Module 8

MODULE 8
DEVELOPMENT OF CAPITAL MARKETS IN INDIA

8.1 INTRODUCTION

The Indian capital market’s history can be traced back to 1861 when the American Civil War
began and the East India Company securities were traded in the country. The tremendous
increase in exports to the United Kingdom and United States was seen with the opening of the
Suez Canal during the 1860s. During this period, several companies were formed and many
banks came to the fore to handle the finances relating to these trades. Many of these were
registered under the British Companies Act, and the Stock Exchange, Mumbai, came into
existence in 1875.
Earlier, business was essentially confined to company owners and brokers, with very little
interest evinced by the general public. They were basically an unincorporated body of
stockbrokers, and they started doing business in the city under a banyan tree.

Due to the American war and the battles in Europe there had been much fluctuation in the stock
market. Sir Phiroze Jeejeebhoy dominated the stock market scene from 1946 to 1980. His word
was law and he had a great deal of influence over both brokers and the government. He was a
good regulator and many crises were averted due to his wisdom and practicality. The BSE
building, icon of the Indian capital markets, is called P.J. Tower in his memory.

In India the importance were being given to the formation of institutions and markets in the year
1951. The Indian Contract Act 1872, were the parent regulation and after that the Securities
Contract Regulation Act 1956 came into force, which formulated the basic law to be followed by
security markets in India. To regulate the issue of share prices, the Controller of Capital Issues
Act (CCI) was passed in 1947.

In the last 140 years of the existence the stock markets have had many turbulent times. Mr. T.T.
Krishnamachari, the then finance minister, with the imposition of wealth and expenditure tax in
1957 led to a huge fall in the markets. The dividend freeze and tax on bonus issues in 1958-59

also had a negative impact. War with China in 1962 was another memorably bad year, with the
resultant shortages increasing prices all round. This led to a ban on forward trading in
commodity markets in 1966, which was again a very bad period, together with the introduction
of the Gold Control Act in 1963. The markets have witnessed several golden times too. Retail
investors began participating in the stock markets in a small way with the dilution of the Foreign
Exchange Regulation Act (FERA) in 1978. Multinational companies, with operations in India,
were forced to reduce foreign shareholding to below a certain percentage, which led to a
compulsory sale of shares or issuance of fresh stock. Indian investors, who applied for these
shares, encountered a real lottery because those were the days when the CCI decided the price at
which the shares could be issued. There was no free pricing and their formula was very
conservative.

The next big boom and mass participation by retail investors happened in 1980, with the entry of
Mr. Dhirubhai Ambani. Dhirubhai can be said to be the father of modern capital markets. The
Reliance public issue and subsequent issues on various Reliance companies generated huge
interest. The general public was so unfamiliar with share certificates that Dhirubhai is rumoured
to have distributed them to educate people.

Mr. V.P. Singh’s fiscal budget in 1984 was path breaking for it started the era of liberalization.
The removal of estate duty and reduction of taxes led to a swell in the new issue market and
there was a deluge of companies in 1985. Mr. Manmohan Singh as Finance Minister came with a
reform agenda in 1991 and this led to a resurgence of interest in the capital markets. The mid-
1990s saw a rise in leasing company shares, and hundreds of companies, mainly listed in
Gujarat, and got listed in the BSE. The end- 1990s saw the emergence of Ketan Parekh and the
information, communication and entertainment companies came into the limelight. This period
also coincided with the dotcom bubble in the US, with software companies being the most
favoured stocks.

There was a meltdown in software stock in early 2000. Mr. P Chidambaram continued the
liberalization and reform process, opening up of the companies, lifting taxes on long-term gains
and introducing short-term turnover tax. The markets have recovered since then and we have

witnessed a sustained rally that has taken the index over 13000. Several systemic changes have
taken place during the short history of modern capital markets.

The landmark development came up with the setting up of the Securities and Exchange Board
(SEBI) in 1992, it obtained the requisite powers and became effective in early 2000. The setting
up of the National Stock Exchange in 1984, the introduction of online trading in 1995, the
establishment of the depository in 1996, trade guarantee funds and derivatives trading in 2000,
have made the markets safer. The introduction of the Fraudulent Trade Practices Act, Prevention
of Insider Trading Act, Takeover Code and Corporate Governance Norms, are major
developments in the capital markets over the last few years that has made the markets attractive
to foreign institutional investors.

8.2 MEANING

The capital market is a market for long –term funds both equity and debt- and funds raised
within and outside of the country.

ILLUSTRATIONS:

It can be said that capital market is a market in which money is provided for periods longer than
a year, as the raising of short-term funds takes place on other markets (e.g., the money market).
The capital market includes the stock market (equity securities) and the bond market (debt).

The capital markets can be divided into two parts: (i) Primary Market and (ii) Secondary Market.
The primary market refers to the long –term flow of funds from the surplus sector to the
government and corporate sector (through primary issues) and to banks and non-banks financial
intermediaries (through secondary issues). A primary issue of the corporate sector leads to
capital information (creation of net fixed assets and incremental change in inventories). The
secondary market is a market for outstanding securities. Unlike primary issues in the primary
market which result in capital information, the secondary market facilitates only liquidity and
marketability of outstanding debt and equity instruments.

8.3 EVOLUTION

For a developing economy like India, capital market play an important role as it connects the gap
between savings and investment also the fund requirement in met which is important for
companies. Thus there are two components of India capital market –Equity market and Debt
market.

