FINANCIAL INSTITUTIONS & MARKET

UNIT 3. PRIMARY MARKET

The primary market is where new securities (such as stocks, bonds, or other financial
instruments) are created and sold to investors for the first time. It plays a crucial role in
capital formation for companies and governments by allowing them to raise funds directly
from investors. Let’s explore its key features and the main players involved:

Key Features of the Primary Market

1. Issuance of New Securities:

o The primary market is where securities are issued for the first time. These are
known as Initial Public Offerings (IPOs) for stocks, and can also include
bond offerings, private placements, and rights issues.
2. Direct Fundraising for Issuers:
o In this market, the issuer (a company or government) directly raises funds by
selling securities to investors. The proceeds from the sale go directly to the
issuer.
3. No Trading Between Investors:
o Unlike the secondary market (e.g., stock exchanges), there is no trading
between investors in the primary market. Securities are sold directly from the
issuer to the buyer (investors).
4. Price Determination by Issuer:
o The price of securities in the primary market is typically set by the issuer,
often with the help of investment banks or underwriters. This price is based on
factors like the company's valuation, investor demand, and market conditions.
5. Different Types of Offerings:
o Initial Public Offering (IPO): When a private company offers shares to the
public for the first time.
o Follow-on Public Offering (FPO): When an already listed company issues
more shares to the public.
o Private Placement: Sale of securities to a small group of institutional
investors rather than the general public.
o Rights Issue: An offering of additional shares to existing shareholders,
usually at a discount.
o Preferential Allotment: Shares are issued to a select group of investors, often
at a discounted price.
6. Regulation:
o Primary markets are highly regulated by government authorities, such as the
Securities and Exchange Commission (SEC) in the U.S. or the Securities
and Exchange Board of India (SEBI). This ensures that all offerings are
transparent and protect investors' interests.

Main Players in the Primary Market

1. Issuers (Companies, Governments, and Corporations):

o Corporations: Companies issue stocks (equity) or bonds (debt) to raise funds
for expansion, new projects, debt repayment, or working capital.
o Governments: Governments issue bonds (such as Treasury bonds) to fund
infrastructure projects, social programs, or to bridge budget deficits.
o Municipalities: Local governments may also issue bonds (municipal bonds)
to finance public projects like schools, hospitals, or transportation systems.
o
 2. Investment Banks and Underwriters:
o Investment banks (such as Goldman Sachs, JPMorgan, or Morgan Stanley)
play a critical role in the primary market by underwriting new securities. They
help the issuer set the offering price, market the securities, and ensure
compliance with regulatory requirements.
o Underwriting: Investment banks take on the risk of buying all or a portion of
the new securities and selling them to the public. They either underwrite the
issue entirely or work with a syndicate of other banks to distribute the risk.
3. Investors:
o Retail Investors: Individual investors who buy new securities for personal
investment. They typically participate in IPOs through brokerage accounts.
o Institutional Investors: Large organizations such as mutual funds, pension
funds, insurance companies, and hedge funds. They often buy large quantities
of securities and are usually the first to be offered new issues.
o High Net Worth Individuals (HNIs): Wealthy individuals who may be able
to buy significant amounts of securities during IPOs or private placements.
4. Regulatory Authorities:
o Securities and Exchange Commission (SEC) (USA), Securities and
Exchange Board of India (SEBI), Financial Conduct Authority (FCA)
(UK), and other country-specific regulatory bodies oversee and regulate the
primary market. They ensure transparency, enforce disclosure requirements,
and protect investors from fraud or misconduct.
5. Stock Exchanges (Facilitators of Listings):
o Although securities are first sold in the primary market, exchanges like the
New York Stock Exchange (NYSE), NASDAQ, or Bombay Stock
Exchange (BSE) often play a role in the listing of newly issued securities.
Once the issuance process is complete, the securities are listed for trading in
the secondary market.
6. Brokerage Firms:
o Brokerage firms facilitate access for individual and institutional investors to
participate in primary market offerings. They serve as intermediaries between
issuers and investors by enabling clients to purchase newly issued securities.
7. Securities Depositories:
o Institutions such as Depository Trust & Clearing Corporation (DTCC) in
the U.S. or National Securities Depository Limited (NSDL) in India are
responsible for holding and transferring securities in electronic
(dematerialized) form, ensuring smooth transactions and settlement.
8. Legal and Financial Advisors:
o Legal firms, accountants, and financial advisors assist issuers in ensuring that
all regulatory, compliance, and financial aspects of the offering are in place.
They help prepare necessary documents, such as prospectuses, and offer
strategic advice during the issuance.

