Introduction of Financial markets
Financial markets are a vital component of the financial system. Efficient financial markets are crucial for rapid economic development, as they enhance the process of capital formation and facilitate the flow of savings into productive investments. Often referred to as the backbone of the economy, financial markets provide the monetary support necessary for sustainable economic growth.
A financial market encompasses the entire network of organizations and institutions that provide short, medium, and long-term funds. It serves as a platform for the creation and exchange of financial assets, such as shares, bonds, and mutual funds. Essentially, it is the marketplace where financial transactions occur either in the form of generating new financial assets or exchanging existing ones.
Financial markets, along with banks, play an important intermediary role by mobilizing funds between savers and investors. They match the supply of funds with the demand, thereby performing the allocative function of channeling capital into the most productive investment opportunities.
When this allocative function is performed efficiently, it results in:
- Higher returns for households (savers), and
- Optimal allocation of scarce resources to firms with the highest productivity.
Financial Market
A financial market refers to any marketplace where buyers and sellers engage in the trading of financial assets such as shares, bonds, currencies, and other financial instruments. It serves as a vital link between surplus and deficit units—that is, between lenders (savers) and borrowers (investors).
Financial markets are broadly classified into two categories:
- Capital Market – Deals with long-term securities having a maturity period of more than one year.
- Money Market – Deals with short-term debt instruments with a maturity period of less than one year.
These markets play an essential role in a country's economic development. They facilitate the flow of funds in the savings-investment process and form a crucial part of the overall financial system.
Modern financial markets also offer high liquidity, enabling the easy and quick conversion of financial assets into cash. With the advancement of internet technology and the introduction of online trading platforms and Demat accounts, transactions have become faster, more efficient, and more transparent.
Financial markets are characterized by:
- Efficient pricing based on supply and demand
- Low transaction costs
- Wide participation including corporations, financial institutions, individuals, and governments
Key Features of Financial Markets:
- They act as a channel through which funds from surplus units (savers) are transferred to deficit units (borrowers).
- They serve as platforms for the creation and exchange of financial assets, but are not sources of finance themselves.
- Participants include households, businesses, governments, and financial institutions, who may trade directly or through brokers and dealers.
Financial Market and Economic Sectors
In any economic system, there are two key sectors:
- Households – The primary savers
- Business Firms – The primary investors
The financial market acts as a crucial intermediary between these two sectors. It allows households to invest their surplus funds while enabling businesses to raise capital for their operations and growth. This process is known as the “allocative function” of the financial market.
Mechanisms of Financial Intermediation
Funds can be mobilized from savers (households) to investors (business firms) through two primary mechanisms:
- Banks – Households deposit their surplus funds in banks, which then lend these funds to business firms.
- Financial Markets – Households directly purchase securities (such as stocks or bonds) issued by businesses, thereby providing capital.
This process of channeling funds from savers to investors is called financial intermediation.
Functions of Financial Market:
- Creation of Financial Assets – Issuance of new securities like shares or bonds.
- Exchange of Financial Assets – Buying and selling of existing securities in secondary markets.
- Liquidity and Valuation – Providing a platform for asset valuation and liquidity.
Definitions of Financial Market
- A financial market is defined as a marketplace for the exchange of capital and credit, which includes both money markets and capital markets.
- A financial market refers to a platform where the creation and trading of financial assets such as shares, debentures, bonds, derivatives, and currencies take place. It plays a crucial role in allocating scarce resources within an economy by acting as an intermediary between savers and investors, effectively mobilizing funds from surplus units to deficit units.
Functions of Financial Market
1.Mobilization of Savings
Financial markets encourage individuals and institutions to save by offering a range of financial instruments. These savings are then channeled into the most productive investments, contributing to economic efficiency and growth.
2.Efficient Allocation of Resources
By directing funds to the sectors and projects with the highest potential returns, financial markets ensure optimal allocation of capital.
3.Facilitating Price Discovery
Financial markets help determine the market prices of financial instruments through the forces of supply and demand. This process reflects the value of securities and ensures fair pricing.