The equity market in India is one of the oldest in the Asia region. The stock market in India had
been active for about 150 years that played a significant role in developing risk markets. This
also helped in promoting enterprise and supporting the growth of industry. As we have already
studied that the stock market in India began in the 1860s during the American Civil War that led
to a sudden surge in the demand for cotton from India resulting in setting up of a number of joint
stock companies that issued securities to raise finance. This trend was akin to the rapid growth of
securities markets in Europe and the North America in the background of expansion of railroads
and exploration of natural resources and land development. There were about 1,000 brokers with
the stock markets functioning from three places in Mumbai; between 9 am- 7 pm. Share prices
rose sharply even at that time. Bombay, at that time, was a major financial centre having housed
31 banks, 20 insurance companies and 62 joint stock companies.

The first stock exchange was established in Mumbai. Before the first exchange set up the market
was completely under the control of local enterprises. Later other stock exchanges came up in
cities like Ahmadabad, Hyderabad, Madras etc. there are a number of factors that led to faster
growth of the Indian stock market. Some of them are Foreign Exchange Regulation Act (FERA)
which bought in foreign investment by various multinational firms. This in turn increased the
scope of capital market.
Many economic and financial reforms helped greatly in the growth of the capital market.

The trading processes and the infrastructure required were improved with the current demand
and the technological improvement. The importance of an efficient micro market infrastructure
was realized.

Stock markets have been showing phenomenal growth since 1990s. This has been possible
because of growing participation of both Indian and foreign investments, also the wide range of
reforms and regulations that has been bought time to time based on the market and economic
conditions. Foreign Institutional investment which is one important component has shown a
continuous growth since inception. Stock market slowly became technology oriented i.e. they
became computerized and manual transaction decreased. This helped in saving time, cost and
reduced the risk of error. Electronic trading, digital certification, straight through processing,
electronic contract notes, online broking have made the market more dynamic.

The products offered at the stock market also increased from mere equity to derivative, future,
option and many more. The proper risk management system came into place reducing the risk of
payment defaults. The demutualization and corporatization of all stock exchanges is nearing
completion and the boards of the stock exchanges now have majority of independent directors.
The knowledge of people regarding stock market also is one important factor leading to the
growth of the Indian stock market. The number of high net worth individual has been increasing
who invest in the stock market either directly or through mutual funds.

8.4 IMPACT OF CAPITAL MARKET ON INDIAN ECONOMY

The capital market is a long term finance for corporate and government. It is a market for
securities, where companies and governments can raise long term funds. Selling stock and
selling bonds are two ways to generate capital and long term funds. It provides a new avenue to
corporate and government to raise funds for long term. It also helps to bridge investment–savings
gap.

Capital market expands the investment options available in the country, which attracts portfolio
investments from abroad. Domestic savings are also facilitated by the availability of additional
investment options. This helps to connect the investment and savings and paves the way for
economic development. Capital market in any country provides the corporate and government to
raise long term finance at a low cost as compared to other modes of raising finance. Therefore

capital market is important, more so for India as it embarks on the path of becoming a developed
country. Capital market provides the investors both domestic as well as foreign, various
instruments to invest their surplus funds. Not only it provides an avenue to park surplus funds
but it also helps the investors to reap decent rewards on their investment. This realization has
resulted in increased investments in capital market both from domestic as well as foreign
investors in Indian capital market.

8.5 CONDUCIVE TO IMPLEMENTATION OF MONETARY POLICY

Since RBI controls the movement and availability of money in the economy. When RBI follows
the expansionary policy it purchases government securities from the bond market and sells the
same in the in the secondary market. This process has some effect on the interest rates. Thus
capital market helps RBI in applying the monetary policy.

Capital market is said to be the face of the economy. This is so because when capital market is
stable, investments flow into capital market from within as well as outside the country, which
indicates that the future prospects of the economy are good.

8.6 STRUCTURE

The capital market consists of the primary markets and the secondary markets and there is a
close link between them. The primary market creates long-term instruments through which
corporate entries borrow from the capital market. But secondary market is the one which
provides liquidity and marketability to these instruments. These markets interact with one
another. If the secondary market is active it enables the corporate entities to enter the new issue
market or the primary market and raise funds. Simultaneously the depth of the secondary market
depends upon the activities of the primary market because it is only when more corporate entities
enter into the market and raise funds through the market that more instruments are available in
the secondary market for the purpose of improved activities in this market.

8.7 MARKET COMPONENTS

8.7.1 EQUITY

Stock or any other security representing an ownership interest.
On the balance sheet, the amount of the funds contributed by the owners (the
stockholders) plus the retained earnings (or losses), also referred to as "shareholder's
equity".
In the context of margin trading, the value of securities in a margin account minus what
has been borrowed from the brokerage. In the simplest term Equity is an ownership in
any asset after all the debts associated with it are paid off. Stock share termed as equity as
they give ownership of the company to the person who possesses it. Since they are the
owner any profit earned by the company are first paid to the debenture and bond holders.
After all the obligations are met, if still anything left is distributed among the equity
holders as per the number of stocks held by them. Equity delivers good results if held for
a longer period of time. On the other hand short term investment in equity is very risky
and volatile. Most of the time fund and portfolio managers suggest long term investment
if the investment equity oriented.

8.7.2 DERIVATIVES

8.7.2.1 DIFFERENT TYPES OF DERIVATIVES: FORWARDS

A forward contract is an agreement between two parties wherein settlement takes place at a
specified future date but at a price agreed today eg.:- On 1st October a farmer entering into a
forward contract to sell 1000 KGs of wheat on 31st December at 50 Rs/Kg.

8.7.2.2 DIFFERENT TYPES OF DERIVATIVES: FUTURES

It is agreement between two parties to buy/sell an asset on a specified future date at a certain
price.

