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October 26, 1999


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Devangshu Datta

Why is demat a pain?

A virtual queue is an apparent oxymoron. But Indian systemic inefficiency has turned it into reality. The dematerialisation process for paperless trading of shares has created a virtual queue, which will take months, if not years, to process. It has also highlighted several inefficiencies in the new system and thrown up an important new tax issue.

Demat ought to take care of many inefficiencies. The tedious process of physically transferring ownership of shares is shortened. Instead of several months, ownership is supposed to change hands instantly. The chance of a bad transfer because a signature doesn't match is reduced to zero. So are the opportunities of thievery in the mail or forged share certificates. The twin problems of odd lots and jumbo lots both disappear since it is possible to trade either a single demat share or lakhs at a shot.

So demat solves various familiar problems that plague every stock market that operates with physical paper. No wonder when SEBI initiated the process of demat it was welcomed wholeheartedly by most investors.

Some insecure company managements dislike rapid, unsupervised transfer of ownership. The odd unscrupulous investor who deliberately messed up his signature and gave bad delivery in order to obtain interest-free cash also dislikes demat. But the vast majority welcomed it. One instantly beneficial effect was the easing of brokerage rates. Another was a vast increase in institutional volumes.

But then problems started surfacing. First of all, the demand for demat services was severely under-estimated. According to estimates, there are now 9 million pending individual applications for demat accounts. The system has been overloaded and reached a breaking point. As a result, somebody opening a demat account can expect to spend several months waiting for the paperwork to be completed.

Meanwhile, a physical trading route does exist for the individual investor who needs to raise cash in a hurry. But while a physical sale is possible, all transfers (in the shares of designated companies) now involve a compulsory demat. Since the buyer of physical securities must factor in a long waiting period, there is a wide differential between paper trade quotes and demat quotes. The discount on physical paper is now around 15 percent, or more.

The amount of paperwork involved in the demat process is also seriously painful. Some of it is absurd. For example, if Mr and Mrs Haridoss Paul hold some shares in the name of Mr & Mrs Haridoss Paul and a second batch in the name of Mrs & Mr Haridoss Paul, they will need to open two demat joint accounts with their names reversed! There are other niggling little details.

Brokers and banks are therefore quite reluctant to initiate the process for their clients. Some refuse outright. Others disregard the SEBI directives and insist that demat clients open low-interest or zero-interest accounts as a sort of extra fee. At a minimum deposit of Rs 1,000 per demat account and 9 million individual accounts, the amount already blocked in these low-interest or zero-interest accounts adds up to around Rs 900 crore. Assuming this trend continues, and given that there are more than 23 million individual investors, the eventual cost of demat would include sub-optimal returns on about Rs 2,300 crore. That is a large and unforeseen opportunity cost for any new system.

There are further problems. The simple fraud of stealing a share certificate out of the mail and selling it in the kerb is no longer possible with a demat account. But the only proof of ownership for demat shares is a receipt. Trades and transfers are carried out on the basis of that piece of paper. Anybody who has the account number and knows the details can order a transfer of shares from one account to the other very easily.

Forgery is actually easier. The receipt itself isn't too difficult to duplicate either. Frauds of this nature haven't started happening yet at least on a large enough scale to draw attention. But it is something that gives the investor pause for serious thought. It's bound to occur sooner or later. And given the lack of a paper trail, it will be difficult to establish the fraud, let alone prosecute and offer relief to victims.

Another problem lies in the tax treatment of demat shares. With dated physical transfer certificates, it is fairly easy to calculate Capital Gains Tax (CGT) liability. Suppose the investor has two lots of shares of the same company. One lot was bought several years ago and is hence, liable only to long-term capital gains tax, in case of a sale. This is levied at 10 per cent flat or an inflation-indexed at 22 per cent whichever is lower. The second lot was, however, bought within the last fiscal. This is liable to 33 per cent short-term CGT in the event of a sale.

If you sold a physical lot, presumably you would deliver the older set to minimise the payout. But in case of a demat, there is an extremely grey area about which CGT rate should be levied. The Central Board of Direct Taxes hasn't worked out a clear procedure for distinguishing the earlier lot from the later lot. You could find yourself locked in a dispute and facing a demand for short-term capital gains tax. This is obviously of major significance.

There are several more niggling problems. In theory, the demat is supposed to be within 24 hours. However, PSU bank timings don't conveniently overlap trading times. Banking hours close at 2 pm while trading continues till 4.30 pm. On average, a transfer will take 48 hours or more. On occasion, the demat account may be temporarily credited with shares pending confirmation of a transfer. An unwary investor who sells without ensuring that he has actually received a confirmed transfer is open to everything starting from severe embarrassment and ending with charges of fraud.

None of these problems are insurmountable. But it will require a coordinated effort from various agencies to sort them out. SEBI and RBI have to come up with a way of streamlining the demat process and regularising the status of deposits accepted, if any. The NSDL and CSDL will have to speed up their registration procedures and devise a more foolproof system of receipt and transfer. Banks and stock exchanges will have to coordinate working hours and the use of temporary entries. The CBDT will have to come up with clear tax guidelines.

None of these are processes, which needed to be ratified or mandated by Parliament. So the excuse of political instability cannot be trotted out for delays. Demat has already been in progress for a year.

How much longer will it take to clear up the virtual queue? Your guess is as good as mine.

Devangshu Datta

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