4.Creation and Allocation of Credit and Liquidity
Financial markets enable the creation of credit and ensure liquidity by providing mechanisms for buying and selling financial assets, making it easy for investors to enter or exit positions.
5.Intermediation Between Savers and Investors
Financial markets act as intermediaries, connecting savers (surplus units) with investors (deficit units), thereby facilitating the flow of funds in the economy.
6.Supporting Balanced Economic Growth
By funding businesses, governments, and infrastructure projects, financial markets contribute to the overall development and stability of the economy.
7.Providing Financial Convenience
Financial markets offer various services, such as online trading and instant transactions, which enhance the ease and efficiency of financial dealings.
8.Reducing Transaction Costs
Organized financial markets lower the cost of financial transactions through competition, transparency, and scale.
9.Providing Information for Decision-Making
Financial markets offer a wealth of timely and accurate information about securities, market trends, and the economic environment, helping investors make informed decisions.
10.Catering to Credit Needs of Businesses
Financial markets provide diverse funding options for business organizations, including short, medium, and long-term credit.
11.Providing Liquidity to Financial Assets
By enabling quick and easy buying and selling of financial instruments, financial markets ensure that assets can be converted into cash without significant loss of value.
Types of Financial Market
Financial markets are classified based on the maturity period of the financial instruments traded within them. They are broadly divided into two main categories:
1. Money Market
The money market deals with short-term financial instruments that have a maturity period of less than one year. It is primarily used for meeting short-term liquidity needs.
Common Money Market Instruments:
- Treasury Bills (T-Bills): Short-term government securities with maturities ranging from a few days to one year.
- Commercial Paper (CP): Unsecured promissory notes issued by companies to raise short-term funds.
- Call Money: Very short-term funds lent or borrowed for one day to a few days, usually between banks.
- Certificate of Deposit (CD): Time deposits issued by banks that offer fixed interest for a specific term.
- Commercial Bill: A short-term negotiable instrument used in trade transactions.
2. Capital Market
The capital market deals with long-term financial instruments that have a maturity period of more than one year. It is used for long-term investments and capital formation.
The capital market is further divided into:
- Primary Market: Also known as the new issue market, it deals with the issuance of new securities directly by companies to investors. This includes instruments such as equity shares, preference shares, debentures, and bonds.
- Secondary Market: Also known as the stock market or aftermarket, it facilitates the buying and selling of existing securities. It provides liquidity to investors and helps in price discovery.
Note: The primary and secondary markets are interlinked. Securities such as equity shares, preference shares, debentures, and bonds issued in the primary market are subsequently traded in the secondary market.
Money Market
The money market is a financial market that deals in short-term monetary assets with a maturity period of up to one year. It is primarily used for meeting short-term financial needs of businesses, governments, and financial institutions. Unlike stock exchanges, the money market has no physical location, and most transactions are conducted electronically, via telephone or the internet.
The money market serves two key purposes:
- Meeting the short-term financial requirements of businesses and governments.
- Facilitating the temporary investment of surplus funds to earn safe and quick returns.
Common Money Market Instruments
- Treasury Bills (T-Bills): Short-term government securities issued by the RBI with maturities ranging from 91 to 364 days.
- Commercial Paper (CP): Unsecured short-term promissory notes issued by large corporations to raise working capital.
- Call Money: Overnight funds borrowed or lent by banks and financial institutions.
- Certificate of Deposit (CD): Time deposits issued by banks, offering fixed interest over a specified short-term period.
- Commercial Bill: A negotiable instrument used in trade finance, typically drawn by a seller on the buyer for payment at a future date.
Major Participants in the Money Market
- Reserve Bank of India (RBI)
- Commercial Banks
- Life Insurance Corporation of India (LIC)
- General Insurance Corporation of India (GIC)
- Non-Banking Financial Companies (NBFCs)
- State Governments
- Large Corporate Houses
- Mutual Funds
Key Features of the Money Market
- Short-Term Nature: Deals in financial instruments with maturities of up to one year.
