In studying the capital market theory we deal with issues like the role of the capital markets, the

major capital markets in the US, the initial public offerings and the role of the venture capital in
capital markets, financial innovation and markets in derivative instruments, the role of securities
and the exchange commission, the role of the federal reserve system, role of the US Treasury and
the regulatory requirements on the capital market.
The market where investment funds like bonds, equities and mortgages are traded is known as
the capital market . Thefinancial instruments that have short or medium term maturity periods
are dealt in the money market whereas the financial instruments that have long maturity periods
are dealt in the capital market.
The issues that have been mentioned above to explain the capital market theory may be discussed
under the following heads:

Role of the Capital Market

The main function of the capital market is to channelize investments from the investors who have
surplus funds to the investors who have deficit funds. The different types of financial instruments
that are traded in the capital markets areequity instruments, credit market instruments,
insurance instruments, foreign exchange instruments, hybrid instruments and derivative
instruments. The money market instruments that are traded in the capital market are Treasury
Bills, federal agency securities, federal funds, negotiable certificates of deposits, commercial paper,
bankers' acceptance, repurchase agreements, Eurocurrency deposits, Eurocurrency
loans, futures and options.
Initial Public Offering and the role of Venture Capital in the capital market
The companies raise their long term capital through the issue of shares that are floated in the
capital market in the form of Initial Public Offering. The venture capital are the funds that are raised
in the capital market via the specialized operators. This is also a very important source of finance
for the innovative companies.

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
tradeable 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.

• 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.

• 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.

Regulatory Framework

In India, the capital market is regulated by the Capital Markets Division of theDepartment 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 thereunder.

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. The following
departments of SEBI take care of the activities in the secondary market:-

 Market Intermediaries Registration and Supervision Department (MIRSD) - concerned with

the registration, supervision, compliance monitoring and inspections of all market
intermediaries in respect of all segments of the markets, such as equity, equity derivatives,
debt and debt related derivatives.

 Market Regulation Department (MRD) - concerned with formulation of new policies as well
as supervising the functioning and operations (except relating to derivatives) of securities
exchanges, their subsidiaries, and market institutions such as Clearing and settlement
organizations and Depositories.

 Derivatives and New Products Departments (DNPD) - concerned with supervising trading at
derivatives segments of stock exchanges, introducing new products to be traded and
consequent policy changes.

Policy Measures and Initiatives

A number of initiatives have been undertaken by the Government, from time to time, so as to
provide financial and regulatory reforms in the primary and secondary market segments of the
capital market. These measures broadly aim to sustain the confidence of investors (both domestic
and foreign) in the country’s capital market.

The policy initiatives that have been undertaken in the primary market during 2006-07 include:-
  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.

(any one introduction)

Evolution of stockexchange

Indian Stock Markets are one of the oldest in Asia. Its history dates back to nearly 200
years ago. The earliest records of security dealings in India are meagre and obscure. The
East India Company was the dominant institution in those days and business in its loan
securities used to be transacted towards the close of the eighteenth century.

By 1830's business on corporate stocks and shares in Bank and Cotton presses took place in
Bombay. Though the trading list was broader in 1839, there were only half a dozen brokers
recognized by banks and merchants during 1840 and 1850.

The 1850's witnessed a rapid development of commercial enterprise and brokerage business
attracted many men into the field and by 1860 the number of brokers increased into 60.

In 1860-61 the American Civil War broke out and cotton supply from United States of
Europe was stopped; thus, the 'Share Mania' in India begun. The number of brokers
increased to about 200 to 250. However, at the end of the American Civil War, in 1865, a
disastrous slump began (for example, Bank of Bombay Share which had touched Rs 2850
could only be sold at Rs. 87).

At the end of the American Civil War, the brokers who thrived out of Civil War in 1874,
found a place in a street (now appropriately called as Dalal Street) where they would
conveniently assemble and transact business. In 1887, they formally established in Bombay,
the "Native Share and Stock Brokers' Association" (which is alternatively known as " The
Stock Exchange "). In 1895, the Stock Exchange acquired a premise in the same street and
it was inaugurated in 1899. Thus, the Stock Exchange at Bombay was consolidated.

Indian Stock Exchanges - An Umbrella Growth

The Second World War broke out in 1939. It gave a sharp boom which was followed by a
slump. But, in 1943, the situation changed radically, when India was fully mobilized as a
supply base.

On account of the restrictive controls on cotton, bullion, seeds and other commodities,
those dealing in them found in the stock market as the only outlet for their activities. They
were anxious to join the trade and their number was swelled by numerous others. Many new
associations were constituted for the purpose and Stock Exchanges in all parts of the
country were floated.

