INDIAN CAPITAL MARKETS REFORMS

The securities market has two interdependent and inseparable segments, the new issues (primary market) and the stock (secondary) market. PRIMARY MARKET The primary market provides the channel for sale of new securities. Primary market provides opportunity to issuers of securities; government as well as corporates, to raise resources to meet their requirements of investment and/or discharge some obligation. SECONDARY MARKET Secondary market refers to a market where securities are traded after being initially offered to the public in the primary market and/or listed on the Stock Exchange. Majority of the trading is done in the secondary market. Secondary market comprises of equity markets and the debt markets.

Reforms Since 1990s

Corporate Securities Market With the objectives of improving market efficiency, enhancing transparency, preventing unfair trade practices and bringing the Indian market up to international standards, a package of reforms consisting of measures to liberalise, regulate and develop the securities market was introduced. The practice of allocation of resources among different competing entities as well as its terms by a central authority was discontinued. The issuers complying with the eligibility criteria were allowed freedom to issue the securities at

market determined rates. The secondary market overcame the geographical barriers by moving to screen based trading. Trades enjoyed counter-party guarantee. The trading cycle shortened to a day and trades are settled within 2 working days, while all deferral products were banned. Physical security certificates almost disappeared. The following paragraphs discuss the principal reform measures undertaken since 1992. SEBI Act, 1992: It created a regulator (SEBI), empowered it adequately and assigned it with the responsibility for (a) protecting the interests of investors in securities, (b) promoting the development of the securities market, and (c) regulating the securities market. DIP Guidelines: Major part of the liberalisation process was the repeal of the Capital Issues (Control) Act, 1947 in May 1992. With this, Governments control over issue of capital, pricing of the issues, fixing of premia and rates of interest on debentures etc. ceased and the market was allowed to allocate resources to competing uses. In the interest of investors, SEBI issued Disclosure and Investor Protection (DIP) guidelines. Screen Based Trading: The trading on stock exchanges in India used to take place through open outcry without use of information technology for immediate matching or recording of trades. This was time consuming and inefficient. This imposed limits on trading volumes and efficiency. In order to provide efficiency, liquidity and transparency, NSE introduced a nationwide on-line fully-automated screen based trading system (SBTS) where a member can punch into the computer quantities of securities and the prices at which he likes to transact and the transaction is executed as soon as it finds a matching sale or buy order from a counter party.

 Trading Cycle: The trades accumulated over a trading cycle and at the end of the cycle, these were clubbed together, and positions were netted out and payment of cash and delivery of securities settled the balance. This trading cycle varied from 14 days for specified securities to 30 days for others and settlement took another fortnight. The exchanges, however, continued to have different weekly trading cycles, which enabled shifting of positions from one exchange to another. Rolling settlement on T+5 basis was introduced in respect of specified scripts reducing the trading cycle to one day. It was made mandatory for all exchanges to follow a uniform weekly trading cycle in respect of scripts not under rolling settlement. All scrips moved to rolling settlement from December 2001. T+5 gave way to T+3 from April 2002 and T+2 since April 2003. The market also had a variety of deferral products like modified carry forward system, which encouraged leveraged trading by enabling postponement of settlement. The deferral products have been banned. The market has moved close to spot/cash market. Derivatives Trading: To assist market participants to manage risks better through hedging, speculation and arbitrage, SC(R)A was amended in 1995 to lift the ban on options in securities. However, trading in derivatives did not take off, as there was no suitable legal and regulatory framework to govern these trades. Demutualization: Historically, brokers owned, controlled and managed stock exchanges. In case of disputes, the self often got precedence over regulations leading inevitably to conflict of interest. The regulators, therefore, focused on reducing dominance of members in the management of stock exchanges and advised them to reconstitute their governing councils to provide for at least 50% non-broker representation.

 Depositories Act: The earlier settlement system on Indian stock exchanges gave rise to settlement risk due to the time that elapsed before trades are settled. Trades were settled by physical movement of paper. This had two aspects. First, the settlement of trade in stock exchanges by delivery of shares by the seller and payment by the purchaser. The stock exchange aggregated trades over a period of time to carry out net settlement through the physical delivery of securities.To obviate these problems, the Depositories Act, 1996 was passed to provide for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline both the stages of settlement process, the Act envisages transfer of ownership of securities electronically by book entry without making the securities move from person to person. Investor Protection: The SEBI Act established SEBI with the primary objective of protecting the interests of investors in securities and empowers it to achieve this objective. SEBI specifies the matters to be disclosed and the standards of disclosure required for the protection of investors in respect of issues and issues directions to all intermediaries and other persons associated with the securities market in the interest of investors or of orderly development of the securities market. The Central Government established a fund called Investor Education and Protection Fund (IEPF) in October 2001 for the promotion of awareness amongst investors and protection of the interest of investors.

