Summary: As the Government examines a once-in-a-generation consolidation of securities market legislation, an outdated liability provision quietly threatens the very infrastructure that underpins India’s capital markets.

India’s capital markets have come a long way since 1996. When the Depositories Act was enacted that year, the ambition was radical: to replace a creaking paper-based settlement system — burdened by forged certificates, delayed transfers, and rampant investor fraud — with a clean, electronic, dematerialised infrastructure. Three decades on, that ambition has been spectacularly realised. India today has over 224 million demat accounts and two depositories — NSDL and CDSL — that are the bedrock of every securities transaction in the country.

Yet buried within the Act that made all of this possible is a provision that made perfect sense in 1996 and makes very little sense in 2026. Section 16 of the Depositories Act imposes an absolute obligation on depositories to indemnify beneficial owners for any loss caused by the negligence of a depository participant. As the Government of India now examines the proposed Securities Markets Code — which contains a substantially similar provision in Clause 62 — it is the right moment to ask whether this liability architecture still serves its purpose, or whether it has quietly become a systemic fault line.

The Original Logic Was Sound

To appreciate why Section 16 needs reform, one must first understand why it was introduced. In the mid-1990s, Indian investors were deeply suspicious of the dematerialisation project. Physical share certificates were tangible assets; surrendering them to an electronic holding system, administered by unfamiliar intermediaries called “depository participants”, felt like a leap of faith. Investor reluctance threatened to derail the entire project.

The legislative response was to make the depository — a heavily capitalised, SEBI-regulated entity — the insurer of the last resort. If a depository participant caused a loss through negligence, the depository would be responsible for compensating the affected investor. This was a powerful assurance. It shifted the risk from the investor, who could not realistically evaluate the creditworthiness of individual depository participants, to the depository, which was purpose-built to bear systemic responsibility.

Section 16 was a masterpiece of regulatory design for its time. The problem is that its time has passed — and the world it was designed for no longer exists.

What the Statute Actually Says

Section 16 — Depositories Act, 1996 “Without prejudice to the provisions of any other law for the time being in force, any loss caused to the beneficial owner due to the negligence of the depository or the participant, the depository shall indemnify such beneficial owner.”

The provision is stark in its simplicity. Regardless of whether the negligence is the depository’s own or that of an entirely separate participant entity — a bank, a broker, a non-banking financial company — the depository bears the indemnity obligation. The statute does give the depository a right to recover losses from the negligent participant, but as anyone who has pursued insolvency proceedings against a wound-up entity will readily appreciate, a right of recovery is very different from actual recovery.

Three Decades of Market Transformation

The assumptions that justified Section 16 in 1996 have been systematically dismantled by market evolution. Consider the operational reality today.

First, dematerialisation is now universal. There is no longer any investor reluctance to overcome.  The original trigger for absolute depository liability — the need to build investor confidence in a novel system — simply does not exist.

In 1996, the Depositories were conceptually envisioned as trade repositories and hence the primary purpose of Depositories was to covert the physical shares into a dematerialised form. Today the role of Depositories has been significantly augmented with Depositories graduating into providing platforms for transactions, pledge, direct payouts etc. The stature of Depositories has rightfully been included as MIIs and as frontline regulators alongside Stock Exchanges and Clearing Corporations. And yet, when such failures occur, Section 16 requires the Depository to make good the loss — first, and potentially without adequate scope for recovery in most cases.

Second, and more fundamentally, the scale of operations of depository participants has exploded. There are currently hundreds of registered depository participants operating millions of demat accounts across India. A large bank-backed depository participant may manage millions of accounts. With that scale comes a commensurate increase in operational risks: system errors, internal fraud, incorrect instruction processing, KYC failures, cyber vulnerabilities — all events that occur within the depository participant’s own systems, under the depository participant’s own control, and for which the depository has limited   ability to prevent through various control measures and periodic inspections.

