What is Capital Markets? Types, Functions, Institutions, Primary and Secondary Market

  • Post last modified:21/02/2022
  • Reading time:34 mins read

What is Capital Markets?

Capital market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities.

So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issuing various securities such as shares debentures, bonds, etc.

The market where securities are traded is known as the Securities market. It consists of two different segments namely primary and secondary markets. The primary market deals with new or fresh issues of securities and is, therefore, also known as the new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as the stock market or stock exchange.


Types of Capital Markets

Types of capital markets can be classified into two category:

  1. Primary Market
  2. Secondary Market

Primary Market

Primary market provides an opportunity to the issuers of securities, both Government and corporations, to raise funds through the issue of securities. The securities may be issued in the domestic or international markets, at face value, or at a discount (i.e. below their face value) or at a premium (i.e. above their face value).

The primary market issuance is done either through a public issue or private placement. Under the Companies Act, 1956, an issue is referred to as public, if it results in the allotment of securities to 50 investors or more.

However, when the issuer makes an issue of securities to a select group of persons not exceeding 49, and if it is neither a rights issue (i.e. issued only to existing investors) nor a public issue (i.e. made available to any member of the general public to invest in), itis called a private placement. When a company makes a public issue of its equity shares for the first time, it is called an initial public offer (IPO) and subsequent issues are follow-on public offers (FPO).

Features of primary markets are:

  • The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

  • In a primary issue, the securities are issued by the company directly to investors.

  • The company receives the money and issues new security certificates to the investors.

  • Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

  • The primary market performs the crucial function of facilitating capital formation in the economy.

  • The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions.

  • The financial assets sold can only be redeemed by the original holder.

Secondary Market

A secondary market refers to a market, where securities that are already issued by the Government or corporations, are traded between buyers and sellers of those securities. The securities traded in the secondary market could be in the nature of equity, debt, derivatives etc.

As clear from the above, the primary market transactions directly affect the issuing company’s balance sheet (i.e. the financial statement of its assets and liabilities as on any date). For instance, if the company issues equity shares, the equity share capital in its balance- sheet will increase.

On the other hand, secondary market transactions in those equity shares have no impact on the issuing company’s balance sheet. The ownership of the shares will move from the seller to the buyer – but the issuing company’s balance sheet is not affected.

Features of secondary market are:

  • The most important feature of the secondary market is to create liquidity in securities. Liquidity means immediate conversion of securities into cash.

  • Secondary market comes after primary market, i.e. any new security cannot be sold for the first time in the secondary market. New securities are first sold in the primary market and thereafter comes the turn of the secondary market.

  • The secondary market has a particular place which is called Stock Exchange. However, it is not essential that all the buying and selling of securities will be done only through stock exchange. Two individuals can buy or sell them mutually. This will also be called a transaction of the secondary market. Generally, most of the transactions are made through the medium of stock exchange.

  • The rates of shares and other securities often fluctuate in the share market. Many new investors enter this market to exploit this situation. This leads to an increase in investment in the industrial sector of the country and hence increases new investment.

Difference between Primary and Secondary Market


Difference Between Primary Market and Secondary Market

Following are the difference between primary market and secondary market:

  1. Function
  2. Participants
  3. Listing Requirement
  4. Determination of Prices

Function

While the main function of the primary market is to raise long-term funds through fresh issues of securities, the main function of the secondary market is to provide a continuous and ready market for the existing long-term securities.

Participants

While the major players in the primary market are financial institutions, mutual funds, underwriters and individual investors, the major players in the secondary market are all of these and the stockbrokers who are members of the stock exchange.

Listing Requirement

While only those securities can be dealt with in the secondary market, which has been approved for the purpose (listed), there is no such requirement in the case of the primary market.

Determination of Prices

In the case of the primary market, the prices are determined by the management with due compliance with SEBI requirements for the new issue of securities. But in the case of the secondary market, the price of the securities is determined by forces of demand and supply of the market and keeps on fluctuating.


Functions of Capital Market

Capital market has a crucial significance to capital formation. For a speedy economic development adequate capital formation is necessary. The significance of capital market in economic development is explained below:

Mobilization of Savings and Acceleration of Capital Formation

In developing countries like India, the importance of capital market is self-evident. In this market, various types of securities help to mobilize savings from various sectors of population. The twin features of reasonable return and liquidity in the stock exchange are definite incentives to the people to invest in securities. This accelerates the capital formation in the country.

Raising Long-Term Capital

The existence of a stock exchange enables companies to raise permanent capital. The investors cannot commit their funds for a permanent period but companies require funds permanently. The stock exchange resolves this dash of interest by offering an opportunity to investors to buy or sell their securities, while permanent capital with the company remains unaffected.

