Submitted by: Submitted to: Amit Dr.

Yogesh Maheshwari PGPMX 2012-14, Term II and Resources Assignment 1 February 25, 2013

Mishra Financial System

Financial Markets in India: The Way Forward

Contents Executive Summary. Money Market Evolution. Capital Market Evolution. Money Market: Contemporary Instruments and Players. Capital Market: Contemporary Instruments and Players. Regulatory Environment of Financial Markets. The Way Forward.

Executive summary
The report aimed to study the history of Indian financial market which is one of the oldest among its peer markets of the emerging markets in the world. The history of Indian capital markets dates back 200 years toward the end of the 18th century when India was under the rule of the East India Company. The financial market in India today is more developed than many other sectors. Today there are 21 regional securities exchanges in India in addition to the centralized NSE (National Stock Exchange) and OTCEI (Over the Counter Exchange of India). However the stock markets in India remained stagnant due to stringent controls on the market economy that allowed only a handful of monopolies to dominate their respective sectors. The Indian money market is a market for short-term and long term funds with maturity ranging from overnight to one year and includes financial instruments that are deemed to be close substitutes of money. Capital markets are financial markets for the buying and selling of long-term debtor equity-backed securities. These markets channel the wealth of savers to those who can put it to long-term productive use, such as companies or governments making long-term investments. A key division within the capital markets is between the primary markets and secondary markets. India has a financial system that is regulated by independent regulators in the sectors of banking, insurance, capital markets, competition and various services sectors. In a number of sectors Government plays the role of regulator. Ministry of Finance, Government of India looks after financial sector in India. Finance Ministry every year presents annual budget on February 28 in the Parliament. The annual budget proposes changes in taxes, changes in government policy in almost all the sectors and budgetary and other allocations for all the Ministries of Government of India. The annual budget is passed by the Parliament after debate and takes the shape of law. Securities and Exchange Board of India (SEBI) established under the Securities and Exchange aboard of India Act, 1992 is the regulatory authority for capital markets in India. India has 23 recognized stock exchanges that operate under government approved rules, bylaws and regulations. These exchanges constitute an organized market for securities issued by the central and state governments, public sector companies and public limited companies. A deeper look into the Indian financial Market reveals the hurdles and its way forward in the growth of the Indian economy.

Financial Markets in India

As an investor we are obsessed with profit and loss, bulls and bears and various other technical and psychological aspects of investing. Because of so much noise we are normally familiar with most famous investment avenues like Stock Market, Bonds, MFs as everyone talks about it. But our understanding of how exactly the financial market in India operates suffers due to lack of awareness. In this article we will try to understand the technical and functional structure of Financial Market so that as an individual investor you can take more informed decisions and take your knowledge of financial market to the next level.

Structure of Financial Market

Following picture clearly depicts the important blocks of Indian Financial Market together with governing body and the functional aspects.

As the structure is clear lets focus on some important aspects of the building blocks and figure out why it is designed like this. Capital Market Money Market Operates through recognized Its a virtual market and operates through exchanges(BSE/NSE) phone lines, fax, computers and internet. Individual Investors can participate in Individual Investors cannot participate as secondary market investment amount is very large Primarily for long term investments although short term investment options are also there Primarily for short term lending and borrowing High Risk/High Return market Its more secure in comparison Capital Market is governed by SEBI Money market is regulate by RBI

