, financial institutions, etc include the following: • Debentures • Bonds • Commercial paper • Floating rate bonds • Zero coupon bonds • Intercorporate deposits • Certificates of deposits

502 Capi tal Markets

Exhibit 9 shows the profile of debt instruments. Exhibit 9

Profi le of Debt Instrument

ROLE OF BOND MARKET

Bond market plays an important role in the economic development of a country in the following manner: 1. Efficient mobilization and allocation of financial and other resources in the economy 2. Financing the development activities of the government 3. Transmitting signals for the implementation of various monetary and other policies of the central bank of the country 4. Facilitating the efficient liquidity management in tune with the overall short-term and long-term objectives of the economic planning PRICE DETERMINATION—FACTORS

The price of a bond in the markets is determined by the operation of the forces of demand and supply. The bond price is influenced by the following factors: 1. General economic conditions 2. Money market and capital market conditions 3. Political and social conditions 4. Credit quality of the issuer 5. Interest rate prevalent in the market 6. The rates of new issues

Deb t Ma rket

503

YIELD OF BOND

Yield refers to the percentage rate of return paid on a bond in the form of interest. It is the effective rate of interest paid on a bond or a note. Yield to Maturity (YTM) is the most popular method of measuring the bond yield. YTM refers to the percentage rate of return paid on a bond, note or other fixed income security if the instrument is bought and held till maturity date. The YTM is calculated on the basis of coupon rate, length of time to maturity and the market price. It is the IRR of the bond and is identified as that trial rate of interest at which the issue price of the bond is equated with the sum of the present value of future cash flows (debt service payments—interest and the principal) of the bond. Current yield is the coupon rate divided by the market price and this gives an approximation of the present yield. YIELD AND PRICE

Yield and the market price of the bond are inversely related. Accordingly, a rise in price will decrease the yield and a fall in the bond price will increase the yield. There will be an immediate and predictable effect on the price of bonds with every change in the level of interest rate. Where the prevailing interest rate in the market rises, the price of outstanding bonds will fall to equate the yield of older bonds in line with the higher-interest new issues. This happens as there will be few takers for the lower interest coupon bonds. This results in fall in prices. The price fall will be to the extent where the same yield is obtained on the older bonds as is available for the newer bonds. Conversely, where the prevailing interest rates fall, the price of outstanding bonds will rise until the yield of older bonds is low enough to match the lower interest rate on the new bond issue. On account of such factors as market rate of interest, coupon rate of interest and the time to maturity, the value of a bond will keep varying throughout its life and therefore, likely to be either higher or lower than the original face value. SECONDARY DEBT MARKET

The market where bonds are bought and sold is known as the ‘secondary debt market’. Its segments are as follows: Wholesale Debt Market

This comprises of institutions and agencies such as banks, financial institutions, RBI, primary dealers, insurance companies, provident funds,

504 Capi tal Markets

mutual funds, corporate entities, and foreign institutional investors. The two type of transactions that are executed in a wholesale debt market are an outright sale or purchase and a repo trade. Stock exchanges offer orderdriven screen based trading facilities for government securities. The trading activity on the system is however restricted with most trades today being put through in the brokers’ offices and reported to the exchange through their electronic system which provides for reporting of ‘Negotiated Deals’ and ‘Cross Deals’. Settlement The settlement for the various trades is finally carried out through the SGL account of the RBI except for transfers between the holders of constituent SGL account in a particular bank or institution like intra-account transfers of securities held at the banks and CCIL. As regards broker-intermediated transactions, the settlement responsibility for the trades in the wholesale market is primarily on the clients and the broker has no role to play in the same. The member has only to report the settlement details to the exchange for monitoring purposes. The exchange reports the trades to RBI regularly and monitors the settlement of these trades. Trading modules The GILT permits trading in the wholesale debt market through the following modules: a. Order Grabbing System which provides for active interaction between the market participants in keeping with negotiated deal structure of the market b. Negotiated Deal Module which permits the reporting of trades undertaken by the market participants through the members of the exchange c. Cross Deal Module which permits reporting of trades undertaken by two different market participants through a single member of the exchange Retail Debt Market

This comprises of individual investors, small trusts and other legal entities, besides participants in the wholesale market. REPOS AND NORMAL BUY OR SELL

An outright buy or sell transaction is one where there is no intended reversal of the trade at the point of execution of the trade. The buy or sell transaction is an independent trade and is no way connected with any other trade at the same or a later point of time.

Deb t Ma rket

505

A repo is ready forward trade transaction where the said trade is intended to be reversed at a later point of time at a specified rate. The rate will include the interest component for the period between the two opposite legs of the transactions. In a repo transaction one participant sells securities to another with an agreement to purchase them back at a later date. The trade is called a ‘repo transaction’ from the view point of the seller and it is called a ‘reverse repo’ from the view point of the buyer. Repos facilitate creation of liquidity by permitting the seller to avail of a specific sum of money (value of the repo trade) for a certain period in lieu of payment of interest by way of the difference between the prices of the two trades. Repos and reverse repos are commonly used in the money markets as instruments for short-term liquidity management. They are also called as a collateralized lending and borrowing mechanisms. Banks and financial institutions usually enter into reverse repo transactions to manage their reserve requirements or manage liquidity. BROKEN PERIOD INTEREST

