Indian Financial System 4

Notes on:

1 Credit Information & Credit Bureau [CB]*

2 Credit Rating and Credit Rating Agency [CRA]*

3 Financial Markets Intermediaries and their role
   in Public Issue of Securities3

43 Dematerialization [Demat] of Securities
5.Demutualization of Stock Exchanges**

( *Acknowledgement: Extract from relevant internet sites)

Credit Information & Credit Bureau [CB]

While the market for consumer credit is expanding, it is also getting riskier. The defaults on loans, credit card payments, etc., are on the rise. As the size of the Indian market grows and competition increases, speed in risk assessment is of utmost importance not only to decide to extend credit but also to decide upon appropriate pricing. Availability and analysis of credit information is assuming great importance. In India, lenders undertake the process of risk assessment independently. Credit assessment is currently based on insufficient data simply because information on total credit exposure is not maintained at a central point. This severely limits the scope of these internal risk assessment processes. Considering the fact that the demand for credit is increasing and delinquencies are rising, it is desirable to have comprehensive credit information from an independent agency. Research in developed countries has proven that the establishment of a credit information bureau leads to a significant reduction in non-performing assets (NPAs). The benefits of a Credit Bureaus[CBs] CBs facilitate increased access to credit. The existence of CBs bureaus in developed countries has facilitated increased market penetration of credit (to more than 66% as a percentage of GDP) while keeping non-performing loans in check (approximately 1% of outstanding credit). The widespread availability of credit has led to higher standards of living for developed country populations. The increased demand for lending products has increased the number of lenders in the market, stimulated innovation and price competition to win business. This helps create lower interest and funding costs to nearly all consumers. Another significant benefit that will result from credit information is the advent of differential pricing. Currently, owing to the lack of comprehensive credit information, all borrowers are charged an interest rate with an assumed level of default risk. This means that all borrowers are assumed defaulters and thus pay a premium that in developed countries is only applied to previously defaulting borrowers. As credit grantors begin to use comprehensive credit information they will be able to differentiate between good paymasters and defaulters. Hence, borrowers who have diligently serviced their loans in the past will be able to demand cheaper loans in the future. Past defaulters will also have an opportunity to improve their credit histories by servicing their debt obligations in a timely fashion and thus have access to lower interest rates. In addition, credit grantors will be able to use price in order to differentiate their loan products in an increasingly commoditized credit market. The Indian credit industry has only recently begun to offer differential pricing to their customers. As the competitive environment becomes increasingly cutthroat, Credit Information Reports (CIR) will play a pivotal role in the speed and confidence with which credit grantors will be able to increase their business volume At the front line, the use of Credit Information Reports (CIR) accessed from a credit bureau will enable credit grantors’ loan officers to accurately evaluate borrower risk by making comprehensive credit histories available to decision makers. CIRs will serve as the first level of due diligence in the appraisal of a credit application. The use of CIRs will make processing loan applications easier by sometimes eliminating the need to research and verify borrower details. The CIRs will facilitate an objective and transparent assessment of credit applications. Concurrent borrowers and serial defaulters will be identified and eliminated early in the approval process (consequently eliminating associated recovery and write-off costs). Similarly, premium borrowers will be identified and serviced faster. Ultimately, CIRs will enable Members to judiciously mix relationship-based lending and information-based lending. A beneficial result of faster loan processing times will be the reduced turn-around-time approving loan applications. The average loan in India is sanctioned in 2-3 days. Processing times will be reduced significantly because credit grantors will not need to verify borrower details before they make a credit decision as they will be already be available on a CIR. There is ample evidence of this from a number of case studies performed by the World Banks. A few salient points are included below: Ø  For a bank in Canada: processing time decreased from 9 days to 3 days in 18 months since CIR-use was institutionalized Ø  For a bank in the US: processing time decreased from 3-4 weeks to a few hours Ø  For a bank in the Netherlands: processing time decreased from 8-10 hours to 15 minutes for existing clients and 45 minutes for new clients Ø  For another bank in the US: average cost of processing a small business loan decreased from $250 to $100 after-CIR use was institutionalized CIR will enable loan officers to make objective and informed credit decisions quickly and cost-effectively. The use of CIRs will enable them to improve the quality of their credit portfolios and increase their lending volumes while reducing their delinquencies and loan processing costs. This translates in to wider profit margins. In addition, CBs typically offer value-added risk management solutions such as credit scoring, fraud detection, decision products and a wide range of other credit decision tools, which complement the needs of the credit industry. Impact of credit information Credit information is a catalyst that facilitates the development of economies and improves the standard of living in all income segments. The widespread use of credit data provides more consumers with access to the lending resources they need and lowers operating and risk costs for credit grantors, which in turn is passed on to consumers with demonstrated credit performance in the form of lower interest rates. By increasing the volume and quality of credit data, more consumers have access to loans, mortgages and other forms of credit, which helps spur economic development The impact that the existence of a credit bureau will have on both the Indian economy and population is difficult to quantify in this nascent stage of the Indian credit bureau’s existence. Still, there is abundant proof available from developed countries that the credit bureau concept is more than just a commercial business model. A credit information bureau is a business catalyst that perfectly blends a capitalistic business model (it is for-profit) and a socialist attitude in that it facilitates the development of a country and its people Credit Information Bureau (India) Limited [CIBIL] In 1999, the Government of India [GOI] and the RBI recognized the need for a credit information bureau, which would tackle the issue of burgeoning non-performing loans among credit grantors. The GOI has drafted Master Legislation called the Credit Information Companies Act, -Inter-alia stipulating rules that will stringently govern the business of credit information collection and dissemination - which has been tabled in the Lok Sabha  2004-05. This led to its support for the establishment of India’s first credit information bureau: CIBIL. CIBIL is a composite organization, which comprises a Consumer Bureau and a Commercial Bureau. CIBIL with the task to collate and disseminate positive and negative credit information pertaining to individuals] and non-individual borrowers. Currently, the Consumer Bureau has 8 million borrower records in its database. The Commercial Bureau will collect data of non-individual borrowers CIBIL has a centralized database, which will share information among credit grantors. This information is available to a closed user group (CIBIL’s Members) in the form of Credit Information Reports (CIRs), which are made available ONLY for making credit decisions. Currently, 103 credit grantors are members of CIBIL. They include all major players - Banks, Non-Banking Finance Companies, Housing Finance Companies, State Financial Corporations, Financial Institutions and Credit Card Companies – representing more than 85% of the total credit outstanding in the country. .

