Is fractional share investing possible in India?

March 20, 2022
Rainmatter

Thanks to the dramatic increase in the internet native young investor crowd, we keep getting questions about why fractional shares aren’t allowed in India like the US. Coincidentally, we recently, along with a startup, had applied to SEBI under the SEBI Regulatory Sandbox to try and enable a way to allow fractional trading of shares in India, but the application was rejected. The requests made under the Sandbox were relaxations towards Clause 25.1 & 25.3 of the SEBI Master Circular for stockbrokers, with respect to the way client money and securities are currently handled by intermediaries. We thought of sharing a few things we learned along the way.

Robinhood & race to 0 brokerage

Robinhood changed US broking when it launched free investing and trading in 2015. It took a while for the incumbents to react, but In 2019, Interactive Brokers (IB) and Charles Schwab sparked a pricing war among US brokers. IB set the ball rolling by launching a Lite plan with 0 brokerage. Schwab quickly followed suit and went to 0 brokerage across all segments. In a span of a week, pretty much all the major brokers like TD Ameritrade, E*Trade, and Fidelity went to 0. This also sparked a wave of consolidation, with Schwab acquiring TD and Morgan Stanley acquiring E*trade.  

The US always had fractional investing given the way the system of holding shares works there, but wasn’t popular among retail investors because not many brokers offered it. But now that pretty much all the major brokers went to 0 brokerage, fractional share investing became attractive since investors didn’t have to pay $5-$7 a trade. Soon after the pricing wars, everyone from Schwab, IB, Robinhood to Fidelity announced fractional share investing offerings. It made sense because millennials didn’t have a lot of money in their accounts. The median account balance in Robinhood was $240 for example, it would be higher among other brokers but not dramatically high.

The timing couldn’t have been better because new traders, investors, and trading volumes hit record highs post-pandemic in the US and around the world. Fractional trading took off. Now people with even $10 dollars could buy a slice of Amazon, whose share price is $3200+.

Stockbrokers in India vs the US

Before we talk about why fractional trading isn’t possible in India, there are a few differences you need to understand about how Indian and US brokers work. In India, brokers are only allowed to act as an agent of clients placing orders. All orders have to be sent to the exchanges, where they are matched and executed. In the US, a broker can also act as a dealer and a broker. They are commonly known as broker-dealers

A “broker” is broadly defined in the US as any person engaged in the business of effecting transactions in securities for the account of others. 

Unlike a broker, who acts as an agent, a dealer acts as a principal. A “dealer” is defined as any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise.

Broker-dealers in the US have a lot more flexibility in terms of where and how they execute orders. They can either send orders to stock exchanges as an agent/broker or be the counterparty to trades as a principal/dealer or send it to a market maker for execution. Market markers in the US typically pay brokers commissions for orders sent to them—this controversial practice is known as payment for order flow (PFOF). Just to be clear, this isn’t possible in India. All orders are sent, matched, and executed on stock exchanges like NSE, BSE, and MCX.  

All big US brokers in the US like Robinhood, Charles Schwab, and Interactive Brokers are broker-dealers.

Beneficial ownership and the concept of street name

In India, when you want to invest, you open both a trading and demat account. A trading account is an interface through which you place orders. A demat account is where all the securities like stocks and bonds you purchase are held. To offer demat services, a trading member (broker) becomes a participant with depositories like CDSL and NSDL. All shares in India are held by depositories, and investors have beneficial ownership of the shares that they purchase, and they can access them through a depository login apart from the broker login at any point in time. 

Things are a little different in the US, there’s no concept of demat there. So, US investors just open a trading account. In the US, dematerialized shares purchased can either be held in the investor’s name or in the broker-dealer’s name (street name). The street name concept allows the broker-dealers to own stocks in their own name and enables them to pass a “book-entry” for which the client is the beneficiary as per its records. Pretty much all the major brokers follow the street name method of holding securities. 

Street name method of holding securities is one of the reasons brokers were able to offer trading at 0 brokerage. Since the securities are held in the street name, brokers can generate revenue by lending these securities to short-sellers and offering seamless margin funding—these revenues, in turn, subsidized 0 brokerage.   

How does fractional investing work?