The concept of broken period interest or the accrued interest arises where interest on bonds are received after certain fixed intervals of time by the holder who enjoys the ownership of the security at a certain point of time. Therefore, an investor who has sold a bond, which makes half-yearly interest payments three months after the previous interest payment date, would not receive the interest due to him for these three months from the issuer. The interest on these three previous months would be received by the buyer who has held it for only the next three months but receives interest for the entire six months as he happens to be holding the security at the interest payment date. Therefore, in the case of a transaction in bonds occurring between the two interest payment dates, the buyer would pay interest to the seller for the period from the last interest payment date up to the date of the transaction. The interest, thus calculated, would include the previous date of interest payment but would not include the trade date. GUIDELINES FOR ISSUE OF DEBT INSTRUMENTS

Following are the guidelines that must be adhered to, by a listed corporate enterprise offering convertible/non-convertible debt instruments through an offer document:

506 Capi tal Markets

Credit Rating

1.

2.

3.

No public or rights issue of debt instruments (including convertible instruments) in respect of their maturity or conversion period shall be made unless credit rating from a credit rating agency has been obtained and disclosed in the offer document In respect of a public/rights issue of debt security greater than or equal to Rs. 100 crores, two ratings from two different credit rating agencies shall be obtained and such ratings including the unaccepted credit ratings, shall be disclosed All the credit ratings obtained during the three years preceding the public or rights issue of debt instrument (including convertible instruments) for any listed security of the issuer company shall be disclosed in the offer document

Deben ture Tru stee

1. Appointment In case of issue of debenture with maturity of more than 18 months, the issuer shall appoint a debenture trustee. The names of the debenture trustees must be stated in the offer document. 2. The trust deed A trust deed shall be executed by the issuer company in favor of the debenture trustees within six months of the closure of the issue. 3. Trustee powers Trustees to the debenture issue shall be vested with the requisite powers for protecting the interest of debenture holders including a right to appoint a nominee director on the Board of the company in consultation with institutional debenture holders. 4. Certificate The merchant banker shall, alongwith the draft offer document, file with the Board, certificates from their bankers that the assets on which security is to be created are free from any encumbrances and the necessary permissions to mortgage the assets have been obtained or a No Objection Certificate from the financial institutions or banks for a second or pari passu charge in cases where assets are encumbered. 5. Trustee duty a. To ensure that the lead financial institution/investment institution monitors the progress in respect of debentures raised for project finance/modernization/expansion/ diversification/normal capital expenditure b. To ensure that the lead bank for the Company monitors debentures raised for working capital funds

Deb t Ma rket

c.

d.

e.

507

To obtain a certificate from the company’s auditors in respect of utilization of funds during the implementation period of projects and in the case of debentures for working capital, certificate shall be obtained at the end of each accounting year To ensure that debenture issues by companies belonging to the groups for financing replenishing funds or acquiring share holding in other companies are not permitted To supervise the implementation of the conditions regarding creation of security for the debentures and debenture redemption reserve

Debenture Redempti on Reserves (DRR)

Creation A company has to create DRR in case of issue of debenture with maturity of more than 18 months. The issuer shall create DRR in accordance with the provisions given below: a. If debentures are issued for project finance DRR can be created up to the date of commercial production b. The DRR in respect of debentures issued for project finance may be created either in equal installments or higher amounts if profits so permit c. In the case of partly convertible debentures, DRR shall be created in respect of nonconvertible portion of debenture issue on the same lines as applicable for fully nonconvertible debenture issue d. In respect of convertible issues by new companies, the creation of DRR shall commence from the year the company earns profits for the remaining life of debentures e. Company shall create DRR equivalent to 50 percent of the amount of debenture issue before debenture redemption commences f. Draw from a DRR is permissible only after 10 percent of the debenture liability has actually been redeemed by the company g. The requirement of creation of a DRR shall not be applicable in case of issue of debt instruments by infrastructure companies Treatment DRR shall be treated as a part of general reserve for consideration of bonus issue proposals and for price fixation related to post-tax return.

508 Capi tal Markets

Distribution of Dividends

1.

2.

3.

In the of case of new companies, distribution of dividend shall require approval of the trustees to the issue and the lead institution, if any In the case of existing companies prior permission of the lead institution for declaring dividend exceeding 20 percent or as per the loan covenants is necessary if the company does not comply with institutional condition regarding interest and debt service coverage ratio Dividends may be distributed out of profit of particular years only after transfer of requisite amount to DRR. If residual profits after transfer to DRR are inadequate to distribute reasonable dividends, company may distribute dividend out of general reserve

Redemption

The issuer company shall redeem the debentures as per the offer document. Creation of Charge

1. 2.

3.

4.

5.

6.

