RESEARCH - 11

The relationship between new issue markets and stock exchange.

The functions of stock exchange

The issue mechanism followed in Indian markets. SECTION TITLE Financial Assets A financial
asset/Instrument/security is a claim against another economic unit and is held as a store of value
and for the return that is expected. While the value of a tangible/physical asset depends on its
physical properties such as buildings, machines, furniture vehicles and so on, a financial asset
represents a claim to future cash flows in the form of interest, dividends and so on. They are a claim
on a stream of income and/or particular assets. The entity/economic unit that offers the future cash
flows is the issuer of the financial instrument¶ and the owner of the security is the investor¶.
Depending upon the nature of claim/return, an instrument may be (i) debt (security) such as bonds,
debentures, term loans, (ii) equity (security) shares and (iii) hybrid security such as preference shares
and convertibles, Based on the type of issuer, the security may be (1) direct (2) indirect and (3)
derivative. The securities issued by manufacturing companies are direct assets (e.g.
shares/debentures). Indirect assets are claims against financial intermediaries (e.g. units of mutual
funds). The derivative instruments include options and futures. The prevalence of a variety of
securities to suit the investment requirements of heterogeneous investors, offers differentiated
investment choice to them and is an important element in the maturity and sophistication of the
financial system. Financial Intermediaries Financial Intermediaries are institutions that channelise
the savings of investors into investments/loans. As institutional source of finance, they act as a link
between the savers and the investors, which results in institutionalisation of personal savings. Their
main function is to convert direct financial assets into indirect securities. The indirect securities offer
to the individual investor better investment alternative than the direct/primary security by pooling
which it is created, for example, units of mutual funds. The main consideration underlying the
attractiveness of indirect securities is that the pooling of funds by the financial intermediary leads to
a number of benefits to the investors. The services/benefits that tailor indirect financial assets to the
requirements of the investors are (i) convenience, (ii) lower risk, (iii) expert management and (iv)
lower cost. Convenience Financial intermediaries convert direct/primary securities into a more
convenient vehicle of investment. They divide primary securities of higher denomination into
indirect securities of lower denomination. They also transform a primary security of certain maturity
into an, indirect security of a different maturity. For instance, as a result of the
redemption/repurchase facility available to unitholders of mutual funds, maturities on units would
conform more with the desires of the investors than those on primary securities. Lower Risk The
lower risk associated with indirect securities results from the benefits of diversification of
investments. In effect, the financial intermediaries transform the small investors in matters of
diversification into large institutional investors as the former shares proportionate beneficiary
interest in the total portfolio of the latter. Expert Management Indirect securities give to the
investors the benefits of trained, experienced and specialised management together with
continuous supervision. In effect, financial intermediaries place the individual investors in the same
position in the matter of expert management as large institutional investors. Low Cost Low cost is
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the benefits of investment through financial intermediaries are available to the individual investors
at relatively lower cost due to the economies of scale. The major financial intermediaries are banks,
insurance organisations, both life and non-life/ general, mutual funds, non-banking financial
companies and so on. Financial Markets Financial markets perform a crucial function in the financial
system as facilitating organisations. Unlike financial intermediaries, they are not a source of funds
but are a link and provide a forum in which suppliers of funds and demanders of loans/investments
can transact business directly. While the loans and investments of financial intermediaries are made
without the direct knowledge of the suppliers of funds (i.e. investors), suppliers in the financial
market know where their funds are being lent/invested. The two key financial markets are the
money market and the capital market. Money Market The money market is created by a financial
relationship between suppliers and demanders of short-term funds which have maturities of one
year or less. It exists because investors (i.e. individuals, business entities, government and financial
institutions) have temporarily idle funds that they wish to place in some type of liquid asset or short-
term interest-earning instrument. At the same time, other entities/ organisations find themselves in
need of seasonal/ temporary financing. The money market brings together these suppliers and
demanders of short- term liquid funds. The broad objectives of money market are three-fold: An
equilibrating mechanism for evening out short-term surplus and deficiencies in the financial system;
A focal point of intervention by the central bank (e.g. Reserve Bank of India) intervention for
influencing liquidity in the economy; and A reasonable access to the users of short-term funds to
meet their requirements at realistic/ reasonable cost and temporary deployment of funds for
earning returns to the suppliers of funds.

