Indian Capital Market: Recent Developments and Policy Issues

Indian stock markets have over the last couple of decades advanced from a relatively slumber to
a rapidly evolving and active stock exchange. This change has been aided by the rapid changes
in the economy and the advancement in technology. Advanced technology has facilitated the
modernization of the Indian securities market especially the secondary market. Today there are
22 stock exchanges in India, the first being the Bombay Stock Exchange (BSE), which began
formal trading in 1875, making it one of the oldest in Asia. In terms of the number of companies
listed and total market capitalization, the Indian equity market is considered large relative to the
country’s stage of economic development. The two major exchanges of India are the Bombay
Stock Exchange (BSE) and National Stock Exchange (NSE).
The equity market capitalization of the companies listed on the BSE was US$1.63 trillion as of
December 2010, making it the 4th largest stock exchange in Asia and the 8th largest in the
world. BSE has the largest number of listed companies in the world. As of December 2010,
there are over 5,034 listed Indian companies and over 7700 scrips on the stock exchange, the
Bombay Stock Exchange has a significant trading volume. Though many other exchanges exist,
BSE and the National Stock Exchange of India account for the majority of the equity trading in
India. While both have similar total market capitalization (about USD 1.6 trillion), share volume
in NSE is five times that of BSE.
There have been significant reforms in the regulation of the securities market since 1992 in
conjunction with overall economic and financial reforms. In 1992 the SEBI Act was enacted
giving SEBI statutory status as an apex regulatory body. And a series of reforms was introduced
to improve investor protection, automation of stock trading, integration of national markets, and
efficiency of market operations. India has seen a tremendous change in the secondary market for
equity. In 1993 SEBI made all exchanges shift to screen-based trading, in order to make the
exchanges more transparent. The first exchange to be based on an open electronic limit order
book was the National Stock Exchange (NSE), which started trading debt instruments in June
1994 and equity in November 1994. Despite these improvements in microstructure, the Indian
capital market has seen wide volatility during the last ten years. The amount of capital issued
was 3506 crore in 2000 it peaked at 26547 crore in 2007-08 and later dipped to 12637 crore in
2008-09.
The BSE-30 index or Sensex, the sensitive index of equity prices which stood at 6006 in
February 2000 rose to 18000 in January 2008 before falling to 8701.07 on October 24, 2008 later
it recovered spectacularly to 20,893.6 in November 2010. A major reason for this volatility was
the inflow of FDI into Indian capital market during the period 2006 to 2008. But the sub-prime
induced crisis in the world economy specially the US economy and the consequent pressure on
the foreign institutional investors saw large scale outflow of capital in 2008. Subsequently the
Indian economy proved to be much more insulated from the crisis and the consequent recovery
improved sentiments and saw the markets rising back to pre January 2008 levels.
The Indian capital market has gone tremendous changes in terms of regulatory framework and
transparency but a lot needs still to be done. India still plagued by ineffective corporate
governance as evidenced by the Satyam Computers scam. Accounting systems are still anarchic
and needs to be allied to internationally acceptable accounting practices. The dominance of
promoter family on the boards is another issue which needs to be addressed in the interest of
investor justice. The legal mechanism need to be tightened to better protect small share holders’
rights and their capacity to monitor corporate activities. Market information is a crucial public
good that should be disclosed or made available to all participants to achieve market efficiency.
SEBI should also monitor more closely cases of insider trading. The capital market cannot thrive
alone; it has to be integrated with the other segments of the financial system. The global trend is
for the elimination of the traditional wall between banks and the securities market. Securities
market development has to be supported by overall macroeconomic and financial sector
environments. Further liberalization of interest rates, reduced fiscal deficits, fully market-based
issuance of Government securities and a more competitive banking sector will help in the
development of a sounder and a more efficient capital market in India.