Credit Rating and Credit Rating Agency [CRA]

Credit Rating

• Credit Rating Provide an independent and objective credit measure in the form of a consistent rating scale to players [Issuers and Investors] in the financial markets [like money, capital, credit and structured products markets]
• Credit rating is the CRA’s opinion on the general creditworthiness of an obligor [issuer/borrower] or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation
• A credit rating is an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. A simple alphanumeric symbol is normally used to convey a credit rating

Credit rating is

• Is provided on globally consistent standard scale
• It is measure of Default
• It is applied to entities and securities
• It is assigned in local and foreign currencies

Ex: A Corporate is issuing both local and foreign currency bonds.

The CRA’s opinion can be on the general creditworthiness of the Corporate [issuer] and/or with regard to the particular local/ foreign currency bond issuance.

Credit Rating Agency [CRA]

• The Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 offers various guidelines with regard to the registration and functioning of the credit rating agencies in India.
• CRAs  are offered guidelines regarding the credit rating procedure, by the Act.
• The registration procedure includes application for the establishment of a CRA, matching the eligibility criteria and providing all the details required. T
• CRAs have to undergo the strict examination procedure with regard to the details furnished by them.
• CRAs  are required to prepare internal procedures, abidance with circulars.
• The CRAs are provided with compliance officers and are required to show their accounting records.

Functions of Credit Rating Agency [CRA]

The primary function of the Credit Rating Agencies [CRA] is to provide credit ratings to the service providers of various forms of debt products and services. [Ex. Credit rating  of Tata Motors as an issuer of bonds]

They are also meant to provide ratings to the debt instruments being provided by these service providers [Ex. Credit rating off the particular issue of bonds by Tata Motors].

Their main function is to grade the different sector and companies in terms of performance and offer solutions for up gradation

The CRAs offer varied service like mutual consulting services including operation up gradation and risk management

CRAs have special sections to carry on research and development work of the industries

CRAs provide training to the employees and executives of the companies for better management

CRAs examine the risk involved in a new project, chalk out plans to manage the risks successfully and also reduce the extent of risks all these by doing thorough research

Into the respective industry

CRAs offer service to the mutual fund sector through the application of fund utilization services

The Ratings industry in India

• CRAs in India has been built up to its present position over a period of fifteen years. Over the years, credit ratings have evolved into a 90-crore market, with ~ 7 agencies providing rating services, and significant pull from investors for the product.
• The ratings business in India has seen three phases.

Ø  First phase: there was no experience of credit ratings, and virtually no awareness, on the part of investors and issuers.

Ø  Second phase: saw the advent of regulatory support for credit ratings, with the introduction and increasing rigor of regulations covering primarily the markets for public issue of debt and for fixed deposits.

Ø  Third phase: involved measures aimed at protecting smaller investors. These measures also amounted to regulatory recognition of the role of credit ratings and the quality of the effort put in till then, in estimating credit quality. With these measures, credit ratings rapidly passed out of the arcane realm of high finance, and into the lexicon of the individual market participant. This phase also saw the arrival of competition, in the form of foreign rating agencies  & other domestic agencies entering the market.

Clients of the CRAs

• The clients of the CRAs are those entities that deal in the provision of debt products and services [I.e issuance of debt products like bonds,debentures, fixed deposits(FD) commercial paper(CP), pass/pay  thru certificates(PTC)]
• The providers of securities like the companies, the banks/financial institutions, the governmental organizations at the state and central level and special purpose entities are the major clients of the credit rating agencies.
• The non-profit seeking organizations and the national governments also avail the services of the CRAss.

Basis of CRAs and Difference with Credit Bureaus [CBs]

• There is a certain basis to the activities of the credit rating agencies.
• The rating is mainly provided as per the creditworthiness of the debtor.
• This means the credit rating agency judges if the debtor would be able to pay the loan back or not.
• They tailor the rate of interest of the particular debt instrument  being borrowed by the debtor [Example: based on the credit rating of a particular bond issue the issuer and the investor would be able to determine the rate of interest] .
• Even though the CRAs and  the CBs operate in a similar domain the difference between them  lies in the fact that the CBs only deal with the individual borrowers  whereas the clients of the CRAs are mainly institutions.
• A credit rating agency provides an opinion relating to future debt repayments by borrowers. A credit bureau provides information on past debt repayments by borrowers. Trade creditors are generally the main users of credit bureau information, while financial investors typically use credit ratings.
• Information relating to a company's track record in debt servicing, supplied by credit bureaus, is one of the inputs that is used by a credit rating agency while assigning a rating.

Credit Rating is not

• A recommendation to buy or sell investments
• A way of defining good or bad companies
• An audit

The fundamentals of credit ratings are

• Ratings are forward looking – medium term time horizon of 3-5 years
• The objective is stability – they should not necessarily reflect market volatility
• The risk measured is probability of default and not trading risk or loss given default

Rating opinions assess

• The Issuer [Say Tata Motors] for  capacity & willingness to meet financial commitments. The issuer can be Government [Sovereign], Corporate and a Counterparty
• The Issue [Tata Motors Bond] for  creditworthiness of a specific financial
• obligation

Benefits of Credit Ratings to Issuers/Counterparties

• Supports disclosure & transparency
• Provides independent peer comparisons
• Enhances terms and conditions of borrowings
• Enhances access to new sources of funds/markets

Benefits of Ratings to Investors

• Assist in portfolio monitoring
• Benchmark for risk premium
• Information and reference point
• Simple global measure of credit risk

