What is Pledging and How Does it Work?

Pledging of shares in simple terms means taking a loan against the securities you own. It is a popular way of raising capital for individuals and companies, to meet their working capital requirements, clear existing debt etc.

A share pledge means taking a loan against the shares in possession. In the process of pledging, companies, promoters, and individuals do retain their ownership of the shares.

A pledge meaning indicates keeping something as collateral.

Pledging allows investors to trade in high volumes as they have access to higher capital. Pledge meaning in the share market is to keep shares as collateral. Individual investors also pledge shares to obtain debt from banks or financial institutions to fund their trading margins.

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How does the pledging of shares work?

Due to limited cash margins, investors may lose opportunities in the market. In such cases, investors pledge their shares for margins called collateral margin, which is further utilised for trading in different segments of the market. The collateral margin is received after a percentage deduction called a haircut.

The margin received from pledging of shares is used for trading equity, intraday, futures and options etc. As the nature of the stock market is dynamic and ever changing, the value of the pledged shares may fall at any point. In case of a fall, the investors and promoters must give more cash or pledge more shares to meet the margin requirements. The lenders have clauses with specific terms and conditions in the contracts in scenarios like these. Investors should evaluate these terms before they avail of loans against shares.

What is a haircut?

A haircut margin in the case of pledging shares is to safeguard the interests of the lender. A haircut margin is the difference amount between the actual value of the shares against the collateral value.

Let us assume, as an investor you are pledging shares with an actual value of Rs. 10 lakhs as per its current stock prices. The collateral value of these shares will be less than 10 Lakhs. The lender may provide a collateral value of let’s say Rs. 8 Lakhs. This means that the haircut percentage is 20% in this case.

The lender does this due to the volatile nature of the stock market. If the share prices fall rapidly in an event, the lender may suffer significant losses if they don’t keep the haircut percentage.

Advantages of Pledging Shares

  • Pledging involves obtaining a secure loan from the lender against the shares you own. Availing of secured loans is simple and they also attract low-interest rates compared to unsecured loans.
  • Access to additional cash for various financial requirements, such as margin for trading or other financial needs is one of the key advantages of pledging shares.
  • If an investor pledges shares, there is no tax liability associated with it.
  • Pledging does not require the borrower to sell these shares. This means that if the markets are increasing the investment value also increases, and at the same time it also provides additional cash to the investors. Additional benefits like dividend income also stay intact and borrowers receive the benefit of it.

Disadvantages of Pledging Shares

  • A disadvantage of pledging shares is the risk associated with it.
  • If the borrower defaults on the loan where shares are pledged as collateral, the lender may sell the shares in the market to recover the loan amount.
  • The selling of shares by the lender for the high net-worth investor may lead to a further collapse in the prices of these shares, affecting other shareholders in the process.
  • If the promoter of a company defaults on loans where shares are pledged as collateral, this can leave a negative impression of the company and its share prices can be impacted negatively for extended periods.

How do investors or promoters pledge shares?

  • The investor or promoter has to submit a request for pledging shares using a terminal.
  • After receiving a request from the investor, the terminal forwards the request to National Securities Depository Limited (NSDL) or Central Depository Services Limited (CDSL).
  • The National Securities Depository Limited or Central Depository Services Limited authenticates the request via email or mobile to verify the PAN or BO ID.
  • Once the request is approved, the collateral margin is available for trading to investors and promoters.

Conclusion

Pledged shares meaning is to take loans against the shares that you hold as an investor. For promoters, pledging acts as a last resort to raise funds for various financial needs of their organisation. For individual investors, pledging can be a recourse strategy to invest in the market and not lose any profits. It also enables investors to trade in high volumes as it unlocks higher margins for them. Investors and promoters can get the best benefits of pledging shares with better due diligence in terms of planning and strategizing this activity.

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