Introduction to Depository — why the paper had to go

The system that had to be replaced

Before 1996, buying shares in India meant buying paper. And the paper was the problem.

The earlier settlement system on Indian stock exchanges was highly inefficient and risky. It was characterized by an increased number of bad deliveries, mutilation of share certificates, slow transfer of securities, theft, forgery, and other irregularities.

To see why, split settlement into its two halves. There are primarily two legs to the settlement of securities — one is the transfer of securities and funds, and the second is the transfer of ownership. Both legs were broken.

Leg one — moving the securities. This was done by physical movement of securities, which meant couriers, envelopes and delay.

Leg two — moving the ownership. This is the leg people forget. Owning a share certificate is not the same as being on the company's register. Every transfer involved physical movement of paper securities to the issuer for registration and endorsement of change in ownership on the security certificate. The certificate had to travel to the company, be endorsed, and travel back.

The consequences were exactly what you would expect:

• In most cases the process of transfer took more than the stipulated time in the Companies Act.
• A significant proportion of transactions were recorded as bad deliveries due to faulty compliance of paper work — a signature slightly off, a form filled wrongly, and the whole delivery bounced.
• Costs and delays in settlement went up.
• Liquidity was restricted.
• Investor grievance redress became quite time consuming, and in some cases even intractable.

The Depositories Act, 1996

To obviate these problems, the Depositories Act, 1996 was passed. It provided for the establishment of depositories in the securities market with the objective of ensuring free transferability of securities with speed, accuracy and security.

Memorise the objective in those words — speed, accuracy and security — and the three mechanisms the Act uses to deliver it:

1. Making securities of public limited companies freely transferable, subject to certain exceptions.
2. Dematerialisation of the securities for holding and transfer in the depository mode.
3. Maintaining the ownership records in a book entry form.

The six key features of the Indian depository system

Multi-Depository System. The Depositories Act, 1996 provides for a multi-depository system. There can be various entities providing depository services. The Act deliberately allowed more than one, to ensure that there is competition in the depository services. India ended up with two: National Securities Depository Limited (NSDL) and Central Depository Services (India) Limited (CDSL).

Dematerialisation. The model adopted in India provides only for dematerialisation of securities — a significant step towards a completely paper-free securities market. And note what dematerialisation actually involves: securities issued in physical form are destroyed and an equivalent number of securities are credited into the security holder's beneficial owner's account. The certificate is not stored. It is destroyed.

Depository services through depository participants. The Depositories Act, 1996 provides that the depositories provide their services to the security holders through their agents called Depository Participants (DPs). Their appointment is subject to the conditions prescribed under the SEBI (Depositories and Participants) Regulations, 2018 and other applicable conditions.

Fungibility. In the depository system, the securities in dematerialised form are not identified by distinctive numbers and certificate numbers as in the physical environment. Thus all securities in the same class are identical with each other and are interchangeable. The workbook's own example: all equity shares in the class of fully paid up shares are interchangeable.

Registered Owner and Beneficial Owner. This is the most-tested idea in the chapter, so read it slowly. In the depository system, the ownership of securities dematerialised is vested in the security holder. The depository is recorded as a Registered Owner in the books of the Issuer, and in the records of the depository the security holder is recorded as the Beneficial Owner (BO). He is called the beneficial owner because he is entitled to the benefits arising out of such securities. And crucially: the ownership rights and liabilities rest with the Beneficial Owner. All the rights, duties and liabilities underlying the security belong to the Beneficial Owner.

The depository's name on the company's register is a bookkeeping convenience. It carries no economic interest whatever.

Free transferability of shares. Transfer of shares held in dematerialised form takes place freely through an electronic book-entry system, maintained and operated by NSDL and CDSL, who enable transfer among individual demat account holders.

The six institutions that make it work

The depository system is not one organisation. Several institutions facilitate its smooth functioning and enable issuers of securities to interact with investors in the primary as well as the secondary market:

So what exactly is a depository?

The Depositories Act defines a depository to mean "a company formed and registered under the Companies Act, 1956 and which has been granted a certificate of registration under sub-section (IA) of section 12 of the Securities and Exchange Board of India Act, 1992."

The principal function of a depository is to provide a facility for investors to hold and transfer securities in dematerialised form and in book-entry form. The securities are transferred by debiting the transferor's depository account and crediting the transferee's depository account.

The Bank for International Settlements (BIS) puts it more broadly: a depository is "a facility for holding securities which enables securities transactions to be processed by book entry. Physical securities may be immobilised by the depository or securities may be dematerialised (so that they exist only as electronic records)."

That definition contains two different models, and India chose one of them.

Dematerialisation versus immobilisation

In India, we have adopted the system of dematerialization, as against immobilization which is practiced in some foreign countries.

Immobilisation means a process by which physical securities are held in a licensed central depository for the account of the beneficial owners of such securities, and such immobilized securities can either be transferred by electronic or book entries on the records of a licensed central depository.

