Depositaries and Mutual Funds

Module 6
MBA III Semester Finance Elective
Merchant Banking and Financial Services
Ranjani J
 Depositories, Stock Broking and
Mutual Funds
• Depositories
• Stock Broking
• Mutual Funds
 Definition-Depository
According to the Federal Financial Institution’s
Examination Council (FFIEC), a depository is
defined as, “An institution that holds funds or
marketable securities for safekeeping.
Depositories may be privately or publicly
operated, allow securities transfers through
book-entry, and offer funds accounts
permitting funds transfers as a means of
payment.”
 Definition 2- Depository
A Depository facilitates holding of securities in the
electronic form and enables securities transactions
to be processed by book entry by a Depository
Participant (DP), who as an agent of the depository,
offers depository services to investors. According to
SEBI guidelines, financial institutions, banks,
custodians, stockbrokers, etc. are eligible to act as
DPs. The investor who is known as beneficial owner
(BO) has to open a demat account through any DP
for demat of his holdings and transferring securities.
 Dematerialization and Rematerialization
• Dematerialization - a process by which the BO’s physical share
certificates are taken back by issuing company (IC) through the
DP, checked and if found in order, demat is confirmed by the
IC and an equivalent number of shares credited to the BO’s
account held by DP in electronic form. The entire process of
demat of shares is required to be completed within a period of
15 days.
• Rematerialization-BOs have an option of converting their
electronic holding into share certificates on demand. This
conversion is called Rematerialization (remat). Requires a
request, through an application in Remat Request Form (RRF)
to the DP for a remat and through a similar process like the
reversal of demat, the issuing company issues new certificates
to BO for the remat shares. The process of remat is completed
within a period of 30 days.
Depositories and the Demat and
Remat Process
 Functioning of Depository system
• Operation- Similar to the operation of money account in the
Banking system-Share certificates deposited in a depository
and individual account opened with the shares for which
certificates are deposited.
• To utilize the services offered by a depository, it is compulsory
to open an account with the depository through a 'Depository
Participant'. The Shareholder can transfer the shares between
accounts without handling share certificates. It also leads to
safekeeping of securities.
• Costs- Depending upon the services rendered by each
Depository, the investors have to pay the charges for the
services like account opening, account maintenance,
transactions and custody charges. Charges differ from DP to
DP and between Depository systems. Investors have to
identify their own DP for their transactions of Demat
 Role of Depositories
The Depository performs its functions through a network of
Depository Participants (DPs) who interact with the Clearing
Members and Investors. The Depository functions include:-
• Enabling the surrender and withdrawal of securities through
demat and remat to and from the depository system,
• Maintaining investors' holdings in the electronic form through
computers,
• Effecting settlement of securities traded on the stock
exchanges and receipt of non corporate benefits like bonus,
rights in electronic form
• Carrying out settlement of "off market trades" (i.e. trades not
done on the stock exchanges)
• Status update to the Share Registrar/Issuer about the BOs
• Stock lending and borrowing and pledging/ hypothecation of
demat securities, freezing/locking an investor’s account
 Role of Depository Participants (DPs)
Similar to brokers, who act on behalf of a client in the stock
market, a Depository Participant is the BOs’ representative in
the depository system. Financial Institutions / Banks /
Custodian / Stock Brokers etc. can become DPs provided they
meet the necessary requirements and guidelines prescribed
by SEBI. DP serves as a link between the investor and the
Company through NSDL / CDSL for demat of shares and other
electronic transactions. DP services include
• Maintaining the securities account balances
• Enabling surrender (demat) and withdrawal (remat) of BO
securities to and from the depository.
• Delivering and receiving shares in BO account on their
instructions
• Periodical status reports to BO
Depositories –Rights and Obligations
• Depository appoints DP as its agent through whom
any person can avail depository facility
• Depository deemed owner including transfer of
ownership on behalf of BO but no voting rights
• BO can pledge/hypothecate his shares with the
depository with its prior approval after which the
latter would record the same in its books as evidence
of the pledge/hypoth.
