Role and Functions of Financial Intermediaries in Capital Market

A direct interaction between millions of individual savers and thousands of corporate borrowers is practically impossible without trusted institutional bridges.

Financial Intermediaries are the specialized institutions that facilitate capital flow, handle asset transfers, reduce transaction costs, conduct credit ratings, and maintain custody of financial assets in the capital market.

1. What is Financial Intermediation?

Financial intermediation is the process by which an institutional entity pools funds from ultimate savers, transforms maturities and risk profiles, and directs those funds to economic units requiring productive capital.

2. The Indian Depository System: NSDL and CDSL

Before 1996, Indian share trading was plagued by paper-based physical share certificates. Investors suffered from postal theft, forged certificates, physical mutilation, and “bad deliveries” that delayed settlements by up to two months.

To eliminate these risks, Parliament enacted the Depositories Act, 1996, establishing the modern electronic depository architecture:

The Two National Depositories

1. National Securities Depository Limited (NSDL):
   • Incepted: August 1996 as India’s first electronic depository.
   • Promoted by: National Stock Exchange (NSE), Industrial Development Bank of India (IDBI), and Unit Trust of India (UTI).
2. Central Depository Services (India) Limited (CDSL):
   • Incepted: February 1999.
   • Promoted by: Bombay Stock Exchange (BSE), State Bank of India, and other leading commercial banks.

Key Concepts in Depository Operations

• Depository: An organization that holds securities (shares, debentures, bonds, mutual fund units) in electronic, fungible form at the request of the shareholder through an account.
• Depository Participant (DP): An agent of the depository acting as the liaison between the depository and the retail investor. DPs include commercial banks (SBI, HDFC Bank) and stock brokerage firms (Zerodha, Groww, Angel One). An investor opens their demat account with a DP.
• Beneficial Owner (BO): The true underlying investor who owns the economic rights (dividends, voting power) of the shares held in the depository account.
• Fungibility: All securities of the same class in electronic demat form are interchangeable. Unlike paper share certificates that carried unique physical distinctive numbers, demat shares have no distinctive certificate numbers.

Dematerialization vs. Rematerialization

3. Stock Brokers and Sub-Brokers

• Stock Broker: A registered member of a recognized stock exchange (BSE/NSE) holding a valid registration certificate issued by SEBI. Brokers are legally authorized to buy, sell, or deal in securities on behalf of clients or on their own proprietary account.
• Discount Brokers vs. Full-Service Brokers:
  • Full-Service Brokers (e.g., ICICI Direct, Motilal Oswal): Offer comprehensive advisory, research reports, dedicated relationship managers, and branch offices, charging a percentage brokerage on turnover.
  • Discount Brokers (e.g., Zerodha, Groww): Provide pure-play digital execution platforms charging low, flat fees per executed order (e.g., INR 20 per trade) without personalized investment advisory.

4. Credit Rating Agencies (CRAs)

Investors purchasing debt debentures or corporate fixed deposits cannot personally evaluate a corporation’s balance sheet strength or default risk. Credit Rating Agencies provide an objective, professional evaluation of the borrower’s debt-servicing ability:

• CRISIL Limited: Established in 1987 as India’s pioneer credit rating agency.
• Benefits to Market:
  • Protects investors from committing capital to financially distressed corporations.
  • Helps high-rated companies borrow funds at lower interest rates from the market.

5. Merchant Bankers, Custodians, and Portfolio Managers

1. Merchant Bankers (Investment Bankers):
   • Manage public issues (IPOs), advise on corporate financial restructuring, handle mergers, acquisitions, takeovers, and corporate valuation.
2. Custodians of Securities:
   • Institutional entities that physically and electronically safekeep securities, monitor corporate actions (dividends, stock splits), and manage settlements exclusively for institutional investors like Foreign Portfolio Investors (FPIs) and mutual funds.
3. Portfolio Managers:
   • Financial experts registered with SEBI under Portfolio Management Services (PMS) regulations who manage tailored investment portfolios for High-Net-Worth Individuals (HNIs) with a minimum statutory investment threshold (currently INR 50 lakh).

Important Exam Questions for Revision

1. Short Answer Question (3-4 Marks): Distinguish between a Depository and a Depository Participant (DP) with Indian examples.
2. Medium Answer Question (7-8 Marks): Explain the process and advantages of Dematerialization (Demat) for Indian retail equity investors.
3. Long Essay Question (14-15 Marks): Discuss the role, functions, and importance of various financial intermediaries in the Indian capital market, with special reference to Depositories and Credit Rating Agencies.