8.8 REFORMS IN INDIAN SECURITIES MARKET:

Reform in any area is necessary to bring necessary changes and to be on par with the current
situation. Various countries are adopting different capital market reforms to strengthen their
economy. All the countries have had various capital market reforms in the past and are having
currently too. These reforms have helped them by bringing new ideas and techniques. Since the
capital market is globalised the economic or financial change in one economy effects the other,
so the reforms have to be made keeping in mind not only the nation’s situation but all
other aspects that will be affected by the same. SEBI has announced a number of far-reaching
reforms to promote the capital market and protect investor interests. Reforms in the secondary
market have focused on three main areas:

Structure and functioning of stock exchanges.
Automation of trading and post trade systems.
The beginning of surveillance and monitoring systems.

Computerized online trading of securities, and setting up of clearing houses or resolution
guarantee funds were made compulsory for stock exchanges. Section 117(2) talks about
imposing fine in case of Failure/Delay in filing certain resolutions but after 2018 amendment
non-compliance would result in penalty instead of fine. Stock exchanges were allowed to
expand their trading to locations outside their jurisdiction through computer terminals.

Thus, major stock exchanges in India have in progress of locating computer terminals in far-
flung areas, while minor regional exchanges are planning to consolidate by using centralized
trading under a federated structure. Online trading systems have been started in almost all stock
exchanges. Trading is much more transparent and faster than in the past.

Until the early 1990s, the trading and settlement infrastructure of the Indian capital market was
deprived, trading on all stock exchanges was through open outcry, settlement systems were
paper-based, and market intermediaries were largely unregulated.

The regulatory structure was fragmented and there was neither complete registration nor an apex
body of regulation of the securities market. Stock exchanges were run as “brokers clubs” as their
management was mainly composed of brokers. There was no prevention on insider trading, or
fraudulent and unfair trade practices.

Since 1992, there has been intensified market reform, resulting in a big development insecurities
trading, particularly in the secondary market for equity. The majority stock exchanges have
introduced online trading and set up clearing houses/corporations. A depository has become
operational for script less trading and the regulatory arrangement has been overhauled with most
of the powers for amendable the capital market vested with SEBI.

The Indian capital market has practiced a process of structural transformation with operations
conducted to standards equal to those in the developed markets. It was opened up for investment
by foreign institutional investors (FIIs) in 1992 and Indian companies were permitted to increase
resources abroad through Global Depository Receipts (GDRs) and Foreign Currency Convertible
Bonds (FCCBs).

The primary and secondary segments of the capital market extended rapidly, with greater
institutionalization and wider participation of individual investors accompanying this growth.
But, various problems, including lack of confidence in stock investments, institutional overlaps,
and other governance issues, continue as obstacles to the improvement of Indian capital market
efficiency.

8.8.1 REFORMS IN THE INDIAN CAPITAL MARKET:

As a first step to reform the capital market, the Securities and Exchange Board of India
(SEBI), which was earlier set up in April 1988 as a no statutory body under an
administrative arrangement, was given statutory powers in January 1992 through an
enactment of the SEBI Act, 1992 for regulating the securities markets. Investor protection
and orderly development are two main objectives in the SEBI act1992 of the capital
market.

The most significant development in the primary capital market has been the introduction
of free pricing. The issuers of securities are now allowed to raise the capital from the
market without requiring any consent from any authority either for making the issue or
for pricing it. However, the issue of capital has been brought under SEBI’s purview in
that issuers are required to meet the SEBI guidelines for Disclosure and Investor
Protection, which, in general, cover the eligibility norms for making issues of capital
(both public and rights) at par and at a premium by various types of companies,
reservation in issues, etc.

The abolition of capital issues control and the freeing of the pricing of issues led to
unprecedented upsurge of activity in the primary capital market as the corporate
mobilized huge resources. It, inter alia, exposed certain inadequacies of the regulations.
Therefore, without seeking to control the freedom of the issuers to enter the market and
freely price their issues, the SEBI further strengthened the norms for public issues in
April 1996. Section 53(3) which talks about Prohibition of Issue of shares at discount
earlier had the provision of fine or imprisonment or both to officer in default and fine to
Company but after 2018 amendment it says that Company and every officer in default
liable to penalty equivalent to amount raised through issue of shares at discount or INR
5,00,000/- whichever is less. The Company shall also be liable to refund all money
received with interest @ 12 % p.a. Alongside, SEBI raised the standards of disclosure in
public issues to enhance their transparency for improving the levels of investor
protection. Issuers of capital are now required to disclose information on various
aspects, such as, track record of profitability, risk factors, etc. Issuers now also have the
option of raising resources through fixed price floatation or the book building process.

Trading infrastructure in the stock exchanges has been modernized by replacing the open
outcry system with on-line screen based electronic trading, unlike several of the
developed countries where the two systems still continue to exist on the same exchange.
In all, 23 stock exchanges in India have approximately 8,000 trading terminals spread all

over the country. This improved the liquidity of the Indian capital market and a better
price discovery.

The trading and settlement cycles were initially shortened from 14 days to 7 days.
Subsequently, to further enhance the efficiency of the secondary market, rolling
settlement was introduced on a T+5basis. With effect from April 1, 2002, the settlement
cycle was further shortened to T+3 for all listed securities. The settlement cycle is now
T+2.

All stock exchanges in the country have established clearing houses. Consequently, all
transactions are settled through the clearing house only and not directly between
members, as was practiced earlier.

Several measures have been undertaken/ strengthened to ensure the safety and integrity of
the market. These are: margining system, intra-day trading limit, exposure limit and
setting up of trade/settlement guarantee fund.

