Definition of Securities Market

Corporate securities and government securities constitute important investment avenues for savers. These are traded in the securities market. Creation of a portfolio and periodic revision of the portfolio involves buying and selling of securities in the securities market. An understanding of the working of securities market is, therefore, essential for practicing portfolio management. However, the functioning of the securities market is too vast a subject to be confined within a single chapter. An attempt is made in this chapter to explain the basic features of securities market.

Financial Market

A market is a place used for buying and selling goods. This is the commonest meaning of the word ‘market’. The usual features of a market are a place, some buyers, some sellers, some commodity to be exchanged for money or some other commodity. What transpires in a market is an exchange of a commodity between a buyer and a seller. However, such an exchange can take place even without a common meeting place or physical space. Hence, a physical place is not an essential constituent of a market. It is rather the mechanism used for the exchange of goods.

In an ordinary market what is usually exchanged is a physical commodity such as fruits, grains, etc. In modern day markets, these commodities are valued in monetary terms and exchanged for money. A commodity that is in demand is exchanged between buyers and sellers in the market.

In an economy, the various economic units such as individuals in the household sector, business units in the industrial and commercial sector, and government organisations and departments in the government sector are engaged in various economic activities and transactions involving money. Some of them spend more money than they earn and end up in financial deficit while others earn more money than they spend, thus ending up in financial surplus. The deficit generators are usually the units in the industrial, commercial and government sectors. The surplus generators are mostly the units in the household sector. The deficit generators who are known as ultimate borrowers would like to borrow funds from the surplus generators who are the primary lenders. Such transfer of funds is possible and also necessary to sustain the development of the economy.

The transfer of funds between primary lenders and ultimate borrowers takes place through the creation of securities or financial assets. If an individual is not spending all his income on consumption, he will want to find a temporary repository for his current savings until they are required to finance future consumption. This involves the purchase of a financial asset or security. If the investor deposits the money in the fixed deposit of a commercial bank, the bank issues him a fixed deposit receipt which is a financial asset. The individual is purchasing a financial asset and thereby transferring the surplus funds at his disposal to a financial intermediary. The bank, in turn, may lend the money to a business unit through the creation of a loan agreement.

Let us consider another instance of transfer of funds. A company in need of funds may issue shares to mobilize funds. In a public issue of shares, any individual with surplus funds may participate. If shares are allotted to such an individual, the company which is the borrower of funds will issue a share certificate to the investor who is the lender of funds. In such a situation a financial asset in the form of a share certificate is being exchanged. This exchange represents a marketing transaction and presupposes a market which nevertheless has no physical location.

The commodity being exchanged is a financial asset instead of a physical asset. The lender of funds (or investor) is the buyer of the asset and the borrower of funds is the seller of the asset (or issuer of the security). The mechanism or system through which financial assets are created and transferred is known as the financial market. When the financial assets transferred are corporate securities and government securities, the mechanism of transfer is known as securities market.

Segments of Financial Market

Different types of securities are traded in the securities market. These may include ownership securities, debt securities, short-term securities, long-term securities, government securities, non-government or corporate securities. The nature of return and risk involved in short-term securities is vastly different from that of long-term securities. Hence, on the basis of the maturity period of securities traded in the market, the securities market is segmented into money market and capital market.

Money market is the market for short-term financial assets with maturities of one year or less. Treasury bills, commercial bills, commercial paper, certificate of deposit, etc. are the short-term securities traded in the money market. These instruments being close substitutes for money, the market for their trading is known as money market.

Money market is the main source of working capital funds for business and industry. It provides a mechanism for evening out short-term surpluses and deficits. The short-term requirements of borrowers can be met by the creation of money market securities, which can be purchased by lenders with short-term surpluses to park their funds for short durations. In India, the money market has a narrow base with limited number of participants who are mostly financial institutions.

Capital market, on the other hand, is the market segment where securities with maturities of more than one year are bought and sold. Equity shares, preference shares, debentures and bonds are the long-term securities traded in the capital market. The capital market is the source of long-term funds for business and industry.

Types of Financial Market

The financial market may be classified as primary market or secondary market depending on whether the securities traded are newly issued securities or securities already outstanding and owned by investors. Private companies and public sector enterprises, in need of money, may issue securities such as shares, debentures, bonds, commercial papers, etc. to raise required capital. Individual investors and institutional investors may invest in these securities. The market mechanism for the buying and selling of new issues of securities is known as primary market. This market is also termed as new issues market because it deals in new issues of securities.

