Saturday, March 18, 2006

Impact of Dematerialisation and Depository


Dematerialisation of shares is an important milestone in the annals of Indian Capital Markets. Understanding and measuring the impact of it on various segments is necessary since it stirred the microstructure of Indian capital markets in general and stock exchanges in particular. Demand and Supply forces determine prices of a product. Liquidity plays an important role in the interplay of demand and supply forces. The impact of dematerialisation on liquidity in the Indian stock exchanges is quantified and analysed. Quality of shares changed for better owing to dematerialisation and thus investors are expected to earn higher returns as a natural step, albeit, for sometime only. Changes in quality of shares are expected to cause changes in demand and supply for shares, which in turn, influences the levels in share prices (volatility). All these three issues are studied in the present paper. Liquidity and returns improved substantially in the post-demat period while volatility was very much below the daily changes permitted.


Dematerialised securities trading, settlement and custody has changed considerably the market microstructure of Indian stock exchanges. Dematerialisation is the process by which "physical certificates of an investor are converted to an equivalent number of securities in electronic form". The converted securities are owned, traded and utilised like physical securities. Order routing, trading and settlement, that is delivery and payment in demat form, changed the way markets started functioning. These changes have brought tremendous impact on the behaviour of investors, stock exchanges, depository participants and custodians.

Generally, an investor would look for more liquidity to less liquidity in a stock. Higher liquidity means lower transaction costs and easy entry and exit options. Therefore, higher liquidity is preferred. Ownership transfer of demat shares is quite fast. Investors would be able to churn their portfolio many a times over, contributing to the increase in turnover and liquidity. This paper attempts to measure post-demat increased level of activity (liquidity). Whenever a new product is made available, there will be an additional demand for that particular product. Dematerialised shares are definitely superior to physical (paper) form of shares. Physical form of shares are fraught with fake, forgery, stolen and duplicate problems. Logically speaking, higher demand should emanate for demat shares, which is expected to push up (pull down to a lesser extent) shares prices resulting in higher returns (lesser losses) to the investors compared to pre-demat period.

This higher demand will continue for sometime (adjustment period lasting, sometimes, a few months) only. Once all investors understand the merits and value of demat shares or when all shares of all stocks are demated, then the superior or higher returns will disappear or will not be there. Some markets are quite quick enough to discount the new information while some other markets take longer time (a few weeks to a few months) to discount the new information. In this period, investors can make abnormal profits. In terms of abnormal returns, dematerialised shares produced positive returns which are significant.

What is Dematerialisation?

Dematerialisation (“Demat” in short form) signifies conversion of a share certificate from its physical form to electronic form for the same number of holding which is credited to your demat account which you open with a Depository Participant (DP).

Dematerialisation is a process by which the physical share certificates of an investor are taken back by the Company and an equivalent number of securities are credited in electronic form at the request of the investor. An investor will have to first open an account with a Depository Participant and then request for the dematerialisation of his share certificates through the Depository Participant so that the dematerialised holdings can be credited into that account. This is very similar to opening a Bank Account.

Dematerialisation of shares is optional and an investor can still hold shares in physical form. However, he / she has to demat the shares if he / she wishes to sell the same through the Stock Exchanges. Similarly, if an investor purchases shares, he / she will get delivery of the shares in demat form.

What is a Depository?

A Depository (NSDL & CDSL) is an organisation like a Central Bank where the securities of a shareholder are held in the electronic form at the request of the shareholder through the medium of a Depository Participant.

If an investor wants to utilise the services offered by a Depository, the investor has to open an account with the Depository through a Depository Participant.

Depository Participant

Similar to the brokers who trade on your behalf in and outside the Stock Exchange; a Depository Participant (DP) is your representative (agent) in the depository system providing the link between the Company and you through the Depository. Your Depository Participant will maintain your securities account balances and intimate to you the status of your holding from time to time. According to SEBI guidelines, Financial Institutions like banks, custodians, stockbrokers etc. can become participants in the depository. A DP is one with whom you need to open an account to deal in electronic form. While the Depository can be compared to a Bank, DP is like a branch of your bank with whom you can have an account.


