Introduction to the Financial System

What this chapter covers

This chapter carries about 5 per cent of the III-C examination, and it is the map of everything the rest of the syllabus regulates.

LEARNING OBJECTIVES: After studying this chapter, you should know about the following components of financial system: Financial Market · Financial Markets Infrastructure Institutions (MIIs) · Financial Intermediaries · Financial Securities

1.1 The financial system

The Financial System refers to the entire set of institutionalized arrangements by which funds are transferred from surplus units to deficit units at terms acceptable to both sides.

Who is who: households as a sector represent the surplus unit, whereas corporations and governments collectively represent deficit units.

And what it is made of: an efficient financial system plays an important role in economic development and it consists of financial market, financial instruments and financial intermediaries.

Three components — market, instruments, intermediaries — which is exactly how this chapter is organised, and why the first review question answers Financial Markets.

What it does: the role of the financial system is to gather or pool money from surplus units i.e., people and businesses that have more than they need currently and transmit or allocate those funds to deficit units i.e., those who can use them for investment. A larger flow of funds and efficient allocation of them leads to better economic output and welfare of the economy and society.

And how well it must do it: the financial market should also function efficiently and at a minimal cost in cooperation with the other constituents of the financial system.

1.1.1 Financial markets

A Financial Market can be defined as the market in which financial assets such as equities, bonds, currencies and derivatives are created or transferred. It is a mechanism that allows traders to deal in financial securities, commodities, etc., at low costs, which reflects the efficiency of the market.

Note "created or transferred" — that single phrase contains the primary and secondary market distinction.

Money market. Money market is a market for financial assets that are close substitutes for money. It is a market for short term funds and instruments having a maturity period of one or less than one year. Money market provides short term debt financing and investment.

What trades there: bankers' acceptances, Negotiable Certificates of Deposit (NCDs), repos, and Treasury Bills (T-bills), call/notice money market, and commercial papers.

Capital market. Capital market is a market for securities, where business enterprises and government can raise long term funds. It is generally defined as a market in which money is provided for periods longer than a year.

It splits in two: the Stock Market, which helps in raising funds through the issue of shares or stock, and the Bond Market, which helps in raising funds through the issue of bonds. Bonds in India are issued by the Government (both State and Central), Corporations, and Municipal Bodies. And capital markets also provide the mechanism for the subsequent trading of stocks and bonds.

Primary and secondary. Both the capital market and the money market have two interdependent and inseparable segments, the primary market and the secondary market.

The primary market is used by issuers for raising fresh capital from investors by making initial public offerings or rights issues, or offers for sale of equity or debt; on the other hand, the secondary market provides liquidity to these instruments through trading and settlement on the stock exchanges.

Why one needs the other: an active secondary market promotes the growth of the primary market and capital formation since the investors in the primary market are assured of a continuous market where they have an option to liquidate their investments.

And the neat contrast: in the primary market, the issuer has direct contact with the investor, while in the secondary market, the dealings are between two investors, and the issuer does not come into the picture.

Three more markets complete the set.

The Forex market deals with multicurrency requirements, which are met by the exchange of currencies. Depending on the applicable exchange rate, the transfer of funds takes place in this market. This is one of the most developed and integrated markets across the globe.

Credit market is a place where banks, Financial Institutions (FIs), and Non-Banking Financial Companies (NBFCs) provide short, medium, and long-term loans to corporates and individuals.

Insurance market facilitates the transfer of various risks from individuals, business houses, and bodies corporate to insurance companies.

1.2 Market Infrastructure Institutions

Depositories are institutions that hold securities of investors in electronic (dematerialized) form, for a fee. The investors remain the beneficial owners of the securities.

The investor keeps beneficial ownership — the depository merely holds.

A Depository Participant (DP) is the registered agent of the Depository concerned, and it is through the DP that an investor gets the services of the depository. It can be compared to a branch of a bank where individuals maintain their savings accounts. The DP interacts with the investor and furnishes the record pertaining to an investor's portfolio. The DP also facilitates the release of securities when sold, or the recording of securities when bought or obtained on allotment.

