Stock Lending and Borrowing: The market is full of interesting concepts, both simple and complex. The simple version of the market is trading and investing in stocks and mutual funds. The complex version is knowing the internal mechanisms that go into the system that we know as the stock market. One such complex mechanism is stock lending and borrowing.
In this article, we’ll try to explain stock lending and borrowing in a simplified and understandable way.
What is Stock Lending and Borrowing?
SLB, also known as securities lending and borrowing is a process through which investors and investment firms borrow securities for a specified period of time. The securities that are lent and borrowed are stocks, commodities, and derivative contracts.
SLB improves liquidity in the market, while also allowing the investors who hold the stock to earn money on their stocks through lending.
(Securities)Stock Lending and Borrowing: How It Works
The SLB system allows traders to borrow shares that they don’t own at present or also lend the stocks they own to other traders. Stock lending and borrowing transactions aren’t free, as they attract interest rates and collateral pledging, for a fixed tenure.
SLB works in favor of both parties – The Lender earns money through the interest on issuing stocks to other entities and the borrowers benefit by short selling.
The parties involved in the SLB transaction must sign a security lending agreement, which specifies the terms of lending, tenure, interest rate, collateral, and fees. The collateral that has to be provided against the borrowed securities should be equal to 100 percent of the Along with the technical details of the agreement, it also mentions the deadline for returning the securities and a clause that states that lenders may take the securities back before the expiration date.
Perks Of Stock Lending and Borrowing:
The system of Stock lending and borrowing wouldn’t exist if both parties benefited from it. Here are some of the perks of stock lending and borrowing, from lender and borrower perspectives.
From the Lender’s Perspective:
Extra Income: Generate extra income from a stagnant portfolio. This is through the fees charged on lending along with the interest income for the lending tenure.
Diversification: Stock lending is also seen as a form of diversification where investors can hedge the risk of stocks held by lending them.
Lower Risk: Apart from the interest and borrowing fees, the lenders receive collateral against the shares they issue to borrowers. There’s also no counterparty risk as the National Securities Clearing Corporation (NSCCL) guarantees the securities lending transactions.
Corporate Action Benefits: Even though the securities are lent, the lenders are still entitled to corporate actions such as dividends and bonuses during the lending tenure.
From The Borrower’s Perspective:
Short Selling: The borrowers can short-sell stocks, giving them additional options in the market.
Meet Obligations: SLB allows borrowers to meet their obligations in case they are short for delivery and want to avoid an auction in the cash segment.
Risk Of Stock Lending and Borrowing:
Every investment carries risk, including stock lending and borrowing. The risk involved in SLB puts both lenders and borrowers in a tricky position.
Price Fluctuation: If you are a lender, the main risk is a price drop/fall in the value of the collateral received from the borrower. This is apart from the concerning risk of default and insolvency of the borrower.
Collateral Timing Risk: A timing risk is where the lender sends the securities before receiving the collateral, putting themselves at a higher risk.
Borrower Insolvency: The assumption that borrowers will return lent securities is realistic to the point that they do not go bankrupt/insolvent. A borrower in this situation is legally incapable of repaying any of his loans and debt obligations, and that leaves the lender at a complete loss.
Requirements For Securities Lending and Borrowing In India:
Stock lending and borrowing is a complex mechanism that very skilled and experienced traders and investors know to apply. The requirements to participate in SLB depend on the stock broker and their policy. To know the actual details to begin stock lending and borrowing, contact your stock broker.
Stock lending and borrowing is an interesting and unique practice that can prove to be very fruitful to traders, irrespective of being a lender or a borrower. However, it is recommended that you learn everything there is to know about SLB before getting involved. That’s all for this article on SLB. We hope you found it educational. Till next time, Happy Investing.
Written By – Karan N
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