UNIT I FINANCIAL MARKETS IN INDIA (MBA NOTES)

 

Indian financial system and markets – structure of financial markets in India –Types-Participants in financial Market – Regulatory Environment, - RBI, CCIL, Common securities market, Money market, - Capital market - Governments philosophy and financial market – financial instruments

Financial system are of crucial significance to capital formation. The process of capital formation involves three distinct, although inter-related activities.

v  Saving : the ability by which claims to resources are set aside and become available for the other purpose.

v  Finance : The activity by which claims to resources are  either assembled from those released by domestic  savings, obtained from abroad etc.

v  Investments :   the activity by which resources are  actually committed to production.

The Indian Financial System

The Indian financial system can also be broadly classified into the formal (organised) financial system and the informal (unorganised) financial system. The formal financial system comes under the purview of the Ministry of Finance (MoF), the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), and other regulatory bodies. The informal financial system consists of:

• Individual moneylenders such as neighbours, relatives, landlords, traders, and storeowners.

• Groups of persons operating as ‘funds’ or ‘associations.’ These groups function under a system of their own rules and use names such as ‘fixed fund,’ ‘association,’ and ‘saving club.’

• Partnership firms consisting of local brokers, pawnbrokers, and non-bank financial intermediaries such as finance, investment, and chit-fund companies.

Informal Financial System

Advantages

• Low transaction costs

• Minimum default risk

• Transparency of procedures

Disadvantages

• Wide range of interest rates

• Higher rates of interest

• Unregulated

COMPONENTS OF THE FORMAL FINANCIAL SYSTEM

The formal financial system consists of four segments or components. These are: financial institutions, financial markets, financial instruments, and financial services.

Financial Institutions

These are intermediaries that mobilise savings and facilitate the allocation of funds in an efficient manner.

Classification of Financial Institutions

• Banking and non-banking
• Term finance
• Specialised
• Sectoral
• Investment
• State-level

1. Financial institutions can be classified as banking and non-banking financial institutions. Banking institutions are creators and purveyors of credit while non-banking financial institutions are purveyors of credit. While the liabilities of banks are part of the money supply, this may not be true of non-banking financial institutions. In India, non-banking financial institutions, namely, the developmental financial institutions (DFIs), and non-banking financial companies (NBFCs) as well as housing finance companies (HFCs) are the major institutional purveyors of credit.
2.  Financial institutions can also be classified as term-finance institutions such as the Industrial Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), the Industrial Financial Corporation of India (IFCI), the Small Industries Development Bank of India (SIDBI), and the Industrial Investment Bank of India (IIBI).
3. Financial institutions can be specialised finance institutions like the Export Import Bank of India (EXIM), the Tourism Finance Corporation of India (TFCI), ICICI Venture, the Infrastructure Development Finance Company (IDFC), and
4. Sectoral financial institutions such as the National Bank for Agricultural and Rural Development (NABARD) and the National Housing Bank (NHB).
5. Investment institutions in the business of mutual funds Unit Trust of India (UTI), public sector and private sector mutual funds and insurance activity of Life Insurance Corporation (LIC), General Insurance Corporation (GIC) and its subsidiaries are classified as financial institutions.
6. There are state-level financial institutions such as the State Financial Corporations (SFCs) and State Industrial Development Corporations (SIDCs) which are owned and managed by the State governments.

Financial Markets

Financial markets are a mechanism enabling participants to deal in financial claims. The markets also provide a facility in which their demands and requirements interact to set a price for such claims.

The main organised financial markets in India are the money market and the capital market. The first is a market for short-term securities while the second is a market for long-term securities, i.e., securities having a maturity period of one year or more.

Financial markets can also be classified as primary and secondary markets. While the primary market deals with new issues, the secondary market is meant for trading in outstanding or existing securities.

