How Does Pledging Work and What Is It?

If you are a day trader or a long-term investor, you may have heard the term "pledging of shares." Both individual investors and company promoters have the option of pledging shares. But what does "pledging shares" actually mean? How does it function? Let's explore this further.

What is Pledging?

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. 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.

Different Share Pledge Types

Placing up your shares as collateral for additional margin is known as pledging. However, you have a choice between two share-pledging options. The first is fairly simple, while the second is intriguing. Let's go over both types in the section that follows.

1. Margin Pledge

Margin Pledge is a process in which users can pledge their stocks to the broker in return for a collateral margin that can be utilised for trading.

Let’s understand this better via an example; suppose I am an investor who has shares of RIL, TCS, and Infosys worth Rs 2,00,000 in his holding. Now a trading opportunity arises but due to a lack of funds, I am unable to seize it. So, I decided to pledge my stocks to the broker. He then deducts a % haircut (Haircut is the amount that covers the risk a broker is exposed to if the collateral share prices move erratically) of say 20% from the total value of my stocks (calculated at their current market price), i.e., Rs 40,000 and gives me the remaining value of Rs 1,60,000 as a collateral margin which I can now use for trading opportunities.

2. Margin Trading Facility (MTF)

Margin Trading Facility or Margin Trade Facility (MTF) allows you to get more leverage for trading stocks while pledge margin benefit allows you to get more margin for trading in any segment. That’s the first difference.

The second difference between MTF and pledge margin is that MTF requires you to pledge the stocks you’ve bought using the facility on the same day, before 9 PM. You can’t pledge other stocks – just the ones bought using MTF. Or, you could use cash as collateral too.

Stocks bought using MTF have to typically be pledged within T+1 day from the day of purchase (T).

Advantages of Pledged Shares

1. By pledging, you ask the lender for a safe loan that is secured by your stock holdings. Secured loans are easier to obtain and have lower interest rates than unsecured loans.

2. One of the main benefits of pledging shares is the availability of additional cash for various financial requirements, such as margin for trading or other financial needs.

3. When an investor pledges shares, there is no tax obligation involved.

4. The borrower need not sell these shares in order to pledge them. This implies that if the markets rise, the value of investments will rise as well, giving investors access to more money at the same time. Additionally, borrowers continue to benefit from additional benefits like dividend income.

Disadvantages of Pledged Shares

1. The risk associated with stock pledges is one of the disadvantages of stock pledges.

2. Shares pledged as collateral for a loan may be sold on the open market by the lender to recoup the loan balance if the borrower defaults on the loan.

3. The lender's sale of the high net worth investor's shares could cause a further decline in their value, impacting other shareholders as a result.

4. If the promoter of a company defaults on loans for which shares are pledged as collateral, this may harm the company's reputation and its share prices for a considerable amount of time.

How do promoters or investors pledge their shares?

1. The investor or promoter must use a terminal to submit a request for the pledge of shares.

2. The terminal sends an investor's request to either National Securities Depository Limited (NSDL) or Central Depository Services Limited (CDSL) after receiving it.

3. To confirm the PAN or BO ID, the National Securities Depository Limited or Central Depository Services Limited authenticates the request via email or mobile.

4. Investors and promoters can trade with the collateral margin once the request has been approved.

Conclusion

Taking out loans against the shares you own as an investor is what is meant by pledged shares. Pledges are a last-ditch effort by promoters to raise money for their organisation's various financial needs. Individual investors may use pledging as a backup plan to invest in the market without suffering a loss. Additionally, because it gives investors access to higher margins, it allows them to trade in large volumes. Investors and promoters can get the best benefits of pledging shares with better due diligence in terms of planning and strategizing this activity.