Securities, which were earlier held in physical form, have been dematerialized and their
transfer is done through electronic book entry, which has eliminated some of the
disadvantages of securities held in physical form. There are two depositories operating in
the country.

In India, all listed companies are now required to furnish to the stock exchanges and also
publish unaudited financial results on a quarterly basis. To enhance the level of
continuous disclosure by the listed companies, the SEBI decided to amend the Listing
Agreement to incorporate the Segment Reporting, Accounting for Taxes on Income,
Consolidated Financial Results, Consolidated Financial Statements, Related Party
Disclosures and Compliance with Accounting Standards.

The Indian capital market is also increasingly integrating with the international capital
markets. One of the significant steps towards integrating Indian capital market with the

international capital markets was the permission given to Foreign Institutional Investors
(FIIs) such as, mutual funds, pension funds and country funds to operate in the Indian
markets. Indian firms have also been allowed to operate in the Indian markets. Indian
firms have also been allowed to raise capital from 14 international capital markets
through issues of Global Depository Receipts (GDRs), American Depository Receipts
(ADRs), Euro Convertible Bonds (ECBs), etc.

Boards of various stock exchanges, which in the past included mainly brokers, have been
broad-based in order to make them more widely representative so that they represent
different interests and not just the interests of their members. Reconstituted Governing
Boards have now broker and non-broker representation in the ratio of 50-50 apart from
the Executive Director who has a seat on the Board and is required to be a non-broker
professional. To remove the influence of brokers in the functioning of stock exchanges,
the SEBI decided that no broker member of the stock exchange shall be an office bearer
of an exchange or hold the position of President, Vice President, Treasurer, etc. Efforts
are afoot to demutualise and corporatize the stock exchanges.

Apart from stock exchanges, various intermediaries, such as mutual funds, stock brokers
and sub-brokers merchant bankers, portfolio managers, registrars to an issue and share
transfer agents, underwriters, debenture trustees, bankers to an issue, custodian of
securities, venture capital funds and issuers have been brought under the SEBI’s
regulatory purview.

There are now regulations in place governing substantial acquisition of shares and
takeovers of companies. The Regulations are aimed at making the takeover process more
transparent and to protect the interests of minority shareholders.

Trading in derivative products, such as stock index future, stock index options and
futures and options in individual stocks have also been introduced.

Capital market is one of the most important segments of the Indian financial system. It is the
market available to the companies for meeting their requirements of the long-term funds. It refers
to all the facilities and the institutional arrangements for borrowing and lending funds. In other
words, it is concerned with the raising of money capital for purposes of making long-term
investments. The market consists of a number of individuals and institutions (including the
Government) that canalise the supply and demand for long -term capital and claims on it. The
demand for long term capital comes predominantly from private sector manufacturing industries,
agriculture sector, trade and the Government agencies. While, the supply of funds for the capital
market comes largely from individual and corporate savings, banks, insurance companies,
specialised financing agencies and the surplus of Governments.

8.9 DIVISION OF INDIAN CAPITAL MARKETS:

The Indian capital market is broadly divided into the gilt-edged market and the industrial
securities market.

The gilt-edged market refers to the market for Government and semi-government
securities, backed by the Reserve Bank of India (RBI). Government securities are
trade able debt instruments issued by the Government for meeting its financial
requirements. The term gilt-edged means 'of the best quality'. This is because the
Government securities do not suffer from risk of default and are highly liquid (as they
can be easily sold in the market at their current price). The open market operations of
the RBI are also conducted in such securities.
The industrial securities market refers to the market which deals in equities and
debentures of the corporates. It is further divided into primary market and secondary
market.

8.9.1 PRIMARY MARKET (NEW ISSUE MARKET):

Deals with 'new securities', that is, securities which were not previously available and are offered
to the investing public for the first time. It is the market for raising fresh capital in the form of
shares and debentures. It provides the issuing company with additional funds for starting a new

enterprise or for either expansion or diversification of an existing one, and thus its contribution to
company financing is direct. The new offerings by the companies are made either as an initial
public offering (IPO) or rights issue.

8.9.2 SECONDARY MARKET/ STOCK MARKET (OLD ISSUES MARKET OR
STOCK EXCHANGE):

Is the market for buying and selling securities of the existing companies. Under this, securities
are traded after being initially offered to the public in the primary market and/or listed on the
stock exchange. The stock exchanges are the exclusive centres for trading of securities. It is a
sensitive barometer and reflects the trends in the economy through fluctuations in the prices of
various securities. It been defined as, "a body of individuals, whether incorporated or not,
constituted for the purpose of assisting, regulating and controlling the business of buying, selling
and dealing in securities". Listing on stock exchanges enables the shareholders to monitor the
movement of the share prices in an effective manner. This assist them to take prudent decisions
on whether to retain their holdings or sell off or even accumulate further. However, to list the
securities on a stock exchange, the issuing company has to go through set norms and procedures

8.10 LAWS APPLICABLE ON CAPITAL MARKETS OF INDIA

In India, the capital market is regulated by the Capital Markets Division of the Department of
Economic Affairs, Ministry of Finance. The division is responsible for formulating the policies
related to the orderly growth and development of the securities markets (i.e. share, debt and
derivatives) as well as protecting the interest of the investors. In particular, it is responsible for
(i) institutional reforms in the securities markets, (ii) building regulatory and market institutions,
(iii) strengthening investor protection mechanism, and (iv) providing efficient legislative
framework for securities markets, such as Securities and Exchange Board of India Act, 1992
(SEBI Act 1992); Securities Contracts (Regulation) Act, 1956; and the Depositories Act, 1996.
The division administers these legislations and the rules framed there under.