The security shall be created within six months from the date of issue of debentures If for any reasons the company fails to create security within 12 months from the date of issue of debentures, the company shall be liable to pay 2 percent penal interest to debenture holders If security is not created even after 18 months, a meeting of the debenture holders shall be called within 21 days to explain the reasons thereof and the date by which the security shall be created If the issuing company proposes to create a charge for debentures of maturity of less than 18 months, it shall file with the Registrar of Companies particulars of charge under the Companies Act Where no charge is to be created on such debentures, the issuer company shall ensure compliance with the provisions of the Companies (Acceptance of Deposits) Rules, 1975, as, unsecured debentures/bonds are treated as “deposits” for purposes of these rules The proposal to create a charge or otherwise in respect of such debentures, may be disclosed in the offer document alongwith its implications

Deb t Ma rket

509

Letter of Option

A letter of option containing disclosures with regard to credit rating, debenture holder resolution, option for conversion, justification for conversion price and such other terms which the Board may prescribe from time to time shall be filed with the Board through an eligible merchant banker, in the following cases:

Roll over of NCDs and PCDs The nonconvertible portions of PCD/NCD issued by a listed company, value of which exceeds Rs. 50 lakhs, can be rolled over without change in the interest rate subject to the following conditions: a. An option shall be compulsorily given to debenture holders to redeem the debentures as per the terms of the offer document b. Roll over shall be done only in cases where debenture holders have sent their positive consent and not on the basis of the nonreceipt of their negative reply c. Before roll over of any NCDs or non-convertible portion of the PCDs, a fresh credit rating shall be obtained within a period of six months prior to the due date of redemption and communicated to debenture holders d. Fresh trust deed shall be executed at the time of such roll over and fresh security shall be created in respect of such debentures to be rolled over where the existing trust deed or the security documents provide for continuance of the security till redemption of debentures fresh security may not be created Conversion of instruments into equity capital a. In case, the convertible portion of any instrument such as PCDs, FCDs, etc issued by a listed company, value of which exceeds Rs. 50 lakhs and whose conversion price was not fixed at the time of issue, holders of such instruments shall be given a compulsory option of not converting into equity capital b. Conversion shall be done only in cases where instrument holders have sent their positive consent and not on the basis of the nonreceipt of their negative reply c. Where issues are made and cap price with justification thereon, is fixed beforehand in respect of any instruments by the issuer and disclosed to the investors before issue, it will not be necessary to give option to the instrument holder for converting the instruments into equity capital within the cap price

510 Capi tal Markets

d.

In cases where an option is to be given to such instrument holders and if any instrument holder does not exercise the option to convert the debentures into equity at a price determined in the general meeting of the shareholders, the company shall redeem that part of debenture at a price which shall not be less than its face value, within one month from the last date by which option is to be exercised. The provisions above shall not apply if such redemption is to be made in accordance with the terms of the issue originally stated

Conversion of debentures issued under consent of CCI a. In case, the value of convertible portion of any instrument such as PCDs, FCDs, etc issued by a listed company exceeds Rs. 50 Lakhs and where in terms of the consent issued by the Controller of Capital Issues, the price of conversion of PCDs/FCDs is to be determined at a later date by the Controller b. Such price and the timing of conversion shall be determined at a general meeting of the shareholders subject to the consent of the holders of PCDs/FCDs; for the conversion, terms shall be obtained individually and conversion will be given effect to only if the concerned debenture holders send their positive consent and not on the basis of non-receipt of their negative reply c. Such holders of debentures, who do not give such consent, shall be given an option to get the convertible portion of debentures redeemed or repurchased by the company at a price, which shall not be less than face value of the debentures d. Where the consent from the Controller of Capital Issues stipulates cap price for conversion of FCDs/ PCDs, the board of the company may determine the price at which the debentures may be converted e. In case of issue of debentures fully or partly convertible made in the past and where the conversion was to be made at a price to be determined by the CCI at a later date, the price of conversion and time of conversion shall be determined by the issuer company in a meeting of the debenture holders, subject to the following: 1. The decision in the said meeting of debenture holders may be ratified by the shareholders in their meeting 2. Such conversions shall be optional for acceptance on the part of individual debenture holders

Deb t Ma rket

511

3.

f.

g.

The dissenting debenture holders shall have the right to continue as debenture holders if the terms of conversions are not acceptable to them Where issue of PCDs and FCDs is made pursuant to the consent given by the Controller of Capital Issues and the consent specifies the timing of conversion but the price of conversion of PCDs/ FCDs is to be determined at a later date, the following shall be complied with: 1. The consent of the shareholders is to be obtained only for the purposes of fixing the price of conversion and not for the pre-poning and postponing the timing of the conversion approved by CCI 2. The conversion price shall be reasonable (in comparison with previous conversion price where the terms of the issue provide for more than one conversion) and the conversion price shall not exceed the face value of that part of the convertible debenture, which is to be converted 3. In cases where an option is to be given to the debenture holders and, if any debenture holder does not exercise the option to convert the debentures into equity at a price determined in the general meeting of the shareholders, the company shall redeem that part of debenture at a price which shall not be less than its face value within one month from the last date by which option is to be exercised In cases of issues of debentures fully or partly convertible, irrespective of value made in the past, where conversion was to be made at a price to be determined by CCI and the consent order does not provide for a specific premium or a cap price for conversion, the draft letter of option to the debenture holders filed with the Board shall contain justification for the conversion price

Othe r Re qu ir em en ts

1.

2.

No company shall issue FCDs having a conversion period of more than 36 months, unless conversion is made optional with “put” and “call” option If the conversion takes place at or after 18 months from the date of allotment, but before 36 months, any conversion in part or whole of the debenture shall be optional at the hands of the debenture holder

512 Capi tal Markets

3.

