What is Pledging and How Does it Work?
If you are an active investor in the market, you may come across several terms and concepts as far as investments are concerned. In the share market, too, there are many such terms, and one of them is the pledging of shares. One of the most common questions an investor has is what does pledge mean in the share market?
Well, to answer that, keep reading.
What is Pledging and How Does It Work?
Since shares are assets, they can be pledged by a firm’s promoters as a loan to fund the company’s operational and financial requirements. In the Indian market, the promoters of a firm listed on the exchange are seen as the majority shareholders.
Though the practice of pledging shares is common, it is among the last resort for a promoter to raise funds for the company. However, if a promoter needs to borrow capital, then pledging shares can be a workable solution, especially if liquidity is a problem and the market is volatile.
Individual investors can also pledge their shares if they want to trade higher volumes. These shares can be pledged in their demat account, which is known as Margin against Shares. The investor receives the collateral margin after a certain deduction called a “haircut” had been made to the margin.
SEBI’s Guidelines on Investors’ Pledging of Shares
Since September 2020, pledging of shares has become compulsory in the capital markets, as per a directive by the Securities and Exchange Board of India (SEBI). Before this mandate was issued, stockbrokers would offer investors trading limits as per the holdings in the demat accounts and also the cash balance in the trading account.
However, these securities were considered as collaterals if the investor opted for a margin, and subsequently, if needed, the stockbroker could take the shares from an investor’s demat account. Since this was already agreed to by the client while signing the agreement, it was considered to be in line with the Power of Attorney (POA).
Under the new rule by SEBI, the shares can be pledged by the client through the broker, and only the depositories, National Securities Depository Ltd and Central Depository Services India Ltd, can execute the process after the investor gives a confirmation via OTP authentication.
Pledged Shares Meaning in the Share Market
When a promoter pledges the shares to a lender, it means that the shares are being used as collateral against a loan. When the stock market is bullish, pledging of shares can seem to be a good move considering that investors are optimistic and the market moves upwards. However, there could be potential problems when the economy slows down, and the market becomes bearish.
Also Read: What is Bear Market & how to invest in falling market?
When promoters pledge shares, they retain the ownership of the shares. Since the interest rates are on the rise, it is not uncommon for promoters to collateralise their shares. However, in a falling market scenario, this practice could lead to a volatile price fluctuation if a firm’s majority owner pledges a huge number of their shares. This will also affect the company’s share price. When share prices fall, the total value of the pledged shares also drops.
As a result, the promoter will have to seek out more assets as collateral or could also be compelled to sell these shares to prevent the loan from becoming a bad one.
Though many investors may not know what pledging of shares is, it is important for investors to always look at the promoters’ pledging of shares before they invest in the shares of a company.
Also Read: What is Cumulative Preferences Shares?
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Frequently Asked Questions
Usually, only shares of listed companies can be pledged. But if an unlisted company pledges its shares, there is a procedure that involves a board resolution to be passed.
Yes, pledged shares can be sold. However, the investor can only sell the shares a day after the shares have been delivered or on T+2. So, if the shares are bought on Monday, they can be sold on Wednesday and not on Tuesday.
Pledging of shares is not risky, but at the same time, it is not one of the first options an investor or a promoter would opt for. Shares are pledged for a loan in the case of promoters, while investors pledge shares for a higher volume of trading.