The stock market deals in long-term securities both private and government. It is the most important component of the capital market. The latter deals in long-term funds of all kinds, whether raised through open-market securities or through negotiated loans not resulting in market paper.
Open-market securities are securities (or market paper) that are bought and sold openly in the market (like marketable goods) and can change hand any number of times. The negotiated loans have to be negotiated directly (or through a broker) between the borrower and the lender. They appear only in the account books of the lenders and the borrowers’ promissory notes which are not salable in the market. The scope and structure of the stock or securities market are shown in Figure 3.2.
The stock market comprises several distinct markets in securities. The most important distinction is that between the market for corporate securities and the market for government securities.Corporate securities are instruments for raising long- term corporate capital from the public.
The stock market organization provides separate arrangements for the new issues of securities and for buying and selling of old securities. The former market is known as the ‘new issues market’ and the latter market as the ‘secondary market’. Both kinds of markets are essential for servicing corporate borrowers and investors.
The New Issues Market:
The essential function of the new issues market is to arrange for the raising of new capital by corporate enterprises, whether new or old. This involves attracting new investible resources into the corporate sector and their allocation among alternative uses and users. Both ways the role is very important.
How fast the corporate industrial sector grows depends very much on the inflow of resources into it, apart from its own internal savings. Equally important is the movement of sufficient venture capital into new fields of manufacturing crucial to the balanced growth of industries in the economy and in new regions for promoting balanced regional development.
The new issues may take the form of equity shares, preference shares or debentures. The firms raising funds may be new companies or existing companies planning expansion. The new companies need not always be entirely new enterprises. They may be private firms already in business, but ‘going public’ to expand their capital bases. ‘Going public’ means becoming public limited companies to be entitled to raise funds from the general public in the open market.
For inducing the public to invest their savings in new issues, the services of a network of specialised institutions (underwriters and stockbrokers) is required. The more highly developed and efficient this network, the greater will be the inflow of savings into organized industry. Till the establishment of the Industrial Credit and Investment Corporation of India (ICICI) in 1955, this kind of underwriting was sorely lacking in India. Instead, a special institutional arrangement, known as the managing agency system had grown. Now it has become a thing of the past.
The new institutional arrangements for new corporate issues in place of the discredited managing agency system started, taking shape with the setting up of the ICICI in 1955. Soon after (1956) the LIC joined hands. The new system has already attained adulthood under the leadership of the Industrial Development Bank of India (IDBI).
Apart from the ICICI and the other important participants in the new issues market is the major term- lending institutions such as the UTI, the IFCI, commercial banks. General Insurance Corporation (GIC) and its subsidiaries, stock brokers, and investment trust. Foreign institutional funds from the World Bank and its affiliates, International Development Association (IDA) and International Finance Corporation, are also channeled through the all-India term-lending institutions (IDBI, ICICI, and IFCI).
Managing successful floatation of new issues involves three distinct services:
(ii) Underwriting and
(iii) Distribution of new issues.
The origination requires careful investigation of the viability and prospectus of new projects. This involves technical evaluation of a proposal from the technical-manufacturing angle, the availability of technical know- how, land, power, water and essential inputs, location, the competence of the management, the study of market demand for the product (s), domestic and foreign, over time, financial estimates of projected costs and returns, the adequacy and structure of financial arrangements (promoters’ equity, equity from the public, debt-equity ratio, short-term funds, liquidity ratios, foreign exchange requirement and availability), gestation lags, etc., and communication of any deficiencies in the project proposal to the promoters for remedial measures.
All this requires well-trained and competent staff. A careful scrutiny and approval of a new issue proposal by well-established financial institutions known for their competence and integrity improves substantially its acceptability by the investing public and other financial institutions. This is especially true of issues of totally new enterprises.
Underwriting means guaranteeing, purchase of a stipulated amount of a new issue at a fixed price. The purchase may be for sale to the public or (for one’s own portfolio or for both the purposes. If the expected sale to the public does not materialize, the underwriter absorbs the unsold stock in its own portfolio. The underwriter assumes this risk for commission, known as underwriter’s commission.
The company bringing out the new issue agrees to bear this extra cost of raising funds, because thereby it is assured of funds and the task of sale of stock to the public or others is passed on entirely to underwriters. Mostly, underwriting is done by a group of underwriters, one or more of whom may act as group leaders. The group (or consortium) underwriting distributes risks of underwriting among several underwriters and enhances substantially the capacity of the system to underwrite big issues.
Distribution means sale of stock to the public. The term-lending institutions, the LIC, the UTI and several other financial institutions^ usually underwrite new issues as direct investments for their own portfolios. For them, there is no problem of sale of stock to the public. But, under the law, a part of the new public issue must be offered to the general public. This is placed with stockbrokers who have a system of inviting subscriptions to new issues from the public.
In normal times it is their distributive capacity which determines the extent of the public participation in new issues. During periods of stock market boom the demand for new issues from the public also goes up. New issues of well-known houses and issues underwritten by strong institutions generally have a good public response.