Stock Exchanges are an important constituent of the secondary market of the Capital Market. Stock Exchange means a body of individuals or a body incorporated under the Companies Act to assist, regulate, or control the business of buying, selling, or dealing in securities.

Clearing Corporation is an entity that is established to undertake the activity of clearing and settlement of trades in securities or other instruments or products that dealt with or traded on a recognized stock exchange and includes a clearing house and a limited purpose clearing corporation.

The limited purpose clearing corporation details are specified under Chapter IV-A of Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2018.

Social Stock Exchange is a newly introduced concept by SEBI in India. As per SEBI ICDR Regulations, 2018, Social Stock Exchange is a separate segment of a recognized stock exchange having nationwide trading terminals permitted to register Not for Profit Organizations (NPOs) and/or list the securities issued by Not for Profit Organizations in accordance with provisions of these regulations.

A separate segment, not a separate exchange — and it registers NPOs as well as listing what they issue.

1.3 Financial intermediaries

A large variety and number of intermediaries provide intermediation services in the Indian securities market. They are the entities who are involved in the business of managing individual portfolios, executing orders, dealing in or distributing securities etc.

Merchant Bankers are entities that specialize in assisting companies to originate issues of securities, their assistance covering advising the client on the timing of an issue and advising the company on the selection of underwriters, brokers, bankers and others, e.g., drafting the prospectus and verifying the accuracy of the claims made therein interacting with regulators/exchanges.

Bankers to Issues are scheduled banks that are engaged by companies to accept application money, allotment or call money, undertake refund of application money and pay dividend or interest warrants.

Registrars and Share Transfer Agents are persons registered under the SEBI (Registrars to an Issue and Share Transfer Agents) Regulations, 1993. They provide services relating to a public or rights issue. It includes collating data on subscriptions to an issue, preparation of basis of allotment, crediting shares to the Demat accounts of the allottees etc.

Collating data on subscriptions is the third review question — that is the registrar, not a bank, custodian or venture capital fund.

Transfer Agents are persons that maintain record of holders of securities and deal with all matters connected with transfer or redemption of securities or incidental activities of a company so that it reflects changes in ownership of shares consequent upon trading and also handle dividend payouts and communications relating to other corporate actions.

Stock Brokers who are registered with SEBI provide different types of services which include the undertaking of secondary market transactions on behalf of their clients, that is, by executing buy or sell transactions communicated by investors. They earn a commission, commonly referred to as brokerage, and also play a role in the marketing of new issues of securities by informing and advising investors of new issues.

And the definition: according to SEBI Stock Brokers Regulations 1992, a stock broker means a person having trading rights in any recognised stock exchange and includes a trading member.

Portfolio Managers are individuals or firms that administer the portfolios of individuals or provide advice or direction to that effect, for a fee or a share in the profits or a combination of the two.

Mutual Funds are trusts that mobilize funds from investors by issuing units and undertake to invest the money in a manner consistent with the specified investment objective.

Two shapes: there are two types of investment schemes: open-end and closed-end. In the former, demand for units is met by a fresh supply, so there is no limit on the number of units that can be issued. With closed-end funds, there is a limit on the number of units that can be issued and following issuance, units are traded in the secondary market. Closed-end funds have a specified maturity, unlike open-end funds.

Custodians are entities that hold securities or gold or gold-related instruments on behalf of institutional investors, e.g., mutual funds and insurance companies. Custodians maintain and reconcile the records relating to the assets held and also monitor corporate actions such as dividend payments or rights issues on behalf of their clients. In short, custodians are mainly into trade settlement, safekeeping, benefit collection, reporting and accounting.

Safekeeping and record-keeping — the second review question.

And the crucial distinction: one point of distinction is that a Depository has the right to effect transfer of beneficial ownership while a custodian does not.

According to SEBI Custodian regulations, "custodian" means any person who carries on or proposes to carry on the business of providing custodial services.

Warehouse means any premises (including any protected place) conforming to all the requirements including manpower specified by the Authority by regulations wherein the warehouse keeper takes custody of the goods deposited by the depositor and includes a place of storage of goods under controlled conditions of temperature and humidity.