Role of ratings

• An independent benchmark of creditworthiness
• Widely accepted by investors/counterparties as a convenient and objective tool for differentiating credit quality
• Credit quality transparency = more efficient capital market (finer pricing, wider access)

The utility of ratings

• A third party to sort the abundant information available
• Access to management
• Independent viewpoint
• Consistency
• Wide universe of comparisons

Impact of ratings - Influence grown because of:

• Expansion in issuers/issuance volume
• Disintermediation and growing interest in credit among investors
• High leverage of issuers cf. previous economic cycle
• Greater volatility of bond spreads [credit spreads/risks spreads and impact on equity]

Types of Credit Rating

• Issuer Credit Rating (ICR) or Counterparty Credit Rating (CCR) [Example: Reliance Industries long term credit rating is AAA by FITCH/ India’s sovereign rating as assigned by  S&P is BBB rating]
• Issue Rating [Example: L&T Finance’s bond issue was rated AA+ by CARE]
• Program Rating[Example: Tata Motors series A3 & A4 Pass thru certificates[PTCs] under its securitization program has been assigned AA+(So) by CRISIL
• Bank Loan Rating:[Example: ICRA has assigned LB+ and A4 ratings to bank facilities of Garnet Speciality]

Some Rating Symbols and associated meaning

Symbol(Rating category)	Description(with regard to the likelihood of meeting the debt obligations on time)
AAA	Highest Safety
AA	High Safety
A	Adequate Safety
BBB	Moderate Safety
BB	Inadequate Safety
B	High Risk
C	Substantial Risk
D	Default

“SO” Ratings: Structured Obligation ratings are ratings that are based on a ‘credit enhancement‘ mechanism and/or a structured payment mechanism. These enable the rated instrument to achieve a rating that is higher than the issuer‘s stand-alone rating. Such credit enhancements can take many forms such as a guarantee from another company or setting aside specific cash flows exclusively for debt repayment.

Long-term rating scales and its meanings

• AAA – Highest rating - obligor’s capacity to meet financial commitment is extremely strong.”
• A – “Somewhat more susceptible to adverse changes in economic conditions capacity to meet financial commitment is still strong.”
• BBB – Adequate protection- but changes in economic conditions could lead to weakened capacity
• BB – Faces uncertainties during adverse economic conditions
• B – Possesses current capacity- but likely to be impaired
• CCC – Vulnerable to non-payment- needs favorable business climate to meet obligations

What is ‘IPO Grading’?

IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI, to the initial public offering (IPO) of equity shares or any other security which may be converted into or exchanged with equity shares at a later date. The grade represents a relative assessment of the fundamentals of that issue in relation to the other listed equity securities in India. Such grading is generally assigned on a five-point point scale with a higher score indicating stronger fundamentals and vice versa as below.

IPO grade 1: Poor fundamentals

IPO grade 2: Below-average fundamentals

IPO grade 3: Average fundamentals

IPO grade 4: Above-average fundamentals

IPO grade 5: Strong fundamentals

IPO grading has been introduced as an endeavor to make additional information available for the investors in order to facilitate their assessment of equity issues offered through an IPO

Bank Loan Rating The bank loan market is much larger than the bond market, given the wide reach of banks and the large funds at their disposal when compared with capital market participants. Banks lend to various entities, many of whom have not felt the need for or do not have the ability to access bond markets; many such entities have therefore not been rated so far. Now, however, with the advent of Basel II regulations, which encourage banks to better calibrate the credit risk on their books, bank loan ratings (BLRs) are gradually coming into their own in India. A CRAs BLR is ans opinion on the relative degree of risk associated with timely payment of interest and repayment of principal on a specified bank facility. CRAs assigns BLRs on the same long-term and short-term rating scales as it does its other credit ratings. BLRs can be used by banks to determine risk weights for their loan exposures, in keeping with the Reserve Bank of India's (RBI's) April 2007 Guidelines for Implementation of the New Capital Adequacy Framework.

Benefits of a Bank Loan Rating [BLR] For Banks: The new guidelines from RBI create an incentive for banks to use BLRs, by giving significant relief in the capital that banks must hold against their corporate loan exposures. The highest relief of 80 per cent is available for 'AAA' and 'P1+' rated exposures, but there is substantial relief for exposures that are rated below the highest category as well. For instance, both 'A' category-rated long-term loans and 'P2' category-rated short-term facilities provide 50 per cent relief. BLRs will also be a key input for appropriate pricing of credit risk by banks. For Borrowers  BLR will help borrowers obtain more precise risk-based pricing on bank loans. Borrowers may also benefit when the capital savings that the banks enjoy are reflected in loan pricing. In the long run, as many lower rated borrowers obtain BLRs, and the market understands the risk associated with such lower ratings, access to markets for lower rated corporate is likely to improve significantly. For the Debt Market BLRs will help develop a secondary market for loans, and will provide a uniform scale for analyzing credit risk of bank loans. Over time, they will contribute immensely to the development of a Credit Default Swap market, where ratings on the underlying reference obligations are indispensable.

Leading Credit Rating Agencies 

• Some of the leading CRAs of the world are Standard & Poor's, Fitch Ratings & Moody's.
• The CRAs in India are:

Ø  CRISIL: Credit Rating Information Services of India Ltd [association with Standard & Poor]

Ø  ICRA: Investment Information & Credit Rating Agency of India [association with Moody’s]

Ø  CARE: Credit Analysis & Research Limited

Ø  FITCH India

Ø  ONICRA Credit Rating Agency of India Limited (rating agency for Individuals and Small & Medium Enterprises {SME})

Ø  SMERA: SME Rating Agency of India

Ø  Brickwork Ratings India Pvt Ltd

Ø  CredEx: Rating agency being started by Dun & Bradstreet and SIDBI

Financial Markets Intermediaries and their role in Public Issue of Securities4

 ( *Acknowledgement: Extract from related internet sites)

• Financial Market Intermediaries (in short Intermediaries) are one of the key six constituencies of Financial Market. The  other five are Investors, Regulators, Opinion Makers, Issuers and Knowledge  makers
• The role of intermediaries makes the market vibrant, and to function
   smoothly and continuously
• Intermediaries possess professional expertise and play an promotional
   role in organizing a perfect match between the supply and demand for
   capital in the market
• All those, institutions or individuals, who help to bring the savers and
   seekers of capital and enable a regular flow of funds from supply to
   demand points as also who provide technical, accounting, financial and legal & other related services at the time of issuances of securities [like an IPO]  are intermediaries
• Thus a commercial bank, an insurance company, a mutual fund, stock
    exchange or depository are as much intermediaries, as are brokers,
  merchant bankers, Registrars etc

• All intermediaries are service providers and are an integral part of the
   all types of Financial Markets and especially so in Capital Market and  Money Market.