1. Institutional Structure
There are quite a few institutions that are directly and/or indirectly connected with dematerialised operations of securities. Understanding the inter-linkages and functional responsibilities of these institutions will help us to have correct and holistic perspective about functioning of dematerialisation. The institutions connected with demat operations include; a) Depositories, b) Stock Exchanges (SEs), c) Clearing Corporations (CCs) / Clearing Houses (CHs), d) Depository Participants (DPs), e) Registrars and Transfer Agents (RTAs). Both the depositories NSDL and CDSL are primarily promoted by the two leading stock exchanges viz., National Stock Exchange of India Ltd (NSE) and The Stock Exchange, Mumbai (BSE) respectively. Besides, there are many other institutional promoters in both the depositories. Both are registered as organisations-for-profit and professionally managed. Inter-connectivity between these two depositories has been established, thus DPs and investors can transfer smoothly their shares from one account to another between the depositories. Most of the stock exchanges are connected with the depositories to provide trading in dematerialization segment. Eventually, all the exchanges will be connected to either of or both the depositories. Resultantly, functioning of exchanges altered with the commencement of depositories; shorter trade cycles, negligible bad-deliveries, immediate transfer of beneficial ownership and lower transaction costs. An in-depth study on transaction cost for equity shares in India by Raju (2000) revealed substantial decrease in transaction costs and observed that the dematerialisation as one of the important factor for this trend.

Functioning of clearing corporations / clearing houses materially changed after the entry of depositories; reduced manpower requirements and faster clearing operations. It also helped them to diversify into related businesses such as on-line stock lending. Depository participants are the new commercial intermediaries that sprang up. They interpose between investor and depository. It can be stated that they are the back-bone for the success of dematerialisation. RTAs facilitate dematerialisation and rematerialisation of shares.

2. Market Microstructure
Trading in dematerialised shares brought in many changes to the entire structure of the capital market functioning. With the introduction of demat, stock exchanges switched over (with a choice) from five day accounting period to T + 5 trading and settlement for demat stocks. Even for demat stocks dual settlement is in operation: fixed account period as well as rolling settlement. This partial change to T + 5 rolling settlement system is a major shift in the market. Thus dematerialisation smoothly paved the way for rolling settlement and India joined other developed markets that are following T+ settlement system. In the physical segment there is a long gap between delivery and payment. This gap narrowed down, and it is almost on Delivery Versus Payment basis (DVP). This near real time DVP reduced market risks considerably. Clearing corporations / clearing houses and stock exchanges are able to smoothly coordinate and settle the trades effectively and timely. Clearing corporations / Clearing houses are electronically directly connected to depositories that make settlements faster and easier. Trading in dematerialised shares attracts lesser brokerage and custodial charges, as a result. Reduced transaction costs prompts investors to trade more frequently resulting in higher volumes.

This also makes bid-ask-spreads narrower, which reduces implicit transaction costs.

3. Review of Literature
The usefulness of an event study comes from the fact that, given rationality in the market place, the effect of an event will be reflected immediately in asset prices. Thus the event’s economic impact can be measured using asset prices observed over a relatively short time period. In the academic finance field, event study methodology has been applied to variety of firm specific and economy wide events. The event studies are also used in the field of law and economics by Schwert (1981) to measure the impact on the value of a firm of a change in the regulatory environment. The first published event study is by Dolley (1933) which examined the price effects of stock splits, studying nominal price changes at the time of the split. Over the decades from the early 1930s until the late 1960s the level of sophistication of event studies increased. Mayer and Bakay (1948), Baker (1956, 1957, 1958) and Ashley (1962) are examples of studies during this time period. The improvements include removing general stock market price movements and separating out confounding events. In the late 1960s seminal studies by Ball and Brown(1968) and Fama, Fisher, Jensen, and Roll (1969) introduced the methodology that is essentially still in use today. Ball and Brown considered the information content of earnings, and Fama, Fisher, Jensen, and Roll studied the effects of stock splits after removing the effects of simultaneous dividend increases.

