What is Dematerialization?

Indian investor community has undergone sea changes in the past few years. India now has a very large investor population and ever increasing volumes of trades. However, this continuous growth in activities has also increased problems associated with stock trading. Most of these problems arise due to the intrinsic nature of paper based trading and settlement, like theft or loss of share certificates. This system requires handling of huge volumes of paper leading to increased costs and inefficiencies. Risk exposure of the investor also increases due to this trading in paper.

Some of these risks are :

Delay in transfer of shares.
Possibility of forgery on various documents leading to bad deliveries, legal disputes etc.
Possibility of theft of share certificates.
Prevalence of fake certificates in the market.
Mutilation or loss of share certificates in transit.
The physical form of holding and trading in securities also acts as a bottleneck for broking community in capital market operations.

The introduction of NSE and BOLT has increased the reach of capital market manifolds. The increase in number of investors participating in the capital market has increased the possibility of being hit by a bad delivery. The cost and time spent by the brokers for rectification of these bad deliveries tends to be higher with the geographical spread of the clients. The increase in trade volumes lead to exponential rise in the back office operations thus limiting the growth potential of the broking members. The inconvenience faced by investors (in areas that are far flung and away from the main metros) in settlement of trade also limits the opportunity for such investors, especially in participating in auction trading. This has made the investors as well as broker wary of Indian capital market. In this scenario dematerialized trading is certainly a welcome move.

Dematerialization or “Demat” is a process whereby your securities like shares, debentures etc, are converted into electronic data and stored in computers by a Depository. Securities registered in your name are surrendered to depository participant (DP) and these are sent to the respective companies who will cancel them after “Dematerialization” and credit your depository account with the DP. The securities on Dematerialization appear as balances in your depository account. These balances are transferable like physical shares. If at a later date, you wish to have these “demat” securities converted back into paper certificates, the Depository helps you to do this.

Depository

Depository functions like a securities bank, where the dematerialized physical securities are traded and held in custody. This facilitates faster, risk free and low cost settlement. Depository is much like a bank and perform many activities that are similar to a bank.

NSDL and CDS

At present there are two depositories in India, National Securities Depository Limited (NSDL) and Central Depository Services (CDS). NSDL is the first Indian depository, it was inaugurated in November 1996. NSDL was set up with an initial capital of US$28mn, promoted by Industrial Development Bank of India (IDBI), Unit Trust of India (UTI) and National Stock Exchange of India Ltd. (NSE). Later, State Bank of India (SBI) also became a shareholder.

The other depository is Central Depository Services (CDS). It is still in the process of linking with the stock exchanges. It has registered around 20 DPs and has signed up with 40 companies. It had received a certificate of commencement of business from Sebi on February 8, 1999.

These depositories have appointed different Depository Participants (DP) for them. An investor can open an account with any of the depositories’ DP. But transfers arising out of trades on the stock exchanges can take place only amongst account-holders with NSDL’s DPs. This is because only NSDL is linked to the stock exchanges (nine of them including the main ones-National Stock Exchange and Bombay Stock Exchange).

In order to facilitate transfers between investors having accounts in the two existing depositories in the country the Securities and Exchange Board of India has asked all stock exchanges to link up with the depositories. Sebi has also directed the companies’ registrar and transfer agents to effect change of registered ownership in its books within two hours of receiving a transfer request from the depositories. Once connected to both the depositories the stock exchanges have also to ensure that inter-depository transfers take place smoothly. It also involves the two depositories connecting with each other. The NSDL and CDS have signed an agreement for inter-depository connectivity.

Depository Participant

NSDL carries out its activities through various functionaries called business partners who include Depository Participants (DPs), Issuing corporates and their Registrars and Transfer Agents, Clearing corporations/ Clearing Houses etc. NSDL is electronically linked to each of these business partners via a satellite link through Very Small Aperture Terminals (VSATs). The entire integrated system (including the VSAT linkups and the software at NSDL and each business partner’s end) has been named as the “NEST” (National Electronic Settlement & Transfer) system.

The investor interacts with the depository through a depository participant of NSDL. A DP can be a bank, financial institution, a custodian or a broker. Just as one opens a bank account in order to avail of the services of a bank, an investor opens a depository account with a depository participant in order to avail of depository facilities.

Benefits of Dematerialization

Transacting the depository way has several advantages over the traditional system of transacting using share certificates. Some of the benefits are:

Trading in demat segment completely eliminates the risk of bad deliveries, which in turn eliminates all cost and wastage of time associated with follow up for rectification. This reduction in risk associated with bad delivery has lead to reduction in brokerage to the extent of 0.5% by quite a few brokerage firms.
In case of transfer of electronic shares, you save 0.5% in stamp duty.
You also avoid the cost of courier/ notarization/ the need for further follow-up with your broker for shares returned for company objection
In case the certificates are lost in transit or when the share certificates become mutilated or misplaced, to obtain duplicate certificates, you may have to spend at least Rs500 for indemnity bond, newspaper advertisement etc, which can be completely eliminated in the demat form.
You can also receive your bonuses and rights into your depository account as a direct credit, thus eliminating risk of loss in transit.
You can also expect a lower interest charge for loans taken against demat shares as compared to the interest for loan against physical shares. This could result in a saving of about 0.25% to 1.5%. Some banks have already announced this.
RBI has increased the limit of loans against dematerialized securities as collateral to Rs2mn per borrower as against Rs1mn per borrower in case of loans against physical securities.
RBI has also reduced the minimum margin to 25% for loans against dematerialized securities as against 50% for loans against physical securities.

What is Dematerialization?