Financial markets: functions, structure and the regulatory map

Detail

1. What financial markets do

• Financial market = a place or system where people buy and sell financial claims (shares, bonds, bills, derivatives).
• Main job: moving savings to borrowers.
• Savers (mostly households) have spare money.
• Borrowers (firms and governments) need money to invest or spend.

• Markets link the two directly, without a bank loan in between. This is called direct finance. A bank loan is indirect finance, because the bank stands in the middle.

• Three other functions:

• Price discovery. Buyers and sellers together set the price of a share or bond. The price shows what the market thinks the asset is worth today.
• Liquidity. You can sell an asset quickly and get cash. A liquid market makes people more willing to invest for the long term, because they know they can exit.

• Risk-sharing. One company's risk is spread over lakhs of shareholders, so no single person carries all of it.

• Worked example: price discovery in a bond (Class 12, Money and Banking)

• A bond pays a fixed coupon (yearly interest) of ₹100. It has no end date (a perpetual bond).
• Price of such a bond = Coupon ÷ Market interest rate.
• If the market rate is 10%: price = 100 ÷ 0.10 = ₹1,000.
• If the market rate rises to 12.5%: price = 100 ÷ 0.125 = ₹800.
• Rule: bond prices and interest rates move in opposite directions. When rates rise, old bonds that pay less become less attractive, so their price falls.

2. How financial markets are classified

Basis	Types	Simple meaning
Tenor (how long)	Money market (up to 1 year) vs capital market (over 1 year)	Short-term cash needs vs long-term investment funds
Claim	Debt (bonds, loans) vs equity (shares) vs hybrid (convertibles, preference shares)	Lender vs owner vs a mix of both
Stage	Primary (new issue) vs secondary (trading existing securities)	Company gets money only in the primary market
Venue	Exchange-traded (standard, cleared) vs OTC (over the counter)	Public, rule-bound trade vs a private deal between two parties
Delivery	Spot (immediate) vs derivatives (future contracts)	Buy now vs agree today on a price for a later deal

• Money market = the market for short-term funds (up to 1 year). Examples are treasury bills, call money, commercial paper and certificates of deposit. Banks, the RBI and big firms use it to manage day-to-day cash.
• Capital market = the market for long-term funds, where equity shares, bonds and other securities are issued and traded.
• Primary vs secondary market:
• Primary market. The company sells new shares, for example in an IPO (Initial Public Offering). The money goes to the company.

• Secondary market. Investors trade existing shares among themselves on the stock exchange. The company gets no new money. But a busy secondary market makes the primary market work, because buyers know they can sell later.

• Exchange-traded vs OTC:

• Exchange trades use standard contracts. A clearing corporation stands between buyer and seller, so if one side fails to pay, the other side is still protected.

• OTC deals are custom-made between two parties. This carries counterparty risk (the risk that the other side does not pay).

• Derivative = a contract whose value comes from an underlying asset such as a share, a commodity, a currency or an interest rate. Examples are futures, options and swaps. Derivatives are used to hedge (reduce risk) and also to speculate.

3. Key instruments defined

• Equity share = a unit of ownership in a company.
• It carries voting rights.
• It carries a residual claim: the shareholder gets what is left after all other obligations (workers, lenders, taxes) are paid. So the shareholder earns the most in good years and loses first in bad years.
• Class 7 analogy 1 (restaurant): you borrow from friends to expand your restaurant. In return for a share of profits, they become part-owners.
• Class 7 analogy 2 (chapati): a company is like a big chapati. Each share is one piece.
• Companies issue shares to raise funds. Investors buy them hoping the price will rise, and for dividends (a share of profit paid out).

• Worked example: a company has 1 crore shares. You own 10,000 shares. You own 10,000 ÷ 1,00,00,000 = 0.1% of the company, and you get 0.1% of any dividend paid.

• Preference share = a share that:

• is paid its dividend first, before equity holders;
• gets its capital back before equity holders if the company closes;
• usually has no voting rights.

• It is a hybrid: it has a fixed payment like debt, but it is legally part of share capital like equity.

• Bond (debenture) = a debt instrument. The issuer borrows money and promises fixed interest (coupon) plus return of the principal on a set date. A bondholder is a lender, not an owner.

4. The stock market in India

• Stock market = the market, organised through stock exchanges such as BSE and NSE, where shares and other securities are bought and sold.
• BSE (Bombay Stock Exchange):
• Set up in 1875 as the Native Share and Stock Brokers' Association.
• It is Asia's oldest stock exchange.