- High Liquidity: Instruments are easily tradable, making them highly liquid.
- Low Risk: Due to short-term maturity, the risk of default is relatively low.
- Low Returns: Returns are generally lower compared to long-term instruments because of the short duration and lower risk.
- No Physical Marketplace: Transactions are conducted through telecommunication networks and online platforms.
- Frequent Issuance and Trading: Instruments are issued and traded daily, allowing for flexible fund management.
- Cost-Effective: Provides a relatively inexpensive way to manage short-term funding needs.
Treasury Bills (T-Bills)
Treasury Bills are short-term borrowing instruments issued by the Reserve Bank of India (RBI) on behalf of the Government of India. They are used to meet the government’s short-term liquidity requirements and are one of the safest money market instruments.
T-Bills are also known as “Zero Coupon Bonds” because they do not carry any interest (coupon). Instead, they are issued at a discount to their face (par) value and redeemed at full value upon maturity. The difference between the issue price and face value constitutes the investor’s return.
Key Features of Treasury Bills
- Issued by RBI on behalf of the Government of India.
- Also known as Zero Coupon Bonds – no periodic interest is paid.
- Maturity Period: Less than one year – commonly issued for 14 days, 91 days, 182 days, and 364 days.
- Issued at Discount, Redeemed at Par: For example, a T-Bill with a face value of ₹1,00,000 might be issued at ₹98,000. At maturity, the investor receives ₹1,00,000.
- Discount = ₹2,000, which is the return (interest earned).
- Form: Issued as a promissory note.
- Denominations: Available in multiples of ₹25,000.
- Highly Liquid: Easily tradable in the money market.
- Negligible Risk: Very safe investment due to government backing and the credibility of the RBI.
- Assured Yield: Returns are guaranteed, making them attractive to risk-averse investors.
Example:
- Issue Price: ₹98,000
- Face Value (Redemption Amount): ₹1,00,000
- Maturity Period: 91 days
- Return (Interest): ₹2,000
- Minimum Investment: ₹25,000
Treasury Bills are ideal for short-term investors looking for safe, liquid, and government-backed investment options with predictable returns. They play a crucial role in money market operations and short-term government financing.
Commercial Paper (CP)
Commercial Paper is a short-term, unsecured, and negotiable promissory note issued by large, creditworthy companies to raise funds for their short-term financial needs. It is issued at a discount and redeemed at face value, making it a cost-effective alternative to bank borrowing.
Key Features of Commercial Paper
1.Unsecured Instrument:
It is not backed by collateral, hence only issued by firms with strong credit ratings.
2.Maturity Period:
Typically ranges from 15 days to 1 year.
3.Negotiable Instrument:
CPs are freely transferable through endorsement and delivery.
4.Issued at Discount, Redeemed at Par:
The difference between the issue price and face value represents the return to the investor.
5.Alternative to Bank Loans:
Companies prefer CP to reduce their borrowing costs, as it often carries lower interest rates than bank loans.
6.Bridge Financing:
CP is frequently used for bridge financing to cover immediate costs such as floatation expenses (e.g., brokerage, prospectus, legal fees) when a company plans to raise long-term funds through shares or debentures.
7.Denominations:
- Minimum investment: ₹5,00,000
- Issued in multiples of: ₹5,00,000
Example – Use in Bridge Financing
Suppose a company plans to raise funds by issuing equity or debentures, but the process involves initial costs such as preparing legal documents, paying brokerage, and issuing a prospectus. To cover these upfront expenses, the company may issue Commercial Paper. Once the long-term funds are raised, the CP is repaid. This interim use is called bridge financing.
Summary
Commercial Paper is an efficient tool for companies to meet short-term liquidity needs, especially when they have a strong credit rating. For investors, it offers a relatively safe and flexible short-term investment with better returns than traditional bank deposits.
Call Money
Call Money refers to short-term funds borrowed by commercial banks from one another to maintain their Cash Reserve Ratio (CRR), as mandated by the Reserve Bank of India (RBI). It is a form of inter-bank lending and is repayable on demand, with a maturity period ranging from 1 day to 15 days.