• The market Regulator, SEBI regulates various intermediaries in the
    primary and secondary markets through its Regulations for these
    intermediaries.
• SEBI has defined the role of each of the intermediary, the eligibility
   criteria for granting registration, their functions and responsibilities and
   the code of conduct to which they are bound.
• These Regulations also empower SEBI to inspect the functioning of
    these intermediaries and to collect fees from them and to impose
    penalties on erring entities
• The Primary & Secondary Market Intermediaries, inter-alia, are:

Ø  Merchant Bankers

Ø  Registrars to an issue

Ø  Share Transfer Agents

Ø  Bankers to an issue

Ø  Debenture Trustees

Ø  Underwriters

Ø  Brokers and Sub-Brokers

Ø  Depositories and Depository Participants

Ø  Custodians, Escrow Agents,etc

Ø  Accounting, Finance, Legal & other Service Providers

• The Intermediaries playing an active role in Initial Public offer of Shares [or any public and/or private placement of securities [both share and bonds] , inter-alia, are:

Ø  Merchant Bankers

Ø  Book Running Lead Bank

Ø  Lead Bank

Ø  Bankers to the issue

Ø  Underwriters

Ø  Depository and Depository Participants

Ø  Registrars

Ø  Share Transfer Agents

Ø  Custodians

Ø  Rating Agencies

Ø  Chartered Accountants

Ø  Legal Consultants

Ø  Brokers

• Role of Merchant Bankers

Ø  A "Merchant Banker" [also known as Investment Banker] could be defined as "An organisation that acts as an intermediary between the issuers and the ultimate purchasers of securities in the primary security market"

Ø  Merchant Banker has been defined under the Securities & Exchange  Board of India (Merchant Bankers) Rules,  1992  as "any person who is engaged in the business of issue  management either by making arrangements regarding selling, buying or subscribing to securities as manager, consultant, advisor or rendering corporate advisory service in relation to such issue management"

Ø  Reform measures were initiated in the capital market from 1992, starting with the conferring of statutory powers on the Securities and Exchange Board of India (SEBI) and the repeal of Capital Issues Control Act and the abolition of the office of the Controller of Capital Issues. These have brought about significant improvement in the functional and regulatory efficiency of the market, enabling the Merchant Bankers shoulder greater legal and moral responsibility towards the investing public

Ø  A Merchant banker can also don the role of Lead Banker, Book Running Lead Managers, Co Lead /BRM, Bankers to the Issue, Underwriters [ they can underwrite whole/part of the share/bond issue and also in  the case of private placement of bond issue first take up the entire issue in their book, release the money to the Issuers and latter on depending on market conditions off-load to the bonds to other market players/investors]

• Role of Lead Managers and Book Running Lead Manager

Ø  Lead managers are independent financial institution appointed by the company going public.  Companies appoint more then one lead manager to manage big IPO's. They are known as Book Running Lead Manager and Co Book Running Lead Managers. Ø  The BRM to the issue appoint syndicate members who enter the bids of the investors in the book building system. Syndicate members are intermediaries registered with SEBI who also carry underwriting activity Ø  Their main responsibilities are to initiate the IPO processing, help company in road shows, creating draft offer document and get it approve by SEBI and stock exchanges and helping company to list shares at stock market.

• The Book Running Lead Managers (BRLMs), are the key intermediaries to an issue.

Ø  A merchant banker possessing a valid SEBI registration in accordance
 with the SEBI (Merchant Bankers) Regulations, 1992 is eligible to act as
 a Book Running Lead Manager to an issue

Ø  The BRLMs shall ensure compliance with the stipulated requirements
  and completion of prescribed formalities with the stock exchanges, RoC
  and SEBI including finalisation of prospectus and RoC filing

Ø  The merchant banker shall be responsible for ensuring that Lead
 Managers fulfill their functions and enable them to discharge their
 responsibility through suitable agreements with the company

• Role of a Lead Manager Pre and Post issue:

  

Ø  In the pre-issue process, the Lead Manager (LM) takes up the due
 diligence of company's operations/ management/ business plans/ legal
 etc

Ø  Other activities of the LM include drafting and design of offer
 documents, prospectus, statutory advertisements and memorandum
 containing salient features of the prospectus.

Ø  The LM also draws up the various marketing strategies for the issue

Ø  The post-issue activities including management of escrow accounts, coordinate  non-institutional allocation, intimation of allocation and dispatch of refunds to  bidders etc are performed by the LM

Ø  The post offer activities for the offer will involve essential follow-up steps, which   include the finalization of trading and dealing of  instruments and dispatch of  certificates and demat of delivery of shares, with the various agencies connected  with the work such as the registrar(s) to the offer and bankers to the offer and the  bank handling refund business

Ø  The Lead Managers state that they have examined various documents
  including those relating to litigation such as commercial, patent
 disputes, disputes with collaborators etc. and other materials in
 connection with the finalization of the offer document pertaining to the
 said issue [Due Diligence]

Ø  The lead manager coordinates with the registrar to ensure follow up so
  that that the flow of applications from collecting bank branches,
  processing of the applications and other matters till the basis of
 allotment is finalized, dispatch security certificates and refund orders
 completed and securities listed

Ø  The Lead Merchant Banker shall ensure that Bankers to the issue are
  appointed in all the mandatory collection centres as specified in DIP
  guidelines

