Role of Financial Intermediaries in Capital Markets
While buying and selling stocks seems like a straightforward process, there needs to be a governing authority that ensures tight control to keep malpractices and frauds at bay. Imagine reading about an IPO in the newspaper that seems ideal, investing in it, and realizing that it was a scam!
The governing authority needs to make sure that no such instances occur. Also, it needs to make investors feel secure by creating an environment based on control and air-tight processes to improve investments in securities.
Hence, in 1992, the Securities and Exchanges Board of India (SEBI) was established. It had two simple objectives:
- Protect the interests of investors
- Regulate and promote securities market in India
To achieve both its objectives, SEBI designed processes that had multiple checkpoints by creating stock market intermediaries. In India, there are four primary intermediaries in the stock market:
- Stock Broker
- Depository or Depository Participant
- Bank
- Clearing Corporation
Before we get into the details of these intermediaries, let’s take a quick look at the process of buying or selling stocks:
Process for Buying or Selling Stocks
- You place an order for buying/selling stocks through a broker. This is possible online or offline. Every broker is registered with specific stock exchanges. Hence, you can place an order only on those exchanges through the said broker. You cannot place a market order directly.
- The market offers you options to buy at your desired rate. If you want to buy a particular stock for Rs 50 and the current market price is Rs 60, then your transaction will not be executed. The market ensures that your trade is closed only when your price expectations meet those of a seller.
- Once the trading day is over, you need to transfer the money to your broker (for buy transactions) or shares (for sale transactions). The broker, in turn, ensures that you receive the shares/money respectively.
The first question that most young investors ask is why does an investor have to go through a broker? Why can’t we deal with the seller directly? Wouldn’t it be more efficient?
While one-on-one dealing would reduce the transaction time, there will be several restrictions.
In any trade, an intermediary plays the role of ensuring trust between two parties. For example, when a house is being sold, a real estate broker plays the role of an intermediary who is trusted by both the buyer and the seller.
Although each of them ensures due diligence on their part, when the actual trade happens, the broker ensures a smooth process.
In the stock markets, the volume of trades is very high. Hence, SEBI designed a process with capital market intermediaries and assigned specific roles to each of them. Let’s look at each of their roles in detail
Companies | Type | Bidding Dates | |
| Regular | Closes 18 Nov | ||
| SME | Closes 18 Nov | ||
| Regular | Opens 19 Nov | ||
| SME | Opens 21 Nov | ||
| Regular | - |
#1. Stock Broker
SEBI has mandated that only registered stockbrokers can execute trades on the exchange. Therefore, all stock exchanges provide a stockbroker license.
This is given after a corporate entity fulfills several eligibility criteria.
For stock trades to happen seamlessly, the market needed an organized platform where they could be listed. Hence, stock exchanges were established.
There are many stock exchanges in India like the
- National Stock Exchange (NSE)
- Bombay Stock Exchange (BSE)
- Calcutta Stock Exchange (CSE)
- Metropolitan Stock Exchange (MSE)
- India International Exchange (India INX), etc.
A share is not necessarily listed on all stock exchanges. Hence, investors must remember that they can only buy/sell stocks that are listed on the particular exchange.
An individual cannot place an order directly on a stock exchange. If SEBI permitted that, then monitoring and controlling the quality of trades would be impossible.
Since all investors have to transact through a stockbroker and all stockbrokers are registered with the stock exchanges, regulating the stock markets is easier.
Typically, a stockbroker offers a wide range of services including :-
- An online or offline interface for trading on the exchange
- A facility where investors can call them and place a buy/sale order
- Ensuring that investors/traders are regularly updated on any changes in the trading or settlement cycles and schedules for delivery or payments.
- Ensuring the financial soundness and genuineness of its clients
- Issuing contract notes for all transactions, etc.
#2. Depository and Depository Participant
When you purchase a share, you become a partner in the company to the extent of the amount invested by you.
But, how do you prove your partnership? You need some documents confirming it, right? This proof is a share certificate.
Earlier, companies used to issue share certificates to all shareholders authenticating their right as a part-owner of the company.
However, as the investment in shares increased, companies and shareholders found the process of issuing and maintaining physical share certificates, cumbersome.
Hence, in the nineties, these share certificates were converted into an electronic or dematerialized form.
This was akin to a savings account. When you deposit physical currency notes into your bank account, all you get is an entry on your account statement, right?
Similarly, share certificates were the physical currencies that were converted into entries in an account.
However, shares couldn’t be stored in a savings account and needed a special electronic place. Hence, Demat accounts were introduced.
SEBI ensured that while Demat accounts needed to be easily available to investors, monitoring and regulating them should not be complex.
Hence, it introduced the concept of a Depository.
A Depository is an entity that holds the records of all securities in an electronic form. SEBI mandated all companies to become members of a depository and maintain electronic records of all the equity and debt securities issued by them.
Also, all depositories have depository participants who offer Demat accounts to individuals where they can store their securities.
In India, there are two Depositories:
- NSDL (National Securities Depository Limited)
- CDSL (Central Depository Services (India) Limited)
Both are regulated by SEBI and have no differences. Post-1996, when dematerialization was introduced, it was made compulsory to buy or sell securities in the Demat form. Hence, a Demat account became a must for anyone wanting to invest in the capital market.
Depositories and Depository Participants play the role of ensuring that the regulating body is aware of the entire list of shareholders in a company at any time defining their role as intermediaries in the capital market.
#3. Bank
Where there are money and a need for regulation – a bank is a must. When an investor purchases shares, he needs to transfer funds to the broker. Also, when he sells them, he needs to receive funds from the broker.
Hence, a bank is one of the essential financial intermediaries in the capital market. It allows SEBI to have a controlled environment during the transfer of funds.
#4. Clearing Corporation
The concept of a clearinghouse or clearing corporation is not new to the financial ecosystem. Banks have been using clearinghouses for settling check payments for years. In the banking system, a clearinghouse ensures that the check is valid and the amount is transferred to the intended recipient.
In the capital markets, a clearing corporation is responsible to ensure that trades are successfully closed.
Let’s say that two investors agree to carry out a trade – Investor ‘A’ wants to buy 100 shares of ABC Ltd. at Rs.50 per share and Investor ‘B’ is willing to sell 100 shares of ABC Ltd. at Rs.50 per share.
The clearing corporation facilitates this trade by making both investors aware of each other’s offer.
It acts as a buyer to every seller and a seller to every buyer thereby guaranteeing the settlement of the trade.
It also ensures that the shares and money are transferred to the rightful owner within the stipulated time.
In fact, clearing corporations maintain funds to guarantee trades in the event of a default.
A clearing corporation performs a range of functions including, but not limited, to:
- Providing clearing and settlement functions
- Ensuring transparency
- Improving market efficiency
- Reduces (or eliminates the need for) post-settlement arbitrations, etc.
In India, there are three clearing corporations:
- The National Security Clearing Corporation Ltd or NSCCL
- The Indian Clearing Corporation or ICCL
- The Multi Commodity Exchange Clearing Corporation Ltd. or MCXCCL
Summing Up Role of Intermediaries in Capital Market
In the capital market, transactions go through three phases – trading, clearing, and settlement. SEBI has designed processes to ensure that at every stage there is a minimal chance of a fraud or a scam by including the above-mentioned intermediaries to increase transparency and reduce risk.
While the process flow is not very complex, the role of intermediaries in the capital market is defined to make investors feel secure and boost the securities market in India.