Nov 16

Depository System in India


Last decade of 19th century will always be seen as the springboard for Indian economy. The Govt. of India after being stung by balance of payment crisis in late 80’s, undertook flurry of reforms which were envisaged in the financial sector regulation, foreign investments and Government control. In spate of these reforms, capital market remained one of the focal areas for overhauling.

Capital market was a marginal institution in the financial market for almost three decades after India’s independence. However, until the reforms the common man kept away from capital markets. Not many companies accessed the capital market and, thus, the quantum of funds mobilized through the market was meagre.

In 1994, National Stock Exchange (NSE) came into existence, which brought an end to the open out-cry system of trading securities which was in vogue for 150 years, and introduced Screen Based Trading System (SBTS). BSE’s On Line Trading System was launched on March 14, 1995. Now the trading in securities is done using screen based trading method on the stock exchange(s) and with this hundreds and thousands of trades started taking place every day.

A major problem, however, continued to plague the market. The Indian markets were literally weighed down by the need to deal with shares in the paper form. Till now, the system of transfer of ownership of securities was grossly inefficient as every transfer was required to be accomplished by the physical movement of paper securities to the issuer for registration and the ownership was evidenced by the endorsement on the security certificate. The process of transfer in many cases took much longer time than two months stipulated in the Companies Act, 1956 or the SCRA.

Problems with Physical Mode of Settlement

A significant proportion of transactions ended up as ‘bad delivery’ due to faulty compliance of paper work, mismatch of signatures on transfer deeds with the specimen records of the issuer or for other procedural reasons. The inherent right of the issuer to refuse the transfer of a security added to the misery of the investors.

The following are some of the major problems faced for physical certificates by the investors:

  1. Inordinate delay in receiving securities after transfer by the companies.
  2. Return of share certificates as bad deliveries on account of signature mismatch or forged signature of transferor or fake certificates.
  3. Delay in receipt of securities after allotment by the companies.
  4. Non receipt of securities.
  5. Procedural delays in getting duplicate shares/ debenture certificates.
  6. Storing physical certificates.

The cumbersome paraphernalia associated with the transfer of securities along with huge paper work, printing of stationary, safe custody of securities, transportation and dispatch added to the cost of servicing paper securities, delay in settlement and restricted liquidity in securities and made investor grievance redressal time consuming and at times intractable.

All these problems had not surfaced overnight but these were compounded by burgeoning trade volumes in secondary market and increasing dependence on securities market for financing trade and industry. The institutions and stock exchanges experienced that the paper certificates are the main cause of investor disputes and arbitration cases. This underscored the need for streamlining the transfer of ownership of securities which was sought to be accomplished by the Depositories Act, 1996.

The Depositories Act, 1996 and its Benefits

The Govt. of India promulgated the Depositories Ordinance in 1995 and both the Houses of the Parliament passed the Depositories Act in 1996. The Act provides a legal basis for establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making the securities of public limited companies freely transferable; (b) dematerializing the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form.

The Depositories Act, 1996 ushered in an era of efficient capital market infrastructure, improved investor protection, reduced risks and increased transparency of transactions in the securities market. It also immensely benefited the issuer companies, in terms of reduced costs and the effort expended in managing their shareholder populace.

Due to the introduction of the depository system, the investors are able to enjoy many benefits like free and instant transferability in a secured manner at lower costs, free from the problems like bad deliveries, odd-lots etc. Today the tradable lot is reduced to “one unit” hence even a common man is able to invest money in one equity share or bond or debenture. Investors are also spared from the problems of preserving the securities held in physical form.

Investor is able to save a lot on account of stamp duty as government has exempted stamp duty on transfer of securities in dematerialized form at present. Other form of transaction costs also come down significantly. For instance, for users of physical paper, transaction costs were halved between 1994 and 1998 while for those using demat mode, transactions costs have come down to one-tenth of previous levels, comparable to those in overseas markets.

The unparalleled success of the introduction of the depository concept in the Indian capital markets is reflected in the on-going successful reduction in the period between trading and settlement, i.e. from T+5 to T+2 rolling settlement. Perhaps, no other single act other than the Depositories Act has had such profound all round impact on every single stakeholder in the Indian capital markets.

