Endgame in sight at NSDL

Institutional change is normally messy and painful; the losers from reforms tend to be sharply focussed and the beneficiaries widely distributed. In comparison with the opposition faced by initiatives such as screen--based trading, reliable weekly settlement, clearing corporation, etc., the depository is one new institution that has enjoyed near--universal support.

Transactions costs in settlement using physical certificates in India have been enormous, through a combination of inefficiencies of paper movement, theft, unscrupulous firms and counterfeiting. Physical certificates are generally thought to be responsible for the peculiar use of futures--style settlement on India's "cash market" for equity, and that in turn has been a major factor impeding development of the equity market.

Yet, when NSDL commenced operations, the early pace of adoption of the depository was disappointingly slow. For an institution which would generate such remarkable reductions in transactions costs -- and costs in settlement in India are amongst the highest in the world -- it seemed surprising to see how few investors appeared to be keen on using it.

To unlock this puzzle, we have to understand a central problem in market liquidity, which is the "network externality" of market liquidity. When orders come to a market, that market is liquid. A new, alternative market would start out with no activity. Hence rational investors may continue to patronise the old market, even if it is badly organised. Every innovation in financial markets faces this problem: new markets tend to fail since orders continue to go to old markets, which makes new markets bereft of orders.

This inherent conservatism in market institutions is a central hurdle in institutional development. By this argument, internationally, in a situation like NSE and BSE, it is routine to expect that (in 1995) NSE would fail. India is a remarkable exception in that NSE was a new market which went on to become India's main stock market. Today, it is the BSE which is at the receiving end of this problem: since NSE is the main market, spreads at NSE are tighter, so orders go to NSE, which makes NSE spreads tighter, and so on.

The network externality problem is present with the depository. Settlement through NSDL is cheap, provided a counterparty exists who is interested in settling through NSDL! Through 1997, investors waited for each other to adopt NSDL before stepping in themselves. In this gridlock, usage of the depository grew at modest rates like 5% per month.

The network externality is a major rationale underlying public policy interventions into financial markets. A classic example of an intervention designed at breaking this impasse was in late 1997, when SEBI decided that for eight stocks, institutional investors would be forced to only settle through NSDL.

SEBI's directive was applicable from 15 January 1998 onwards. The evidence for demat settlement volume at NSCC shows a kink in growth rates from December 1997 onwards; after this date, demat settlement volume has grown by roughly 30% per month.

This intervention immediately addresses the network externality problem: all institutions were comfortable settling through NSDL since all institutions were settling through NSDL. The moment institutions were settling through NSDL, retail investors waiting on the sidelines became willing to take the plunge with dematerialised trading since they would have the institutions to trade against. There is a kink in the growth rates of the number of investor accounts at NSDL from March 1998 onwards. The initial caution of retail investors was overcome three months after the SEBI directive.

The most remarkable evidence derives from the months of June and July 1998, where over 75% of settlements in the first group of eight stocks took place in demat form. This suggests that the 40,000 investors who have already opened accounts with NSDL supply over 75% of the settlement volume on these eight stocks.

The basic mission of the depository is not to dematerialise securities; it is to enable low--cost and reliable settlement. When we come to a point where over three quarters of settlement in Reliance is done through NSDL, we are close to the ultimate destination, of pure--depository trading. Even if many physical shares exist in the economy, as long as they are not traded, they are unimportant as far as transactions costs are concerned. In this sense, the endgame is now in sight at NSDL. This evidence suggests that roughly six months after SEBI requires that institutions should only settle through NSDL for a given stock, the bulk of the settlement on this stock takes place in demat form.

Now that the endgame is in sight at NSDL, what new vistas does it open up for the equity market? There are myriad activities which a well--functioning depository makes possible.

Rolling settlement
Demat settlement tremendously simplifies the operation of rolling settlement. Even today, with below 25% of settlement volume involving physical shares in some stocks, rolling settlement is now ripe for adoption. The adoption of rolling settlement is subject to network externality problems, and SEBI can once again play a major role in speeding up adoption. Rolling settlement is the vital piece of the puzzle, the absence of which today makes India's equity market backward when compared with international standards.
SEBI should now implement the following policy: Six months after a stock appears in the SEBI--list where institutions must only settle through the depository, that stock should only be traded in India using rolling settlement. At one stroke, this initiative would transform India's equity market in a profound manner.
Complete phaseout of physical settlement
Within a matter of weeks, it would be possible to have stocks where all settlement is required to only be done in demat form. Investors would be free to hold paper certificates, but buying/selling would only take place in demat form. This is the regime in use in most advanced countries.
Stock lending and Money lending
Stocklending involving physical certificates is fraught with the risk of fake shares being returned. Money lending with pledged shares if fraught with the risk of fake shares being pledged. The depository makes stocklending and pledging of shares possible.
Stock option markets
Stock option markets work most smoothly if, upon exercise, the owner of the option buys/sells demat shares. The success of NSDL now paves the way for option markets.

In all, this is a remarkable success of building infrastructure in India's securities industry. From November 1996 to November 1998, in just two years, NSDL would have a major impact in moving India's equity market out of the nightmare of physical certificates. This is similar to the time taken for projects like NSE (which dominated equity trading within one year of commencement of trading) and NSCC (which commenced novation within six months of commencement). These short time--frames are powerful illustrations of the speed with which institutional development can take place.

This underlines the opportunity cost of the time that has passed since mid--1996, when NSE was ready to commence derivatives trading; legal and regulatory hurdles still hold back the onset of exchange--traded derivatives. We would have come a long way, by mid--1998, in the development of derivatives exchanges in India if NSE had commenced trading in mid--1996.

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