Introduction to the Financial System

Introduction to the Financial System (Part 1)

• Financial System: The entire set of institutionalized arrangements by which funds are transferred from surplus units to deficit units at terms acceptable to both sides.
• Components of Financial System:
  • Financial Market: A mechanism that allows traders to deal in financial securities, commodities, etc., at low costs.
  • Financial Markets Infrastructure Institutions (MIIs): Institutions that facilitate the functioning of financial markets, such as depositories, stock exchanges, and clearing corporations.
  • Financial Intermediaries: Entities that provide intermediation services in the financial system, such as merchant bankers, stock brokers, and portfolio managers.
  • Financial Securities: Instruments used to raise funds from surplus units, such as stocks, bonds, and debentures.

Key Concepts

• Financial Market: Can be classified into different subtypes, including:
  • Money Market: A market for short-term funds and instruments with a maturity period of one year or less.
  • Capital Market: A market for securities where businesses and governments can raise long-term funds.
  • Forex Market: A market that deals with multicurrency requirements and facilitates the exchange of currencies.
  • Credit Market: A market where banks, financial institutions, and non-banking financial companies provide short, medium, and long-term loans.
  • Insurance Market: A market that facilitates the transfer of risks from individuals and businesses to insurance companies.
• Financial Markets Infrastructure Institutions (MIIs): Include:
  • Depositories: Institutions that hold securities in electronic form and provide services to investors.
  • Stock Exchanges: Platforms where securities are traded, and prices are determined.
  • Clearing Corporation: An entity that undertakes the activity of clearing and settlement of trades in securities.
  • Social Stock Exchange: A separate segment of a recognized stock exchange that allows not-for-profit organizations to register and list their securities.
• Financial Intermediaries: Include:
  • Merchant Bankers: Entities that assist companies in originating issues of securities.
  • Bankers to Issues: Scheduled banks that accept application money, allotment, or call money, and undertake refund of application money.
  • Registrars and Share Transfer Agents: Persons registered under SEBI regulations who provide services related to public or rights issues.
  • Stock Brokers: Registered entities that provide services to investors, including executing buy and sell transactions.
  • Portfolio Managers: Individuals or firms that administer portfolios of individuals or provide advice or direction for a fee.
  • Mutual Funds: Trusts that mobilize funds from investors and invest in a manner consistent with the specified investment objective.
  • Custodians: Entities that hold securities or gold on behalf of institutional investors and provide services such as trade settlement and safekeeping.
  • Credit Rating Agency: A body corporate that rates securities offered by companies.
  • Debenture Trustee: A trustee of a trust deed for securing any issue of debentures of a body corporate.
  • Vault Manager: A person who carries on the business of providing vaulting services for gold.

Introduction to the Financial System (Part 2)

• Financial Securities: According to the Securities Contracts (Regulation) Act, 1956, the term "securities" encompasses various financial instruments, including:
  • Shares, scrips, stocks, bonds, debentures, and other marketable securities of incorporated companies or pooled investment vehicles
  • Derivatives: Contracts that derive their value from underlying assets, such as debt instruments, shares, loans, or risk instruments
  • Units or instruments issued by collective investment schemes, mutual funds, or pooled investment vehicles
  • Security receipts, government securities, and other instruments declared by the Central Government to be securities
• Types of Securities:
  • Stocks: Represent ownership in a corporation and signify a claim on part of the corporation's assets and earnings
  • Equity Shares: Represent an ownership interest in a company, with residual claims on earnings and assets
  • Preference Shares: Hybrid securities with preferential rights to dividend and repayment of capital, but no voting rights
  • Debentures: Debt securities with a definite life, paying coupon interest at regular intervals
  • Bonds: Debt securities with similar features to debentures, but often secured by specific collateral
• Derivatives:
  • Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price
  • Futures Contracts: Guarantee delivery of a specific quantity of an asset on a specified future date, at the price currently quoted
  • Index Derivatives: Futures contracts based on stock or financial indices, such as the BSE Sensex or NSE Nifty 50
• Other Financial Instruments:
  • Structured Products: Typically comprise bonds, equities, and derivatives, offering capital protection or other features
  • Alternate Investment Fund (AIF): A privately pooled investment vehicle that collects funds from sophisticated investors for investing in real estate, private equity, or hedge funds
  • American Depository Receipts (ADRs): Securities denominated in US dollars, traded on US exchanges, representing a specific number of equity shares of a foreign company
  • Global Depository Receipts (GDRs): Instruments denominated in foreign currency, allowing foreign investors to invest in shares of foreign companies
  • Indian Depository Receipts (IDRs): Rupee-denominated securities traded on Indian stock exchanges, representing a specific number of shares of a foreign company
  • Mutual Fund (MF) Units: Represent the share of investors in the assets of a scheme, with fund managers investing the money to achieve a specified investment objective
  • Exchange-Traded Funds (ETFs): Open-ended mutual funds that allow trading of their units throughout the day
  • Currency Derivatives: Contracts that derive their value from underlying currency amounts, used for risk management in forex and money markets
  • Interest-Rate Derivatives: Contracts that enable investors or borrowers to hedge against the risk of adverse interest-rate movement, including interest-rate futures, swaps, options, and Forward Rate Agreements (FRAs)

Introduction to the Financial System (Part 3)

• Interest-Rate Futures: A financial instrument that allows users to lock in a specific interest rate for a future period. For example, if a banker expects to receive funds in the future and fears a decline in interest rates, he could lock in the higher yield currently quoted by buying an interest-rate futures contract.
• Interest-Rate Swaps: Agreements between two or more parties to exchange a series of cash flows in the same currency over an agreed period of time. This is beneficial when two parties have opposite views on the direction of interest rate movement.
• Interest-Rate Options: A derivative financial instrument that can be used to limit the interest rate to a specific ceiling on floating-rate borrowings (cap) or to earn a minimum rate of return on floating-rate investments (floor).
• Forward Rate Agreement (FRA): A forward contract that allows a borrower to lock in a specified rate of interest for a pre-determined time period in the future. For example, a company can buy a three-month FRA on six-month LIBOR to lock in a specific interest rate.
• Securities Lending and Borrowing Scheme (SLB): A mechanism that allows short sellers to borrow securities for making delivery. This is done through Clearing Corporations of a stock exchange that are registered as Approved Intermediaries (AIs).
• E-warehouse Receipts: Negotiable warehouse receipts issued in electronic format, which serve as an acknowledgement of storage of goods not owned by the warehouse keeper.
• REITs and InvITs: Real Estate Investment Trusts (REITs) and Infrastructure Investment Trusts (InvITs) are innovative vehicles that allow developers to monetize revenue-generating real estate and infrastructure assets while enabling investors to invest in these assets without actually owning them.

Review Questions

• 1. Financial systems consist of banks, non-banks, and financial markets.
• 2. Custodians are responsible for safekeeping and record-keeping of securities.
• 3. Registrars collate data on subscriptions regarding primary issuances.
• 4. As per the Securities Contract Regulation Act (SCRA), the term 'Security' excludes bullion.