NISM Series VI Study Notes: Chapter 6 – Functions of Depository Participant: Dematerialisation

1. Introduction to Dematerialisation & Fungibility

What is Dematerialisation?

Dematerialisation (Demat) is the administrative process of converting physical security certificates (such as shares, bonds, or mutual fund units) into electronic holdings in a book-entry form within a depository system.

• The Core Mechanism: When physical securities are dematerialised, the physical paper certificates are mutilated, defaced, and destroyed. An equivalent number of electronic securities is then credited to the holder’s beneficial owner (BO) account.
• Loss of Identification Features: Once physical certificates undergo dematerialisation, they lose all physical distinguishing features. Specifically, the electronic holdings no longer bear certificate numbers, distinctive numbers, or folio numbers.

The Concept of Fungibility

The depository system operates on the principle of fungibility.

• In a physical environment, share certificates are individualised by distinct serial numbers and certificate numbers.
• In the dematerialised depository system, all securities belonging to the same class are identical and completely interchangeable with one another. This is highly analogous to money in a bank account, where you do not track specific banknotes by their serial numbers.

2. International Securities Identification Number (ISIN)

Every dematerialised security is assigned a unique, internationally recognised code known as the International Securities Identification Number (ISIN).

Overview of ISIN (ISO 6166 Standard)

• Purpose: Developed by the International Standards Organization (ISO) under the ISO 6166 standard, ISIN is designed to facilitate both domestic and international (cross-border) trades.
• Length: An ISIN is a 12-character long alphanumeric identification code.

Components of an ISIN

The 12-character code is divided into three distinct components:

1. The Pre-fix (2 Characters): A two-letter country code as specified under the ISO 3166 standard. For securities issued in India, this pre-fix is always "IN".
2. The Basic Number (9 Characters): Consists of nine alphanumeric characters (including letters and/or digits) that uniquely identify the specific issuer company and security type.
3. The Check Digit (1 Character): A final single digit used for cryptographic/mathematical verification to prevent transcription or data-entry errors.

3. Scope of Dematerialisation: Eligible Securities

Physical securities can only be dematerialised if the issuer company has entered into an agreement with the depositories to offer a demat facility. Once an agreement is executed, a vast array of instruments can be held in book-entry form.

Eligible Categories of Securities

According to the SEBI (Depositories & Participants) Regulations, 1996, the following securities can be dematerialised:

4. Pre-requisites for Dematerialisation

An investor cannot simply demand the dematerialisation of any certificate. The depository system enforces strict pre-requisites before a demat request can be successfully processed:

1. Registered Owner Status: The dematerialisation request must be initiated by the registered holder of the physical securities.
2. Active ISIN Status: The security to be dematerialised must be officially recognised by the depository as eligible. In other words, its ISIN must be active in the depository database.
3. Issuer Connectivity: The company or issuer of the security must have established operational electronic connectivity with the depository.
4. Perfect Name Match: The beneficial owner (BO) must hold a demat account with a Depository Participant (DP) in exactly the same name(s) and sequence as they appear on the physical certificates.
5. Prescribed Application: The request must be submitted using the official, complete, and signed Dematerialisation Request Form (DRF).

5. The Step-by-Step Dematerialisation Process

The operational workflow of dematerialisation requires close coordination among the Beneficial Owner (Client), the Depository Participant (DP), the Depository, and the Issuer / Registrar and Transfer Agent (R&TA).