Promotion of Industrial Growth

The stock exchange is a central market through which resources are transferred to the industrial sector of the economy. The existence of such an institution encourages people to invest in productive channels. Thus it stimulates industrial growth and economic development of the country by mobilizing funds for investment in corporate securities.

Ready and Continuous Market

The stock exchange provides a central convenient place where buyers and sellers can easily purchase and sell securities. Easy marketability makes investment in securities more liquid as compared to other assets.

Technical Assistance

An important shortage faced by entrepreneurs in developing countries is technical assistance. By offering advisory services relating to the preparation of feasibility reports, identifying growth potential and training entrepreneurs in project management, the financial intermediaries in the capital market play an important role.

Reliable Guide to Performance

The capital market serves as a reliable guide to the performance and financial position of corporates, and thereby promotes efficiency.

Proper Channelization of Funds

The prevailing market price of a security and relative yield are the guiding factors for people to channelize their funds in a particular company. This ensures the effective utilisation of funds in the public interest.

Provision of Variety of Services

The financial institutions functioning in the capital market provide a variety of services such as grant of long term and medium-term loans to entrepreneurs, provision of underwriting facilities, assistance in the promotion of companies, participation in equity capital, giving expert advice etc.

Development of Backward Areas

Capital Markets provide funds for projects in backward areas. This facilitates economic development of backward areas. Long term funds are also provided for development projects in backward and rural areas.

Foreign Capital

Capital markets makes possible to generate foreign capital. Indian firms are able to generate capital funds from overseas markets by way of bonds and other securities. Government has liberalised Foreign Direct Investment (FDI) in the country. This not only brings in foreign capital but also foreign technology which is important for economic development of the country.

Easy Liquidity

With the help of secondary market investors can sell off their holdings and convert them into liquid cash. Commercial banks also allow investors to withdraw their deposits, as and when they are in need of funds.

Revival of Sick Units

The Commercial and Financial Institutions provide timely financial assistance to viable sick units to overcome their industrial sickness. To help the weak units to overcome their financial industrial sickness banks and FIs may write off a part of their loan.


Institutions of Capital Market

Capital market activities create the need for different kinds of institutions. A brief on these institutions follows:

  1. Stock Exchange
  2. Clearing Corporation
  3. Merchant Bankers / Investment Bankers
  4. Underwriters
  5. Registrar & Transfer Agents (RTA)
  6. Depository
  7. Mutual Funds
  8. Venture Capital Funds & Private Equity Funds
  9. Foreign Institutional Investors (FII)
  10. Insurance Companies
  11. Pension Funds

Stock Exchange

The National Stock Exchange (NSE) is India’s premier stock exchange. A critical role is to offer a platform for secondary market trades. NSE provides trading in four different segments- Wholesale Debt Market, Capital Market, Futures and Options and Currency Derivatives Segment.

Clearing Corporation

Once trades are executed, the clearing and settlement is handled by the clearing corporation, which may operate as an independent entity or a subsidiary of the exchange. The National Securities Clearing Corporation Ltd. (NSCCL), a wholly-owned subsidiary of NSE, is responsible for clearing and settlement of trades executed at the NSE.

As part of its role, NSCCL provides financial guarantees for all the settlements. This takes care of any counter-party risk. Further, NSCCL helps in managing the risk in the market through an effective margining system.

CRISIL has assigned its highest corporate credit rating of ‘AAA’ to the National Securities Clearing Corporation Ltd (NSCCL). ‘AAA’ rating indicates the highest degree of strength with regard to honouring debt obligations. The rating also factors in NSCCL’s rigorous risk management controls and adequate settlement guarantee cover. Clearing corporations are regulated by SEBI.

Merchant Bankers / Investment Bankers

Issuing companies mobilise money from investors through the issue of securities in the primary market. Merchant bankers assist companies in handling the issue. Merchant Bankers are regulated by SEBI.

Underwriters

The success of a public issue many times depends on the prevailing sentiment in the markets. Companies and their merchant bankers prefer the certainty that the expected funds will be mobilized. This certainty is brought in by appointing Underwriters.

Every underwriter commits to bring in an agreed amount as part of the issue. Thus, if the targeted money is not mobilized in the issue, the underwriters bring in the funds to bail out the issue. Underwriters are regulated by SEBI.

Registrar & Transfer Agents (RTA)

The RTA keeps a record of the shareholders and their shareholding in the company. In a public issue, RTA is responsible for allotting shares to applicants on the basis of the allotment formula that is finalized between the company, its merchant banker and the stock exchange.

The RTA also assists companies in executing various corporate actions such as dividend payments, rights issues (issue of new shares at an agreed price to existing investors) and bonus issues (issue of new shares, free, to existing investors).RTAs are regulated by SEBI.

Depository

Although a company issues securities as part of its resource mobilization exercise, the investor is rarely given a physical certificate. It is normal practice for investors to have a depository account, into which their investments are credited; when they sell any part of their portfolio, the corresponding investments are reduced from their depository account.