Key Features of Call Money
Repayable on Demand:
Call money is a very short-term loan, often repaid within a day or up to 15 days.
Maturity Period:
Ranges from 1 day to 15 days, depending on the agreement.
Call Rate:
The interest rate paid on call money is known as the call rate. It is highly volatile, changing daily or even hourly, depending on liquidity conditions in the banking system.
Inverse Relationship:
There is often an inverse relationship between the call rate and returns on other short-term money market instruments. For example, when the call rate rises, returns on instruments like Treasury Bills may fall.
Used to Maintain CRR:
Banks use call money primarily to adjust their CRR requirements and manage short-term liquidity mismatches.
Purpose and Importance
Liquidity Management:
Ensures smooth functioning of the banking system by helping banks manage their short-term liquidity.
Regulatory Compliance:
Helps banks meet mandatory CRR requirements set by the RBI.
Indicator of Market Liquidity:
Call rate acts as an important indicator of liquidity in the financial system. A high call rate suggests tight liquidity, while a low rate indicates surplus funds.
Summary
Call Money is a critical tool for inter-bank liquidity adjustment and plays a vital role in ensuring the stability of the banking system. Its highly dynamic nature makes it a sensitive indicator of short-term monetary conditions in the economy.
Certificate of Deposit (CD)
A Certificate of Deposit (CD) is a short-term, unsecured, negotiable instrument issued by commercial banks and development financial institutions in bearer form. It is issued against funds deposited by companies, institutions, and individuals, primarily during times of tight liquidity, when bank deposit growth is slow but credit demand is high.
Key Features of Certificate of Deposit
Unsecured and Negotiable:
CDs are not backed by collateral and can be freely transferred (negotiable) by endorsement and delivery.
Maturity Period:
Ranges from 91 days to 1 year (365 days).
Issued by:
- Commercial Banks
- Development Financial Institutions (DFIs)
Bearer Instrument:
Issued in bearer form, meaning ownership is transferred by physical delivery without registration.
Liquidity Tool:
CDs are commonly issued during periods of tight liquidity, helping banks raise funds quickly when individual and household deposits are low, but demand for loans is high.
Mobilizes Large Funds Quickly:
Due to their negotiability and institutional participation, CDs enable banks to mobilize large sums of money over a short period.
Who Can Invest?
- Corporations
- Financial Institutions
- High-net-worth Individuals (HNIs)
- Mutual Funds
Summary
Certificates of Deposit are effective instruments for banks to manage liquidity and for investors seeking short-term, fixed-return investments. They offer higher returns than regular savings accounts, though with slightly higher risk due to their unsecured nature.
Commercial Bill
A Commercial Bill is a bill of exchange used by business firms to finance their working capital requirements. It is a short-term, negotiable, and self-liquidating instrument that helps firms manage credit sales efficiently.
How It Works
- When a business sells goods on credit, the seller (drawer) draws a bill of exchange on the buyer (drawee).
- Once the buyer accepts the bill, it becomes a marketable instrument known as a trade bill.
- If the trade bill is discounted by a commercial bank (i.e., the seller sells the bill to the bank to receive funds before the maturity date), it is then called a commercial bill.
Key Features of Commercial Bill
1.Short-term Instrument:
Used for financing the credit sales of goods, typically maturing within a few months.
2.Negotiable and Self-Liquidating:
The bill is transferable by endorsement and delivery, and it is self-liquidating because it gets extinguished upon payment by the buyer at maturity.
3.Working Capital Finance:
Helps firms to meet their short-term working capital needs without waiting for the buyer to pay.
4.Marketable Instrument:
Once accepted by the buyer, it becomes a trade bill and can be discounted by banks to raise funds.
5.Involves Three Parties:
- Drawer (Seller): Issues the bill.
- Drawee (Buyer): Accepts the bill, agreeing to pay on maturity.
- Bank: May discount the bill to provide immediate funds to the seller.