Process Description

1. DRF Provision: The DP provides the Dematerialisation Request Form (DRF) to the client.
2. Submission: The client fills out the DRF in all respects and submits it to the DP along with the physical security certificates.
3. DP Primary Verification: The DP checks the DRF for validity, completeness, and correctness.
   • If not in order: The DP immediately returns the DRF and physical certificates to the client.
   • If in order: The DP accepts the DRF and issues a formal acknowledgement receipt to the client.
4. Maker-Checker & DRN Generation: The DP enters the details of the demat request into the DP system following the secure maker-checker concept. The system then generates a unique Demat Request Number (DRN), which must be clearly written on the physical DRF.
5. Mutilation of Certificates: To prevent theft or fraud during transit, the DP must ensure that the physical security certificates are defaced and mutilated (typically by punching holes or stamping "Surrendered for Dematerialisation") before they are mailed.
6. Dispatch: The DP forwards the physical DRF and the mutilated certificates directly to the Issuer or its R&T Agent.
7. Daily Electronic Intimation: On a daily basis, the depository electronically intimates all demat requests (DRNs) registered in the system to the respective Issuer or R&T Agent.
8. RTA Verification & Decision: The Issuer/R&TA verifies the physical documents against the electronic records for validity and correctness.
   • Turnaround Time (TAT): The R&T Agent is legally mandated to either confirm or reject the demat request within 15 days from the date of physical receipt of the shares.
9. Electronic Credit: If the documents are valid, the Issuer/R&TA instructs the depository to credit the client’s account. The depository creates the credit balance in the client's account.
10. Client Notification: The DP receives confirmation of the credit entry via the DP system and reflects this on the client's monthly transaction statement.

6. Rejections & Dispute Resolution

Reasons for Rejection of a Demat Request

An Issuer or its R&T Agent can reject a demat request on several grounds:

• Stolen Certificates: The physical security certificates are reported stolen.
• Fake Certificates: The physical certificates are counterfeit or fake.
• Court Orders / Statutory Prohibitions: A court of law or a competent statutory regulatory authority has issued an active order prohibiting the transfer of the underlying securities.
• Duplicate Certificates Issued: The Issuer/R&TA discovers that duplicate certificates have already been issued in respect of the securities with the exact same distinctive numbers.
• Signature Mismatch: In the case of Government Securities (G-Secs), the depository’s G-Sec cell rejects the demat request if the Reserve Bank of India (RBI) rejects the transfer due to a signature mismatch or because the signatories are not registered with the RBI.
  • DP Duty on Rejection: The DP must immediately intimate the client of the rejection by letter or fax, enclosing the official rejection memo sent by the depository or G-Sec cell.

Resolution of Post-Demat Disputes

Once physical shares are dematerialised and successfully credited to a client’s demat account, any subsequent dispute regarding the title of the physical securities must be settled directly amongst the DP, the client, and the Issuer or its R&T Agent.

7. Special Depository Operational Facilities

To make depository operations flexible, depositories offer special "combination" facilities that combine dematerialisation with other corporate updates.

A. Transposition-cum-Dematerialisation

Investors often hold physical certificates in joint names where the sequence of names varies across different certificates (e.g., Certificate A has names "Amit & Raj", Certificate B has "Raj & Amit").

• The Problem: A demat account can only accept shares where the names match the account profile exactly in sequence. Opening multiple demat accounts to accommodate different sequences is expensive and inefficient.
• The Solution: Under the Transposition-cum-Dematerialisation facility, depositories allow clients to transpose (change the order of) the names of joint holders during the demat process.
• Process: The client can get the securities dematerialised into a single joint demat account by submitting the physical certificates along with a Transposition Form and the DRF. The DP processes the name transposition and dematerialisation simultaneously in the same account.

B. Transmission-cum-Dematerialisation

This facility is used when physical certificates are held jointly, and one or more of the joint holders passes away.

• Process: The surviving joint holder(s) can simultaneously remove the deceased co-holder’s name and convert the physical shares into electronic form.
• Requirements: The survivors must submit the physical certificates, a Transmission Form, the DRF, and the deceased's death certificate (original, notarised, or gazetted officer-attested) to the Participant.
• DP Duty: The DP must strictly verify that the target demat account is registered in the names of the surviving holders only.

8. Reverse Processes: Rematerialisation, Destatementization & Restatementization

I. Rematerialisation

Rematerialisation is the exact reverse of dematerialisation. It is the process of converting electronic holdings in a depository account back into physical paper security certificates.