The secondary market, on the other hand, deals with securities which have already been issued and are owned by investors, both individual and institutional. These may be traded between investors. The buying and selling of securities already issued and outstanding take place in stock exchanges. Hence, stock exchanges constitute the secondary market in securities.

Participants in the Financial Market

A financial market is essentially a system by which financial securities are exchanged. This system is composed of participants, securities, markets, trading arrangements and regulations. The major participants are the buyers and sellers of securities or the investors (who are the buyers of securities) and the issuers (who are the sellers of securities). Financial intermediaries are the second major class of participants in the financial system. They play a crucial role in the smooth functioning of the financial system. The investors who are the primary lenders in the financial system would prefer to ‘lend short’, that is, invest their surplus for short durations as they generally have a preference for liquidity. On the contrary, the issuers of securities who are the ultimate borrowers would prefer to ‘borrow long’, that is, borrow for long durations as the funds are generally required for financing long-term investment in fixed assets. This situation gives rise to a fundamental problem in the financial system which was described as the ‘constitutional weakness’ of unintermediated financial markets by Hicks (1939).’ The problem is to match the preferences of the surplus sector to lend short with those of the deficit sector to borrow long. It is the financial intermediaries who resolve this problem. They borrow for short durations from the primary lenders and lend for long durations to the ultimate borrowers. Through the intervention of the financial intermediaries, the ultimate borrower is able to get long-term funding and the primary lender is able to get liquidity on his lending.

There are two types of financial intermediaries in the financial system, namely banking financial intermediaries and non-banking financial intermediaries such as insurance companies, housing finance companies, unit trusts and investment companies. However, it may be noted that the traditional distinction between banking and non-banking institutions isslowly disappearing. As a result of technological innovations and increasing competitive pressures, the traditional distinction between banking and non-banking activities is rapidly disappearing and a universal banking system in which a single institution provides the complete range of financial intermediation services is slowly emerging.

Another group of participants in the financial system comprises the individuals and institutions who facilitate the trading or exchange process in the system. They are primarily brokers who act as agents for the primary lenders or the ultimate borrowers in the purchase or sale of securities. There are also broker dealers who act on their own account by buying and selling securities for a profit. This group also includes institutions which act as registrars, managers, lead managers, share transfer agents, etc. at the time of issue of shares by companies.

Regulatory Environment

The financial system in a country is subject to a set of regulations in the form of various Acts passed by the legislative bodies. The regulatory environment may differ from one country to another. In each country, the regulatory control of the financial system is exercised by designated regulatory authorities. In India, the Ministry of Finance, the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI), etc. are the major regulatory bodies exercising regulatory control and supervision over the functioning of the financial system in the country.

A simple diagrammatic representation of how a security is raised or originated in the financial market is attempted in Fig.

The securities thus issued may be traded or exchanged between investors in securities markets with the help of intermediaries, within the regulatory framework approved by the Government and other regulatory bodies.

New securities are directly issued by the issuing companies to the investors. All the participants in this process of issuing new shares to investors together constitute the primary market or new issues market. Let us analyse the functioning of this primary market.

Primary Market/New Issues Market

When a new company is floated, its shares are issued to the public in the primary market as an Initial Public Offer (IPO). If the company subsequently decides to include debt in its capital structure by issuing bonds or debentures, these may also be floated in the primary market. Similarly, when a company decides to expand its activities using either equity finance or bond finance, the additional shares or bonds may be floated in the primary market.

The primary market or new issues market (NIM) does not have a physical structure or form. All the agencies which provide the facilities and participate in the process of selling new issues to the investors constitute the NIM.

The NIM has three functions to perform. They are:

Origination

Underwriting

Distribution.

Origination

Origination is the preliminary work in connection with the floatation of a new issue by a company. It deals with assessing the feasibility of the project, technical, economic and financial, as also making all arrangements for the actual floatation of the issue. As part of the origination work, decisions may have to be taken on the following issues:

Time of floating the issue

Type of issue

Price of the issue.

Timing of the issue is crucial for its success. The floatation of the issue should coincide with the buoyant mood in the investment market to ensure proper support and subscription to the issue. The type of issue whether equity, preference, debentures or convertible securities, has to be properly analysed at the time of origination work. Pricing of the issue is a sensitive matter, as the public support to a new issue will depend on the price of the issue to a large extent. In the primary market, the price of the security is determined by the issuer and not by the market. New issues are made either at par or at premium. Well-established companies may be able to sell their shares at a premium at the time of a new issue. Further, the pricing of new issues is also regulated by the guidelines on capital issues issued by SEBI.