Summary
Commercial bills are important instruments in trade finance, allowing businesses to convert their receivables into immediate cash and manage their working capital efficiently. They facilitate smooth credit transactions between buyers and sellers while providing liquidity support through banking institutions.
Capital Market
The Capital Market is a platform that facilitates the raising and allocation of medium- and long-term funds. It comprises a network of organizations, institutions, and instruments that channel the savings of the community into productive industrial and commercial enterprises, as well as public investments.
Key Features of Capital Market
Market for Medium and Long-Term Funds:
The capital market deals with funds that have maturities beyond one year, supporting long-term financial needs.
Institutional Framework:
It provides institutional arrangements through which long-term funds, both debt and equity, are raised and invested.
Participants:
The capital market includes development banks, commercial banks, stock exchanges, and other financial institutions.
Financial Instruments:
Common instruments traded in the capital market include:
- Shares (Equity)
- Debentures
- Bonds
- Public deposits
Role in Economic Development
- The capital market plays a crucial role in mobilizing savings and directing them into productive investments, thereby fueling industrial growth.
- A well-functioning capital market is essential for the process of economic development, as it supports the expansion of businesses and infrastructure.
- The development of the financial system, with an efficient capital market at its core, is widely regarded as a necessary condition for sustained economic growth.
Summary
In essence, the capital market acts as a bridge between savers and investors, enabling the efficient transfer of long-term funds to enterprises and projects that drive economic progress.
Primary Market
The Primary Market, also known as the New Issues Market, is the market where securities are sold for the first time. It deals exclusively with the initial issuance of new securities such as shares and bonds.
Functions of the Primary Market
Facilitates Capital Raising:
It enables companies to raise new capital by issuing securities directly to investors for the first time.
Transfer of Funds:
Acts as a channel to transfer investible funds from savers to entrepreneurs to finance various business needs.
Supports Business Growth:
The funds raised may be used for:
- Setting up new projects
- Expansion and diversification
- Modernization of existing projects
- Mergers and acquisitions
Promotes Capital Formation:
The primary market plays a direct and crucial role in the process of capital formation by mobilizing savings into productive investments.
Participants in the Primary Market
- Banks
- Financial institutions
- Insurance companies
- Mutual funds
- Individual investors
Methods of Floatation
1.Offer for Sale:
Securities are offered to the public for subscription.
2.E-IPO (Electronic Initial Public Offering):
Issuance of shares through an online platform.
3.Right Issue:
Existing shareholders are given the right to buy additional shares at a discounted price.
4.Private Placement:
Securities are sold directly to a select group of investors rather than the public.
5.Offer through Prospectus:
A formal document issued by the company detailing the securities being offered, terms, and conditions.
Summary
The primary market is vital for enabling companies to raise fresh capital, thus fueling business expansion and contributing significantly to economic growth.
Method of Floatation: Offer through Prospectus
In this method, a company invites the public to apply for its securities by issuing a prospectus. The prospectus acts as a formal invitation and a detailed advertisement aimed at attracting investors to subscribe to the new securities.
Key Features
Direct Appeal to Investors:
The prospectus makes a direct appeal to potential investors through advertisements in newspapers, magazines, and other media.
Regulatory Compliance:
The content of the prospectus must strictly adhere to the provisions of the Companies Act and the SEBI (Securities and Exchange Board of India) Disclosure and Investor Protection Guidelines to ensure transparency and protect investors.
Role of Underwriters and Brokers:
Companies often engage underwriters or brokers to help in marketing the issue and managing subscription risks.
Listing Requirement:
The securities issued must be listed on at least one recognized stock exchange to facilitate trading.
Underwriting:
The issue may be underwritten, meaning underwriters agree to buy any unsubscribed shares to protect the company from the risk of under-subscription.
Summary
The offer through prospectus is a widely used method for raising capital from the public, providing investors with detailed information and ensuring regulatory safeguards.
Method of Floatation: Offer for Sale
In the Offer for Sale method, securities are not issued directly to the public. Instead, the company first issues the securities to intermediaries such as issue houses and stock brokers at a fixed price. These intermediaries then resell the securities to the investing public at a higher price, earning a margin on the transaction.