Capital Market Reforms and Developments

Over the last few years, SEBI has announced several far reaching reforms to promote the capital
market and protect investor interests. Reforms in the secondary market have focused on three
main areas: structure and functioning of stock exchanges, automation of trading and post trade
systems, and the introduction of surveillance and monitoring systems. Computerized online
trading of securities, and setting up of clearing houses or settlement guarantee funds were made
compulsory for stock exchanges. Stock exchanges have been permitted to operate beyond their
jurisdiction through the use of online trading. This has facilitated better penetration and
participation in the stock markets by the citizens in far flung area. Online trading systems have
made trading much more transparent and quicker than in the past.
At the beginning of the last decade of the 20 th century Indian capital market had a very primitive
trading system wherein the traders used to shout out their orders and settlements were typically,
time consuming and open to manipulations. The Harshad Mehta lead scam of 1991 showed how
the long drawn out settlement process could be used to manipulate the markets. Then the stock
market was the domain of a select few market intermediaries often acting in cahoots with
officials of the exchanges, banks and other financial institutions. There was an urgent need to set
up a body which could comprehensively monitor and administer the functioning of the
exchanges. Since 1992, there has been sustained effort to reform the market functioning,
especially in the secondary market for equity. As a part of these efforts, the Securities and
Exchange Board of India (SEBI) Act, 1992 was enacted. The act empowered SEBI to regulate
the primary and the secondary markets. The abolition of the Controller of Capital Issues enabled
companies to realize fair prices for their equity offerings. More transparent and open trading and
settlement got many foreign institutions investors (FIIs) interested in the Indian market.
Subsequently the FIIs were permitted to invest in Indian Stock markets in 1992 simultaneously;
Indian Companies were allowed to raise capital from abroad through the issue of Global
Depository Receipts (GDRs) and Foreign Currency Convertible Bonds (FCCBs). The
participation of foreign institutional investors and others helped to develop the primary and
secondary market at a rapid pace. But it also meant that there was greater integration of the
Indian markets with markets around the world and events around the world had its impact in
India. The Asian market crisis, the 9/11 bombing of the world trade centre and the subprime
crisis all lead to upheavals in the Indian market, but stronger and prudent regulatory framework
did to a large extent help to prevent extreme volatility in India. A lot still needs to be done as
problem areas do persist.
Stock Market
Primary Market
The 2000-2010 decade was a golden decade for India. During this decade, India’s nominal GDP
nearly trebled from $ 0.5 trillion to $ 1.3 trillion. Per capita income grew by 2.5 times from $427
to $ 1058. Robust economic growth created significant opportunities for the corporate sector.
The decade was marked by emergence of several global-sized Indian companies and mid-sized
challengers across sectors in India. Indian stock market reflected the underlying economic
growth momentum and delivered 18% CAGR, making it one of the best performing emerging
markets of this decade. Market capitalization of the listed Indian companies expanded fourteen
times over the decade. In terms of market capitalization, India is now ranked 8th globally
compared to its 17th position a decade ago. The primary markets have been a prime source for
raising finance by public companies in India. The resource mobilized from the primary market
peaked during 2006-07 at 86629 crores but it drastically fell to 16219 crores in 2008-09. This
variation is a reflection of the fall in investor sentiments due to the global economic crisis as also
the reluctance on part of companies to enter the market in a bearish phase.
Table 1: Resources mobilized from the Primary Market
Year Public Rights Total
Number Amount(R Number Amount Number Amount(Rs.
s. Crores) (Rs.Crores Crores)
)
2000-01 124 5378 27 729 151 6107
2001-02 20 6502 15 1041 35 7542
2002-03 14 3639 12 431 26 4070
2003-04 35 22265 22 1007 57 23272
2004-05 34 24640 26 3616 60 28256
2005-06 103 23294 36 4088 139 27382
2006-07 85 29796 39 3710 124 33506
2007-08 92 54111 32 32518 124 86629
2008-09 22 3582 25 12637 47 16219
Source: Handbook of Statistics in Indian Securities Market, 2009

The market capitalization and turnover in the Indian stock Market has had a roller coaster ride
since 1999-00 the market capitalization fell from 11926 billion rupees to 6319 before rising to
51497 in 2007-08 but it again fell under the effect of the sub-prime crisis to 30930 in 2008-09.
During the same period the turnover also moved in the same direction as the market
capitalization. The movement of market capitalization and turnover is shown in the Table 2.
Table 2: Market capitalization and Turnover in Indian Stock Market
(All measures in billions of rupees, unless stated otherwise)
Year Market Market Turnover Turnover Ratio
Capitalisation Capitalisation/GD (%)
P
2000-01 7,689 54.5 28810 375
2001-02 7492 36.4 8958 120
 2002-03 6319 28.5 9689 153
2003-04 13188 52.3 16209 123
2004-05 16984 54.4 16669 98
2005-06 30222 85.6 23901 79
2006-07 35488 86.0 29015 82
2007-08 51497 109.3 51308 100
2008-09 30930 58.1 38521 125
2009-10 61656 100.02 55168 98

Source: Indian Securities Market Review, NSE (2009).

Equity Price

In the first decade of the 21st century, equity prices have seen very high volatility mainly due to
factors like the bursting of the dotcom bubble and the sub-prime crisis. The sensex stood at
4284.98 as on March 2000 but it fell to 3538 in March 2003 before starting a spectacular bull run
in 2004 which took the sensex to never seen heights of 21206 in March 2008. But 2008 was also
the year of the sub prime crisis and the sensex was highly volatile during the period coming
down to as low as 7697 before recovering to 17793 in March 2010. The PE ration also reflected
the fluctuation in the market and peaked at 25.46 in 2008 before holding steady in the last two
years at around 21. (Please refer Table 3).

Table 3: BSE Sensex and PE Ratio

Year Sensex EPS Growth Sensex Index PE Ratio

EPS Low High Low High
(%)
2000 280 - 3826.82 4284.98 13.67 15.3
2001 216 -29.63 3131.78 3442.89 14.49 15.93
2002 236 8.47 2594.87 3759.96 11 15.93
2003 272 13.25 2828 3538 10.40 13.01
2004 348 27.94 2904 6249.6 8.35 17.96
2005 450 29.31 4227 6721 9.4 14.94
2006 523 16.22 6134 11307 11.73 21.62
2007 718 37.28 8799 14723.88 12.26 20.51
2008 833 16.02 12425.52 21206 14.92 25.46
2009 820 -1.56 7697.39 17480.74 9.39 21.32
2010 830 1.22 9546 17793 11.50 21.44

Source: BSE
Note: Financial year ending March is considered
Risk Management System
SEBI has taken several measures to improve the integrity of the secondary market. Legislative
and regulatory changes have facilitated the corporatization of stockbrokers. Capital adequacy
norms have been prescribed and are being enforced. A mark-to-market margin and intraday
trading limit have also been imposed. Further, the stock exchanges have put in place circuit
breakers, which are applied in times of excessive volatility. The disclosure of short sales and
long purchases is now required at the end of the day to reduce price volatility and further
enhance the integrity of the secondary market.