The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited (1940)
and Hyderabad Stock Exchange Limited (1944) were incorporated.

In Delhi two stock exchanges - Delhi Stock and Share Brokers' Association Limited and the
Delhi Stocks and Shares Exchange Limited - were floated and later in June 1947,
amalgamated into the Delhi Stock Exchnage Association Limited

Post-independence Scenario(2)

Most of the exchanges suffered almost a total eclipse during depression. Lahore Exchange
was closed during partition of the country and later migrated to Delhi and merged with
Delhi Stock Exchange.

Bangalore Stock Exchange Limited was registered in 1957 and recognized in 1963.

Most of the other exchanges languished till 1957 when they applied to the Central
Government for recognition under the Securities Contracts (Regulation) Act, 1956. Only
Bombay, Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore, the well established
exchanges, were recognized under the Act. Some of the members of the other Associations
were required to be admitted by the recognized stock exchanges on a concessional basis,
but acting on the principle of unitary control, all these pseudo stock exchanges were
refused recognition by the Government of India and they thereupon ceased to function.

Thus, during early sixties there were eight recognized stock exchanges in India (mentioned
above). The number virtually remained unchanged, for nearly two decades. During eighties,
however, many stock exchanges were established: Cochin Stock Exchange (1980), Uttar
Pradesh Stock Exchange Association Limited (at Kanpur, 1982), and Pune Stock Exchange
Limited (1982), Ludhiana Stock Exchange Association Limited (1983), Gauhati Stock
Exchange Limited (1984), Kanara Stock Exchange Limited (at Mangalore, 1985), Magadh
Stock Exchange Association (at Patna, 1986), Jaipur Stock Exchange Limited (1989),
Bhubaneswar Stock Exchange Association Limited (1989), Saurashtra Kutch Stock Exchange
Limited (at Rajkot, 1989), Vadodara Stock Exchange Limited (at Baroda, 1990) and recently
established exchanges - Coimbatore and Meerut. Thus, at present, there are totally twenty
one recognized stock exchanges in India excluding the Over The Counter Exchange of India
Limited (OTCEI) and the National Stock Exchange of India Limited (NSEIL).

The Table given below portrays the overall growth pattern of Indian stock markets since
independence. It is quite evident from the Table that Indian stock markets have not only
grown just in number of exchanges, but also in number of listed companies and in capital of
listed companies. The remarkable growth after 1985 can be clearly seen from the Table,
and this was due to the favouring government policies towards security market industry
Growth Pattern of the Indian Stock Market

As on 31st 1946 1961 1971 1975 1980 1985 1991 1995

Sl.No.
December
No. of 7 7 8 8 9 14 20 22
1
Stock Exchanges
No. of 1125 1203 1599 1552 2265 4344 6229 8593
2
Listed Cos.
No. of Stock 1506 2111 2838 3230 3697 6174 8967 11784
3 Issues of
Listed Cos.
Capital of Listed 270 753 1812 2614 3973 9723 32041 59583
4
Cos. (Cr. Rs.)
Market value of 971 1292 2675 3273 6750 25302 110279 478121
5 Capital of Listed
Cos. (Cr. Rs.)
Capital per 24 63 113 168 175 224 514 693
6 Listed Cos. (4/2)
(Lakh Rs.)
Market Value of 86 107 167 211 298 582 1770 5564
Capital per Listed
7
Cos. (Lakh Rs.)
(5/2)
Appreciated value 358 170 148 126 170 260 344 803
8 of Capital per
Listed Cos. (Lak Rs.)

Trading Pattern of the Indian Stock Market(3)

Trading in Indian stock exchanges are limited to listed securities of public limited
companies. They are broadly divided into two categories, namely, specified securities
(forward list) and non-specified securities (cash list). Equity shares of dividend paying,
growth-oriented companies with a paid-up capital of atleast Rs.50 million and a market
capitalization of atleast Rs.100 million and having more than 20,000 shareholders are,
normally, put in the specified group and the balance in non-specified group.

Two types of transactions can be carried out on the Indian stock exchanges: (a) spot
delivery transactions "for delivery and payment within the time or on the date stipulated
when entering into the contract which shall not be more than 14 days following the date of
the contract" : and (b) forward transactions "delivery and payment can be extended by
further period of 14 days each so that the overall period does not exceed 90 days from the
date of the contract". The latter is permitted only in the case of specified shares. The
brokers who carry over the outstandings pay carry over charges (cantango or
backwardation) which are usually determined by the rates of interest prevailing.

