2.1 – What is the stock market?
In the previous chapter, we established that investing in equities is vital to generate inflation-beating returns. Having said that, how do we go about investing in equities? Before we dwell further into this topic, it is essential to understand the market ecosystem and the many different entities involved in making our capital market journey smooth.
Just like the way we go to the neighborhood kirana store or a supermarket to shop for our daily needs, similarly, we go to the stock market to shop (read as transact) for investments. The stock market is where all the participants who wish to transact in shares go. Transact means to buy or sell shares in the context of stock markets. The primary purpose of the stock market is to help you facilitate your transactions. So if you want to buy shares of a company, the stock market helps you meet the seller and vice versa.
Unlike a supermarket, the stock market does not exist in a brick-and-mortar form. It exists in electronic form. You access the market electronically from your computer and conduct transactions (buy or sell). It is also important to note that you can access the stock market via a registered intermediary called the stockbroker. We will discuss the stockbrokers at a later point.
India has two stock exchanges – the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). There were many other exchanges earlier, but none of them survived. So when you talk about the stock markets in India, you are essentially referring to either NSE or BSE. Older stock exchanges like Bangalore Stock Exchange (BgSE), Madras Stock Exchange (MSE), Calcutta Stock Exchange (CSE) have either merged with BSE/NSE or shut shop.
2.2 – Market Participants and the need to regulate them
The stock market attracts individuals and corporations from diverse backgrounds. Anyone who transacts in the stock market is called a market participant. The market participant can be classified into various categories –
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- Domestic Retail Participants – These are people like you and me transacting in markets
- NRI’s and OCI – These are people of Indian origin but based outside India
- Domestic Institutions – These are corporate entities in India
- Domestic Asset Management Companies (AMC) – Mutual fund companies like SBI Mutual Fund, HDFC AMC, Edelweiss, ICICI Pru, etc.
- Foreign Institutional Investors – Non-Indian corporate entities. These could be foreign asset management companies, hedge funds, and other investors.
Now, irrespective of who participates in the market, the agenda for all is to make profitable transactions. More bluntly put – to make money.
When money is involved, human emotions such as greed and fear run high. One can easily fall prey to these emotions and get involved in unfair practices. India has its fair share of such unethical practices. Given this, the stock markets need someone who can set the game rules (commonly referred to as regulation and compliance) and ensure that people adhere to these regulations and compliance, thereby making the markets a level playing field for everyone.
2.3 – The Regulator
In India, the stock market regulator is called The Securities and Exchange Board of India, often referred to as SEBI. SEBI aims to promote the development of stock exchanges, protect the interest of retail investors, and regulate market participants’ and financial intermediaries’ activities. In general, SEBI ensures:
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- The stock exchange conducts its business fairly
- Stockbrokers conduct their business fairly
- Participants don’t get involved in unfair practices
- Corporates don’t use the markets to benefit themselves (Satyam Computers) unduly
- Small investors’ interests are protected
- Large investors with mega cash piles should not manipulate the markets
- Overall development of markets
Given the above objectives, it becomes imperative for SEBI to regulate all the entities which are involved in the market. All the entities mentioned below are directly involved in the stock markets. Malpractice by any of the following entities can disrupt what is otherwise a harmonious market in India.
SEBI has prescribed a set of rules and regulations for each entity. The entity should operate within the legal framework as prescribed by SEBI. The specific rules applicable to a specific entity are made available by SEBI on its website. They are published under the ‘Legal Framework’ section of their site.
| Entity | Example of companies | What do they do? | In simpler words |
|---|---|---|---|
| Credit Rating Agency (CRA) | CRISIL, ICRA, CARE | They rate the creditworthiness of corporate and governments | If a corporate (or Govt) entity wants to avail loan (debt financing), CRAs check for creditworthiness and assign a rating, the basis on which other entities can decide to extend a loan or not. |
| Debenture Trustees | Almost all banks in India | Act as a trustee to corporate debenture | When companies want to raise a loan, they can issue debentures against which they promise to pay interest. The public can subscribe to these debentures. A Debenture Trustee ensures that the debenture obligation is honored |
| Depositories | NSDL and CDSL | Safekeeping, reporting, and settlement of clients’ securities | They act like a digital vault for your shares. The depositories hold your shares and facilitate the exchange of your securities. When you buy shares, these shares sit in your Depositary account, usually referred to as the DEMAT account. |
| Depository Participant (DP) | Most of the banks and few stockbrokers | Act as an agent to the depositories | You cannot directly interact with NSDL or CDSL. You must liaise with a DP to open and maintain your DEMAT account. |
| Foreign Institutional Investors (FII) | Foreign corporate, funds and individuals | Make investments in India | These are foreign entities with interest in investing in India. They usually transact large amounts of money, and hence their activity in the markets has an impact in terms of market sentiment. |
| Merchant Bankers | Karvy, Axis Bank, Edelweiss Capital | Help companies raise money in the primary markets | If a company plans to raise money by floating an IPO, then merchant bankers are the ones who help companies with the IPO process. |
| Asset Management Companies (AMC) |
HDFC AMC, Reliance Capital, SBI Capital | Offer Mutual Fund Schemes | An AMC collects money from the public, puts that money in a single account, and then invests that money in markets intending to make the investments grow and generate wealth. |
| Portfolio Managers/ Portfolio Management System (PMS) |
Capitalmind Wealth PMS, Motilal PMS, Parag Parikh PMS | Offer PMS schemes | They work similarly to a mutual fund except in a PMS; you have to invest a minimum of Rs.50,00,000; however, there is no such cap in a mutual fund. |
| Stock Brokers | Zerodha, Sharekhan, ICICI Direct | Act as an intermediary between an investor and the stock exchange | Stock brokers act as a gateway to the stock markets, giving electronic access to stock markets to facilitate transactions. |
We will elaborate on some of these market intermediaries in the next chapter.
