CHAPTER 1: INTRODUCTION TO THE FINANCIAL SYSTEM

LEARNING OBJECTIVES:
After studying this chapter, you should know about the following components of
financial system:
Financial Market
Financial Markets Infrastructure Institutions (MIIs)
Financial Intermediaries
Financial Securities

1.1 Financial System

The Financial System refers to the entire set of institutionalized arrangements by which funds are
transferred from surplus units to deficit units at terms acceptable to both sides. Households as a
sector represent the surplus unit, whereas corporations and governments collectively represent
deficit units. An efficient financial system plays an important role in economic development and it
consists of financial market, financial instruments and financial intermediaries. The role of the
financial system is to gather or pool money from surplus units i.e., people and businesses that have
more than they need currently and transmit or allocate those funds to deficit units i.e., those who
can use them for investment. A larger flow of funds and efficient allocation of them leads to better
economic output and welfare of the economy and society. In addition to this, the financial market
should also function efficiently and at a minimal cost in cooperation with the other constituents of
the financial system.

1.1.1 Financial Market

A Financial Market can be defined as the market in which financial assets such as equities, bonds,
currencies and derivatives are created or transferred. It is a mechanism that allows traders to deal
in financial securities, commodities, etc. at low costs which reflects the efficiency of the market.
Financial Market can be classified into different subtypes:
Money market is a market for financial assets that are close substitutes for money. It is a market
for short term funds and instruments having a maturity period of one or less than one year. Money
market provides short term debt financing and investment. The money market deals primarily in
short-
of Deposit (NCDs), repos and Treasury Bills (T-bills), call/notice money market, commercial papers.
Capital market is a market for securities, where business enterprises and government can raise long
term funds. It is generally defined as a market in which money is provided for periods longer than a
year. It can be sub classified into Stock Market which helps in raising funds through the issue of

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shares or stock and Bond Market which helps in raising funds through the issue of bonds. Bonds in
India are issued by Government (both State and Central), Corporates and Municipal Bodies. Capital
Markets also provide the mechanism for subsequent trading of stocks and bonds.
Both the capital market and the money market have two interdependent and inseparable segments,
the primary market and the secondary market. The primary market is used by issuers for raising
fresh capital from the investors by making initial public offers or rights issues or offers for sale of
equity or debt; on the other hand, the secondary market provides liquidity to these instruments,
through trading and settlement on the stock exchanges. An active secondary market promotes the
growth of the primary market and capital formation since the investors in the primary market are
assured of a continuous market where they have an option to liquidate their investments. Thus, in
the primary market, the issuer has direct contact with the investor, while in the secondary market,
the dealings are between two investors and the issuer does not come into the picture.
The Forex market deals with the multicurrency requirements, which are met by the exchange of
currencies. Depending on the applicable exchange rate, the transfer of funds takes place in this
market. This is one of the most developed and integrated markets across the globe.
Credit market is a place where banks, Financial Institutions (FIs) and Non-Banking Financial
Companies (NBFCs) provide short, medium and long-term loans to corporates and individuals.
Insurance market facilitates the transfer of various risks from individuals, business houses and
bodies corporate to insurance companies.

1.2 Financial Markets Infrastructure Institutions (MIIs)

Depositories are institutions that hold securities of investors in electronic (dematerialized) form, for
a fee. The investors remain the beneficial owners of the securities. A Depository Participant (DP) is
the registered agent of the Depository concerned and it is through the DP that an investor gets the
services of the depository. It can be compared to a branch of a bank where individuals maintain
their savings accounts. The DP interacts with the investor and furnishes the record pertaining to an

securities when bought or obtained on allotment.

Stock Exchanges are an important constituent of the secondary market of Capital Market. Stock
Exchange means a body of individuals or a body incorporated, under the Companies Act, to assist,
regulate or control the business of buying, selling or dealing in securities.

Clearing Corporation is an entity that is established to undertake the activity of clearing and
settlement of trades in securities or other instruments or products that dealt with or traded on a

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recognized stock exchange and includes a clearing house and a limited purpose clearing
corporation.2

Social Stock Exchange is a newly introduced concept by SEBI in India. As per SEBI ICDR Regulations,
2018, Social Stock Exchange is a separate segment of a recognized stock exchange having
nationwide trading terminals permitted to register Not for Profit Organizations (NPOs) and/or list
the securities issued by Not for Profit Organizations in accordance with provisions of these
regulations.

