Financial Intermediaries: Meaning, Role and Types

Have you ever actually seen the credit roll at the end of a film? A majority skip the long list of names without much thought. Here’s the truth -  That is only a part of the original number of folks who have put effort into giving you the brilliant cinematic experience you’ve just enjoyed. Any ‘production’ involves multiple skilled resources working in your best interest. The same holds true for the share market. 

In stock markets, financial intermediaries work together seamlessly to ensure your experience of buying or selling shares (more complex than movie-watching) is glitch-free, fast, and safe. Though many of these intermediaries fulfil their responsibilities quietly (in fact, you might not even know they exist), they comply closely with SEBI’s regulations to create an efficient trading ecosystem. Hence, they constitute an important part of the Indian financial system and contribute to economic growth.   

Let’s understand what they do in more detail.  

• Registrar  

When a company decides to go public or raise capital from the common man, it first issues shares in the primary stock market through an initial public offering (IPO). Once their IPO application is accepted, institutional or individual investors like you can buy their shares. And that is where a registrar comes into play, as they meticulously maintain the company’s stock records and shareholder information. Here is what they do: 

• Collect applications from investors and track them carefully. 
• Oversee the process of allotting shares to interested investors (as the number of shares is limited) and send allotment letters as well. 
• Ensure that the outstanding number of shares (those currently held by shareholders) is never greater than the number authorised by the company. 
• Track all issued shares and outstanding shares, with a record of the ownership of the shares.
• Decide which shareholders will receive stock dividends and who will receive cash payouts. 

• Underwriter 

Like registrars, underwriters are intermediaries who also work mainly with IPOs. To determine a fair price for the share issued for the first time by a company, underwriters assess the risk surrounding an investment. They collect relevant information and study market trends to evaluate a company’s financial situation and gauge whether the IPO will be viable and beneficial in the long run. They:

• Leverage their in-depth financial knowledge and expertise to protect the interests of all parties involved. 
• Classify and rate a risk, and determine whether it is acceptable or not. 
• Ensure all regulatory requirements are met and set the share price. 
• Buy shares that don’t get sold at the price set or don’t receive enough subscriptions, and later sell them to other investors. 

• Merchant Banker 

In simple terms, merchant bankers are entities that enable companies to raise funds in the primary share market by helping with the IPO process. Floating an IPO can be especially challenging for an SME or start-up, which makes the role of a merchant banker crucial. Axis Bank, JPMorgan Chase, and Edelweiss Capital are among the bankers operating in India. These entities offer financial, strategic, and valuation-related advice to issuing companies and act as intermediaries between potential investors and the company. 

Let’s understand their responsibilities in more detail: 

• Preparing the applicant company:

Merchant bankers help create an appropriate capital structure and IPO plan. They ensure that the applicant company adheres to corporate governance practices and obtains an International Securities Identification Number (ISIN) from depositories like NSDL and CDSL. Merchant bankers educate the company on everything that goes into a successful exchange listing. 

• Appointing intermediaries:

Merchant bankers connect the applicant company to other intermediaries, like underwriter, registrar, compliance officer, depository, statutory auditor, legal advisor, etc. However, the banker first assesses the capability of each intermediary. 

• Conducting due diligence:

To make sure any information in the public domain and documents provided by the applicant are authentic, merchant bankers conduct extensive research. They check the company’s eligibility for the stock exchange in terms of net worth, minimum assets, profitability, operational existence, and so on. The bankers also meet legal advisors, managers, and auditors before sending regulators the due diligence report.

• Prepare Draft Red Herring Prospectus (DRHP):

The DRHP and prospectus cover details about the company’s operations, business model, future plans, financial performance, risks, etc., so that investors can make informed decisions.    Merchant bankers are responsible for conducting due diligence and studying the financial records of their clients to prepare the DRHP. They draft the final prospectus once the DRHP is approved, besides posting the documents on the IPO offering on their website. 

• Fixing the IPO issue price:

After analysing the issuing company’s IPO demand in the market, financial reports, earnings per share, and other relevant parameters, merchant bankers set the IPO issue price. 

• Ensuring the issue is completely underwritten:

After appointing underwriters, merchant bankers make sure that the issuing company’s IPO is fully underwritten, as per SEBI’s guidelines. A certain percentage of the IPO subscription amount is deducted from the banker’s account. This serves as a show of confidence in the success of the IPO and also as a financial guarantee of immediate fund availability for the issuing company in case, there are challenges in selling all the shares in the IPO.  The deduction, additionally, helps meet SEBI guidelines around requirements to demonstrate financial commitment to the process.

• Attracting public attention:

Generating demand for the IPO is a vital responsibility of merchant bankers, who leverage PR activities, announcements, public advertising, and roadshows for the same. This is especially helpful for small and mid-sized companies. 