The Securities and Exchange Board of India (SEBI) is the regulatory authority established under
the SEBI Act 1992, in order to protect the interests of the investors in securities as well as
promote the development of the capital market. It involves regulating the business in stock

exchanges; supervising the working of stock brokers, share transfer agents, merchant bankers,
underwriters, etc; as well as prohibiting unfair trade practices in the securities market.

SEBI has notified the disclosures and other related requirements for companies
desirous of issuing Indian depository receipts in India. It has been mandated that:- (i)
the issuer must be listed in its home country; (ii) it must not have been barred by any
regulatory body; and (iii) it should have a good track record of compliance of
securities market regulations.

As a condition of continuous listing, listed companies have to maintain a minimum
level of public shareholding at 25 per cent of the total shares issued. The exemptions
include:- (i) companies which are required to maintain more than 10 per cent, but less
than 25 per cent in accordance with the Securities Contracts (Regulation) Rules,
1957; and (ii) companies that have two crore or more of listed shares and Rs. 1,000
crore or more of market capitalisation.

SEBI has specified that shareholding pattern will be indicated by listed companies
under three categories, namely, 'shares held by promoter and promoter group'; 'shares
held by public' and 'shares held by custodians and against which depository receipts
have been issued'.

In accordance with the guidelines issued by SEBI, the issuers are required to state on
the cover page of the offer document whether they have opted for an IPO (Initial
Public Offering) grading from the rating agencies. In case the issuers opt for a
grading, they are required to disclose the grades including the unaccepted grades in
the prospectus.

SEBI has facilitated a quick and cost effective method of raising funds, termed as
'Qualified Institutional Placement (QIP)' from the Indian securities market by way of
private placement of securities or convertible bonds with the Qualified Institutional
Buyers.

SEBI has stipulated that the benefit of ‘no lock-in’ on the pre-issue shares of an
unlisted company making an IPO, currently available to the shares held by Venture

Capital Funds (VCFs)/Foreign Venture Capital Investors (FVCIs), shall be limited
to:- (i) the shares held by VCFs or FVCIs registered with SEBI for a period of at least
one year as on the date of filing draft prospectus with SEBI; and (ii) the shares issued
to SEBI registered VCFs/FVCIs upon conversion of convertible instruments during
the period of one year prior to the date of filing draft prospectus with SEBI.

In order to regulate pre-issue publicity by companies which are planning to make an
issue of securities, SEBI has amended the 'Disclosure and Investor Protection
Guidelines' to introduce 'Restrictions on Pre-issue Publicity'. The restrictions, inter
alia, require an issuer company to ensure that its publicity is consistent with its past
practices, does not contain projections/ estimates/ any information extraneous to the
offer document filed with SEBI.

Similarly, the policy initiatives that have been undertaken in the secondary market during 2006-
07 include:-

In continuation of the comprehensive risk management system put in place since May
2005 in T+2 rolling settlement scenario for the cash market, the stock exchanges have
been advised to update the applicable Value at Risk (VaR) margin at least 5 times in a
day by taking the closing price of the previous day at the start of trading and the
prices at 11:00 a.m., 12:30 p.m., 2:00 p.m. and at the end of the trading session. This
has been done to align the risk management framework across the cash and derivative
markets.
In order to strengthen the ‘Know Your Client’ norms and to have sound audit trail of
the transactions in the securities market, 'Permanent Account Number (PAN)' has
been made mandatory with effect from January 1, 2007 for operating a beneficiary
owner account and for trading in the cash segment.
In order to implement the proposal on creation of a unified platform for trading of
corporate bonds, SEBI has stipulated that the BSE Limited would set up and maintain
the corporate bond reporting platform. The reporting shall be made for all trades in
listed debt securities issued by all institutions such as banks, public sector
undertakings, municipal corporations, corporate bodies and companies.

In line with the Government of India’s policy on foreign investments in infrastructure
companies in the Indian securities market, the limits for foreign investment in stock
exchanges, depositories and clearing corporations, have been specified as follows:- (i)
foreign investment up to 49 per cent will be allowed in these companies with a
separate Foreign Direct Investment (FDI) cap of 26 per cent and cap of 23 per cent on
Foreign institutional investment (FII); (ii) FDI will be allowed with specific prior
approval of Foreign Investment Promotion Board (FIPB); (iii) FII will be allowed
only through purchases in the secondary market; and (iv) FII shall not seek and will
not get representation on the board of directors.

The application process of FII investment has been simplified and new categories of
investment (insurance and reinsurance companies, foreign central banks, investment
managers, international organizations) have been included under FII.
Initial issue expenses and dividend distribution procedure for mutual funds have been
rationalised.
Mutual funds have been permitted to introduce Gold Exchange Traded Funds.
In the Government securities market, the RBI has ceased to participate in primary
issues of Central Government securities, in line with the provisions of Fiscal
Responsibility and Budget Management Act (FRBM Act).
Foreign institutional investors have been allowed to invest in security receipts.

Thus, the capital market plays a vital role in fostering economic growth of the country, as it
augments the quantities of real savings; increases the net capital inflow from abroad; raises the
productivity of investments by improving allocation of investible funds; and reduces the cost of
capital in the economy.