1.3 Financial Intermediaries

A large variety and number of intermediaries provide intermediation services in the Indian securities
market. They are the entities who are involved in the business of managing individual portfolios,
executing orders, dealing in or distributing securities etc.

Merchant Bankers are entities that specialize in assisting companies to originate issues of securities.
The range of assistance covers the following:
1. Advising the client on the timing of an issue
2. Advising the company on the selection of underwriters, brokers, bankers and others, e.g.,
drafting the prospectus and verifying the accuracy of the claims made therein interacting with
regulators/exchanges

Bankers to Issues are scheduled banks that are engaged by companies to accept application money,
allotment or call money, undertake refund of application money and pay dividend or interest
warrants.

Registrars and Share Transfer Agents are persons registered under the SEBI (Registrars to an Issue
and Share Transfer Agents) Regulations, 1993. They provide services relating to a public or rights
issue. It includes collating data on subscriptions to an issue, preparation of basis of allotment,
crediting shares to the Demat accounts of the allottees etc.

Transfer Agents are persons that maintain record of holders of securities and deal with all matters
connected with transfer or redemption of securities or incidental activities of a company so that it
reflects changes in ownership of shares consequent upon trading and also handle dividend payouts
and communications relating to other corporate actions.

Stock Brokers who are registered with SEBI provide different types of services which include the
undertaking of secondary market transactions on behalf of their clients, that is, by executing buy or
sell transactions communicated by investors. For their service, stock brokers earn a commission,

2
The limited purpose clearing corporation details are specified under Chapter IV-A of Securities Contracts (Regulation)
(Stock Exchanges and Clearing Corporations) Regulations, 2018.

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commonly referred to as brokerage. Stock brokers also play a role in the marketing of new issues of
securities by informing and advising investors of new issues. According to SEBI Stock Brokers
Regulations 1992, a stock broker means a person having trading rights in any recognised stock
exchange and includes a trading member.

Portfolio Managers are individuals or firms that administer the portfolios of individuals or provide
advice or direction to that effect, for a fee or a share in the profits or a combination of the two.

Mutual Funds are trusts that mobilize funds from investors by issuing units and undertake to invest
the money in a manner consistent with the specified investment objective. The objective could be
to maximize capital growth or to maximize current income or something similar. There are two
types of investment schemes: open-end and closed-end. In the former, demand for units is met by
a fresh supply, so there is no limit on the number of units that can be issued. With closed-end funds,
there is a limit on the number of units that can be issued and following issuance, units are traded in
the secondary market. Closed-end funds have a specified maturity, unlike open-end funds.

Custodians are entities that hold securities or gold or gold-related instruments on behalf of
institutional investors, e.g., mutual funds and insurance companies. Custodians maintain and
reconcile the records relating to the assets held and also monitor corporate actions such as dividend
payments or rights issues on behalf of their clients. In short, custodians are mainly into trade
settlement, safekeeping, benefit collection, reporting and accounting. One point of distinction is
that a Depository has the right to effect transfer of beneficial ownership while a custodian does not.
According to SEBI Custodian regula custodian" means any person who carries on or proposes
to carry on the business of providing custodial services.

Warehouse means any premises (including any protected place) conforming to all the requirements
including manpower specified by the Authority by regulations wherein the warehouse keeper takes
custody of the goods deposited by the depositor and includes a place of storage of goods under
controlled conditions of temperature and humidity.

Credit Rating Agency is a body corporate that is engaged in or proposes to be engaged in, the
business of rating of securities offered by a company, including fixed deposits and credit facilities.
Any person wanting to commence business as a credit rating agency should make an application to
SEBI in the format prescribed by SEBI.

Debenture trustee means a trustee of a trust deed for securing any issue of debentures of a body
corporate. An application by a debenture trustee for a grant of certificate to act as a debenture
trustee shall be made to SEBI as per the prescribed format. According to Mutual Fund Regulations,
trustee means the Board of Trustees or the Trustee Company who hold the property of the Mutual

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Fund in trust for the benefit of the unit holders. Similarly, with respect to the Alternate Investment
Fund (AIF) Regulations, the Trustee is required to ensure certain compliances, for which it imposes
relevant restrictions under the Fund Documents (for example, compliance with providing an exit
mechanism to investors upon a material change in the PPM).