Benefits
Simplifies the Process:
This method saves the company from the formalities and complexities involved in issuing securities directly to the public.
Reduces Company’s Burden:
The intermediaries handle the responsibility of marketing and selling the securities to investors.
Summary
Offer for Sale provides an efficient way for companies to raise capital indirectly through market intermediaries, reducing administrative hassles and speeding up the process.
Method of Floatation: Private Placement
In the Private Placement method, a company sells its securities directly to a select group of institutional investors and individuals, rather than offering them to the general public.
Key Features and Benefits
Faster Capital Raising:
This method enables companies to raise capital more quickly compared to a public issue.
Cost-Effective:
It saves on various mandatory and non-mandatory expenses and formalities associated with a public issue, making it an economical option.
Preferred by Some Companies:
Companies that cannot afford the time and cost of a public issue often prefer private placement. They issue securities privately to investors such as:
- Unit Trust of India (UTI)
- Life Insurance Corporation (LIC)
- General Insurance Corporation (GIC)
- Large individual investors
Selective Allotment:
Securities are allotted to institutional investors and selected individuals based on the company’s discretion.
Summary
Private placement offers a quicker, cost-efficient way for companies to raise funds, especially beneficial for those unable to undertake a full public offering.
Method of Floatation: Right Issue
In the Right Issue method, a company offers new shares to its existing shareholders in proportion to the number of shares they already hold. This process grants existing shareholders a pre-emptive right to subscribe to the new shares before they are offered to the public.
Key Features
Pre-Emptive Right:
Existing shareholders get the first opportunity to buy additional shares according to the terms and conditions set by the company, protecting their ownership percentage.
Proportional Offering:
Shares are offered in proportion to the shareholder’s current holdings, maintaining their relative stake in the company.
Option Period:
Shareholders are given a prescribed time period to exercise their rights and subscribe to the new shares.
Offer to Public:
If existing shareholders do not subscribe within the given time, the company may open the offer to the general public.
Summary
Right issues help companies raise additional capital while giving existing shareholders the opportunity to maintain their ownership percentage, protecting them from dilution.
Method of Floatation: E-IPO (Electronic Initial Public Offering)
In the E-IPO method, a company issues capital to the public through the online system of a stock exchange, leveraging electronic technology to streamline the process. This modern approach replaces traditional paper-based methods with digital applications and allotments.
Key Features
Online Capital Raising:
The company offers its shares to the public electronically via the stock exchange’s online platform.
Registrar with Electronic Connectivity:
A registrar who is electronically connected with the stock exchange is appointed to handle the application and allotment process efficiently.
Role of Lead Manager:
The lead manager coordinates all activities involving various intermediaries such as merchant bankers, bankers to the issue, and escrow account managers.
Agreement with Stock Exchange:
The company must enter into a formal agreement with the stock exchange to facilitate the E-IPO process.
Appointment of SEBI-Registered Broker:
A SEBI-registered broker is appointed to accept applications and place orders with the company on behalf of investors.
Listing Requirement:
Securities issued via E-IPO must be listed on at least one recognized stock exchange to enable trading.
Summary
E-IPOs provide a fast, convenient, and transparent way for companies to raise capital by using electronic platforms, reducing paperwork and enhancing investor accessibility.
Secondary Market
The Secondary Market is the marketplace for the sale and purchase of existing securities. It is also commonly referred to as the stock market or stock exchange.
Key Features
Trading of Existing Securities:
Securities are not issued directly by companies in this market. Instead, existing investors sell their securities to other investors.
Provides Liquidity and Marketability:
It allows investors to buy and sell securities easily, offering liquidity and ensuring marketability of financial instruments.
Contributes to Economic Growth:
By facilitating disinvestment and reinvestment, the secondary market channels funds into the most productive investments, supporting economic development.
Regulated Environment:
All trading, clearing, and settlement activities occur under the regulatory framework of SEBI (Securities and Exchange Board of India), ensuring fair and transparent transactions.