8.10 CAPITAL MARKET IN U.S AND U.K.:

The ascendancy of the US capital markets — including increasing depth of US stock, bond, and
derivative markets — has improved the allocation of capital and of risk throughout the US
economy. Evidence includes the higher returns on capital in the US compared to elsewhere; the

persistent, large inflows of capital to the US from abroad; the enhanced stability of the US
banking system; and the ability of new companies to raise funds. The same conclusions apply to
the United Kingdom, where the capital markets are also well-developed. The consequence has
been improved macroeconomic performance. Over the last decade, US labor productivity has
risen and the United States has outperformed economies dominated by banking-based systems.
Because market prices adjust instantaneously to new information, the development of the capital
markets has introduced new discipline into policymaking.
As a result, the quality of economic policy making has improved over the past few decades. The
development of the capital markets has provided significant benefits to the average citizen. Most
importantly, it has led to more jobs and higher wages. By raising the productivity growth rate,
the development of the capital markets has enabled the economy to operate at a lower
unemployment rate. In addition, higher productivity growth has led to faster gains in real wages.
The capital markets have also acted to reduce the volatility of the economy. Recessions are less
frequent and milder when they occur. As a result, upward spikes in the unemployment rate have
occurred less frequently and have become less severe. The development of the capital markets
has also facilitated a revolution in housing finance. As a result, the proportion of households in
the US that own their homes has risen substantially over the past decade. Effective capital
markets require a firm foundation. This includes the enforcement of laws and property rights,
transparency and accuracy in accounting and financial reporting, and laws and regulations that
provide the proper incentives for good corporate governance. A well-developed financial system
is a spur to growth, macroeconomic performance, and more rapid growth in living standards.

Modern capital markets have two related parts: (1) the debt and equity markets that intermediate
funds between savers and those that need capital, and (2) the derivatives market that consists of
contracts such as options, interest rate, and foreign exchange swaps, typically associated with
these underlying debt and equity instruments. The debt and equity markets help allocate capital
within an economy. The derivatives market helps investors and borrowers to manage the risks
inherent in their portfolios and asset/liability.

In the US, the capital markets have become the dominant element of the financial system in three
ways:-

First, capital markets now outstrip depository institutions in the financial intermediation process.
For example, the share of total credit market debt intermediated by US depository institutions
has fallen by half since 1980, to 23 percent at year-end 2003 from 45 percent. As a result, funds
raised in US debt markets now substantially exceed funds raised through the US banking system.
Second, the US equity market has become more important as an investment vehicle. More than
half of US households owned equity in some form (directly, via mutual funds, or in retirement
accounts) in 2006, up from 36.7 percent in 1986. The development of an equity culture in the
United States has been spurred by the shift from defined benefit pension plans to defined
contribution plans and the widespread use of Individual Retirement Accounts and 401(k)
accounts as long-term investment vehicles.

Third, the derivatives market has grown extraordinarily rapidly. The notional value of derivatives
securities outstanding rose to $197 trillion as of year-end 2003 from about $6.7 trillion at year-
end 1990.1 Interest rate swaps represent the biggest share of this market, followed by foreign
exchange rate swaps and other derivatives obligations such as fixed income and equity-related
options. Credit-derivative obligations are a particularly fast-growing segment of this market.

In the UK, the equity market is also very well developed. However, in contrast to the US, the
debt markets play a lesser role. In the nonfinancial corporate sector, firms still rely on banks and
trade credit for much of their borrowing. However, even here, the role of the debt markets has
been increasing. The corporate bond market has increased its share of total nonfinancial
corporate debt to 26 percent of total debt in 2003, up from 14 percent. Moreover, London is the
centre of the global Eurobond market. Thus, the debt capital markets are better developed in the
UK than the relatively low share of nonfinancial corporate debt implies. In contrast, in other
major developed economies such as France, Germany, and Japan, the banking system still
dominates credit allocation. For the nonfinancial corporate sector, the ratio of capital market
debt to total debt is much lower in France, Germany, and Japan than in the United States.
Moreover, the capital markets have grown slowly in these countries. For the nonfinancial
corporate sector, for example, the share of capital market debt in these countries today is still
well below its share in the US several decades ago. In contrast, it is impressive how, over the

past decade, the capital markets have continued to increase their market share in the UK and the
US despite starting at a higher degree of market penetration. Similarly, the equity markets in
Europe and Japan are less developed than in the United States. At year-end 2003, the market
capitalization-to- GDP ratio for the US equity market was 123 percent, compared to 35 percent
and 78 percent for Germany and Japan, respectively. The UK market capitalization ratio is lower
than the US (74 percent at year-end 2003), comparable to Japan’s, but higher than that of
Germany.

8.11 CAPITAL MARKETS IMPROVE THE ALLOCATION OF CAPITAL AND RISK

The development of the capital markets has generated two major sets of economic benefits. First,
it has improved the allocation of capital. Because the prices of corporate debt and equity respond
immediately to shifts in demand and supply, changes in the outlook for an industry (and/or
company) are quickly embodied in current asset prices. The signal created by such a price
change encourages (i.e., by higher prices) or discourages (i.e., by lower prices) capital inflows
into the industry (and/or company). Businesses with high returns attract additional capital
quickly and easily. When returns drop due to added capacity or a decline in demand, prices drop,
and this signal causes investors to cut the flow of new capital to that industry.

The ability of companies in their early stages of development to raise funds in the capital markets
is also beneficial because it allows these companies to grow very quickly. This growth in turn
speeds the dissemination of new technologies throughout the economy. Furthermore, by raising
the returns available from pursuing new ideas, technologies, or ways of doing business, the
capital markets facilitate entrepreneurial and other risk taking activities.

Second, the development of the capital markets has helped distribute risk more efficiently. Part
of the efficient allocation of capital is the transfer of risk to those best able to bear it either
because they are less risk averse or because the new risk is uncorrelated or even negatively
correlated with other risks in a portfolio.