US broker-dealers enable fractional transactions by transacting with clients on a principal basis, keeping the ownership of shares under the street name by default. This allows them to maintain ownership of the shares and create fractional units for transacting with their clients (on a principal basis) by creating book entries towards each client owning a part or multiple parts of shares. 

Think of it this way. When US investors buy shares, they are held in the broker’s name and the broker maintains a ledger of individual clients and assigns the shares.  

Brokers used the same ledger mechanism of recording stock ownership to offer fractional investing. When an investor buys a fraction of a stock, the broker-dealer buys the stocks and divides them among investors, and holds the stock on its own books. Fractional shares can only be sold back to the broker-dealer from where they were purchased. As you might have realized, the price at which these fractional orders are executed can be an issue. But the SEC has defined fiduciary rules that broker-dealers must follow in terms of what price it transacts principally with their clients, called the National Bid & Best Offer guidelines. The guidelines ensure that fractional orders aren’t executed at prices higher than the market prices. 

For broker-dealers or market participants, there isn’t much risk in offering fractionals. The broker-dealers at all times only bear a maximum market risk of 1 whole share of the stock in which they are enabling fractionals. Broker-dealers maintain inventory of a full share and pass book entries based on the fractional orders from clients. Broker-dealers typically follow certain internal policies of fractionals being made available in a certain share, such as 0.1% of a share & all orders have to be made in multiples of such a fractional percentage.

For example, if Stock X is at a market price of $1000, the broker-dealer would allow clients to transact the stock at multiples of 1$ (i.e. 0.1%). The broker-dealer would keep an inventory of 1 share of Stock X on its books worth $1000. If there are now 3 clients who place orders of say $200, $350 & $150, the broker-dealer would pass separate book entries towards Client A, Client B & Client C, and have a remaining inventory of $300 under its own name in its books. The maximum market risk towards the stock price that the broker-dealer would be taking, in this case, is towards $300. The maximum at all times, in this case, would be the price of one share, i.e., $1000. 

Does India need fractional investing?

Fractional investing makes sense in the US because there are a lot of stocks with higher prices. 

Companies at current market prices of stocks – US vs India

India US
Share Price (in Rs.) Number of companies Share Price (in $USD) Number of companies
0-100 2483 0-10 (upto ~Rs. 750) 2956
100-500 1028 10-50 (upto ~Rs. 3,750) 3712
500-1,000 289 50-100 (upto ~Rs. 7,500) 752
1,000-5,000 278 100-500 (upto ~Rs. 37,500) 661
5,000-10,000 20 500-2,000 (upto ~Rs. 1,50,000) 58
> 10,000 16 > 2,000 (> Rs. 1,50,000) 8

In India, mutual funds & ETFs are the best way for retail investors to get diversified exposure to equities. You could make the case that fractional investing enables younger and newer investors to get a taste of the markets with smaller amounts. 

In India, there are just about 17 companies that have a market price >Rs. 10,000 & about 300+ companies at market price >Rs. 1000. While the requirement may be lower than that of the US on an absolute basis while comparing the per capita income of the US at $52,000 vs India being at $2,000, the requirement of having such an ecosystem in place may appear sooner than later.

Directing indexing is one use case for fractionals. Direct indexing is essentially buying all the individual stocks in an index in the same weights. The advantage is that it allows you to use broad indices like Nifty 100 as a starting point and customize them. Owning shares of an index directly allows tax-loss harvesting, for example, which wouldn’t be possible if you owned a Nifty 100 index fund. 

It also allows customization for specific use cases like If someone wants to own Nifty 100 minus TCS for example, because they have TCS ESOPs. It also allows advisors and investors to apply ESG strategies on Nifty 100 by screening out stocks like sin stocks, oil & gas stocks based on their values. smallcase, with whom we’ve partnered through Rainmatter had been allowing direct indexing since 2017 before it became a thing in the US. You can build your own smallcase and invest in as little as 1 share, but you would still need a few thousand rupees to buy a smallcase which can be reduced using fractional shares. 

Since Indian brokers can only act as agents of clients and not the principal, offering fractional investing isn’t possible. In India, brokers are just the agents who collect orders and send them to the exchanges. Once an order is executed, the shares are held in the name of the clients in a demat account with a depository like CDSL and NSDL. A lot of complex regulatory changes are required if fractional investing were to be made possible in India.