Some of the key risk management measures initiated by SEBI include:-

Categorization of securities

SEBI has grouped securities into various categories on the basis of liquidity and volatility. The
grouping has been done to fix margins for the same. The margin requirements are different for
different groups. A security which is highly volatile attracts a high percentage of margins. A
security which is illiquid again calls for a high percentage of margins as there are more chances
of defaults. The liquidity is measured on the basis of trading done in a particular script on NSE
and impact cost. The impact cost is calculated on the 15th of every month on a rolling basis on the
order book snapshots for the past six months. The impact cost determines the grouping of
particular scrip. The prescribed categorization of stocks for imposition of margins has the
structure as given below:

Group I: Includes those stocks which have been traded for at least 80% of the working
days for the previous 18 months and the impact cost is less than 1%.

Group II: Includes those securities which have been traded for at least 80% of the working days
for the previous 18 months and the impact cost are more than 1%.

Group III: Includes the rest of the securities except in the Trade-for-Trade segment.

VaR based margining system.

VaR Margin is a margin intended to cover the largest loss that can be encountered on 99% of the
days (99% Value at Risk). For liquid securities, the margin covers one-day losses while for
illiquid securities, it covers three-day losses so as to allow the clearing corporation to liquidate
the position over three days. This leads to a scaling factor of square root of three for illiquid
securities. For liquid securities, the VaR margins are based only on the volatility of the security
while for other securities, the volatility of the market index is also used in the
computation. VaR is a single number, which encapsulates whole information about the risk
in a portfolio. It measures potential loss from an unlikely adverse event in a normal
market environment. It involves using historical data on market prices and rates, the current
portfolio positions, and models (e.g., option models, bond models) for pricing those positions.
These inputs are then combined in different ways, depending on the method, to derive an
estimate of a particular percentile of the loss distribution, typically the 99th percentile loss.

· Security sigma means the volatility of the security computed as at the end of the previous
trading day. The volatility is computed as mentioned above.

· Security VaR means the highest of 7.5% or 3.5 security sigma.

· Index sigma means the daily volatility of the market index (S&P CNX Nifty or BSE Sensex)
computed as at the end of the previous trading day. Index VaR means the highest of 5% or 3
index sigma. The higher of the Sensex VaR or Nifty VaR would be used for this purpose.

Mark to Market margins

Mark to market margin is calculated by marking each transaction in security to the closing price
of the security at the end of trading. In case the security has not been traded on a particular day,
the latest available closing price at the NSE is considered as the closing price. In case the net
outstanding position in any security is nil, the difference between the buy and sell values is
considered as notional loss for the purpose of calculating the mark to market margin payable.

MTM Profit/Loss = [(Total Buy Qty * Close price) – Total Buy Value] – [Total Sale Value –
(Total Sale Qty * Close price)]

The MTM margin so collected shall be released on completion of pay-in of the

settlement.
Intra-day trading limits and Gross Exposure Limits

Members are subject to trading limits on the basis of capital contributed. These trading
limits are different for different situations, like it is 33 1/3 times in case of intra day trading
and 8.5 times if in case Rs.1 crore is contributed and 10 times over and above Rs.1 crore
contribution for all open positions. This means that a trader can trade up to 33 1/3 times the
amount contributed, during intra day. This is known as gross intra day exposure. Trade would
mean all buy + sell transactions value. In case the trader wants to carry certain positions as
delivery, then in that case, the exposure will be 8.5 times of the free base capital up to Rs.1
crore. If a member has contributed more than Rs.1 crore, then the exposure limit would be 10
times of the amount contributed over and above Rs.1 crore. This is known as gross exposure on
open positions. SEBI requires the stock exchanges to closely monitor the outstanding positions
of the main Members on a daily basis. For this purpose, exchanges have developed various
market monitoring reports based on certain pre-set parameters. These reports are scrutinized by
officials of the Surveillance Department to ascertain whether a Member has built up excessive
purchase or sale position compared to his normal level of business. Further, it is examined
whether purchases or sales are concentrated in one or more scrips, whether the margin cover is
adequate and whether transactions have been entered into on behalf of institutional clients. Even
the quality of scrips, i.e., liquid or illiquid, is looked into in order to assess the quality of
exposure. Based on an analysis of these factors, the margins already paid and the total capital
deposited by the Member with the exchange, an advance pay-in is called from the concerned
Member.

Time limits of payment of margins

The daily margin for rolling settlements is payable on T+1 day. The margin is collected together
for all settlements for all clients. Members are responsible to compute margin payable and to
make suitable margin payments on the due date. Members are required to deposit the
margin money due in cash, bank guarantee or FDRs, rounded off to the next higher multiple of
Rs.10,000.