A member broker in an Indian stock exchange can act as an agent, buy and sell securities
for his clients on a commission basis and also can act as a trader or dealer as a principal, buy
and sell securities on his own account and risk, in contrast with the practice prevailing on
New York and London Stock Exchanges, where a member can act as a jobber or a broker
only.

The nature of trading on Indian Stock Exchanges are that of age old conventional style of
face-to-face trading with bids and offers being made by open outcry. However, there is a
great amount of effort to modernize the Indian stock exchanges in the very recent times.

Over The Counter Exchange of India (OTCEI)

The traditional trading mechanism prevailed in the Indian stock markets gave way to many
functional inefficiencies, such as, absence of liquidity, lack of transparency, unduly long
settlement periods and benami transactions, which affected the small investors to a great
extent. To provide improved services to investors, the country's first ringless, scripless,
electronic stock exchange - OTCEI - was created in 1992 by country's premier financial
institutions - Unit Trust of India, Industrial Credit and Investment Corporation of India,
Industrial Development Bank of India, SBI Capital Markets, Industrial Finance Corporation
of India, General Insurance Corporation and its subsidiaries and CanBank Financial Services.

Trading at OTCEI is done over the centres spread across the country. Securities traded on
the OTCEI are classified into:

• Listed Securities - The shares and debentures of the companies listed on the OTC
can be bought or sold at any OTC counter all over the country and they should not
be listed anywhere else

• Permitted Securities - Certain shares and debentures listed on other exchanges and
units of mutual funds are allowed to be traded
 • Initiated debentures - Any equity holding atleast one lakh debentures of a
particular scrip can offer them for trading on the OTC.

OTC has a unique feature of trading compared to other traditional exchanges. That is,
certificates of listed securities and initiated debentures are not traded at OTC. The
original certificate will be safely with the custodian. But, a counter receipt is generated out
at the counter which substitutes the share certificate and is used for all transactions.

In the case of permitted securities, the system is similar to a traditional stock exchange.
The difference is that the delivery and payment procedure will be completed within 14 days.

Compared to the traditional Exchanges, OTC Exchange network has the following
advantages:

• OTCEI has widely dispersed trading mechanism across the country which provides
greater liquidity and lesser risk of intermediary charges.

• Greater transparency and accuracy of prices is obtained due to the screen-based

scripless trading.

• Since the exact price of the transaction is shown on the computer screen, the
investor gets to know the exact price at which s/he is trading.

• Faster settlement and transfer process compared to other exchanges.

• In the case of an OTC issue (new issue), the allotment procedure is completed in a
month and trading commences after a month of the issue closure, whereas it takes a
longer period for the same with respect to other exchanges.

Thus, with the superior trading mechanism coupled with information transparency investors
are gradually becoming aware of the manifold advantages of the OTCEI.

National Stock Exchange (NSE)(4)

With the liberalization of the Indian economy, it was found inevitable to lift the Indian
stock market trading system on par with the international standards. On the basis of the
recommendations of high powered Pherwani Committee, the National Stock Exchange was
incorporated in 1992 by Industrial Development Bank of India, Industrial Credit and
Investment Corporation of India, Industrial Finance Corporation of India, all Insurance
Corporations, selected commercial banks and others.

Trading at NSE can be classified under two broad categories:

(a) Wholesale debt market and

(b) Capital market.

Wholesale debt market operations are similar to money market operations - institutions and
corporate bodies enter into high value transactions in financial instruments such as
government securities, treasury bills, public sector unit bonds, commercial paper,
certificate of deposit, etc.

There are two kinds of players in NSE:

(a) trading members and

(b) participants.

Recognized members of NSE are called trading members who trade on behalf of themselves
and their clients. Participants include trading members and large players like banks who take
direct settlement responsibility.

Trading at NSE takes place through a fully automated screen-based trading mechanism
which adopts the principle of an order-driven market. Trading members can stay at their
offices and execute the trading, since they are linked through a communication network.
The prices at which the buyer and seller are willing to transact will appear on the screen.
When the prices match the transaction will be completed and a confirmation slip will be
printed at the office of the trading member.

NSE has several advantages over the traditional trading exchanges. They are as follows:

• NSE brings an integrated stock market trading network across the nation.

• Investors can trade at the same price from anywhere in the country since inter-
market operations are streamlined coupled with the countrywide access to the
securities.

• Delays in communication, late payments and the malpractice’s prevailing in the

traditional trading mechanism can be done away with greater operational efficiency
and informational transparency in the stock market operations, with the support of
total computerized network.