Financial Instruments in the Primary Market

In the primary market, various financial instruments are issued by companies and
governments to raise capital. Here’s a simplified overview of the key instruments:

1. Equity Shares (Common Stock): Equity shares represent ownership in a company,

issued through an Initial Public Offering (IPO). Investors become shareholders and can
receive dividends. Companies use this to raise funds for expansion or new projects.

2. Preference Shares: Preference shares give holders priority over equity shareholders in
receiving dividends, though they often lack voting rights. They are used to raise capital while
offering fixed returns to investors.
3. Bonds: Bonds are debt instruments where investors lend money to a company or
government in exchange for regular interest payments and repayment of the principal at
maturity. These are used to finance long-term projects or repay debts.

4. Debentures: Debentures are unsecured loans taken by companies from the public,
offering fixed returns. They can be convertible (into shares) or non-convertible (pure debt).
Companies issue debentures to fund business needs.

5. Government Securities (G-Secs): These are bonds issued by governments to finance

public spending and are considered safe investments. Examples include U.S. Treasury Bonds
or Indian Government Bonds.

6. Treasury Bills (T-Bills): T-bills are short-term government securities with maturities
of less than a year, issued at a discount and redeemed at face value. They help governments
manage short-term cash needs.

7. Commercial Paper: Commercial paper is short-term, unsecured debt issued by

corporations to meet immediate financing needs, such as payroll or short-term liabilities. It’s
typically used by large companies to manage working capital.

8. Certificate of Deposit (CD): CDs are short-term fixed-income instruments issued by

banks, offering a fixed interest rate for a specified period. Banks issue them to raise short-
term capital.

9. Rights Issue: In a rights issue, companies offer additional shares to existing

shareholders at a discounted price to raise capital, often used for business expansion or debt
repayment.

10. Initial Public Offering (IPO): An IPO is when a company offers its shares to the
public for the first time, allowing it to raise funds for business growth, while investors gain
ownership in the company.

11. Follow-on Public Offering (FPO): An FPO is when a publicly listed company
issues additional shares to raise more funds after an IPO, usually to support further growth or
fund new projects.

12. Private Placement: In a private placement, a company sells securities directly to a

select group of investors (e.g., institutions or wealthy individuals), raising capital without
going public.

13. Sovereign Gold Bonds (SGBs): SGBs are government-issued bonds backed by
gold, allowing investors to earn interest and receive the equivalent value of gold at maturity.
These bonds are an alternative to buying physical gold.

Merits of the Primary Market:

1. Capital Formation: The primary market allows companies and governments to raise
fresh capital, which can be used for expansion, infrastructure development, or debt
repayment.
2. Direct Access to Investors: Companies can raise funds directly from investors,
helping them bypass intermediaries and gain immediate access to large sums of
money.
 3. Ownership and Control: For equity shares, companies sell part of their ownership,
which may increase their market value and allow public participation in the business.
4. Wide Investor Participation: The primary market allows both retail (individual) and
institutional investors to participate, providing companies with a diverse source of
capital.
5. Increased Credibility and Visibility: Companies that issue shares or bonds in the
primary market, especially through an IPO, gain public recognition, credibility, and
trust, which can increase brand value.
6. Economic Growth: By providing capital to businesses, the primary market promotes
investment in new projects, job creation, and overall economic growth.

Demerits of the Primary Market:

1. High Cost of Issuance: Issuing securities in the primary market can be expensive due
to fees paid to investment banks, legal advisors, and regulators, along with the
marketing costs associated with the offering.
2. Time-Consuming Process: Preparing for an IPO or bond issuance requires
significant time for regulatory approval, legal documentation, and investor
presentations.
3. Risk of Under-Subscription: If there is insufficient investor demand, a company
may not raise the required capital, leading to under-subscription, which can damage
its reputation.
4. Dilution of Control (for Equity): Issuing equity shares dilutes ownership, which can
reduce control for original founders or existing shareholders.
5. Regulatory Burden: Issuers must comply with strict regulatory requirements, which
can be costly and burdensome. Regular reporting, transparency, and compliance with
market regulations are required post-issuance.
6. Market Volatility Impact: The success of primary market offerings is subject to
market conditions. If market sentiment is negative (e.g., during an economic
downturn), it may result in poor investor participation or lower valuations.