• The Mechanism: The beneficial owner’s electronic balance is debited, and the Issuer/R&TA prints and issues physical certificates of an equivalent value.
• Right to Remat: Every beneficial owner holding electronic securities has an absolute legal right to convert their holdings into physical form at any point in time.
• Process: The client must submit a request to the Issuer/R&T Agent through their DP using the prescribed Rematerialisation Request Form (RRF).

II. Destatementization (Mutual Fund Units to Demat)

Destatementization is a process that allows Beneficial Owners (BOs) to convert physical Statement of Account (SoA) representing Mutual Fund (MF) units into electronic form to hold them directly in their demat account (specifically supported under CDSL).

III. Restatementization (Demat to Mutual Fund SoA)

Restatementization is the process where Mutual Fund units held electronically in a demat account are converted back into physical form as a Statement of Account (SoA) or physical certificates at the request of the Beneficial Owner.

• Repurchase / Redemption Rule: In the case of repurchase or redemption under restatementization, the payment is directly issued to the BOs by the Asset Management Company (AMC) or R&TA, and the corresponding MF units in the depository system are expunged (deleted).

9. Dematerialisation of Debt, CDs, and CPs

While the basic dematerialisation workflow remains the same, specific debt instruments have minor unique operational guidelines:

A. Debt Instruments

• Depository Admission: To offer demat facilities for debt instruments (bonds, debentures), an Issuer must submit a Letter of Intent to the depository.
• Tripartite Agreement: Once accepted, a tripartite agreement is signed between the depository, the issuer, and the Registrar and Transfer Agent (RTA).
• Demat Process: The procedure for dematerialising debt instruments is identical to that of equity shares. Existing accounts can be used for holding debt instruments.

B. Certificates of Deposit (CD)

• CD Denomination: The minimum size to be subscribed or transacted by an investor through the depository system is Rs. 1 lakh.
• Endorsement Requirement: Before submitting CD certificates to the DP for demat, the client/holder must write on the reverse of the physical CD in the designated space for endorsement, followed by the signature of an authorised official of the holder.

C. Commercial Paper (CP)

• CP Denomination: An investor can subscribe to a minimum of Rs. 5,00,000 or multiples thereof, as the face value of a Commercial Paper in the depository system is taken as Rs. 5,00,000.
• Eligibility: Only those commercial papers that have been made available for dematerialisation by their respective Issuer can be dematerialised.

10. Glossary of Important Terms

• Dematerialisation: The process of surrendering physical security certificates for destruction and receiving an equivalent credit in electronic book-entry form.
• Fungibility: The quality of being identical and completely interchangeable; electronic shares do not have unique serial or certificate numbers.
• ISIN: International Securities Identification Number; a unique 12-character ISO 6166 code assigned to a security.
• DRN (Demat Request Number): A unique system-generated number assigned by the DP system upon entering a demat request.
• Transposition: An operational change rearranging the order of joint holders' names to match a demat account sequence.
• Rematerialisation: The process of converting electronic depository balances back into physical paper certificates.
• Destatementization: The electronic conversion of mutual fund physical Statements of Account (SoA) into a demat account.
• Restatementization: The reverse process where dematerialised mutual fund units are converted back into a physical Statement of Account (SoA).

11. Exam-Focused Key Takeaways

1. Check Digit: The final character of the 12-character ISIN code is a check digit used for mathematical verification.
2. First Two Characters of ISIN: Represent the country code under ISO 3166 (e.g., "IN" for India).
3. Mutilation Obligation: The DP must strictly deface and mutilate physical certificates before dispatching them to the Issuer/RTA.
4. 15-Day RTA Timeline: The R&T Agent must process, confirm, or reject the demat request within 15 days from receiving physical shares.
5. No Inter-Depository Pledge: While equity shares can be pledged, the pledgor and the pledgee must maintain accounts with the same depository.
6. Government Securities Cell: Rejections of G-Sec dematerialisation requests by the RBI are communicated via the depository’s G-Sec cell back to the DP and the client.