Indian Financial System 7

Notes on:

Dematerialization [Demat] of Securities*

Stock Exchanges & Demutualization of Stock Exchanges**

Demat of Securities

• Dematerialization or "Demat" is a process whereby securities like shares, debentures ,bonds, government securities, mutual fund units (even unlisted securities of corporate) etc, are converted into electronic data and stored in computers by a Depository.

• Dematerialisation is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited into the Beneficial Owner’s [BO’s] account with his Depository Participant [DP].

• The process of converting electronic holding to physical form is called rematerialisation. The BO has to fill in the RRF (Remat Request Form) and request  DP for rematerialisation of the balances securities account.

• In the demat process the participants are the Firms (issuer of securities),Investors, Registrar and Transfer Agents  of the Firms[RTA – who can be in-house or outsourced], Depository Participant &
  Depository.

• There is no direct link between the Investors and Depository- the link is through a DP. Also the Firm is linked to the Depository only thru the RTA. The Depository is linked to the Stock Exchanges [thru its Clearing House].

The DP , RTA and the Brokerage House are linked to the Depository

• When a security in physical form is lodged with the DP by an Investor the  same is submitted for demat to the Depository who thru the RTA of the Firm get the security in demat form.

• Similarly in the case of Corporate Action by the Firm the same is processed by the RTA thru Depository to the credit/debit of the Investor’s demat and or Bank accounts with the DP

• When a security in demat form is bought or sold by an Investor it is done thru a broking house and the Investor thru DP and the Firm thru its RTA

And the DP and RTA thru the Depository [ which is linked to the Stock Exchanges] process the securities debit/credit and money credit/debit in the respective demat and bank accounts of the concerned Investors

• A demat account has become a necessity for all categories of investors for as the SEBI under the SEBI (Depository and Participant) Regulations 1996  has  made it  compulsory for trades in all listed scrips to be settled in demat mode (although, trades upto 500 shares can be settled in physical form, physical settlement is virtually not taking place  given the benefits of demat and demerits of physical trading).Further SEBI has taken various policy initiatives to popularize the demat concept. One of them is delivery of demat shares compulsorily for institutional investors and OCBs.

• At the time of demat each security is identified by an ISIN number. ISIN (International Securities Identification Number) is a unique 12 digit alpha-numeric identification number allotted for a security (E.g.- INE383C01018)  by the depository  at the time of admitting such security in the depository system. Different securities issued by the same issuer will have different ISINs [Example Tata Steel equity share and bonds will have different ISIN] as also equity-fully paid up, equity-partly paid up, equity with differential voting /dividend rights issued by the same issuer will have different ISINs.

About BO, DP and Depository

• Beneficial Owner [BO] is a person in whose name a demat account is opened with a Depository thru a DP  for the purpose of holding securities in the electronic form

• Depository Participant DP

Ø  DP  is an agent of the depository who is authorised to offer depository services to investors. Financial institutions, banks, custodians and stockbrokers complying with the requirements prescribed by SEBI/ Depositories can be registered as DP.

Ø  A DP is an agent of the depository through which it interfaces with the investor and provides depository services. There is no direct link between the BO and depository.

Ø  Public financial institutions, scheduled commercial banks, foreign banks operating in India with the approval of the Reserve Bank of India, state financial corporations, custodians, stock-brokers, clearing corporations /clearing houses, NBFCs and Registrar to an Issue or Share Transfer Agent complying with the requirements prescribed by SEBI can be registered as DP.

Ø  Banking services can be availed through a branch whereas depository services can be availed through a DP.

Ø  As on September 30, 2008, a total of 711 DPs (266 NSDL, 445 CDSL) were registered with SEBI

Ø  Following services can be availed of through a DP :

ü  Dematerialisation, i.e. getting physical securities converted into electronic form.

ü  Rematerialisation, i.e. getting electronic securities balances held in a BO account converted into physical form.

ü  To maintain record of holdings in the electronic form.