4. 5.

No issue of debentures by an issuer company shall be made for acquisition of shares or providing loan to any company belonging to the same group and this shall not apply to the issue of fully convertible debentures providing conversion within a period of 18 months Premium amount and time of conversion shall be determined by the issuer company and disclosed The issuer company can freely determine the interest rate for debentures

Additional Disclosures

The offer document shall contain the following additional disclosures: 1. Premium amount on conversion, time of conversion 2. In case of PCDs/NCDs, redemption amount, period of maturity, yield on redemption of the PCDs/NCDs 3. Full information relating to the terms of offer or purchase including the name(s) of the party offering to purchase the khokhas (nonconvertible portion of PCDs) 4. The discount at which such offer is made and the effective price for the investor as a result of such discount 5. The existing and future equity and long-term debt ratio 6. Servicing behavior on existing debentures, payment of due interest on due dates on term loans and debentures 7. That the certificate from a financial institution or bankers about their no objection for a second or pari passu charge being created in favor of the trustees to the proposed debenture issues has been obtained REVIEW QUESTIONS Section A

1. 2. 3. 4. 5. 6. 7. 8. 9.

What is a debt market? What is bond yield? What is a wholesale debt market? What is a retail debt market? What is a ‘repo’? What is a ‘reverse repo’? State the concept of ‘broken period interest’ Who are debenture trustees? How is ‘debenture redemption reserve’ created?

Deb t Ma rket

513

Section B

1. 2. 3. 4. 5. 6. 7.

What are the advantages of a debt market? Bring out the types of risk associated with the debt as a financial instrument. What are the various types of debt instruments? State the role of debt market in the economic development of a country. How is the price of a debt instrument determined? Explain the working mechanism of wholesale debt market. What are the SEBI guidelines relating to the issue of debt instruments by a corporate entity?

Index A A cap 104 A floor 104 Abid Hussain Committee 51 Acceptance 11 Account freezing 455 Ad-hoc margins 436 Additional market-makers 348 Additional market-making 356 Additional trading Floors 481 Additional volatility margins 436 Adjustable rate mortgage (ARM) 12 Advisory services 250 Ahmedabad Shares and Stock Brokers Association 178 Alternative Trading System 478 American Civil War 166 American Depository Receipts (ADRs) 265 American option 104 American Stock Exchange 11, 176 Amex 176 Amex Composite Index 403 Application Acknowledgement Slip 361 Arbitrage 108, 418 Arbitrageurs 108, 230 Arbitration 146 Ariel 18 Ask price 199 Asset Backed Securities 59 Asset Management Companies (AMCs) 39, 74

Association of Mutual Funds of India (AMFI) 40 Association of Securities 177 At-the-money option 104 Atlay Committee 420 Auction markets 16 Auction Tender Notice 224 Auction Trading System 196 Audit Committee 443 Australian Stock Exchange Ltd’ (ASX) 177 Authorized clerks 182 Automated Lending and Borrowing Mechanism (ALBM), 443 Automatic daily margin 436 B B.D. Shah Committee 438 B2 group 37 Backwardation 438 Backwardation charge 475 Bad Delivery 364 Badla 39, 433 Badla system 437 Bank draft 11 Bank of Bengal 166 Bank of Bombay 166 Bankers 11 Bankers Receipts (BR) 35 Bankers to an issue 277 Banking system 13 Banks’ exposure 442 Basle Committee 120 Bear 474

516 Capi tal Markets

Bear raid 475 Bearer debentures 55 Bearish 474 Bengal Bonded Warehouse 166 Best Governing Practices 133 Best Rate Order 430 Bid analysis 262 Bid price 199 Bid-ask bounce 395 Bids 261 Birla Committee of Corporate Governance 303 BL – 250 index 388 Blank transfer 419 Blue Chip companies 354 Bolsa de Madrid 176 BOLT (BSE-On-Line-Trading) 218 Bombay Forward Contracts Control Act 78 Bombay On Line Trading (BOLT) 77 Bombay Securities Control (BSCC) 78 Bombay Stock Exchange 7, 165 Bond market 502 Bonds 14 Bonus Issues Method 259 Bonus shares 259 Book closure 435 Book-building 38, 323 Book-building Method 261 Book-runner 261 Bought-out deal 266, 318 Broken period interest 505 Broker 11, 183, 415 Broker-dealer 199 Brokerage firms 9 Brokers and jobbers 183 Brokers to the issue 279 Brokers/ dealers 17 BSE 37 BSE BANKEX 389 BSE National Index 378 BSE SENSEX 65 BSE TECk 378 BSE-PSU Index 378

BSE-SENSEX 378 Building Investor Confidence 134 Bull 473 Bull operator 437 Bulldog Market 19 Buyouts 34

C ‘C’ group scrip 219 C-STAR (CSE Screen Based Trading And Reporting) 231 Calcutta Stock Exchange 230 Calcutta Stock Exchange Association 178, 231 Call option 103, 417 Call option contract 103 Campus LANS 228 Cancel the certificate of registration 284 Capital gains bond 65 Capital Issues Advisory Committee 79 Capital Issues Control Act 79 Capital market 6, 21, 69 Capital market instruments 47 Capital Redemption Reserve Account 48 Carry-over margin 436 Cash Reserve Ratio (CRR) 14 CCIL 504 Central Bank 14 Central clearing banks 359 Central Depository services Ltd 448 Central Depository Trust 88 Certificate of Accruals on Treasury Securities (CATSs) 61 Certificates of Deposit 354 Chartered 166 Chukada 226 Circuit breaker 37 Circuit filters 215, 443 Clause 49 134 Clearing Corporation 195 Clearing Houses 418, 483