The origination function in the NIM is now being carried out by merchant bankers. In the 1980s, commercial banks in India created special divisions called merchant banking divisions to perform the origination function for floatation of new issues. But now there are separate institutions registered with SEBI as merchant bankers.

Underwriting

The second function performed by NIM is underwriting which is the activity of providing a guarantee to the issuer to ensure successful marketing of the issue. An underwriter is an individual or institution which gives an undertaking to the stock issuing company to purchase a specified number of shares of the company in the event of a shortfall in subscription to the new issue. The stock issuing company can thus ensure full subscription to the new issue through underwriting agreements with different underwriters, even if there is no proper response to the new issue from the investors. Underwriting activity in the NIM is performed by large financial institutions such as LIC, UTI, IDBI, IFCI, general insurance companies, commercial banks and also by brokers. The underwriters earn commission from the issuing company for this activity.

Distribution

The new issue market performs a third function besides the functions of origination and underwriting. This third function is that of distribution of shares. The distribution function is carried out by brokers, sub-brokers and agents. New issues have to be publicised by using different mass media, such as newspapers, magazines, television, radio, Internet, etc. New issues are also publicized by mass mailing. It has become a general practice to distribute prospectus, application forms and other literature regarding new issues among the investing public.

Methods of Floating New Issues

The methods by which new issues of shares are floated in the primary market in India are:

Public issue

Rights issue

Private placement.

Public Issue

Public issue involves sale of securities to members of the public. The issuing company makes an offer for sale to the public directly of a fixed number of shares at a specific price. The offer is made through a legal document called Prospectus. Thus a public issue is an invitation by a company to the public to subscribe to the securities offered through a prospectus. Public issues are mostly underwritten by strong public financial institutions. This is the most popular method for floating securities in the new issue market, but it involves an elaborate process and consequently it is an expensive method. The company has to incur expenses on various activities such as advertisements, printing of prospectus, banks’ commissions, underwriting commissions, agents’ fees, legal charges, etc.

Rights Issue

The rights issue involves selling of securities to the existing shareholders in proportion to their current holding. As per section 81 of the Companies Act, 1956, when a company issues additional equity capital it has to be offered first to the existing shareholders on a pro rata basis. However, the shareholders may forfeit this special right by passing a special resolution and thereby enable the company to issue additional capital to the public through a public issue. Rights issue is an inexpensive method of floatation of shares as the offer is made through a formal letter to the existing shareholders.

Private Placement

A private placement is a sale of securities privately by a company to a selected group of investors. The securities are normally placed, in a private placement, with the institutional investors, mutual funds or other financial institutions. The terms of the issue are negotiated between the company and the investors. A formal prospectus is not necessary in the case of private placement. Underwriting arrangements are also not required in private placement, as the sale is directly negotiated with the investors. This method is useful to small companies and closely held companies for issue of new securities, because such companies are unlikely to get good response from the investing public for their public issues. They can avoid the expenses of a public issue and also have their shares sold.

Principal Steps in Floating a Public Issue

In a public issue, investors are allowed to subscribe to the shares being issued by the company during a specified period ranging from a minimum of three days to a maximum of ten days. The issue remains open during this period for subscription by the public. This is the principal activity in the process of a public issue. Before the issue is opened for public subscription, several activities/ legal formalities have to be completed. These are the pre-issue steps or obligations. Similarly, after the issue is closed, several activities are to be carried out to complete the process of public issue. These activities may be designated as the post-issue tasks. Thus, we can identify three distinct stages in the successful completion of a public issue.

Pre-issue tasks

Opening and closing of the issue

Post-issue tasks.

Pre-Issue Tasks

These are the preparatory obligations to be complied with before the actual opening of the issue.

Drafting and finalisation of the prospectus Prospectusis an essential document ina public issue. The Companies Act 1956 defines a prospectus as: “Any document described or issued as a prospectus and includes any notice, circular, advertisement or other document inviting deposits from the public or inviting offers from the public for the subscription or purchase of any shares in or debentures of a body corporate”. It is the offer document which contains all the information pertaining to the company which will be useful to the investors to arrive at a proper decision regarding investing in the company. It is a communication from the issuer to the investor. The prospectus contains detailed information about the company, its activities, promoters, directors, group companies, capital structure, terms of the present issue, details of proposed project, details regarding underwriting arrangements, etc. SEBI has issued guidelines regarding the contents of the prospectus and these have to be complied with by the company.