This ability to transfer risk facilitates greater risk-taking, but this increased risk-taking does not
destabilize the economy. The development of the derivatives market has played a particularly
important role in this risk-transfer process.
Capital markets in the United States provide the lifeblood of capitalism. Companies turn to them
to raise funds needed to finance the building of factories, office buildings, airplanes, trains, ships,
telephone lines, and other assets; to conduct research and development; and to support a host of
other essential corporate activities. Much of the money comes from such major institutions as
pension funds, insurance companies, banks, foundations, and colleges and universities.
Increasingly, it comes from individuals as well. As noted in chapter 3, more than 40 percent of
U.S. families owned common stock in the mid-1990s.

Very few investors would be willing to buy shares in a company unless they knew they could
sell them later if they needed the funds for some other purpose. The stock market and
other capital markets allow investors to buy and sell stocks continuously.

The markets play several other roles in the American economy as well. They are a source of
income for investors. When stocks or other financial assets rise in value, investors become
wealthier; often they spend some of this additional wealth, bolstering sales and promoting
economic growth. Moreover, because investors buy and sell shares daily on the basis of their
expectations for how profitable companies will be in the future, stock prices provide instant
feedback to corporate executives about how investors judge their performance.

Stock values reflect investor reactions to government policy as well. If the government adopts
policies that investors believe will hurt the economy and company profits, the market declines; if
investors believe policies will help the economy, the market rises. Critics have sometimes
suggested that American investors focus too much on short-term profits; often, these analysts
say, companies or policy-makers are discouraged from taking steps that will prove beneficial in
the long run because they may require short-term adjustments that will depress stock prices.
Because the market reflects the sum of millions of decisions by millions of investors, there is no
good way to test this theory.

In any event, Americans pride themselves on the efficiency of their stock market and other
capital markets, which enable vast numbers of sellers and buyers to engage in millions of
transactions each day. These markets owe their success in part to computers, but they also
depend on tradition and trust -- the trust of one broker for another, and the trust of both in the
good faith of the customers they represent to deliver securities after a sale or to pay for
purchases. Occasionally, this trust is abused. But during the last half century, the federal
government has played an increasingly important role in ensuring honest and equitable dealing.
As a result, markets have thrived as continuing sources of investment funds that keep
the economy growing and as devices for letting many Americans share in the nation's wealth.

8.12 COMPARISON BETWEEN CAPITAL MARKET PREVAILING IN INDIA, U.K
AND IN U.S

The shift from depository institution intermediation to capital markets intermediation appears to
be driven mostly by technological developments. Computational costs have fallen rapidly. As
technology has improved, information has become much more broadly available. This has
improved transparency. As this has occurred, depository institutions have lost some of their
ability to charge a premium for their intermediary services. Often, borrowers and lenders interact
directly, as they find that the lender can earn more and the borrower can pay less by cutting out
the depository intermediary as a middleman. The capital markets are more dominant in the UK
and the US due to specific attributes of these countries. For the United States, economies of scale
and US banking regulation have been important. Scale is relevant because the US is a big
economy with numerous large companies. This fact has aided capital market development
because securities issuance is characterized by relatively high setup costs, but very low
incremental costs as the size of a securities issue increases. This condition implies that as the size
of a transaction increases, the capital markets solution becomes much more compelling than the
alternative of using depository intermediaries.

Banking regulation in the US has two distinguishing features. First, the Glass-Steagall Act of
1933 legally separated the commercial banking and the securities businesses. Although the Act
was fatally weakened by the Federal Reserve’s decision to allow commercial bank holding

companies to establish “Section 20” securities affiliates in the 1980s, the prohibitions established
by the Act were not formally dismantled by Congress until 1999. As a result of the Glass-
Steagall Act, securities firms in the United States operated independently of commercial banks
for most of the past 70 years. This separation fostered intense competition between the two
groups. The fact that most capital-market innovations were developed in the US is presumably
due to the innovation spurred by this competitive struggle. In contrast, in Europe and Japan, the
financial systems have been characterized by universal banks that have been able to compete in
both the commercial banking and investment banking businesses.

The US commercial banking system was regulated with the goal of preventing individual banks
from achieving much economic power. One way this was accomplished was to limit the ability
of banks to expand geographically. Until the past 30 years, banks’ operations were largely
restricted to their home states. In some states, banks were even limited in their ability to establish
branch banking offices within the state. As a consequence, the US banking system has been
much less concentrated than those of other countries. In the UK, development of the capital
markets was spurred by London’s long history as a major financial centre in the global economy.
For example, until World War II, the pound sterling was the world’s reserve currency. Even
today, with the UK’s role in the global economy much diminished, London still ranks first in the
foreign exchange business. The history of London as a financial centre has helped to generate a
virtuous circle based on scale. A larger market results in lower transaction costs and greater
liquidity. Those factors encourage further development at the expense of potential rival markets
in France or Germany. Also, the UK authorities have recognized the strategic benefits of
remaining a leading financial centre. This objective has encouraged an enlightened regulatory
regime, which has caused participants to stay in London or has pulled in business that otherwise
might have been done elsewhere. For example, the Eurobond market developed in the UK during
the 1960s and 1970s largely because of the US enactment of the Interest Equalization Tax in
1963. This tax change encouraged US corporations to move their bond issuance to London to
circumvent the rules enacted in the United States.
Finally, in both the United States and the United Kingdom, capital market development was
spurred by the development of a private pension system. The growth of large corporate pension

plans created a large group of institutional investors who had strong incentives to operate directly
in the capital markets in order to increase the returns on their plans’ assets.

As in the case of Indian capital market, the entry of world players has revolutionised Indian
markets, largely for the better. But problems of understanding the Management Systems and
behaviour of capital market scientifically are vastly ignored by the general investors and unless
these are carefully sorted out with acquired scientific knowledge by the investors, the good times
for investors, large and small, might not last. Further understanding of the Management System
of Capital Market is must for students of Economic, Commerce, Management and Business
Journalism which obviously will help them in their latter professional life.

