Introduction to Capital Market — structure, products, participants and regulators

Where this chapter sits

Chapter 1 carries 7% of the NISM-Series-IX: Merchant Banking paper. It is the scene-setting chapter — the market map on which every later chapter operates.

Three things dominate: the primary/secondary split, the product classification, and which regulator does what.

Why capital markets exist

Capital Markets play a very important role in the development of the economy. It helps in allocating the unutilized resources, i.e., transfer of funds from savers to their efficient users. It provides channels for the allocation of savings to investments.

Who is in it: they consist of investors, who are the backbone of the economy, issuers, regulatory bodies, and intermediaries.

And there are two routes from savings to investment: the movement of capital in the economy from the savings pool to the investment pool is performed by two main platforms of institutional intervention: (a) the Financial institutions and banking framework, and (b) the capital market framework.

The capital market plays the primary role of a facilitator and an intermediary in raising capital and deploying the same in the economy.

1.1.1 The structure

Capital Market provides a platform for the issuers and the investors to come together. It helps the issuers to raise capital for productive deployment in creating economic wealth. At the same time, the capital market offers investment avenues to investors with an appetite for higher risks and returns as compared to savings in bank deposits.

The two divisions: Capital Market is further divided into the Primary Market and Secondary Market, whereas Money Market is classified into Organized Money Market and Unorganized Money Market.

Primary market

Primary Market is the new issue market, which provides an opportunity to issuers of securities, the Government, as well as corporations, to raise resources to meet their requirements of investments and/or discharge some obligations.

If securities are allotted to the public for the first time for the purpose of listing, it is called an Initial Public Offer (IPO).

And the follow-on: if securities are already listed and the issuer company wants to issue a further class of securities to the investors again, it is called a Further Public Offer (FPO).

IPO for the first time; FPO once already listed.

Secondary market

The Secondary Market helps in providing liquidity to the securities which has already been issued in the primary market. In this market, an investor liquidates his own investments.

And a point worth pausing on: since the securities are traded on the stock exchange and the transactions are between two investors, the issuer does not come into the picture.

The issuer receives money only in the primary market. Secondary trading changes who owns the security, not how much capital the company has.

Two mediums: Secondary Markets operate through two mediums, namely, the Over-The-Counter (OTC) market and the Exchange Traded Market.

OTC markets are the informal type of market where trades are negotiated. In this type of market, the securities are traded and settled bilaterally over the counter.

The other option of trading is through the stock exchange route, where trading and settlement are done through the stock exchanges, and the buyers and sellers may not be in touch with each other. The transaction is carried out through SEBI-registered stock brokers and/or authorised persons.

Money market

The money market is a market for financial assets that are close substitutes for money. It is typically a market for short-term funds.

Its instruments: bankers' acceptances, negotiable certificates of deposit (CDs), repos, and Treasury Bills (T-bills), call/notice money market, and commercial paper.

1.1.2 The products

Indian securities markets cover a wide range of products depending on the risk appetite of the investors. For example, if an investor wants to invest in risky products, he has the option to invest in products of the equity market, whereas a risk-averse investor can invest in bond markets, which are comparatively less risky.

The product portfolio of Indian securities markets can be broadly classified into 3 categories: a) Equity Market Products b) Derivative Market Products c) Debt Market Products.

a) Equity market products

The equity segment of the stock exchange allows trading in equity shares, convertibles, warrants, mutual funds, and exchange-traded funds (ETFs).

Equity Shares represent a form of fractional ownership in a business venture. Equity shareholders collectively own the company and also bear the risk and enjoy the rewards of ownership.

Preference Shares represent economic interest that has a superior right as compared to equity shares. Preference shareholders have first preference to receive dividends and return of their capital. Preference shares are therefore paid a fixed rate of dividend and are redeemable within a time period not exceeding 20 years.

Twenty years is the outer limit — a number worth remembering.

Convertibles are instruments that can be converted into equity shares of the issuing company. Convertibles can be issued in the form of debt instruments such as fully or partly convertible debentures or bonds. The conversion can also be structured as mandatory or at the option of the investor.

The abbreviations: Fully Convertible Debentures (FCDs), OFCDs (optional FCDs), and PCDs (Partly Convertible Debentures). And through preference shares, CPS (Convertible Preference Share) or CCPS (Cumulative CPS including dividend payable).

Warrants entitle an investor to buy equity shares after a specified time period at a given price. Warrants provide the right but not the obligation to purchase shares or other securities in the company.

And the cost of not using one: if the warrant is not exercised, the investor stands to lose the amount paid on acquisition of the warrant.

