This article has been written by Rohit Chakraborty, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho and edited by Shashwat Kaushik.

It has been published by Rachit Garg.

Introduction

Capital markets refer to the financial system facilitating the buying and selling of long-term financial assets such as stocks, bonds and other securities on a platform where individuals, companies and governments can raise money by issuing securities and where investors can buy and sell these securities. Capital markets play a critical role in the economy by providing a way for investors to put their money to work and for businesses to access the capital they need to grow and expand.

Background and overview of the capital market in India

Capital markets ensure efficient capital allocation, facilitating economic growth. It is necessary to understand how capital markets work. Capital markets provide a platform to facilitate trade and provide investors with the insights needed to make informed decisions about where and when to invest their money.

Securities markets offer a means of dividing savings and investing into distinct categories.  Financial markets play a vital role in the economy by channelling funds from savers to investors.

The Bombay Stock Exchange Limited (BSE) and the National Stock Exchange Limited (NSE) are India’s two main stock exchanges. The BSE was founded in 1875. It is the oldest stock exchange in Asia. Under the Securities Contracts (Regulation) Act of 1956 (SCRA), the BSE is the first stock exchange to receive permanent recognition from the Indian government. The company is a demutualized entity. The most frequently followed stock market benchmark index in India is the BSE’s equity index, or S&P BSE SENSEX (SENSEX).

1992 saw the establishment of NSE. It is the first electronic trading platform in India with a screen. Several banks and financial institutions founded the NSE to offer:

• Market makers can trade using screen-based, satellite-linked, nationwide online facilities.
• Securities, including debentures, public sector bonds, units, and government securities, are cleared and settled electronically.

The laws, rules, regulations and guidelines applicable to the listing on both of these exchanges are administered by the Securities and Exchange Board of India (SEBI), India’s securities market regulator. The rules and regulations applied to these exchanges are substantially identical.

Classification of capital market

The components of capital markets are:

Commodity market- This segment of the capital market deals with primary products. There are soft commodities, like agricultural products such as coffee, wheat, sugar, cocoa, etc. Hard commodities are mined, such as oil, gold, silver, rubber, etc.

Capital markets- These are the places where debt and equity instruments are bought and sold. Capital markets serve as a conduit for savings and investments between capital providers, such as governments, corporations, and individuals, and capital users, such as retail and institutional investors.

Money market- The money market is for short-term liquidity.

Insurance market- Insurance transfers the risk of loss from one entity to another equitably in exchange for payment in the insurance market. It is a form of risk management primarily used to hedge against the risk of contingent, uncertain losses.

Foreign exchange market- This is a global decentralised market where the main participants are the larger international banks.

Trading on both the exchanges, BSE and NSE, takes place in:

• Equity shares – capital markets;
• Futures and options – derivatives markets;
• Debt securities – debt markets;
• Currency derivatives.

Regulatory framework and legislation

The demand for long-term capital comes predominantly from private sector manufacturers, agriculture, trade, and government agencies. The supply side consists of individuals, corporate savings, insurance savings, banks, specialised financing agencies and the surplus of governments. Regulating this affair, therefore, becomes important to ensure transparency and investor confidence both domestically and internationally.

India’s capital markets are regulated and monitored primarily by:

• Securities & Exchange Board of India (SEBI);
• Department of Economic Affairs, Ministry of Finance, Government of India;
• Ministry of Corporate Affairs, Government of India; and
• Reserve Bank of India.

The regulators draft legislation, issue circulars, notifications, guidelines and regulations from time to time to regulate the securities market in India. They also have the power of oversight over various market participants. The stock exchanges also frame their own rules, regulations and byelaws to regulate the securities market.

The key statutes and regulations governing the securities market are:

The Companies Act of 2013

All the companies listed on a recognised stock exchange must comply with the provisions laid out by this Act, including corporate governance norms. Corporate governance norms include shareholder decision-making processes, auditing standards, etc. These norms ensure transparency for investors in their operations.

The statute deals with issues, allotments, transfers of securities, and various other aspects relating to company management. The statute contains standard disclosures about the public offering of capital, mainly concerning projects and management of the company, information about other listed companies managed by the same management, and risk factors perceived by the management.

The Companies Act also regulates underwriting, use of premiums and discounts on issues, rights and bonus issues, payment of interests and dividends, supply of annual reports, and other information. The statute also provides for insolvency and NCLT/NCLAT provisions.