Unless stock markets provide professionalised service, small investors and foreign investors
will not be interested in capital market operations. And capital market being one of the
major source of long-term finance for industrial projects, India cannot afford to damage
the capital market path. In this regard NSE gains vital importance in the Indian capital
market system.

Chronology of the Indian capital markets.(IMPORTANT)

1830s: Trading of corporate shares and stocks in Bank and cotton Presses in Bombay.
1850s: Sharp increase in the capital market brokers owing to the rapid development of
commercial enterprise.
 1860-61: Outbreak of the American Civil War and ' Share Mania ' in India.
1894: Formation of the Ahmadabad Shares and Stock Brokers Association .
1908: Formation of the Calcutta Stock Exchange Association.

The pattern of growth in the Indian capital markets in the post independence regime can be
analyzed from the following graphs.(IMPORTANT)

From the above graph we find that the number of stock exchanges in India increased at a crawling
pace till 1980 but witnessed a sharp rise thereafter till 1995.

The following diagram shows the trend in the no. of listed companies participating in the Indian
Capital Market . Here again we register a sharp rise after 1980. the number of stocks issued by
the listed companies also show a similar trend.
 Trading
Pattern in the Indian Capital Market(5)

There are mainly two types of transactions that are carried out in the Indian Capital Market, one is
the spot delivery transactions and the other is the forward delivery transactions. The role of
the broker in the Indian Capital Marketis to facilitate the purchase or sale of securities and earn
commission on each transaction.

National Stock Exchange

To inject an international standard to the Indian Stock Market the National Stock Exchange was
started in 1992 by theIndustrial Development Bank of India, Industrial Credit and
Investment Corporation of India, Industrial Finance Corporation in India,
all Insurance Corporations and the selected commercial banks. The trading members and the
participants constitute the players in the national Stock Exchange.

The following are the advantages of the National Stock Exchange over the traditional exchanges:

• The NSE basically integrates the stock market trading network across the nation.
• The investors have the freedom to trade from any part of the nation at the same price.
• Greater operational efficiency and informational efficiency can wipe out the delays in
communication, late paymentsand the malpractices that are common in the traditional trading
grounds.

Capital Market Reforms

and Developments(6)
Reforms in the Capital Market
Over the last few years, SEBI has announced several far-reaching reforms to promote the capital
market and protect investor interests. Reforms in the secondary market have focused on three
a aa

main areas: structure and functioning of stock exchanges, automation of trading and post trade
systems, and the introduction of surveillance and monitoring systems. (See Appendix 1 for a
listing of reforms since 1992). Computerized online trading of securities, and setting up of
clearing houses or settlement guarantee funds were made compulsory for stock exchanges.
Stock exchanges were permitted to expand their trading to locations outside their jurisdiction
through computer terminals. Thus, major stock exchanges in India have started locating computer
terminals in far-flung areas, while smaller regional exchanges are planning to consolidate by
using centralized trading under a federated structure. Online trading systems have been
introduced in almost all stock exchanges. Trading is much more transparent and quicker than in
the past. Until the early 1990s, the trading and settlement infrastructure of the Indian capital
market was poor. 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 comprehensive registration nor an apex body of regulation
of the securities market. Stock exchanges were run as “brokers clubs” as their management
was largely composed of brokers. There was no prohibition on insider trading, or fraudulent
and unfair trade practices (see Appendix 2). Since 1992, there has been intensified market reform,
resulting in a big improvement in securities trading, especially in the secondary market for equity.
Most stock exchanges have introduced online trading and set up clearing houses/corporations. A
depository has become operational for scripless trading and the regulatory structure has been
overhauled with most of the powers for regulating the capital market vested with SEBI. The
Indian capital market has experienced a process of structural transformation with operations
conducted to standards equivalent to those in the developed markets. It was opened up for
investment by foreign institutional investors (FIIs) in 1992 and Indian companies were allowed
to raise resources abroad through Global Depository Receipts (GDRs) and Foreign Currency
Convertible Bonds (FCCBs). The primary and secondary segments of the capital market
expanded rapidly, with greater institutionalization and wider participation of individual investors
accompanying this growth. However, many problems, including lack of confidence in stock
investments, institutional overlaps, and other governance issues, remain as obstacles to the
improvement of Indian capital market efficiency.
Stock Market
There are 22 stock exchanges in India, the first being the Bombay Stock Exchange (BSE), which
began formal trading in 1875, making it one of the oldest in Asia. Over the last few years, there
has been a rapid change in the Indian securities market, especially in the secondary market.
Advanced technology and online-based transactions have modernized the stock exchanges. In
terms of the number of companies listed and total market capitalization, the Indian equity market
is considered large relative to the country’s stage of economic development. The number of listed
companies increased from 5,968 in March 1990 to about 10,000 by May 1998 and market
capitalization has grown almost 11 times during the same period.
The debt market, however, is almost nonexistent in India even though there has been a large
volume of Government bonds traded. Banks and financial institutions have been holding a
substantial part of these bonds as statutory liquidity requirement. The portfolio restrictions on
financial institutions’ statutory liquidity requirement are still in place. A primary auction market
for Government securities has been created and a primary dealer system was introduced in 1995.
There are six authorized primary dealers. Currently, there are 31 mutual funds, out of which 21
are in the private sector. Mutual funds were opened to the private sector in 1992. Earlier, in 1987,
banks were allowed to enter this business, breaking the monopoly of the Unit Trust of India
(UTI), which maintains a dominant position. Before 1992, many factors obstructed the expansion
of equity trading. Fresh capital issues were controlled through the Capital Issues Control Act.
Trading practices were not transparent, and there was a large amount of insider trading