Credit Rating Agency is a body corporate that is engaged in or proposes to be engaged in, the business of rating of securities offered by a company, including fixed deposits and credit facilities.

Debenture trustee means a trustee of a trust deed for securing any issue of debentures of a body corporate. The word carries across regimes: according to Mutual Fund Regulations, trustee means the Trustee Company that holds the property of the Mutual Fund in trust for the benefit of the unit holders; and under the Alternate Investment Fund (AIF) Regulations, the Trustee is required to ensure certain compliances, for which it imposes relevant restrictions under the Fund Documents (for example, compliance with providing an exit mechanism to investors upon a material change in the PPM).

Vault Manager means any person who carries on or intends to carry on the business of providing vaulting services.

Vaulting service in relation to gold means the storage and safekeeping of gold deposited with the Vault Manager, by the depositor, for the purpose of trading in Electronic Gold Receipts (EGRs) and providing services incidental thereto, and includes utilizing the services of assayers empaneled with the Stock Exchanges for testing as per the gold standard, wherever required · coordination with depositories for creation, transfer and extinguishment of Electronic Gold Receipt · and providing deposit, storage and withdrawal services to the beneficial owners.

Where this came from. The Central Government had, in the Union Budget for 2021-22, announced that SEBI would be the regulator for gold exchanges and accordingly finance ministry had notified electronic gold receipts (EGRs), the instrument representing gold, as securities, paving the way for the launch of gold exchanges. The vault manager's obligations include accepting deposits, storage and safekeeping of gold, creation as well as withdrawal of EGR, grievance redressal and periodic reconciliation of physical gold with the records of depository.

1.4 Financial securities

According to the Securities Contracts (Regulation) Act, 1956, the term "securities" encompasses:

a) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or a pooled investment vehicle or other body corporate;

b) Derivative;

c) units or any other instrument issued by any collective investment scheme to the investors in such schemes;

d) security receipt as defined in section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

e) units or any other instrument issued by any mutual fund scheme or pooled investment vehicle;

f) any certificate or instrument (by whatever name called), issued to an investor by any issuer being a special purpose distinct entity which possesses any debt or receivable, including mortgage debt, assigned to such entity, and acknowledging beneficial interest of such investor in such debt or receivable;

g) Government securities;

h) such other instruments as may be declared by the Central Government to be securities;

i) rights or interest in securities;

j) Zero coupon zero principal instruments.

What is not there is as important as what is. Bullion appears nowhere in the list — which is the fourth review question. Gold reaches the securities market only through an Electronic Gold Receipt, which is a security because the Central Government notified it under limb (h).

And limb (j) is recent. In exercise of the powers conferred by sub-clause (iia) of clause (h) of section 2 of the SCRA, 1956... the Central Government declared "zero coupon zero principal instruments" as securities, meaning an instrument issued by a Not for Profit Organisation which shall be registered with Social Stock Exchange segment of a recognised Stock Exchange.

Derivative itself is defined widely — a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities; commodity derivatives; and such other instruments as may be declared by the Central Government to be derivatives.

The instruments

Stock means a type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.

Equity shares represent an ownership interest in a company. The claim of equity shareholders on earnings and assets (in the event of liquidation) comes last and hence is residual in nature. Equity shareholders expect to benefit from dividends and price appreciation. They have both collective and individual rights such as the right to elect directors, the right to transfer shares, attend and vote at general meetings.

Residual is the key word — last in line, and therefore the holder of the upside.

Preference shares are securities that have a preferential right to dividend and repayment of capital. These shares do not carry voting rights except when their rights are affected. These are hybrid securities as they combine features of both equity and debt. They bear dividends, similar to equities, which may or may not be paid, and offer no collateral as security. The preference shares have a finite life and the dividend is a stated per cent of par value, similar to debt securities.

Hybrid, and the reason is spelt out — dividend uncertainty and no collateral from equity; finite life and a stated rate from debt.

Debentures are debt securities having a definite life during which they pay coupon, which is interest at a specified rate on the par value, at regular intervals, typically every six months. Bonds too are debt securities with similar features except that internationally the distinguishing feature of bonds is that they are secured by specific collateral. In India, long-term debt securities issued by the Government of India or State Government or partially by any one of them are called bonds.