4. Methodology
The event of importance in the present study is the start-date of compulsory dematerialised trading in equity shares. Therefore, task of conducting an event study and identifying the period over which the event started having its impact on various variables are of interest to. In order to measure impact of the event (demat) on the behaviour of various identified variables (liquidity, returns and volatility), there is a need to consider equal lengths of time periods, as much as possible, before and after the event. Therefore, data on various variables before and after the compulsory trading in dematerialised shares are obtained for various lengths. Trading and settlement in shares, for all classes of investors, is made compulsory starting from January 4, 1999 in select group of companies. Thereafter, gradually, more number of companies are added to the list of compulsory demat trading and settlement.

4.1 Data and Sample Characteristics
Demat was introduced in phased manner in India. For different classes (institutional and retail) of investors varying levels (compulsory and optional) of dematerialisation has been introduced at different points of time. Compulsory dematerialisation is one where all classes of investors (institutional as well as retail) need to trade and settle only in demat form with an exception that a small investor has been permitted to deliver in physical form who has 500 or fewer shares. Second category of dematerialisation is only for institutional investors who are required to trade only in demat form but not the small investors. Yet, another class where almost all the investors by their own volition trade in demat form. The study considered the first style of demat (compulsory) for the analysis because in this category all investors are required to trade and settle in the demat form while in other categories exceptions are granted to some classes of investors. If exceptions are granted, then certain classes of investors have options. These investors trade and settle in physical segment also. Trading and settling in physical form, however, distorts the full impact of demat. Owing to this reason, the study did not consider non-compulsory demat trading and settling segments. In order to measure the full impact of demat, it should be applicable to all classes of investors.

4.1.1 Demat Companies
Compulsory trading in the demat form for all classes of investors was introduced starting from January 4, 1999 in a phased manner. In each phase, a number of companies were added to compulsory demat category. In the first phase 12 companies on January 4, 1999, in the second phase 19 companies from February 15, in the third phase 33 more companies from April 5, and in the fourth phase 40 scrips were included with effect from May 31, 1999. Study considered first three phases only starting from January 4, 1999 till April 5, 1999. Further, it is intended to have minimum of six months of post-demat period which will give reasonable number of data points for statistical and econometric analysis. Selection of the companies for the study is made by using random sampling technique.

4.1.2 Control Group of Companies
Another matching sample group of companies is considered for the study. Matching is, generally, done on the basis of relevant parameters. Parameters considered consist of size of company, market capitalisation, paid-up capital/number of shares outstanding, number of shares traded, sales and others. In this study, the most relevant parameter is number of shares outstanding. In order to measure liquidity, returns and volatility, control group of companies on the basis of paid-up capital of the companies is selected. Paid-up capital has direct bearing on the number of shares issued and traded. Thus, it rightly represents liquidity. Paid-up capital is also a size parameter so that it can be used to measure returns and volatilities. Similar econometric analysis is carried out on control group to examine the impact of a non-occurrence of the event on this group. Results of control group and study group are compared and analysed. Analysis throws up impact (in this case demat) or no-impact on sample companies. Control group of companies that are not subjected to the proposed change (in this case dematerialisation). Matching of companies has been done first on the basis of industry classification and then paid-up capital. Companies from demat group and non-demat group are matched on the basis of industry classification and paid-up capital in that order. In many instances, it was always not possible to get two companies having similar paid-up capital (one from demat and another from non-demat group). Then, nearest company in terms of paid-up capital which is closer to demat company, is considered. In some instances, there was no company having paid-up capital closer to demat company's paid-up capital, therefore, for these companies where there is no matching company available. Thus, fewer number of companies are considered in control group for the analysis. Inequality in both the groups in terms of number of companies will not pose any methodological problem since the study is not a cross-sectional comparison.

For the control group also, computation of liquidity, abnormal returns and volatility by using the same methodology as is explained below. Since control group is not exposed to dematerialisation, the companies are free from demat influence. Ceterus paribus, changes in liquidity, returns and volatility should be equal in both the sets. If changes in liquidity, returns and volatility are more in non-control group, than that is recorded in controlled group, then the difference can be attributed to the demat. The hypothesis is that demat has no impact on liquidity, returns and decrease volatility. Absence of positive growth in all the three parameters in controlled group and presence of growth in these parameters in the demat groups clearly indicates that demat does affirmatively influence liquidity, returns and volatility.

