Financial Market in India
Financial markets in India comprise in the main, (a) the credit market, (b) the money market, (c) the foreign exchange market, (d) the debt market and (f) the capital market. With banks now venturing into insurance activities, the bancassurance market is poised for significant growth. Additionally, the derivatives market, encompassing both over-the-counter and exchange-traded instruments, has gained prominence. The Indian Financial System plays a pivotal role in the economic development of our nation. Effectively managing the flow of funds between the country’s savers and prudent investors or businessmen, this system ensures the mutual benefit of both parties. Various financial institutions, including banks, insurance companies, and pension funds, collectively constitute the financial system, delivering essential financial services to individuals, partnership firms, and both private and public companies.
The credit market
India’s credit landscape comprises institutional and non-institutional sources. Major institutional credit providers include banks, non-banking financial institutions (NBFCs), development financial institutions (DFIs), and housing finance companies (HFCs). Non-institutional sources encompass moneylenders, indigenous bankers, and trade credit providers. Credit is structured into short-term, medium-term, and long-term categories. While banks and NBFCs primarily address short-term needs, Foreign Institutional Investors (FII) and Foreign Portfolio Investors (FPI) play a crucial role in medium and long-term funding. The actual credit duration depends on factors like the production-sale cycle. Commercial banks in India are classified as commercial banks and co-operative banks, further divided into public sector banks, regional rural banks, and private sector banks, covering both domestic and foreign entities.
Financial Institutions : Financial institutions play a crucial role in the financial services sector, encompassing banks, trust companies, insurance companies, brokerage firms, and investment dealers. Their pursuit of higher returns leads them to lend money to businesses, fostering accelerated growth and increased supply of goods and services. All-India financial institutions (AIFIs) include specialized financial institutions, all-India development banks, refinance institutions, and investment institutions. Among them, all-India development banks (IDBI, IFCI, ICICI, SIDBI, and IIBI) hold a significant position, providing essential medium and long-term project finance to industries, contributing to the efficient allocation of economic resources.
Non-Banking Financial Companies (NBFCs) : Non-Banking Financial Companies (NBFCs) have become integral to various business services, providing essential functions like loans and credit facilities, retirement planning, money markets, underwriting, and merger activities. An NBFC is a company registered under the Companies Act, 1956, engaged in various financial activities, including loans and advances, acquisition of securities, insurance business, leasing, chit business, etc. It excludes institutions primarily involved in industrial or agricultural activities, purchase or sale of goods (other than securities), or providing certain services. NBFCs come in various types, such as investment companies, hire purchase finance companies, loan companies, mutual benefit financial companies, equipment leasing companies (also known as Nidhis), miscellaneous non-banking companies (Chit Funds), and residuary non-banking companies.
Housing Finance Companies (HFCs) : Housing Finance Companies (HFCs) play a crucial role in enhancing urban living by offering affordable housing facilities, including innovative solutions like lease rental discounting. In India, investments in housing primarily come from personal funds, informal credit markets, and the formal sector, which includes funding provided by the Central and State Governments and institutions like GIC, commercial banks, LIC, specialized housing finance institutions, and cooperative banks. Established in April 1970, HUDCO provides loans and technical support to state and city-level organizations. Over 95% of loan disbursements are accounted for by the top 29 leading HFCs with refinance facilities from the National Housing Bank (NHB).
Money Market Structure
Money markets play a crucial role in balancing short-term demand and supply of funds, regulated through monetary policy. Key money market instruments include Call money, Certificates of deposit, Treasury bills, short-term government securities like repos, Bankers’
acceptances, Commercial paper, and Inter-corporate funds. Inter-bank money markets and central bank lending ensure liquidity for banks, while private non-bank instruments like commercial paper and commercial bills provide liquidity to the commercial sector.
Foreign Exchange Market Structure
The foreign exchange market in India consists of three segments: the Reserve Bank, authorized dealers (ADs), and customers. The Reserve Bank of India (RBI) acts as the custodian of the country’s
foreign exchange reserves, managing their investment. Transactions occur first between the RBI and authorized dealers, followed by interbank transactions among ADs. The third segment involves transactions between ADs and their corporate customers. In March 1993, various measures were introduced to broaden and enhance the forex market.
1st : Banks now have the freedom to:
Establish net overnight position limits and gap limits, subject to formal approval by the Reserve Bank.
Engage in trading open positions in overseas markets.
Set interest rates for NRI deposits, with a mandatory link to LIBOR for FCNR(B) deposits,
and maturity periods ranging from one to five years (with a minimum of one year for FCNR(B) deposits).
2nd : Inter-bank borrowings are now excluded from the statutory pre-emption list.
3rd : Banks are authorized to use derivative products for asset-liability management, primarily for hedging purposes.
