CHAPTER 2: INTRODUCTION TO SECURITIES MARKETS (PART 2)

Market Participants and their Activities

1. Market Infrastructure Institutions (MIIs) and Other Intermediaries

The Indian securities market relies on a robust network of intermediaries and market infrastructure institutions registered with the Securities and Exchange Board of India (SEBI). These entities operate collectively to reduce transactional friction, manage credit risk, ensure operational efficiency, and protect investor interests.

A. Stock Exchanges

Stock Exchanges are the foundational pillars of secondary market trading.

• Core Function: They provide an organized, regulated electronic trading platform where buyers and sellers can transact in already-issued securities.
• Order Matching System: Trading on modern stock exchanges occurs via electronic trading terminals that feature an anonymous order matching system. This anonymity ensures fairness and prevents market manipulation by keeping the identities of buyers and sellers hidden during trade execution.

B. Depositories

Depositories are specialized institutions that act as custody banks for securities in electronic form.

• Core Function: They hold securities—such as equity shares, debentures, bonds, government securities (G-Secs), and mutual fund units—on behalf of investors in electronic/dematerialised form.
• Registered Depositories in India: Currently, there are two SEBI-registered depositories in India:
  1. National Securities Depository Limited (NSDL)
  2. Central Depository Services Limited (CDSL)

C. Depository Participants (DPs)

An investor cannot interact with CDSL or NSDL directly. DPs serve as the intermediary link.

• Core Function: A Depository Participant (DP) acts as an authorized agent of the depository. It interfaces directly with the investors and provides essential depository services.
• Dematerialisation: DPs enable investors to hold and transact in securities in the dematerialised form. DPs can be financial institutions, banks, or stock brokerage houses.

D. Trading Members & Stock Brokers

Stock Brokers are the gatekeepers to the exchange trading terminals.

• Core Function: They are registered members of a Stock Exchange who facilitate buy and sell transactions of investors on stock exchanges.
• Operational Mode: They execute orders on stock exchange terminals for their clients in exchange for fees or commissions.

E. Authorised Persons (APs)

APs expand the geographic and operational reach of brokerage firms.

• Core Function: They are registered agents of stock brokers (previously referred to as sub-brokers) who are registered with the respective stock exchanges.
• Purpose: APs help brokers reach a larger number of investors by extending their localized networks.

F. Custodians

Custodians serve the safe-keeping needs of large institutional investors.

• Core Function: A custodian is an entity vested with the responsibility of holding funds and securities of its large clients.
• Target Clients: Typically serve large institutional clients, such as banks, insurance companies, and Foreign Portfolio Investors (FPIs).

G. Clearing Corporations

Clearing Corporations act as risk-mitigators and trade facilitators.

• Core Function: They play an important role in safeguarding the interest of investors in the securities market.
• Operational Responsibility: Clearing agencies ensure that members on the Stock Exchange meet their obligations to deliver funds or securities. By guaranteeing settlements, they eliminate counterparty credit risk.

H. Clearing Banks

Clearing Banks connect the banking system with the clearing mechanism.

• Core Function: They act as an important intermediary between clearing members and the clearing corporation.
• Requirement: Every clearing member needs to maintain a dedicated account with the clearing bank to process fund payouts and pay-ins.

I. Merchant Bankers

Merchant Bankers manage corporate entry into the capital markets.

• Core Function: They are entities registered with SEBI that act as issue managers, investment bankers, or lead managers.
• Purpose: They help an issuer access the security market with an issuance of securities by assisting in structuring offerings, drafting prospectuses, and managing pricing.

J. Underwriters

Underwriters absorb the risk of undersubscription in primary issues.

• Core Function: They are intermediaries in the primary market who undertake to subscribe to any portion of a public offer of securities which may not be bought by investors.
• Commitment Benefit: If the public does not fully subscribe to an offering, the underwriters buy the unsold shares, protecting the issuing company from capital shortfall.

2. Institutional Participants and Their Activities

Institutional participants are large, entity-level players that pool funds from various savers to invest across diverse asset classes under specific investment policies.

A. Mutual Funds

Mutual Funds are the primary vehicle for retail capital pooling.

• Definition: A mutual fund is a professionally managed collective investment scheme that pools money from many investors to purchase securities on their behalf.
• Investible Assets: They collect money to invest in various opportunities like shares, debentures, and other securities in line with their stated objectives.

B. Pension Funds

Pension Funds secure long-term retirement savings.

• Definition: These funds are established to facilitate and organize the investment of retirement funds.
• Funding Sources: Contributions are made by employees and employers, or even only employees in some cases.

C. Insurance Companies

Insurance companies manage risk and invest surplus premiums.

• Core Business: Their primary commercial activity is to insure assets.
• Types of Entities: Depending on the type of assets insured, there are various insurance companies like life insurance, general insurance, etc.

D. Alternative Investment Funds (AIFs)

AIFs cater to high-net-worth individuals (HNIs) and institutional investors looking for non-traditional strategies.