Vault Manager means any person who carries on or intends to carry on the business of providing
vaulting services3. Vaulting service in relation to gold means the storage and safekeeping of gold
deposited with the Vault Manager, by the depositor, for the purpose of trading in Electronic Gold
Receipts (EGRs) and providing services incidental thereto, and includes:

(i) utilizing the services of assayers empaneled with the Stock Exchanges for testing as per the
gold standard, wherever required;
(ii) coordination with depositories for creation, transfer and extinguishment of Electronic
Gold Receipt; and
(iii) providing deposit, storage and withdrawal services to the beneficial owners.

1.4 Financial Securities

According to the Securities Contracts (Regulat
a) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of
a like nature in or of any incorporated company or a pooled investment vehicle or other
body corporate;
b) Derivative4;
c) units or any other instrument issued by any collective investment scheme to the investors
in such schemes;
d) security receipt as defined in section 2 of the Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest Act, 2002;
e) units or any other instrument issued by any pooled investment vehicle;
f) any certificate or instrument (by whatever name called), issued to an investor by any issuer
being a special purpose distinct entity which possesses any debt or receivable, including
mortgage debt, assigned to such entity, and acknowledging beneficial interest of such
investor in such debt or receivable, including mortgage debt, as the case maybe;

3
The Central Government had, in the Union Budget for 2021-22, announced that SEBI would be the regulator for gold exchanges
and accordingly finance ministry had notified electronic gold receipts (EGRs), the instrument representing gold, as securities, paving
the way for the launch of gold exchanges. The Vault manager are regulated as a SEBI intermediary for providing vaulting services
meant for gold deposited to create EGRs. The obligations of the Vault Manager include accepting deposits, storage and safekeeping
of gold, creation as well as withdrawal of EGR, grievance redressal and periodic reconciliation of physical gold with the records of
depository.

4 As per SCRA, derivative includes a security derived from a debt instrument, share, loan, whether secured or unsecured, risk

instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of
prices, of underlying securities; commodity derivatives; and such other instruments as may be declared by the Central Government
to be derivatives.

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 g) Government securities;
h) such other instruments as may be declared by the Central Government to be securities;
i) rights or interest in securities;
j) Zero coupon zero principal instruments5

Stock means a type of security that signifies ownership in a corporation and represents a claim on

Equity shares represent an ownership interest in a company. The claim of equity shareholders on
earnings and assets (in the event of liquidation) comes last and hence is residual in nature. Equity
shareholders expect to benefit from dividends and price appreciation. They have both collective
and individual rights such as the right to elect directors, the right to transfer shares, attend and vote
at general meetings.

Preference shares are securities that have a preferential right to dividend and repayment of capital.
These shares do not carry voting rights except when their rights are affected. These are hybrid
securities as they combine features of both equity and debt. They bear dividends, similar to equities,
which may or may not be paid, and offer no collateral as security. The preference shares have a
finite life and the dividend is a stated per cent of par value, similar to debt securities.

Debentures are debt securities having a definite life during which they pay coupon, which is interest
at a specified rate on the par value, at regular intervals, typically every six months. Bonds too are
debt securities with similar features except that internationally the distinguishing feature of bonds
is that they are secured by specific collateral. In India, long-term debt securities issued by the
Government of India or State Government or partially by any one of them are called bonds.

Warrants are long-term call options issued by a company, which give the holder the right to buy
equity shares from the company at a specified price known as the subscription price or exercise
price. Warrants are separately tradable and their price behaviour is linked to that of the underlying
equity share.

Derivatives are financial contracts that derive their values from underlying assets or groups of
assets. Some common forms of derivatives instruments are as follows:

Options are contracts that give the holder the right, but not the obligation, to buy or sell
some underlying asset. For example, a call option on an equity share gives the holder the

5 In exercise of the powers conferred by sub-clause (iia) of clause (h) of section 2 of the SCRA, 1956 (42 of 1956), the
C
instrument issued by a Not for Profit Organisation which shall be registered with
Social Stock Exchange segment of a recognised Stock Exchange in accordance with the regulations made by SEBI.

