What is Pledging of Shares?

At one point or another, we may find ourselves in a situation where we require a certain amount of capital. A common solution to this is borrowing a loan by pledging an asset for the monetary requirement.

Property, home, car, deposits, etc., are the most popular collateral options for getting a loan. But have you heard about pledging shares? Yes, you heard it right; most investors and promoters use this practice to collect funds. Let us learn more about its regulatory implications, requirements, advantages, and disadvantages. 

What is Pledging of Shares?

Share Pledging is an agreement in which one uses existing shareholdings as collateral to raise funds for one’s investing needs for a specified period. In this process, a shareholder (the pledgor) uses their shares as security credit, also called collateral margin, to borrow against them.

The pledged stocks don’t leave the borrower’s demat account during the tenure of the borrowing. Instead, a pledge is marked on behalf of the broker under a separate demat account labelled ‘TMCM – Client Securities Margin Pledge Account’ for this purpose (TMCM stands for Trading Member Clearing Member). The broker then re-pledges these securities in favour of the Clearing Corporation and obtains margins.

If the pledgor fails to meet the loan obligations, the pledgee has the right to sell the pledged shares to recover the outstanding amount.

How Much Amount Can One Borrow Against the Shares?

Knowing that the value of shares is volatile, it is obvious to get the question of the amount of funds one can raise by putting the shares as collateral. Fluctuations in the market value of pledged shares affect the collateral’s value. Investors must ensure the collateral value meets the minimum agreed upon in the contract. When the shares’ value drops below the minimum level, the borrower must provide more shares or pay cash to cover the shortfall.

According to RBI regulations, a loan-to-value (LTV) ratio of 50% must always be maintained when lending based on a stock pledge.

How Share Pledging Works?

1. First, shareholders or promoters approach a financial institution to express their intent to pledge their shares to get a loan. To determine the loan amount, the lender assesses the shares’ quality, liquidity, and volatility.
2. Upon approval, both parties enter into a formal pledge agreement. This document has details of the terms and conditions, including the loan amount, interest rate, tenure, and conditions under which the lender can sell the shares.
3. Lenders typically do not provide loans equal to the full value of the pledged shares. They apply a margin, popularly known as a “haircut“, which is a percentage reduction from the market value of the shares. It serves as a buffer in case the stock price drops.
4. Once the loan is repaid, the investor can request the lender to release the pledge, regaining complete control over their shares.
5. If the borrower defaults or the share price falls below a certain threshold, the lender can sell the pledged shares in the open market to recover their dues.

Example of Share Pledging

Imagine a public company, XYZ Industries. You have 1,000 shares of this company worth ₹50,000. The share has been constantly performing well, and you don’t want to sell it. However, you need ₹40,000 for your new project. 

You approach a financial institution and pledge 1,000 of your shares (worth ₹50,000) to get a loan of ₹40,000. The bank agrees to lend you ₹40,000, but they keep all 1,000 shares as security.

Read Also: Margin Pledge: Meaning, Risks, And Benefits

Who Can Pledge Shares?

• Promoters are typically the founders or the company’s primary owners who have a significant stake in it. They often pledge shares to raise capital for business expansion and personal needs or to finance new projects without diluting their ownership in the company.
• Institutional Investors include entities like mutual funds, insurance companies, and pension funds that hold large shares in various companies. They can pledge shares to raise short-term liquidity or to leverage their investment positions.
• Individual Shareholders who own company shares, not necessarily in large quantities. Individual shareholders can pledge shares to meet financial needs.
• Companies that hold shares of other companies as part of their investment portfolio. Companies might pledge these shares to raise funds for working capital, debt repayment, or strategic investments.

Advantages of Share Pledging

The following are some benefits of Share Pledging:

• Share pledging allows shareholders to access funds without selling their shares, which is useful for personal or business financial needs.
• Shareholders retain ownership and voting rights by pledging shares instead of selling them.
• Shareholders can leverage their holdings to obtain loans for further investment or expansion, potentially enhancing returns.
• Pledged shares can be released once the loan is repaid, offering a flexible financing option without permanent loss of ownership.

Disadvantages of Share Pledging

The following are some limitations of Share Pledging:

• If the borrower fails to repay the loan, the lender can sell the pledged shares, resulting in a loss of control.
• The value of pledged shares is subject to market fluctuations, which can lead to additional collateral demands or share sales by the lender if prices drop significantly.
• Loans obtained through share pledging come with high interest and fees.

Read Also: Margin Call: – Definition and Formula

Conclusion

Following a structured approach, pledging shares is viable for stakeholders seeking liquidity without selling their holdings. While keeping shares as collateral, one has to pay an interest rate on the loan. Thus, getting good shareholding returns will be a good option to mitigate this interest expense. Understanding share market indicators and trends is essential to making an informed decision.

Frequently Asked Questions (FAQs)