There are two components of the secondary market: over-the-counter (OTC) market and the exchange traded market. The government securities market is an OTC market. In an OTC market, spot trades are negotiated and traded for immediate delivery and payment while in the exchange-traded market, trading takes place over a trading cycle in stock exchanges. Recently, the derivatives market (exchange traded) has come into existence. 

Types

• Money market

• Capital market

Segments

• Primary market

• Secondary market

 

Financial Instruments

A financial instrument is a claim against a person or an institution for payment, at a future date, of a sum of money and/or a periodic payment in the form of interest or dividend.

Financial instruments represent paper wealth shares, debentures, like bonds and notes.

Many financial instruments are marketable as they are denominated in small amounts and traded in organised markets. This distinct feature of financial instruments has enabled people to hold a portfolio of different financial assets which, in turn, helps in reducing risk. Different types of financial instruments can be designed to suit the risk and return preferences of different classes of investors.

 

Types of Financial Securities

• Primary- direct securities- bonds, debentures

• Secondary- indirect securities- bank deposits, insurance and mutual fund units

Distinct Features

• Marketable

• Tradeable

• Tailor-made

Types of Financial Instruments

Financial instruments may be divided into two types: cash instruments and derivative instruments.

Cash Instruments

• The values of cash instruments are directly influenced and determined by the markets. These can be securities that are easily transferable.
• Cash instruments may also be deposits and loans agreed upon by borrowers and lenders.

Derivative Instruments

• The value and characteristics of derivative instruments are based on the vehicle’s underlying components, such as assets, interest rates, or indices.
• An equity options contract, for example, is a derivative because it derives its value from the underlying stock. The option gives the right, but not the obligation, to buy or sell the stock at a specified price and by a certain date. As the price of the stock rises and falls, so too does the value of the option although not necessarily by the same percentage.
• There can be over-the-counter (OTC) derivatives or exchange-traded derivatives. OTC is a market or process whereby securities–that are not listed on formal exchanges–are priced and traded.

Types of Asset Classes of Financial Instruments

Financial instruments may also be divided according to an asset class, which depends on whether they are debt-based or equity-based.

Debt-Based Financial Instruments

Short-term debt-based financial instruments last for one year or less. Securities of this kind come in the form of T-bills and commercial paper. Cash of this kind can be deposits and certificates of deposit (CDs).

Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans.

Equity-Based Financial Instruments

Securities under equity-based financial instruments are stocks. Exchange-traded derivatives in this category include stock options and equity futures. The OTC derivatives are stock options and exotic derivatives.

Financial Services

These are those that help with borrowing and funding, lending and investing, buying and selling securities, making and enabling payments and settlements, and managing risk exposures in fi nancial markets.

The major categories of financial services are funds intermediation, payments mechanism, provision of liquidity, risk management, and financial engineering.

·         Funds intermediating services link the saver and borrower which, in turn, leads to capital formation. New channels of financial intermediation have come into existence as a result of information technology.

·         Payment services enable quick, safe, and convenient transfer of funds and settlement of transactions.

·        Liquidity is essential for the smooth functioning of a financial system. Financial liquidity of financial claims is enhanced through trading in securities. Liquidity is provided by brokers who act as dealers by assisting sellers and buyers and also by market makers who provide buy and sell quotes.

·         Financial services are necessary for the management of risk in the increasingly complex global economy. They enable risk transfer and protection from risk. Risk can be defi ned as a chance of loss. Risk transfer of services help the financial market participants to move unwanted risks to others who will accept it. The speculators who take on the risk need a trading platform to transfer this risk to other speculators.

·         Financial engineering presents opportunities for value creation. These services refer to the process of designing, developing, and implementing innovative solutions for unique needs in funding, investing, and risk management. Restructuring of assets and/or liabilities, off balance sheet items, development of synthetic securities, and repackaging of financial claims are some examples of financial engineering.

The producers of these financial services are financial intermediaries, such as, banks, insurance companies, mutual funds, and stock exchanges. Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, and credit-rating.