Summary
The secondary market plays a crucial role in providing investors with the ability to trade securities efficiently, while supporting capital formation and economic growth through a regulated and transparent system.
Stock Exchange
The stock exchange plays a pivotal role in the growth of industry and commerce, significantly impacting the overall economy. While the primary market handles the issuance of new shares and debentures for companies going public or already listed, the stock exchange serves as a common platform where buyers and sellers actively trade existing securities.
Definition
According to the Securities Contracts (Regulation) Act, a stock exchange is defined as:
“An institution or a 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.”
In essence, the stock exchange is an institution that provides a regulated marketplace for the buying and selling of existing securities.
Key Roles
Liquidity Provider:
It facilitates the easy conversion of securities into cash and vice versa, providing liquidity to investors.
Promotes Safety:
The stock exchange ensures safety and transparency in transactions, thereby enhancing the creditworthiness of individual companies.
Economic Indicator:
Stock market indices serve as a barometer of the economy, reflecting economic trends and investor sentiment.
Functions of Stock Exchange
1.Providing Liquidity and Marketability:
Enables investors to easily buy and sell securities.
2.Pricing of Securities:
Facilitates the determination of fair market prices through demand and supply.
3.Safety of Transactions:
Regulates and supervises trading to protect investors.
4.Contributes to Economic Growth:
Channels savings into productive investments.
5.Spreading Equity Culture:
Encourages wider public participation in equity investments.
6.Providing Scope for Speculation:
Offers opportunities for short-term trading and speculation, contributing to market dynamics.
Stock Exchange: Past vs. Present
In the Past:
- Securities were traded physically on the floor of the stock exchange using the open outcry system or auction system.
- Under the auction system, brokers shouted out prices, and deals were made by selling shares to the highest bidder.
- The process was manual, less transparent, and prone to delays and errors.
In the Present:
- The auction system has been replaced by an online, screen-based electronic trading system.
- Trading is now conducted electronically through centralized platforms, enhancing speed and accuracy.
Trading Procedures on a Stock Exchange
1.Selection of a Broker:
Investors choose a registered broker to facilitate their trades.
2.Opening a Demat Account:
Investors open a Demat (dematerialized) account with a depository to hold securities in electronic form.
3.Placing the Order:
Investors place buy or sell orders through their brokers electronically.
4.Executing the Order:
Orders are matched and executed on the trading platform.
5.Settlement:
The transfer of securities and funds takes place to complete the transaction.
Advantages of Electronic Trading Systems (Screen-Based Trading)
- Ensures Transparency: Trades are visible and verifiable, reducing manipulation.
- Increases Information Efficiency: Real-time access to price and volume data.
- Improves Operational Efficiency: Faster execution and settlement of trades.
- Enables More Participants: Investors from across the country can participate easily.
- Provides a Single Trading Platform: Consolidates trading activities in one place, simplifying access.
Physical Form vs. Electronic Form of Securities
- Physical Form (Share Certificates): Earlier, shares were issued in paper certificates. This system had several problems such as:
- Theft or loss of certificates
- Fraudulent or fake certificates
- Delays in transfer of ownership
- Extensive paperwork
- Electronic Form (Demat System): To overcome these issues, the dematerialization system was introduced. Securities are held electronically in Demat accounts maintained by depositories, eliminating risks and delays associated with physical certificates.
Dematerialization
Dematerialization is the process by which physical securities held by an investor are converted into electronic form. Instead of holding paper share certificates, the investor is provided with an electronic entry in a Demat account, representing ownership of the securities.
In simple terms, dematerialization means cancelling physical certificates and replacing them with an electronic record, allowing investors to hold and trade securities digitally.
Key Points
- Dematerialization converts physical share certificates into electronic form.
- The electronic securities are held in a Demat account.
- The reverse process, where electronic holdings are converted back to physical certificates, is called Rematerialization.
Procedure for Dematerialization
1.Open a Demat Account:
The investor opens a Demat account through a Depository Participant (DP) by filling out the necessary forms and submitting required documents.