Thus, a depository account serves the same purpose for securities, as a bank account serves for money. NSE, along with some other institutions, promoted India’s first depository, National Securities Depository Ltd (NSDL). Central Depository Services (India) Ltd is the other depository that operates in the country. The depositories have made an instantaneous electronic transfer of securities possible.

Demat (Dematerialised) settlement has eliminated the bad deliveries and associated problems which existed in the physical settlement of securities transactions in the country. To prevent physical certificates from sneaking into circulation, it has been made mandatory for all newly issued securities to be compulsorily traded in dematerialised form.

Now, the public listed companies making IPO of any security for Rs.10 crore or more have to make the IPO only in dematerialised form. Depositories are regulated by SEBI.

Mutual Funds

Mutual Funds are vehicles to mobilise funds from investors, through various schemes. The funds are then invested in line with the scheme guidelines, for the benefit of investors. Mutual Funds in India are regulated by SEBI.

Venture Capital Funds & Private Equity Funds

Businesses need to reach a certain size, before they are in a position to mobilize funds from the public at large. Their resource requirements until then can be met through Venture Capital Funds and Private Equity Funds. The Venture Capital funds invest at a very early stage in a company, and are prepared to take the risk of the venture failing.

Private Equity funds tend to invest at a later stage, after the business has demonstrated some progress in executing its business model. At times, the difference between these two categories of funds is lost in the market. Venture Capital Funds need to register with SEBI. Foreign venture capital investors are also regulated by RBI.

Foreign Institutional Investors (FII)

Institutional investors are organizations who invest their own funds or pool sums of money from investors and invest those sums in investible assets such as equity, debt, government securities, commodities etc.

FIIs are institutional investors from or registered in a country outside of the one in which they are currently investing. FIIs invest their proprietary (own) funds or pool money and invest on behalf of “broad-based” funds, corporates, foreign individuals etc. FIIs are entitled to operate as such, based on their registration with SEBI and the RBI.

The detailed eligibility and operating guidelines exist for FIIs (can be found on SEBI and RBI websites). Investments by FIIs enjoy full capital account convertibility. They can invest in a company under portfolio investment route upto 24% of the paid up capital of the company.

This can be increased up to the sectoral cap / statutory ceiling, as applicable to the Indian companies concerned, bypassing a resolution of its Board of Directors followed by a special resolution to that effect by the company at its general body. FIIs are regulated by both SEBI and RBI.

Insurance Companies

Life insurance policies that are taken to cover the lives of individuals are typically of long tenors. Often they extend over several decades. Insurance companies invest the funds available with them in the primary and secondary markets.

Life insurance companies thus become a source of long term funds in the capital market.Insurance companies are regulated by Insurance Regulatory & Development Authority (IRDA). For their operations in the capital market, they also need to comply with the capital market regulations of SEBI.

Pension Funds

People look towards pensions to give them a regular stream of income during their retirement years. The regulatory framework in the area is still evolving. Anyone can buy an annuity product from an insurance company, by paying a lump sum amount. Companies too can buy such contracts from insurance companies, on behalf of employees.

The annuity payments from the insurance company under the contract fulfil the need for a regular stream of income for a retired employee. These operations of insurance companies are regulated by IRDA. New Pension Scheme (NPS) is a pension scheme regulated by the Pension Fund Regulatory and Development Authority (PFRDA).

The NPS provides for regular contributions by individuals or employers of individuals towards a pension plan. The contributions accumulate during the earning years of the individual. Towards retirement, the accumulations are to be used to buy an annuity from an insurance company.

Like insurance, pension funds are a source of long-term funds for the capital market. As seen above, different aspects of pension are regulated by PFRDA and IRDA. Pension funds also need to comply with the capital-market related regulations of SEBI while investing in the markets.


Primary Market Process

An entrepreneur having an idea looks for people who will provide the seed capital to help him take the initial idea forward. Family, relatives, friends, colleagues and former colleagues are typical seed capital investors, also called angels.

They invest based on their comfort with and confidence in the entrepreneur. Seed capital investors need the clarity that their investment can be completely written off, if, for any reason, the entrepreneurial idea does not work out. Assuming the idea progresses well, the entrepreneur soon needs larger sums of money than is possible to collect from his immediate circle of family, friends and associates.

He needs venture capital. Venture capital investors are long-term investors who are prepared to take the risk that the entrepreneurial project can fail. However, if it succeeds, they reap profits, because their investment happens at a low business valuation.

Once the pilot is ready and there is greater clarity on the efficacy of the business model, the entrepreneur is confident that his idea will work. He now starts thinking of scaling up. In such a situation, where project risks are less, private equity capital can be attracted. Private equity investors invest at higher business valuations than venture capital investors and invest with a shorter time horizon.