• Making the market:

Once the shares are issued, merchant bankers develop the market for them and address any liquidity problems that the issuing company might face. They ensure that any market order gets executed at the quoted quantity and price. 

Credit Rating Agency 

When a company issues shares in the stock market to raise funds, they are essentially like a borrower or debtor. So, before an investor like you (who is basically lending money to the company) buys the shares, you must know if the investment is worth the risk. This is where financial intermediaries like credit rating agencies step in to assess the creditworthiness of the company and their shares so that you can gain the necessary confidence and protect your interests before making a purchase. 

Before assigning a rating, these agencies study the business and its operations, cash flow, management quality, market position, technology, industry, and the economy. ICRA, CRISIL, and CARE are some of the well-known credit rating agencies. Here is how they benefit different players:   

• Investors:

Credit rating agencies help investors make share trading decisions by offering a clear picture of the associated risk and regularly updating the rating. They help investors gauge the issuer’s financial strength and comprehend the investment proposal. Investors get to save a lot of effort and time, as these agencies do all the necessary analysis. 

• Issuers:

These agencies enable the issuing company to establish an accurate image in the share market, generate brand awareness (especially if they are start-ups or in early stages), and garner investor trust. If they are deemed low-risk, the company can raise capital even at a modest return rate. 

• Other financial intermediaries:

Since credit ratings can be easily understood by the common man (for example, an investor with a low-risk appetite will choose a share with an AAA rating even if expected interest is low), other intermediaries won’t need to waste time on explaining returns and risks to their clients. When investors think independently, it eases the task for advisors, too.  

• Regulators:

Credit rating agencies give regulators a clearer picture of an issuing company by collating and analysing both qualitative and quantitative information, which ensures transparency. This way, regulators can easily identify companies that are performing well and those that are not. It also helps them take necessary action against defaulting issuers.   

Debenture Trustees 

A debenture, also known as a bond, is issued by a company to raise capital from institutions and the general public. The company promises to pay a certain interest against it. So, if you subscribe to these bonds, a debenture trustee ensures that the issuer honours their promise and that your rights are protected. In India, almost all banks play this role. The responsibilities of a debenture trustee usually include:  

• Ensuring that those who hold debentures get their principal and interest payments on time.  
• Tracking the performance of the company issuing debentures by studying parameters like profitability, liquidity, and financial health. Trustees can undertake necessary action to protect debenture holders in case the performance declines. 
• Ensuring that the company issuing debentures is complying with relevant agreements and regulations, so there is no legal breach. 
• Holding security and ensuring that it is maintained and enforced appropriately in case the issuing company fails to fulfil its obligations. The trustee can also take legal steps on behalf of debenture holders if the company defaults.  
• Providing debenture holders with relevant information related to the debenture, including maturity date, rate of interest, security offered by the company, etc.  

• Acting as the medium of communication between the issuing company and debenture holders. 

Depositories and Depository Participants 

Purchasing a share of a company means you can claim ownership of a certain percentage of the business. However, you need to prove the same, which means you need some sort of documentation. Though there was a time when companies issued physical certificates and shareholders maintained the same (till 1996, to be precise), it became inefficient over time. So, today, you get to hold shares in dematerialised or electronic form in Demat accounts. 

As it is crucial to monitor and regulate such accounts, SEBI introduced the concept of depositories. These are secured digital vaults that facilitate trading apart from holding your shares, which makes them a crucial financial intermediary. In other words, a depository account is a Demat account where your shares sit after you purchase them. Also, your Demat account and the trading account of your broker are interlinked. 

So, here is what happens when you want to buy or sell shares:  

• Say, you want to buy the shares of a certain company XYZ. Once you inform your broker about the same, they will open the trading account, check XYZ’s share prices, and make the purchase. Your trading account’s role is over once the transaction is complete. Your Demat account will be credited with XYZ’s shares automatically.  
• In case you wish to sell XYZ’s shares, your broker will log in to the trading account, check the price, and do the needful. They will debit the shares you were holding from your Demat account since the trading and Demat accounts are linked.  

Now, let’s take a look at how the existence of depositories helps in different ways. 

Advantages of Depositories:

• Dematerialisation:

Since they convert physical certificates into an electronic format, depositories remove inefficiencies and risks like forgery, theft, loss, and transfer delays.    

• Centralised maintenance of records:

Depositories handle the centralised recordkeeping of all the securities held by investors like you. Details such as transactions, holdings, and so on are included in the records, which minimises administrative complexities.  

• Electronic settlement:

Depositories facilitate the seamless exchange of securities between buyers and sellers electronically. When a trade takes place on a stock exchange, depositories make sure that the shares are transferred from the seller's Demat account to the buyers without any hassle. This also reduces counterparty, settlement, and systemic risks.  