• Its index, the Sensex, tracks 30 large companies. It is an index number (Class 11, Index Numbers): its base year is 1978-79 = 100. If the Sensex reads 80,000, the value of these shares is about 800 times their base-year level.

• From paper to screen:

• Class 7 notes that deals were once done on paper tickets.
• Paper share certificates and open-outcry trading (brokers shouting bids on the floor) have given way to computer screens.

• Shares are now held in electronic form in demat accounts (dematerialised accounts, where shares are stored like money in a bank account).

• NSE (National Stock Exchange):

• Set up in 1992.
• Began screen-based equity trading in 1994. This brought all-India access, faster trades and more open pricing.
• Its main index is the Nifty 50.

5. Financialisation of household savings

• Financialisation of household savings = households shifting their savings from physical assets (gold, property) and plain bank deposits into financial assets such as mutual funds, equity, NPS and insurance. This theme runs through the whole topic.
• Why it matters:
• Savings in gold lie idle and add to imports.
• Savings in shares and bonds flow to firms, which then invest and create jobs.

• Households get a chance at higher long-term returns, but also bear market risk.

• Latest official data (Economic Survey 2025-26):

• Share of equity and mutual funds in yearly household financial savings rose from 2% (FY12) to over 15.2% (FY25) [5].
• Individual investors' share in equity ownership reached 18.8% (September 2025). Household equity wealth rose by about ₹53 lakh crore between April 2020 and September 2025 [5].
• 235 lakh demat accounts were added in FY26 (till December 2025), taking the total beyond 21.6 crore [5].
• Unique investors crossed 12 crore in September 2025; nearly one-fourth are women [5].
• The mutual fund industry had 5.9 crore unique investors (end-December 2025). Of these, 3.5 crore (November 2025) came from beyond the top cities, showing that market participation is spreading to smaller towns [5].

6. The regulatory map

Regulator	Domain	Legal basis
SEBI (Securities and Exchange Board of India)	Securities markets, mutual funds, AIFs, credit rating agencies; commodity derivatives since the FMC merger (Sept 2015)	Non-statutory body from 1988; statutory under the SEBI Act 1992
RBI (Reserve Bank of India)	Money market, G-secs (government securities), forex, interest-rate and currency derivatives	RBI Act 1934 and other laws
IRDAI (Insurance Regulatory and Development Authority of India)	Insurance	IRDA Act 1999
PFRDA (Pension Fund Regulatory and Development Authority)	Pensions: NPS (National Pension System), APY (Atal Pension Yojana)	Set up 2003; statutory under the PFRDA Act 2013
IFSCA (International Financial Services Centres Authority)	Single regulator for the GIFT City IFSC	IFSCA Act 2019; set up 2020
MCA (Ministry of Corporate Affairs)	Company law	Companies Act 2013
FSDC (Financial Stability and Development Council)	Coordinates all the regulators	Chaired by the Finance Minister

SEBI

• AIF (Alternative Investment Fund) = a privately pooled fund, such as a venture capital, private equity or hedge fund, for rich or institutional investors.
• Credit rating agency = a firm that grades how safe a borrower's debt is (e.g. AAA = safest).
• How SEBI got its powers:
• Set up in 1988 as a non-statutory body (it had no legal power to punish).
• The Harshad Mehta scam (1992) showed how weak market supervision was.

• SEBI got statutory powers in January 1992 through the SEBI Act, 1992 [3].

• SEBI's legal mandate under the Act has three parts [3]:

• to protect the interests of investors in securities;
• to promote the development of the securities market;

• to regulate the securities market.

• FMC merger:

• The Forward Markets Commission (FMC) used to regulate commodity futures.
• SEBI took over regulation of the commodity derivatives market on 28 September 2015, when FMC merged with SEBI [2][4].
• Reason: commodity derivatives and securities derivatives work in similar ways, so one regulator can apply one set of rules to both [2].

FSDC

• Constituted on 30 December 2010 [6].
• Chair: Union Finance Minister [6].
• Members include the RBI Governor, Finance Secretary, Secretaries of the Department of Economic Affairs and the Department of Financial Services, the Chief Economic Adviser, and the heads of the financial regulators (SEBI, IRDAI, PFRDA, IFSCA) [6].
• Role: watches over the stability of the whole financial system, sorts out disputes between regulators, and pushes financial literacy and inclusion.
• It is a council, not a regulator. It has no statutory powers over markets.
• 29th meeting held in Mumbai (June 2025) [7].