Mutual Fund pools money from numerous investors who wish to save or make investments having similar investment objectives. A fund invests the money in stocks, bonds, short-term money-market instruments, other securities or assets, or some combination of these investments, depending on the objectives of the fund.

With a risk note: there are funds that invest in equities, better known as equity MF schemes, which are considered riskier than debt mutual funds.

An Exchange Traded Fund is a fund that can invest in either all of the securities or a representative sample of securities included in the index. Its advantage: the ETFs offer a one-stop exposure to a diversified basket of securities that can be traded in real time, like an individual stock example gold exchange-traded fund.

b) Derivative market products

A Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity, or any other asset.

The derivatives segment in India allows trading in equities, currency, and commodities. There are two types of derivative instruments, viz., Futures and Options, that are traded on the Indian stock exchanges.

An index/Stock Future is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Index/Stock Options are of two types - calls and puts. Calls give the buyer the right, but not the obligation, to buy a given quantity of the underlying asset at a given price on or before a given future date. Puts give the seller the right, but not the obligation, to sell a given quantity of the underlying asset at a given price on or before a given date.

A slip in the workbook's wording. The sentence above says puts give the seller the right to sell. In the definition that follows for calls, the right sits with the buyer — and the same is true of puts: the buyer of a put holds the right to sell; the seller (writer) takes on the obligation. Answer on that basis.

Currency derivatives. Currency Derivatives trading was introduced in the Indian financial markets with the launch of currency futures trading in the USD-INR pair on the National Stock Exchange of India Limited (NSEIL) on August 29, 2008.

Currently in India, currency futures contracts are traded on four INR pairs, i.e., USDINR, EURINR, GBPINR, and JPYINR, and on three cross currency pairs, i.e., EURUSD, GBPUSD, and USDJPY, on the recognized stock exchanges.

Four INR pairs and three cross pairs — seven in all.

Commodity Derivatives markets are markets where raw or primary products are exchanged. These raw commodities are traded on regulated commodities exchanges, in which they are bought and sold on the basis of standardized contracts for a specified future date. They facilitate trading of commodities such as gold, silver, and various agricultural goods.

Interest Rate Futures trading is based on a notional 10-year coupon-bearing Government of India (GOI) security.

And it settles differently from everything else: these contracts are settled by physical delivery of deliverable grade securities using the electronic book entry system of the existing depository's viz., NSDL and CDSL, and the Public Debt Office of the Reserve Bank, unlike the cash settlement of the other derivative products.

c) Debt market products

The Debt market consists of Bond markets, which provide financing through the issuance of debentures and bonds, and enable the subsequent trading thereof. These instruments can be traded in OTC or exchange-traded markets.

In India, the debt market is broadly divided into the government securities (G-Sec) market and the corporate bond market.

Government Securities Market. The Government needs an enormous amount of money, and one of the important sources of borrowing funds is the government securities market.

Why they are safe: these securities do not carry default risk as the government guarantees the payment of interest and the repayment of principal. They are therefore referred to as gilt-edged securities.

Who issues and who buys: Government securities are issued by the central government, state government, and semi-government authorities. The major investors in this market are banks, insurance companies, provident funds, state governments, and FPIs.

And the two forms: Government securities are of two types - treasury bills and government dated securities.

Corporate Bond Market. Corporate bonds are bonds issued by firms, corporate and are issued to meet needs for expansion, modernization, restructuring operations, mergers, and acquisitions.

Its investors: banks, financial institutions, insurance companies, mutual funds, FPIs, etc. And two routes: corporations adopt either the public offering route or the private placement route.

Debentures and bonds are pure debt instruments that carry a periodic interest payment (called 'coupon') or a cumulated terminal payment without any periodic interest (called 'zero coupon').

Two protections: they are usually secured against assets of the company or other collateral, and they are also rated by one or more independent credit rating agencies, especially if they are issued through public offerings.

Plus the money market instruments: Treasury Bills, Commercial Papers, and Certificates of Deposits.

1.1.3 The participants

Issuer means any company/corporation making an offer of securities. They are the people who actually approach the market, stating their specific objectives and collecting funds from the general public by offering securities.

Investors are the persons who actually invest their funds in the securities offered by the issuer. They are broadly categorised as Retail Investors, Institutional Investors, and Non-Institutional Investors.

The retail threshold: investors investing upto Rs. Two lakh in a single public issue transaction is termed as Retail investors, whereas institutional investors comprise domestic financial institutions, mutual funds, FPIs, etc, commonly known as Qualified Institutional Buyers (QIBs).