PRIMARY MARKET
Since 1991/92, the primary market has grown fast as a result of the removal of investment
restrictions in the overall economy and a repeal of the restrictions imposed by the Capital Issues
Control Act. In 1991/92, Rs62.15 billion was raised in the primary market. This figure rose to
Rs276.21 billion in 1994/ 95. Since 1995/1996, however, smaller amounts have been raised due
to the overall downtrend in the market and tighter entry barriers introduced by SEBI for
investor protection
a aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa aaa a

EQUITY PRICE
For the past 12 years, equity prices have seen two extended periods of declining prices and two
periods of rising prices. Between April 1986 and March 1988, Sensex decreased from 589 to 398,
or by 32 percent. Prices also fell between March 1992, when the monthly closing level of Sensex
was 4,258, and April 1993, when the level was 2,122, a decline of 50.5 percent. Prices generally
rose for extended periods from March 1988 to March 1992 and from May 1993 to August 1994.
The monthly closing level of Sensex climbed from 398 in March 1988 to 4,285 in March 1992,
an increase of more than 10 times. In the second period of extended rising equity prices, Sensex
increased 1.16 times. Since 1995, it has fluctuated around the 3,000-4,000 mark (see Figure 1).
In April 1998, it hovered around 3,000. In the period of declining prices, from August 1994
to March 1998, the price-earnings (P/E) ratio fell more sharply than prices (Figure 1). In March
1998, the monthly average Sensex P/E ratio was 15.65 while the figure for October 1993 was
38.76.

CIRCUIT BREAKER(IMP)
SEBI has imposed price limits for stocks whose market prices are above Rs10 up to Rs20, a daily
price change limit and weekly price change limit of 25 percent. BSE imposes price limits as a
circuit breaker system to maintain the orderly trading of shares on the exchange (Table 3).
BSE’s computerized trading system rejects buy or sell orders of a stock at prices outside the price
limits. The daily price limit of a stock is measured from the stock’s closing price in the previous
trading session. The weekly price limit is based on its closing price of the last trading in the
previous week, usually its closing price on the previous Friday.
SHORT SALES AND LONG PURCHASES
SEBI regulates short selling in the stock market by requiring all stock exchanges to enforce
reporting by members of their net short sale and long purchase positions in each stock at the end
of each trading day.

Stock Lending
A scheme for regulating stock lending was introduced in February 1997, following changes in tax
regulations. Stock lending can take place through an intermediary registered for this purpose with
SEBI, and which has a minimum capital of Rs500 million. Lenders and borrowers of securities
have to enter into agreements with the intermediary. Stock lending facilitates the timely
settlement of transactions on the stock exchanges, especially in an environment where physical
delivery of certificates is required for settlement.
Introduction of Derivatives Trading
At present, there are no exchange traded derivatives or over-the-counter derivative markets in the
country. However, a new law has been passed permitting the trading of derivatives. This followed
recommendations for the establishment of a regulatory framework for derivatives by a committee
chaired by L.C. Gupta. It is expected that derivatives trading will soon form part of the Indian
securities market.