Money Market Evolution

The evolution of money market in India could be traced to the late 1980s when the Working Group on Money Market (Chairman: N. Vaghul) made a series of recommendations for developing various segments of the money market. The administered interest rate system in the money market was dismantled. A series of measures were undertaken to build the institutional infrastructure for the money market. The Discount and Finance House of India (DFHI) was established in 1988 to promote secondary market activity in money market instruments, followed by a system of primary dealers in 1996 as a mechanism for developing the Gilt Market. The segment for Certificate of Deposits came into being in 1989. The money market expanded further to cover segments for Commercial paper (1990), Repos with Reserve Bank (1992), Market Repos, Forward Rate Agreements/ Interest Rate Swaps (1999) and Collateralised Borrowings and Lending Obligations (2003). The development of the payment system infrastructure was strengthened with the formation of the Clearing Corporation of India Limited. (CCIL) in April 2002, introduction of the Negotiated Dealing System (NDS) in February 2002 and the implementation of real time gross settlement (RTGS) system from April 2004. The profile of money market has also been changing in the recent period. There have been indications of a more balanced development of the money market. Participants have been increasingly switching from the uncollateralised call/ notice money market to the collateralised segments, driven by standardisation of accounting practices, broad basing of eligibility criteria, and the gradual phasing out of non-banks from the call market and lower Cash Reserve Ratio (CRR) requirements. In recent years, although the call money and repo markets continued to be dominated by few top lenders, they were not able to extract monopoly rents as call rates and market repo rates persistently ruled below the Reserve Banks repo rate. While mutual funds have emerged as the largest supplier of funds in the repo and CBLO markets, PDs are increasingly becoming the major borrowers in the call/ notice money market. The integration of various segments of the money market has improved after the introduction of the Liquidity Adjustment Facility (LAF). The correlation coefficient between interest rates of CDs, CPs, 91-day Treasury Bills and repo rate with the call money rate improved steadily from 0.32, 0.54, 0.61 and 0.36 respectively, during the period April 1993 to may 2000 to 0.93, 0.90, 0.95 and 0.87 during June 2000 to June 2004. Correlation coefficients turned out to be lower after netting out the repo rate reflecting the influence of the LAF in promoting money market integration. The integration of money market segments was further validated by confirmation of the existence of co-integrated relationship among money market rates. The degree of cointegration has strengthened in the recent period. i.e. June 2000 to June 2004.

Capital Market Evolution

Before 1991, investment in the most important areas of the economy was a public sector monopoly, private investment was carefully directed, and foreign investment discouraged. Even in areas that were not a public sector monopoly, severe licensing restrictions regulated the amount of investment a private firm could undertake. Capital markets were constrained by five particular government policies: The government owned and controlled almost all of the banking system and prevented foreign and domestic institutions from entering it. The insurance and pension fund industry was government owned and had to invest most of its assets in low-yielding government securities. Nearly all interest rates were set by the government, and financial institutions were directed on how they should allocate some of their investments. Banks had to meet high reserve requirements, and the funds were used to finance the governments fiscal deficit in effect preempting private investment. Private capital markets were small and needed government approval (including government determination of price and terms) on new capital issues. Since 1991, there has been a substantial and steady liberalization of the economy to increase the role for market forces. Most interest rates have been deregulated. Foreign investment has been permitted to enter both debt and equity markets. The private sector has been allowed to set up mutual funds. Government control of the prices of initial public offerings (IPOs) has ended. Finally, better regulation, enforced disclosure, and investor protection have greatly improved the integrity of the private capital market. Although the changes in the last six years have been substantial, a large number of problems remain. The banking system is still predominantly government owned and inefficient. Government crowding out of private investment continues, including through (declining) reserve requirements.

Above chart shows the growth of largest stock exchange NSE by volume in last 10 years.

Money Market: Contemporary Instruments and Players

The entire money market in India can be divided into two parts. They are organized money market and the unorganized money market. The unorganized money market can also be known as an unauthorized money market. Both of these components comprise several constituents. The following chart will help you in understanding the organizational structure of the Indian money market.

Money Market Instrument Call/ Notice/ Term Money Repo/ Reverse Repo Inter Corporate Deposits Commercial Paper Certificate of Deposit T-bills Inter Bank Participation Certificate

Primary Players: Banks, Corporate, Financial Institutions, Provident Funds, Primary Players

Following are some of the important money market instruments or securities. (a) Call Money: Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies in between one day to a fortnight. The rate of interest paid on call money loan is known as call rate. (b) Treasury Bill: A treasury bill is a promissory note issued by the RBI to meet the short-term requirement of funds. Treasury bills are highly liquid instruments that means, at any time the holder of treasury bills can transfer of or get it discounted from RBI.These bills are normally issued at a price less than their face value; and redeemed at face value. So the difference between the issue price and the face value of the treasury bill represents the interest on the investment. These bills are secured instruments and are issued for a period of not exceeding 364 days. Banks, Financial institutions and corporations normally play major role in the Treasury bill market. (c) Commercial Paper: Commercial paper (CP) is a popular instrument for financing working capital requirements of companies. The CP is an unsecured instrument issued in the form of promissory note. This instrument was introduced in 1990 to enable the corporate borrowers to raise short-term funds. It can be issued for period ranging from 15 days to one year. Commercial papers are transferable by endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major player of commercial paper market. (d) Certificate of Deposit: Certificate of Deposit (CDs) is short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, co-operatives and companies. (e) Trade Bill: Normally the traders buy goods from the wholesalers or manufactures on Credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or in immediate need of money he/she can draw a bill of exchange in favor of the buyer. When buyer accepts the bill it becomes a negotiable instrument and is termed as bill of exchange or