4th :Authorized dealers are permitted to borrow abroad to enhance the integration of domestic and overseas money markets. However, such external borrowings are subject to careful scrutiny, considering their impact on the dealers’ capital base.
In the Indian forex market, inter-bank transactions exhibit a “day trading” pattern due to restrictions on overnight overbought and oversold positions. Participants engage in day trading to capitalize on intra-day exchange rate movements without violating daily position limits. The forex market is predominantly over-the-counter (OTC), with an average daily volume of approximately USD 33 billion. The Reserve Bank’s active presence aims to maintain orderly market conditions. The Indian exchange rate is influenced by factors such as RBI intervention, inflation, imports and exports, interest rates, and operational dynamics.
Structure of Debt Market
The domestic debt market consists of three primary segments: Government securities, PSU Bonds Market, and Corporate Securities Market, which includes private corporate debt and DFIs bonds. The government securities market is dominant, while the other segments lack depth
and liquidity. Investment instruments entail risks such as credit risk, interest rate risk, settlement risk, and liquidity risk. Corporate papers carry credit risk due to business condition changes, whereas government securities have zero credit risk. Major participants in the debt market include banks, financial institutions, insurance companies, FIIs, and mutual funds.
Government Securities Market : The introduction of auction-based yields has boosted secondary market activity, primarily aiming at creating a price discovery process. Government securities are generally issued at face value. In India, the sale of Government securities occurs through auctions, pre-determined prices, coupons, and tap issues. Auctions are conducted in a discriminatory, multiple price quoted, sealed bid format. To enhance retail market participation and provide greater liquidity to retail investors, the Reserve Bank allows banks to freely buy and sell Government securities on a daily basis at prevailing market prices, removing restrictions on the period between sale and purchase. Types of government securities include Treasury Bills (T-Bills), Treasury Notes, Treasury Bonds, Cash Management Bills (CMBs), and State Development Loans (SDLs), which are debt securities issued by state governments to finance their needs.
Secondary Market Window (SMW) : In the secondary market, government securities are traded after their issuance or sale on primary markets. Central banks are pivotal in the secondary market, acting as price makers by offering two-way quotes through their sales window to enhance liquidity for government securities.
Discount House Arrangements : Discount and Finance House of India (DFHI) was initially established in April 1988 to enhance the money market. A discount house specializes in large-scale trading, discounting, and negotiating bills of exchange or promissory notes, including government bonds and Treasury bills. The Securities Trading Corporation of India (STCI) was formed in May 1994 to develop an efficient institutional infrastructure for an active secondary market in Government securities and public sector bonds. DFHI and STCI later evolved into Primary Dealers (PDs).
Primary Dealer System : The primary dealer system became operational in 1996 with the goal of enhancing the securities market infrastructure and improving secondary market trading, liquidity, and turnover in Government securities. Primary dealers are registered entities with the RBI, holding a license to transact or buy and sell government securities. They buy government securities directly from the RBI with the intention of reselling them to other buyers. In the secondary market, PDs act as market makers, providing continuous two-way quotes to ensure liquidity and support the success of primary market operations. PDs deal in treasury bills, commercial bills, CDs, CPs, short-term deposits, call money market, and government securities.
Satellite Dealers : In December 1996, the Reserve Bank granted registration to nine entities as Satellite Dealers (SDs) in the Government securities market. These SDs are also provided limited liquidity support by the Reserve Bank, and currently, four SDs are in operation. Primary Dealers (PDs) are akin to Merchant Bankers to the Government of India, constituting the first tier of the G-securities market. It’s noteworthy that some SDs have transitioned into PDs. Satellite Dealers collaborate with Primary Dealers, forming the second tier of the market, providing retail outlets to encourage the voluntary holding of Government securities among a wide investor base.
Gilt Funds : Gilt funds are debt funds primarily invested in government securities. The Reserve Bank encouraged the establishment of mutual funds exclusively dealing in gilts, known as gilt funds, to promote mutual fund schemes dedicated to Government securities and broader investor participation. The Reserve Bank provides liquidity support, approximately 20% of the G-Sec investment. Gilt funds are deemed riskier among debt funds, as a sharp fall in interest rates can significantly increase the Net Asset Value (NAV) of a Gilt Fund.
Other Debt Markets : A significant portion of corporate debentures in India falls into the hybrid category, combining characteristics of both debt and equity. Development Finance Institutions (DFIs), supported by the Government of India, primarily invest in the development of the private sector across various projects and sub-sectors to promote job creation and sustainable economic growth. Over the past decade, DFIs have issued bonds with varying maturities, ranging from 1 year to as long as 20 years. Secondary market activity in the debt segment remains low and subdued, both at BSE and the Wholesale Debt Market Segment of the NSE, partly due to a limited number of securities and partially due to a lack of interest from retail investors.