What are Depositories?
Have you ever wondered where the the shares you own/bought are stored? Just like a bank holds your funds, an institution called a depository keeps shares and other securities safe. In this article, we will understand what a depository is, its different types, functions, and its role in the financial markets. Additionally, we will understand a few concepts and topics related to depositories.
What are Depositories?
Depositories are institutions that hold your shares and other securities in an electronic or dematerialised (Demat) form. Brokers are privately owned companies, and entrusting them with your equity shares and other assets is risky. There exists a possibility of brokers engaging in unethical activities using your securities. Depositories exist to prevent such a risk.
A depository acts as a custodian of Demat accounts and shares. Depository participants open Demat accounts, serving as intermediaries between investors and the depository. One can store shares, exchange traded funds (ETFs,) bonds, debentures, certificates of deposits, Government Securities (GSecs), and much more in a depository.
What is Dematerialisation?
Dematerialisation is the process of converting physical paper securities (such as share certificates, bonds, and other financial instruments) into electronic or digital form. In other words, it involves the transformation of tangible paper-based assets into electronic records.
Depositories in India
In India, there are two depositories:
1. National Securities Depositories Ltd (NSDL)
NSDL is the oldest and largest depository in India. It came into existence through the Depositories Act of 1996 and commenced operations in 1996. It was the first depository to provide trading services in electronic format. According to the Securities & Exchange Board of India (SEBI), NSDL has around 2.4 crore active investors, with more than 36,123 depository participant service centres across 2,000 cities.
2. Central Depository Services Ltd (CDSL)
Established in 1999 in Mumbai, CDSL is the second-largest depository in our country after NSDL. It provides services like holding financial securities in the electronic format and facilitating trade and settlement of orders. This depository holds all types of stocks and securities. According to SEBI, CDSL has more than 5.2 crore active customer accounts with around 21,434 depository participant service centres.
In India, every broker must register with at least one of the two depositories. Brokers like Zerodha and Upstox are registered with CDSL, while Sharekhan and Kotak Securities are registered with both NSDL and CDSL. Each broker has a unique 'DP number' from the depository they are registered with. Some brokers are DPs at both NSDL and CDSL.
Functions of Depositories
Depositories act as a custodian for your securities. It securely holds and safeguards securities, including stocks, bonds, mutual funds, and other financial instruments, on behalf of investors. This eliminates the need for physical possession of paper certificates and reduces the risk of loss, theft, or damage.
Dematerialisation is the process of converting financial securities in physical form into electronic format or demat form. Depositories perform dematerialisation. This conversion simplifies the process of transferring ownership and eliminates the need for physical delivery.
Depositories immobilize physical securities, making them no longer transferable through physical means. Instead, ownership is electronically transferred, improving both security and efficiency.
4. Book-Entry System
Depositories maintain electronic records of securities ownership. They act as intermediaries in the transfer of securities between buyers and sellers. Depositories update their records to reflect changes in ownership after each transaction. This enables the seamless transfer of ownership between buyers and sellers. This book-entry system eliminates the need for physical record-keeping and reduces paperwork.
5. Settlement Services
Depositories facilitate the settlement of securities transactions by ensuring that securities are transferred from sellers to buyers and that payment is made to the sellers. This reduces settlement risks and delays.
6. Ownership Transfer Facilitation
Depositories have facilities for transferring securities from one account to another. This is especially important in the case of unlisted securities. Since unlisted securities are not publicly traded, they cannot be sold in the open market like public securities.
CDSL provides Easi/Easiest Portal to transfer securities manually.
7. Corporate action processing
Depositories process corporate actions such as dividends, stock splits, mergers, and rights issues. They ensure that shareholders receive the benefits or instructions associated with these actions.
8. Facilitation of Trading
Depositories make it easier for investors to buy and sell securities. When investors trade on stock exchanges or in over-the-counter (OTC) markets, depositories handle the transfer of ownership behind the scenes, ensuring a smooth transaction process.
9. Reduction in Settlement Risks
By providing a centralised system for settlement and record-keeping, depositories reduce the risk of settlement failures, errors, and discrepancies.
10. Proxy Voting
Some depositories offer proxy voting services. Proxy voting refers to the vote cast by one person or firm on behalf of another.
What is a Book Entry System?
Book entry is a method of electronically tracking ownership of securities, eliminating the need for physical certificates to be issued to investors. This allows investors to trade or transfer securities without having to present a paper certificate as proof of ownership. When an investor purchases a security, they receive a receipt and the information is stored electronically.
Depository vs Clearinghouse
A Depository is a facility that holds and maintains records of securities in demat form. A Clearing House is responsible for validating, clearing, and settling trades executed on a stock exchange or other trading platform.
Who are Depository Participants (DPs)?
Although Depositories are the custodian of securities, investors cannot directly interact with them. It can only be done through a depository participant (DP). The DP acts as an intermediary between the depository and investors. It's a depository participant who opens a Demat account with a depository.
In India, most of the brokers themselves are the Depository Participants.
What are Depository Receipts (DRs)?
A Depository Receipt (DR) represents ownership in a foreign company. It's a security that trades like an ordinary share on a local exchange. This means that publicly listed shares of a foreign company can be traded on an exchange outside its home market. To create a depository receipt, the equity shares of the foreign company are deposited in a bank (which serves as the depository) in the country where the shares will be traded. Subsequently, the depository issues receipts that represent the deposited shares.
Global Depository Receipts (GDRs)
Companies issue global depository receipts (GDRs) outside their home country and beyond the United States. The depository bank that issues GDRs is generally located (or has branches) in the countries on whose exchanges the shares are traded. A key advantage of GDRs is their exemption from foreign ownership and capital flow restrictions that the issuing company's home country might impose since they are sold beyond its borders.
American Depository Receipts (ADRs)
An American depository receipt (ADR) is a US dollar-denominated security that trades like a common share on US exchanges. They enable foreign companies to raise capital from US investors. Note: An ADR is one form of a GDR. However, not all GDRs are ADRs because GDRs cannot be publicly traded in the United States.
Role of Depositories in Capital Markets
Depositories play a crucial role in capital markets and investment infrastructure. They provide essential services that facilitate the efficient and secure functioning of the financial markets. Their role includes various aspects of the financial system, including securities trading, settlement, and investor protection. Depositories streamline the process of holding and trading securities, enhance transparency, reduce risks, and provide valuable services to investors, issuers, and other market participants. Their role is essential in promoting market integrity and investor confidence.