• Furnish info to Issuer company at specified intervals
• BO right to withdraw from depository and indemnity
against any losses due to Depository or DP.
 Advantages of Depositories
• Bad deliveries and risks associated with physical certificates
such as loss, theft, mutilation of certificate etc. eliminated
• Eliminated large volumes of paper work involved in filling in
transfer deeds and lodging the transfer documents & Share
Certificates with the Issuer Company
• Immediate transfer and registration of shares transacted (at
the end of every settlement cycle, which is 4 working days i.e.
T+3) and therefore faster settlement cycle and faster
realization of sale proceeds
• Faster disbursement of Corporate benefits like Rights, Bonus
etc.
• Reduction in costs in terms of brokerage, transaction costs,
stamp duty etc.,
• Availability of periodical status report to investors on their
holding and transactions
 Depositories-Origin in India
• Reform of Securities Markets-Intro of Scrip-less or `DEMAT’
Trading Mechanism since 1996-Eliminated physical trading and
transfer of securities
– cut delays
– costs savings
– improved volumes and efficiency of trading
– In order to bring on par with International markets and attract
FIIs
• Depository System operates under framework of Depositories
Act 1996 and SEBI (Depositories and Participants) Regulation,
1996. Depositories and DPs have to register with SEBI and pay
reg.fee
• Compliance officer required to be appointed by Dep/DP to
monitor compliance and redress grievances
• SEBI has right to inspection of books and
suspension/cancellation of registration of Deps/DPs for non-
compliance or default
 Existing Depositories in India
NDSL and CDSL
• National Securities Depositories Limited
(NSDL) -1st depository-Sponsored by UTI, NSE
SBI, HDFC Bank and Citi Bank
• Central Depositories Services Limited (CDSL)
–Sponsored by BSE jointly with leading banks
such as SBI, Bank of India, Bank of Baroda,
HDFC Bank, Standard Chartered Bank, Union
Bank of India and Centurion Bank.
Stock Broking Services and SEBI
Guidelines
A stock broker is a member of a recognized stock
exchange who buys, sells or deals in securities . A SB
has to be registered with SEBI subject to payment of
fees, abiding by bye laws and rules and regulations
and Redressal of grievances as required by SEBI
A sub broker acts on behalf of a stockbroker as an
agent or otherwise for assisting investors in buying,
selling or dealing in securities but not a member of the
stock exchange though he is required to be obtain
certificate of registration with SEBI and compliance
with bye laws and rules and regulations and Redressal
of grievances as required by SEBI
 Stock Broking Services and SEBI
Guidelines-Continued
• Foreign brokers can act only on behalf of
registered FIIs after disclosing to SEBI names
and registration numbers of the overseas stock
exchanges in which they trade as
brokers/dealers and operate through their
rupee accounts , reporting status of
transactions to RBI and following repatriation
norms
• SEBI guidelines-Registration, Code of Conduct,
Obligations /Responsibilities, Inspection,
Penalty and default, Redressal of grievances
 Mutual Funds-SEBI Definition
Mutual fund is a mechanism for pooling the resources by
issuing units to the investors, also called unit holders, and
investing funds in securities in accordance with objectives as
disclosed in offer document. Investments in securities are
spread across a wide cross-section of industries and sectors
and thus the risk is reduced. Diversification reduces the risk
because all stocks may not move in the same direction in the
same proportion at the same time. Mutual fund issues units
to the investors in accordance with quantum of money
invested by them. The profits or losses are shared by the
investors in proportion to their investments. The mutual
funds normally come out with a number of schemes with
different investment objectives which are launched from time
to time. A mutual fund is required to be registered with SEBI
which regulates securities markets before it can collect funds
from the public.