 

Need of Financial Services for

• Borrowing and funding

• Lending and investing

• Buying and selling securities

• Making and enabling Payments and settlements

• Managing risk

 

1.            Hire Purchase Services the legal term for conditional sales contract with an intention to finance consumers towards vehicles, white goods etc. If a buyer cannot afford to pay the price as a lump sum but can afford to pay a percentage as a deposit, the contract allows the buyer to hire the  goods for a monthly rent.
2.       Leasing Services or tenancy is a service that transfers rights to possess specific property. Leasing service includes the leasing of assets to other companies either on operating lease or finance lease.
3.          Housing Finance Services means financial services related to  development and construction of residential and commercial properties.  An Housing Finance Company approved by the National Housing Bank may undertake the services /activities such as Providing long term finance for the purpose of constructing, purchasing or renovating any  property etc.
4.        Asset Management Company is managing and investing the  pooled funds of retail investors in securities in line with the stated  investment objectives and provides more diversification, liquidity, and  professional management service to the individual investors. Mutual Funds are comes under this category.
5.       Venture Capital Companies is a unique form of financing activity that is undertaken on the belief of high-risk-high-return.  Venture capitalists invest in those risky projects or companies  (ventures) that have success potential and could promise  sufficient return to justify such gamble

 

Meaning of Capital market: 

Capital markets are financial markets for the buying and selling of long-term debt or long term securities having a maturity-period (age) of one year or more. These markets channel/direct the wealth of savers to those who can put it to long-term productive/useful use, such as companies or governments making long-term investments/capital spending. Financial regulators/watchdogs such as the Securities and Exchange Board of India (SEBI), oversee/direct the capital markets in their jurisdictions/areas to protect investors against fraud/dishonesty among other duties. 

Definition of Capital market: 

Capital market is a market for long-term funds-both equity and debt-and funds raised within and outside the country. 

The capital market aids economic growth by mobilizing the savings and directing the same towards productive use. This is facilitated through the following measures or ways: 

1. Issue of „primary securities‟ in the primary market,‟ i.e., directing cash flow from the surplus sector to the deficit sectors such as the government and the corporate sector. 

2. Providing liquidity and marketability of outstanding debt and equity instruments. 

 

Features/Characteristics of Capital Market: 

1.      Link between savers and investors: The capital market acts as an important link between savers and investors. The savers are lenders of funds while investors are borrowers of funds. The savers who do not spend all their income are called “Surplus units” and the investors/borrowers are known as “deficit units”. The capital market is the transmission mechanism between surplus units and deficit units. It is a conduit through which surplus units lend their surplus funds to deficit units.

2.      Deals in Long Term fund: Capital market provides funds for long and medium term. It does not deal with channelizing saving for less than one year

3.      Utilizes Intermediaries: Capital market makes use of different intermediaries such as brokers, underwriters, depositories etc. These intermediaries act as working organs of capital market and are very important elements of capital market. 

4.      Capital formation: The capital market prides incentives to savers in the form of interest or dividend to transfer their surplus fund into the deficit units who will invest it in different businesses. The transfer of funds by the surplus units to the deficit units leads to capital formation. 

5.      Government Rules and Regulations: The capital market operates freely but under the guidance of government policies. These markets function within the framework of government rules and regulations, e.g., stock exchange works under the regulations of SEBI which is a government body. 

6.      Basis for industrialization: Capital market generates long term funds, which are essential for the establishment of industries. Thus, capital market acts as a basis for industrialization. 

7.      Accelerating the pace of growth: Easy and smooth availability of funds for medium and long period encourages the entrepreneurs to take profitable ventures/businesses in the field of trade, industry, commerce and even agriculture. It results in the all round economic growth and accelerates the pace of economic development. 

8.      Generating liquidity: Liquidity means convertibility into cash. Shares of the public companies are transferable i.e., in case of financial requirements these shares can be sold in the stock market and the cash can be obtained. This is how capital market generates liquidity.