Event studies pose certain research methodological challenges as to whether the changes in the behaviour of variables studied are due to, entirely, the impact of the event or there are any other exogenous factors responsible for the change. One way of overcoming of this problem is to construct and observe the behaviour of control group.

4.2 Data and Period
For each company and index, daily closing prices are taken from the National Stock Exchange of India Ltd (NSE) before and after dematerialisation period till October 8, 1999. The study considered a six months pre- and post-demat period for the analysis. The benchmark index considered for the purpose of research analysis is the S&P CNX Nifty. It is quite logical to take S&P CNX Nifty as the reference benchmark since all other relevant data are considered from NSE.

Number of shares traded for each company in pre- and post-demat period are also collected for the same length of the time. Three groups of companies consisting of seven, ten and eleven are selected from the first, second and third groups where compulsory demat trading started form January 4, 1999, February 15, 1999 and April 5, 1999 respectively. Names of the companies are given in Annexure AI. The daily closing stock prices of these companies are collected from National Stock Exchange of India Ltd starting from July 1, 1998 to July 7, 1999 for group 1, from August 17, 1998 to August 10, 1999 for group 2 stocks and for Group 3 stocks the data is collected from October 5, 1998 to October 8, 1999. The benchmark index S&P CNX Nifty data are also collected for the respective corresponding periods. Besides, information on daily trading volumes in quantity and value terms and number of daily trades also obtained for the same periods for all the stocks.

4.3 Liquidity
The data on trading volumes in both value and quantity terms and number of trades are also analyzed to see the impact of dematerialisation. In order to observe whether there is any growth (lack of it) in the number of shares traded in the post-demat period compared to pre-demat period, growth rates are calculated over the pre-demat period.

4.4 Returns
Returns from a company before and after demat should be the same, if demat has no influence on returns. If demat influences them (returns) then there should be abnormal returns. In the following paragraphs, explained methodology, adopted to measure returns, abnormal returns, significance of abnormal returns both for demat and control group of companies. These procedures are advocated by Campbell, Lo and Makinlay(1997) in their seminal work.

4.5. Volatility
Volatility has become a topic of enormous importance to almost anyone who is involved in the financial markets even as a spectator. To many among the general public, the term is simply synonymous with risk. High volatility is to be deplored, because it means that security values are not dependable and the capital markets are not functioning as well as they should. While investor protection and solvency of financial institutions are paramount concerns underlying public regulation of securities markets, it is also evident that the regulatory framework is to a considerable extent based on the premise that unregulated securities markets are fragile and prone to inefficiencies and systemic crises.

The absolute values of closing stock prices are converted into continuously compounded returns. The returns data is analyzed to compute standard deviation for each month starting from the event day for both pre- and post demat periods covering a maximum of six months period. Besides, cumulative standard deviation from the event day for pre- and post-period is also computed. In order to avoid the swings of extreme values three per cent of return observations are eliminated form both the sides of the data.

5. Abnormal Returns
It is well recorded in the literature of financial economics that earning abnormal returns consistently is impossible. There could be some occasions; short periods, during which one can obtain abnormal positive or negative returns. The occasions include macro or micro-economic as well as non-economic shocks. Dematerialisation of shares is one such a micro-economic event. In the present research study makes an attempt to study the possibility of investors earning abnormal returns. Demat stocks are better quality products compared to non-demat stocks of the same company for the reasons mentioned elsewhere.

Therefore, there will be a greater demand for these stocks. Higher demand naturally pushes up share prices resulting in higher positive returns. This is what exactly the study has tried to measure and find out whether there is any positive impact of dematerialisation on returns if so what is the extent of it. Abnormal
returns are measured for the first three months and six months in the case of group I, group II and for group III shares. Since these are expressed in terms of percentages there will not be any problem in interpretation.


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