ü  Settlement of trades by delivering / receiving underlying securities from / in BO accounts.

ü  Settlement of off-market trades i.e. transactions between BOs entered outside the Stock Exchange.

ü  Providing electronic credit in respect of securities allotted by issuers under IPO or otherwise.

ü  Receiving on behalf of demat account holders non-cash corporate benefits, such as, allotment of bonus and rights shares in electronic form or securities resulting upon consolidation, stock split or merger / amalgamation of companies.

ü  Pledging of dematerialised securities & facilitating loans against shares.

ü  Freezing of the demat account for debits, credits, or both.

ü  Internet facilities if  the DP is registered for the same with the depository.

• The process of opening a demat account through a DP of depository is very simple and easy. It is similar to the opening of a bank account.

Ø  Investor has to first choose a DP based on his convenience and the DP's charges.

Ø  Besides submitting an application in the prescribed form, the investor should submit a photocopy of the PAN card along with the original as proof of identity and address proof such as passport, ration card, etc to the DP.

Ø  Before opening the demat account, the investor will have to execute an agreement on a stamp paper to be provided by the DP, which defines the rights and obligations of both, the investor and the DP.

Ø  On opening a demat account, a unique BO ID (Beneficial Owner Identification) Number is allotted, which should be quoted in all future transactions.

Depository

• A Depository is a facility for holding securities, which enables securities transactions to be processed by book entry. To achieve this purpose, the depository may immobilize the securities or dematerialise them (so that they exist only as electronic records).

• India has chosen the dematerialization route. In India, a depository is an organisation, which holds the BOs securities in electronic form, through a registered DP.

• A depository functions somewhat similar to a commercial bank. To avail of the services offered by a depository, the investor has to open an account with a registered DP

• A depository is an organisation which holds securities (like shares, debentures, bonds, government securities, mutual fund units etc.) of investors in electronic form at the request of the investors through a registered Depository Participant.  It also provides following services related to transactions in securities.

Ø  Holds securities in an account

Ø  Transfers securities between accounts on the instruction of the BO account holder

Ø  Facilitates transfer of ownership without having to handle securities

Ø  Facilitates safekeeping of securities

• A demat account can be opened only though a DP registered with a depository .The investor has a choice to open another demat account with any DP linked to any depository. The investor can have more than one demat account and it can be with Nil balance of securities
•  
• At present two Depositories viz. National Securities Depository Limited   (NSDL) and Central Depository Services (India) Limited (CDSL) are registered with SEBI. The minimum networth stipulated by SEBI for a depository is Rs.100 crore

The Depository system has the following benefits to different groups:

·       Benefit to the Country

Ø  The depository system helps the capital market to be more liquid, attracting more foreign investors and is in compliance with international standards, as it creates efficient and risk-free trading environment.

Ø  It minimises the settlement risks and frauds in carrying out transactions in capital markets and thus can restore faith of investors in capital markets.

Ø  It helps to reduce delay in trading practices creating investor friendly atmosphere in the capital markets.

·       Benefit to the Company

Ø  The depository system helps in reducing the cost of new issues due to less printing and distribution cost.

Ø  It increases the efficiency of the registrars and transfer agents and the Secretarial Department of the company.

Ø  It provides better facilities for communication and timely services with shareholders, investor etc

·       Benefit to Brokers

Ø  The depository system reduces risk of delayed settlement.

Ø  It ensures greater profit due to increase in volume of trading.

Ø  It eliminates chances of forgery – bad delivery.

Ø  It increases overall of trading and profitability.

Ø  It increases confidence in investors.

