Pleding of Shares: What is it & How it Works?| Espresso

What is Pledging of Shares?

Pledging of shares is an option that the shareholders of an organisation use to secure loans to meet their working capital requirements and fund other acquisitions or business ventures. Simply put, a shareholder in a company pledges a share to avail of a loan in a pledging. While pledging the shares, the promoters retain their rights over the company.

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However, when the share prices fluctuate in the equity trading market, the collateral value also changes. And when the pledged share values with a lender fall below a level, it causes the ‘margin call’. Here, the promoters need to account for the deficit in the collateral value.
Also Read: What is collateral Amount in Demat Account?

Banks can also sell the shares being pledged in the open once the borrower cannot repay the exact collateral value as mentioned in the contract. The pledged stocks are lost once they are sold in the open share market. This diminishes the shareholding of the promoters, and, the stock value gets reduced.

What is Pledging of Shares & How Does it Work?

Many shareholders have ETFs and stocks in their holdings with limited cash margins. Due to this, they often lose out on trading opportunities. In such cases, they can pledge their ETFs and shares for collateral margins, which they will receive post a deduction of a certain percentage known as a ‘haircut’.

Share pledging is usually the last resort for shareholders to raise funds. And when a promoter pledges his share, it means that he has no other options left for raising the required amount of money. Therefore, it is relatively safer for the promoter to use debt or equity as collateral. However, pledging shares is only favourable in the equity markets when the share prices move upwards.
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For a business, share pledging is often a bad sign as it suggests a lack of capital, unhealthy cash flow patterns, and shareholders’ incapability to match the working capital needs. Similarly, pledging of shares can be boring for companies as well. This is because the promoters need to maintain the collateral value by providing additional shares to the lenders whenever their value lessens. And in case the promoters fail to do so, lenders will have the right to sell off the shares in the open market for recovering their money. This can lead to a decrease in the shareholding in the company for the promoters.

What is a Haircut?

A haircut in pledging of shares refers to a percentage of the difference between the market value of an asset and the value that is used as collateral. For example, if the market value in equity trading is ₹2000 and the collateral value is ₹1000, the haircut deduction percentage is 50%.

How Does pledging of shares Happen?

Here is a simple 4-step process of pledging of shares

  • Step 1: The shareholder or promoter initiates a request for share pledging using the stock trading terminal.
  • Step 2: The stock trading terminal then sends the request to the NSDL/CSDL for confirmation once it receives the pledging request from the promoter.
  • Step 3: Next, NSDL/CSDL authenticates the request from the trading terminal with an email or mobile authentication process for PAN/BOID.
  • Step 4: Once the authentication is approved, the collateral margin is made available to the promoters for trading in the equity trading

Conclusion

Pledging shares is a typical way to access funds for a business. However, a few negative experiences in the past have provided a negative connotation to this particular instrument in the share market. Usually, share pledging denotes poor cash flow patterns and credit crunch. Therefore, the shareholders will be unable to meet their future financial goals for the business's goodwill. However, promoters often pledge shares to meet their personal needs as well.

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Frequently Asked Questions

Yes. Securities present in Demat (dematerialised) mode can be pledged in the equity trading market.

If a promoter takes a loan against securities owned by him, the securities are pledged in favour of the lender (Pledgee). Here, the borrower is called a ‘Pledger’, and the lender is called a ‘Pledgee’.

Yes. Officially all kinds of securities can be pledged in the share market. However, it depends on the pledgee to accept a certain kind of security as a pledge or not.

Pledging of shares involves creating a lien on the stocks promoters hold in their Demat account in favour of their broker. So, for example, if you have 100 shares of a company in your Demat account, you can create a pledging of shares in favour of your broker.