NISM Series VI Chapter II Study Notes — Part 2: Depository Setup, Compliance, and Core Functions

Establishment, Compliance, and Core Operational Functions of a Depository

Regulatory Framework & Eligibility Criteria for Setting Up a Depository

Under the Indian regulatory framework, a depository cannot operate as an informal or unregulated entity. It is governed by a strict intersection of the Depositories Act, 1996, the Securities and Exchange Board of India (SEBI) Act, 1992, and the Companies Act, 2013.

Statutory Registration Requirement

To set up and run a depository, an entity must fulfill two primary legal steps:

1. Corporate Incorporation: The depository must be formed and registered as a corporate body under the Companies Act.
2. SEBI Registration: As per the provisions of the SEBI Act, 1992, a depository can deal in securities and offer depository services only after receiving a formal Certificate of Registration from SEBI.

Financial and Sponsorship Eligibility Criteria

Setting up a depository requires substantial financial backing and institutional credibility. SEBI regulations lay down strict thresholds regarding ownership, net worth, and sponsorship:

• Sponsorship: Only specified categories of institutions (such as public financial institutions, banks, or stock exchanges) are permitted to sponsor a depository company. These promoters are also formally known as its sponsors.
• Minimum Net Worth: The depository company must have a minimum net worth of Rs. 100 crore.
• Sponsor Equity Holding Limit: The sponsor(s) of the depository must hold at least 51 percent of the total equity capital of the depository company.
• Stock Exchange Sponsor Limit: If a stock exchange is one of the sponsors of the depository, its equity holding is capped. A stock exchange cannot hold more than 24 percent of the paid-up equity share capital of the depository.
• Depository Participant (DP) Equity Holding Limit: Participants of the depository can hold the remaining balance of the equity capital. However, to prevent conflicts of interest and concentration of control, no single depository participant is allowed to hold, at any point of time, more than 15 percent of the equity capital of that depository.

Mandatory Record-Keeping and Regulatory Compliance

Depositories maintain the ultimate electronic record of ownership for the nation’s financial assets. To ensure systemic integrity and trace audits, SEBI regulations mandate that every depository preserve and maintain a comprehensive set of records and documents for a minimum period of five years.

Prescribed Records and Documents

Every registered depository is legally obligated to maintain the following books and data files:

• Demat and Remat Transaction History: Detailed records of all securities that have undergone dematerialisation (conversion from physical to electronic) and rematerialisation (conversion from electronic back to physical).
• Ownership Transfer Audit Trail: The chronological logs of securities transfers, which must capture the names of the transferor (seller/giver), the transferee (buyer/receiver), and the exact dates of the transfers.
• Beneficial Owner Registry: A comprehensive, updated register and index of all Beneficial Owners (BOs) holding accounts within the depository.
• Daily End-of-Day (EOD) Balance Records: Highly granular details of the specific securities holdings of every beneficial owner, captured as of the end of each business day.
• Instruction Logbook: Records of all electronic and physical instructions received from and sent to depository participants (DPs), issuer companies, R&T agents, and beneficial owners.
• Pledge and Hypothecation Records: Comprehensive data showing the approval, notice, entry, and cancellation of pledges or hypothecation created on dematerialised securities.
• Registry of Eligible Securities: A structured record listing all securities and ISINs that have been formally declared eligible for dematerialisation within that depository.
• Other Prescribed Records: Any additional reports, logs, or documents specified by SEBI from time to time to ensure safe and orderly depository operations.

Core Functional Services of a Depository

A depository operates as a central node in the financial ecosystem, offering several vital services that allow electronic markets to function seamlessly. These core functional services are delivered via the depository's network of Depository Participants (DPs):

1. Account Opening

Before an investor can interact with the electronic securities market, they must open a depository account.

• This is called a Beneficiary Account or Beneficial Owner (BO) Account.
• Because depositories do not interface with retail clients directly, the investor must open this account through a registered Depository Participant (DP).
• DPs are legally established as agents of the depository, and the account opening process mirrors that of opening a bank account.