 Structure of Mutual Funds
• The Sponsor- contribution 40% of net worth of
AMC
• The Trustees- min of 75% should be
independent of Sponsor-custody of MF
property
• The Custodians-1 per MF- custody of securities
bought by MF
• Asset Management Company (AMC) –
Investment manager of MF-1 per MF-With
SEBI permission can also act as underwriter
 Types of Mutual Funds
• Operational Classification -
1. Open ended scheme, 2. Close ended 3. Interval based
• Return-based Classification -
1. Income fund scheme 2. Growth fund 3. Conservative fund
• Investment -based Classification -
1. Equity fund scheme, 2. Bond fund, 3. Balanced fund,
4. Sectoral fund, 5. Fund of fund, 6. Leveraged fund,
7. Gilt fund, 8. Index fund, 9. Tax saving schemes,
10. Others-Load, no-load, MMMF, Offshore MF, property art
commodity energy funds etc
 Mutual Funds
Role/Advantages/Features
• Mobilizing small savings
• Avenue for Investment
• Professional management
• Diversification
• Better liquidity
• Reduced risks
• Investment protection due to good regulation
• Switching between investments and schemes
• Tax benefits
• Low transaction costs and convenience
• Regular returns and capital appreciation
 Exchange Traded Funds
• An innovative investment vehicle that combines the features
of a close ended and open ended mutual fund. Available in
US-1993 (S&Ps depository receipts or SPDRs or SPIDERS)
Europe since 1999. Traditionally index funds following specific
indices but since 2008, SEC allowed first actively managed ETF
• ETFs holds assets such as stocks or bonds and ETFs can be
traded on the stock exchanges at prices that are more or less
close to the actual intra-day NAV of the underlying assets of
the Fund. However, ETFs cannot be redeemed by an
individual investor for the underlying shares. Instead, large
institutional buyers termed as ‘Authorized Participants’(AP)
alone can buy shares from the ETF that too in lots of tens of
thousands termed as “creation units” of ETF shares which can
be exchanged for a basket of the underlying securities. The
other individual investors can use a retail brokerage to trade
in these ETF shares in the secondary market
 ETFs versus Mutual Funds
• Costs-Lower expense ratio-lower shareholder related
expenses, exempt from investing cash contributions,
and cash redemptions (only in kind)-hence no need
to maintain cash reserves and savings on brokerage
expenses , MFs charge front end and back end loads
no loads on ETFs, no short term trading fees
• Taxation-ETFs structured for tax efficiency so more
attractive than MFs-no redemption –so realization of
capital gains by MFs on redemption taxable in hands
of shareholders not so in ETFs
• Trading- Stock like features and can be traded like
stocks during trading hours and post trading hours
also at times-MFs can be traded only at day end at
the MFs closing price
 ETFs in India
Record prices have forced many of India's
traditional gold-jewelry buyers out of the market
in recent months, but a new source of demand is
on the rise -- investors looking for the safety and
convenience of exchange-traded funds backed by
gold. Six fund houses - Benchmark Asset
Management Co., Kotak Mahindra Mutual Fund,
UTI Asset Management Co., Reliance Capital
Asset Management Ltd., Quantum Mutual Fund
and SBI Mutual Fund - already offer gold ETFs in
India.
 Hedge Funds
In simple terms, Hedge funds are investment
vehicles or investment funds that take big
bets on a wide range of assets and specialize
in sophisticated investment techniques. Some
of these funds have made huge amounts of
money for their investors in recent years.
They are meant to perform well in falling as
well as rising markets. A study in 2007 showed
that Hedge funds accounted for 1/3 of the
stocks traded on LSE and 1/5 of those traded
in NYSE.
