Understanding Securities Markets and Performance — the foundation

Where this chapter sits

This is Chapter 1 of the Securities Markets Foundation paper, worth 10% of the marks. The exam is 120 minutes, 100 marks, 60% to pass, and there is no negative marking — so on this paper you should attempt every question.

The chapter is definitional. Almost every mark here comes from knowing what is on a list — which instruments are securities, which entities are intermediaries, which regulator was set up under which Act. Learn the lists.

What the securities market is

The financial market consists of various types of markets (money market, debt market, equity market), investors (buyers of securities), issuers of securities (users of funds), intermediaries, and regulatory bodies such as SEBI and RBI.

The securities markets provide a regulated institutional framework for an efficient flow of capital (equity and debt) from investors to businesses. They provide a channel for allocation of savings to investments — so the savings of households, business firms and government can be channelised to fund the capital requirements of business enterprises and government.

Savings are linked to investments through instruments called securities — financial instruments issued by companies, financial institutions or the government to raise funds, purchased by investors who convert their savings into financial assets.

What counts as a security

The term is defined in Section 2(h) of the Securities Contracts (Regulation) Act, 1956. Securities include:

Three items have been added under clause (i) and are commonly tested:

• Onshore rupee bonds issued by multilateral institutions like the Asian Development Bank and the International Finance Corporation.
• Electronic Gold Receipts (EGR) — declared securities by Gazette notification dated 24 December 2021. An EGR is an electronic receipt issued on the basis of deposit of underlying physical gold in accordance with SEBI regulations.
• Zero Coupon Zero Principal (ZCZP) instruments — declared securities by Gazette notification dated 16 July 2022. These are issued by not-for-profit organisations registered with Social Stock Exchanges.

Note also what derivative covers under the SCRA:

• A security derived from a debt instrument, share, loan (secured or unsecured), risk instrument or contract for differences.
• A contract deriving its value from prices or an index of prices of underlying securities.
• Commodity derivatives.
• Such other instruments as the Central Government may declare. And a point students miss: derivatives are created by exchanges.

What is NOT a security — learn this list

• Bank deposits.
• Inter-corporate deposits.
• Company fixed deposits.
• Deposits with housing finance and other finance companies.
• Chit funds.
• Benefit funds.
• Insurance policies.
• Investment in provident funds or pension funds.

All these are financial arrangements between two parties that are not in the form of transferable securities.

The deposit versus the CD — the whole idea in one comparison

Suppose a bank accepts a 1-year deposit from a customer. This is a transaction between the bank and its customer. The bank will repay the deposit only to that customer. The interest rate is fixed when the deposit is accepted. If the customer needs money earlier, the deposit can be broken but may attract penalties. The bank may issue a fixed deposit receipt — but that receipt is not transferable.

Now suppose the bank instead issues a certificate of deposit (CD), which is a security. Same 1-year tenor, same interest rate. But the customer can hold it till maturity or transfer it to another customer before maturity. Whoever holds it on the maturity date submits it and collects the maturity value. And when it transfers, the price is what both parties agree as the market rate at that time.

That is the whole difference. When a monetary transaction between two parties is structured using a security, the flexibility to both parties is higher.

Features of securities

• A security represents the terms of exchange of money between two parties.
• Issuance lets borrowers raise money at a reasonable cost; ownership lets investors convert savings into financial assets which provide a return. The objectives of the issuer and the investor are complementary.
• The enterprise lists these securities on a stock exchange to ensure the security is liquid and to provide information about its activities and financial performance.
• The issuer provides the terms on which the capital is being raised.
• The investor has a claim to the rights represented by the security — which may involve ownership, participation in management, or claims on assets.
• Securities are broadly classified into equity and debt.

And the definitions that recur throughout the paper: return refers to the benefits the investor will receive; risk refers to the possibility that the expected returns may not materialise.

The institutional structure of securities markets enables three things: assuming risks in exchange for returns, evaluating risk and return based on information available, and transferring risk when the investor sells to another investor willing to bear it.

Structure: two segments

The primary market, also called the new issue market, is where issuers raise capital by issuing securities to investors.

The secondary market, also called the stock or securities exchange, facilitates trade in already-issued securities, thereby enabling investors to exit from an investment. Risk is transferred from one investor (seller) to another (buyer).

The line to memorise: the primary market creates financial assets, and the secondary market makes them marketable.

They are described as two interdependent and inseparable segments — not two separate markets.