FRAGMENTED MARKET(IMP)
Of the 22 stock exchanges in the country, 17 haveintroduced screen-based trading. With the
expansionof trading networks of BSE and other stockexchanges beyond their original
jurisdictions, an increasingnumber of investors in different parts ofthe country are within the
reach of a national marketsystem. This has raised informational efficiencyand helped rapid
market integration.NSE, which provides a screen-based order drivensystem, has already extended
its network to morethan 100 centers in the country that are connected toits central computer via
its satellite network. TheOver-the-Counter Exchange of India (OTCEI) alsoprovides a nationwide
electronic system for tradingrelatively smaller stocks. BSE has introduced its ownscreen-based
quote-driven trading system. However,the market is still fragmented and needs further
integration.The international trend is to consolidate and mergeexisting stock exchanges rather
than to set up newones. In the UK, there were about 20 stock exchangesin the late 1960s, which
were reduced toabout half a dozen in 1972 and further down to one,i.e., the London Stock
Exchange, in 1986. NSE hasalready provided connectivity to more than 100 cities,and other
major stock exchanges are in the processof extending their trading terminals outside their
places of operation. Thus, it is questionable whetherIndia needs as many as 22 stock exchanges,
evenaking into account the vastness of the country
SPECULATIVE INVESTMENT(IMP)
Turnover in the Indian stock exchanges is high, implyingthat they are dominated by speculative
investments,which is not unusual in emerging markets.However, trading volumes in the Indian
capital marketare fairly large compared to those in other emergingmarkets. While price levels
have been depressed,the total turnover on BSE and NSE has been increasing.The combined
turnover for 1996/97 was almostthree times the level of the previous year. Figure 3shows the total
turnover of stock trading on all 22stock exchanges in India. The annual average growthrate from
1994/95 to 1996/97 was 56 percent in nominalterms.Table 7 compares the dollar turnovers and
liquidityratios on BSE and NSE with stock exchanges inother economies in 1996. The combined
turnover onBSE and NSE, which are both located in Mumbai,exceeded that of some other stock
markets in Asia.This is because of the remarkably high liquidity ratioon NSE. Considering that
the majority of about 6,000stocks listed on BSE have low liquidity, it can be inferredthat a group
of the 1,500 most traded stockson BSE would also have a considerably high liquidityratio (Endo
1998). The substantial increase in turnovermay be attributed primarily to the recent expansion
of the NSE’s trading network. But this alsoreflects the fact that the Indian stock market is
dominatedby speculative investments for short-term capitalgains, rather than long-term
investment

CLEARING, SETTLEMENT, AND DEPOSITORIES(IMP)

Account settlement period of stock exchanges thatearlier had a 14-day trading cycle has been
shortenedto seven days (effectively five days because oftwo intervening no trading days on
Saturday andSunday). Both BSE and NSE process net obligationsover a five-day account period
and completethe settlement on the 15th day from the commencementof trading for an account
period. Other stockexchanges are also moving into this cycle. In thecase of NSE, the National
Securities Clearing Corporation,Ltd., its wholly owned subsidiary, providesa settlement
guarantee. In the case of BSE, the clearinghouse is operated by Bank of India Shareholding
Ltd., which is jointly owned by BSE and the Bank ofIndia.In India, certificates of securities are
registeredwith the issuer. For Government securities, therecord of ownership is kept by RBI,
which maintainsa Subsidiary General Ledger in its Public DebtOffice. Transfer of ownership
takes place throughbook entry transfer in this ledger. In the case ofcorporate securities, the issuer
maintains a registerof members or holders of securities, and the issuersor their register or transfer
agents have to physicallyreceive the securities from a transferee accompaniedby a transfer deed
signed by the transferorbefore a transfer is effected. There are nobearer securities in India. The
majority of the settlementof transactions in the securities market continuesto be based on physical
movement of certificates.This results in delays, bottlenecks, and anincrease in transaction costs
besides creating variousrisks for market participants such as bad delivery,fraud, and theft.
Because the clearing andsettlement infrastructure in the stock exchangescannot keep up with the
flow of paper, especiallyas trading expands to different parts of the country,the exchanges have
been unable to shorten settlementcycles or move to rolling settlement, whichare essential to
reduce settlement risk.The Depositories Act of 1996 allows for dematerializationof securities in
depositories and the transferof securities through electronic book entry. Asthe depository network
expands and the proportionof dematerialized securities in depositories increases,the benefits are
expected to extend to the vast majorityof market participants. The National SecuritiesDepository,
Ltd. (NSDL) has been granted a certifi-cate of commencement of business by SEBI. As of
May 1998, 197 issues (about 50 percent of marketcapitalization) have appliedfordematerialization
andabout 10 percent of them have been dematerialized.In contrast, only three issues had signed
for the sameas of November 1996. If about 300 to 400 issuesapply for dematerialization, they will
cover about 90percent of trading volume. As of May 1998, therewere 52 depository participants,
which include brokers,banks, and custodians—an increase from 22participants in 1996. Thus, it is
expected that dematerializationof trade will proceed quickly although itscompletion may still take
some time.