A different threshold applies to tax-free bonds. For tax-free, secured, redeemable, and non-convertible bonds, Retail individual Investors means those individual investors, Hindu Undivided Family (through Karta), and Non Resident Indians (NRIs)... applying for upto Rupees Ten lakhs in each issue and individual investors investing more than Rupees Ten lakhs shall be classified as High Net Worth Individuals.

Rs. 2 lakh generally; Rs. 10 lakh for those particular bonds.

The intermediaries

As per the SEBI Act, 1992, intermediaries include stock brokers, share transfer agents, bankers to an issue, self-certified syndicate bank (SCSBs), trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers, mutual funds and such other intermediaries who may be associated with securities markets in any manner, depositories, depository participants, custodians of securities, credit rating agencies.

Stock Brokers are members of a stock exchange... can either be individuals or corporations. They give their advice and recommendations relating to investment opportunities to their clients... and they execute the trade on their clients' behalf on the exchange.

And a change to note: SEBI has discontinued the category of sub-broker as a market intermediary, and they have been migrated to a category known as Authorized Person and/or Trading member. An Authorised Person or "AP" means a person, individual, partnership firm, LLP or body corporate who is appointed by a stock broker (including trading member) and who provides access to the trading platform of a stock exchange as an agent of the stock broker.

Custodians provide custodial services including the safekeeping of the securities. Custodians may also be clearing members like Professional Clearing Members (PCMs), but not trading members. They settle trades on behalf of the clients of the trading members when a particular trade is assigned to them for settlement.

A custodian may clear but may not trade.

Depositories — defined under the Depositories Act, 1996, and their principal function is to provide a facility for investors to hold and transfer securities in dematerialised form.

Currently, there are two Depositories in India, Central Depository Services Limited (CDSL) and National Securities Depository Limited (NSDL).

Depository Participants (DPs) are the depository's agents, appointed by the depository with the approval of SEBI. And according to SEBI regulations, amongst others, three categories of entities, i.e., Banks, Financial Institutions, and a body corporate engaged in providing financial services, provided certain conditions are fulfilled, can become DPs.

Merchant Bankers — the subject of this whole exam — means any entity that is engaged in the business of issue management, either by making arrangements regarding selling, buying, or subscribing to securities or acting as manager, consultant, adviser, or rendering corporate advisory service in relation to such issue management.

They need to be registered with SEBI to act and perform as a Merchant Banker.

What they do: managing capital issues, managing individual funds, and advising clients on the proper valuation of securities and often the underwriting of issues.

And two further functions: Merchant Banks are also involved in conducting due diligence in connection with public offers, as well as being responsible for compliance matters under SEBI Regulations. Merchant Banks are also eligible to conduct the valuation of securities and provide independent opinions for regulatory requirements.

Others may join them: other market participants such as money-market dealers, commercial banks and financial institutions, share brokers and investment funds may also obtain separate registration as Merchant Bankers.

Registrars and Transfer Agents. Registrars to an issue are entities, who on behalf of any Body Corporate collect applications from investors in respect of an issue, keep proper record of applications and monies received from investors and assists body corporate to determine basis of allotment, process and despatch allotment letters, refund orders or certificates in respect of an issue.

Share transfer agents maintain the record of holders of securities issued by such a body corporate and deal with all matters connected with the transfer and redemption of its securities.

And an in-house option, with a threshold: a share transfer agent can also be a department or division (by whatever name called) of a body corporate performing the above activities if, at any time, the total number of holders of securities issued exceeds one lakh.

SCSBs are bankers to an Issue registered with the SEBI, which offers the facility of Application Supported by Blocked Amount.

And who else may take applications: in addition to the Self Certified Syndicate Banks (SCSBs), Syndicate Members and Registered Brokers of Stock exchanges, the Registrars to an Issue and share transfer Agents (RTAs) and Depository Participants (DPs) registered with SEBI are also permitted to accept application forms (both physical as well as online) in public issues.

1.1.4 The regulators

In order to have effective functioning and proper development of the market, there is a need for a regulator. Amongst other tasks, the first and foremost task of the regulator would be to protect the interests of investors and to ensure that there is no violation of rules and regulations.

And overlap is expected: in India, securities markets are regulated by different regulators, and hence, there may be instances where there is a regulatory overlap.

SEBI — the securities market regulator. Under the SEBI Act 1992, it is "responsible for protecting the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto".

It also regulates the issue of new securities, has the power to make rules for regulating the stock exchange, provides a license to dealers and brokers, and deals with fraud and inconsistencies in the capital market.