trade bill. This trade bill can now be discounted with a bank before its maturity. On maturity the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.

Capital Market: Contemporary Instruments and Players

Capital Market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities. So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issue various securities such as shares debentures, bonds, etc. In the present chapter let us discuss about the market for trading of securities. The market where securities are traded known as Securities market. It consists of two different segments namely primary and secondary market. The primary market deals with new or fresh issue of securities and is, therefore, also known as new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as stock market or stock exchange. Primary Players: Individual Investor, Financial Institutions, Banks, Corporate Primary Market The Primary Market consists of arrangements, which facilitate the procurement of long term, funds by companies by making fresh issue of shares and debentures. Secondary Market The secondary market known as stock market or stock exchange plays an equally important role in mobilizing long-

term funds by providing the necessary liquidity to holdings in shares and debentures Broad Constituents in the Indian Capital Markets

Fund Raisers, Fund Providers, Organizations, Market Regulators

Intermediaries,

With a population of more than a billion, a mere 1% of the population participates in capital markets, and of that only a fraction is active

Capital Market Instrument Equities Bonds Mutual Funds Derivatives Commodities Currencies

Classification of players by supply and demand for capital Issuers Investors Intermediaries

With regard to the role played by intermediaries that of facilitating contact between investors and issuers economic

theory distinguishes between financing provided through bank loans, so-called "intermediated" financing, to financing through the issuance of securities, "disintermediated" financing. In the first case (intermediated financing), the resources of agents with a financing capacity (deposits, in particular from households) are made available via banks to agents with financing requirements (companies). The crucial role of banks in this regard is to enable the short-term time horizon of the first group to be transformed into the long-term time horizon (investment) of the latter. In the second case, agents with financing requirements capture public savings directly through the issuance of securities (stocks and bonds), which are acquired by agents with financing capacity. The description "disintermediated" used for this form of financing is somewhat misleading as intermediaries operating in this second situation are in fact more numerous and diverse than in the previous case, and once again the banks play a central role Participants in the Securities Market SAT, regulators (SEBI, RBI, DCA, DEA), depositories, stock exchanges (with equity trading, debt market segment, derivative trading), brokers, corporate brokers, sub-brokers, FIIs, portfolio managers, custodians, share transfer agents, primary dealers, merchant bankers, bankers to an issue, debenture trustees, underwriters, venture capital funds, foreign venture capital investors, mutual funds, collective investment schemes.

Regulatory Environment of Financial Markets

The financial system in India is regulated by independent regulators in the field of banking, insurance, capital market, commodities market, and pension funds. However, Government of India plays a significant role in controlling the financial system in India and influences the roles of such regulators at least to some extent In India, the capital market is regulated by the Capital Markets Division of the Department of Economic Affairs, Ministry of Finance. The division is responsible for formulating the policies related to the orderly growth and development of the securities markets (Le. share, debt and derivatives) as well as protecting the interest of the investors. The following are the major financial regulatory bodies in India: Statutory Bodies via parliamentary enactments: Reserve Bank of India: Reserve Bank of India is the apex monetary Institution of India. It is also called as the central bank of the country. The Reserve Bank of India was established on April 1, 1935 in accordance with the provisions of the Reserve Bank of India Act, 1934. The Central Office of the Reserve Bank was initially established in Calcutta but was permanently moved to Mumbai in 1937. The Central Office is where the Governor sits and where policies are formulated. Though originally privately owned, since nationalization in 1949, the Reserve Bank is fully owned by the Government of India. Securities and Exchange Board of India: SEBI Act, 1992: Securities and Exchange Board of India (SEBI) was first established in the year 1988 as a nonstatutory body for regulating the securities market. It became an autonomous body in 1992 and more powers were given through an ordinance. Since then it regulates the market through its independent powers. Part of the Ministries of the Government of India: Forward Market Commission India (FMC): Forward Markets Commission (FMC) headquartered at Mumbai, is a

regulatory authority which is overseen by the Ministry of Consumer Affairs, Food and Public Distribution, Govt. of India. It is a statutory body set up in 1953 under the Forward Contracts (Regulation) Act, 1952 This Commission allows commodity trading in 22 exchanges in India, out of which three are national level. 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.