What is the concept of Dematerialization and Immobilization?

Conversion of securities from physical (paper) form to electronic form can be achieved by two methods dematerialization or immobilization.

Under the dematerialization method, the securities, issued in physical form are destroyed and exactly equal numbers of securities are created in the depository system, which are credited into the account of the investor. Unlike physical securities, the securities converted into electronic form do not have any distinctive numbers and they are treated as equal and replaceable in all ways i.e. securities in electronic form are fungible. All subsequent transactions (transfer of ownership) of such securities take place in book-entry form by debiting or crediting the respective buyer’s and seller’s demat account.

Under the immobilization method, securities in physical form are given credit and the physical certificates are stored or lodged with an organization, which acts as a custodian – a securities depository. Subsequent transactions in such immobilized securities take place through book-entries.

India has adopted dematerialization method where as immobilization has been adopted by some of the countries like Hong Kong and USA. Japan has adopted both, dematerialization as well as immobilization for achieving a paper-less securities market.

Whether a country has adopted immobilization or dematerialization, the investor has a right to get the securities converted back into physical form through a process called rematerialization, in case of need.

Feb 08

Before Investing in Mutual Fund

A mutual fund is just the connecting bridge or a financial intermediary that allows a group of investors to pool their money together with a predetermined investment objective. When you invest in a mutual fund, you are buying units or portions of the mutual fund and thus on investing becomes a shareholder or unit holder of the fund.

Mutual funds are considered one of the best available investments being very cost efficient and also easy to invest in as compare to others. Thus by pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. But the biggest advantage to mutual funds is diversification, by minimizing risk & maximizing returns.

Mutual funds are set up to buy many stocks as they automatically diversify in a predetermined category of investments, i.e. growth companies, emerging or mid size companies, low-grade corporate bonds, etc. The most basic level of diversification is to buy multiple stocks rather than just one stock.

Regulatory Authorities

To protect the interest of the investors, SEBI formulates policies and regulates the mutual funds. It notified regulations and issues guidelines from time to time. MF either promoted by public or by private sector entities including one promoted by foreign entities is governed by these Regulations.

SEBI approved Asset Management Company (AMC) manages the funds by making investments in various types of securities. Custodian, registered with SEBI, holds the securities of various schemes of the fund in its custody.

The Association of Mutual Funds in India (AMFI) reassures the investors in units of mutual funds that the mutual funds function within the strict regulatory framework. Its objective is to increase public awareness of the mutual fund industry.

Types of returns

There are three ways, where the total returns provided by mutual funds can be enjoyed by investors:

  • Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all income it receives over the year to fund owners in the form of a distribution.
  • If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
  • If fund holdings increase in price but are not sold by the fund manager, the fund’s shares increase in price. You can then sell your mutual fund shares for a profit. Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

Advantages of Investing Mutual Funds:

  • Professional Management: The basic advantage of funds is that, they are professionally managed by well qualified professional. Investors purchase funds because they do not have the time or the expertise to manage their own portfolio. A mutual fund is considered to be relatively less expensive way to make and monitor their investments.
  • Diversification: By purchasing units in a mutual fund instead of buying individual stocks or bonds, investors’ risk is spread out and minimized up to certain extent. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others.
  • Economies of Scale: Mutual fund buy and sell large amounts of securities at a time, thus help to reducing transaction costs, and help to bring down the average cost of the unit for their investors.
  • Liquidity: Just like an individual stock, mutual fund also allows investors to liquidate their holdings as and when they want.
  • Simplicity: Investments in mutual fund is considered to be easy, compare to other available instruments in the market, and the minimum investment is small. Most AMCs have automatic purchase plans popularly known as SIP where investor can reap the benefit of mutual fund by investing as little as Rs. 50 per month basis.

Disadvantages of Investing Mutual Funds:

  • Costs: The biggest source of AMC income is generally from the entry & exit load which they charge from investors, at the time of purchase. The mutual fund industries are thus charging extra cost under layers of jargon.
  • Dilution: Because funds have small holdings across different companies, high returns from a few investments often don’t make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.
  • Taxes: When making decisions about your money, fund managers don’t consider your personal tax situation. For example, when a fund manager sells a security, a capital-gain tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.