They tend to expect an opportunity to sell their investments in about 2 years through a sale either to some strategic investor or as part of the IPO of the company. Strategic investors are investors who invest in a company because it fits their business strategy.

For example, an automobile company’s investment in one of its auto ancillary suppliers. Financial investors invest in a company because they see value in it. Angel investors, venture capital investors and private equity investors are examples of financial investors. They will sell of their shares at some stage.

Thus, their behaviour pattern is different from strategic investors, who are driven by the strategic fit, rather than potential gain on sale of the shares. An entrepreneur looking for pure funding and the benefit of the investor’s connections will go for financial investors. If he wants some kind of technical or commercial capabilities too, he may look for a strategic investor.


Secondary Market Process

Secondary market is the place for sale and purchase of existing securities. It enables an investor to adjust his holdings of securities in response to changes in his assessment about risk and return. It also enables him to sell securities for cash to meet his liquidity needs.

It essentially comprises of the stock exchanges, which provide a platform for trading of securities and a host of intermediaries who assist in trading of securities and clearing and settlement of trades. The securities are traded, cleared and settled as per the prescribed regulatory framework under the supervision of the Exchanges and SEBI:

  1. Stock Exchange
  2. Wholesale Debt Market (WDM) Segment
  3. Futures & Options (F&O) Segment
  4. Currency Derivatives Segment (CDS) Segment
  5. Membership

Stock Exchange

The stock exchanges are the exclusive centres for trading of securities. Listing of companies on a Stock Exchange is mandatory to provide an opportunity to investors to invest in the securities of local companies. The trading volumes on exchanges have been witnessing phenomenal growth for last few years. For example, the National Stock Exchange (NSE) is India’s premier stock exchange.

A critical role is to offer a platform for secondary market trades. NSE provides trading in four different segments- Wholesale Debt Market, Capital Market, Futures and Options and Currency Derivatives Segment.

Wholesale Debt Market (WDM) Segment

This segment commenced its operations in June 1994. It provides the trading platform for wide range of debt securities, which includes State and Central Government securities, T-Bills, PSU Bonds, Corporate debentures, Commercial Papers, Certificate of Deposits etc.

Capital Market (CM) Segment

This segment commenced its operations in November 1995. It offers a fully automated screen based trading system, known as the National Exchange for Automated Trading (NEAT) system. Various types of securities e.g. equity shares, warrants, debentures etc. are traded on this system.

Futures & Options (F&O) Segment

This segment provides trading in derivatives instruments like index futures, index options, stock options, and stock futures, and commenced its operations at NSE in June 2000.

Currency Derivatives Segment (CDS) Segment

This segment commenced its operations on August 29, 2008, with the launch of currency futures trading in US Dollar-Indian Rupee (USD- INR). ‘Interest rate futures’ was another product made available for trading on this segment with effect from August 31, 2009.

Membership

There are no entry/exit barriers to the membership of any stock exchange. Anybody can become a member by complying with the prescribed eligibility criteria and exit by surrendering membership without any hidden cost.

The members are admitted to different segments of the Exchange subject to the provisions of the Securities Contracts (Regulation) Act, 1956, the SEBI Act, 1992, the rules, circulars, notifications, guidelines, etc. issued hereunder and the byelaws, rules and regulations of the Exchange. Members can trade on stock exchanges on behalf of their clients.


Difference between Money Market and Capital Market

Money MarketCapital Market
DefinitionIs a component of the financial markets where short-term borrowing takes placeIs a component of financial markets where long-term borrowing takes place
Maturity PeriodLasts anywhere from 1 hour to 90 days.Lasts for more than one year and can also include a lifetime of a company.
Credit InstrumentsCertificate of deposit, Repurchase agreements, Commercial paper, Eurodollar deposit, Federal funds, Municipal notes, Treasury bills, Money funds, Foreign Exchange Swaps, short-lived mortgage and asset-backed securities.Stocks, Shares, Debentures, Bonds, Securities of the Government.
Nature of Credit InstrumentsHomogenous. A lot of various causes problems for investors.Heterogeneous. A lot of varieties are required.
Purpose of LoanShort-term credit is required for small investments.Long-term credit is required to establish business, expand business or purchase fixed assets.
Basic RoleLiquidity adjustmentPutting capital to work
InstitutionsCentral banks, Commercial banks, Acceptance houses, Nonbank financial institutions, Bill brokers, etc.Stock exchanges, Commercial banks and Nonbank institutions, such as Insurance Companies, Mortgage Banks, Building Societies, etc.
RiskRisk is smallRisk is greater
Market RegulationCommercial banks are closely regulated to prevent occurrence of a liquidity crisis.Institutions are regulated to keep them from defrauding customers.
Relation with Central BankClosely related to the central banks of the country.Indirectly related with central banks and feels fluctuations depending on the policies of central banks.

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