I n d ex

Closing prices 219 CM (Clearing Member) 222 CNX Nifty Junior 391 Collar 104 Collateral security 14 Collective Investment Schemes (CIS) 126 Commercial paper 10 Commercial paper market 10 Committee on Corporate Governance 37 Commodity exchange 174 Commodity linked bonds 34 Companies Act in 1850 178 Companies formed by conversion of partnership firm 294 Company Fixed Deposits 53 Compensation Committee 264 Composite Index to Market Capitalization 372 Composite issues 293 Compulsory market-making 355 Compulsory Rolling Settlement (CRS) Segment 219 Computer-to-Computer Link (CTCL) 239 Confirmation Memo 143 Confirmation memo - Form ‘C 143 Connected Persons 158 Contact note 431 Contango 438 Contango charge 474 Contract Note - Form ‘A 143 Contract Note - Form ‘B 143 Contract notes 488 Convertible Debentures 56 Copenhagen Stock Exchange 176 Cornering 419 Corporate bond 12 Corporate equity 11 Corporate securities 28 Corporate stock 5 Council of Associated Stock Exchanges 176 Counter deals 359

517

Counter party default 195 Counter receipt 350, 359, 360 Counter-party risk 500 Credit lines 12 Credit rating 506 Credit Rating Information and Services India Limit 31 Credit risk 500 Credit unions 8 Cross Deal Module 504 Cross Deals 504 Currency Swaps 98 Customer’s Protection Fund (CPF) 147

D Daily margins 436 Dave Committee 343, 349, 356 Dealer Trading System 197 Dealers 185 Debenture Redemption Reserves 507 Debenture Trustees 281 Debentures 14, 55 Debentures and Bonds 55 DebtMarket(WDM)7, 233, 499 Debt portfolio 110 Debt securities 14 Deemed Connected Persons 158 Deep Discount Bonds 33 Default Risk 500 Defaulters committee (DC), 147, 148 Defence of India (DOI) 79 Defence of India Rule 94-C 78 Delhi Regional Clearing House 77 Delivery and Receive Orders 225 Delivery Instruction Slip 457 Delivery out 144, 222 Delivery-versus-Payments 245 Demat account 144, 455 Dematerialization 447, 450 Department of Company Affairs (DCA) 41

518 Capi tal Markets

Department of Economic Affairs 265 Depositories Act, 1996 32, 140 Depository 26, 447 Depository institutions 8 Depository market 8 Depository Participant (DP) 144, 222, 448 Depository Participants (DPs) 280 Depository services 447 Derivative 92 Derivatives 37, 91 Derivatives Policy Group (DPG) 120 Derivatives Trading 229 Detachable warrants 50 Development Financial Institutions (DFIs) 15, 40 Differential pricing 291 Director General of Technical Development 80 Directorate of Stock Exchanges 425 Discount houses, acceptance houses, bill market, 6 Dividends 11 Docking Company 166 Domestic arbitrage 418 Domestic market 19 Double option 417 Dow Jones Global Indices 375 Dow Jones Industrial Average 397 Draft prospectus 262, 329 DRR 507 Due diligence certificate 273

E E-Commerce Act 494 E-IPO 492 East India Company 166, 178 ECNs (Electronic Communication Network) 484 Electronic book 227 Electronic Commerce Act 494 Electronic Data Information Filing and Retrieval 39 Electronic Fund Transfer System 43

Electronic Trade Confirmation (ETC) 488 Electronic Trading 451 Electronic transmission 497 Eleventh day 263 Employees Stock Option Scheme 264 Empress Maria Theresa 175 Encash bond 65 Enforceability risk 119 Englishman 166 ‘Equipref’ Shares 33 Equity 14 Equity financing 29 Equity market 7 Equity Shares 49 Escrow account (Primary issue account 257 Euro Convertible Bonds 62 Euro currency market 58 Euro Issues 34 Euro market 19 Eurobond Market 7 Eurobonds 7 European Deposit Receipts 34 European option 104 European Stock Exchange 34 Exchange Traded Fund (ETF) 241 Exchange-traded options 34 Exclusive Listing 348 Exit Route Scheme 219 Export-Import Bank of India (EXIM Bank) 16 External market 19

F Factoring 30 FCDs 511 Federal Reserve Board of US 427 Federation of Indian Stock Exchanges (FISE) 42 Fee-based activity 318 FII route 37 Financial assets 8

