The Indian Capital Market: Structure

What a security is, in law. Section 2(h) of the Securities Contracts (Regulation) Act 1956 defines securities to include shares, scrips, stocks, bonds, debentures, debenture stock and other marketable securities of a like nature in or of any incorporated company or other body corporate, derivatives, units of a collective investment scheme, government securities and rights or interests in securities. The definition matters because whether an instrument is a security decides which regulator governs it.

The participants

Issuers: companies raising capital, and the Central and State Governments raising debt.

Investors: retail investors; domestic institutional investors, principally mutual funds, insurers and pension funds; and foreign portfolio investors.

Intermediaries, which SEBI registers and regulates under section 11(2)(b) and (ba) of its Act: stock brokers, sub brokers, share transfer agents, bankers to an issue, trustees of trust deeds, registrars to an issue, merchant bankers, underwriters, portfolio managers, investment advisers, depositories and their participants, custodians, and credit rating agencies.

Institutions:

• Stock exchanges, which provide the trading platform. In India the two national exchanges dominate.
• Depositories, which hold securities in electronic form, so that a share is a book entry rather than a paper certificate. This is dematerialisation, and it is the single change that made modern Indian trading possible.
• Clearing corporations, which settle trades and stand between buyer and seller so that neither bears the other's default risk.
• Credit rating agencies, which grade debt instruments so that an investor who cannot analyse the issuer can still price the risk.

How a share reaches an investor

The process, in order, because a question sometimes asks for it.

1. The company appoints a merchant banker to manage the issue.
2. It prepares a prospectus disclosing its business, finances and risks, and files it with SEBI.
3. The issue is priced, either at a fixed price or through a book building process in which bids at different prices are collected within a band and the price is discovered from them.
4. Underwriters agree to take up any part of the issue the public does not.
5. The issue opens; applications are made and money is blocked in the applicant's own bank account until allotment.
6. The registrar to the issue processes applications and makes the allotment.
7. Shares are credited to the successful applicant's demat account with a depository participant.
8. The shares are listed on a stock exchange, after which they trade in the secondary market and the price is made by supply and demand.

Note where the money goes at each stage. In steps 1 to 7 it goes to the company, which is capital formation. From step 8 onwards it passes between investors, and the company receives nothing further.

The debt market, which is larger and less noticed

Most discussion of the capital market is about shares, and by value the debt market is much larger. It has two parts.

Government securities. The Central and State Governments borrow by issuing dated securities, which the Reserve Bank manages as debt manager to the Government. This market is the foundation of the entire interest rate structure, because the yield on a government security of a given maturity is the risk free rate for that maturity.

Corporate bonds. Companies issue debentures and bonds, rated by credit rating agencies. India's corporate bond market is small relative to its bank credit, which is a standing criticism: firms borrow from banks what they might better raise from the market, and banks therefore carry risks that could be dispersed.

A worked example: two ways to raise 200 crore rupees

Sahyadri Cements needs 200 crore rupees for a new plant.

Route one: an equity issue. It offers shares to the public. It receives 200 crore and pays no interest. Dividends are payable only if there are profits and only if the board declares them. But the existing owners' shareholding is diluted, so they own a smaller share of a larger company, and the new shareholders acquire voting rights.

Route two: a debenture issue. It borrows 200 crore for seven years at a fixed rate. Ownership and control are untouched. But the interest must be paid whether or not the plant earns, and the principal must be repaid on the due date, so the risk of the project now rests entirely on the existing owners.

The choice, stated as a principle. Equity is expensive and forgiving; debt is cheap and unforgiving. A company facing an uncertain project finances it with equity, and a company with predictable cash flows uses debt because it is cheaper and does not dilute. That trade off is the whole of corporate finance and it is worth stating in a sentence.

What the secondary market contributes. Neither route is available if the investor cannot get out. Nobody subscribes to a seven year debenture or an undated share unless there is a market on which it can be sold. The secondary market creates no capital and makes all of it possible.

What beginners get wrong

"The capital market is the stock exchange." The exchange is the secondary market for listed securities. The capital market also includes the primary market and the debt market, and the debt market is larger by value.

"When share prices rise the company gets more money." It does not. Once shares are listed, trading is between investors. A higher price helps the company only when it next issues shares.

"An offer for sale raises money for the company." It does not: the money goes to the selling shareholders. Only a fresh issue brings money to the company.

"A bonus issue is a benefit." It capitalises reserves and gives every shareholder more shares in the same proportion. Nothing is raised and nobody's proportionate interest changes.

"Debentures are safer for the company." They are safer for the investor and riskier for the company, because interest and principal must be paid regardless of profit.

Limits

Access is uneven. A large listed company can raise capital at will; an unlisted small enterprise cannot, which is the equity gap identified in [Policies for MSMEs].

The corporate bond market is shallow relative to bank credit, so risk that could be spread across many investors sits instead on bank balance sheets.

Household participation, though rising fast, remains concentrated. [The Growth of the Indian Capital Market] gives the figures and the qualification.