So there are two ways to run a depository. India picked the one that removes paper.

Put plainly: under immobilisation the certificate still exists, locked in a vault, and only the record of who owns it moves. Under dematerialisation the certificate is destroyed and nothing physical remains. Both allow book-entry transfer. Only one gets rid of the paper.

In simple terms, a depository is an organisation where securities of an investor are held and transferred in electronic form.

The five layers of law

The operations of depositories in India are regulated primarily under the following legal framework:

1. The Depositories Act, 1996.
2. SEBI (Depositories and Participants) Regulations, 2018.
3. Bye-laws of the Depository approved by SEBI.
4. Operating Instructions of the depository.
5. Prevention of Money Laundering Act, 2002.

Note the ordering — it runs from statute down to day-to-day operating detail, with PMLA sitting alongside as a separate obligation.

What the Depositories Act achieved

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.

For issuer companies, the gain was reduced costs and the effort used in managing their shareholder populace.

For investors: free and instant transferability in a secured manner at lower costs, free from problems like bad deliveries and odd-lots. And one change that mattered more than it sounds — today the tradable lot is reduced to "one unit", which has enabled even a common man to invest money in one equity share or bond or debenture. Before this, shares traded in market lots, so a small investor either bought a whole lot or bought an odd lot that nobody wanted at a fair price. Investors are also spared the problems of preserving securities held in physical form.

The two depositories

How a depository comes into existence

Only a company registered under the relevant Companies Act (as amended) can set up a depository in India, subject to the criteria laid down by the relevant regulations.

Before commencing operations, depositories should obtain a certificate of registration and a certificate of commencement of business from SEBI. Two certificates, not one — and they come in that order.

Eligibility. A depository company must have a minimum net worth of ₹100 crore, plus the other criteria prescribed by SEBI including automatic data processing systems, a network through which continuous electronic means of communication is established, and adequate infrastructure requirements. Ownership of a depository and shareholding in a depository is as per the SEBI (Depositories & Participants) Regulations, 2018.

Registration. As per the provisions of the SEBI Act, a depository can deal in securities only after getting a certificate of registration from SEBI.

Commencement of business. A depository that has got a certificate of registration can act and function as a Depository only if it obtains a certificate of commencement of business from SEBI. For this, it must apply to SEBI within one year from the date of receiving the certificate of registration.

SEBI grants it only if satisfied that the depository has adequate systems and safeguards to prevent manipulation of records and transactions. The matters SEBI examines:

1. Net worth of not less than ₹100 crores.
2. Bye-Laws approved by the Board of SEBI.
3. Automatic data processing systems protected against unauthorised access, alteration, destruction, disclosure or dissemination of records and data.
4. The network connecting depository, participants, issuers and issuers' agents secure against unauthorised entry or access.
5. Standard transmission and encryption formats established for electronic communication of data.
6. Physical or electronic access to premises, facilities, data processing systems, data storage sites including back-up sites, and the communication network controlled, monitored and recorded.
7. A detailed operational manual explaining all aspects of functioning, including the interface and method of transmission of information between depository, issuers, issuers' agents, DPs and beneficial owners.
8. Records protected against loss or destruction, with back-up facilities at a location different from that of the depository.
9. Adequate arrangements including insurance for indemnifying beneficial owners for any loss caused by the wrongful act, negligence or default of the depository, or its participants, or any employee of the depository or participant.
10. That granting the certificate is in the interest of investors in the securities market.
11. The Board shall, before granting the certificate of commencement of business, make a physical verification of the infrastructure facilities and systems established by the depository.

That last one is worth noticing. SEBI does not take the application on trust — someone goes and looks.

Who is a Depository Participant?

A Depository Participant (DP) is described as an agent of the depository, and is a registered entity with SEBI under section 12(1A) of the SEBI Act 1992. They are the intermediaries between the depository and the investors.

The relationship between DP and depository is governed by an agreement between the two under the Depositories Act 1996, SEBI (Depositories and Participants) Regulations 2018, and the Bye-laws of the Depository.

And the registration point, which is a workbook review question: in a strictly legal sense, a DP is an entity registered as such with SEBI under the provisions of the SEBI Act. A DP can offer depository related services only after obtaining a certificate of registration from SEBI. Not from the depository. Not from the exchange. From SEBI.

The wall between depository and investor

Here is a rule with real operational consequence: a depository cannot directly open accounts and provide services to clients.

Any person willing to avail of the services of the depository can do so by opening a demat account through any Depository Participant of a Depository, and needs to acknowledge the "Rights and Obligation Document" provided by the Depository Participant.

That document has a history worth knowing. The term "Beneficial Owner-Depository Participant Agreements" has been replaced with a common document, "Rights and Obligations of the Beneficial Owner and Depository Participant", vide SEBI Circular Ref. No. MIRSD/12/2013, dated 4-12-2013. An agreement each DP drafted became one standard document nobody can vary.