·       The benefits of demat to the investors are enumerated below:-

1.     A safe and convenient way to hold securities

2.     Immediate transfer of securities

3.     No stamp duty on transfer of securities

4.  Elimination of risks associated with physical certificates such as bad delivery, fake securities, delays, thefts etc

5.     Reduction in paperwork involved in transfer of securities

6.     Reduction in transaction cost

7.     No odd lot and/or market lot problem, even one share can be traded

8.     Nomination facility

9.  Change in address recorded with DP gets registered with all companies in which investor holds securities electronically eliminating the need to correspond with each of them separately

10. Transmission of securities is done by DP eliminating correspondence with companies

11. Automatic credit into demat account of shares, arising out of bonus/split/consolidation/merger etc.Easy Corporate actions on securities

12. Holding investments in equity and debt instruments in a single  account

Stock Exchanged & Demutualization of Stock Exchanges

What is stock exchange

• Typically, the majority of an exchange's membership is made up of broker-
   dealer organizations which represent investors in the market place, buying and selling shares on behalf of their clients [the current trend is
   demuatalision of stock exchanges]
• An exchange provides the regulatory oversight and the facilities in which the  brokers work - the space, phone lines, computers, the linkages with other
• In order to provide a secure and regulated trading environment, each
  exchange, acting as a self-regulatory organization, with the rules and
  standards established by say the SEC [ the government regulatory body that  monitors all U.S. securities markets] or SEBI [Securities & Exchange Board  of India]

• Importance of stock exchange
• One of the key advantages is that stock exchanges are an efficient medium  for raising resources and channeling savings from the public by way of issue
   of equity / debt capital by joint stock companies listed on the stock
   exchanges
• The second main benefit is the wide dispersal of information and the need
   to disclose adequate information — not only the quarterly or year-end
   financial results, but also major events that have an impact on the working  of the company
• The third important feature stock exchanges provide the platform for
   secondary market trading in a most transparent manner benefiting all
   investors  and aid in liquidity and price discovery
• Stock exchange like NSE has been playing a catalytic role and has
   significantly contributed to the reforming of the secondary markets in India in terms of microstructure, market practices, trading volumes, use of state-of- the-art technology and by use of satellite communication rapidly expand services across the length and breadth of the country

Future outlook of Stock Exchanges

• With increasing globalization and consolidation amongst exchanges, the
   future of the regional stock exchanges, around 22 in India, is likely to be
   very uncertain and even their very survival is a question mark
• Sebi has permitted the regional exchanges to form subsidiary
   companies, which are akin to super brokers. These companies have
   acquired membership of both BSE and NSE at confessional entry fees
   and permitted their members to trade on the BSE and NSE thus
   increasing trade volumes and business in both BSE and NSE
• The stock markets of the future will have a redefined purpose and
   reinvented architecture due to the advent and widespread use of
   technology. Information and stock price quotations will be available
   almost instantaneously and more importantly investors can act on this data by executing a trade from anywhere at any time
• This new market will bring benefits to investors, listed companies, and
   the economies of countries. Trading will be cheaper, faster and
   settlement will be simpler and with reduced risk
• Raising capital for companies will be easier, thus contributing directly to
   economic expansion.
• The leaders in this new world of investing will be the ones willing to be
   agents of change, to best meet the needs of investors and companies,
   and to do what is best for these two principal stakeholders in the capital
   markets
• If done right, the stock markets of the future will be even better vehicles
   than today in helping companies grow, creating jobs, providing fair
   investment opportunities for people, and in improving economies
• Both the exchanges, BSE and NSE, are visionary, proactive and
   increasingly use leading-edge technologies to effectively compete in the
   global environment.
• In the not-too-distant future, once full capital account convertibility is
   permitted in stock exchanges could well witness an expansion of trading
   volumes with resultant economic benefits to India

Demutualization of Stock Exchanges

Demutualization refers to the legal structure of an exchange whereby the ownership, the management and the trading rights at the exchange are segregated from one another.

In a mutual exchange, the three functions of ownership, management and trading are concentrated into a single Group. Here, the broker members of the exchange are both the owners and the traders on the exchange and they further manage the exchange as well.

The stock exchange was structured as an Association of Persons [AOP] or a Club.

This at times can lead to conflicts of interest in decision making.