9.      Increase the national income: Funds flow into the capital market from individuals and financial intermediaries which are absorbed by commerce, industry and government. It thus facilitates the movement of stream of capital to be used more productively and profitability to increase the national income. 

10.  Productive investment: The capital market provides a mechanism for those who have savings transfer their savings to those who need funds for productive investments. It diverts resources from wasteful and unproductive channels such as gold, jewelry, conspicuous consumption, etc. to productive investments. 

11.  Stabilization of the value of securities: A well- developed capital market comprising expert banking and non-banking intermediaries brings stability in the value of stocks and securities. It does so by providing capital to the needy at reasonable interest rates and helps in minimizing speculative activities. 

12.  Encourages economic growth: The capital market encourages economic growth. The various institutions which operate in the capital market give quantities and qualitative direction to the flow of funds and bring rational allocation of resources. They do so by converting financial assets into productive physical assets. This leads to the development of commerce and industry through the private and public sector, thereby encouraging/inducing economic growth

An ideal capital market is one: 

1. Where finance is available at reasonable cost. 

2. Which facilitates economic growth. 

3. Where market operations are free, fair, competitive and transparent. 

4. Must provide sufficient information to investors. 

5. Must allocate capital productively. 

 

The Indian money market

The average turnover of the money market in India is over Rs. 1,00,000 crore daily. This is more than 3 per cent let out to the system. This implies that 2 per cent of the annual GDP of India gets traded in the money market in just one day. Even though the money market is many times larger than the capital market, it is not even a fraction of the daily trading in developed markets.

Role of the Reserve Bank of India in the Money Market

The Reserve Bank of India is the most important constituent of the money market. The market comes within the direct purview of the Reserve Bank regulations.

The aims of the Reserve Bank’s operations in the money market are

• to ensure that liquidity and short-term interest rates are maintained at levels consistent with the monetary policy objectives of maintaining price stability;
• to ensure an adequate flow of credit to the productive sectors of the economy; and
• to bring about order in the foreign exchange market.

The Reserve Bank influences liquidity and interest rates through a number of operating instruments— cash reserve requirement (CRR) of banks, conduct of open market operations (OMOs), repos, change in bank rates, and, at times, foreign exchange swap operations

 

Money Market Centres

There are money market centres in India at Mumbai, Delhi, and Kolkata. Mumbai is the only active money market centre in India with money flowing in from all parts of the country getting transacted there.

MONEY MARKET INSTRUMENTS

The instruments traded in the Indian money market are

1. Treasury bills (T-bills);

2. Call/notice money market—Call (overnight) and short notice (up to 14 days);

3. Commercial Papers (CPs)

4. Certificates of Deposits (CDs)

5. Commercial Bills (CBs)

6. Collateralised Borrowing and Lending Obligation (CBLO)

TREASURY BILLS

Treasury bills are short-term instruments issued by the Reserve Bank on behalf of the government to tide over short-term liquidity shortfalls. This instrument is used by the government to raise short-term funds to bridge seasonal or temporary gaps between its receipts (revenue and capital) and expenditure. They form the most important segment of the money market not only in India but all over the world as well.

T-bills are repaid at par on maturity. The difference between the amount paid by the tenderer at the time of purchase (which is less than the face value) and the amount received on maturity represents the interest amount on T-bills and is known as the discount. Tax deducted at source (TDS) is not applicable on T-bills.

Features of T-Bills

They are negotiable securities.

They are highly liquid as they are of shorter tenure and there is a possibility of inter-bank repos in them.

There is an absence of default risk.

They have an assured yield, low transaction cost, and are eligible for inclusion in the securities for SLR purposes. They are not issued in scrip form. The purchases and sales are effected through the Subsidiary General Ledger (SGL) account.