Payout of margin
The margins deposited in cash on a given day may, if NSCCL chooses not to exercise its lien,
be returned to the member on the subsequent day after adjustment for margin, additional
base capital and any other funds dues. NSCCL may, at its discretion may retain part or
whole of the amount releasable cash margin, with respect to any member as a risk
containment measure.

Upfront margins collection

Members are required to ensure collection of upfront margin from their clients at rates
mentioned below and deposit the same in a separate clients account, in respect of trades in
Normal market which would result in a margin of Rs.50,000/- or more, after applying the
specified margin percentages.

Index based market wide circuit breakers

Circuit breaker limit helps to reduce excessive speculation by stopping order flow and help
improve market liquidity. In India, both NSE and BSE introduced the concept of circuit breaker.
NSE has introduced it post 2000. Circuit breaker system applies to both stocks and market as a
whole.

Index wide circuit Limit

The index-based market-wide circuit breaker system applies at 3 stages of the index movement,
either way viz. at 10%, 15% and 20%. These circuit breakers when triggered bring about a
coordinated trading halt in all equity and equity derivative markets nationwide. The market-wide
circuit breakers are triggered by movement of either the BSE Sensex or the NSE S&P CNX
Nifty, whichever is breached earlier. This circuit limits works on the principle that any unusual
movement should be contained by providing certain cooling of period. The cooling off period is
determined by the extend of the breach and its timing.

Stock wise circuit limits

Both NSE and BSE have implemented the circuit limit system on the stocks. They have applied
the stock wise circuit limit system at four levels i.e. 2%, 5%, 10% and 20%. Circuit limits like
any other concept have both pros and cons. The presence of circuit filters, the traders/investors’
fear of erosion of wealth is not rapid when compared to not having circuit limits. However the
stock might rise due to genuine corporate action in which case the circuit limit prevents the
stocks from reflecting its true value. The need for circuit-filters lacks support of empirical
evidence on its effectiveness. But in the case of specific situations where it is clear that the
equilibrium value of the asset will change, then it makes no sense to have circuit breakers.

Investor Protection Fund

Despite the various efforts taken by the regulators and exchange, some problems do arise. A
cushion in the form of Investor Protection Funds (IPFs) is set up by the stock exchanges.
Investor Protection Fund (IPF) has been set up as a trust under Bombay Public Trust Act, 1950
under the name and style of National Stock Exchange Investor Protection Fund Trust and is
administered by the Trustees. The IPF is maintained by NSE and the purpose of the IPF is to take
care of investor claims, which may arise out of non-settlement of obligations by the trading
members. The IPF is also used to settle claims of such investors whose trading member has
been declared a defaulter. Further, the stock exchanges have been allowed to utilize interest
income earned on IPF for investor education, awareness and research. The maximum amount of
claim payable from the IPF to the investor (where the trading member through whom the
investor has dealt is declared a defaulter) is Rs.10 lakh.

Retail Investor

SEBI has been quite aware of the fact that retail investors in the primary market may be crowded
out by the big ticket investors. Hence it defined Retail Individual Investor in a public issue as
under:

(i) Fixed price issue: Retail Individual Investor is one who applies for allotment equal to or less
than 10 marketable lots.

(ii) Book built issue: Retail Individual Investor is one who applies for up to 1000 securities.

Later SEBI modified the definition and used the quantum of investment as the criteria, hence a
retail investor was redefined as the one who invested upto Rs. 50,000/- which was later amended
to Rs. 1,00,000/-. Most recently in October 2010 SEBI again amended the Disclosure and
Investor Protection Guidelines and extended the monetary limit for retail investor to Rs.2,
00,000/- and the same forms part of ICDR, 2009. The Securities and Exchange Board of India
(SEBI) has also mandated that a certain portion of any Initial Public Offering (IPO) should be
reserved for retail individual investors (RII). The original reservation stood at 25 per cent which
was hiked to 35 percent in the year 2005. This move has indeed helped the retail individual
investors but at the same time SEBI has been forced to reconsider this quota due to its misuse
which resulted in the IPO scam where the retail investors quota was cornered by large investors
through fake demat accounts.

Institutional Investors

Mutual Funds

Indian investors were exposed to mutual funds through UTI established in 1964. But mutual
investments were more a tax planning device than any strategic investment due to the various
exemptions provided on investments in mutual funds managed by UTI. Since 1987 public sector
banks and insurance companies set up mutual fund and latter in 1993, other private players
entered the market and made the industry more competitive and responsive to investor needs.
The SEBI (Mutual Fund) Regulations notification of 1993 brought about a restructuring of the
mutual fund industry. It mandated an arm’s length relationship between the fund sponsor,
trustees, custodian, and asset Management Company. This is in contrast to the previous practice
where all three functions, namely trusteeship, custodianship, and asset management, were often
performed by one body, usually the fund sponsor or its subsidiary. FIIs registered with SEBI
were permitted to invest in domestic mutual funds, whether listed or unlisted.
The 1993 Regulations have been revised from time to time keeping in view the need for
transparency, corporate governance and investor protection. The revised regulations strongly
emphasize the governance of mutual funds and increase the responsibility of the trustees in
overseeing the functions of the asset management company. Mutual funds are now required to
obtain the consent of investors for any change in the “fundamental attributes” of a scheme, on
the basis of which unit holders have invested. The revised regulations require disclosures in
terms of portfolio com-position, transactions by schemes of mutual funds with sponsors or
affiliates of sponsors, with the asset Management Company and trustees, and also with respect to
personal transactions of key personnel of asset management companies and of trustees. Mutual
funds investors are required to furnish their PAN details and bank account details. Dividend
payouts and redemption payout has been mandated through bank accounts.