Capital Market

The capital market is a financial relationship created by a number of institutions and arrangements
that allows suppliers and demanders of long-term funds (i.e. funds with maturities exceeding one
year) to make transactions. It is a market for long-term funds. Included among long-term funds are
securities issues of business and Government. The backbone of the capital market is formed by the
various securities exchanges that provide a forum for equity (equity market) and debt (debt market)
transactions. Mechanisms for efficiently offering and trading securities contribute to the functioning
of capital markets which is important to the long-term growth of business. Thus, the capital market
comprises of (I) stock/security exchanges/markets (secondary markets) and (2) new issue/primary
market [initial public offering (IPO) market]. Relationship Between New Issue Market (NIM) and
Stock Exchange The industrial securities market is divided into two parts, namely, NIM and stock
market. The relationship between these parts of the market provides an insight into its organisation.
One aspect of their relationship is that they differ from each other organisationally as well as in the
nature of functions performed by them. They have some similarities also.

Differences

The differences between NIM and stock exchanges pertain to (i) Types of securities dealt, (ii) Nature
of financing and (iii) Organisation.

New vs Old Securities

The NIM deals with new securities, that is, securities which were not previously available and are,
therefore, offered to the investing public for the first time. The market, therefore, derives its name
from the fact that it makes available a new block of securities for public subscription. The stock
market, on the other hand, is a market for old securities which may be defined as securities which
have been issued already and granted stock exchange quotation. The stock exchanges, therefore,
provide a regular and continuous market for buying and selling of securities. The usual procedure is
that when an enterprise is in need of funds, it approaches the investing public, both individuals and
institutions, to subscribe to its issue of capital. The securities thus floated are subsequently
purchased and sold among the individual and institutional investors. There are, in other words, two
stages involved in the purchase and sale of securities. In the first stage, the securities are acquired
from the issuing companies themselves and these are, in the second stage, purchased and sold
continuously among the investors without any involvement of the companies whose securities
constitute the stock-intrude except in the strictly limited sense of registering the transfer of
ownership of the securities. The section of the industrial securities market dealing with the first
stage is referred to as the NIM, while secondary market covers the second stage of the dealings in
securities.

Nature of Financing

Another aspect related to the separate functions of these two parts of the securities market is the
nature of their contribution to industrial financing. Since the primary market is concerned with new
securities, it provides additional funds to the issuing companies either for starting a new enterprise
or for the expansion or diversification of the existing one and, therefore, its contribution to company
financing is direct. In contrast, the secondary markets can in no circumstance supply additional funds
since the company is not involved in the transaction. This, however, does not mean that the stock
markets have no relevance in the process of transfer of resources from savers to investors. Their role
regarding the supply of capital is indirect. The usual course in the development of industrial
enterprise seems to be that those who bar the initial burden of financing a new enterprise, pass it on
to others when the enterprise becomes well established. The existence of secondary markets which
provide, institutional facilities for the continuous purchase and sale of securities and, to that extent,
lend liquidity and marketability, play an important part in the process.

Organisational Differences

The two parts of the market have organisational differences also. The stock exchanges have,
organisationally speaking, physical existence and are located in a particular geographical area. The
NIM is not rooted in any particular spot and has no geographical existence. The NIM has neither any
tangible form any administrative organisational set up like that of stock exchanges, nor is it
subjected to any centralised control and administration for the consummation of its business. It is
recognised only by the services that it renders to the lenders and borrowers of capital funds at the
time of any particular operation. The precise nature of the specialised institutional facilities provided
by the NIM is described in a subsequent section.

Similarities

Nevertheless, in spite of organisational and functional differences, the NIM and the stock exchanges
are inseparably connected.

Stock Exchange Listing

One aspect of this inseparable connection between them is that the securities issued in the NIM are
invariably listed on a recognised stock exchange for dealings in them. In India, for instance, one of
the conditions to which a prospectus is to conform is that it should contain a stipulation that the
application has been made, or will be made in due course for admitting the securities to dealings on
the stock exchange. The practice of listing of new issues on the stock market is of immense utility to
the potential investors who can be sure that should they receive an allotment of new issues, they
will subsequently be able to dispose them off any time. The absence of such facilities would act as
some sort of psychological barrier to investments in new securities. The facilities provided by the
secondary markets, therefore, encourage holdings of new securities and, thus, widen the
initial/primary market for them.