Behaviour of Indian capital Market, specially, stock market is always interesting, challenging
and if one understands it, it becomes pleasantly rewarding.

But more recently, especially after the liberalisation of the Indian economy in early nineties,
general investors find that the Indian capital market is behaving in such a way it is beyond their
imagination or understanding. So, they are now very much eager to know how with minimum
risk one can achieve maximum gain from Indian stock or capital market. They are now
increasingly becoming aware that scientific understanding of capital market is must to reap best
harvest from it. So, more and more investing people and students of Finance Management are
becoming increasingly dependent on reliable scientific stories of economic and business dailies
and periodicals.

Investing people, at present, are becoming more eager to listen not to rumours but to scientific
reasoning of the movements of prices of a share scrip, bond or mutual fund.

Scientific reasoning of the movements of capital market mostly depend on the different scientific
parameters and different laws and regulations implement by the capital market regulatory
authorities time to time. Besides these, other fundamental and technical reasons also influence
Indian capital market.

8.13 CONCLUSIONS

The changing attitudes towards the role of the private sectors in the development of Indian
economies have facilitated the development of the capital markets because of the inherent
potential of these markets to meet the fixed-capital needs of the private sector. Capital markets
can ensure the efficient and sustainable funding of governments, corporations and banks for
large-scale or long-term projects. In this regard, developing countries are working towards
reforming and deepening financial systems, through the expansion of capital markets in order to
improve their ability to mobilize resources and efficiently allocate them to the most productive
sectors of the economy.

Significant progress has been made in the development of many stock markets in India. The
growth in market capitalization in India has been described as remarkable in the last decade, new
legal and regulatory regimes are being set up and progress is being made in the development of
market infrastructure such as the automation of trading and settlement. However, emerging stock
markets face significant challenges to their development and growth. Hence, the need to ensure
that legal, technical and operational structures are in place so that India and other emerging
capital markets function like their counterparts in more developed countries.

The history of Indian capital markets shows that retail investors are yet to play a substantial role
in the market as long-term investors. Retail participation in India is very limited considering the
overall savings of households. Investors who hold shares in limited companies and mutual fund
units are about 20-30 million. Those who participated in secondary markets are 2-3 million.
Capital markets will change completely if they grow beyond the cities and stock exchange
centres reach the Indian villages. Both SEBI and retail participants should be active in spreading
market wisdom and empowering investors in planning their finances and understanding the
markets.

NSE should increasingly play an educational role and embark on a vigorous campaign to market
itself and educate potential investors about the opportunities available in the market and how to
effectively exploit them. The efforts to improve public awareness of the opportunities available

in the capital markets in India need to be strengthened by using a variety of means of
communication such as media campaigns through the radio, television and newspapers, engaging
in one-on-one meetings with eligible firms and potential investors, and distribution of literature
to firms and potential investors across the country. The NSE and Members of Institute of Cost
And Works Accountants (CMA) should compile a list of potential issuers of both equity and debt
and initiate contact with them to educate and improve their awareness of the benefits and
relevance of capital markets for their operations. In addition the two institutions should set up
branch offices at the district and provincial levels to facilitate outreach to the general public.
Investor education may also be done through incorporating information on investment and the
capital markets in the high school and college curriculum to enhance the awareness by the
younger generation of Indian who make up more than half of the total population. The effective
conduct of operations and implementation of the marketing campaigns is important, this may be
achieved through hiring members of staff well trained in marketing, research and market
analysis.

It is essential for the NSE to diversify the products available to potential issuers and investors.
Examples of products that can boost activity in the market include a futures and options market
that will be attractive to the agricultural sector and the establishment of an Over-The-Counter
(OTC) market for companies that are currently ineligible to list at NSE such as medium-sized
family businesses as well as eligible companies that issue shares but are not listed at NSE such as
cooperative societies.

For the overall development of capital markets, NSE needs to relax the minimum requirements
for trading securities in order to accommodate companies that have shares that are transferable to
members of the public yet they do not meet the stringent listing requirements. The challenge will
be to simplify and ease listing conditions without compromising investor protection.
Streamlining public offering procedures and limiting the number of market agents involved in
the issuing process are examples of simplification of the listing requirements.

Continued privatization of state enterprises is essential as the most viable source of equity. In this
regard, the implementation of the privatization bill through the stock exchange will increase the

supply of equity in the market and trigger resurgence of primary equity activity. However, weak
and non-performing public enterprises should not be dumped in the market in the guise of
privatization.

Pursuit of the development of the life-insurance industry is important in order to generate long-
term funds that can be invested in the NSE. Modernization of the trading system to improve
liquidity, attract foreign investors and reduce transaction costs is necessary. Automation of
trading will complement the current automation of the depository, settlement and delivery and
facilitate the ability of the market to cope with increase in new listings or increased trading and
turnover particularly with the imminent privatization of many state-owned companies.

Continued macroeconomic stability and lengthening of maturity of government debt will
encourage the development of the bond market. Economic and political policies directly affect
confidence and activity in the market, hence the need for close public-private partnership
between the government and the private sector to ensure that policies are formulated with
guidance from both sectors with an objective to ensure the overall economic welfare.

The Capital Markets Authority has been criticized as being heavy-handed in its approach to
regulation of the capital markets. Its relationship with the NSE has been described as adversarial.
A more supportive approach that is proactive and creative in enhancing a more vibrant
environment will enable CMA to be a catalyst in rather than a hindrance to development of the
market.