Key takeaways from this chapter
- The stock market is the place to transact in equities.
- Stock markets exist electronically and can be accessed through a stockbroker.
- There are many different market participants operating in the stock markets.
- Every entity operating in the market has to be regulated and can operate only within the framework prescribed by the regulator.
- SEBI is the regulator of the securities market in India. They set the legal framework and regulate all entities interested in operating in the market.
- Most importantly, you need to remember that SEBI is aware of what you are doing, and they can flag you down if you are up to something fishy in the markets!
I dont quite understand whats the role of a depository. All the shares are in electronic form. If I buy a share, it should come into my trading account. If I sell a share it should go from my trading account to the buyer’s trading account. This buying and selling and transfer of shares should be facilitated by the stock exchange, of course electronically. What is the role of a depository here? And to add to that why should I interact with the depository through a DP. All transactions are electronic, why shouldnt the end user interact with the depository directly?
Similarly, why couldnt I open a trading account directly with NSE. Why should I need a broker/sub broker? Whatever fees/charges that I pay to broker, I can directly pay to the NSE. Sorry Zerodha…nothing against you 🙂
My colleague Venu Madhav says this –
The depositories has various functions, allowing to hold shares in electronic form is just one of them. A trading account is an account/window through which you execute transactions, after which if the transaction has resulted in an asset creation such asset would be held somewhere. It is electronically held in your demat account. A Demat account, similar to a bank account is a place where your hold your shares in electronic format.
Some other functions of a DP are:
a) Dematerialization – The process of converting material shares into electronic format
b) Transfers & Transmissions – Moving shares from one demat to another
c) Settlement of securities
d) Pledging of dematerialised securities
e) Facilitating Securities Lending & Borrowing
There are brokerages to assist clients to trade through the Stock Exchange.Its similar to how if you’d like to buy vegetables, you’d go to a shop and not to the farmer 🙂 Imagine there were no brokers and you had to deal with the Exchange directly. How many clients can one Stock Exchange cater to? It’d be a monopoly where you’d have to be happy with what you got. Having intermediaries ensures you get better services and products.
Fantastic explanation. Thanks for clarifying
Welcome!
Good explanation
But , for a new comer or i myself had intrested in investing but i really dont understand how it works
Please read through Varsity, I’m sure you will like it and get more confident in markets.
You mentioned that without the intermediaries, there will be a monopoly in the stock markets, and the customer will have to be happy with what he gets, I am curious as to how exactly, this monopoly gets created. How exactly, do intermediaries reduce this? Could you give an example?
Ah…not exactly monopoly. I’m talking about exchanges core competency of ensuring that the markets run seamlessly where every participant is given a similar treatment. Intermediaries help in building this eco system and bringing in new participants.
Thanks a ton.
Stock broker is a part of Depositary Participant entity .Also Stock broker also mentioned as separate entity, which i find bit confusing .Can you please clarify ?
Both entities are different. DP’s job is to store shares in DEMAT. Broker’s job is the facilitate the transaction.
A stock broker and DP can be same?
Yes.
Explained very well sir…..n for brokrage service the example(shopkeeper vs farmer) that you aply is really mind blowing….!!!!!!!
Good luck and happy learning, Rohit!
Awesome explanation…☺️?
Happy learning 🙂
The market participants are necessary to provide better services in this industry. Since there are lot of financial transactions with millions of customer and billions of transactions practically it is not possible to provide services from one entity. So the specific roles and responsibility are allocated to each different entity to expedite the services for the end users, in terms of financial and asset (equity or other instruments ) settlement and also to provide value added services.
Awesome Vinay!
Thanks Karthik/Venu/Vinay
Thanks for that explanation, Vinay.
