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Understanding Stock Lending And Borrowing Mechanism

28 Nov 2023

Introduction

Stock markets offer several opportunities for investors and traders to earn profits. They can buy stocks at lower prices and sell them at higher prices to take advantage of market fluctuations. However, that’s not the only way to profit from the stock markets. You can also lend or borrow stocks from other investors to generate additional income.

Stock lending and borrowing (SLB) is a crucial yet one of the most ignored aspects of the equity markets. It helps maintain liquidity in the market and facilitates various trading strategies for investors.

Keep reading to learn more about the stock lending and borrowing mechanism, including its working, benefits, and risks. Keep reading.

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What is stock borrowing and lending?

Stock lending and borrowing is a process that allows you to lend or borrow stocks from other investors or financial institutions to generate additional income. It involves a temporary exchange of shares between two parties – a lender and a borrower – often for a pre-determined period. This exchange is based on specific terms and conditions mentioned in a lending agreement.

The lender is an individual or an institutional investor who owns the securities and is willing to lend them to another investor. Similarly, the borrower is an individual who plans to borrow securities from another investor for a specific period, typically to cover a short position or to implement other trading strategies. In return, the borrower may have to pay interest to the lender at a pre-decided interest rate. As per the Securities and Exchange Board of India (SEBI), investors can borrow stocks for a maximum tenure of 12 months.

Additionally, to mitigate the risk associated with lending, the lender may ask the borrower to provide collateral in the form of cash, government securities, or other assets. Collateral is a security deposit, ensuring the lender is protected if the borrower fails to return the borrowed shares. The value of the collateral is typically higher than the value of the borrowed shares.

Reasons for stock lending and borrowing

Investors can engage in the process of stock lending and borrowing for a variety of reasons. They include:

  • Short Selling

One of the most common reasons investors borrow stocks is to engage in short selling. It allows an investor to sell borrowed shares in the market only to repurchase them at a lower price before the end of the loan term.

For example, suppose an investor A owns 1000 shares of ABC company worth Rs. 1 lakh. The value of each share is Rs. 100. Another investor, B decides to borrow these shares from A for two months at an interest fee of 1% per month of the total value of the shares. Investor B then sells these shares in the market, hoping their prices will fall.

Suppose the price of the ABC shares fell to Rs. 90 per share after two months. So, the total profit that Investor B made by short selling is Rs. (100 – 90) x 1,000, i.e., Rs. 10,000. The interest that Investor B needs to pay to Investor A is 1% of Rs. 1 lakh for two months, i.e., Rs. 2,000. So, his net profit would be Rs. (10,000 – 2,000), i.e., Rs. 8,000.

  • Settlement Obligations

Another reason for investors to borrow stocks is to fulfill their settlement obligations. For example, suppose Investor A has sold a Call Options contract to Investor B, hoping the prices of the underlying shares would fall. However, the opposite happened, and Investor B decided to exercise his options contract to buy shares from Investor A at a reduced price.

In such a situation, Investor A can borrow stocks from another investor or a financial institution to fulfill his settlement obligation.

  • Market Liquidity

Stock lending and borrowing can also contribute to market liquidity. When different investors engage in the lending and borrowing of stocks, it results in several transactions being made, which in turn, leads to an increased liquidity in the market.

The SLB mechanism also prevents an investor from hoarding particular stocks. It, in a way, ensures that these stocks are readily available in the market for trading, contributing to higher market liquidity.

To conclude

Stock lending and borrowing is a valuable mechanisms for investors, allowing them to generate additional income, fulfil their settlement obligations, and ensure higher market liquidity. But while the benefits are substantial, you must be aware of the associated risks and adhere to SEBI’s regulations to avoid losses.

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