Foreign Institutional Investors (FII’s)

FIIs have been allowed to invest in the Indian securities market since September 1992 when the
Guidelines for Foreign Institutional Investment were issued by the Government. The SEBI
(Foreign Institutional Investors) Regulations were enforced in November 1995, largely based on
these Guidelines. The regulations require FIIs to register with SEBI and to obtain approval from
the Reserve Bank of India (RBI) under the Foreign Exchange Regulation Act to buy and sell
securities, open foreign currency and rupee bank accounts, and to remit and repatriate funds.
Once SEBI registration has been obtained, an FII does not require any further permission to buy
or sell securities or to transfer funds in and out of the country, subject to payment of applicable
tax. The entities eligible to invest through the FII route should meet the following criteria:
i. an institution established or incorporated outside India as a pension fund, mutual fund,
investment trust, insurance company or reinsurance company;
ii. An International or Multilateral Organization or an agency thereof or a Foreign Governmental
Agency, Sovereign Wealth Fund or a Foreign Central Bank;
iii. an asset management company, investment manager or advisor, bank or institutional portfolio
manager, established or incorporated outside India and proposing to make investments in India
on behalf of broad based funds and its proprietary funds, if any;
iv. a Trustee of a trust established outside India, and proposing to make investments in India on
behalf of broad based funds and its proprietary funds, if any.
v. University fund, endowments, foundations or charitable trusts or charitable societies. Broad
based fund means a fund established or incorporated outside India, which has at least 20
investors with no single individual investor holding more than 49 percent of the shares or units of
the fund. If the broad based fund has institutional investor(s), then it is not necessary for the fund
to have 20 investors. Further, if the broad based fund has an institutional investor who holds
more than 49 percent of the shares or units in the fund, then the institutional investor must itself
be a broad based fund.
In addition to registering with SEBI, FIIs also have investment restrictions. An FII can invest
only in the following:
i. Securities in the primary and secondary markets including shares, debentures and warrants of
companies, unlisted, listed or to be listed on a recognised stock exchange in India
ii. Units of schemes floated by domestic mutual funds including Unit Trust of India, whether
listed or not listed on a recognised stock exchange; units of scheme floated by a Collective
Investment Scheme.
iii. Dated Government securities and
iv. Derivatives traded on a recognised stock exchange
v. Commercial paper
vi. Security receipts
vii.Indian Depository Receipts
The total investments in equity and equity related instruments (including fully convertible
debentures, convertible portion of partially convertible debentures and tradable warrants) made
by a FII in India, whether on his own account or on account of his sub- accounts, should not be
less than 70 per cent of the aggregate of all the investments of the Foreign Institutional Investor
in India, made on his own account and on account of his subaccounts.
Foreign investors, whether registered as FIIs or not, may also invest in Indian securities outside
the FII process. Such investment requires approval from the Foreign Investment Promotion
Board (FIPB) and RBI, or only from RBI depending on the size of investment and the industry in
which the investment is to be made. Investment in Indian securities is also possible through the
purchase of Global Depository Reciepts (GDRs) and American Depositary Reciepts (ADR).
Foreign currency convertible bonds and foreign currency bonds issued by Indians that are listed,
traded, and settled overseas are mainly denominated in dollars. Foreign financial service
institutions have also been allowed to set up joint ventures in stock broking, asset management
companies, merchant banking, and other financial services firms along with Indian partners.
A positive contribution of the FIIs has been their role in improving the stock market
infrastructure. The SEBI has no doubt contributed much in improving the stock exchange
infrastructure. However, it is doubtful whether one would have witnessed such rapid
developments in computerising the operations of the stock markets and introduction of paperless
trading in the demat form if the FIIs had not built up pressure on the authorities to move in this
direction.The FIIs are playing an important role in bringing in funds needed by the equity
market. Additionally, they are contributing to the foreign exchange inflow as the funds from
multilateral finance institutions and FDI are insufficient. However, the fact remains that FII
investments are volatile and market driven, but this risk has to be taken if the country has to
ensure steady inflow of foreign funds.