At present, there are 91-day, 182-day, and 364-day T-bills in vogue. The 91-day T-bills are auctioned by the RBI every Friday and the 364-day T-bills every alternate Wednesday, i.e., the Wednesday preceding the reporting Friday. Treasury bills are available for a minimum amount of Rs. 25,000 and in multiples thereof.

The call money market is a market for very short-term funds repayable on demand and with a maturity period varying between one day to a fortnight. When money is borrowed or lent for a day, it is known as call (overnight) money. Intervening holidays and/or Sundays are excluded for this purpose. When money is borrowed or lent for more than a day and up to 14 days, it is known as notice money. No collateral security is required to cover these transactions. The call money market is a highly liquid market, with the liquidity being exceeded only by cash. It is highly risky as well as extremely volatile.

A commercial paper is an unsecured short-term promissory note issued at a discount by creditworthy corporates, primary dealers and all-India financial institutions.

A commercial paper is an unsecured short-term promissory note, negotiable and transferable by endorsement and delivery with a fixed maturity period. It is generally issued at a discount by the leading creditworthy and highly rated corporates to meet their working capital requirements. Depending upon the issuing company, a commercial paper is also known as a finance paper, industrial paper, or corporate paper.

CERTIFICATES OF DEPOSIT

Certificates of deposit (CDs) are unsecured, negotiable, short-term instruments in bearer form, issued by commercial banks and development financial institutions.

Certificates of deposit were introduced in June 1989. Only scheduled commercial banks excluding Regional Rural Banks and Local Area Banks were allowed to issue them initially. Financial institutions were permitted to issue certificates of deposit within the umbrella limit fixed by the Reserve Bank in 1992.

Certificates of deposit are time deposits of specific maturity similar to fixed deposits (FDs). The biggest difference between the two is that CDs, being in bearer form, are transferable and tradable while FDs are not. Like other time deposits, CDs are subject to SLR and CRR requirements. There is no ceiling on the amount to be raised by banks. The deposits attract stamp duty as applicable to negotiable instruments.

They can be issued to individuals, corporations, companies, trusts, funds, associates, and others.

A commercial bill is one which arises out of a genuine trade transaction, i.e. credit transaction. As soon as goods are sold on credit, the seller draws a bill on the buyer for the amount due. The buyer accepts it immediately agreeing to pay amount mentioned therein after a certain specified date. Thus, a bill of exchange contains a written order from the creditor to the debtor, to pay a certain sum, to a certain person, after a creation period. A bill of exchange is a ‘self-liquidating’ paper and negotiable/; it is drawn always for a short period ranging between 3 months and 6 months.

COLLATERALISED BORROWING AND LENDING OBLIGATION (CBLO)

The Clearing Corporation of India Limited (CCIL) launched a new product–Collateralised Borrowing and Lending Obligation (CBLO)—on January 20, 2003 to provide liquidity to non-bank entities hit by restrictions on access to the call money market. CBLO is a discounted instrument available in electronic book entry form for the maturity period ranging from 1 day to 19 days. The maturity period can range up to one year as per the RBI guidelines. The CBLO is an obligation by the borrower to return the borrowed money, at a specified future date, and an authority to the lender to receive money lent, at a specified future date with an option/privilege to transfer the authority to another person for value received. The eligible securities are central government securities including treasury bills with a residual maturity period of more than six months. There are no restrictions on the minimum denomination as well as lock-in period for its secondary market transactions.

 

Characteristics of Financial Markets

• Financial markets are characterised by a large volume of transactions and the speed with which financial resources move from one market to another.

• There are various segments of financial markets such as stock markets, bond markets—primary and secondary segments, where savers themselves decide when and where they should invest money.

• There is scope for instant arbitrage among various markets and types of instruments.

• Financial markets are highly volatile and susceptible to panic and distress selling as the behavior of a limited group of operators can get generalised.

• Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of their depositors.

• Negative externalities are associated with financial markets. A failure in any one segment of these markets may affect other segments, including non-financial markets.