Participants

Investors are individuals or organisations with surplus funds. They split into two categories:

• Retail investors — individual investors who invest money on their personal account.
• Institutional investors — organisations that invest large sums and employ specialised knowledge and investment skills.

The workbook's own example: if A saves ₹5,000 from her salary every month and buys mutual fund units, she is a retail investor. ABC Mutual Fund buying 50,000 shares of XYZ Industries Ltd is an institutional investor.

Some institutions such as mutual funds are institutional investors by objective — investing in securities is their primary business. Others have a different primary business but surplus funds to invest. Banks and financial institutions may operate in several capacities but also run an actively managed treasury department.

Institutional investors manage returns and risk through formal processes for (a) evaluating and selecting the securities they buy, (b) reviewing and monitoring what they hold, and (c) formally managing the risk, return and holding periods.

Issuers are organisations that raise money by issuing securities. They must be authorised by appropriate regulatory authorities. The common issuers:

• Companies — short-term and long-term capital for business operations.
• Central and State Governments — debt securities to finance their deficits (the extent to which government expenses are not met by income from taxes and other sources).
• Local governments and municipalities — debt securities for development needs. Government agencies do not issue equity securities.
• Financial institutions and banks — equity or debt for capital needs beyond deposits and government grants.
• Public sector companies — as part of the government's disinvestment programme.
• Mutual funds — units of a scheme.
• Investment trusts such as REITs, InvITs and AIFs — units of a scheme.

Securities are issued in the name and under the common seal of the issuer, and the primary responsibility of meeting the obligations is with the issuer. Earlier they were issued as paper certificates; since the mid-1990s securities are issued in electronic form, and previously issued certificates were converted — a process called dematerialisation.

The seventeen intermediaries

Under the SEBI (Intermediaries) Regulations, 2008:

1. Asset Management Companies.
2. Portfolio managers.
3. Merchant bankers.
4. Underwriters.
5. Stock brokers.
6. Authorized Persons.
7. Clearing members of a clearing corporation.
8. Trading members of the derivative segment of a stock exchange.
9. Bankers to an issue.
10. Registrars of an issue.
11. Share transfer agents.
12. Depository participants.
13. Custodians of securities.
14. Trustees of trust deeds.
15. Credit rating agencies.
16. Investment advisers.
17. KYC registration agencies.

The distinctions that get tested

AMC vs portfolio manager. Both are investment specialists who select and manage a portfolio. But AMCs are permitted to offer securities (called units) that represent participation in a pool of money. Portfolio managers do not offer any security and are not permitted to pool the money collected from investors — they act on behalf of the investor in creating and managing a portfolio. Both charge a fee.

Merchant bankers, also called issue managers, investment bankers or lead managers, evaluate capital needs, structure an appropriate instrument, price it, and manage the entire issue process until the securities are issued and listed. They also perform underwriting — they promise to pick up that portion of an offer which may not be bought by investors. The specialists who do this in the government bond market are called primary dealers.

Stock brokers are registered trading members of stock exchanges. All secondary market transactions on stock exchanges have to be conducted through registered brokers.

Authorized persons (AP) are agents of the brokers, previously referred to as sub-brokers, and are registered with the respective stock exchanges.

Clearing members vs trading members. Trading members put through the trades for buying and selling, on their own behalf or for customers. Clearing members receive funds and securities for completed transactions and settle the payment of money and delivery of securities.

Bankers to an issue are appointed during a new issue. They collect application forms and money and report collections to the lead managers. They send applications and investor details to the registrars. Finally they transfer the funds mobilised to the bank accounts of the issuer.

Registrars and Share Transfer Agents maintain the records of investors for the issuer — first holder and joint holders, address, bank account details, signatures, and nominations about who should receive the benefits after their death.

Depository participants enable investors to hold and transact securities in dematerialised form. DPs open investor accounts; brokers and banks offer DP services. The split to remember: investor-level accounts in securities are held and maintained by the DP; the company-level accounts of securities issued are held and maintained by the depository. In other words, DPs act as agents of the Depositories.

Custodians typically work with institutional investors, holding securities and bank accounts on their behalf, managing delivery of securities and money after a trade, keeping accounts, and possibly valuing the portfolio. Custodians are usually large banks.

Trustees are appointed when the beneficiaries may not be able to directly supervise whether their money is being managed in their best interest. Mutual fund trustees supervise the asset managers; debenture trustees ensure the lenders' interests are protected.

Credit rating agencies provide a professional opinion about the ability of the issuer to meet obligations for payment of interest and return of principal, using rating symbols so investors can assess the default risk.