I n d ex

Financial capital 13 Financial instruments 9 Financial market 1 Financial risk 91 Financial sector liberalization 26 Financial security 14 Financial services market 7 Financial swaps 96 Firm allotment 261 Firm Underwriting 309 Fixed rate payer 98 Fixed-rate 12 Fixed-rate mortgage 12 Flat margin 439 Floating rate bonds 58, 61 Floor price 323 Foreign arbitrage 418 Foreign Currency Convertible Bonds (FCCBs) 26, 34 Foreign market 19 Foreign Venture Capital Investors (FVCIs) 38 FORTUNE 500 Index 404 Forward contracts 95 Forward dealing 420 Forward delivery contract 417 Forward Rate Agreement (FRA) 100 Frank Russell - 3000 Index 404 Fully Fault Tolerant Stratus Machine 373 Fund-based activity 266, 318 Fungible 460 Futures and options 349 Futures contracts 100

G G.S. Patel Committee (GSPC) 87,439 Gambling 471 General Insurance Corp. of India (GIC) 200 Geneva 176 Gerstenberg 309 Gestation period 321 GILT 504

519

Gilt-Edged Market 27 Gilts 354 Global Depository Receipts (GDRs) 26, 34, 265 Global Finance Diary 376 Gorwala Committee 81, 420 Government securities 15 Government Securities market 27 Graded margin system 437 Graded system of market making 356 Green field ventures 200 Grey market 321

H Half commission men 182 Hand delivery 431 Harshad factor 35 HCL, Comment 373 Hedge 98 Hedgers 108, 230 Hedging 417 House requirements 427 Hybrid trading system 197

I IDBI 16 Immediate or Cancel Order 430 Implicit interest 10 In-the-money option 104 Income Bonds 59 Index bond 65 Index Committee 379 Index Divisor 380 Index funds 242 Index options 38 Indexed Bonds 60 India Index Services Limited 411 Indian Money Market 13 Indian Stock Exchanges Services Corporation (ISES) 42 Indigenous bankers and moneylenders 14 Industrial Credit and Investment Corporation of India 313

520 Capi tal Markets

Industrial Development Bank of India 313 Industrial Finance Corporation of India (IFCI) 15 Industrial securities 15 Industrial Securities Market 28 Information Systems Department (ISD) 220, 221 Infrastructure bonds 65 Infrastructure Development Finance Corporation 290 Infrastructure Leasing and Financing Services Ltd. 290 Initial 256 Initial Counter Receipt 361 Initial listing 301 Initial margin 427 Initial Public Offer (IPO) 227, 256 Initial Public Offering (IPO) 491 Initiated debentures 355 Insider Information 158 Insider trading 70, 157 Insider Trading Menace 187 Institute of Chartered Accountants of India (ICAI) 288 Insurance 8 Integrated stock exchange system 42 Interconnected Stock Exchange of India 203 Interest rate risk 500 Interest rate swaps 98 Internal market 19 International 120 International Association of Insurance Supervisors 120 International market 19 International Organization of Securities Commission 39, 135 International Securities Consultancy (ISC) 233 Internet 477 Internet Stock Trading 477 Internet Trading 477 Investigative services 250 Investment Committee 443 Investment companies 313

Investment Corporation of India Ltd 313 Investor Awareness Program 148 Investor protection 139 Investor Service Cell 232 Investors 472 Investor’s Grievance Redressal Committee 146 Investor’s or Customer’s Protection Fund 147 Investors’ Services Cell (ISC) 141, 142, 145 Invest OTC Card 347 IPOs 492 IRR 503 Irredeemable Debentures 56

J J.R. Varma Committee 440 Jobbers 184, 415 Joint underwriting 310 Junk Bonds 60

K K.B.Chandrasekhar Report on Venture Capital Funds 37 Kerb deals 482 kerb trading 425, 430 KLD-NASDAQ Social Index 402 Kumar Mangalam Birla Report 37, 133

L Lame duck 475 Last-in-first 296 Lead book runner 328 Lead Merchant Banker 258, 288 Legal risk 119 Letter of credit 11 Letter of offer 258 Letter of option 509 Level I subscribers 368 Level II subscribers 368

I n d ex

521

Level III subscribers 368 Leveraged Buyout (LBO) 60 LIBOR 58, 99 Life Insurance Corporation of India 313 Limit order 430 Limited Discretionary Order 430 Listed debt 353 Listed equity 349, 353 Listed mutual funds 354 Listed securities 16 Listing 299 Listing agreement 39, 300, 304 Loan associations 8 Local Area Bank 289 Lock-in periods 318 Lock-in requirements 297 London Stock Exchange 176 Long position 103, 199

Memorandum of Association 50 Merchant bankers or lead managers 271 Mid-cap companies 346 Milan Stock Exchange 175 Minimum Public offer 212 Model Rules for stock exchanges 39 Modified Carry-forward System 440 Money market instruments 9 Money market m utual funds 9 Morison Committee 420 Mortgage 12 Mortgage loans 8 Municipal bonds 13 Mutual associations 8 Mutual Fund Service System (MFSS) 243 Mutual Funds 30 Mutual savings banks 8

M

N

M.J. Pherwani Committee 88 Maintenance margin 428 Malegam Committee 89 Managing agency system 314 Mandiwala 474 Margin 418, 435 Margin account 426 Margin agreement 428 Margin call 428 Margin Trading 198, 418, 425 Margining system 39 Market Capitalization-Weighted I ndex 379 Market risk 112 Market Surveillance 132 Market Surveillance Division 132 Market Trade 452 Market- makers 197, 199, 345 Market-making 355 Matador market 19 Materialization 450 Maximum brokerage 143