 REGULATIONS ON MUTUAL FUNDS
1. Restrictions on borrowing except to meet short term
liquidity gaps for repurchase or redemption of units or
payment of dividend
2. Carry forward transactions not permitted
3. Derivative transaction on recognized stock exchanges
permitted within SEBI framework
4. Underwriting on SEBI approval permitted
5. Prohibited from investment in unlisted securities
6. Cannot own more than 10 percent of any company’s paid
up capital carrying voting rights
7. Can make investments in other schemes of the same
mutual fund upto 5 percent of the NAV
8. Can make investment only in transferable securities in the
money or capital market
 Accounting Aspects-Measuring Operational
Efficiency of a MF
• Net Return-Gross return – Expenses (Max limit laid down
by SEBI)
• Net Asset Value (NAV)-Intrinsic value of a unit- Value
obtained on sale of the unit by the unit holder back to the MF
NAV per unit = [ TMV CL] UOS
where,
TMV = Total market value of investment + written down value of fixed assets +
the cost value of other current assets
CL = current liabilities and UOS = number of outstanding units in that scheme

• Load- SEBI norms on who bears the load

where,
ARi = Average rate of return for portfolio `i’ during a period
ARf = Average rate of return on a risk-free investment during the period
βt = Slope of portfolio `i’ characteristic line which represents the
portfolio relative volatility and its systematic risk
PM = The Treynor Portfolio performance measure for the period
• Sharpe Model –
PM (ARi ARf) Nt

where,
Nt = Standard deviation of rate of returns for the portfolio for the
period
 Working of a Mutual Fund
Source: wwwmutualfundsindia.com
 History of Mutual Funds in India
• 1963-UTI first MF set up under act of Parliament in
1963 by RBI and delinked from RBI in 1978 with IDBI
taking over administrative and regulatory control
• 1987- Other public sector MFs set up by Public
Sector Banks, LIC and GIC, came up.SBI Mutual Fund
first non UTI PSMF
• 1993- Private sector MFs allowed and first
regulations on MFs came into being
• 1996-Comprehensive revised SEBI (MF) Regulations
1996
• 2003- UTI bifurcated into two entities following US
64 scam of 2001.
 The UTI US 64 Debacle
• Administered prices, lack of transparency in investments, virtually
no competition and protection assured. When bull market it
worked in a declining market administered NAV did not work.
According to the Investor Grievances Forum, as of 2001, the UTI
had invested in 1,426 private companies, of which only 81 show
appreciation and as many as 654 are either non-traceable or non-
tradable. The investment in 1,345 companies has depreciated some
47 per cent. “Every aspect of UTI business seems imperfect:
products, positioning, perception, performance and practice……It
is a balanced fund which is perceived as income fund, which many
years ago was a debt fund, in mid-’90s was rewarding as an
equity fund, and is priced like a bond which does not guarantee
return but government works out a bailout package when equity
assets deplete: pretty confusing. And its offer letter does not state
anything.” -Dhirendra Kumar, in Economic Times
• `Security, safety, regular income, trust of two crore investors'' was
the plank. It was positioned as an income scheme with sketchy
disclosures
 The US 64 Debacle - Hidden Facts
• The UTI never told its investors that the portfolio composition
and its investment strategy could not lead to stable regular
dividends (which was expected by the retired and the
pensioners who had invested in as also the retail investors).
• The steady decline in the dividend yield was never
highlighted. The yield on July price for 2000-01 of 7.4 per cent
was close to the levels that prevailed 30 years ago.
• The fact that adjusted for risk of the 65 per cent exposure to
equities, the returns are much lower and, in the process,
unsuspecting investors have been put to great peril
• It also failed to reveal that it was facing problems as early as
1998 when it received a massive bailout of Rs.3300 crore at
taxpayers’ expense
 US 64 Debacle- Hidden Facts
• The ballooning of scheme size was largely on account of
corporate flows which various UTI chairmen have coveted in
their pursuit of self-set targets. Never had the UTI revealed
the composition of inflows and corpus as between retail and
corporate investors. Nor had it ever told long-term investors
whom it began urging in 2001 amidst large scale liquidation
by investors in panic, to stay on as to the kind of impact that
these hot money flows had had on the value of assets.
• The Deepak Parekh Committee had recommended an NAV-
based pricing system within three years. The UTI planned to
move to that mode from January 2002. It did not mention
the implications of the NAV switch for the investors. The fact
that long-term investors could be staring at a 20 per cent
erosion to face value and at least 5 per cent drop over May
2001 prices were quietly brushed under the carpet
 The Fall of US 64
• In 2001, according to available figures, the UTI invested Rs.3,400 crores in just
six out of a total portfolio of 44 scrips. This was eroded by 60 per cent. It also
sank Rs.1,300 crores in another five scrips, whose value has dropped to a
miserable Rs.300 crores (by 77 per cent). By March/April 2001, US-64's net
asset value (NAV) had probably plunged below par (Rs.10). But the UTI
continued to sell and re-purchase US-64 above Rs.14. In June 2001 there was
a gap of over Rs. 6,000 crore between the market value of net assets and the
scheme’s value at its administered re-purchase price. A hole of Rs. 6,000 crore
in a Rs. 20,000 crore scheme and with US-64’s net sales turning negative from
October 2000, there was no alternative but to put a freeze on repurchase.