The draft prospectus has to be approved by the Board of Directors of the company. The draft prospectus has also to be filed with SEBI and the Registrar of companies. The final prospectus has to be prepared as per the suggestions of SEBI and filed with SEBI and the Registrar of companies.

Selecting the intermediaries and entering into agreements with them Severalintermediaries are involved in the process of a public issue. These intermediaries have to be registered with SEBI. Important categories of intermediaries are the following:

Merchant Banker: Merchant banker is any person or institution which is engagedin the business of issue management either as manager, consultant, adviser, or by rendering corporate advisory service in relation to such issue management. Merchant bankers play an important role in the process of managing a public issue. It is the duty of the merchant bankers to ensure correctness of the information furnished in the prospectus as well as to ensure compliance with SEBI rules, regulations and guidelines regarding public issue of securities. Merchant bankers are registered with SEBI in four categories, with different eligibility criteria for each category.

Registrar to an Issue: Registrar to an issue is any person or institution entrustedwith the following functions in connection with a public issue:

Collecting applications from investors.

Keeping a record of applications and monies received from investors

Assisting the stock issuing company in determining the basis of allotment of securities in consultation with the stock exchange.

Finalising the list of persons entitled to allotment of securities.

Processing and despatching allotment letters, refund orders, certificates and other related documents.

Share Transfer Agent: Share transfer agent is a person or institution which maintainsthe records of holders of securities of a company on behalf of that company. The share transfer agent is authorised to effect the transfer of securities as well as the redemption of securities wherever applicable.

BANKER TO AN ISSUE: Banker to an issue is a scheduled bank entrusted with thefollowing activities in connection with a public issue:

Acceptance of application and application monies

Acceptance of allotment or call monies

Refund of application monies

Payment of dividend or interest warrants.

The intermediaries are service providers possessing professional expertise in the relevant areas of operation. The market regulator, SEBI, regulates the various intermediaries in the primary market through its regulations for these intermediaries.

SEBI has defined the role of each category of intermediary, the eligibility criteria for granting registration, their functions and responsibilities, and the code of conduct to which they are bound.

The stock issuing company has to select the intermediaries such as merchant banker, registrar to the issue, share transfer agent, banker to the issue, underwriters, etc. and sign separate agreements with each of them to engage them for the public issue.

Attending to Other Formalities

The prospectus and application forms have to be printed and despatched to all intermediaries and brokers for wide circulation among the investing public. An initial listing application has to be filed with the stock exchange where the issue is proposed to be listed. An abridged version of the prospectus along with the issue opening and closing dates has to be published in newspapers.

Opening and Closing of The Issue

The public issue is open for subscription by the public on the pre-announced opening date. The application forms and application monies are received at the branches of the bankers to the issue and forwarded by these bankers to the Registrar to the issue. Two closing dates are prescribed for the closing of the public issue.

The first of these is the ‘earliest closing date’ which should not be less than three days from the opening date. If sufficient applications are received by the company, the company may choose to close the issue on the earliest closing date itself. The other closing date is the final or latest closing date which shall not exceed ten days from the opening date.

Post-Issue Tasks

After closing of the public issue, several activities are to be carried out to complete the process of public issue. They are:

All the application forms received have to be scrutinised, processed and tabulated.

When the issue is not fully subscribed to, it becomes the liability of the underwriters to subscribe to the shortfall. The liability of each underwriter has to be determined.

When the issue is oversubscribed, the basis of allotment has to be decided in consultation with the stock exchange.

Allotment letters and share certificates have to be despatched to the allottees. Refund orders have to be despatched to the applicants whose applications are rejected.

Shares have to be listed in the stock exchange for trading. For this purpose.the issuing company has to enter into a listing agreement with the stock exchange.

Book Building

Companies may raise capital in the primary market by way of public issue, rights issue or private placement. A public issue is the selling of securities to the public in the primary market. The usual procedure of a public issue is through the fixed price method where securities are offered for subscription to the public at a fixed price. An alternative method is now available which is known as the book building process. Although book building has been a common practice in most of the developed countries, the concept is relatively new in India. SEBI announced guidelines for the book building process, for the first time, in October 1995.

Under the book building process, the issue price is not fixed in advance. It is determined by the offer of potential investors about the price which they are willing to pay for the issue. The price of the security is determined as the weighted average at which the majority of investors are willing to buy the security. Thus, under the book building process, the issue price of a security is determined by the demand and supply forces in the capital market.