The rights and obligations of depositories, depository participants, issuers and beneficial owners are spelt out clearly in the Depositories Act, the SEBI (Depositories and Participants) Regulations, 2018 and the Bye-laws of the Depository.

The depository's own obligations

Depositories have the rights and obligations conferred upon them under the Depositories Act, the regulations made under it, the Bye-Laws approved by SEBI, and the agreements made with participants, issuers and their R&T agents.

• Every depository must have adequate mechanisms for reviewing, monitoring and evaluating the depository's controls, systems, procedures and safeguards. It should conduct an annual inspection of these procedures and forward a copy of the inspection report to SEBI.
• It must ensure that the integrity of the automatic data processing systems is maintained at all times, and take all precautions so that records are not lost, destroyed or tampered with. In the event of loss or destruction, sufficient back up of records should be available at a different place.
• It should take adequate measures including insurance to protect the interests of the beneficial owners against various types of risks.
• It must extend co-operation to the beneficial owners, issuers and issuers' agents, custodians of securities, other depositories and clearing organisations, as necessary for effective, prompt and accurate clearance and settlement of securities transactions.
• The depository should indemnify beneficial owners of securities for any loss caused to them due to the negligence of the DP. Where the loss is caused due to the negligence of a DP, the depository shall have the right to recover it from such DP.

That last obligation is the investor's real protection, and it is the one candidates get wrong. The investor is made whole by the depository first. The depository then goes after the DP. He is never left to fight his DP alone.

Bye-Laws

A depository is required to make Bye-Laws governing its operations. The Bye-Laws have to be in conformity with the Depositories Act and the regulations made thereunder, and need to be approved by SEBI before becoming effective.

Records a depository must keep

Two different retention periods apply to the same set of documents, and the exam knows it:

The period of maintaining documents under the PMLA was reduced from 10 years to 5 years vide Gazette notification dated January 04, 2013.

The records themselves:

• Records of securities dematerialised and rematerialised.
• The names of the transferor, transferee, and the dates of transfer of securities.
• A register and an index of beneficial owners.
• Details of the holdings of the securities of beneficial owners as at the end of each day.
• Records of instructions received from, and sent to, participants, issuers, issuers' agents and beneficial owners.
• Records of approval, notice, entry and cancellation of pledge or hypothecation.
• Details of participants.
• Details of securities declared to be eligible for dematerialisation in the depository.
• Such other records as may be specified by SEBI.

Every depository shall intimate SEBI the place where the records and documents are maintained.

A depository is also a company. So whether listed or unlisted it must also comply with the Companies Act for maintaining certain registers. The main ones are below.

The seven functions of a depository

(a) Facilitating account opening, modification and closure. An investor must first open an account with a DP registered with a depository. The process of opening a demat account is very similar to that of a bank account. Two freedoms worth noting: an investor has the option of opening an account with several DPs, or opening several accounts with a single DP. He signs and submits an account opening form and an acknowledgement of receipt of the copy of the Rights and Obligation document. The form and contents of the Rights and Obligation document are specified by SEBI.

(b) Facilitating dematerialisation. One of the primary functions of a depository is to eliminate or minimise the movement of physical securities in the market, achieved through demat. Dematerialisation is the process of converting securities held in physical form into holdings in book entry form.

(c) Facilitating account transfer. The depository gives effect to all transfers resulting from the settlement of trades and other transactions between various beneficial owners by recording entries in the accounts of such beneficial owners.

(d) Facilitating transfer and registration. A transfer is the legal change of ownership of a security in the records of the issuer. In the physical world this needed endorsement, execution of a transfer instrument and payment of stamp duty. The depository accelerates the transfer process by registering the ownership of shares in the name of the depository. Under a depository system, transfer of security occurs merely by passing book entries in the records of the depositories, on the instructions of the beneficial owners.

(e) Corporate actions. A depository may handle corporate actions in two ways. In the first case, it merely provides information to the issuer about the persons entitled to receive the corporate benefits. In the other case, the depository itself takes the responsibility of distribution of corporate benefits. Both are permitted — a point the workbook tests directly as a true/false.

(f) Facilitating pledge and hypothecation. Securities held with the depository may be used as collateral to secure loans and other credits. Using depository services for this makes the process very simple and cost effective. But the two depositories do it differently:

(g) Linkages with the clearing system. The clearing system performs the functions of ascertaining the pay-in (sell) or pay-out (buy) of brokers who have traded on the stock exchange. Actual delivery of securities to the clearing system from the selling brokers, and delivery of securities from the clearing system to the buying broker, is done by the depository. For this, depositories and the clearing system should be electronically linked.

Apart from these, the two depositories in India perform a variety of other functions such as providing nomination and transmission facility to investors and IPO-related facilities.