2.Submit Physical Certificates:
The investor submits the physical share certificates along with a Dematerialization request form to the DP.
3.Verification and Confirmation:
The registrar or the company confirms the request and initiates the dematerialization process.
4.Account Credit:
Once verified, the shares are converted to electronic form, and the investor’s Demat account is credited with the equivalent number of shares.
5.Trading and Operations:
The investor can now easily buy or sell shares and other securities through a broker or the DP, all managed electronically via the Demat account.
Depository Participant (DP)
The Depository Act was enacted in 1996 to facilitate the free transferability of securities with speed, accuracy, and security. To modernize trading, SEBI introduced a system where all share trading is conducted in electronic form, eliminating the need for physical certificates.
What is a Depository Participant (DP)?
- A Depository Participant (DP) acts as an intermediary between the investor and the depository.
- The DP is authorized to maintain and operate the Demat accounts where dematerialized securities are held.
- Investors open Demat accounts through DPs to hold and trade securities electronically.
What is a Depository?
- A depository is an institution or organization that holds securities in electronic form and facilitates their trading.
- It is a technology-driven electronic storage system that eliminates paperwork related to share certificates, transfer forms, and other documentation.
- The depository ensures safe, speedy, and accurate transfer of securities without physical movement.
Major Depositories in India
- National Securities Depository Limited (NSDL)
- Central Depository Services Limited (CDSL)
Both NSDL and CDSL provide electronic custodial services for investors.
Key Terms Related to Depository
- Depository Participant (DP): The agent or intermediary through whom investors open and operate Demat accounts.
- Beneficial Owner: The actual owner of the securities who holds the rights over them, while the depository holds the securities electronically.
- Issuer: The company or entity that issues securities to investors.
Trading Procedure on a Stock Exchange
1.Selection of a Broker
Choose a registered stockbroker who will act as an intermediary for buying and selling securities on your behalf.
2.Opening Demat Account with Depository
Open a Demat account through a Depository Participant (DP) to hold shares in electronic form.
3.Placing an Order
Place a buy or sell order for securities through your broker.
4.Match the Share and Best Price
The stock exchange’s electronic system matches buy and sell orders at the best available price.
5.Executing the Order
Once a match is found, the order is executed, and a trade is confirmed.
6.Issue of Contract Note
The broker issues a contract note to the investor confirming the details of the trade.
7.Delivery of Shares or Making Payment
Buyer makes payment, and the seller delivers the shares (usually electronically via Demat accounts).
8.Settlement Cycle
The process where payment and shares are exchanged between buyer and seller within a specified period (usually T+2 or T+3 days).
9.Pay Out Day Working
The day when the actual transfer of funds and securities occurs.
10.Delivery of Shares in Demat Form
The securities are credited to the buyer’s Demat account, completing the transaction.
Types of Operators on a Stock Exchange
- Brokers - Registered members who act as agents for buyers and sellers and facilitate trading.
- Jobbers - Dealers who buy and sell securities for their own account, providing liquidity to the market.
- Bulls - Investors or traders who expect prices to rise and hence buy securities to profit from the increase.
- Bears - Investors who expect prices to fall and may sell securities or short sell to benefit from the decline.
- Stag - Speculators who buy securities in a new issue with the intention of selling them quickly at a profit.
FAQs
What is a Demat account?
A Demat account holds securities in electronic form, eliminating the need for physical certificates. It is mandatory for trading in the stock market.
How does trading happen on a stock exchange?
Trading happens through brokers who place buy or sell orders electronically. Orders are matched based on price and quantity, and transactions are settled within a specified time.
What is a contract note?
A contract note is a legal document issued by a broker to the investor, confirming the details of a trade such as price, quantity, and date.
What is the role of a broker?
A broker acts as an intermediary between buyers and sellers, executing trades on behalf of clients.
What is the difference between Bulls and Bears?
- Bulls expect prices to rise and buy securities.
- Bears expect prices to fall and sell securities or short sell.
