The stock market can be an ambitious place for investors to grow their wealth. Have you ever considered the question of why few people become so rich so quickly and few lose everything they had? Well, the answer is they use risks with caution.
One such tool is the margin pledge of shares in the stock market. If used wisely, it can make you big bucks quickly.
In this blog post, we will take a closer look at these concepts, delving into the reasons behind their utilisation and examining their pros and cons.
What is the pledging of shares?
Similar to the concept of a mortgage, pledging is a process that involves using one’s shareholding as collateral to obtain a loan. In this procedure, a shareholder or the individual offering the pledged shares (known as the pledgor) entrusts their shares to a lender (referred to as the pledgee) as a form of assurance for a loan or credit.
The ownership of these shares remains with the pledgor throughout this arrangement, ensuring they can still receive dividends and exercise their voting rights.
If the pledgor fails to meet their loan commitments, the pledgee may possess the right to sell the pledged shares to retrieve the outstanding loan amount. The pledging of shares as collateral security is a strategy often employed by investors and promoters to gain access to capital while retaining full ownership of the company’s shares.
Understanding pledging through an example
Let us consider a scenario where an investor with holdings in listed securities is valued at Rs. 3,00,000. Suddenly, a promising trading opportunity arises, but the investor lacks the necessary funds to take advantage of it. So they decide to pledge their securities.
Upon pledging the shares, the broker implements a certain percentage of reduction, known as a “haircut,” to account for the risk associated with potential erratic movements in the market prices of the collateral shares.
In this instance, the haircut amounts to 20% of the total value of my stocks, which results in Rs 60,000. Consequently, the broker provides the remaining amount as collateral margin, which is equal to Rs 2,40,000. The margin can now be used to participate in the trading opportunity spotted earlier due to a lack of funds.
Why do promoters pledge shares?
Promoters and major shareholders have several motivations for opting to pledge their shares:
Pledging shares offers promoters a means to raise funds for various purposes, including supporting business expansion, acquiring assets, or investing in new ventures. They can take up this expansion without diminishing their ownership stake in the company.
Promoters may employ the funds obtained through pledging in the share market for personal endeavours, such as real estate purchases, financing personal projects, or addressing financial emergencies.
Pledging in the share market serves as a swift source of liquidity for promoters when they encounter immediate financial requirements. This approach allows them to access funds without selling their shares on the open market, which could potentially hurt the company’s stock price.
By using shares as collateral, promoters can retain control over the company. This approach allows them to preserve their voting rights and continue influencing corporate decision-making.
How to pledge shares to get collateral margins?
To pledge shares, an investor needs to have a demat account. The process involves submitting a formal request to pledge your securities. It is important to note that not all traded shares can be pledged, so you should select shares that are eligible for pledging.
After you have submitted your pledge request, you can expect to receive an SMS and email notification from the depository within a few hours. To activate the pledge, you will need to authorise the request at the depository.
Once the pledge request has been successfully processed and authorised, you can anticipate receiving margin funds in your trading account on the subsequent trading day. This margin will provide you with the financial flexibility needed for your trading activities.
What is the unpledging of shares?
Share unpledging involves the action of cancelling the pledge that was initially placed on a particular share. This is done when you settle your outstanding dues and clear the loan that was secured against the pledged shares, resulting in the shares being unpledged.
When you decide to pledge your shares, the value of the pledged shares is determined based on their market value at that time. Given that market values are subject to continuous fluctuations, it becomes imperative to always maintain the value of the collateral.
If, for any reason, the market value decreases and you fail to possess adequate funds to cover the deficit in the collateral’s value, you will incur a cash shortfall charge. This charge is imposed to compensate for the deficiency in the collateral’s value and ensure the lender’s security.
Risks associated with shares pledged
Let us understand the risks associated with pledging of shares:
Risk of loss
If the share price falls significantly and the borrower cannot meet the loan obligations, the lender has the right to sell the pledged shares, potentially causing a loss of ownership and control for the promoter.
Share pledging can sometimes be viewed negatively by investors and stakeholders, as it may indicate financial stress or a lack of confidence in the company’s prospects.
Borrowing against pledged shares typically incurs interest expenses, which can be a financial burden if the share price doesn’t perform as expected.
Pledging and unpledging of shares are financial strategies that serve various purposes in the world of investments and corporate finance. While they offer advantages such as access to capital and the retention of control, they also come with risks, including potential loss of ownership and market perception issues.
It is crucial for promoters and shareholders to carefully consider the implications and potential consequences before deciding to pledge their shares.
Moreover, regulators and stakeholders play an essential role in monitoring and ensuring transparency in share-pledging activities to maintain the stability and integrity of financial markets.