Table 4: FII Investments in India

Period No. of Purchases Sales Net

FII’s (Rupees (Rupees Investment
million). million). (Rupees
million).
2000-01 527 740,506 641,164 99,342

2001-02 490 499,199 411,650 87,549

2002-03 502 470,601 443,710 26,891

2003-04 540 1,448,575 990,940 457,635

2004-05 685 2,169,530 1,710,730 458,800

2005-06 882 3,449,780 3,055,120 394,660

2006-07 997 5,205,090 4,896,680 308,410

2007-08 1319 9,480,196 8,389,304 1,090,892

2008-09 1635 6,145,810 6,603,920 -458,110

2009-10 1713 8,464,400 7,037,810 1,426,580
Source: SEBI
Figure 1: Number of FII’s and net Investments
The monthly trend in FII investments during 2009-10, as depicted in Table 4, shows that net FII
investment remained positive for the entire fiscal year; in contrast to 2008-09 in which net FII
inflows were negative for eight months. The total net investment by FIIs in 2009-10 stood at Rs.
1,426,580 million. After witnessing a tumultuous year of investment, these record FII
investments have given a boost to the Indian markets during the last year and a half. The net
addition in SEBI registered FIIs failed to keep up the momentum seen in 2007-08 and 2008-09
wherein there was addition of 322 and 316 FIIs respectively. There was a net addition of 78
SEBI registered FIIs in 2009-10 which took their total number to 1,713 at end March 2010
compared to that of 1,635 at the end of March 2009 (Table 4 and figure 1).
Policy Issues
Regulatory Framework
Regulation of Intermediaries
The primary function of Sebi is to regulate affairs of the securities market such as stock
exchanges. It registers and regulates function of intermediaries which are associated with the
capital market. These include stockbrokers, sub-brokers, merchant bankers, bankers and
registrars to issues, underwriters, share transfer agents, portfolio managers, investment advisors,
depositories, custodians of securities and foreign institutional investors (FIIs). Organisations
such as rating agencies, which are not intermediaries, but are related to the capital market, are
also regulated by SEBI.Collective investment schemes such as mutual funds and venture capital
also come under the ambit of SEBI. In a collective investment scheme, contributions made by
investors are pooled in and used in accordance with the set objectives of the scheme.
The registration system in place helps SEBI to regulate explicit players in the market but it has
very little control over a host of implicit players like the investment advisors, the economic
analysts, print and television journalists. There have been instances when these intermediaries
have impacted the market. "Regulation of non-registered entities rendering investment advice to
specific clients will require enormous resources and reach. There are likely to be lakhs of
advisers and distributors. It is not feasible for Sebi to regulate such a large number directly as a
frontline regulator within its current resources or even with resources likely to be available to it
in foreseeable future even after taking into account its expansion plans," Sebi
Capital adequacy standards foster confidence in the financial markets and should be designed to
allow a firm to absorb some losses, particularly in the event of large adverse market moves, and
to achieve an environment in which a securities firm could wind down its business over a
relatively short period without loss to its customers or the customers of other firms and without
disrupting the orderly functioning of the financial markets. The capital adequacy requirements
for registered market participants in India are still much below desired levels. This has attracted a
large number of market participants into the Indian market this large number participants pose a
challenge to the ability of SEBI to effectively monitor them.
Stock Broker
The Indian law defines a stockbroker simply as a member of a recognized stock exchange.
Therefore, a registered stockbroker is a member of at least one of the recognized Indian stock
exchanges. Stockbrokers are not allowed to buy, sell, or deal in securities, unless they hold a
certificate granted by SEBI. At the end of March 2009, they numbered 8,652. Each stockbroker
is subject to capital adequacy requirements consisting of two components: basic minimum
capital and additional or optional capital related to volume of business. The basic minimum
capital requirement specified by SEBI regulation is Rs. 10,00,000/- . However the stock
exchanges can require their respective members to deposit with them larger amounts.
Sub Broker
Most stockbrokers in India are still relatively small. They cannot afford to directly cover every
retail investor in a geographically vast country and in such a complex society. Thus, they are
permitted to transact with sub brokers as the latter play an indispensable role in intermediating
between investors and the stock market. An applicant for a sub broker certificate must be
affiliated with a stockbroker of a recognized stock exchange. A sub broker application may take
the form of sole proprietorship, partnership, or corporation. A sub broker acts on behalf of the
stock broker but often in practice the broker treats his sub-broker as a counter party thus
preventing the privity of investors with the broker. To provide better clarity and transparency
SEBI has initiated of criminal actions on complaints received against unregistered sub-brokers in
suitable cases. The board has also revived the institution of “remisier”. A Remisier is a person
who is engaged by a member-broker primarily to solicit business in securities on a commission
Basis. Remisiers can operate trading terminals at member’s office only. It has also prohibited
dealing between unregistered sub brokers or unregistered remisiers. With the advancement in
internet technology, investors can also obtain live updates on the current stock market and could
now choose to invest via online trading without the need to rely on subbrokers or remisiers.
Online trading is an electronic client ordering system which allows an investor, to place orders
electronically via the Internet to investment banks and stock brokerage companies.
Regulators:
The powers and functions for regulation of the capital market is vested in different bodies. The
Stock Exchange Board of India (SEBI) is the primary body responsible for regulation of the
securities market, deriving its powers of registration and enforcement from the SEBI Act,1992.
There was an existing regulatory framework for the securities market provided by the Securities
Contract Regulation (SCR) Act and the Companies Act, administered by the Ministry of Finance
and the Department of Company Affairs (DCA) under the Ministry of Law, respectively. SEBI
has been delegated most of the functions and powers under the SCR Act and shares the rest with
the Ministry of Finance. It has also been delegated certain powers under the Companies Act.
Securities and Exchange Board of India (SEBI) was set up as an administrative arrangement in
1988. In 1992, the SEBI Act was enacted, which gave statutory status to SEBI. It mandates SEBI
to perform a dual function: investor protection through regulation of the securities market and
fostering the development of this market. In addition to registering and regulating intermediaries,
service providers, mutual funds, collective investment schemes, venture capital funds and
takeovers, SEBI is also vested with the power to issue directives to any person(s) related to the
securities market or to companies in areas of issue of capital, transfer of securities and
disclosures. It also has powers to inspect books and records, suspend registered entities and