A Systemic Risk Hidden in Plain Sight

The financial consequences of this framework have grown in direct proportion to the growth of India’s demat ecosystem. NSDL and CDSL are classified as Market Infrastructure Institutions — a designation that acknowledges their systemic importance. The failure of either would be an event of extraordinary consequence for India’s capital markets, affecting not just investors but the settlement of every trade, every corporate action, and every securities pledge in the country.

The absolute indemnity obligation under Section 16 creates exactly the kind of exposure that could, in a stress scenario, threaten that stability. Imagine a large depository participant — a major broker or bank — suffering a significant operational failure affecting lakhs of accounts. The resulting claims against the depository could be of a scale that strains its financial resources and diverts capital from where it is most needed: technology investment, cybersecurity, and operational resilience. Three consequences follow:

• Depositories facing unlimited indemnity claims cannot adequately invest in technology upgrades or cybersecurity — capabilities that are not optional for modern securities infrastructure.
• The current framework creates a classic moral hazard: depository participants bear no financial consequence for their own operational failures, which blunts the incentive to invest in better systems.
• The right to recovery against a negligent participant is theoretically available but practically illusory — particularly if the participant is insolvent or has been deregistered.

A Proposal for Reform: Shared Liability and an Industry Fund

The reform that is needed is not a dilution of investor protection — it is a restructuring of how that protection is delivered. Two complementary mechanisms would achieve this.

First, a principle of shared liability based on the locus of negligence should replace the current absolute obligation. Where the negligence is attributable to the depository’s own infrastructure, the depository should bear full liability. Where it is attributable to a depository participant’s operations — which will be the case in the overwhelming majority of incidents — the participant should bear primary liability, with the depository’s role limited to facilitating claim resolution rather than acting as the financial guarantor.

Second, a statutory Depository Participant Indemnity Fund (DPIF) should be established to ensure that beneficial owners are never left without recourse, even where a depository participant is unable to pay. The DPIF would be funded by mandatory annual contributions from all registered depository participants — a SEBI-prescribed modest percentage of net profits — and administered under SEBI’s oversight.

DPIF Feature	Proposed Structure
Corpus	Annual contribution of 0.5%–1% of net profits by each registered depository participant, prescribed by SEBI.
Administration	Committee under SEBI aegis, with representation from NSDL, CDSL, and the depository participant industry.
Claim Trigger	Beneficial owner who has suffered loss due to the negligence of the participant and cannot recover from the participant directly.
Subrogation	Upon DPIF payment, the Fund is subrogated to the rights of the beneficial owner against the negligent participant.
Caps	SEBI to prescribe maximum per-claim and aggregate annual limits, reviewed periodically.

This structure mirrors principles already embedded in analogous frameworks globally. In the United States, DTCC participants contribute to settlement guarantee funds. The EU’s Central Securities Depositories Regulation allocates liability proportionately between CSDs and participants. In each case, the entity with operational control of the function that gave rise to the loss bears the primary financial consequence — a principle that aligns incentives and distributes risks rationally.

The Opportunity Presented by the Securities Markets Code

The Government’s current exercise of consolidating India’s securities market legislation into a unified Securities Markets Code is a rare opportunity. Such wholesale legislative reforms come perhaps once in a generation. To enact a new code that simply perpetuates the liability architecture of Section 16 — without engaging with the systemic risks it now creates — would be a significant missed opportunity.

Clause 62 of the proposed Code, as currently understood, carries the same absolute indemnity framework forward. The reform proposed here is not radical. It does not remove investor protection; it relocates and strengthens it. It does not exempt depository participants from consequences; it ensures that they bear those consequences directly. And it ensures that the depositories — which are, in the truest sense, critical national infrastructure — remain financially robust enough to fulfil their central role in India’s capital markets for the decades ahead.

The test of good securities regulation is not simply whether it protects investors today, but whether the mechanisms it creates remain viable as markets evolve. Section 16 passed that test in 1996. Thirty years later, it is time to ask whether the mechanism needs to be updated — not abandoned but updated — so that it can continue to serve its purpose in the far larger and more complex market that India now has.

The Securities Markets Code presents that opportunity.

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