• Definition: Under SEBI Regulations 2012, an AIF is defined as a primarily privately pooled investment vehicle that collects funds from sophisticated investors for investing in accordance with a defined investment policy.
• Categorization under SEBI Regulations 2012:
  • Category I AIF: Invests in start-ups, early-stage ventures, social ventures, SMEs, infrastructure, or other sectors.
  • Category II AIF: AIFs that do not fall in Category I and III and do not undertake leverage or borrowing other than to meet temporary day-to-day operational requirements.
  • Category III AIF: Employs diverse or complex trading strategies and may employ leverage, including through investment in listed or unlisted derivatives.
• Recognized Fund Types: Venture Capital Funds, Angel Funds, Private Equity Funds, Debt Funds, Infrastructure Funds, SME Funds, Hedge Funds, and Social Venture Funds are listed as AIFs.

E. Foreign Portfolio Investors (FPIs)

FPIs channel international capital into Indian markets.

• Definition: An FPI is an entity established or incorporated outside India that proposes to make investments in India.
• Registration Requirement: These international investors must register with SEBI to legally participate in the Indian securities markets.

F. Investment Advisers

Advisers guide retail and institutional asset allocation.

• Core Function: They work with investors to help them decide on asset allocation and make choices of investments.
• Scope of Work: They tailor recommendations based on an assessment of client needs, time horizons, return expectations, and risk-bearing capacity.

G. Employees' Provident Fund Organisation (EPFO)

The EPFO is a massive domestic retirement asset manager.

• Definition: It is a statutory body set up under the Employees’ Provident Funds & Miscellaneous Provisions Act, 1952.
• Market Significance: It manages retirement funds of private/public sector workers, channeling large investments into secure markets.

H. National Pension System (NPS)

NPS is a voluntary, long-term pension-cum-investment system.

• Definition: NPS is a pension-cum-investment scheme launched by the Government of India to provide old-age security to citizens of India.

I. Family Offices

Family offices manage concentrated generational wealth.

• Definition: A family office can be defined as the ecosystem that a family builds around itself to manage its wealth.

J. Corporate Treasuries

Corporate treasuries manage internal liquidity and financial risks for businesses.

• Traditional Role: The role of the corporate treasury has traditionally been that of a manager of financial risks and a provider of liquidity.
• Key Focus Areas: Their focus areas range from debt management to capital structure management.
• Core Responsibilities: They carry the primary responsibility of raising long-term funds and minimizing the cost of capital.

3. Comparative Matrix: Intermediaries vs. Institutional Participants

To simplify the distinct structural roles of these market players, they can be classified under two main functions:

4. Key Takeaways & Glossary of Chapter 2 (Part 2)

Key Takeaways

1. The Infrastructure Backbone: Stock Exchanges, Depositories, and Clearing Corporations form the non-commercial infrastructure (MIIs) that guarantees trading integrity, dematerialisation safety, and settlement guarantees.
2. The Intermediary Value Chain: Merchant bankers structure primary issuances, underwriters absorb subscription risks, brokers execute trades on exchanges, and custodians safeguard institutional holdings.
3. Sophisticated Buy-Side Diversity: Institutional players such as mutual funds, pension funds, insurance companies, and AIFs represent different pools of capital with highly specialized risk-return-liquidity profiles.
4. Corporate & Public Pension Scales: Massive statutory frameworks like the EPFO and NPS manage long-term retirement savings for millions of citizens, making them highly influential capital allocators.

Essential Terms Glossary

• Anonymous Order Matching: A system used by stock exchanges where buy and sell orders are automatically matched on electronic screens without showing counterparty identities to maintain fair execution.
• Dematerialisation (Demat): The process of converting physical paper security certificates into electronic form, held securely in depository accounts.
• Central Counterparty (CCP): The role played by a Clearing Corporation where it becomes the buyer to every seller and the seller to every buyer, eliminating counterparty credit risk.
• Alternative Investment Fund (AIF): A privately pooled investment vehicle collecting funds from HNIs and institutional players, categorized into Category I, II, and III based on strategy and leverage.
• Foreign Portfolio Investor (FPI): An overseas entity or fund registered with SEBI to invest in Indian stock, bond, and derivative markets.
• Corporate Treasury: The internal corporate department responsible for capital structure, debt raising, risk mitigation, and optimizing short-term cash surpluses.

5. Chapter 2 Comprehensive Revision Quiz (Parts 1 & 2)

Test your knowledge of Chapter 2 concepts:

1. Which market directly supports the primary market by providing liquidity and an exit route for investors?
   • Answer: The Secondary Market (Resale Market).
2. What are the names of the two SEBI-registered depositories operating in India?
   • Answer: Central Depository Services Limited (CDSL) and National Securities Depository Limited (NSDL).
3. An unlisted company wants to issue shares to the public for the first time. What is this method of issue called?
   • Answer: Initial Public Offering (IPO).
4. Which entity acts as the central counterparty to guarantee that stock exchange members meet their fund and security delivery commitments?
   • Answer: The Clearing Corporation.
5. What is the minimum investment value required to invest in an Alternative Investment Fund (AIF) in India?
   • Answer: One crore rupees (Rs. 1 Crore).
6. Under which statutory act was the EPFO set up?
   • Answer: Employees’ Provident Funds & Miscellaneous Provisions Act, 1952.
7. What is the key functional difference between a Discretionary Portfolio Manager and a Non-Discretionary Portfolio Manager?
   • Answer: A discretionary portfolio manager independently manages and makes transaction decisions for each investor’s funds, whereas a non-discretionary manager must consult the client and act only on client directions for every transaction.