Napoleon of Finance 166 Narasimham Committee 88 NASDAQ 1, 176, 343, 368, 386, 482 NASDAQ Bank Index 401 NASDAQ Biotechnology Index 401 NASDAQ Composite Index 400 NASDAQ Computer Index 401 NASDAQ Financial-100 Index 400 NASDAQ Industrial Index 401 NASDAQ National Market Composite Index 400 NASDAQ National Market Industrial Index 401 NASDAQ Telecommunications Index 402 NASDAQ Transportation Index 402 NASDAQ-100 Index 398 NASSCOM 371 National 19, 177 National Bank for Agriculture 16 National Clearing and Settlement Corporation 88 National Depository System 32

522 Capi tal Markets

National Securities Clearing Corporation Limited 77, 372 National Securities Depositories Limited (NSDL) 372, 448 National Stock Exchange (NSE)16, 261, 368 National Stock Exchange System 88 National Stock Market System 201 Nationalized banks 14 Native Shares and Stock Brokers Association 178 Negotiated Deal Module 504 Net Asset Value (NAV) 40, 80 Net offer to the public 262 New Issues Market (NIM) 28 New York Stock Exchange (NYSE) 1, 176, 434 Next Part XIII 86 NIM 249 No Complaints Certificate 258 Non-banking institutions 15 Non-convertible debenture (NCD) 32, 56 Non-depository market 8 Non-listing 306 Non-scheduled banks 13 Non-specified list 433 Non-specified Securities 433 Non-voting equity shares 51 NSDL 32 NYSE Composite Index 405

O OASIS system 371 Objection Cycle 226 Odd-lot securities 434 Off-balance sheet activity 91 Off-market transactions 221 Offshore market 19 Ombudsman 149 On Banking Supervision 120 On-line Real Time (OLRT) Surveillance System 216 On-line Stock Trading 477

Open Order 430 Operational risk 118 Option 1, 103 Option dealings 417 Order Execution 430 Order Grabbing System 504 Order Placing 430 Order Routing System (ORS) 477, 479 Organization of Securities Commissions (IOSCO) 120 Organized money market 14 Origination 250 Oslo Stock Exchange 176 OTCEI 343 Out-of-the-money option 104 Over the Counter Exchange of India (OTCEI) 29, 136, 261 Over-the-Counter (OTC) 1, 120, 345 Over-the-Counter Contracts 482 Over-the-Counter Exchanges 16 Overall margin 436 Ownership securities 14

P Par value 50 Par Value and Book Value 50 Parallel loans 96 Parallel trading 370 Participating debentures 57 Patel Committee Report 82 Pay-in of funds 223 Pay-in-date 262 PCDs 511 Pension funds 9 Permanent Counter Receipt (PCR), Sales Confirmatio 350, 361 Permitted debentures 349 Permitted equity 349 Permitted group 231 Permitted securities 219 Pherwani committee 32, 201 Placement portion category 261 Pledging 453 Pool account 223

I n d ex

Port Trusts, Improvement Trusts, State Electricity 15 Portfolio manager 75 Post-dated cheque 11 Preference shares 14, 47 Preliminary prospectus 256 Premium-hunter 475 Price band 262, 323 Price discovery function 94 Price discovery process 3 Price rigging 50 Price risks 91, 500 Primary debt market 7 Primary Insiders 157 Primary market 4, 28, 249 Principal centers 13 Private placement 49, 266, 319 Private Placement Method 255 Private Sector Banks 289 Procedures 433 Profit Earning Capacity Value (PECV) 80 Promoters’ contribution 293, 295 Proprietary interest 59 Prospectus 253, 490 PSU Bonds, Commercial Paper 354 Public issue by unlisted companies 293 Public Offer (IPO) 256 Public sector banks 14 Pucca Sauda Book 431 Purchase Confirmation Slips (PCSs) 364 Pure Prospectus Method 253 Put and call option 417 Put option 103, 417 Put option contract 103

Q Qualified Institutional Buyers (QIBs) 38 Qualified participants (QPs) 370

523

R Raging Speculation 186 Ready delivery contract 78, 417 Recognized Stock Exchange 299, 300, 479 Red herring 256 Redeemable debentures 56 Regional Rural Banks (RRBs) 14 Regional Stock Exchange (RSE) 288 Registrar of Companies (ROC) 288 Registrars and Custodians 359 Registrars to an Issue 280 Registration 277 Reinvestment rate risk 500 Rematerialization 451 Rembrandt market 19 Remisiers 182 Renaissance 175 Repo 10, 504 Repo trade 504, 505 Repo transaction 505 Report of the Joint Task Force of the Committee on 39 Repurchase agreement 10 Reserve Bank of India 14 Retirement Bonds 64 Reverse book-building 338 Reverse repo 505 Revised Forward Trading System 439 Rigging the market 419 Rights Issue Method 257 Rights of Investors 141 Rights renunciations 219 Ring-less trading 347 Risk Capital Foundation of IFCI, Venture Fund of IDBI 30 Rolling settlement 37, 136, 434 Rolling T+3 settlement system 364 Rural banking 14