Ø  The LM also ensures follow-up with bankers to the issue to get quick
  estimates of collection, advising the issuer about closure of the issue,
  based on the correct figures

Ø  The Lead Managers state that they have examined various documents including those relating to litigation like commercial disputes, patent disputes, disputes with collaborators etc. and other materials in connection with the finalization of the offer document pertaining to the said issue; and on the basis of such examination and the discussions with the Company, its Directors and other officers, other agencies, independent verification of the statements concerning the objects of the issue, projected profitability, price justification, etc., they state that they have ensured that they are in compliance with SEBI, the Government and any other competent authority in this behalf

• Role of Bankers to the Issue

Ø  Bankers to the issue, as the name suggests, carries out all the activities of ensuring that the funds are collected and transferred to the Escrow accounts. The Lead Merchant Banker shall ensure that Bankers to the Issue are appointed in all the mandatory collection centers as specified in DIP Guidelines. The LM also ensures follow up  with bankers to the issue to get quick estimates of collection and advising the issuer about closure of the issue, based on the correct figures.

Ø  Role of Custodian &  Depository

Ø  A custodian is an entity which holds the documentary evidence of the title to property belonging like share certificates, etc for safekeeping.

Ø  In Clearing Corporation, custodian is a clearing member but not a trading member.

Ø  Custodian settles trades assigned to him by trading members.

Ø  Custodian is required to confirm whether it is going to settle a particular trade or not. If it is confirmed, the Clearing Corporation assigns that obligation to that custodian and the custodian is required to settle it on the settlement day. If the custodian rejects (if there are mismatches due to errors in the system) the trade, the obligation is assigned back to the trading member. Only on receipt of the rejection message, the broker shall cancel the rejected contract note and issue a fresh contract note bearing a new number.

• Role of  Depository

Ø  A depository is an entity where the securities of an investor are held in electronic form.

Ø  Depositories help in the settlement of the dematerialized securities. Each custodian/clearing member is required to maintain a clearing pool account with the depository.

Ø  Depository  is required to make available the required securities in the designated account on settlement day.

Ø   The depository runs an electronic file to transfer the securities from accounts of the custodians/clearing member to that of Clearing Corporation. As per the schedule of allocation of securities determined by the Clearing Corporation, the depositories transfer the securities on the payout day from the account of the Clearing Corporation to those of members/custodians.

Ø  The Depository performs its functions through a network of Depository
  Participants (DPs) who interact with the Clearing Members and Investor

Ø  The Depository carries out following functions through its participants:

ü  Enabling the surrender and withdrawal of securities through the process of demat and remat to and from the depository system

ü  Maintaining investors' holdings in the electronic form through computers

ü  Effecting settlement of securities traded on the stock exchanges

ü  Carrying out settlement of "off market trades" (i.e. trades not done on
 the stock exchanges)

ü  Advising periodically to the Share Registrar / Issuer about the
beneficial owners of the securities

• Role of Depository Participant

Ø A Depository Participant is issuers & investors representative in the
       depository system

Ø  Financial Institutions / Banks / Custodian / Stock Brokers etc. can
 become DPs provided they meet the necessary requirements and
 guidelines prescribed by SEBI

Ø   DP serves as a link between the investor and the Company through
  NSDL/CDSL for dematerialization of shares and other electronic
  transactions

Ø  DP provides various services with regard to your holdings such as:

ü  Maintaining the securities account balances

ü  Enabling direct debit and credit of securities, surrender (dematerialization ) and withdrawal (rematerialization) of securities to
 and from the depository

ü  Delivering and receiving shares in to demat account on instructions 

ü  Giving update with regard to status of holdings periodically

• Role of Registrar

Ø  The registrar finalizes the list of eligible allottees after deleting the invalid
  applications and ensures that the corporate action for crediting of shares
  to the demat accounts of the applicants is done and the dispatch of
  refund orders to those applicable are sent 

Ø  The Registrar is one of the key intermediary in the IPO activities

Ø  The Registrar's role starts with the filing of Prospectus with the
  SEBI/Registrar of companies by the Issuer 

Ø  The Registrar has to send Banker’s Instructions and collect the
  subscription figure on daily basis and process the applications after
  closure of issue within the prescribed time, so that, basis of allotment
  may get approved from the Stock Exchanges and securities are credited
  in the investor’s account and refund order dispatched to the investor 

Ø  The Registrar has to take care of investor grievances at least for 6
  months from the closure of the issue.  

• Underwriters to the Issue

Ø  Underwriting is one of the techniques of marketing securities which is commonly used by a company. In order to procure sufficient funds and make the issue a success. The company utilities the services of the underwriters.

Ø  'Underwriting is an agreement entered into before the shares are brought before the public that in the event of the public not taking up the whole of them or the number mentioned in the agreement, the underwriter will, for an agreed commission, take an allotment of such part of the shares as the public has not applied for

Ø  Underwriters take upon the responsibility of selling the securities issued by the company or in other words, they offer a guarantee to the company for the sale of securities.

Ø  If shares and debentures offered are not taken up by the public, the underwriters are under an obligation to take the remaining shares or debentures at the issue price.

Ø  The agreement the company and the under-writers is called underwriting. For this service, the underwriters are paid an agreed commission not exceeding the limit fixed by the Companies Act that is 5 % of issue price in case of shares an 2 ½ % in case of debentures.

Ø  In case of under subscription, they have the obligation to subscribe to
 the left over portion By entering into the agreement with underwriters thee company has not to worry at all about the sale of securities because of the guarantee cover provided by the underwriters.

Ø  Underwriting is a good technique of marketing the securities. The importance of under-writing can be adjudged by the following advantages:

ü   Assurance of Adequate Finance: Underwriting is a guarantee given buy the underwriters to take up the whole issue or remaining shares, not subscribed by public. In the absence an underwriting agreement, a company may face a situation where even minimum subscription is not received and, it will have to go, into liquidation. In case of an existing company, it may have to postpone its projects for which the issue was meant. As a result of an underwriting contract, a company has not to wait till the shares have been subscribed before entering into the required contracts for purchase of fixed assets etc. it can go ahead with its plan confidently. Thus, underwriting agreement assures of the required funds within a reasonable or agreed time.