• Corporate actions:

Depositories are also responsible for ensuring that investors get benefits like bonus issues and dividends on time and accurately.  

• Interoperability:

Depositories work in tandem with stock exchanges as well as clearing corporations to ensure fuss-free settlement between different participants in the market, irrespective of where the trade occurs.  

Depositories in India 

There are two in our country:

• National Securities Depository Limited (NSDL)
• Central Depository Services (India) Limited (CDSL)

There are no differences between them and both are under SEBI’s regulatory purview. 

However, it is not possible to open a Demat account by interacting with the CDSL or NSDL directly. You need to get in touch with a depository participant (DP), who can help you create a Demat account. In other words, they are regulated by the SEBI and act as a bridge between you and a depository. Most banks and some stockbrokers play the role of DP in India.

List of Depository Participants in India:

Stockbrokers 

Even before we tell you all there is to know about stockbrokers, it is common knowledge that stockbrokers are a crucial financial intermediary acting as the bridge between you (the investor) and the stock exchange. As per SEBI, only those stockbrokers who are registered can carry out trades, which is why all stock exchanges offer a license for brokers. Also, remember that an individual is not allowed to place a stock order directly on the exchange since tracking and controlling the trade quality would become impossible. 

So, essentially, a stockbroker helps you invest in shares, bonds, mutual funds, and ETFs in the stock market, after you open a trading account with them. You can ask these questions before picking a broker: 

• Is the broker’s platform simple and easy to understand?
• Does the broker offer an efficient support system? 
• Is it easy to access trade books, profit and loss reports, tax documents, etc.? 
• What is the broker’s net worth, and are they profitable? 
• Does the broker offer investor education initiatives? 

After selecting a broker and setting up Demat and trading accounts, you can start stock trading. However, make a note of the following ways in which you can communicate with the broker: 

• Call the broker, use your account code or client code to identify yourself, and then place a transaction order. The broker will execute and confirm the same on the call itself. 
• The broker will help you access the market through a trading terminal, and once you log in, you can go through live price quotes and place an order on your own. 
• In case you are tech-savvy, you can ask brokers to provide you with APIs and pay them a fee. 

So, a stockbroker makes your life easy as an investor in the following ways:

• Helping you to access markets and enabling transactions 
• Educating you on markets, addressing your questions, and offering support in terms of trade and call
• Issuing contract notes that provide details of the transactions you have conducted during a day
• Facilitating the transfer of funds from your trading to your bank account or vice versa 
• Offering you a back-office where you can access insightful account-related reports

Since different brokers charge different fees or brokerage, research, compare, and then choose one that offers services worth your money.

Foreign Institutional Investors (FIIs) 

Such investors might include foreign corporations, funds, and individuals interested in investing in India. Since their transactions involve substantial amounts of money, their activities tend to affect the overall cash inflow and market sentiment. FIIs are regulated by SEBI in our country, and the Reserve Bank of India (RBI) decides the level of participation from such investors. FIIs might include foreign mutual funds, trust funds, hedge funds, pension funds, and so on. These intermediaries shape the stock market and the Indian financial system in the following ways: 

• FIIs impact the volatility of stock markets as when they increase investments, the capital market index shoots up. The opposite happens when their investments decline. This causes stock prices to fluctuate. 
• Foreign investment drives financial innovation and helps in the development of hedging instruments that can minimise risks and boost stability in financial markets. 
• By ensuring a decent influx of equity capital, FIIs strengthen the capital structure of companies in India and address gaps in investment. They also encourage competition in the financial market and drive overall economic growth.  

Asset Management Companies (AMCs) 

These companies offer mutual fund schemes or pool a substantial amount of money from the general public and invest it in different sectors and varied financial instruments like bonds, stocks, and other securities. The objective is to grow the investments and generate wealth. Reliance Capital, HDFC AMC, and SBI Capital are a few such companies in India. Here is what you need to know about them:  

• AMCs allow investors to diversify investments and spread out the risk in a strategic manner. 
• They understand your financial goals and risk appetite, conduct careful and thorough research, and provide knowledge-backed guidance for the best possible returns. 
• AMCs appoint expert fund analysts and managers to undertake investment decisions for you. They also ensure regulatory compliance, account for all funds, and share regular updates on your fund’s performance. 

Portfolio Managers 

Portfolio managers are somewhat like AMCs and have an in-depth understanding of stock markets. They can help you choose the right mix of investment tools based on your risk profile and goals. They handle portfolios comprising multiple assets, guide you to make strategic investment decisions, and reap the maximum returns possible. Such managers take care of the following:

• Putting together a balanced portfolio to minimise your risk in a volatile market environment. 
• Diversifying by investing in various assets across sectors to hedge against market fluctuations and ensure decent returns in the long run. 
• Rebalancing or returning a portfolio to its initial allocation periodically so you can capture profits and get more scope to grow your wealth. It often involves selling stocks that are priced high to invest in those that are priced low. 
• Portfolio managers purchase undervalued stocks and sell them when there is a spike in their values so you can make more money than expected. They analyse market trends for the same.
• They also manage your fund in such a way that you are guaranteed modest but steady returns in the long term. 

