Capital Markets: Types, Difference, Significance, Institutions

  • Post last modified:23/12/2021
  • Reading time:17 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 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).

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.


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.


Significance of Capital Market

The significance of capital market in economic development is explained below:

  1. Mobilisation of Savings
  2. Channelization of Funds into Investments
  3. Industrial Development
  4. Modernization and Rehabilitation of Industries
  5. Encourage Investors to invest in Industrial Securities
  6. Reliable Guide to Performance

Mobilisation of Savings

Capital market is an organized institutional network of financial organizations, which not only mobilizes savings through various instruments but also channelizes them into productive avenues. By making available various types of financial assets, the capital market encourages savings.

By providing liquidity to these financial assets through the secondary markets capital market is able to mobilize large amounts of savings from various sections of the people such as individuals, families, and associations. Thus, the capital market mobilizes these savings and make them same available for meeting the large capital needs of industry, trade and business.

Channelization of Funds into Investments

Capital market plays a crucial role in economic development by channelizing funds in accordance with development priorities. The financial intermediaries in the capital market are better placed than individuals to channel the funds into investments that are more favourable for economic development.

Industrial Development

Capital market contributes to industrial development in the following ways:

  • It provides adequate, cheap and diversified finance to the industrial sector for various purposes.|
  • It provides funds for diversified purposes such as for expansion, modernization, upgradation of technology, establishment of new units etc.
  • It provides a variety of services to entrepreneurs such as provision of underwriting facilities, participating in equity capital, credit rating, consultancy services, etc. This helps to stimulate industrial entrepreneurship.

Modernization and Rehabilitation of Industries

Capital market can contribute towards modernization, rationalization and rehabilitation of industries. For example, the setting up of development financial institutions in India such as IFCI, ICICI, IDBI and so on has helped the existing industries in the country to adopt modernization and replacement of obsolete machinery by providing adequate finance.

Technical Assistance

An important bottleneck 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 in stimulating industrial entrepreneurship. This helps to stimulate industrial investment and thus promotes economic development.

Encourage Investors to invest in Industrial Securities

The secondary markets in securities encourage investors to invest in industrial securities by making them liquid. It provides facilities for continuous, regular and ready buying and selling of securities. Thus, industries are able to raise substantial amounts of funds from various segments of the economy.

Reliable Guide to Performance

The capital market serves as a reliable guide to the performance and financial position of corporate, and thereby promotes efficiency. It values companies accurately and toes up manager compensation to stock values. This gives incentives to managers to maximize the value of companies. This stimulates efficient resource allocation and growth.


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 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.

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, by passing 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 pension 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 fulfils the need for the 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 the 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 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 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.


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