Securities Contracts (Regulation) Act of 1956 (SCRA)

This statute virtually controls all aspects of securities trading and the running of stock exchanges, directly or indirectly. The aim of the SCRA is to prevent undesirable transactions in securities. The stock exchanges determine their own listing regulations in conformity with the minimum listing criteria set out in the Securities Contract (Regulation) Rules, 1957. The Act gives the Central Government and SEBI regulatory jurisdiction over:

• stock exchanges through a process of recognition and continued supervision,
• contracts in securities, and
• listing of securities on stock exchanges.

A stock exchange is to be recognised only if the conditions prescribed by the Central Government are fully adhered to. Organised trading activity in securities takes place on a specified recognised stock exchange.

Securities & Exchange Board of India Act of 1992 (SEBI Act)

SEBI is provided with statutory powers for:

• protecting the interests of investors in the securities market;
• promoting the development of the securities market;
• regulating the securities market, such as issue and transfer of securities, insider trading, futures and options trading, etc. to protect investors’ interests;
• promote awareness among investors;
• training of intermediaries about the safety of the market;

and all matters connected to the parameters above. The objectives of SEBI have been laid down in the preamble of the SEBI Act.

The Reserve Bank of India Act of 1934 (RBI Act)

The RBI Act exercises concurrent authority over contracts pertaining to the sale and purchase of securities, gold-related securities, money market securities and securities derived from the same, and ready-forward contracts in debt securities.

The RBI Act defines a security as a “bond, debenture, debenture stock, deposit receipt, certificate of deposit, security receipt, unit of a mutual fund or any other instrument of a similar nature, issued by a body corporate or by any other person.” A gold-related security is a security that is linked to the price of gold. A money market security is a security that is issued with a maturity of less than one year. A security derived from a money market security is a security that is created by combining two or more money market securities. A ready-forward contract for a debt security is a contract to buy or sell a debt security at a future date at a predetermined price.

The RBI Act gives the RBI the power to regulate and supervise the trading of securities, gold-related securities, money market securities and securities derived from the same, and ready-forward contracts in debt securities. The RBI can impose requirements on the participants in these markets, such as requirements for capital adequacy, margin requirements, and reporting requirements. The RBI can also take action against market participants who violate the law.

The RBI Act also gives the RBI the power to investigate and prosecute violations of the law. The RBI can impose penalties on market participants who violate the law, such as fines, imprisonment, or both.

The Depositories Act of 1996

This statute provides for the dematerialization of shares, eliminating the risks associated with physical certificates. It allows the electronic transfer of shares from one depository member to another without changing ownership rights over them. The primary objective of the Depositories Act is:

• making securities freely transferable, subject to certain exceptions; all securities are transferable freely in the depositories mode, restricting the company’s right to use its discretion in effecting the transfer of securities;
• dematerialization of the securities in the depository mode; and
• providing for maintenance of ownership records in a book entry form.

The Banking Regulation Act of 1949 

This legislation establishes control over banking infrastructure in India. The Act also aims at protecting the interests of the depositors through provisions like the opening/closing of accounts, deposits and withdrawals, among other things.

The Act was enacted in 1949 in the wake of the banking crisis of the 1930s. The crisis had led to a loss of confidence in the banking system, and the government felt the need to enact legislation to regulate the banking industry and protect the interests of depositors.

The Act establishes a regulatory framework for banks in India. It defines a bank as “any company which transacts the business of banking.” The Act also sets out the powers and functions of the Reserve Bank of India (RBI), which is the central bank of India. The RBI is responsible for regulating the banking system and ensuring the safety and soundness of banks.

The Act also provides for the establishment of a Deposit Insurance Corporation (DIC). The DIC is responsible for providing deposit insurance to depositors at banks. Deposit insurance protects depositors against the loss of their deposits in the event of a bank failure. The Act has been amended several times since its enactment. The most recent amendment was made in 2017. The amendment introduced a number of changes to the Act, including changes to the definition of a bank, the powers of the RBI, and the deposit insurance scheme.

The Banking Regulation Act of 1949 is a vital piece of legislation that plays a key role in regulating the banking industry in India. The Act helps to ensure the safety and soundness of banks, and it protects the interests of depositors.