SEBI guidelines define book building as: “A process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document”.

Book building is a process of price discovery. It puts in place a pricing mechanism whereby new securities are valued on the basis of the demand feedback following a period of marketing. It is an alternative to the existing system of fixed pricing.

A public issue of securities may be made through the fixed price method, the book building method, or a combination of both. In case the issuing company chooses to issue securities through the book building route, then as per SEBI guidelines the issuer company can select any of the following methods:

100 per cent of the offer to the public through the book building process.

Seventy-five per cent of the offer to the public through the book building process and twenty-five per cent through the fixed price method at the price determined through book building.

Ninety per cent of the offer to the public through the book building process and ten per cent through the fixed price method.

The issue of the fixed price portion is conducted like a normal public issue after the book built portion is issued.

The steps involved in the process of book building may be listed out as follows:

The issuer appoints a merchant banker as the lead manager and book runner to the issue.

The book runner forms a syndicate of underwriters. The syndicate consists of book runner, lead manager, joint lead managers, advisors, co-managers and underwriting members.

A draft prospectus is submitted to SEBI without a price or price band. The draft prospectus is then circulated among eligible investors with a price band arrived at by the book runner in consultation with the issuer. Such a prospectus is known as a Red Herring prospectus.

The book runner conducts awareness campaigns, which include advertising, road shows and conferences.

Investors place their orders with syndicate members. These members collect orders from their clients on the amount of securities required by them as well as the price they are willing to pay.

The book runner builds up a record known as Book after receiving orders from members of the syndicate. He maintains detailed records in this regard. The book is thus built up to the size of the portion to be raised through the book building process. When the book runner receives substantial number of orders, he announces closure of the book. A book should remain open for a minimum of three working days. The maximum period for which the bidding process may be allowed is seven working days.

On the basis of the offers received, the book runner and the issuer company then determines the price at which the securities shall be sold.

The book runner finalises the allocation to syndicate members. Procurement agreements are signed between issuer and the syndicate members for the subscription to be procured by them.

The final prospectus along with the procurement agreements is then filed with the Registrar of companies within two days of the determination of the offer price.

The book runner collects from the institutional buyers and the underwriters the application forms along with the application monies to the extent of the securities proposed to be allotted to them/subscribed by them.

Book building is a process wherein the issuer of securities asks investors to bid for their securities at different prices. These bids should be within an indicative price band decided by the issuer. Here investors bid for different quantity of shares at different prices. Considering these bids, issuer determines the price at which the securities are to be allotted. Thus, the issuer gets the best possible price for his securities as perceived by the market or investors.

Role of Primary Market

Primary market is the medium for raising fresh capital in the form of equity and debt. It mops up resources from the public (investors) and makes them available for meeting the long-term capital requirements of corporate business and industry. The primary market brings together the two principal constituents of the market, namely the investors and the seekers of capital. The savings or surplus funds with the investors are converted into productive capital to be used by companies for productive purposes. Thus, capital formation takes place in the primary market. The economic growth of a country is possible only through a robust and vibrant primary market.

In the secondary market, shares already purchased by investors are traded among other investors. Operations in the secondary market do not result in the accretion of capital resources of the country, but indirectly promotes savings and investments by providing liquidity to the investments in securities, i.e. the investors have the facility to liquidate their investments in securities in the secondary market.

Regulation of Primary Market

For companies, raising capital through the primary market is time consuming and expensive. The issuer has to engage the services of a number of intermediaries and comply with complex legal and other formalities. The investor faces much risk while operating in the primary market. Fraudulent promoters may try to dupe the investors who opt to invest in a new issue. Investors in the primary market need protection from such fraudulent operators.

Up to 1992, the primary market was controlled by the Controller of Capital Issues (CCI) appointed under the Capital Issues Control Act, 1947. During that period, the pricing of capital issues was regulated by CCI. The Securities and Exchange Board of India (SEBI) was formed under the SEBI Act, 1992, with the prime objective of protecting the interests of investors in securities as well as for promoting and regulating the securities market. All public issues since January 1992 are governed by the rules, regulations and guidelines issued by SEBI.

SEBI has been instrumental in bringing greater transparency in capital issues. It has issued detailed guidelines to standardise disclosure obligations of companies issuing securities. Companies floating pubic issues are now required to disclose all relevant information affecting investors’ interests. SEBI constantly reviews its guidelines to make them more market friendly and investor friendly.