Methods of Floating New Issues

When a company or entity wants to raise capital, it can use various methods of floating new
issues in the primary market. Here are the four main methods:

1. Public Issue (Initial Public Offering - IPO): A public issue, commonly known as an
Initial Public Offering (IPO), is when a company offers its shares or securities to the public for the
first time. The company invites the general public to buy shares at a predetermined price through the
stock market. The capital raised goes directly to the company for expansion or other purposes.

 Key Point
o The company becomes publicly listed on a stock exchange.
o The process is regulated by authorities (like SEBI in India or the SEC in the U.S.).
o The company must comply with transparency and reporting requirements.
 Example: A startup going public through an IPO to raise funds for growth.

2. Offer for Sale: In an Offer for Sale (OFS), existing shareholders (often promoters or financial
institutions) sell their shares to the public, rather than the company issuing new shares. The
shareholders appoint intermediaries (such as investment banks) to sell their shares to the public.
This does not raise new capital for the company, as the money goes to the selling shareholders.
  Key Points:
o The company doesn’t receive funds, but ownership is transferred to the new
investors.
o Often used by large shareholders or venture capitalists to exit their investment.
 Example: Promoters selling part of their stake in a company to the public via an OFS.

3. Rights Issue:

 Definition: A Rights Issue is when a company offers additional shares to its existing
shareholders, giving them the "right" to purchase shares at a discounted price, in proportion
to their current holdings.
 How It Works: The company raises funds by giving its current shareholders the first option
to buy more shares. This is often done to raise capital without issuing shares to the general
public.
 Key Points:
o It ensures that existing shareholders maintain their ownership percentage.
o Typically used to raise funds for specific projects, debt repayment, or expansion.
o Shareholders can choose to either exercise their rights or sell them to others.
 Example: A company offering existing shareholders the option to buy one additional share
for every three shares they hold.

4. Private Placement:

 Definition: In a Private Placement, a company sells securities directly to a select group of

investors, such as institutional investors, rather than through a public offering.
 How It Works: The company raises funds by issuing shares, bonds, or other securities to a
small group of investors, often with fewer regulatory requirements compared to a public
offering.
 Key Points:
o It’s quicker and less costly than an IPO, as it doesn’t involve widespread public
distribution.
o The company can raise capital from high-net-worth individuals, private equity firms,
or other institutions.
o Used by companies that want to raise funds quickly and avoid the complexities of
public offerings.
 Example: A startup raising capital from venture capital firms or a large company issuing
bonds directly to institutional investors.

Problems of Indian Primary Market

1. High Costs of Issuance:

Issuing new securities involves significant expenses, including fees for investment banks, legal
services, regulatory approvals, and marketing. These high costs make it difficult for smaller
companies to access the market and raise capital.

2. Complex and Lengthy Procedures:

The regulatory approval process is often time-consuming and complicated, involving multiple
compliance requirements. This complexity causes delays and can result in companies missing
opportunities during favorable market conditions.
3. Under-Subscription:

During weak market conditions or when there is insufficient demand, companies may not raise the
desired amount of capital, leading to under-subscription. This damages the company’s reputation
and impacts its financial goals.

4. Lack of Investor Awareness:

Many retail investors lack sufficient knowledge about the primary market, which reduces their
participation. This limited awareness among individual investors affects overall demand for new
securities, especially for smaller companies.

5. Market Volatility:

The primary market is sensitive to economic, political, and global factors, leading to frequent
volatility. This uncertainty makes investors cautious and can disrupt the success of new issues.

6. Poor Corporate Governance:

Weak corporate governance and lack of transparency in some companies reduce investor trust.
Concerns about unethical practices make investors hesitant to participate in new issues, lowering
overall demand.

7. Pricing Inefficiencies:

Incorrect pricing of shares, either overvalued or undervalued, affects investor interest. Overpricing
can lead to poor demand, while underpricing results in the company losing potential capital, creating
inefficiencies in the market.

8. Regulatory Hurdles:

Excessive regulatory requirements can be burdensome, especially for smaller companies. While
regulations are essential for investor protection, the complexity and cost of compliance discourage
some companies from entering the market.

9. Lack of Liquidity:

Smaller companies and lesser-known issues often suffer from low liquidity, meaning there is limited
investor interest and trading activity. This makes these issues less attractive and affects their
performance in the market.

10. Overdependence on Institutional Investors:

The market relies heavily on institutional investors like mutual funds and foreign institutional
investors. If they reduce participation, it can lead to under-subscription and marginalize retail
investors, reducing overall market diversity.