 Globalization: Indian securities market is getting increasingly integrated with the rest of the world. Indian companies have been permitted to raise resources from abroad through issue of ADRs, GDRs, FCCBs and ECBs. ADRs/GDRs have two-way fungibility. Indian companies are permitted to list their securities on foreign stock exchanges by sponsoring ADR/GDR issues against block shareholding. NRIs and OCBS are allowed to invest in Indian companies. FIIs have been permitted to invest in all types of securities, including government securities. The investments by FIIs enjoy full capital account convertibility. They can invest in a company under portfolio investment route upto 24% of the paid up capital of the company. New Products in the F&O Segment: The year 2008 witnessed the launch of new products in the F&O Segment. The mini derivative (futures and options) contracts on S&P CNX Nifty were introduced for trading on January 1, 2008. The mini contracts are a fraction of normal derivative contracts and extend greater affordability to individual investors, helps the individual investor to hedge risks of a smaller portfolio, offers low levels of risk in terms of smaller level of possible downside compared to a big size contract and also increases overall market liquidity and participation. The Long Term Options Contracts on NSEs S&P CNX Nifty were launched on March 3, 2008. The long-term options are similar to short-term options, but the later expiration dates offer the opportunity for long-term investors to take a view on prolonged price changes without needing to use a combination of shorter term option contracts. Short Selling: Pursuant to the recommendations of the Secondary Market Advisory Committee (SMAC) of SEBI and the decision of the SEBI Board, it was decided to permit all classes of investors to short sell. Short selling is defined as selling a stock which the seller does not own at the time of trade.

It increases liquidity in the market, and makes price discovery more efficient. Besides, it curbs manipulation of stocks as informed investors are able to go short on stocks they feel are higher than fair value. This facility was available to non-institutional investors. Vide a circular in February 2008, SEBI permitted all classes of investors, viz., retail and institutional investors to short sell. It, however, does not permit naked short sales and accordingly, requires participants to mandatorily honour their obligation of delivering the securities at the time of settlement. It does not permit institutional investor to do day trading i.e., square-off their transactions intra-day. Direct Market Acess: During April 2008, Securities & Exchange Board of India (SEBI) allowed the direct market access (DMA) facility to the institutional investors. DMA allows brokers to offer clients direct access to the exchange trading system through the brokers infrastructure without manual intervention by the broker. DMA facility give clients direct control over orders, help in faster execution of orders, reduce the risk of errors from manual order entry and lend greater transparency and liquidity. Cross Margining: Many trading members undertake transactions on both the cash and derivative segments of an Exchange. They keep separate deposits with the exchange for taking positions in two different segments. In order to improve the efficiency of the use of the margin capital by market participants and as in initial step towards cross margining across cash and derivatives markets SEBI allowed Cross Margining benefit in May 2008. Research in Securities Market In order to deepen the understanding and knowledge about Indian capital market, and to assist in policy-making, SEBI has been promoting high quality research in capital market. It has set up an in-house research department, which brings out working papers on a regular

basis. In collaboration with NCAER, SEBI brought out a Survey of Indian Investors, which estimates investor population in India and their investment preferences. SEBI has also tied up with reputed national and international academic and research institutions for conducting research studies/projects on various issues related to the capital market. Testing and Certification The intermediaries, of all shapes and sizes, who package and sell securities, compete with one another for the chance to handle investors/issuers money. The quality of their services determines the shape and health of the securities market. In developed markets and in some of the developing markets, this is ensured through a system of testing and certification of persons joining market intermediaries in the securities market. This sort of arrangement ensures that a person dealing with financial products has a minimum standard of knowledge about them, market and regulations so as to assist the customers in their dealings. This allows market participants and intermediaries to build their own tailored staff development strategies and improves career prospectus of certified professionals, while maintaining and enhancing the confidence of the investors in the market.

BRIEF ABOUT FORWARD, FUTURES AND OPTIONS

Derivatives Market in India Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI permitted the derivatives segments of two stock exchanges NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sensex) index. This was followed by approval for trading in options which commenced in June 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. Futures and Options contracts on individual securities are available on more than 200 securities. Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/ corporation duly approved by SEBI and notified in the official gazette.

Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays prepared price.

 Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two types calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Distinction between Forward,Futures and Options

Contract

Forward Future agreement that obliges the buyer and seller

Contract Size Depending on the transaction and the requirements of the contracting parties. Standardized Expiry Date Depending on the transaction

Futures Options Future agreement that Future agreement where the obliges the buyer and seller seller is obliged, but the buyer has an "option" but not an obligation Standardized Standardized

Transaction method Guarantees

Negotiated directly by the buyer and seller None. It is very difficult to undo the operation; profits

Quoted and traded on the Exchange

Standardized. American style options can be exercised at any time. European style options can only be exercised at expiry. Quoted and traded on the Exchange

Both parties must deposit The buyer pays a premium to an initial guarantee the seller. The seller deposits (margin). The value of the an initial guarantee (margin)

operation is marked to with subsequent deposits made market rates with daily depending on the market. The settlement of profits and underlying asset can be used as losses. guarantee. None. It is difficult Futures Exchange. Options Exchange. Operation Secondary to quit the operation; Operation can be quit prior can be quit prior to expiry. Market profit or loss at to expiry. Profit or loss can Profit or loss can be realized at expiry. be realized at any time. any time. Clearing House Clearing House Institutional The contracting parties Guarantee Cash settled. Contracts are usually closed When a long position is Settlement prior to expiry by taking a exercised it may be settled by compensating position. At delivery or cash settled. A long expiry contracts can be position which is out-of-thecash settled or settled by money is usually cancelled delivery of the underlying. prior to expiry.

and losses are cash settled at expiry.