Quick revision

1. Primary market: securities issued for the first time and the money goes to the issuer. Secondary market: existing securities traded among investors and the issuer gets nothing.
2. The key idea: liquidity in the secondary market is what makes long term capital raising possible in the primary one.
3. Methods of issue: public issue, including an initial public offering; rights issue; private placement and qualified institutions placement; preferential allotment; bonus issue, which raises nothing; and offer for sale, in which the money goes to the selling shareholder.
4. Section 23 of the Companies Act 2013 governs issue by a public company; section 2(h) of the Securities Contracts (Regulation) Act 1956 defines securities.
5. Instruments: equity shares, preference shares, debentures and bonds, government securities, mutual fund units and derivatives, ranked on winding up as creditors, then preference, then equity.
6. Intermediaries, registered under section 11(2)(b) and (ba) of the SEBI Act: brokers, merchant bankers, registrars, bankers to an issue, underwriters, portfolio managers, investment advisers, depositories and participants, custodians and credit rating agencies.
7. Institutions: stock exchanges, depositories enabling dematerialisation, clearing corporations, and credit rating agencies.
8. Equity is expensive and forgiving; debt is cheap and unforgiving.

Test yourself

1. Distinguish the primary market from the secondary market. In the primary market securities are created and issued for the first time and the consideration is received by the issuer, so this is where capital formation actually occurs; its methods include public issues, whether an initial or a further public offering, rights issues to existing shareholders, private placements and qualified institutions placements, preferential allotments, bonus issues, which capitalise reserves and raise nothing, and offers for sale, in which existing shareholders sell and the proceeds go to them rather than to the company. In the secondary market, securities already issued are traded between investors on stock exchanges, and the issuing company receives nothing. The two are nevertheless inseparable, because an investor will subscribe to a long dated bond or an undated share only if there is a market on which it can later be sold, so the liquidity of the secondary market is what makes the primary market possible.

2. What is a security in Indian law, and why does the definition matter? Section 2(h) of the Securities Contracts (Regulation) Act 1956 defines securities to include shares, scrips, stocks, bonds, debentures, debenture stock and other marketable securities of a like nature in or of any incorporated company or other body corporate, derivatives, units or other instruments issued by a collective investment scheme, government securities and such other instruments as may be declared to be securities, together with rights or interests in securities. The definition matters because it determines the regulatory perimeter: an instrument that is a security falls under the securities laws administered by the Securities and Exchange Board of India, while an instrument that is a deposit falls to the Reserve Bank, and disputes about which regulator governs a novel instrument turn on this definition.

3. Describe how a share reaches an investor in a public issue. The company appoints a merchant banker to manage the issue and prepares a prospectus disclosing its business, finances and risks, which is filed with the Securities and Exchange Board of India. The issue is priced either at a fixed price or through book building, in which bids at different prices within a band are collected and the price is discovered from them. Underwriters agree to subscribe to any unsubscribed portion. The issue opens, applications are made and the application money is blocked in the applicant's own bank account until allotment. The registrar to the issue processes applications and makes the allotment, and shares are credited to the successful applicant's demat account with a depository participant. The securities are then listed on a stock exchange, after which they trade in the secondary market at prices set by supply and demand, and the company receives nothing further.

4. Compare equity and debt as sources of long term finance. Equity confers ownership; the return is a dividend which is payable only out of profits and only if declared, together with any appreciation in the value of the share, and on winding up the equity holder ranks last. Debt confers no ownership; interest is payable whether or not the company earns a profit, the principal must be repaid on the due date, and the lender ranks ahead of shareholders on winding up, a secured debenture holder first. The practical consequence is that equity is expensive but forgiving, since it imposes no fixed obligation but dilutes the existing owners' stake and their control, whereas debt is cheaper but unforgiving, since it leaves ownership untouched but places the whole risk of the project on the existing owners. A firm with uncertain returns therefore leans towards equity and one with predictable cash flows towards debt.

5. Why is the secondary market described as creating no capital and making all of it possible? Because trading in the secondary market transfers existing securities between investors, so no new funds reach the issuer and no new productive asset is created by the transaction itself. Its indispensability lies elsewhere. An investor asked to part with money for thirty years, or permanently in the case of an equity share, will do so only if the holding can be converted back into cash when needed. The existence of a market in which the security can be sold at a fair price at short notice is what makes the original subscription acceptable, so the depth and fairness of the secondary market determine how much capital the primary market can raise and at what cost.

6. What is dematerialisation and why did it matter? Dematerialisation is the holding of securities in electronic form as a book entry with a depository, in place of a physical certificate, with the investor's holding maintained through a depository participant. It mattered because paper certificates made trading slow, costly and unsafe: transfer required physical delivery and registration, certificates could be lost, forged or contain defects in title, and settlement took weeks. In electronic form transfer is instantaneous, the risks of bad delivery and forgery largely disappear, settlement cycles could be shortened dramatically, and the cost of trading fell far enough for retail participation on a national scale to become possible. It is therefore the structural change on which almost every later development in the Indian capital market rests.