Hi, it is impossible for a stock exchange to handle clients directly. It is only a facilitator. Like we buy our train tickets from IRCTC since it would not be easy for the Railways Dept to cater to everyone’s buying needs, similarly there has to be stockbrokers who do the due-diligence and get the customers and connect them through the mechanism of a stock market. Since a stockbroker also handles various other services and can be accessed easily we need their presence. We pay a fee as brokerage for receiving such services.
Depositories are those who actually “hold” our shares/securities with them and they are authorized by the govt. A Depository Participant helps the Beneficiaries like you and me to get in and get out our shares by handling our transactions. Only our shares going out and coming is facilitated by Depository Participants while the shares are actually held by the Depositories. Again the problem is volume which just the depositories cannot handle while a DP can handle through their logistics and infrastructure.
Very well articulated Balaji, thanks 🙂
Thanks Balaji
When you say logistics and Infrastructure. What exactly are those?
Depository is Like a Server Computer ( or Central Bank / Bank HO ) Main Entity .
DP is like a Client Computer ( or Bank or Branch ) Members ( Brokers ) .
Your shares are lying in DP A/c ( Demat A/c ) not Trading A/c .
Demat A/c are using only for depositing shares & securities ( Similar to your Bank A/c , there you are depositing money )
Trading A/c is window to Buy & Sell Shares ( Like a Cash counter or ATM or CDM ) in Bank .
We are keeping Funds as Initial margin in Trading a/c , Your trading A/c is linked with demat A/c by a POA for automatic debit & credit securities .
If you are buying amount debited from Trading A/c , Shares will credited in Demat A/c ( DP A/c ) .
If you are selling amount will credited to the Trading A/c & Shares will be debited from Demat A/c ( DP A/c ).
NSE is Stock Exchange .
Brokers are Members of Exchange .
Trades are settling by the entity Clearing Corporation ( NSCCL ) Electronic clearing cordinating with Stockexchanges ,Depostorys Members ( Brokers ) ,DPs , Clearing banks , Custodians etc.
SEBI is the Regulator .
If SEBI is Regulating brokers the clients are also regulating it is very difficult to regulate retailers .
Direct membership available for Foreign Institutions .
Nice explanation . thanks 🙂
As the name suggests, a depository is place where things are stored. In the securities market terms, it is an organization where shares, debentures, bonds, mutual funds are held in electronic form. It does so at the investors/client’s request which is made through a registered DP. Apart from the custodial services a depository also facilitates dematerialisation of securities.
All these services are provided to the client not directly by the depository. It provides these services through its agent referred to as the Depository Participant. These agents ( DP’s) are generally registered with the SEBI. As per the SEBI amongst the others, the three categories of participants who can become a DP are Banks, Financial Institutions and Trading members registered with the SEBI.
Why is zerodha not a Depository Participant?Most other brokers are.
I guess setting up a DP is on the cards, but not sure about the time line.
Hi Jomi,
Initially when we took membership at the Exchanges, our constituent type was of a registered partnership firm. This was because the membership for a partnership firms gets processed faster. As per NSDL & CDSL rules, partnership firms can’t be registered as DP. However we should have our own DP soon.
How much (and why) being a DP matters to the retail clients?
DP is an agent to a Depository. When you buy shares, these shares has to be parked at the Depository account. You are permitted to open a depository account only through a DP. Some trading members like Zerodha are DPs as well, it offers a lot of convenience to clients when you have all accounts in 1 place.
What is the difference between Nsdl&csdl
Both of them are Depositories (in fact there are only 2 depositories in India). No difference between the two.
Both NSDL and CDSL are depositories which hold the investors securities in electronic form. The key difference is , NSDL works for the National Stock Exchange and the CDSL works for the Bombay Stock exchange.
Portfolio Management System-They work similar to a mutual fund except in a PMS you have to invest a minimum of Rs.25,00,000 however there is no such cap in a mutual fund.What do you mean by “Cap” here???
Cap simply refers to a limit. When investing in MF, you can invest any amount you wish (starting from Rs.500/-) where as in PMS service you need to invest a minimum of Rs.25,00,000/-.
It basically means a floor not a cap.
What is the difference between hedge funds and MF? Both of them collect operating capital from individual investors and try to appreciate it by investing in different asset classes, but how do you differentiate them? Are there any hedge funds in the Indian market?
Thank you!
A main difference is with the regulations. Hedge Funds are largely unregulated however a MF is very tightly regulated. Also, the capital that they collect is referred to as a ‘fund’. There are quite a few hedge funds operating in India, suggest you look at AIF category 3 funds.
Hedge Funds are usually reserved for large institutional investors, they have a minimum investment requirement wich is even more than that of PMS. Also, unlike mutual funds, hedge funds employ any and every strategy in order to generate alpha (return), like shorting a stock, using leverage and using derivatives.