Warrants are long-term call options issued by a company, which give the holder the right to buy equity shares from the company at a specified price known as the subscription price or exercise price. Warrants are separately tradable and their price behaviour is linked to that of the underlying equity share.

Derivatives are financial contracts that derive their values from underlying assets or groups of assets.

Options are contracts that give the holder the right, but not the obligation, to buy or sell some underlying asset. A call option gives the right to buy the underlying at a specific price known as the exercise price or strike price; a put option gives the holder the right to sell the underlying at a specific price. A call option would be bought if the buyer expects the price of the underlying to rise, while a put option will be bought if the buyer expects the price of the underlying to decline.

The asymmetry is the point: while the holder of the option is under no obligation to perform any action, it is the writer who is obligated to perform, that is, deliver securities on exercise of a call, or make payment on exercise of a put. For granting the privilege of either buying or selling a stock, the writer receives a payment known as premium. Options positions can be offset before expiration.

Futures contracts guarantee delivery of a specific quantity of a specified asset on a specified future date, at the price currently quoted. If an investor anticipates the spot price on the delivery date to be higher than the quoted futures price today, then he or she may buy the contract hoping to make a profit. But, if an investor anticipates the spot price to be lower than today's quoted futures price, then the contract could be sold. Positions in futures contracts can be offset before the delivery date.

Index Derivatives: Futures contracts based on stock or financial index i.e., BSE Sensex or NSE Nifty 50 are known as Index Derivatives.

Exchange-traded derivative contracts are standardized in terms of the quantity, quality, time and place of delivery. They are transacted on an organised futures exchange.

Structured Products typically comprise bonds, equities, and derivatives as an underlying asset class. These products come either with Capital protection (full or partial principal return) or without capital protection features. Private banks, Wealth management firms, and NBFC (Non-Banking Financial Companies) offer structured products in India. It is typically suited for high net-worth investors who are looking for low risk and portfolio diversification for good returns.

Alternate Investment Fund (AIF) means any fund established or incorporated in India which is a privately pooled investment vehicle that collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. It is a form of a pooled-in vehicle for investing in real estate, private estate, private equity and hedge funds. AIF adds diversification to a portfolio and helps mitigate the risk.

Privately pooled, from sophisticated investors — the two features that distinguish an AIF from a mutual fund.

ADR is an acronym for American Depository Receipt which is a security denominated in US Dollars, traded at US exchanges, representing a specific number of equity shares of a foreign company that are traded in the foreign country.

GDR is an acronym for Global Depository Receipt. It is an instrument denominated in foreign currency that allows foreign investors to invest in shares of foreign companies which are listed and traded in the foreign country. As an example, a Euro-denominated GDR issued by an Indian company will have a certain number of Rupee-denominated equity shares underlying it. The GDR may trade freely in the overseas security market where it is listed. A GDR holder may opt to liquidate the investment, in which case, the underlying shares will be released for sale by the custodian in India.

IDR is an acronym for Indian Depository Receipt. It is a Rupee-denominated security which is traded in Indian stock exchanges, representing a specific number of shares of a foreign company. An IDR offers Indian investors, access to foreign securities that are listed and traded at foreign exchanges.

And a word that goes with all three: when security is termed fungible, it refers to the feature that allows an instrument to be replaced by another of a similar description, for instance, an ADR, vis-à-vis its underlying share.

Mutual Fund (MF) units represent the share of the investors/ unit holders in the assets of the scheme. The fund managers invest the money collected to try and achieve the specified investment objective.

Exchange-traded Funds (ETFs) are open-ended mutual funds that allow trading of their units throughout the day. This facility is in contrast to conventional mutual funds where buying and selling happen at the closing Net Asset Value (NAV) of the day or of the following day, depending on the precise time at which the investor placed the order. ETFs are passively managed investment options, while mutual funds are actively managed investment options.

Currency Derivatives (CDs) are contracts between buyers and sellers, whose values are derived from the underlying assets, i.e., the currency amounts. These are risk management tools in the forex and money markets.