Somnath Mukherjee

Business/Legal @ Zerodha/Rainmatter

15 comments

  1. Prakash Gosavi says:

    A very good article.

    It must also be noted that fractional ownership of shares has another highly probable–and perhaps, unintended–consequence which may prove dangerous for the young and impulsive beginners. Because of the low entry barrier, they may develop the casino mentality where the player is tempted to throw small money at every roll of the dice, every spin of the roulette wheel or every hand of a card game, only to realise too late that that’s a surefire way to exhaust even a sizable bankroll.

  2. Santosh says:

    Well written!

  3. Anil Kedlaya says:

    Very well explained. Thanks for sharing.

  4. Anand Dhiresh Jasrapuria says:

    Great insight on the difference in US & India stock market..

  5. Deepak Subramanian says:

    Very well articulated. Thanks for this

  6. Shivaram says:

    Well summarised. Its time will come if retail participation has to be increased from the current levels

  7. Aniruddh says:

    Great explanation! Loved the article.

  8. Kushal says:

    This is a very detailed article. thanks for the clear understanding.

    However, almost with every paragraph that went by, I felt the Indian risk management system seems to be far more evolved and robust. Brokers holding shares in the name of clients could introduce systematic risk, right? price matching, risk management, verification of transactions etc become far more dubious if a broker is just making entries in a ledger than actual crediting the ownership to the investor. One can say the same about banks, but again, a bank’s money management policies are highly regulated by RBI, requiring all sorts of collateral for the leverage on its books etc. Would SEBI ever go in managing the risk on the book of a broker and monitor it on a regular basis? Perhaps it already does. But personally, I would never trust a broker (baring the top 3-5 profitable large ones) to be prudent in managing these practices. and regulations are designed for the entire industry, not the select few trustworthy institutions

  9. Yogesh says:

    Nice article, summarizes well the key factor which makes it hard for offering fractional shares in India. In India as shares are held in actual customers names directly at depository it makes process transparent from holding perspective and prevents reconciliation and regulatory oversight overheads for brokers to provide the holding in their books to regulators and depositories.
    Smallcase offering mentioned here seems attractive but it does not really track the index or sector/theme its being created on. It leaves the responsibility on the customer to closely track and rebalance which is not an easy task for novice investors. Frequent rebalances would lead to excessive expense in trading charges.
    Also in my view comparison of number of Stocks in a price in US and India seems to be arbitrary. In my view using a comparable purchasing parity would have been more practical and insightful.

  10. Atul says:

    Thank you for posting an insightful article.
    Blockchain technology (digital ledger entry) can be applied to enable fractional investments in stocks listed in India.

  11. Jagadeesh R says:

    One other thing missing in Indian markets is automatic dividend reinvestment. US brokers/exchanges gives provision to automatically reinvest dividend amount in the same stocks. It is good to have this option in India also

  12. Mukesh says:

    Great insightful article.

    Having experienced both systems, can safely say that Indian systems although offers less flexibility are much more robust and risk defined.

    Another dimension which comes into picture with fractal ownership is if you are owning a fractal share, on company books, you are not recorded as owner of the share. The broker becomes direct owner of the share and representative of thousands of shareholders. Not sure how that affects whole structure of ownership.

    Secondly, does broker need to report on how many fractal shares along with their valuation?

    Thanks again for breakdown of logic behind non availability of fractal shareholding in Indian market.

  13. Mukesh says:

    WRONG!!
    think of micro savings use case.
    startups like Jar thriving on the fractional ability of digital gold. Such micro investors lose the opportunity to have exposure to equity and build up wealth. Fractional share investing is inevitable. It is just the matter of time.

  14. Girish says:

    It’s important to bring in the fractional share buy concept although the market prices may not seem high in the eyes of SEBI and they will point us at Mutual Funds etc, It helps early focus and traction to the market for early investors.

    Having immense amount of retail investors will be a great boost to our economy and a shield against FIIs and FDs.

  15. VRS says:

    “When an investor buys a fraction of a stock, the broker-dealer buys the stocks and divides them among investors, and holds the stock on its own books.”

    Whether above statement means that buy order of investor will not go through exchange? If so, whether broker-dealer will act as counterparty to buy trade? Also whether these buy fraction orders will be grouped to form whole number and only then place order as Principal buy on exchange?

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