Payment and Settlement Systems 

Payment and settlement systems ensure efficiency and security alongside reducing the cost of transactions. This landscape, comprising both gross and net settlement systems, is regulated by the RBI, so that all parties adhere to standards, norms, and legalities for the sake of transparency and accountability.  These are the common types of payment and settlement systems in use currently:

• Paper clearing, express cheque clearing, cheque truncation system
• Electronic clearing service for bulk electronic transactions 
• Card payments (including credit, debit, and electronic) 
• Real Time Gross Settlement (RTGS)
• National Electronic Funds Transfer (NEFT)
• Immediate Payment Service (IMPS)
• Unified Payments Interface (UPI)
• e-Money 
• Cash 

Owing to the digital revolution, investors have multiple payment and settlement systems to choose from these days. The latest systems facilitate real-time transactions, can be accessed via mobile devices, and are witnessing widespread acceptance. In fact, these systems have pervaded the stock market too, allowing both buyers and sellers to conduct transactions seamlessly and in seconds.  

Crowdfunding Platforms 

Though crowdfunding is a relatively new concept in our country, it works somewhat like a stock market, as a large group of investors can come together to help an entity (individual or company) raise capital and accomplish a specific goal. The term itself is an indication as to how the funding is obtained from the crowd. 

Crowdfunding platforms serve as vital connectors between businesses seeking funds and a wide array of potential investors, expanding their reach beyond traditional sources like family, friends, angel investors, and venture capitalists. These platforms usually operate online, offering greater access and visibility. Crowdfunding in India manifests in various forms, each with its own characteristics and regulations. However, it's important to note that equity-based crowdfunding is not permitted under SEBI regulations.

• Reward-Based Crowdfunding:

This type involves raising funds for projects such as movie promotions, software development, civic projects, or scientific research. Backers are typically rewarded with products, services, or acknowledgements related to the project.

• Debt-Based Crowdfunding:

Here, entrepreneurs or borrowers initiate a campaign to raise funds. Investors contribute with the understanding that the money is a loan and should be repaid with interest.

• Donation-Based Crowdfunding:

In this model, contributions are made towards social or personal causes without any expectation of financial return. Common causes include medical expenses, disaster relief, and other charitable endeavours.

• Litigation Crowdfunding:

This confidential form of crowdfunding is used to raise funds for legal cases. If the case is won, investors are repaid as per the agreed terms.

Ketto, Milaap, and Rangde are among some well-known crowdfunding platforms in India. 

Banks 

In the Indian financial system, as well as the stock market, banks have a simple yet vital role to play as financial intermediaries. They facilitate smooth fund transfer between your trading and bank accounts. You can also link more than one bank account to your trading account, for transferring funds and trading. However, it is possible to withdraw funds to only one bank account (also known as a primary account).  

Remember that money obtained through buybacks as well as dividend payments are transferred to the primary account. The latter is not only linked to your trading account, but also to transfer agents, the depository, and the registrar. Though a Demat account is offered by a depository, a trading account by a broker, and a bank account by a bank, all three are interconnected to give you a hassle-free experience. 

Among banks, it is also important to highlight the role played by custodian banks. These entities hold securities in the physical or electronic form on behalf of asset owners or investors, to prevent loss or theft.  The securities they safeguard may include stock certificates, bonds, cash, etc. 

Clearing Corporations 

These corporations ensure that the settlement for every trade or transaction happens properly, safely, and accurately. For instance, say you want to buy one share of the company XYZ, priced at ₹500. That means another investor must be ready to sell you that share at that price. During the transaction, your trading account will be debited by ₹500, while the seller’s account will be credited with ₹500. 

So, here is what the clearing corporation will do:

• Identify the seller and buyer and match the process of credit and debit
• Ensure there is no default from either of the parties (for example, the seller cannot back out after selling)

While you won’t need to directly interact with clearing corporations, know that they are regulated extensively. These entities also play a crucial role in margining, which comes into play when you are trading complicated instruments like options and futures. 

Currently, India has three such clearing corporations:

• Indian Clearing Corporation (ICCL)
• National Security Clearing Corporation (NSCCL)
• Multi Commodity Exchange Clearing Corporation (MCXCCL)

That is enough food for thought in this chapter. We’ll let you digest the expansive nature of the markets and information we’ve provided on the multiple key characters who toil every second to ensure you have a seamless experience when you make your trades.  See you in the next chapter!