August 2020: Depositories – positively impacted during the pandemic

In this newsletter, we wish to talk about a business which has been positively impacted during the pandemic – depositories. A depository is an institution where securities are stored. All the stocks that investors own are stored in depositories, via depository participants, who are agents of the depository. Many years back, stocks were held in physical form, and some of us may be aware of the many problems in dealing with physical shares like the long time period between the purchase of stocks and them being registered in your name, not to forget the extreme strain on your tongue in affixing multiple share transfer stamps on the share transfer forms. All this was eliminated when the government introduced paper less trading with the help of depositories.

What attracts us to the depositories business is that it is a regulated duopoly with stiff barriers to entry in the form of a license from the regulator. Also, the percentage holding that a promoter can own over the long term in a depository is only 15% – hence there is a disincentive to enter this business. NSDL and CSDL are the only two players in the market with both players having an almost equal market share (CDSL was trailing until recently, but has caught up of late). So while NSDL has mostly institutional participants (like HDFC Bank, ICICI Bank etc), CDSL has a larger following among broker depository participants. The recent gain in market share by discount brokers (Zerodha, 5 paisa, etc) has placed CDSL in a strong position competitively. Duopolies are attractive to own because they make for strong and sustainable profitability.

The depository business is also blessed with non-linearity – in the sense that once a depository has achieved stability, an incremental increase in revenue is not accompanied by a concomitant increase in expenses – as the business scales up and operating leverage kicks in, the operating margins of the business should expand.

During the pandemic, CDSL has seen a major increase in its business due to various reasons. For one, there is a large increase in new depository accounts as a part of a global phenomenon where retail investors are jumping on to the liquidity bandwagon. It is also possible that in this extreme situation introduced by the pandemic there is a greater emphasis on saving and investment. CDSL has also seen a dramatic increase in its market share over the last few months as discount brokers have gained a larger market share during the last few months. CDSL also offers a number of value added services like e-voting, e-AGM (Annual General Meeting) of companies, e-KYC, etc. These have received a tremendous boost during the pandemic because of the social distancing imperative. SEBI has recently introduced new margin requirements for all trades beginning 1-Sep-20 – depositories are expected to play a nodal role in pledging securities in order to provide margin to complete trades – both for buying and selling of securities.

Over the long term, the depository business offers good long term potential as more and more Indians enter the capital market. Further opportunities exist in terms of unlisted companies adopting the digital means of holding shares – this business is seeing decent traction over the last couple of years and is expected to be a long term driver for growth. One can also visualise other asset classes, like mutual funds, debt securities and even possibly real estate using depositories over the long term. The business is asset light, requiring very little fixed assets or working capital and is therefore a good fit for our universe of quality companies.