A demutualised exchange, on the other hand, has all these three functions clearly segregated, i.e. the ownership, management and trading are in separate hands.

Demutalised exchange is more akin to a corporate with clear focus on segregation of functions, corporate governance, stakeholders interests, profit motive and sustainable growth model.

Two stock exchanges in India, the National Stock Exchange (NSE) and Over the Counter Exchange commenced as demutualised exchange and BSE became demutualised by 2006

• Demutualization refers to the legal structure of an exchange whereby the ownership,  the management and the trading rights
• Demutualization is basically a transition from ‘mutually-owned’ association to company with limited liability owned by shareholders. It involves transforming mutually-owned entity to a business corporation and, subsequently privatizing of company so formed
• Demutualization is mandated by SEBI to address issue of conflict of interest
• Post-demutualization, the stock exchange company has the option to go for listing on the stock exchange

• By separating ownership and trading rights and creating a corporate governance structure, demutualization helps stock exchanges to access capital markets to meet their resource needs

• Advantages of Demutualization:
• Leads to greater investment and innovation
• Takes care of conflicts of interest between brokers and stakeholders.
• Turns a public utility or association into a commercial enterprise, giving  operational freedom to the management
• Would facilitate induction of professional management which would mean greater transparency in operations, accountability and discipline
•  As a corporate entity, the stock exchange would enjoy flexibility in management and access to capital markets to the meet their resource needs and spin-off of divisions or subsidiaries, mergers and acquisitions are easily possible

§  Post demutualization the stock exchange can float its equity and list
     itself on the stock exchange for trading

§    Many professionally-managed stock exchanges are self-listed. For
        example, the New York Stock Exchange (NYSE) is a listed 
        company and trades on NYSE. Other examples of self-listed stock
        exchanges includes Chicago Mercantile Exchange,
        Chicago Board of Trade, Euronext-Liffe, Bursa (Malaysia),  London
        Stock Exchange (LSE) and NASDAQ

• Short Note on Book Building Process

Ø  In 1998 Securities and Exchange Board of India (SEBI) allowed every issuer of equity shares of Rs 250 million and above to have an option to make an issue through the Book Building Process

Ø  Book Building refers to the collection of bids from investors, which is based on an indicative price range, the issue price being fixed after the bid closing date.

Ø  The principal intermediaries involved in a book building process are the company, Book Running Lead Manager (BRLM) and syndicate members who are intermediaries registered with SEBI and eligible to act as underwriters. Syndicate members are appointed by the BRLM.

Ø  The book building process is undertaken basically to determine investor appetite for a share at a particular price. It is undertaken before making a public offer and it helps determine the issue price and the number of shares to be issued.

Ø  The process begins with consultations between issuer company, the fund managers and the institutional investors.

Ø  The above process is used to derive a price-band with a median point at which the demand for the company’s stock is maximum.

Ø  The issuer company, in tandem with the lead manager and the book runner, then fixes a price band for the issue. The investor is informed of the price band and he then bids at a price he thinks appropriate.

Ø  The bidding is done just like an open auction. The bidding period is kept open for at least five working days. The advertisement announcing the bidding contains the date of the opening of the offer and the closing date.

Ø  The issue document contains the name of syndicate members who are entitled to receive the bids. Even the offer document contains the conditions of accepting the bids and the procedure of bidding.

Ø  The bidding centers are electronically connected to maintain transparency and also eliminate the time lag between making and receiving of the bid. Individual and institutional investors have to place their bids only through the ‘syndicate members’ who have the right to vet the bids.

Ø  The bids can be revised innumerable number of times before the issue closes.

Ø  To maintain transparency in the bidding process, at the end of every bidding session the demand for the issue is shown in the graph format on the terminals.

Ø  Once the company gets various bids from the investor, it decides the final price at which it is willing to issue the stock. Since the company has already decided the quantum of funds it wants to raise it finalizes the number of shares it will now price band for the issue . The issue price for the placement portion and offer to the public shall be the same.