Investment advisers help investors choose securities based on their needs, time horizon, return expectations and ability to bear risk, and create financial plans.

KYC Registration Agencies

A KRA provides a centralised system wherein KYC information is uploaded by securities market intermediaries. SEBI has mandated a uniform KYC procedure for mutual funds, brokers, depository participants, portfolio managers and venture capital funds.

The key benefit: KYC once completed is valid across all SEBI-registered intermediaries — across the whole capital market. KRAs must share data with other KRAs through an inter-operability process (IOP) and onward to all SEBI registered intermediaries, so that retail investors are not inconvenienced in the KYC documentation.

KRAs may also share information with other market regulators such as RBI, IRDAI and PFRDA, if those regulators notify so.

How a KRA independently validates an Aadhaar-based KYC — three checks:

• UIDAI for Aadhaar.
• OTP for mobile number and email id, or based on successful delivery status of Email/SMS.
• Income Tax database for PAN.

On successful completion, the KYC status is updated.

SEBI has also created an investor charter for KRAs explaining their services, investor rights, key functions, do's and don'ts, and grievance redressal, to be shared through websites, emails and office displays. And SEBI mandates that registered intermediaries ensure digital KYC processes are accessible and inclusive for persons with disabilities, including those with visual impairments.

The code of conduct

All intermediaries must be registered with SEBI and follow a SEBI-mandated code of conduct, whose key points are:

• Protection of investor interests.
• Providing fair, professional and skilled services.
• Avoiding collusion with other intermediaries to the detriment of investors.
• Providing adequate and timely information to clients.
• Maintaining appropriate financial and physical infrastructure.

The regulators

The responsibility for regulating the securities market is shared by SEBI, the RBI, the Department of Economic Affairs (DEA) of the Ministry of Finance, and the Ministry of Corporate Affairs (MCA).

SEBI in detail

The main objective of SEBI is to facilitate growth and development of the capital markets and to ensure that the interests of investors are protected. Its functions:

• Recognising and regulating stock exchanges. The Securities Contracts (Regulation) Act, 1956 is administered by SEBI. It provides direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges. Recognition requires representation of the Central Government on each stock exchange by such number of persons not exceeding three as the Central Government may nominate. Exchanges must furnish periodic reports, submit bye-laws for SEBI's approval, and send daily monitoring reports.
• Codifying and notifying regulations covering all activities and intermediaries.
• Overseeing the primary markets through the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 — covering public and rights issuances, Qualified Institutions Placement (QIP), eligibility requirements, preferential issues, bonus issues, and Indian Depository Receipts (IDRs). For debt, SEBI notified the SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021.
• Routine inspections of intermediaries, and investigations into price manipulation, artificial volume creation, insider trading, violation of the takeover code, public issue related malpractice or other unfair practices. SEBI has surveillance mechanisms internally and prescribed surveillance standards at stock exchanges.
• Powers to call for information, summon persons for interrogation, examine witnesses and conduct search and seizure, and to penalise violators — the penalty may take the form of suspension, monetary penalties and prosecution.
• Regulations to prohibit insider trading — trading by persons connected with a company having material information that is not publicly available. Companies must have a code of conduct, appoint a compliance officer, ensure periodic disclosure of holdings by insiders, and ensure data confidentiality. If proved, penalties include monetary penalties, criminal prosecution, prohibiting persons from securities markets, and declaring transactions void.

RBI in detail

RBI regulates the money market and foreign exchange market segments. As manager of the government's borrowing programmes, RBI is the issue manager for the government and controls and regulates the government securities market. It is the regulator of the Indian banking system and ensures banks follow prudential norms. Its monetary, forex and credit policies influence the supply of money and credit, which in turn impact interest rates and borrowing costs of banks, government and other debt issuers.

The five roles of the securities market

A well-developed securities market is usually associated with strong economic growth.

1. Orderly channel for transfer of funds. Primary markets channelise savings from millions of investors to borrowers in an organised and regulated manner. Before securities markets, banks performed this. The expansion of securities markets has contributed to the process of financial disintermediation. In plain words, companies can go around the bank. A company may find it more cost-efficient to raise funds by issuing commercial paper or bonds than by obtaining a traditional line of credit or term loan from a bank.

2. Generate productive investments. Individual savings of many households are mobilised into generating productive capacity for the country, facilitating long-term growth, income and employment. The workbook's example: an individual or single household could not set up a large steel plant, but a company issuing securities to many investors can.