And commodities too: SEBI regulates Commodity derivatives which is included in the definition of derivatives under the Securities Contracts (Regulation) Act, 1956.

RBI — the money market, which deals with bonds and deposits, is regulated by the Reserve Bank of India (RBI). It looks at the macroeconomic conditions and decides the rate of interest to be paid on government securities, as well as important factors like the Statutory Liquidity Ratio (SLR) and the Cash Reserve Ratio (CRR).

And its balancing role: it works with the Government to balance the growth of the country with factors such as inflation, current account deficits, and the exchange rates of the rupee vis-à-vis the global currencies.

MCA — the Ministry of Company Affairs (MCA), through the Registrar of Companies, regulates the Corporate Sector. It is primarily concerned with the administration of the Companies Act, 2013.

And another statute: the Ministry is also responsible for administering the Competition Act, 2002, though regulatory orders in individual cases are passed by the Competition Commission of India.

IRDAI — the watchdog for the insurance sector, with the mission "to protect the interests of the policyholders, to regulate, promote and ensure orderly growth of the insurance industry". It has the mandate to register new insurance issuers, deal with issues of policyholders, and specify the code of conduct of the insurance business.

PFRDA — mandated to regulate the pension sector in India. It was formed through the PFRDA Act of 2003. And since 2008, the pension contributions of the central government employees have been invested by professional pension fund managers in accordance with Government of India guidelines, under the regulation of the PFRDA.

MOF — the Ministry of Finance (MOF) works through the Reserve Bank of India to regulate the securities market to the extent of investments into India by foreign or Non-Resident Indian investors. Under the Foreign Exchange Management Act, 1999, [which] came into force in 2000.

How they interlock

All the authorities have an interrelation with each other. The workbook's worked illustration:

If a company is issuing equity shares in the securities market for the first time, the company has to comply with the provisions of the Companies Act, which falls within the purview of the MCA and the offices of the Registrar of Companies and the Regional Directors under the MCA. The issue process is regulated under SEBI Regulations. Apart from this, if the issue is subscribed to by the foreign investors or Non-resident Indians, such investments will be subject to the RBI regulations as well.

And sector regulators may sit on top: if a company is a bank or an insurance company, it is primarily regulated by the RBI or IRDAI, respectively. Once the company decides to come with an IPO and lists its shares, thereafter, it also comes within the jurisdiction of SEBI as a listed company.

A single IPO can engage four regulators at once.

1.1.5 The investment banker in private equity

Investment bankers are usually appointed by companies seeking to raise capital through private equity sources such as venture capital funds and later-stage private equity funds. Such transactions may also include investors seeking to sell their existing stakes in companies to other private equity investors.

The banker's role is advisory: in such transactions, the investment banker's role is primarily of an advisory nature to assist the company or the investor from the sell side. The investment banker plays a key role in identifying the buy-side investors and thereafter conducting the whole deal process till the transaction culminates successfully.

The five aspects:

Growth Plan Formulation — advise the company on the arriving at the growth plan and capital investment required so that the necessary financial forecasts can be furnished to the investors. This would require an extensive study of the company's past performance, growth opportunities, competitor analysis, market trends, and other parameters.

Transaction Structuring — to come up with the correct instrument, quantum of capital to be raised, and the capital structure of the company pre and post the proposed transaction.

Arriving at Pre-Money Valuation — investment bankers conduct the valuation of the company for the proposed transaction in order to arrive at the sell-side pitch to the investors and arrive at the transaction structure. And it must be defensible: valuation should be based on established norms for such transactions and meet necessary regulatory pricing requirements for preferential allotments.

Offer Literature, Data Room Assistance — investment banks prepare the entire transaction-related literature, such as the 'teasers' or preliminary information memorandum, the detailed information memorandum, financial models for the business forecast, and the proposed transaction. They also assist in the compilation of the information and documents for the preparation of the data room, based on which the potential buyers conduct their pre-investment due diligence.

With a disclosure standard: the information memorandum should incorporate the necessary corporate disclosures that are required for investors to make an informed investment decision.

Leading the Transaction — investment banks handhold the entire transaction from the initial stage till the parties execute definitive agreements to bring the transaction to a close.

The process includes conducting meetings, leading negotiations for drawing up the term sheet, ensuring fair valuation for the sellers, co-ordination with the sellers, the company's team and other agencies such as accounting and legal firms for completion of due diligence, audit and necessary certifications, furnishing of disclosure statements, representations and warranties and execution of documents.