Demat Account for Share Trading

Along with electronic trading, introduction of dematerialization—conversion of physical shares into electronic form--in the mid-90s was the other radical move that changed the character of the Indian market forever, and for the better. 

It gave another leg-up to the Indian market in its quest to rub shoulders with its global counterparts, eliminate frauds by companies and brokers, improve the efficiency of stock exchange clearing houses, reduce brokerage rates and attract more FIIs.

Need for demat

The birth of NSDL was inevitable once the National Stock Exchange commenced operations in November with electronic trading, instead of the open outcry system being followed by rival Bombay Stock Exchange.

Electronic trading made price discovery more efficient, it also sent volumes soaring. There were transactions happening everyday, but all the trades would be cleared once a fortnight. And therein lay the headache for the stock exchanges in settling the trades—ensuring that sellers got their money and buyers, their shares.

Often, truckloads of share certificates would land up at the clearing houses of BSE and NSE. As an experiment, regional clearing corporations were tried out. But that did not work, the main problem being the transportation of physical shares.

Then there was the problem of fake and forged shares. Many foreign institutional investors were reluctant to invest in India because of this problem. Companies were as guilty of forging share certificates as the brokers and other market players. Physical share certificates had distinctive numbers. 

Companies would pledge one set of shares with lenders, borrowing money against them. They would then print another bunch of certificates with the same distinctive numbers, and introduce them in the market through a friendly broker or through one of their own privately-owned companies. They could do so, safe in the knowledge that the original set of shares would be in the custody of the lenders so long as there was no default on the interest payments.

Often, investors would not know if the shares were forged, unless they sent it to the company to get it registered in their name. But many investors never bothered to have the shares transferred to their name, and held it under what was known in market parlance as 'street name.' 

Sometimes the shares would do a few rounds between buyers and sellers before they were eventually sent to the company to be transferred in the buyer’s name. And if the shares turned out to be fake or forged, the onus was on the broker (introducing broker) through whom the seller had sold the shares. The broker would then have to get his client to either replace the shares or return the money. 

That too was quite a task since some clients would quietly vanish after having sold the shares. The broker would then be held responsible for the fake shares. Quite a few small brokers went out of business, paying for the misdeeds of their clients.

Due to the problem of bad deliveries, brokers became wary of accepting clients. The flip side of this was that investors found it difficult to get a good broker. That is because brokers would accept clients only if somebody would recommend them.

The beginning

The enactment of Depositories Act in August 1996 paved the way for establishment of NSDL, promoted by domestic institutions.

The core team at NSDL had the option of going for either immobilisation or dematerialisation. In immobilisation, the physical share certificates remains with the depository in its vault. The depository would acknowledge the shares and make an electronic entry. NSDL chose to follow the example of Japan which had opted for dematerialization, than the US, which had chosen immobilization.

Overcoming challenge

The challenges faced by NSDL as it went about on its mission were threefold.

First was to persuade companies to allow investors the option to hold shares in demat form.

The second was to have a wide network of depository participants by getting banks and brokerages to be its agents, and thirdly to convince investors to hold shares in the electronic form.

NSDL felt that the third part would be the most difficult since traditional investors would not be comfortable with the idea of holding their investments as an electronic entry. But to its surprise, the response to demat was much better than had expected.

NSDL officials met up with many companies to sell them the idea of demat. Many companies signed up in the initial phase, but later the number stagnated. That was because many other companies were skeptical about the concept, and wanted to see for themselves how investors responded to it, before joining it.

The next leg was more difficult: convincing banks to sign up with NSDL as depository participants. In the mid-90s, broking firms suffered from a lack of credibility. So while brokers were keen to sign up with NSDL, that did not help NSDL’s cause since retail investors did not trust the brokers enough to open a demat account with them. 

So NSDL had to get banks on its side to popularise the concept of demat. This was a slow process. It was difficult to explain capital markets to the banks. For some reason, they were averse to the idea of having anything to do with the capital markets. NSDL officials tried telling them that just as they held funds, it (NSDL) held shares. Finally banks saw the point. That was a key turning point for the concept of demat.

Having a large network of depository participants was crucial to the success of dematerialisation. It would have been physically impossible for the NSDL to single-handedly cope with the massive volume of physical shares that had to be dematerialised. Investors would submit physical shares to the depositary participant, which would send those to the company’s transfer agent after notifying NSDL.

It was during the process of dematerialisation that many instances of fake shares came to light, which otherwise would have gone unnoticed. Many companies had more shares in circulation than were legitimately issued by them.

Finally came the investors. Initially, there were two segments on the stock exchanges: the physical segment and the demat segment. In the beginning, liquidity in the physical segment was better, and that in the demat segment was a problem.

This led to a vicious cycle wherein low liquidity discouraged investors from trading in demat shares, which in turn further reduced liquidity.

That is when SEBI stepped in. The regulator ruled that institutional investors could buy the shares in any form. But if they had to sell those shares, it had to be in the electronic form only. That automatically ensured that institutions would dematerialize the physical shares they bought. This helped boost trading volumes in the demat segment. 

Dematerialisation immensely helped reduce the settlement risk and shortened settlement cycles, both of which were critical for upgrading the clearing and settlement system.

And while retail investors were quicker to embrace the idea of electronic shares, the promoters of some of the reputed companies would need prodding from SEBI.

It was only as late as June 2011 that SEBI made it mandatory for promoters of all listed companies to hold shares in the demat form only. Data available with the regulator showed that promoters of nearly 50 percent listed companies, still held shares in physical form. And these included quite a few blue-chip companies and public sector giants.

As of December 31, 2016, the NSDL boasts of a little over 1.5 crore demat accounts. A very low figure for a country like India, which is trying to promote financial instruments over traditional asset classes like gold and real estate.