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 right to buy the underlying at a specific price known as the exercise price or strike price. On
the other hand, a put option gives the holder the right to sell the underlying at a specific
price. A call option would be bought if the buyer expects the price of the underlying to rise,
while a put option will be bought if the buyer expects the price of the underlying to decline.
The seller of the option is also known as the writer of the option. While the holder of the
option is under no obligation to perform any action, it is the writer who is obligated to
perform, that is, deliver securities on exercise of a call, or make payment on exercise of a
put. For granting the privilege of either buying or selling a stock, the writer receives a
payment known as premium. Options positions can be offset before expiration.
Futures contracts guarantee delivery of a specific quantity of a specified asset on a specified
future date, at the price currently quoted. If an investor anticipates the spot price on the
delivery date to be higher than the quoted futures price today, then he or she may buy the
contract hoping to make a profit. But, if an investor anticipates the spot price to be lower
itions in futures
contracts can be offset before the delivery date.
Index Derivatives: Futures contracts based on stock or financial index i.e., BSE Sensex or NSE Nifty
50 are known as Index Derivatives. The underlying asset of these derivatives are the stock market
indices.

Exchange-traded derivative contracts are standardized in terms of the quantity, quality, time and
place of delivery. They are transacted on an organised futures exchange.

Structured Products Structured products typically comprise bonds, equities, and derivatives as an
underlying asset class. These products come either with Capital protection (full or partial principal
return) or without capital protection features. Private banks, Wealth management firms, and NBFC
(Non-Banking Financial Companies) offer structured products in India. It is typically suited for high
net-worth investors who are looking for low risk and portfolio diversification for good returns

Alternate Investment Fund (AIF) AIF means any fund established or incorporated in India which is
a privately pooled investment vehicle that collects funds from sophisticated investors, whether
Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of
its investors. It is a form of a pooled-in vehicle for investing in real estate, private estate, private
equity and hedge funds. AIF adds diversification to a portfolio and helps mitigate the risk.

ADR is an acronym for American Depository Receipt which is a security denominated in US Dollars,
traded at US exchanges, representing a specific number of equity shares of a foreign company that
are traded in the foreign country.

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GDR is an acronym for Global Depository Receipt. It is an instrument denominated in foreign
currency that allows foreign investors to invest in shares of foreign companies which are listed and
traded in the foreign country. As an example, a Euro-denominated GDR issued by an Indian
company will have a certain number of Rupee-denominated equity shares underlying it. The GDR
may trade freely in the overseas security market where it is listed. A GDR holder may opt to liquidate
the investment, in which case, the underlying shares will be released for sale by the custodian in
India.

IDR is an acronym for Indian Depository Receipt. It is a Rupee-denominated security which is traded
in Indian stock exchanges, representing a specific number of shares of a foreign company. An IDR
offers Indian investors, access to foreign securities that are listed and traded at foreign exchanges.
When security is termed fungible, it refers to the feature that allows an instrument to be replaced
by another of a similar description, for instance, an ADR, vis-à-vis its underlying share.

Mutual Fund (MF) units represent the share of the investors/ unit holders in the assets of the
scheme. The fund managers invest the money collected to try and achieve the specified investment
objective.

Exchange-traded Funds (ETFs) are open-ended mutual funds that allow trading of their units
throughout the day. This facility is in contrast to conventional mutual funds where buying and selling
happen at the closing Net Asset Value (NAV) of the day or of the following day, depending on the
precise time at which the investor placed the order. ETFs are passively managed investment options,
while mutual funds are actively managed investment options.

Currency Derivatives (CDs) are contracts between buyers and sellers, whose values are derived
from the underlying assets, i.e., the currency amounts. These are risk management tools in the
forex and money markets. These may be options or futures or swaps, which offer investors the
facility to lock in the rate at which they wish to buy or sell a particular currency. As an example, an
Indian exporter with Kuwaiti Dinar receipts who expects an appreciation of the Indian Rupee could
buy a put option, to sell Dinar. In contrast, an Indian importer with Euro liability and expecting the
foreign currency to appreciate could buy a call option on Euros. Alternatively, the Indian exporter
could sell a futures contract in Kuwaiti Dinar and the Indian importer could buy a futures contract
in Euros. Currency Swaps are agreements between parties that facilitate borrowing in foreign
currencies at lower costs. For instance, a British firm may need Euros while a French firm may
require Pounds Sterling. However, taking comparative advantage into account, it may be a better
option for the British and French firms to raise funds in their respective currencies and then enter
into a swap. The principals are also re-exchanged at maturity.