3. Liquidity. Secondary markets allow securities to be sold and converted to cash. The example given: an investor buys 100 shares of XYZ Ltd at ₹25; a year later they quote at ₹45; he can sell and earn ₹20 per share, a total of ₹2,000. By ensuring liquidity, the market gives investors the confidence to block their funds in long-term investments such as equity shares and long-term bonds.

4. Price discovery. Buyers and sellers come together, interact and arrive at a consensus about the "fair price" of the security. Prices are determined by the actions of millions of buyers and sellers, rather than being dictated by the regulator or the government.

5. Information signalling through prices. Information about the issuer is reflected quickly in secondary market prices — particularly useful for small investors who tend to have limited access to company or industry information. The example: a poor monsoon hurts fertiliser and seed companies, so their share prices may fall if rains are expected to be inadequate — the declining prices signal that sales and profits are likely to decline.

Technology in the securities market

Markets in the 19th century were primitive and unorganized. Stock brokers met at the famous banyan tree in front of the Mumbai Town Hall and transacted business in the streets of the Fort area in Mumbai.

In the 1990s the stock market switched to electronic trading, and pit trading or open outcry trading was replaced by screen-based trading. Initially clients dictated orders to brokers who entered them in trading terminals; telephone-based orders were later replaced by online trading and mobile trading.

However, the boom in electronic and internet trading over the past twenty years has exposed stock exchanges and intermediaries to the risk of cyber-attacks — which is why the next framework exists.

Cyber Security and Cyber Resilience Framework (CSCRF)

The two definitions, which are examined as a pair:

• Cyber Security encompasses all tools, measures and processes intended to PREVENT cyber-attacks.
• Cyber Resilience measures the ability of an organization to prepare and respond to a cyber-attack, continue functioning DURING it, and RECOVER from it.

Under the CSCRF, the Market Infrastructure Institutions (MIIs) are five:

• Stock Exchanges.
• Depositories.
• Clearing Corporations.
• KYC Registration Agencies (KRAs).
• Qualified Registrars and Transfer Agents (QRTAs).

The five cyber resiliency goals:

These goals map to cybersecurity functions: Governance, Identify, Protect and Detect all sit under Anticipate; Respond sits under Withstand and Contain; Recover sits under Recover; and Evolve stands on its own.

Some specifics worth carrying into the hall:

• Access to systems should be for a defined purpose and period and not simply by virtue of a person's rank in the organization.
• Measures include strong password controls, two-factor security and logs of user access. They also include stringent supervision of outsourced and vendor staff and restriction of physical access to critical systems. Add Full-disk and File-based Encryption, hardened hardware and software, media disposal policies, and vulnerability assessment.
• Periodic audits by a CERT-In empanelled Information Security (IS) auditing organization.
• All cybersecurity incidents must be reported in a timely manner through the SEBI incident reporting portal, with an Incident Response Management plan, a Cyber Crisis Management Plan (CCMP), Root Cause Analysis, and forensic analysis for detailed investigation.
• The Board, Partner or Proprietor must approve the list of critical systems and the cybersecurity policy document.
• REs are solely accountable for all aspects related to third-party services.
• The category of an RE is decided at the beginning of the financial year based on the previous financial year's data, and remains the same throughout the financial year irrespective of any changes in parameters during the year.
• Where systems are managed by vendors, the SEBI guidelines must be adhered to by the vendors.
• All REs are mandated to conduct a cyber audit at a specified periodicity.

The two sandboxes — do not mix them up

The idea behind the Regulatory Sandbox: the Global Financial Crisis of 2008 emphasised the need for better regulation of financial services firms, creating constant friction between regulators and financial services providers. The Regulatory Sandbox aims at resolving this friction. The term was coined by the UK Financial Conduct Authority in 2015, and since then regulators from more than 20 countries have adopted the concept.

SEBI's eligibility criteria:

• The proposed innovation should be genuine and add value to existing offerings in the Indian market.
• There should be a genuine need for live testing.
• The proposed innovation should not pose any risks to the financial system.

FinTech applicants are required to inform their clients about the risks involved in testing the product.

The relaxation, and its limit: SEBI may grant partial or comprehensive relaxation from certain regulatory requirements during the testing period. However, no exemption will be granted from the investor protection, Know-Your-Customer (KYC) and Anti-Money Laundering (AML) rules.

On completion of the testing, SEBI will decide whether the innovation should be permitted to be introduced in the market on a large scale.