Debt Market(IMP)
HIGH STATUTORY LIQUIDITY REQUIREMENT
The debt market is not well developed in India. Eventhough the volume of Government bonds
outstandingis large, banks and other financial institutionshold a substantial part of these bonds as
liquidityrequirement. The statutory liquidity requirement (ontop of cash requirement of 10
percent) has beenreduced from 25 to 23 percent. But this is still highand should be further
decreased to activate the privatedebt market.
MARK-TO-MARKET
Banks tend to hold Government securities to maturityto avoid a capital loss on the balance sheet.
Until1996, only 40 percent of the portfolio of Governmentsecurities had to be marked-to-market.
Starting fiscalyear 1996/97, the requirement has been raised to50 percent for existing banks and
100 percent forthe new private sector banks.The pattern of ownership of Government securities
is shown in Table 9. The biggest holders ofboth central and state Government securities are
commercial banks, with more than two thirds ofthe total. Life insurance companies have also
increasedtheir holdings of Government securities.Banks and life insurance companies are captive
markets for Government securities due to the portfoliorestrictions imposed on them. Meanwhile,
themarket for private companies’ debentures is notyet well developed.

PRIMARY DEALERS
Table 10 shows the market borrowings of the centraland state Governments. The total issue of
Governmentsecurities and net borrowing of the Governmenthave increased.A primary auction
market for Government securitieshas been created and six primary dealers havebeen authorized
by RBI.2 However, the auctions stilldo not seem to take place fully on a market basis,mainly
because Government securities are not issuedat completely market rates.Other factors seem to be
inhibiting the marketclearing mechanism in the primary auction market.First, there is yet no
preannounced notification amountin 364-day and 14-day auctions. This procedure enables
RBI to determine in a flexible manner eitherthe cutoff price or the amounts to be accepted.
Removinguncertainty by notifying auction volumes willbring about more transparency in the
auction procedure.Second, noncompetitive bids are allowed in 91-day and 14-day Treasury bill
auctions. Since stateGovernments are major noncompetitive bidders inIndia, their participation in
Treasury bill auctionscauses further uncertainty in auction volumes.

PRIVATE PLACEMENT
The number of private placements has risen in recentyears. It is estimated that about 40 percent
of total resources mobilized by public and privatecompanies in the Indian capital market in
1995/96was through private placement, and this increasedfurther to close to 50 percent in
1996/97 (Table11). The share of the public sector in total privateplacements was about 70 percent
in 1995/96, whichrose to about 84 percent in 1996/1997. There areseveral advantages to tapping
private placementsinstead of resorting to public issues. However, certainproblems need to be
addressed for the welldirectedand efficient functioning of the market.At present, there is no
transparency in this marketand virtually little information. In developed markets,the regulatory
authorities indicate the frameworkwithin which private placements have to
function.

Capital Market Regulations

Overview

In keeping with the broad thrust of the ongoing programs of economic reform,
the mechanism of administrative controls over capital issues has been
dismantled and pricing of capital issues is now essentially market determined.
Regulation of the capital markets and protection of investor's interest is now
primarily the responsibility of the Securities and Exchange Board of
India (SEBI), which is located in Bombay.

Accordingly, SEBI's functions include:

• Regulating the business in stock exchanges and any other securities

markets
• Registering and regulating the working of collective investment
schemes, including mutual funds.
• Prohibiting fraudulent and unfair trade practices relating to securities
markets.
• Promoting investor's education and training of intermediaries of
securities markets.
• Prohibiting insider trading in securities, with the imposition of monetary
penalties, on erring market intermediaries.
• Regulating substantial acquisition of shares and takeover of companies.
• Calling for information from, carrying out inspection, conducting
inquiries and audits of the stock exchanges and intermediaries and self
regulatory organizations in the securities market.

Keeping this in view, SEBI has issued a new set of comprehensive guidelines
governing issue of shares and other financial instruments, and has laid down
detailed norms for stock-brokers and sub-brokers, merchant bankers, portfolio
managers and mutual funds.

On the recommendations of the Patel Committee report, SEBI on 27 July 1995,

permitted carry forward deals. Some of the major features of the revised carry-
forward transactions as directed by SEBI are:

• Carry forward deals permitted only on stock exchanges which have

screen based trading system.
• Transactions carried forward cannot exceed 25% of a broker's total
transactions on any one day.
• 90-day limit for carry forward and squaring off allowed only till the 75th
day (or the end of the fifth settlement).
• Daily margins to rise progressively from 20% in the first settlement to
50% in the fifth.