• Huge parts of the investments of US 64 became irrecoverable. Possible insider
information on closing of the repurchase window led to big outflows in April-
May 2001, especially by corporates; investor base shrunk from 2 crores to 45
lakhs by June 2001. P.S. Subramanyam , Chairman UTI taking responsibility
and resigned
• Failed investment decisions in the tech sector and sharply rising and falling
stocks during the dot-com bubble and, among others, in Reliance Industries in
the mid-1990s; archaic pricing structure and its overall poor performance, led
to a large scale erosion in its value
 Wading out of Troubled Waters
• July 2001-Finance ministry rolls out a Rs 300-crore rescue package which offers
unitholders the opportunity to liquidate their holdings and achieve capital
appreciation through a step-up repurchase till May 2003. Investors can offer up
to 3,000 units for repurchase between August 2001 and May 2003. The
repurchase price in August fixed at Rs 10 per unit to be increased by 10 paise
every month.
• The Central Bureau of Investigation (CBI) raids the residences of former UTI
chairman P S Subramanyam and other senior officials in connection with a case
of conspiracy relating to private placement of shares of Cyberspace Infosys.
Other senior officials whose houses have been raided are executive directors M
M Kapur and S K Basu and general manager Prima Madhuprasad. Late in the
evening, CBI interrogates Subramanyam in connection with the fiasco.
• Meanwhile, the government appoints a 3-member high level committee
headed by former RBI deputy governor S S Tarapore to probe UTI activities.
New UTI chief M Damodaran mapped out a four-pronged strategy to restore
investor confidence: moving the government for infusion of funds, paring the
total corpus of UTI, splitting US-64 into 2-3 schemes and hiring professional
fund managers. It also holds discussions with private sector banks for a line of
credit.
 Wading out of Troubled Waters
• September –December 2002-The government issues an ordinance to
restructure UTI which includes repealing of the UTI Act and bifurcating the
Trust into UTI-I and UTI-II. UTI-I will comprise US-64 and other assured
return schemes with a total asset base of Rs 25,000 crore. All NAV-based
schemes with an asset base in excess of Rs 17,000 crore to go under the
umbrella of UTI-II. The UTI board also decides to split US-64 into two
schemes: UTI-I to have the administered price segment of US-64, while US-
2002, the NAV-based segment will fall under UTI-II.
• The Parliament grants its approval for bifurcation of UTI into UTI-I and UTI-
II. As per the bill, UTI-I will not float any new scheme and all the existing
commitments will be met by the government. UTI-II will be started as a
Sebi-regulated, asset managed and market competing scheme. All the UTI
employees will either be put on the UTI-II register or absorbed in UTI Bank,
with an option to take VRS.
• SBI, PNB and Bank of Baroda obtain RBI permission for setting up an AMC to
handle UTI-II. This LIC-led consortium is to invest Rs 2.5 crore each in the
AMC which is likely to start with an initial capital of Rs 10 crore. The
government plans to transfer UTI's NAV-based schemes with a total corpus
of over Rs 17,000 crore to the new AMC and intends to privatize it after
making it financially strong in 3-5 years.
 The Way Ahead- UTI and US 64
• UTI is split into two with effect from 1
February 2003, UTI I (UTI Trustee Company (P)
Ltd) and UTI II (UTI Asset Management
Company (P) Ltd.) UTI II will be known as UTI
Mutual Fund.
Source: http://www.capitalmarket.com/CMEdit/SFArtDis.asp?SFSNO=56&SFESNO=6
Depositories, Stock Broking and Mutual Funds-End of module

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