Every share you buy on an Indian exchange eventually lands in a demat account, and two institutions quietly make that possible. Retail participation has surged in recent years, and many new investors now watch the NSDL Share Price with fresh curiosity after the company’s public listing. Long before that, the CDSL Share Price had already become a favourite among those who wanted exposure to the plumbing of the capital market rather than to any single industry. Understanding how these businesses earn their money offers a different lens on the growth of Indian investing.
What Depositories Actually Do
A depository is like a bank for securities (shares, bonds, etc). The shares purchased are credited into the investor’s demat account in electronic form and in a paperless manner. Depositories facilitate clearing and settlement of trades and ensure that the securities are delivered to the right owner.
The investors do not directly interact with the depositories but deal with depository participants (banks, brokers etc.) who in turn, interact with the depositories. There is a certain security and regulatory benefits that a depository brings into the system as per the Securities and Exchange Board of India.
How is the business model different?
Depositories earn revenues from transaction charges, annual issuer fees, account maintenance charges, new account opening charges, e-voting charges, KYC-related charges and various data licensing fees.
The business model is a scalable one. Once the technology infrastructure is set up, the incremental cost of adding new accounts is negligible, and hence the revenues from such accounts contribute to the bottom line with a high margin. The cost-benefit structure of these companies has been beneficial for the companies involved and they have witnessed high operating margins, consistent cash flows and minimal capital expenditures for setting up the technology infrastructure.
The boom in retail participation
The number of demat accounts in India has risen exponentially over the past few years. It has gone from a few crore to over fifteen crore. Some of the factors that contributed to this growth were easy open account facilities on mobile trading applications, systematic investment plans in mutual funds educated a lot of the salaried population, initial public offerings created a larger pool of new investors and financial awareness through social media channels.
Every new account that gets opened contributes directly to the revenues of these companies. The higher the transaction volume, the higher is the revenue from transaction charges. A word of caution here would be that the growth rates of these companies do not always reflect the number of new accounts as seen in the headlines. These companies also experience a certain attrition rate among the active account holders and hence the focus should be on how many accounts are active as opposed to the total number of accounts.
The market cycles have an impact on revenues too!
Despite being a recession proof business, the revenues of depository companies are sensitive to market conditions. A bullish market creates a surge in equity trading, IPOs and hence demat account openings. In a prolonged bearish market, these factors witness a slowdown. The annual issuer fees and account maintenance charges are relatively stable and do not reduce sharply even in a bad market year. Considering the entire revenue base, the impact on margins in a bad market is not that significant. Analysts usually look at the revenue mix of these companies to understand how much earnings are exposed to volatile transaction charges.
Competition and policy risks
There are only 2 depositories in India and they have a duopoly over the market. There are several barriers to entry which prevents new players from entering the market. This gives an edge to the existing players in terms of pricing and market share.
Depositories are highly regulated entities and any move by the market regulator to bring in changes to the fee structure would affect the revenues of these companies. There is a constant debate around capping the fees charged by depositories and the impact on retail investors. Policy changes by the market regulator could be a risk for such companies and hence investors should watch out for such developments.
Another risk would be technology risks. These companies have huge amount of data that is processed everyday and any glitch in the technology or any data breach could result in regulatory action and loss of credibility. Technology spending and related expenses are crucial for such companies and hence it is important to evaluate such companies based on their spending towards cybersecurity, disaster management and other areas of technology innovation.
Valuations and what to watch out for
Companies with high margins and minimal capital expenditure have certain valuation characteristics which are better understood in comparison with similar companies in the same sector. Investors should compare the Price-to-Earnings multiple and understand how many years of earnings growth have factored into the valuation. Metrics such as Return on Equity and Dividend payout ratio also help us compare and contrast between similar companies. Companies that have a track record of not reducing dividends during poor market conditions are good examples of companies with healthy cash flow generation capabilities.
Some key metrics to watch out for every quarter are the number of new accounts, number of active accounts, revenue mix, product innovation that drives new revenue streams, and management commentary on technology and regulatory risks. A balanced approach to diversifying across different sectors (banking, consumer, industrials, etc.) is advisable when building a portfolio with such stocks since these stocks are usually sensitive to market movements and could expose the investor to unnecessary risks. Position sizing should be determined by the risk tolerance level of the individual investor.
The boom in retail participation in India is a long-term structural trend, and depositories benefit directly from this trend. They are key beneficiaries of a thriving capital market and play an important role in any market reforms. A deeper understanding of these companies enables the investor to take a well-informed decision on building an indirect exposure to capital markets. Investors should conduct their own research and due diligence before investing in such companies. This article is meant for educational purposes and is not a recommendation on investment decisions.