The Way Forward:

Problems in Indian Financial Market Limited Investor Awareness of financial instruments Comparably, higher trading costs Lack of Product Innovation: balancing viability with Innovation Risk Management: towards international standards of Compliance Low Retail Participation

Summarized below are some recommendations which could move Indian capital markets closer to eciency and scale greater heights Investor education and regulation of mutual fund distributors Allowing AMCs the exibility to charge fees Innovative products across dierent asset classes including Operationalisation of REMFs Amending tax regime to encourage domestic AMCs to manage foreign Funds from India Allowing higher investment by domestic institutional investors such as insurance companies, pension funds and provident funds to make investments in capital markets Make tax regime friendly for issuers/ investors of IDRs Make implementation of proposal of SME stock exchange eective Reduction in the current withholding tax of 20% on income from debt securities to encourage investment in debt market. Developing a legal and regulatory framework for Islamic nance and structure new capital market products that are Shariah compliant Allowing institutional investors to participate in commodity markets Strengthening the autonomy of the FMC

Strategic Environment for Domestic and Foreign firms: Unification The current trend worldwide and the present debate within the country, suggests that the end of stratification between sectors and consolidation within sub-sectors would be inevitable. For example the financial services sector may be broadly categorized into following sub-sectors: commercial banking, investment banking, development banking, asset management, securities trading and distribution, insurance and NBFCs. Unification in the shape of cross-over between banking and insurance and the emergence of bancassurance is a case in point. Customer Centric Approach Exposure to global practices has made the Indian customer more discerning and demanding. There has been a clear shift towards those entities that are able to offer products and services in the most innovative and cost efficient manner. The financial services sector will need to adopt a better customercentric business focus. It will also have to create value for its shareholders as well as its customers, competing for the capital necessary to fund growth as well as for customer market share. Engage in multi-pronged strategies for expanding economic opportunity A firms primary focus should be to develop inclusive business models that make those services widely accessible. Constraints in the system however mean that inclusive business models often require complementary strategies to be viable. For example plans to offer financial transactions via mobile phone may require active engagement with governments across countries to align the incentives and policies of financial and telecommunications regulators. There is particularly significant opportunity for commercial banks to play leadership roles in institutional capacitybuilding, applying their expertise to strengthen entire systems. Increase Penetration Financial services in India still remain largely underpenetrated and there lies the opportunity for high growth. Foreign banks are likely to be allowed to acquire local banks when the next stage of banking reforms is proposed and increased FDI limit in insurance will offer good opportunities in the insurance sector. Low penetration in the pension market makes it a lucrative business segment. India also

offers a once in a lifetime opportunity for PE funds to invest in the infrastructure asset class across the board ranging from core sectors such as power, roads, transport to social asset classes such as healthcare, education, environment. Other service economy infrastructure sectors like telecom, ISPs, financial payment gateways also offer massive opportunities. Collaboration In the financial services sector, engagement with microfinance institutions, international financial institutions, and multilateral and bilateral donors is common, particularly around microfinance. Large commercial banks have the potential to serve as lynchpins in the dynamic transformation of financial markets to offer expanding economic opportunity to the poor. While individual firms must naturally choose the strategies most appropriate for them, strong collaboration capabilities will almost certainly be essential both within the financial sector and beyond. Anticipate best practices in Regulation The changes in the financial services landscape have taken place against a wider systemic backdrop of easing of controls on interest rates and their realignment with market rates, gradual reduction in resource pre-emption by the government, relaxation of stipulations on concessional lending and removal of access to concessional resources for financial institutions. The financial regulatory system in India today is far more conscious and better equipped, institutionally and legally, to demand and enforce necessary disclosures and compliance with laid norms for protection of the users of the system as well as the credibility and efficacy of the system itself.