2. Dematerialisation

Dematerialisation is the process through which physical certificates are converted into electronic book-entry holdings.

• The investor submits physical certificates along with a Dematerialisation Request Form (DRF) to their DP.
• Once the physical certificates are verified by the Issuer or its R&T Agent and found in order, the physical paper is cancelled/destroyed, and the depository is authorized to credit an equivalent balance of electronic securities to the investor's BO account.

3. Account Transfer

The depository facilitates all transfers of electronic holdings resulting from transactions between different beneficial owners.

• It records these transfers by debiting the seller's account and crediting the buyer's account.
• This applies to both exchange-cleared trades (market transactions) and private transfers (off-market transactions).

4. Transfer and Registration

In the physical era, transferring shares required sending the physical transfer deed and certificate to the company's registrar for manual endorsement—a process prone to delays and bad delivery.

• Under the depository system, transfer of ownership occurs instantaneously by passing electronic book entries in the records of the depository.
• The depository system eliminates the separate, tedious step of manual registration of ownership by the issuer company.

5. Corporate Actions

When an issuer company declares benefits to its shareholders, the depository acts as the crucial data bridge:

• On the designated cut-off date (known as the Record Date or Book Closure period), the depository provides the issuer or its R&T Agent with a precise report of all beneficial owners holding the security.
• This report includes tax-status details and registered bank account numbers.
• Monetary Benefits: The Issuer/R&T Agent pays cash corporate actions (such as dividends and interest) directly to the BO's bank account.
• Non-Monetary Benefits: For non-cash actions (such as bonus issues, stock splits, or mergers), the new securities are automatically credited to the BOs' demat accounts by the depository.

6. Pledge and Hypothecation

Dematerialised securities can be used as collateral to secure loans, overdrafts, and other credit facilities.

• The borrower (pledgor) and lender (pledgee) must both hold beneficial accounts within the same depository, as inter-depository pledges are not permitted.
• The pledged securities are locked and transferred to a segregated or collateral account through electronic book entries.
• This ensures that while the securities are pledged, they cannot be sold or transferred by the borrower.
• Ownership remains with the pledgor (borrower), meaning cash and non-cash corporate benefits continue to accrue to them. If the borrower defaults, the pledgee can invoke the pledge and claim beneficial ownership.

7. Linkages to the Clearing System

Actual settlement of stock exchange trades requires the physical exchange of securities for funds. The depository provides the physical infrastructure for this transfer:

• It establishes a electronic link with the Clearing Corporation / Clearing House of the stock exchanges.
• On settlement day, the depository coordinates the automated debit of sold securities from the selling broker’s pool account (pay-in) and the credit of purchased securities to the buying broker’s pool account (pay-out) for onward transfer to the retail buyer's BO account.

High-Yield Key Takeaways for the NISM Series VI Exam

• Sponsor Equity Rule: Sponsors must hold at least 51% of the depository's equity capital.
• Exchange Cap: If a stock exchange sponsors a depository, its equity share is capped at a maximum of 24%.
• DP Concentration Cap: No individual Depository Participant (DP) can hold more than 15% of a depository's equity capital.
• Financial Threshold: A depository in India must have a minimum net worth of Rs. 100 crore.
• Record Retention Rule: All critical depository documents, registers of beneficial owners, daily EOD balances, and transaction logs must be preserved for a minimum of 5 years.
• Dual Registration: A depository must be incorporated under the Companies Act and registered with SEBI under Section 12(1A) of the SEBI Act, 1992.

High-Yield Terms & Concepts

• Sponsor / Promoter: The eligible financial institutions, banks, or stock exchanges that establish and fund a depository.
• Record Date: The cut-off date announced by an issuer company to determine which beneficial owners are eligible to receive dividends, interest, bonus shares, or other corporate benefits.
• Pledgor: The borrower/investor who pledges their dematerialised securities as collateral to secure a credit facility.
• Pledgee: The lender (typically a bank or financial institution) in whose favour a pledge is created over dematerialised securities.
• Clearing Corporation: An institution associated with stock exchanges that manages the clearing and settlement of trades.