Prevention of Money Laundering Act of 2002 (PMLA)

It is legislation by parliament to prevent money laundering. The Act contains provisions for confiscation of property derived from money laundering. Anti-money laundering is a set of procedures, laws, or regulations designed to stop/curb the practice of generating income through illegitimate activities or criminal activities such as drug trafficking, terrorist funding or indulging in processes that make the transaction look legitimate.

Know Your Customer Guidelines (KYC Guidelines) have been introduced in the capital market based on this Act. PMLA requires all market participants, intermediaries and other institutions connected to the capital market to maintain a record of transactions done through them, monitor and report suspicious transactions to the Financial Intelligence Unit (FIU), Government of India.

Power and responsibilities of SEBI

SEBI brings out circulars, including master circulars, regulations, rules, etc., from time to time. A few of such regulations are:

• SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (ICDR Regulations)
• SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations)
• SEBI (Substantial Acquisition of Shares and Takovers) Regulations, 2011 (Takeover Regulations)
• SEBI (Prohibition of Insider Trading) Regulations, 2015 (PIT Regulations)
• SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Market) Regulations, 2003 (FUTP Regulations)
• SEBI (Investment Adviser) Regulations, 2013 (IA Regulations)

The regulatory jurisdiction of SEBI extends to corporations in matters related to the issuance of capital, the transfer of securities and all intermediaries associated with the market. SEBI can conduct inquiries, audits, and inspections of all concerns and adjudicate offences under the Act. The Board has the power to register and regulate all market intermediaries and penalise them in cases of violations of the provisions of the SEBI Act and the rules and regulations of SEBI. SEBI has been given full autonomy and authority to regulate and develop an orderly securities market.

SEBI is a quasi-judicial body. The orders of SEBI are appealable before the Securities Appellate Tribunal (SAT) and then to the Supreme Court. SEBI has concurrent powers under the SCRA, along with the Department of Economic Affairs (DEA) under the Ministry of Finance.

Capital markets in India have two interdependent segments, the primary market for   issuers and the secondary market known as the stock market. An active secondary market promotes the growth of the primary market and capital formation since investors in the primary market are assured of a continuous market where they have the option to liquidate their investments.  

The primary market is used by the issuers to raise fresh capital from investors through initial public offerings (IPOs), rights issues or offers for sale (OFS) for the sale of equity or debt. An issuer undertaking an IPO has to apply to one or more stock exchanges, seek in-principle approval for listing its securities, and select one as the “designated stock exchange.” The issuers have to enter into an agreement with a depository for dematerialization before filing the offer document. In India, there are two depositories: Central Depository Services (India) Ltd. (CDSL) and National Securities Depository Ltd. (NSDL).

Trading in equity shares of the issuer begins only after the stock exchanges issue a trading notice in relation to those shares. A listed company can raise additional equity share capital. The method for the same is mentioned under the ICDR Regulations and the Companies Act. There are other necessary requirements but those are beyond the scope of this article.   

Secondary markets provide liquidity to the instruments used by unlisted companies to raise money through trading and settlement on stock exchanges. The players in the primary market are merchant bankers, mutual funds, financial institutions, foreign portfolio investors (FPIs), domestic institutional investors (DIIs) and individual investors. The conditions of a secondary market are:

• transfers real assets into financial assets,
• buying and selling of securities as a method to attract new capital by means of issuing new securities,
• investing money for short and long term periods to derive profit, and
• price determination as means to determine the balance between demand and supply.

Registrars and transfer agents, custodians and depositories are other capital market intermediaries that provide important infrastructural services to both markets.  

Continuing obligations- Pre and Post-Listing Compliances are listed in the SEBI (LODR) Regulations. The LODR Regulations are applicable to listed entities for equity shares, convertible securities, non-convertible debt securities, non-convertible redeemable preference shares, etc. on a recognised stock exchange. The LODR Regulations are based on a broad set of principles, namely the International Organisation of Securities Commission (IOSCO) principles for periodic disclosures. The principles of corporate governance are in line with the principles laid out in the Organisation for Economic Cooperation and Development (OECD).

Market abuse- The FUTP Regulations prohibit any person from using any manipulative or deceptive device for the procurement or sale of any securities of a company. Fraud in the FUTP Regulations is comprehensively defined as:

• an act or omission,
• expression or concealment,
• whether in a deceitful manner or otherwise,
• that persuades any other person to deal in securities,
• whether there is gain or loss, and
• such activities result in market abuse.