cancel registration.
Reserve Bank of India (RBI) has regulatory involvement in the capital market, but this has been
limited to debt management through primary dealers, foreign exchange control and liquidity
support to market participants. It is RBI and not SEBI that regulates primary dealers in the
Government securities market. RBI instituted the primary dealership of Government securities in
March 1998. Securities transactions that involve foreign exchange transactions need the
permission of RBI. The exchanges are required to appoint a professional, non member executive
director who is accountable to SEBI for the implementation of its directives on the regulation of
stock exchanges.
Other than SEBI and RBI the individual stock exchanges also have a vital role to play in the
regulation of the capital markets in India. The various stock exchanges like NSE, BSE, OTC,
ISE etc have a governing board with fifty percent non-broker public representatives and a SEBI
representative. This helps to prevent conflict of interest among the governing board members.
Thus Indian capital markets do have a comprehensive regulatory mechanism in place.
Unfortunately the regulatory mechanism has been found wanting in protecting investor interest
in past due to lack of will power to enforce statutory requirements due to the various pulls and
pressure exerted from different sources as also corruption within the organizations. The silver
lining is the inevitable integration of the Indian markets with the international markets and
participation of FII’s who will look for better transparency, control on Kerb trades and
prevention of insider trading.
Self Regulatory Organisations (SROs)
Self-regulatory organizations (SROs) is the way forward in regulating various participants.
Indian stock exchanges are SROs and the SEBI too has chosen governance mechanisms to deal
with issues related to conflicts of interest – rule-making is in the domain of the board of directors
of a stock exchange and not of shareholders; 50% of the board of directors comprise SEBI-
approved independent members; and finally, SEBI retains the right to alter these mechanisms
such that independent oversight is enhanced. Despite the use of the SRO model in India, SEBI
plays an important role as overall regulator. For example, the chief executive officer of the
exchange (who is also the regulator) is appointed by SEBI and senior executives in charge of risk
surveillance and related activities report to the board. SEBI’s model rules and byelaws play an
important role in shaping stock exchange rules and norms, which in any case can only be
changed with prior SEBI approval. Further, SEBI screens exchange shareholders so that they
meet the “fit and proper person” criterion and mandates, as do many other jurisdictions in the
world, a maximum limit of 5% so as to ensure a diversified pattern of shareholding. The
integrated market surveillance system (IMSS) is quite unique in allowing SEBI to deal directly
with market abuse.
Debt Market
The debt market in India comprises mainly of two segments viz., the Government securities
market consisting of Central and State Governments securities, Zero Coupon Bonds (ZCBs),
Floating Rate Bonds (FRBs), T-Bills and the corporate securities market consisting of FI bonds,
PSU bonds, and Debentures/Corporate bonds. Government securities form the major part of the
market in terms of outstanding issues, market capitalization and trading value. Government
securities form the oldest and most dominant part of the debt market in India. The market for
government securities comprises the securities issued by the central government, state
governments and state-sponsored entities. In the recent past, local bodies such as municipal
corporations have also begun to tap the debt market for funds. The Central Government
mobilizes funds mainly through issue of dated securities and T-bills, while State Governments
rely solely on State Development Loans. The major investors in sovereign papers are banks,
insurance companies and financial institutions, which generally do so to meet statutory
requirements. Bonds issued by government-sponsored institutions like DFIs, infrastructure-
related institutions and the PSUs, also constitute a major part of the debt market. The gradual
withdrawal of budgetary support to PSUs by the government since 1991 has increased their
reliance on the bond market for mobilizing resources. The preferred mode of raising capital by
these institutions has been private placement, barring an occasional public issue. Banks, financial
institutions and other corporate have been the major subscribers to these issues. The Indian
corporate sector relies, to a great extent, on raising capital through debt issues, which comprise
of bonds and CPs. Of late, most of the bond issues are being placed through the private
placement route. These bonds are structured to suit the requirements of investors and the issuers,
and include a variety of tailor-made features with respect to interest payments and redemption.
Corporate bond market has seen a lot of innovations, including securitized products, corporate
bond strips, and a variety of floating rate instruments with floors and caps. In the recent years,
there has been an increase in issuance of corporate bonds with embedded put and call options.
While some of these securities are traded on the stock exchanges, the secondary market for
corporate debt securities is yet to fully develop.
The Indian debt market also has a large non-securitized, transactions-based segment, where
players are able to lend and borrow amongst themselves. This segment comprises of call and
notice money markets, inter-bank market for term money, market for inter-corporate loans, and
market for ready forward deals (repos). Typically, short-term instruments are traded in this
segment. The market for interest rate derivatives like FRAs, IRSs is emerging to enable banks,
PDs and FIs to hedge interest rate risks.
Policy Recommendations
Over the last few years, there have been substantial reforms in the Indian capital market. But
there are still many issues to be addressed to make it more efficient in mobilizing and allocating
capital. Investor confidence in stock investment is low. This must be regained in order to
encourage capital mobilization through primary market issues. Further strengthening of investor
protection, and improvements in transparency, corporate governance, and monitoring will be
necessary. The capital market infrastructure, such as accounting standards and legal mechanisms,
should also be improved to this end. On the supply side, to encourage corporate firms to rely
more on stock markets for their source of financing, the issuing costs in terms of length of time
required and administrative burden should be streamlined.
Accounting Principles
The accounting principles in India are guided by the standards issued by The Institute of
Chartered Accountants of India (ICAI). The Indian GAAP standards while comprehensive are
still long way off from the International financial standards. The ICAI has been releasing
standards from time to time and has revised, deleted and curtailed standards in the light of new
and additional standards as well as the experience of the industry. With the activity in the capital
market increasing, foreign institutional investment coming heavily to India as well as Indian
companies going global through global depository receipts (GDRs) and American depository
receipts (ADRs), Indian accounting standard should match the international Generally Accepted
Accounting Principles (GAAP).

