The ABC of stock lending

After SEBI reintroduced short-selling by institutional investors from April 21, 2008, investors may have yet another option and make the best use of their idle shares. The stock lending and borrowing scheme, an essential element in short-selling to take off, allows investors to lend shares to potential arbitrageurs and short-sellers for a fee. And, what’s more, the entire stock lending and borrowing (SLB) mechanism is supervised by the National Securities Clearing Corporation (NSCCL), thus ensuring a safe system. If your stock is in demand, you could easily pocket a return of around 7-8 per cent per annum for your idle shares.

But why should market players borrow your shares? Arbitrageurs, as they are called, look for possible differences in the prices of stocks in the spot and futures markets. In this case, if there’s a huge discount in a stock’s futures trading price compared to its spot price, arbitrageurs sell shares borrowed from you, buy its futures immediately, and pocket the difference after paying you a fee.

This can only be done if the futures settlement coincides with the stock lending and borrowing settlement period. Shortsellers, on the other hand, are bearish on a stock, and want to borrow your shares, sell the same, and buy it back when the spot prices have fallen. Here, too, they can pocket the difference after paying the lenders a fee. Short-sellers can make a loss if their calls go wrong, but they still have to pay the fee for the borrowed shares.

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For now, SEBI has restricted short-selling and, therefore, your lending list, to 227 stocks that are traded on the futures and options (F&O) segment, so that limits your lending options.

The infrastructure for SLB is similar to the one for normal stock trading. An automated screen-based order matching system provided by the clearing houses of stock exchanges matches the trades. The settlement is done through the NSCCL, where banks, custodians and brokers can become participants by registering. Participants who want to lend or borrow securities can do so either on their own account, or on behalf of their clients. To use this facility on behalf of a client, a participant has to enter into an agreement with each client and apply to NSCCL for allotment of a unique client ID number.

The SLB scheme gets carried out in terminals as mentioned earlier from Monday to Friday between 10 a.m. and 11 a.m. and all orders are matched on a price-time priority. The pay-in and pay-out of funds and securities are through designated bank accounts and securities settlement accounts, respectively.

Lending curbs

SEBI has, however, restricted the quantum of lending. Total SLB transactions cannot exceed 10 per cent of the free-float equity of a company, or 10 per cent of the subscribed capital in the company. No participant can have open positions of more than Rs 50 crore or 10 per cent of market-wide position limits, whichever is lower. Individuals, however, will not be able to have open positions over one per cent of the market-wide position limits.

For the individual investor, his shares are secure. However, he could make a mark-to-market loss for one day if the share price moves up during the transit period. “The lender’s risk is generally limited to miscalculating the period of lending or the timing of lending,” says Sandip Raichura, Head, e-broking and New Initiatives, DBS Cholamandalam.

When you lend your shares, you are not able to access the same till the lending and borrowing settlement is over, which is nine days. On the other hand, a borrower who wants to short-sell loses if his call goes wrong. Besides, the transaction costs are high, so a borrower will have to play it extra safe. Says Bhavesh Shah, Vice President, Research, Asit C. Mehta Investment Intermediates: “In SLB, the risk-reward ratio does not favour the investor who short-sells. There is a large cost of carrying and the call could go wrong in a short span of time, resulting in big losses.”

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Margins are high— around 40 to 46 per cent of the value of the transaction, and this increases the cost of transaction and leads to low volumes. Says Shah: “High networth individuals can participate in SLB.”

Participants have to deposit collateral of Rs 10 lakh with the NSCCL. A stock lending transaction is completed within nine days. After a short-seller sells shares, he borrows the shares from the SLB. Both the lender and borrower are expected to maintain deposits.

For now, the stock lending mechanism has been slow to take off due to the long and tedious paperwork. Also, borrowers have to settle their transaction within eight days, which, market players contend, is too short a period to take a call on a stock’s price movement. But as more institutions and retail investors participate, stock lending will come of age. Says Sailav Kaji, Head, Derivatives and Strategy, PINC Research: “Despite this daunting prospect, SLBs do help in the price discovery process and provide a liquidity boost where the ownership of a stock is either heavily concentrated or non-promoter holding is very low.” Experts say that the broad market is struggling due to a host of macroeconomic issues, like inflation, and elections. It’s probably a time when you can look for opportunities to lend your shares.