The worked example given: an Indian exporter with Kuwaiti Dinar receipts who expects an appreciation of the Indian Rupee could buy a put option, to sell Dinar. In contrast, an Indian importer with Euro liability and expecting the foreign currency to appreciate could buy a call option on Euros. Alternatively, the Indian exporter could sell a futures contract in Kuwaiti Dinar and the Indian importer could buy a futures contract in Euros.

Currency Swaps are agreements between parties that facilitate borrowing in foreign currencies at lower costs. For instance, a British firm may need Euros while a French firm may require Pounds Sterling. However, taking comparative advantage into account, it may be a better option for the British and French firms to raise funds in their respective currencies and then enter into a swap. The principals are also re-exchanged at maturity.

Interest-rate Derivatives are contracts that enable investors or borrowers to hedge against the risk of adverse interest-rate movement. These include interest-rate futures, interest-rate swaps, interest-rate options and Forward Rate Agreements (FRAs).

Interest-rate Futures are contracts in which the underlying asset is a debt security, for example, futures on Treasury Bills (T-Bills), Commercial Papers (CP) or Government Securities. If a corporate treasurer apprehends a fall in interest rates by the time surplus funds are received, he could lock in the higher yield currently quoted by buying an interest-rate futures contract. On the other hand, if a banker fears a rise in interest rates by the time he enters the market to raise funds, he could lock in the lower rate currently quoted by selling an interest-rate futures contract.

Interest-rate Swaps are agreements between two or more parties to exchange the series of cash flows in the same currency over an agreed period of time. And the distinguishing feature: in an interest-rate swap, the principals are not exchanged — unlike a currency swap, where the principals are also re-exchanged at maturity.

Interest-rate Options... can be caps or floors. A cap is bought to limit the interest rate to a specific ceiling on floating-rate borrowings, in the event that the benchmark rate starts rising. A floor is bought to earn a minimum rate of return on floating-rate investments, in the event that the benchmark rate begins to decline.

A Forward Rate Agreement (FRA) is an over-the-counter forward contract that enables a borrower (or lender) to lock in an interest rate today for a specified borrowing (or lending) period that will begin at a predetermined time in the future. It is based on a notional principal amount, which is used only for calculating the settlement amount and is not exchanged between the parties.

The worked example: a company planning a six-month loan starting after three months and expecting rates to rise may enter a 3×9 FRA at a fixed rate of, say, 7%. At the start of the loan period the agreed fixed rate is compared with the prevailing reference rate for the six-month period. If the reference rate is higher than 7%, the seller of the FRA pays the difference to the company, thereby compensating for the higher borrowing cost. Conversely, if the reference rate is lower than 7%, the company pays the difference to the seller. The settlement is made in cash and is typically based on the present value of the interest differential.

Securities Lending and Borrowing Scheme (SLB). Short Selling means selling a stock that the seller does not own at the time of the trade. Short selling can be done by borrowing the stock through Clearing Corporations of a stock exchange that are registered as Approved Intermediaries (AIs). Short selling can be done by retail as well as institutional investors. The Securities Lending and Borrowing mechanism allows short sellers to borrow securities for making delivery.

E-warehouse receipts. Warehouse receipt means an acknowledgement in writing or in the electronic form issued by a Repository regulated by WDRA for storage of goods not owned by the warehouse keeper. E-warehouse receipts are negotiable warehouse receipts issued in electronic format.

REITs and InvITs. Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) are innovative vehicles that allow developers to monetise revenue-generating real estate and infrastructure assets while enabling investors or unit holders to invest in these assets without actually owning them.

Both sides gain: such monetization benefits developers by allowing them to release capital for funding new infrastructure/real estate projects, and provides liquidity to investors or unit holders as the units of the trust are listed on exchanges. And REITs and InvITs enjoy favourable tax treatment, including exemption from tax deduction at source for dividend distributed to REITs and InvITs.

The chapter's review questions confirm that the financial system consists of banks, non-banks and financial markets; that safekeeping and record-keeping of securities are done by custodians; that registrars collate data on subscriptions to primary issuances; and that bullion is excluded from the SCRA definition of securities.