S S&P 100 Index 405 S&P 500 Index 405, 406

524 Capi tal Markets

S&P CNX Defty 391 S&P CNX Nifty 390 S&P Global 1200 406 Sale Confirmation Slip (SCS) 361, 362 Salient features 365 Samurai market 19 Sauda sheets 433 Savings and loan associations 8 Schedule VI of the Companies Act, 1956 287 Scheduled banks 13 Scheduled commercial banks 13 SCRA 38 Screen Based Trading 136 Screen Based Trading System (SBTS) 209 Scripless trading 26 Scroll slip 222 SEBI 77, 123 Secondary debt market 7, 503 Secondary Insiders 157 Secondary market 4, 5, 29, 251 Section 205 287 Section 205 (3) 259 Secured debentures 56 Secured Premium Notes (SPN) 57, 61 Securities and Exchange Commission (SEC) 77 Securities Appellate Tribunal (SAT) 128 Securities Contracts (Regulation) Act, 1956 38, 81, 343 Securities Exchange Act, 1934 77 Securities Lending Scheme 438 Securities market 6, 21 Securities pay-in 223 Securities Trading Corporation of India Ltd 202 Security listing 299 Self-certification 439 Sensex 229 Sensex futures 229 Sensex Index 229 Settlement guarantee mechanism 195

Settlement risk 117, 118 Settlement Systems (CPSS) 39 SFCs Act 15 Shall be disclosed 506 Share mania 167 Share transfer 431 Share transfer agents 280 Shelf registration 34 Short position 103 Short selling 438 Short-sellers 419 Shri Kalyanasundaram Committee 30 SIDCs 16 Single jobber 431 Single Window Service 455 Small Corporates Offering Registration (SCOR) 491 Small investors 139 Souda books 232 South Sea Bubble 167 Specialist 196, 198 Specified or special delivery 431 Specified securities 432 Speculation 471 Speculators 108, 230, 472, 473 Sponsorship 356 Spot delivery 431 Spot delivery contract 416 Spread 199 Spring Street Brewery IPO 492 Stag 475 State Bank of India 14 State Cooperative Banks 13 State Financial Corporations 314 State Industrial Development Corporations (SIDCs) 38 Statement in lieu of prospectus 318 Statutory Liquidity Ratio (SLR), Credit Authorizat 14 Stock Exchange 16, 165, 174, 299 Stock Exchange of Singapore (SES) 488 Stock Exchanges of Great Britain and Ireland 176 Stock futures 38

I n d ex

Stock Holding Corporation of India 88 Stock Market Index 375 Stock option 38, 264 Stock scams 41 Stock-lending 438 Stockholders, bondholders 12 Stockinvest 33 Stop Loss Order 430 Sub-markets 6 Sub-underwriting 310, 317 Subsidiary General Ledger 245 Suspend the certificate of registration 283 Swap spread 99 Swaps 96 Swaption 104 Syndicate underwriting 310 Systemic risk 119

T T – notes 10 T + 5 434 T+3 39 T+3 basis 221 T+3 in Rolling Settlements 224 T-bills 10 Tarawaniwalas 184, 185, 415, 431 Tax Free Bonds 65 TCS (Tata Consultancy Services) 16 TDICI, RCTC and TFCI 25 TECK mark 386 Tejiwala 473 Temporary Counter Receipt (TCR) 350 The English Man 230 The National Stock Exchange of India Limited 233 The Native Share and Stockbrokers Association 210 Third Market 17 Threadneedle Street 176 TMT sectors 384 Tokyo Stock Exchange 176, 210

525

Tradable Warrants 58 Trade Guarantee Fund 148, 483 Trader Work Stations (TWSs) 218, 228 Transactional exposure 110 Transfer Deed (TD) 359, 361, 419, 431 Transfer form 419 Transferred Permanent Counter Receipt 361 Transmission 453 Transnational corporations 109 Transposition 453 Treasury bills 8, 10 Treasury bonds 10 Treasury Investment Growth Receipts’ (TIGRs) 60 Trustee Companies 39 Tulip mania 167 Turn 184 Twin-track system 440 Two ratings from two different credit rating 506

U U.S. Treasury bills 9 Under-pricing 80 Under-subscription 263 Underlying asset 92 Underwriter 275, 309, 315 Underwriting agencies 313 Underwriting agreement 309, 312, 316 Underwriting commission 309, 317 Union list 81 Unit Trust of India 313 Unit-64, Monthly Income Plan, and IISFUS ’97 354 United East India Company 175 Universal Accounting Practices 38 Unlisted securities 346 Unorganized markets 13 Unorganized money market 14 Unsecured or naked debentures 56

526 Capi tal Markets

V

Y

Vaghul Committee 30 Valid Contract Note 143 Value-at-Risk (VaR) 244 Venture capital financing 29 Vienna Stock Exchange 175 voluntary market-making 356 VSATs (Very Small Aperture Terminals) 43, 228, 350, 373 Vyaj-badla 440

Yankee market 19 Yield of bond 503 Yield refers 503 Yield to Maturity (YTM) 503

W Wall Street 1 Warrants 54 Wash Sales 419 Wholesale 233 Wholesale debt market 503 World War II 78

Z Z category 145 Z Group 215 Zero Coupon Bonds 60 Zero Coupon Yield Curve (ZCYC) 244 Zero interest FCDs 58 Zero-interest Fully Convertible Debentures 58 ZEROs 61