Control

The stock exchanges exercise considerable control over the organisation of new issues. In terms of
regulatory framework related to dealings in securities, the new issues of securities which seek stock
quotation/listing have to comply with statutory rules as well as regulations framed by the stock
exchanges with the object of ensuring fair dealings in them. If the new issues do not conform to the
prescribed stipulations, the stock exchanges would refuse listing facilities to them. This requirement
obviously enables the stock exchange to exercise considerable control over the new issues market
and is indicative of close relationship between the two.

Economic Interdependence

The markets for new and old securities are, economically, an integral part of a single market² the
industrial securities market. Their mutual interdependence from the economic point of view has two
dimensions. One, the behavior of the stock exchanges has a significant bearing on the level of
activity in the NIM and, therefore, its responses to capital issues: Activity in the new issues market
and the movement in the prices of stock exchange securities are broadly related: new Issues
increase when share values are rising and vice versa.1 This is because the two parts of the industrial
securities market are susceptible to common influences and they act and react upon each other. The
stock exchanges are usually the first to feel a change in the economic outlook and the effect is
quickly transmitted to the new issue section of the market. The second dimension of the mutual
interdependence of the two parts of the market is that the prices of new issues are influenced by the
price movements on the stock market. The securities market represents an important case where
the stock-demand-and-supply curves, as distinguished from flow-demand-and-supply curves, exert a
dominant influence on price determination. The quantitative predominance of old securities in the
market usually ensures that it is these which set the tone of the market as a whole and govern the
prices and acceptability of the new issues. Thus, the flow of new savings into new securities is
profoundly influenced by the conditions prevailing in the old securities market the stock exchange.

RESEARCH - 22
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 PLAYERS/INTERMEDIARIES IN THE NEW ISSUE MARKET

There are many players in the new issue market. The important of them are the following:

1. Merchant bankers:
They are the issue managers, lead managers, co-managers and are responsible to the company
and SEBI. Their functions and working are described in a separate chapter.
2. Registrars to the issue:
Registrars are an important category of intermediaries who undertake all activities connected
new issue management. They are appointed by the company in consultation with the
merchant bankers to the issue. Registrars have a major role, next to merchant bankers, in
respect of servicing of investors.
The roles of registrar in the pre-issue, during the currency of issue, pre-allotment and post-
allotment are described below:
Role of registrar in pre-issue
1. Suggest draft application form to the merchant bankers.
2. Help in identifying the collection centres. The choice of collection centre and of collecting
banker is critical to the issue.
3. Assist in opening collection accounts with banks and lay down procedure for operation of these
accounts.
4. Send instructions to collecting branches, for collection of application along with cheques,
drafts, stock invest separately and remittance of funds.
5. Workout modalities to receive the collection figures on a regular basis until the subscription
list are closed.

During the currency of issue

1. Receive the collection figures every day.

2. Tabulate and classify the collection data on the basis of the standard proforma of slabs of
shares applied for.
3. Keep the merchant bankers and the company informed of the progress of total subscriptions.
4. Inform the stock exchange about the closure of issue.

Pre- allotment work

1. Get all application forms from the collecting bankers and sort out valid and invalid application
forms.
2. The valid applications are to be categorized and grouped as cash, draft and stock invest
applications.
3. Reclassify the valid applications eligible for allotment.
4. Prepare the list with inverted numbers and then approach the regional stock exchange for
finalizing the basis of allotment, in the event of over subscription.
5. Finalize the allotments as per the basis approved by the stock exchange.
6. Tally the final list approved for allotment and rejections with the inhouse control numbers and
correct mistakes, if any.

Allotment work

The most important work of a registrar is allotment of shares. The system of proportional
allotment was adopted for new issues in 1993. A new quota system was approved by SEBI in
April, 1995. According to the new system 50% of quota is for small investors and another
50% for other categories. The small investors include all applicants upto 1,000 shares. It has
also been revised recently.

Post allotment work

1. Get the letters of allotment and refund orders printed ready for dispatch. They have to be
mailed on or before 70 days from the closing date of subscription. For any delay, get the
permission of the Registrar of Companies and the relevant stock exchange.
2. Submit all statements to the company for their final approval.
3. Arrange to pay the brokerage and underwriting commission and submit their relevant
statements.
4. Assist the company in getting the allotted shares listed on the stock exchange.