ü   Benefit of Expert Advice: An incidental advantage of underwriting is that the issuing company gets the benefit of expert advice. An underwriter of repute would go into the soundness of the plan put forward by the company before entering into an agreement and suggest changes wherever necessary, enabling the company to avid certain pitfalls.

ü  Increase in Goodwill of the Company: The good underwriters being men or firms of financial integrity an established reputation. As we have already explained that underwriters satisfy themselves with the financial integrity of the company and viability of the plan, the investors therefore, runs much less risk when they buy shares or debentures which have been underwritten by them. They assure of the soundness of eh company. Thus, good underwriters increase the goodwill of the company.

ü  Geographical Dispersion of Securities: Generally, underwriters maintain working arrangement wit other underwriters and broken throughout the country and in other countries too and as such, they are able to tap the financial resources for the company not only in on particular area but also in other areas as well. In this way marketability of securities increases and geographical dispersion of shares and debentures in promoted.

ü  Service to Prospective Buyers: Underwriters render useful services to the perspective buyers of securities by giving them expert advice regarding the safe investment in sound companies. Sometimes they publish information and their expert opinion in respect of various companies. Thus, they render useful services to the buyers of securities too.

Ø  The main functions of underwriters are as follows:

ü   Purchase of Securities: The main function of underwriters is to purchase the securities of financially sound Companies either direct from the company or from the market. Thus, they maintain their goodwill in the market a stockists of good securities.

ü  Distribution of Securities:Underwriters distribute the securities to the real investors after entering the agreement with the issuing company. The underwriters take up securities under an obligation under underwriting contract or sometimes make firm underwriting and distribute such securities to the investors by selling them int the market at the earliest.

ü  Supplying Information of Companies: Underwriters supply important information in regard to investors attitude, market conditions etc. to the issuing company and to suggest necessary changes in their financial plans.

ü  Supplying Information of Companies: Customers or investors in securities get valuable information from underwriters regarding the financial position an the policies of different companies. Sometimes their expert advice are published in journals etc.

ü  Exchange in Securities: Underwriters provide stability in the price of securities by purchasing an selling the various securities by maintaining equilibrium in the demand and supply position of the securities and thus keep the market alive.

ü  Other Services: Underwriters sometimes finance the projects of the company. They also inform the investors about opportunities but this type of service is not popular in India. It is much popular in U.S.A

Ø  The underwriting agreement can be different types as under:

ü  Hard [Firm] underwriting is when an underwriter agrees to buy his commitment at its earliest stage. Generally, underwriters agree to buy such number of shares or debentures which are not to be taken up by the public The underwriter guarantees a fixed amount to the issuer from the issue. Thus, in case the shares are not subscribed by investors, the issue is devolved on underwriters and they have to bring in the amount by subscribing to the shares. The underwriter bears a risk which is much higher in soft underwriting. Such an arrangement  creates confidence in the minds of investing public.

ü  Soft underwriting is when an underwriter agrees to buy the shares at later stages as soon as the pricing process is complete. And the underwriter, immediately places those shares with institutional players. The risk faced by the underwriter as such is reduced to a small window of time. Also, the soft underwriter has the option to invoke a force Majeure (acts of God) clause in case there are certain factors beyond the control that can affect the underwriter’s ability to place the shares with the buyers.

ü  Sub-undewriting is in case of large issue, an underwriter does not wish to carry the whole risk on his shoulders, he may enter into the contract wit other underwriters to share the risk. This contract entered into between the main underwriter and the other underwrites is called Sub-underwriting an he other underwriters are called Sub-underwriters. The company is nowhere in the picture. Sub-underwriters are offered a commission slightly below the underwriting commission.

ü  Syndicate Underwriting is an underwriting agreement between the issuing company and 2-3 or more firms of underwriters to underwriters a large issue. They agree with the company to share the joint responsibility in an agreed ratio. Some-times, these underwriters to the contract form a new consortium or syndicate. Such a system is called Syndicate Underwriting. It is very popular in Germany.

Ø  Rating Agencies:

Ø  Credit rating agencies offer grading of IPOs/ rating of securities under
 issue for which they take into account the fundamentals of the issues

• Chartered Accountants:

Ø  Play leading role as advisors to the Company tapping the capital market

Ø  Conduct due diligence

Ø  Act as auditors

Demat of Securities

• Dematerialization or "Demat" is a process whereby securities like shares, debentures ,bonds, government securities, mutual fund units (even unlisted securities of corporate) etc, are converted into electronic data and stored in computers by a Depository.

• Dematerialisation is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited into the Beneficial Owner’s [BO’s] account with his Depository Participant [DP].

• The process of converting electronic holding to physical form is called rematerialisation. The BO has to fill in the RRF (Remat Request Form) and request  DP for rematerialisation of the balances securities account.

• In the demat process the participants are the Firms (issuer of securities),Investors, Registrar and Transfer Agents  of the Firms[RTA – who can be in-house or outsourced], Depository Participant &
  Depository.

• There is no direct link between the Investors and Depository- the link is through a DP. Also the Firm is linked to the Depository only thru the RTA. The Depository is linked to the Stock Exchanges [thru its Clearing House].

The DP , RTA and the Brokerage House are linked to the Depository

• When a security in physical form is lodged with the DP by an Investor the  same is submitted for demat to the Depository who thru the RTA of the Firm get the security in demat form.