It is the placing of the issues of small companies that continues to be the Achilles’ heels of the new issues market. For loosening the grip of monopoly houses on the industrial economy of the country, it is necessary that new entrepreneurs are encouraged. For this, special efforts need be stepped up further for promoting small issues.
Broadly speaking, there are three main ways of floating new issues:
(i) By the issue of a prospectus to the public,
(ii) By private placement and
(iii) By the rights issue to the existing shareholders.
What we have described above is the first method. The issue of a public prospectus giving details about the company, issue, and the underwriters is the last act in the drama and is an open invitation to the public to subscribe to the issue. Private placement means that the issue is not offered to the general public for subscription but is placed privately with a few big financiers.
This saves the company the expenses of public placement. It is also faster. Rights issue means issue of rights (invitations) to the existing shareholders of an old corporation to subscribe to a part or whole of the new issue in a fixed proportion to their shareholding. Such an issue is always offered at a certain discount from the going market price of the already-trading shares of the company.
The discount is in the nature of a bonus to the shareholders. Obviously, a rights issue is open only to an existing public limited corporation, not to a new one. Old corporations also increase their capitalisation (paid-up capital) by declaring bonus to their shareholders, which means issue of new shares to them in a fixed ratio to their shareholdings without charging any price from them. This is a way of converting a part of accumulated reserves into companies paid- up capital.
The Secondary Market in Old Issues:
This market deals in existing securities. Its main function is to provide liquidity to such securities. Liquidity of an asset means its easy convertibility into cash at short notice and with minimal loss of capital value. This liquidity is provided by providing a continuous market for securities, that is, a market where a security cart be bought or sold at any time during business hours at small transaction cost and at comparatively small variations from the last quoted price.
This, of course, is true of only ‘active’ securities for which there are always buyers and sellers in the market. ‘Activeness’ is a property of individual securities, not of the market. The function of providing liquidity to old stocks is important both for attracting new finance and in other ways. It encourages prospective investors to invest in securities, old or new, because they know that any time they want to get out of them into cash, they can go to the market and sell them off.
In the absence of any organized securities market, this will not be easily feasible. So, the investing public will keep away from securities. Then, the secondary market provides an opportunity to all concerned to invest in securities and when they like. This opens a way for continuous inflow of funds into the market.
This is especially important for such investors who do not want to risk their funds by investing in new ventures, but are perfectly willing to invest in the securities of on-going concerns. On the other end, there are venturesome investors who invest in new issues in the hope of making capital gains later when the new concerns have established themselves well.
In a sense, they season new issues and sell them off when the market acceptability of these issues has improved. With their funds released from sale of their old holdings, they can move into other new issues coming into the market. Thus, investment into new issues is facilitated greatly by the operations of the secondary market.
The new investment is influenced in another way too by what is happening in the secondary market. The latter acts as an important indicator of the investment climate in the economy. When stock prices of existing securities are rising and the volume of trading activity in the secondary market goes up, new issues also tend to increase as the new issues market (underwriters, stockbrokers, and investors) is (are) better prepared and more willing to accept new issues. This is also a good time for companies to come forward with new issues.
When the secondary market is in doldrums, the new issues market also languishes. The underwriters are reluctant to underwrite and stockbrokers reluctant to assume the responsibility of selling new issues to the public. Then, firms are also advised to postpone their new issues for better times.
There are two segments of the secondary market:
(a) Organized stock exchange,
(b) Over-the-counter market.
The latter deals in such securities as are not ‘listed’ on an organized stock exchange. These are securities of small companies and have only a limited market. Their prices are determined through direct negotiation between stock brokers and not through open bidding as is the case with ‘listed’ securities on a stock exchange. The main action of the stock market is concentrated on these exchanges. We explain briefly their organization and functioning.
9 Most Important Functions of Stock Exchange/Secondary Market
1. Economic Barometer:
A stock exchange is a reliable barometer to measure the economic condition of a country.
Every major change in country and economy is reflected in the prices of shares. The rise or fall in the share prices indicates the boom or recession cycle of the economy. Stock exchange is also known as a pulse of economy or economic mirror which reflects the economic conditions of a country.
2. Pricing of Securities:
The stock market helps to value the securities on the basis of demand and supply factors. The securities of profitable and growth oriented companies are valued higher as there is more demand for such securities. The valuation of securities is useful for investors, government and creditors. The investors can know the value of their investment, the creditors can value the creditworthiness and government can impose taxes on value of securities.
3. Safety of Transactions:
In stock market only the listed securities are traded and stock exchange authorities include the companies names in the trade list only after verifying the soundness of company. The companies which are listed they also have to operate within the strict rules and regulations. This ensures safety of dealing through stock exchange.
4. Contributes to Economic Growth:
In stock exchange securities of various companies are bought and sold. This process of disinvestment and reinvestment helps to invest in most productive investment proposal and this leads to capital formation and economic growth.
5. Spreading of Equity Cult:
Stock exchange encourages people to invest in ownership securities by regulating new issues, better trading practices and by educating public about investment.
6. Providing Scope for Speculation:
To ensure liquidity and demand of supply of securities the stock exchange permits healthy speculation of securities.