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Interest-rate Derivatives are contracts that enable investors or borrowers to hedge against the risk
of adverse interest-rate movement. These include interest-rate futures, interest-rate swaps,
interest-rate options and Forward Rate Agreements (FRAs).

Interest-rate Futures are contracts in which the underlying asset is a debt security, for example,
futures on Treasury Bills (T-Bills), Commercial Papers (CP) or Government Securities. An investor
may trade in interest-rate futures with the objective of locking in a certain yield or borrowing rate.
To illustrate, if a corporate treasurer apprehends a fall in interest rates by the time surplus funds
are received, he could lock in the higher yield currently quoted by buying an interest-rate futures
contract. On the other hand, if a banker fears a rise in interest rates by the time he enters the market
to raise funds, he could lock in the lower rate currently quoted by selling an interest-rate futures
contract.

Interest-rate Swaps are agreements between two or more parties to exchange the series of cash
flows in the same currency over an agreed period of time. For instance, two prospective borrowers
may have opposite views on the direction of interest rate movement in the

party, say, A, it may be beneficial for A to borrow fixed-rate and for B to borrow floating-rate and
then for the two to enter into a swap. In an interest-rate swap, the principals are not exchanged.

Interest-rate Options is a derivative financial instrument. It can be caps or floors. A cap is bought
to limit the interest rate to a specific ceiling on floating-rate borrowings, in the event that the
benchmark rate starts rising. A floor is bought to earn a minimum rate of return on floating-rate
investments, in the event that the benchmark rate begins to decline. Spread transactions and
combinations involving multiple options to craft specific pay-out or receipt patterns are also
possible.

Forward Rate Agreement (FRA) is a forward contract by which a borrower locks in a specified rate
of interest for a pre-determined time period in the future. For example, assume that a company is
planning to seek a six-month loan after three months. The company expects short-term rates to
rise. So, it could buy a three-month FRA on six-month LIBOR at, say 7 % (using, LIBOR, that is, the
London Inter-bank Offer Rate as the reference rate in the transaction). At the end of three months,
if the six-month LIBOR is greater than 7 %, the bank which sold the FRA will pay the excess sum to
the company. On the other hand, if the LIBOR turns out to be lower than 7 %, the company will pay
the difference to the bank.

Securities Lending and Borrowing Scheme (SLB): Short Selling means selling a stock that the seller
does not own at the time of the trade. Short selling can be done by borrowing the stock through
Clearing Corporations of a stock exchange that are registered as Approved Intermediaries (AIs).

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Short selling can be done by retail as well as institutional investors. The Securities Lending and
Borrowing mechanism allows short sellers to borrow securities for making delivery.

E-warehouse receipts: Warehouse receipt means an acknowledgement in writing or in the

electronic form issued by a Repository regulated by WDRA for storage of goods not owned by the
warehouse keeper. E-warehouse receipts are negotiable warehouse receipts issued in electronic
format.

REITs and InvITs

Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) are innovative
vehicles that allow developers to monetise revenue-generating real estate and infrastructure assets
while enabling investors or unit holders to invest in these assets without actually owning them. Such
monetization benefits developers by allowing them to release capital for funding new
infrastructure/real estate projects, and provides liquidity to investors or unit holders as the units of
the trust are listed on exchanges. Apart from these, REITs and InvITs enjoy favourable tax treatment,
including exemption from tax deduction at source for dividend distributed to REITs and InvITs.

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Review Questions
1. Financial systems consist of banks, non-banks and ______________.
(a) Bullion Markets
(b) Financial Markets
(c) Money lenders
(d) NGOs

2. Safekeeping and record-keeping of securities are done by ___________.

(a) Custodians
(b) Venture Capital Funds
(c) Brokers
(d) Mutual Funds

3. Who amongst the following collates data on subscriptions regarding primary issuances?
(a) Banks
(b) Custodians
(c) Venture Capital Funds
(d) Registrars

4. As per the Securities Contract Regulation Act (SCRA), the term 'Security' excludes which of the
following?
(a) Shares
(b) Bonds
(c) Derivatives
(d) Bullion

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