On 26 January1995, the government promulgated an ordinance amending the

SEBI Act, 1992, and the Securities Contracts (Regulation) Act, 1956.
In accordance with the amendment adjudicating mechanism will be created
within SEBI and any appeal against this adjudicating authority will have to be
made to the Securities Appellate Tribunal, which is to be separately constituted.
These appeals will be heard only at the High Courts.

The main features of the amendment to the Securities Contract (Regulation)

Act, 1956, are:

• The ban on the system of options in trading has been lifted.

• The time limit of six months, by which stock exchanges could amend
their bye-laws, has been reduced to two months.
• Additional trading floors on the stock exchanges can be established only
with prior permission from SEBI.
• Any company seeking listing on stock exchanges would have to comply
with the listing agreements of stock exchanges, and the failure to comply
with these, or their violation, is punishable.

Fraudulent and Unfair Trade Practices

SEBI is vested with powers to take action against these practices relating to
securities market manipulation and misleading statements to induce
sale/purchase of securities.

Inspection and Enforcement

SEBI has the powers of a civil court in respect of discovery and production of
books, documents, records, accounts, summoning and enforcing attendance of
company/person and examining them under oath. SEBI can levy fines for
violations related to failure to submit information to SEBI / to enter into
agreements with clients / to redress investor grievances, violations by mutual
funds/stock brokers and violations related to insider trading, takeovers etc.

3. Summary
The regulatory initiatives and institutional reforms described above have put
the Indian
securities markets in 2007 well beyond the crisis-ridden 1990s. The adoption
of
international quality trading and settlement mechanisms and the reduction of
transaction
costs, have generated enormous interest among institutional investors, who
in turn
have helped introduce and disseminate improved disclosure standards and
create
growth in market volume and liquidity. In 2007, the Indian securities markets
present a
picture of better efficiency, liquidity, transparency and regulatory oversight,
so
crucial to fostering investor confidence and participation.

Regulation Information disclosures in Indian Securities Contract Regulation Act is

Companies Act, Issue provisions in administered by SEBI. SEBI has a
Capital Issues (Control) Act, Trading range of regulations covering various
regulations in Securities Contract aspects of the capital markets.
Regulation Act

Regulator Central Government Departments SEBI

Capital Market Access by Controlled by CCI Free access subject to compliance
Companies with
Disclosure and investor protection
guidelines of SEBI

Organization of exchanges Association of persons with limited or Corporate structure

unlimited liability
Management of exchanges Boards made up of members and few Demutualised format with
public representatives management
that is independent of membership
Membership pattern of Dominated by individuals who inherit Increased share of institutional
exchanges memberships. members. Membership on the basis of
capital adequacy requirements
Pricing of Issues Determined by CCI Determined by the market forces.
Book
building process with red herring
prospectus
Issue Process Limited institutional participation. Separate subscriptions by institutional
Retail and retail investors
distribution by brokers and merchant
bankers.
Trading mechanism Floor based open outcry system Screen based electronic open order
book
Trading hours 11 am to 2pm 10 am to 3.30 pm

Execution of trades Through market makers On-line anonymous execution

Brokerage Included and grossed into price (gala). Separately disclosed. Estimated at
Estimated at 3.5% -4% 0.50% for retail 0.10% for institutional
investors
Settlement of trades Batch settlement. 15-day account Rolling Settlement. T+2 cycles
periods. Settlement cycle completion
in
21 days.
Delivery of securities Physical form Demat form
Counter party risk High. Incidence of bad delivery and Eliminated through Clearing
fraudulent transfer high. corporation and settlement guarantee
funds
Risk Management Ad hoc margining system imposed by VaR based margins computed using
exchanges. risk management systems, multiple
times of the day.

2. 2007: A Modern Dynamic

Capital Market
The market has been transformed in the 15 years since SEBI emerged as the
statutory
regulator of India’s securities market. India’s market in 2007 features a
developed
regulatory environment, a modern market infrastructure, a steadily
increasing market
capitalization and liquidity, better allocation and mobilization of resources, a
rapidly
developing derivatives market, a robust mutual fund industry, and increased
issuer
transparency. Table 1.1 compares some key market statistics for Indian
markets in 1992
and 2007.

Table 1.1 - Key Market Characteristics 1992 vs. 2007

Key Market Characteristics 1992 200719911111116466666644364119912554555445456564g
Market Capitalisation ($billion) 144.6 987.2
Market Capitalisation to GDP (%) 57 87
Number of registered foreign institutional investors 0 987
Number of mutual funds 6 38
Number of demat accounts 0 6362845
Value traded to listed stock (%) 11% 71%
Turnover ratio (%) 20% 82%
Market volatility (%) 3.3% 1.1%
Annual derivative volumes ($bn) 0 1601