Insider trading- Insider dealing in India is governed by the PIT Regulations. The PIT Regulations lay down the framework within which insiders can communicate information and deal in securities. An insider is prohibited from communicating, providing, or allowing access to any unpublished price sensitive information (UPSI) relating to the company or its securities to any person, including other insiders. An insider is also prohibited from communicating such information to any other person to enable trading in the securities of the company. “Insider” has been defined as a person under Reg 2(g) as

• connected person; or
• in possession of or having access to UPSI.

Reg 2(d)(i) defines “connected person” as

• one who, previously for 6 months, was associated, directly or indirectly, with the company in any capacity;
• it includes frequent communication with its officers;
• contractual, fiduciary or employment relationship; or
• by virtue of being a director, officer or employee of the company, or holds any position, including a temporary or permanent professional or business relationship between himself and the company, that allows such persons directly or indirectly to access UPSI or can be reasonably expected to allow such access.

Conclusion

Over time, India’s capital market has seen a rapid increase, becoming one of Asia’s most important financial markets. The Indian stock market is among the world’s largest and is significant in determining economic activity, savings and investments. India’s trading systems provide various features, such as real-time pricing feeds, risk management tools, automated order execution, and portfolio management services, that make it easier for investors to trade in them.   

Several steps have been taken by the Government of India to increase investor confidence and improve the ease of doing business in India. Efforts to reform the equity capital markets in India commenced with the 2018 overhaul of the ICDR Regulations. Several measures have been taken by SEBI to strengthen corporate governance in listed companies through the LODR Regulations and subsequent amendments.

In the case of Harshad Mehta vs. Central Bureau of Investigation (1992), there were instances of how funds were channelled illegally and the stock market was manipulated by those in the money market. The same is the story in Ketan Parekh vs. SEBI (2006). The recent SEBI order in the Baap of Charts case is an example of a lack of awareness among the public about the regulatory issues surrounding the market.

PMLA has been enacted to prevent the channelling of illegal funds for legitimate activities. Several regulations have been brought about by SEBI to plug the loopholes, prevent embezzlement of funds, defraud, prevent unfair trade practices, etc. The IA Regulations are a step in the right direction as far as advisory activities are concerned.

 As with capitalization, the concentration of wealth is a point of concern. Concentration of wealth causes imbalances in society. Investors are earning more and more to increase their profits, so money gets accumulated only in the hands of a few. The regional stock exchanges are affected by the major stock exchanges, as there is a much greater preference to invest in the latter due to its greater liquidity. There is a necessity to regulate the pool of funds with banks as financial scams take place due to private dealings with the banks.

References

• https://blog.elearnmarkets.com/capital-market-regulators/#:~:text=Money%20Market%20Securities%20are%20short,Market%20pitches%20long%2Dterm%20investments.&text=The%20Ministry%20of%20Finance%20
• https://blog.ipleaders.in/overview-of-capital-market-and-its-regulation-in-india-a-critical-analysis/
• https://www.legalservicesindia.com/article/2283/Working-of-Capital-Market-In-India.html
• https://www.taxmann.com/post/blog/basic-primer-to-the-indian-capital-market/ 
• https://egyankosh.ac.in/bitstream/123456789/37983/1/Unit-15.pdf   
• https://www.bsebti.com/blog/capital-markets-in-india-overview-trading-systems-how-they-work
• https://www.investopedia.com/terms/c/capitalmarkets.asp   https://uk.practicallaw.thomsonreuters.com/1-504-9519?comp=pluk&navId=6BEB18586F7D7EED11F9DED3A6E31031&transitionType=Default&contextData=(sc.Default)&firstPage=true
• https://www.sebi.gov.in/legal/regulations/may-2023/securities-and-exchange-board-of-india-issue-of-capital-and-disclosure-requirements-regulations-2018-last-amended-on-may-23-2023-_72390.html      
• https://www.sebi.gov.in/legal/regulations/oct-2023/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirements-regulations-2015-last-amended-on-october-23-2023-_78921.html   
• https://www.sebi.gov.in/legal/regulations/nov-2022/securities-and-exchange-board-of-india-prohibition-of-insider-trading-regulations-2015-last-amended-on-november-24-2022_65864.html     
• https://www.sebi.gov.in/legal/regulations/jan-2022/securities-and-exchange-board-of-india-prohibition-of-fraudulent-and-unfair-trade-practices-relating-to-securities-market-regulations-2003-last-amended-on-january-25-2022-_55604.html

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