Qualifications for Registrars to the issue

To be appointed as Registrar to the issue, registration with SEBI is essential. The criteria
adopted by SEBI for registration are the competency and expertise, quality of manpower,
their track record, adequacy of infrastructure such as computers, storage space etc. and capital
adequacy. A net worth of Rs.6 lakhs is essential for Registrars. SEBI has laid down a code of
 conduct for their observance. They have to maintain proper books of accounts and registers
for a period of three years.

3. Collecting and co-ordinating bankers:

Collecting bankers collect the subscriptions in cash, cheques, stock invest etc.
Co-ordinating bankers collect information on subscriptions and co-ordinate the collection
work. They monitor the work and inform it to the registrars and merchant bankers.
Collecting banker and co-ordinating banker may be the same bank or different banks.
4. Underwriters and brokers:
Underwriting is an agreement whereby the underwriter promises to subscribe to a specified
number of shares or debentures or a specified amount of stock in the event of public not
subscribing to the issue.
Brokers along with the network of sub brokers market the new issues. They send their own
circulars and applications to the clients and do follow up work to market the securities.

FUNCTIONS:

The main function of a new issue market is to facilitate transfer of resources from savers to
the users. The savers are individuals, commercial banks, insurance companies etc. The users
are public limited companies and the government. The new issue market plays an important
role of mobilizing the funds from the savers and transfers them to borrowers for production
purposes, an important requisite of economic growth. It is not only a platform for raising
finance to establish new enterprises but also for expansion/diversification/modernizations of
existing units. In this basis the new issue market can be classified as follows:

1. Market where firms go to the public for the first time through Initial Public Offering (IPO).

2. Markets where firms which are already trading raise additional capital through Seasoned
Equity Offering (SEO).
 The main function of a new issue market can be divided into a triple services function:

1. Origination

2. Underwriting

3. Distribution

Origination

It refers to the work of investigation, analysis and processing of new project proposals.
Origination starts before an issue is actually floated in the market. There are two aspects in
this function:

1. A careful study of the technical, economical and financial viability to ensure soundness of the
project. This is a preliminary investigation undertaken by the sponsors of the issue.

2. Advisory services which improve the quality of capital issues and ensure its success.

The function of origination is done by merchant bankers who may be commercial banks, all
India financial institutions or private firms. The success of the issue depends, to a large
extent, on the efficiency of the market. The origination itself does not guarantee the success
of the issue. Underwriting, the special service is required in this regard.

Underwriting

It is an agreement whereby the underwriter promises to subscribe to a specified number of

shares or debentures or a specified amount of stock in the event of public not subscribing to
the issue. If the issue is fully subscribed, then there is no liability for the underwriter. If a part
of the share issues remain unsold, the underwriter will buy the shares. Thus, underwriting is a
guarantee for the marketability of shares.

Method of underwriting

An underwriting agreement may take any of the following three forms:

i. Standing behind the issue: Under this method, the underwriter guarantees the sale of a
specified number of shares within a specified period. If the public do not subscribe to the
specified amount of issue, the underwriter buys the balance in the issue.

ii. Outright Purchase: The underwriter, in this method, makes outright purchase of shares and
resells them to the investors.

iii. Consortium Method: Underwriting is jointly done by a group of underwriters in this method.
The underwriters form a syndicate for this purpose. This method is adopted for large issues.

Distribution

It is the function of sale of securities to ultimate investors. This service is performed by

brokers and agents who maintain a regular and direct control with ultimate investors.

MEANING:

The industrial securities market in India consists of new issue market and stock exchange.
The new issue market deals with the new securities which were not previously available to
the investing public, i.e., the securities that are offered to the investing public for the first
time. The market, therefore, makes available a new block of securities for public
subscription. In other words, new issue market deals with raising of fresh capital by
companies either for cash or for consideration other than cash.

The new issue market encompasses all institutions dealing in fresh claim. These claims may
be in the form of equity shares, preference shares, debentures, right issues, deposits etc. All
financial institutions which contribute, underwrite and directly subscribe to the securities are
part of new issue market.

STOCK EXCHANGE:
The stock exchange is a market for old securities, i.e., those which have been already issued
and listed on a stock exchange. These securities are purchased and sold continuously among
investors without the involvement of the companies. Stock exchange provides not only free
transferability of shares but also makes continuous evaluation of securities traded in the
market.