Corporate Governance
Corporate governance is an issue in India as the industry is dominated by family run business
and the independent director has been nothing more than lip service. This was most evident in
the Satyam Scam where the board of directors failed in their collective responsibility to the
shareholders of the company. Inter- locking and “pyramiding” of corporate control within family
managed groups make it difficult for outsiders to track the business realities of individual
companies in these behemoths. The managers either own the majority stake, or maintain control
through the aid of other block holders like financial institutions. Their own interests, even when
they are the majority shareholders, may not coincide with those of the other – minority –
shareholders. This often leads to exploitation of minority shareholder value. Such violations of
minority shareholders’ rights also comprise an important issue for corporate governance. There
fore there is a need for SEBI and the Ministry of Company Affairs to ensure more accountability
from the board especially the independent directors.

Transaction Costs
The trading in securities involves a certain amount of costs which are known as transaction costs.
These are cost incurred in the process of acquiring a security. The transaction costs in India have
increased due to the imposition of Securities transaction tax and the service tax. There have been
consistent effort by SEBI to reduce the securities transaction cost for instance it has mandated
the use of ASBA (Application Supported by Blocked Amounts) in the IPO process. The
objective of introducing ASBA is to ensure that the investor’s funds leave his bank account only
upon allocation of shares in public issues. The ASBA process also ensures that only the requisite
amount of funds is debited to the investor’s bank account on allotment of shares. In this
mechanism, the need for refunds is completely obviated.
The settlement cycle in India is T+2 days i.e. Trade + 2 days. It has increased the efficiency and
transparency in Indian markets. This would result in lowering of trade costs and make Indian
markets a more attractive destination for global investors. It has been SEBI endeavor to make the
Indian markets, one of the most competitive and efficient markets of the world. The T+2
settlement period requires firms to streamline trading processes by way of a foolproof, faster,
cost effective and universally acceptable mode of communication among market participants.

Need for a Vibrant Debt Markets

The Debt Market in India is in its infancy, both in terms of the market participation and the
structure required for efficient price discovery. Primary corporate debt market is dominated by
non-banking finance companies and relatively a very small amount of funds are raised by
manufacturing and other service industries through this market.
Indian firms are still seeking bank finance as the path to fulfill the funding requirements. While,
the secondary market activities in corporate bonds have not picked up till date. Efforts of
Securities Exchange Board of India (SEBI) and the stock exchanges to bring the trading to
electronic stock exchange platforms have not yielded desired results.
Conclusion
The structural changes introduced by the Government and Reserve bank of India have made in
the government securities market has improved transparency in the market dealings. These are
changes in method of primary auctions, deepening the market with new market participants like
Primary Dealers, Borrowings at market determined rates, and creating technology platforms like
NDS to recognize the institutional characteristics of the market. The same kind of impetus has
been lacking in the corporate bond markets in India and as a result this major source of corporate
funding is all but non-existent. The market capitalization and number of participants have
increased but there is still a need to make the equity markets accessible to people in the remote
areas. There is a need to create better awareness among the investors so that investments become
well thought out decisions rather than speculative ones. Another major regulatory action required
is in ensuring that there is a more accountability among the directors and issues of corporate
governance are addressed. The recent past has also shown that the IPO pricing mechanism is not
well calibrated as the prices tend to crash after listing, loosing money for the investors.
But on balance SEBI has definitely made an impact on the way the markets function. It has
brought in more and better oversight mechanisms, there has been consistent attempt to protect
the interests of the small investors such as the quota for small investors and discount in the IPO
pricing for small investors. In terms of enforcement, SEBI has achieved considerable progress in
terms of detecting and disposing of instances of non-compliance or infractions. This has also
been borne out by the relatively orderly functioning of the trading and settlement systems with
hardly any instances of payment crises shutting down the exchanges as in the past until the mid-
nineties.