The main function of stock market is to provide ready market for sale and purchase of securities. The presence of stock exchange market gives assurance to investors that their investment can be converted into cash whenever they want. The investors can invest in long term investment projects without any hesitation, as because of stock exchange they can convert long term investment into short term and medium term.
8. Better Allocation of Capital:
The shares of profit making companies are quoted at higher prices and are actively traded so such companies can easily raise fresh capital from stock market. The general public hesitates to invest in securities of loss making companies. So stock exchange facilitates allocation of investor’s fund to profitable channels.
9. Promotes the Habits of Savings and Investment:
The stock market offers attractive opportunities of investment in various securities. These attractive opportunities encourage people to save more and invest in securities of corporate sector rather than investing in unproductive assets such as gold, silver, etc.
- Unethical practices: Many unethical practices are rampant in Indian stock markets. Prices of shares are artificially increased before rights issues by circular trading. Gullible members of public who buy such shares find the prices of such shares dropping greatly and lose their money.
- Misinformation: Funds are raised from investors promising investment in projects yielding high returns. But some promoters divert the money to speculative activities and other personal purposes. Investors who invest their money in such companies ultimately lose their money.
- Absence of Genuine Investors: A very small proportion of purchases and sales effected in a stock exchange are by genuine investors. Speculators constitute a major portion of the market. Many of the transactions are carried out by speculators who plan to derive profits from short term fluctuations in prices of securities. This is evident from the fact that majority of the transactions are of the carry-forward type.
- Fake shares: Frauds involving forged share certificates are quite common. Investors who buy shares unfortunately may get such fake certificates. They would not be able to trace the seller and their entire investment in such fake shares would be a loss.
- Insider trading: Insider trading is a common occurrence in many stock exchanges. Insiders who come to know privileged information use it either to buy or sell shares and make a quick profit at the expense of common shareholders. Though many rules and regulations have been formulated to curb insider trading, it is a continuing phenomenon.
- Unofficial transactions: Unofficial markets exist along with the regular stock exchange. Trading takes place in these unofficial stock exchanges after trading hours of the regular stock exchange. Unofficial buying and selling transactions are entered into in these unofficial stock exchanges (kerb trading and dabba trading) even before an issue opens up for subscription. Though trading in such unofficial stock exchanges are illegal, they continue to exist.
- Prevalence of Price Rigging: Price rigging is a common evil plaguing the stock markets in India. Companies which plan to issue securities artificially try to increase the share prices, to make their issue attractive as well as enable them to price their issue at a high premium. Promoters enter into a secret agreement with the brokers.
- Thin trading: Though many companies are listed in stock exchange, many are not traded. Trading is confined to only around 25% of the shares listed on a stock exchange. Therefore the investors have restricted choice and many shares lack liquidity.
- Excessive Speculation: There is excessive speculation in some shares which artificially results in increasing or decreasing the prices. Increase or fall in prices do not have any relationship with the fundamental strengths or weakness of the company. Many small investors are unaware of this fact. They buy shares based on price movements and ultimately suffer losses.
- Underdeveloped debt market: The debt market in India has not been developed to the required extent. There is very little liquidity in the debt markets.
- Payment crisis: Market players indulge in excessive speculation and trading to profit from the increase and decrease in prices. When movement (increase/decrease) in the security prices is contrary to their expectations they are not able to settle the transaction (pay cash for securities bought).
- Poor liquidity: The main objective of listing shares in a stock exchange is to provide liquidity. But in India, out of over 6,400 companies which are listed, 90 percent of trading is restricted to only 200 to 250 actively traded scrips. There is high volatility (fluctuations) in case of actively traded scrips and low liquidity in the others.
- Inadequate instruments: The markets are dominated by equity. Convertible debenture issues are very rare. Preference shares which would be preferred by fixed return seeking investors are almost nonexistent.
- Influence of Financial Institutions: The equity markets are dominated by large players such as mutual funds. pension funds and insurance companies. Any purchase of sale by them significantly influences the market prices as they buy and sell in bulk quantities. The share prices, therefore do not reflect the fundamentals.
- Domination of FII’s: Foreign institutional investors have come to play a major role in the Indian markets. They have pumped in billions of dollars and buy and sell in large quantities. Any entry (purchase) by FII’s in a particular stock significantly pushes up its prices and any exit (sales) results in a steep fall in prices. FII’s invest and take out their money based on global developments. Any large scale exit by FII’s would trigger a collapse in the Indian markets.
- Odd lots: Odd lots suffer from poor liquidity. The number of odd lot dealers is very less and odd lots have to be sold at a lower price.
- Delay in admitting securities: There is high delay in admitting securities for trading. Sometimes it goes beyond 60 or even 70 days. Therefore, liquidity of investments is affected.
- Poor services: The number of brokers is less and many brokers provide very poor service to investors, There are more than 50,000 sub-brokers and they are totally unregulated. There are many instances of sub brokers committing fraudulent acts and investors losing money.
- Broker defaults: Due to excess speculation in specific shares, broker defaults occur. Such defaults destabilize stock exchanges and results in payment crisis.