• Similarly in the case of Corporate Action by the Firm the same is processed by the RTA thru Depository to the credit/debit of the Investor’s demat and or Bank accounts with the DP

• When a security in demat form is bought or sold by an Investor it is done thru a broking house and the Investor thru DP and the Firm thru its RTA

And the DP and RTA thru the Depository [ which is linked to the Stock Exchanges] process the securities debit/credit and money credit/debit in the respective demat and bank accounts of the concerned Investors

• A demat account has become a necessity for all categories of investors for as the SEBI under the SEBI (Depository and Participant) Regulations 1996  has  made it  compulsory for trades in all listed scrips to be settled in demat mode (although, trades upto 500 shares can be settled in physical form, physical settlement is virtually not taking place  given the benefits of demat and demerits of physical trading).Further SEBI has taken various policy initiatives to popularize the demat concept. One of them is delivery of demat shares compulsorily for institutional investors and OCBs.

• At the time of demat each security is identified by an ISIN number. ISIN (International Securities Identification Number) is a unique 12 digit alpha-numeric identification number allotted for a security (E.g.- INE383C01018)  by the depository  at the time of admitting such security in the depository system. Different securities issued by the same issuer will have different ISINs [Example Tata Steel equity share and bonds will have different ISIN] as also equity-fully paid up, equity-partly paid up, equity with differential voting /dividend rights issued by the same issuer will have different ISINs.

About BO, DP and Depository

• Beneficial Owner [BO] is a person in whose name a demat account is opened with a Depository thru a DP  for the purpose of holding securities in the electronic form

• Depository Participant DP

Ø  DP  is an agent of the depository who is authorised to offer depository services to investors. Financial institutions, banks, custodians and stockbrokers complying with the requirements prescribed by SEBI/ Depositories can be registered as DP.

Ø  A DP is an agent of the depository through which it interfaces with the investor and provides depository services. There is no direct link between the BO and depository.

Ø  Public financial institutions, scheduled commercial banks, foreign banks operating in India with the approval of the Reserve Bank of India, state financial corporations, custodians, stock-brokers, clearing corporations /clearing houses, NBFCs and Registrar to an Issue or Share Transfer Agent complying with the requirements prescribed by SEBI can be registered as DP.

Ø  Banking services can be availed through a branch whereas depository services can be availed through a DP.

Ø  As on September 30, 2008, a total of 711 DPs (266 NSDL, 445 CDSL) were registered with SEBI

Ø  Following services can be availed of through a DP :

ü  Dematerialisation, i.e. getting physical securities converted into electronic form.

ü  Rematerialisation, i.e. getting electronic securities balances held in a BO account converted into physical form.

ü  To maintain record of holdings in the electronic form.

ü  Settlement of trades by delivering / receiving underlying securities from / in BO accounts.

ü  Settlement of off-market trades i.e. transactions between BOs entered outside the Stock Exchange.

ü  Providing electronic credit in respect of securities allotted by issuers under IPO or otherwise.

ü  Receiving on behalf of demat account holders non-cash corporate benefits, such as, allotment of bonus and rights shares in electronic form or securities resulting upon consolidation, stock split or merger / amalgamation of companies.

ü  Pledging of dematerialised securities & facilitating loans against shares.

ü  Freezing of the demat account for debits, credits, or both.

ü  Internet facilities if  the DP is registered for the same with the depository.

• The process of opening a demat account through a DP of depository is very simple and easy. It is similar to the opening of a bank account.

Ø  Investor has to first choose a DP based on his convenience and the DP's charges.

Ø  Besides submitting an application in the prescribed form, the investor should submit a photocopy of the PAN card along with the original as proof of identity and address proof such as passport, ration card, etc to the DP.

Ø  Before opening the demat account, the investor will have to execute an agreement on a stamp paper to be provided by the DP, which defines the rights and obligations of both, the investor and the DP.

Ø  On opening a demat account, a unique BO ID (Beneficial Owner Identification) Number is allotted, which should be quoted in all future transactions.

Depository

• A Depository is a facility for holding securities, which enables securities transactions to be processed by book entry. To achieve this purpose, the depository may immobilize the securities or dematerialise them (so that they exist only as electronic records).

• India has chosen the dematerialization route. In India, a depository is an organisation, which holds the BOs securities in electronic form, through a registered DP.

• A depository functions somewhat similar to a commercial bank. To avail of the services offered by a depository, the investor has to open an account with a registered DP

• A depository is an organisation which holds securities (like shares, debentures, bonds, government securities, mutual fund units etc.) of investors in electronic form at the request of the investors through a registered Depository Participant.  It also provides following services related to transactions in securities.

Ø  Holds securities in an account

Ø  Transfers securities between accounts on the instruction of the BO account holder

Ø  Facilitates transfer of ownership without having to handle securities

Ø  Facilitates safekeeping of securities

• A demat account can be opened only though a DP registered with a depository .The investor has a choice to open another demat account with any DP linked to any depository. The investor can have more than one demat account and it can be with Nil balance of securities
•  
• At present two Depositories viz. National Securities Depository Limited   (NSDL) and Central Depository Services (India) Limited (CDSL) are registered with SEBI. The minimum networth stipulated by SEBI for a depository is Rs.100 crore

The Depository system has the following benefits to different groups:

·       Benefit to the Country

Ø  The depository system helps the capital market to be more liquid, attracting more foreign investors and is in compliance with international standards, as it creates efficient and risk-free trading environment.

Ø  It minimises the settlement risks and frauds in carrying out transactions in capital markets and thus can restore faith of investors in capital markets.

Ø  It helps to reduce delay in trading practices creating investor friendly atmosphere in the capital markets.

·       Benefit to the Company

Ø  The depository system helps in reducing the cost of new issues due to less printing and distribution cost.

Ø  It increases the efficiency of the registrars and transfer agents and the Secretarial Department of the company.

Ø  It provides better facilities for communication and timely services with shareholders, investor etc

·       Benefit to Brokers

Ø  The depository system reduces risk of delayed settlement.

Ø  It ensures greater profit due to increase in volume of trading.

Ø  It eliminates chances of forgery – bad delivery.

Ø  It increases overall of trading and profitability.

Ø  It increases confidence in investors.

