Shares in your portfolio can do more than just reflect the market movement. Through share pledging, you can unlock funds by using your holdings as collateral. This mechanism is often used for liquidity, trading margin, or business financing. However, it also introduces risks that should be understood before using it.
In this blog, we walk through what pledging is, how the process functions, and its impact on the stock valuation
What is Pledging of Shares?
When shares are pledged, it means you’re using your holdings as collateral to obtain funds from a lender. In this arrangement, the borrower remains the owner, but he can’t sell or transfer the securities until the loan is repaid.
This method is commonly used to raise capital without selling the shares. It helps in retaining ownership and also taking advantage of the price appreciation.
In case of non-repayment, the lender can sell the shares kept as collateral to cover the unpaid dues. This is why share pledging is closely tracked by investors and market analysts, especially when it involves promoters of listed companies.
How Does the Pledging of Shares Work?
The pledging of shares requires a structured approach. The key stages are outlined below:
Collateral Agreement
Pledging starts when a shareholder approaches a lender, such as a bank, NBFC, or broker, to obtain a loan or trading margin, offering shares as collateral.
Pledge Creation
A pledge request is placed with the depository participant by the borrower. Once authorised, the shares are flagged as pledged in favour of the lender.
Fund Disbursal
After the pledge is confirmed, funds are provided according to the value of shares used as collateral. The amount is usually lower than the full share value to account for market risk.
Collateral Maintenance
If there is a sharp drop in the value of shares, the borrower needs to provide additional collateral or repay a portion of the loan. This is done to maintain the required collateral level.
Unpledging/Release
Once the borrower repays the loan and interest amount, the shares are released from the pledge, and they return to the normal holdings.
Why Promoters Pledge Shares?
Promoters pledge their shares for various financial and strategic purposes. Below are some common reasons for choosing this route:
- Business Expansion
Promoters pledge shares to raise funds for product launches, infrastructure development, or entry into new markets. - Working Capital Requirements
Promoters may pledge their shares to manage operational expenses such as inventory, salaries, or day-to-day business activities. - Repaying Debt
Pledged shares can be used to raise funds that will help in refinancing or repaying existing loans and reduce financial pressure. - Avoid Dilution
Selling the shares means the promoter’s stake and control in the company will be reduced. Pledging allows access to funds without losing the shareholding. - Funding Other Ventures
Many promoters have investments in multiple businesses. Pledging shares in one company can provide funds for investments or projects in another venture.
What is a Haircut?
A haircut in share pledging means the percentage by which the market value of securities is reduced for lending purposes. It is calculated to determine the amount of funds that can be provided against the shares.
Lenders apply this reduction as a safety margin to manage the risk of price fluctuations. The haircut can vary based on the volatility, liquidity, and risk.
Suppose an investor pledges 1,000 shares of a company, and the market price of each share is ₹400. The total market value:
1,000 × ₹400 = ₹4,00,000
If the lender applies a 25% haircut, only 75% of the share value will be considered.
Total value of pledged shares = ₹4,00,000
Haircut applied = 25%
Eligible collateral value = ₹3,00,000
This means the investor may receive funds based on ₹3,00,000, rather than the full ₹4,00,000 value of the shares.
Impact of Pledging Shares on Stock Valuation
The pledging of shares influences how investors view a company. Investors closely monitor the pledged promoter holdings because they indicate financial leverage and potential risk.
Suppose the promoters of ABC Technologies Ltd. hold 60% of the company’s shares. The total outstanding is 10 crore shares, which makes their holding 6 crore shares. They pledge 35% of their holdings (2.1 crore shares) to raise funds. At this time, the stock is trading at ₹800 per share, giving pledged shares a value of ₹1,680 crore.
If the stock falls to ₹650, the collateral value drops to ₹1,365 crore. Additional collateral or partial repayment may be requested by the lender. If this condition is not met, some pledged shares will be sold, which can put pressure on the stock price.
In such circumstances, investors reassess the company’s financial position and take a cautious approach ahead of the stock price movement .
Advantages of Pledging Shares
Pledging shares is a commonly used practice in financial markets and may be associated with several potential advantages.
- Liquidity Access: Pledging allows shareholders access to funds while continuing to retain their holdings, helping them benefit from future price appreciation.
- Retention of Ownership: The owner has all the holding rights, which means they are entitled to voting rights, dividends, and bonuses.
- Quick and Convenient: The pledging process is carried out by demat systems and broker platforms. It can be easily completed through electronic platforms.
- Flexible Financing: Pledged shares provide funds that can be utilised for a variety of needs, such as expansion, working capital, or as trading margin.
- No Tax Liability: Unlike selling shares, which immediately attracts capital gains tax, pledging does not immediately cause a taxable event.
Disadvantages of Pledging Shares
Share pledging may offer advantages, but it can also create certain challenges:
- Forced Selling: The lender may sell the pledged shares for recovery if the borrower fails to repay the loan or maintain collateral levels.
- Market Volatility: Falling share prices lower the collateral value. It may lead to margin calls or additional collateral requirements.
- Negative Perception: High levels of pledging by the promoters signal financial stress, which can cause the share prices to fall and lower investor confidence.
- Limitations on Trading: In some cases, lenders may place lock-in conditions on the shares, which may reduce the borrower’s financial freedom.
- Interest Costs: Loans or margin obtained against pledged shares carry interest charges, which can increase the overall cost of borrowing if held for a longer period.
How Do Investors or Promoters Pledge Shares?
The process of pledging shares follows a systematic sequence. Below are the typical steps involved in pledging shares:
Step 1: Initiate a Pledge Request
The process starts when an investor or promoter submits a pledge request. The request is placed through a trading platform by selecting the shares to be used as collateral.
Step 2: Confirmation Through Depository
After the request is submitted, the depository (NSDL or CDSL) sends a notification for the pledge confirmation to the shareholder for authorisation.
Step 3: Approve the Pledge Request
The received request has to be approved through a secure authentication process, usually via OTP or a depository link.
Step 4: Shares Marked as Pledged
Once the request gets approved, the selected shares are marked as pledged in the demat account. They cannot be freely traded while the pledge is active.
Step 5: Funds Provided
Based on the collateral value of shares and the applicable haircut, the lender provides trading margin or loan funds to the borrower.
Is Pledging of Shares Good or Bad?
Pledging shares is comparable to pawning an asset. Instead of selling shares, you use them as collateral to obtain funds. The ownership remains with the investor, which allows them to retain their long-term investment position.
Unlike physical assets, the shares are linked to market movement and their value changes depending on the market conditions. If the value of pledged shares declines, lenders may require additional collateral or take steps to recover the loan, which introduces more risk.
Pledging shares isn’t inherently bad or good. It is better to view it as a financial tool that can be effectively used with the right approach.
Conclusion
Pledging shares allows shareholders to raise funds by using their holdings as collateral without losing ownership. It provides liquidity, is convenient, and does not attract taxes. But it also has risks related to price movement and repayment obligations.
Used carefully, pledging shares has the potential to become a practical financial tool in your investment strategy.
FAQs
A pledged share is used as collateral to obtain a loan or trading margin. The shares remain in the investor’s demat account, but they are marked as pledged and cannot be freely sold until the pledge is released.
When shares are pledged, they are used as security for borrowing funds. The shareholder continues to own the shares, but the lender has rights over them until the loan is cleared.
Pledging shares is generally considered a tool rather than something good or bad. Its impact depends on how it is used and the level of risk involved.
Pledged shares cannot be sold while the pledge remains active. The borrower must first repay the obligations and release the pledge before the shares become tradable again.
