Quite often, shareholders ‘pledge’ their shares as securities to access loans. This is one of the quickest and easiest ways to raise funds. Companies pledge their shares to avail of funds for various reasons, such as expanding or meeting the working capital requirement. The borrowing entity retains the ownership of these assets, earning interest and capital gains on the shares.
Traders in the futures and options segment also utilise pledging to get access to the broker’s margin financing. Most traders face the issue of limited cash margins, even after having stocks, ETFs, and MFs in their investment portfolio. This leads to unrealised trading opportunities. To ensure they have the requisite funds, traders can pledge their shares or ETFs as collateral margins. A certain percentage is also deducted, which is known as a ‘haircut’.
In this article, we delve into the margin pledge meaning, how it works, and the risks associated with it.
What is margin pledge?
In stock trading, margin allows traders to leverage and invest in deals without taking massive risks. In fact, your risk exposure is confined to the securities used as leverage through pledges. Should you fail to repay the margin, the stockbroker liquidates the stocks in the margin account to mitigate losses and recoup the debt. Here, the stockbroker acts as a steward for the securities or funds within the margin account.
Let us consider an example to better understand what a pledge for margin is. Suppose an investor ‘X’ has shares in TCS, Infosys, and Accenture worth Rs. 2 lakhs in their holding. Even with a good trading opportunity available, they couldn’t pursue it because of a lack of funds. For this reason, X decided to pledge their stocks to a stockbroker. The broker deducts a 20% haircut from the total value of the stocks, which comes to Rs. 40,000. X will then receive the remaining amount of Rs. 1,60,000 as the collateral margin, which they can use to realise the opportunity.
Thus, pledging for margin provides traders with additional liquidity and the ability to trade larger positions while maintaining a certain level of risk management. Moreover, the price of the margin isn’t fixed and varies from one day to the next based on the closing price of your pledged stocks.
What is pledging of shares?
Pledging of shares refers to a type of financial arrangement in which company promoters pledge their shares as collateral to obtain a loan. In essence, it means taking a loan against securities by offering the company’s shares as collateral. Pledging of shares is a popular way for companies to raise capital and meet their financial needs.
While pledging shares, promoters still hold ownership in the company. The value of the collateral can change due to fluctuations in the market value of the pledged shares. Promoters are required to maintain the minimum agreed-upon collateral value outlined in the contract. If the market value of the pledged shares falls below the minimum limit in the contract, promoters need to pledge more shares or pay cash to bridge the shortfall.
How does the pledging of shares work?
Pledging of shares is a common practice among investors. It allows them to gain access to finance without liquidating their ownership stake in a company. Company promoters and investors who own a significant portion of a company’s shares or high-value shares pledge them as collateral to a lender to raise capital. This capital is then used to meet various financial requirements like business expansion, acquisition, trading, etc. In fact, pledging allows investors to capitalise on trading opportunities without worrying about the lack of cash.
Once the lender evaluates the value of the collateral pledged and the creditworthiness of the promoter, the credit facility or loan terms are decided, and the sum is disbursed. It is important to note that a fall in the market value of the pledged shares can lead to a corresponding drop in the collateral’s value, leading to margin calls. Like all secured loans, once the loan is repaid by the promoter, the pledged shares are returned. However, in the event of a default, the lender reserves the right to sell the shares pledged as collateral and redeem the loan amount.
Why promoters pledge shares?
As mentioned earlier, promoters pledge shares to fulfil different financial requirements like working capital requirements, personal needs, business expansion, or acquisitions. While pledging of shares is considered to be a safer method of raising capital than borrowing, it is often the last resort for company promoters. Most promoters pledge their shares only when other fundraising options have been exhausted.
What is a haircut?
While we briefly mentioned the term ‘haircut’, it is important to understand its significance. After pledging your shares, you do not receive funds corresponding to the market value of the shares you pledge. This is because, in the event of a fall in market value, the broker suffers a loss. Therefore, the broker deducts a small percentage, and this difference between the amount loaned and the actual market value is known as a ‘haircut’.
Thus, this haircut margin protects the lender’s interests at the time of pledging shares. It is used as a precautionary measure against the volatile nature of the stock market.
Furthermore, for overnight positions, the exchanges mandate that traders maintain 50% of the margin in cash and the other 50% in non-cash collateral margin.
Initiating the pledging process
You can initiate the pledging process through your broker using the trading terminal. The request is then sent to the depositories (NSDL/CDSL) for execution. You must then authenticate the request by providing the one-time password. After getting the approval, you can access the collateral margin for trading.
Furthermore, maintaining a minimum margin of 20% is made mandatory by the regulator before carrying out any trade. The trade is settled on the basis of T+1 (that is, one day after the trading day). For example, if you wish to buy stocks worth Rs. 50,000, you must have a Rs. 10,000 margin, even if you sell the stock within a day.
Advantages of pledging shares
Pledging of shares offers the following advantages:
- Pledging shares as collateral allows investors and company promoters to access funds at a low interest rate as compared to unsecured loans that often come with a higher rate of interest.
- Even when shares are pledged as collateral, promoters continue to hold their ownership stake.
- Pledging of shares allows investors to unlock latent liquidity benefits in their current holdings since they don’t have to sell their assets to meet their liquidity requirements.
- Promoters and investors have to shoulder a capital gains tax liability if shares are sold. However, with share pledging, they can avoid this tax liability and still raise capital.
- Appreciation in the market value of the pledged shares due to rising markets can help borrowers secure additional cash with a fresh pledge after the current loan is settled.
- Borrowers also continue to enjoy benefits like dividend income earnings from the pledged shares.
Disadvantages of pledging shares
While the advantages of pledging shares are quite evident, this strategy also has certain disadvantages:
- One of the primary disadvantages of share pledging is the risk of default. If the investor fails to repay the loan, the lender can sell the collateralised shares to redeem the loan amount.
- Share sales by the lender can lower the prices of the share, impacting all other shareholders.
- High levels of pledged shares in a company can alter investor sentiment about the company’s financial standing and drive share prices down.
- A fall in the market value of pledged shares beyond the agreed minimum can trigger margin calls, forcing borrowers to finance the deficit with additional shares or funds.
- When shares are pledged, investors cannot freely sell those shares to take advantage of price appreciation
Points to remember
Here are some of the important points you must remember pertaining to pledging.
- The shares remain in your Demat account until they are sold.
- While stocks remain in your Demat account, you can access margins through pledging.
- The entire pledging process is seamless and digital.
- As the stocks remain in your Demat account, you continue to earn interest and capital gains on the pledged stocks.
Conclusion
Pledging involves using securities in your holding as collateral to secure a loan or margin, allowing you to access funds for trading while the securities remain in your account. Now that you know what margin pledging is, you can easily access collateral margins and leverage positions to increase your profits.
