Investor protection plays an important role in the demand of equity in the market. The concept has to be looked at from different angles taking into account the requirements of various kinds of investors including investors in equity, large institutional investors, foreign investors, investors in debentures, and small investors/deposit holders etc.
It is very well accepted now that weak investor protection increases the cost of external funds, specially the cost of equity. Domestic and portfolio investors are deterrent to hold stocks in countries where minority investor rights are poorly protected. They put corporate governance considerations as the basis of their investment decisions.
The effects on a firm's cash flows are divided between security benefits, which accrue to all shareholders pro-rata, and private benefits, which can only access by controlling shareholders. This division also affects the incentives of different classes of investors to buy stocks and to acquire large stakes.
Wealthy investors select diversification benefits to acquire control of domestic firms in countries with low levels of investor protection. While foreign investors from a country where investors are better protected, prefer to invest in their own country, leading to the familiar home equity bias.
It is found that the demand for equity from controlling shareholders increases when investor protection gets weaker, because it becomes easier to extract private benefits of control. On the other hand, if prices have increased as a consequence of the increased demand from controlling shareholders, then the incentive to invest for portfolio investors has unambiguously decreased.
All-equity portfolio gives superior rate of returns and involves substantial risk-taking
whereas the balanced portfolios offer somewhat less return than the all-equity strategy. However, the returns are still much higher than the benchmark strategy. The shortfall risks involved in these cases are also relatively low.
In India, SEBI has a significant role to play in the capital market regulator in safeguarding the interest of investors. SEBI has developed the framework for Indian capital market in its formative stages subsequent to the liberalization process initiated in the 1990s. Further, there is a need for the framework to develop in a balanced manner, keeping in view the Indian context while enabling best international practices. For this, the regulator must analyze different aspects of capital market operation and the roles played by different intermediaries. The interaction amongst them should also be analyzed so that the capital market is able to deliver finance to meet requirements of the corporate sector promptly, in a cost effective manner and in keeping with the changing requirements of new business models.
Derivatives are financial instruments whose value is entirely "derived" from the value of the underlying asset like securities, commodities, bullion, currency, and live stock. It is categorized into different kind of hybrid contract like forward, future, option, etc.
Investor protection in derivatives requires to be focused on four aspects such as:
Fairness and Transparency: This means that the trading rules should ensure that trading is conducted in a fair and transparent manner. Sales practices adopted by dealers for derivatives would require specific regulation. Regulations are needed to be designed to control the inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging.
Safeguard for clients' moneys: Money and securities deposited by clients with the trading members should be kept in a separate clients' account and should be attachable for meeting the broker's own debts. Again, it should be verified that trading by dealers on own account is totally segregated from that for clients.
Competent and honest service: The criteria for selecting trading members should be designed to encourage competent and qualified personnel so that investors/clients are served well. This in turn will necessitate the requirement to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base.
Market integrity: The trading system should make sure that the market's integrity is safeguarded by minimizing the possibility of defaults. This needs framing appropriate rules about capital adequacy, margins, clearing corporation, etc.