IFSC and IFSCA

• International Financial Services Centre (IFSC) = a zone that serves non-residents in foreign currency under its own separate rules. It is inside India, but for financial rules it is treated like foreign territory.
• India's first IFSC is at GIFT City (Gujarat International Finance Tec-City), Gujarat.
• IFSCA is the unified regulator for financial products, services and institutions in IFSCs. It was created under the IFSCA Act, 2019 and has worked since April 2020 [8].
• Before IFSCA: RBI, SEBI, IRDAI and PFRDA each regulated their own part of GIFT City.

• After IFSCA: one regulator handles everything, which is simpler for foreign firms.

• Exchanges at GIFT IFSC: NSE IX, India INX, and the India International Bullion Exchange (IIBX).

• IIBX is India's first international bullion exchange, launched by the Prime Minister in July 2022 [9].

• Aims: fair price discovery for gold, standard quality and traceable sourcing, and more financialisation of gold in India [9].

• Why GIFT City: to bring back financial business, such as rupee derivatives and offshore funds, that now goes to Singapore and Dubai.

7. When regulators overlap

• ULIP dispute (2010):
• ULIP (Unit-Linked Insurance Plan) = a product that mixes life insurance with market investment, much like a mutual fund.
• SEBI said it was an investment product; IRDA said it was insurance.
• An ordinance gave ULIPs to IRDA.

• This dispute is part of the reason FSDC was created in 2010, as a forum to settle turf fights between regulators.

• Crypto: no single regulator covers crypto assets yet (see section 12 of the parent note).

• The lesson: "hybrid" products that mix insurance, investment and banking fall between regulators. This creates regulatory arbitrage: firms design a product to fit under the softest regulator.

Prelims Hooks

• BSE (1875) began as the Native Share and Stock Brokers' Association and is Asia's oldest stock exchange. NSE was set up in 1992 and started screen-based trading in 1994.
• Money market = up to 1 year; capital market = over 1 year. T-bills and commercial paper are money-market instruments, not capital-market ones.
• A company gets new money only in the primary market. Trading on BSE/NSE is secondary market activity.
• Preference shareholders are paid dividend and capital before equity holders but usually have no voting rights. Equity holders have voting rights and a residual claim.
• SEBI: non-statutory from 1988, statutory under the SEBI Act 1992. It took over commodity derivatives from FMC on 28 September 2015 [2][4].
• G-secs, forex and interest-rate/currency derivatives are regulated by the RBI, not SEBI. This is a common "which of the following" trap.
• FSDC (set up December 2010) is chaired by the Finance Minister, not the RBI Governor, and it is not statutory [6].
• IFSCA (IFSCA Act 2019, working since April 2020) is the single regulator for GIFT City IFSC. IIBX (2022) is India's first international bullion exchange [8][9].
• PFRDA was set up in 2003 but became statutory only under the PFRDA Act 2013. IRDA was created by the IRDA Act 1999.
• Bond price and market interest rate move in opposite directions (price of a perpetual bond = coupon ÷ market rate).

Mains Points

• Financialisation of savings: gains and risks.
• Gain: equity and MF share in household financial savings rose from 2% (FY12) to over 15.2% (FY25), and demat accounts exceed 21.6 crore (Dec 2025) [5]. More long-term capital flows to firms, and India depends less on bank loans and foreign money.

• Risk: new retail investors, many from small towns, may take on risk they do not understand, especially in derivatives. So investor education and SEBI's safeguards must grow as fast as participation does.

• Many regulators vs one super-regulator.

• India uses a sectoral model (SEBI, RBI, IRDAI, PFRDA), with FSDC for coordination.
• Merits: each regulator has deep expertise in its own field.
• Demerits: turf disputes (ULIP 2010), gaps (crypto) and regulatory arbitrage in hybrid products.

• Reforms so far: merging FMC into SEBI (2015) and creating IFSCA as a single regulator (2020) show a trend towards convergence where products are similar [2][8].

• GIFT IFSC and financial sovereignty.

• It aims to bring back rupee derivatives, offshore funds and bullion trade now done in Singapore and Dubai.
• This helps with price discovery in India (IIBX for gold) and creates high-skill jobs [9].

• Challenges: capital controls in India, tax certainty, and competing with established global hubs.

• Market reforms after 1991. SEBI's statutory powers (1992), NSE screen trading (1994), demat holding and clearing corporations cut fraud and settlement risk, shifting trading from paper tickets and open outcry to transparent electronic markets. This is useful for GS-III answers on post-1991 reforms and investment.