Define Margin Trading and Depositories

Margin Trading

Investors may purchase securities in the stock exchanges either using their own funds or funds borrowed from banks, brokers, etc. Conservative investors would prefer to use own funds for trading in securities. Other investors may use borrowed funds for buying securities when there is a good opportunity to buy some securities but ready cash may not be available.

Borrowing money from the bank or the broker for purchasing securities is known as margin trading. The investor pays a part of the value of the securities to be purchased; the balance is provided by the broker or the banker. The cash paid by the investor is the margin. For example, if an investor places buy orders for purchase of securities worth ` 50,000 and pays as cash ` 30,000 to the broker, the investor’s margin is 60 per cent of the value of the securities. The balance amount is supplied by the broker.

In margin trading, the investor has to pay interest on the money borrowed to finance the securities transaction. Thus profit or gain from the transaction would be reduced to that extent. Even if there is no gain from the securities transaction, interest on the borrowed funds has to be paid. Margin trading is thus a risky venture.

Depositories

Financial securities such as equity shares, bonds and debentures are issued by companies to the investors who purchase them. They used to be issued in the form of certificates specifying the name of the holder, the number of securities comprised in each certificate, the face value of the security, etc. When the securities are subsequently traded between investors, the seller of the security hands over the certificate to the buyer through the stock exchange clearing house. The buyer then forwards the certificate to the issuing company or its authorised transfer agents to get his name entered in the certificate as the holder of the security. In this practice, the security has a physical form, namely that of a paper certificate.

The physical form of securities is giving way to electronic form of securities wherein a security is represented by an entry in a depository account opened by the investor for the purpose. The transfer of securities on sale of a security is effected through a debit entry in the depository account of the seller and a credit entry in the depository account of the buyer. The securities are issued, held and transferred in dematerialised form or ‘demat mode’. For the demat mode of shareholding, depositories play the most important role. Let us understand what depositories are and how they function.

A depository can be compared to a bank. A bank holds cash for customers and provides services related to transactions of cash. For this a customer opens an account in any of the branches of the bank. A depository holds securities for investors in electronic form and provides services related to transactions of securities. A depository interacts with clients through depository participants (DPs) which are organisations affiliated to a depository. An investor has to open a demat account with a depository participant to avail depository services of holding securities and transferring securities. There are two depositories in India namely:

National Securities Depository Limited (NSDL)

Central Depositories Services (of India) Limited (CDSL)

NSDL was India’s first depository which started functioning on November 6, 1996. CDSL was inaugurated on July 15, 1999. The functioning of these depositories is supervised and regulated by SEBI. Each depository has several depository participants affiliated to it.

SEBI has now made it compulsory for trades in almost all listed securities to be settled in demat mode. For this purpose, registered members of stock exchanges open clearing member accounts or pool accounts with depositories. These pool accounts are used by member-brokers to hold securities from clients and deliver them to the clearing corporation. These accounts are also similarly used to receive securities from the clearing corporation for onward distribution to clients.

The demat accounts opened by investors with depository participants are known as beneficiary accounts. When an investor has sold a security through a member-broker, he has to deliver the security to the member-broker who, in turn, has to deliver it to the clearing corporation. The investor has to authorise his DP to transfer the security from his beneficiary account to the clearing member’s pool account. Accordingly, the beneficiary account of the investor would be debited and the pool account of the clearing member would be credited. The clearing member gives authorisation to his DP to deliver the securities to the clearing corporation.

When an investor has purchased securities through member-brokers he has to receive the securities from the member-brokers. In the first instance, the clearing corporation will instruct its depository to credit the securities to the pool accounts of member-brokers who are entitled to receive them on pay-out day. The member-broker then instructs his DP to debit his pool account and credit the beneficiary account of the client with the securities to be transferred to the client.

An investor holding securities in the physical form, that is, in the form of certificates, has the facility to transfer it to the electronic form through the process of dematerialisation. The process of converting securities held in physical form (certificates) to an equivalent number of securities in electronic form and crediting the same to the investor’s demat account is known as dematerialisation. This is done by the DP on a request from the investor. Securities in demat form (or electronic form) may again be converted back to the physical form (certificates), if desired. This process is known as rematerialisation. At the time of issue of new securities by a company, the securities allotted to an investor can be directly credited to his demat account.

According to the Depositories Act, 1996, an investor has the option to hold securities either in physical form or in dematerialised form. But holding securities in demat form has several advantages. It is safe and also convenient to hold securities in demat form. Transfer of securities in physical form involves despatching of certificates through the postal service. This may result in delay, loss of certificate in transit, theft of certificate, damage to the certificate, etc. In demat form, transfer of securities is instantaneous and effortless. Much paper work is done away with in demat mode.