·       The benefits of demat to the investors are enumerated below:-

1.     A safe and convenient way to hold securities

2.     Immediate transfer of securities

3.     No stamp duty on transfer of securities

4.  Elimination of risks associated with physical certificates such as bad delivery, fake securities, delays, thefts etc

5.     Reduction in paperwork involved in transfer of securities

6.     Reduction in transaction cost

7.     No odd lot and/or market lot problem, even one share can be traded

8.     Nomination facility

9.  Change in address recorded with DP gets registered with all companies in which investor holds securities electronically eliminating the need to correspond with each of them separately

10. Transmission of securities is done by DP eliminating correspondence with companies

11. Automatic credit into demat account of shares, arising out of bonus/split/consolidation/merger etc.Easy Corporate actions on securities

12. Holding investments in equity and debt instruments in a single  account

Stock Exchange & Demutualization of Stock Exchanges

What is stock exchange

• Typically, the majority of an exchange's membership is made up of broker-
   dealer organizations which represent investors in the market place, buying and selling shares on behalf of their clients [the current trend is
   demuatalision of stock exchanges]
• An exchange provides the regulatory oversight and the facilities in which the  brokers work - the space, phone lines, computers, the linkages with other
• In order to provide a secure and regulated trading environment, each
  exchange, acting as a self-regulatory organization, with the rules and
  standards established by say the SEC [ the government regulatory body that  monitors all U.S. securities markets] or SEBI [Securities & Exchange Board  of India]

• Importance of stock exchange
• One of the key advantages is that stock exchanges are an efficient medium  for raising resources and channeling savings from the public by way of issue
   of equity / debt capital by joint stock companies listed on the stock
   exchanges
• The second main benefit is the wide dispersal of information and the need
   to disclose adequate information — not only the quarterly or year-end
   financial results, but also major events that have an impact on the working  of the company
• The third important feature stock exchanges provide the platform for
   secondary market trading in a most transparent manner benefiting all
   investors  and aid in liquidity and price discovery
• Stock exchange like NSE has been playing a catalytic role and has
   significantly contributed to the reforming of the secondary markets in India in terms of microstructure, market practices, trading volumes, use of state-of- the-art technology and by use of satellite communication rapidly expand services across the length and breadth of the country

Future outlook of Stock Exchanges

• With increasing globalization and consolidation amongst exchanges, the
   future of the regional stock exchanges, around 22 in India, is likely to be
   very uncertain and even their very survival is a question mark
• Sebi has permitted the regional exchanges to form subsidiary
   companies, which are akin to super brokers. These companies have
   acquired membership of both BSE and NSE at confessional entry fees
   and permitted their members to trade on the BSE and NSE thus
   increasing trade volumes and business in both BSE and NSE
• The stock markets of the future will have a redefined purpose and
   reinvented architecture due to the advent and widespread use of
   technology. Information and stock price quotations will be available
   almost instantaneously and more importantly investors can act on this data by executing a trade from anywhere at any time
• This new market will bring benefits to investors, listed companies, and
   the economies of countries. Trading will be cheaper, faster and
   settlement will be simpler and with reduced risk
• Raising capital for companies will be easier, thus contributing directly to
   economic expansion.
• The leaders in this new world of investing will be the ones willing to be
   agents of change, to best meet the needs of investors and companies,
   and to do what is best for these two principal stakeholders in the capital
   markets
• If done right, the stock markets of the future will be even better vehicles
   than today in helping companies grow, creating jobs, providing fair
   investment opportunities for people, and in improving economies
• Both the exchanges, BSE and NSE, are visionary, proactive and
   increasingly use leading-edge technologies to effectively compete in the
   global environment.
• In the not-too-distant future, once full capital account convertibility is
   permitted in stock exchanges could well witness an expansion of trading
   volumes with resultant economic benefits to India

Demutualization of Stock Exchanges

Demutualization refers to the legal structure of an exchange whereby the ownership, the management and the trading rights at the exchange are segregated from one another.

In a mutual exchange, the three functions of ownership, management and trading are concentrated into a single Group. Here, the broker members of the exchange are both the owners and the traders on the exchange and they further manage the exchange as well.

The stock exchange was structured as an Association of Persons [AOP] or a Club.

This at times can lead to conflicts of interest in decision making.

A demutualised exchange, on the other hand, has all these three functions clearly segregated, i.e. the ownership, management and trading are in separate hands.

Demutalised exchange is more akin to a corporate with clear focus on segregation of functions, corporate governance, stakeholders interests, profit motive and sustainable growth model.

Two stock exchanges in India, the National Stock Exchange (NSE) and Over the Counter Exchange commenced as demutualised exchange and BSE became demutualised by 2006

• Demutualization refers to the legal structure of an exchange whereby the ownership,  the management and the trading rights
• Demutualization is basically a transition from ‘mutually-owned’ association to company with limited liability owned by shareholders. It involves transforming mutually-owned entity to a business corporation and, subsequently privatizing of company so formed
• Demutualization is mandated by SEBI to address issue of conflict of interest
• Post-demutualization, the stock exchange company has the option to go for listing on the stock exchange

• By separating ownership and trading rights and creating a corporate governance structure, demutualization helps stock exchanges to access capital markets to meet their resource needs

• Advantages of Demutualization:
• Leads to greater investment and innovation
• Takes care of conflicts of interest between brokers and stakeholders.
• Turns a public utility or association into a commercial enterprise, giving  operational freedom to the management
• Would facilitate induction of professional management which would mean greater transparency in operations, accountability and discipline
•  As a corporate entity, the stock exchange would enjoy flexibility in management and access to capital markets to the meet their resource needs and spin-off of divisions or subsidiaries, mergers and acquisitions are easily possible

§  Post demutualization the stock exchange can float its equity and list
     itself on the stock exchange for trading

§    Many professionally-managed stock exchanges are self-listed. For
        example, the New York Stock Exchange (NYSE) is a listed 
        company and trades on NYSE. Other examples of self-listed stock
        exchanges includes Chicago Mercantile Exchange,
         Chicago Board of Trade, Euronext-Liffe, Bursa (Malaysia), London
         stock London Stock Exchange (LSE) and NASDAQ