Pledging of shares is a financial practice where shareholders use their shares as collateral to secure loans. This method has gained popularity among companies looking to raise funds for expansion or other financial needs. However, pledging shares carries potential risks for both the company and its shareholders. Understanding the implications, benefits, and drawbacks of this approach is crucial before entering such agreements.
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 shares functions similarly to a secured loan. Banks or financial institutions provide loans to promoters by accepting their shares as collateral. The loan amount is determined based on the market value of the pledged shares, subject to a haircut deduction. As per the Reserve Bank of India (RBI) regulations, a loan-to-value ratio of 50% must be maintained, ensuring that only half of the share's value is considered for the loan.
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 in share pledging?
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:
- Access to liquidity – Allows investors to secure funds without selling their shares, preserving ownership and potential capital gains.
- Investment opportunities – Enables quick access to funds for new investments or averaging down existing stock holdings.
- Flexible repayment terms – Loans against shares often come with more lenient repayment options compared to personal loans.
- Leverage for growth – Enhances investment capacity, allowing investors to engage in larger trades or business ventures.
Disadvantages of pledging shares
While the advantages of pledging shares are quite evident, this strategy also has certain disadvantages:
- Margin calls – A decline in share prices may trigger margin calls, requiring additional collateral or immediate loan repayment.
- Risk of asset loss – Failure to repay the loan could lead to the forced sale of pledged shares, resulting in permanent asset loss.
- Interest costs – The loan carries interest charges, which may reduce returns if the borrowed funds are not utilised effectively.
- Market volatility risk – Since the loan is backed by fluctuating share prices, it becomes highly risky in volatile market conditions.
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.