• Domestic financial markets are getting integrated with worldwide financial markets. The failure and vulnerability in a particular domestic market can have international ‘ramifications.’ Similarly, problems in external markets can affect the functioning of domestic markets.

In view of the above characteristics, financial markets need to be closely monitored and supervised.

Functions of Financial Markets

The cost of acquiring information and making transactions creates incentives for the emergence of financial markets and institutions. Different types and combinations of information and transaction costs motivate distinct financial contracts, instruments and institutions.

Financial markets perform various functions such as

• enabling economic units to exercise their time preference;

• separation, distribution, diversification, and reduction of risk;

• efficient payment mechanism;

• providing information about companies. This spurs investors to make inquiries themselves and keep track of the companies’ activities with a view to trading in their stock efficiently;

• transmutation or transformation of financial claims to suit the preferences of both savers and borrowers;

• enhancing liquidity of financial claims through trading in securities; and

• providing portfolio management services.

A variety of services are provided by financial markets as they can alter the rate of economic growth by altering the quality of these services.

 

The Clearing Corporation he Clearing Corporation of India Limited

ORGANIZATION

 The Clearing Corporation of India Ltd. (CCIL) was set up in 2001 to provide an institutional infrastructure for the clearing and settlement of transactions in Government Securities, Money Market instruments, Foreign Exchange and other related products. The objective was to bring effi ciency to the transaction settlement process and mitigate the systemic risk emanating from settlement related problems and counterparty risk. CCIL is a payment system operator, authorized by the Reserve Bank of India (RBI) under the PSS Act 2007 to provide guaranteed settlement in Government Securities (G-Secs), Triparty Repo (TREP), Forex and Rupee Derivatives market.

CCIL, through its subsidiary Clearcorp Dealing Systems (India) Limited (CDSL), manages trading platforms in the Money and G-Sec market on behalf of RBI, and also owns trading platforms in the fi xed income, money, forex, and derivative markets. Leveraging from its experience in developing and managing trading systems, CDSL working on RBI’s mandate has developed and successfully launched the first retail forex platform for trading by retail investors in August 2019. Through this platform, retail participants in the forex market for the first time have access to the going market prices thus facilitating greater transparency in the forex market. CCIL also manages the trade repository for the interest rate, forex and credit derivatives markets in India.

The Clearing Corporation of India Ltd was established in April 2001 to render guaranteed clearing and settlement functions concerning transactions in G-Secs, money, derivative markets, and foreign exchange.

The establishment of guaranteed clearing and settlement led to substantial advances in transparency, market efficiency, liquidity, and risk management/measuring practices in these markets, along with additional benefits, such as operating risk and reduced  settlement, savings with respect to settlement costs, etc.

CCIL also offers a non-guaranteed settlement concerning cross-currency transactions and Rupee interest rate derivatives via CLS Bank.

CCIL's compliance with the stringent principles governing its operations as a Financial Market Infrastructure led to its recognition by Reserve Bank of India as a Qualified Central Counterparty (QCCP) in 2014. It also established a Trade Repository for enabling financial institutions to report their transactions via OTC derivatives.

Understanding CCIL in Detail

CCIL is also a trade repository for every OTC transaction in interest rate, Forex, and credit derivative transactions. Portfolio compression is also undertaken on a semi-annual basis for unpaid cleared Forex forward derivative transactions and Rupee Interest Rate Swaps.

CCIL, via its subsidiary Legal Entity Identifiers India Limited, is the Local Operating Unit (LOU) for releasing globally compatible Legal Entity Identifiers (LEIs) in the Indian financial market.

As of today, CCIL is the calculation agent for a few of the big benchmarks utilised by the market under the backing of the Benchmark Administrator, Financial Benchmarks India Limited (FBIL).

 

MARKET SEGMENTS

The main market segments currently covered by CCIL are:-

• Government Securities

 • Money Market

• Forex

• Derivatives

 • Trade Repository