Don’t Sell, LEND Dont Buy, BORROW

Sampath Kumar (name changed), a software professional from Bengaluru, holds 2,000 shares of L&T Finance in his portfolio with other shares. Without trading in them and retaining the ownership of these shares, Kumar earns around Rs 3,000 to Rs 4,000 every month.

Another professional stock trader from Mumbai, Praveen Kamdar (name changed), holds 4,000 shares of PVR Cinema, besides other stocks. This stock falls under the hospitality sector and with post-pandemic restrictions like social distancing, the stock price was beaten down. Yet, Kamdar earns a decent Rs 8,000 to Rs 12,000 every month from his holding.

You may wonder how this is possible. Well, in both cases, these shareholders participated in Securities Lending and Borrowing (SLB) – a platform offered by stock exchanges, where traders can borrow shares they do not own, and can lend the stocks they own. An SLB transaction has a rate of interest and a fixed tenure. The broker’s fee ranges from 5 per cent to 20 per cent depending on the liquidity available on the counter.

Exchange-Traded Product

It is an over-the-counter product in most western countries, where the custodians facilitate transactions of borrowing and lending among institutions. However, in India, SLB is an exchange-traded product. Both National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) offer an anonymous trading platform and give players the advantage of settlement guarantees. While SLB platforms of NSE and BSE are similar, the volumes on NSE’s platform are significantly higher. Hence, it offers lenders and borrowers a secured platform to transact, without the worry of counterparty defaults. More importantly, it gives long-term investors a chance to earn risk-free returns while they still own their shares and enjoy the corporate benefits attached.

The stocks mentioned in the above examples, L&T Finance and PVR Cinema, are available on the SLB segment at lending fees of Rs 1.5 to Rs 2.00 and Rs 20 to Rs 30 per share, respectively, which is paid by the borrower. These rates change daily and are based on the demand-supply position of the respective counter.

SLB was introduced over a decade ago. In December 2007, market regulator Securities and Exchange Board of India (Sebi) issued guidelines to put in place an SLB mechanism. The system became operational in April 2008 and ever since it has been offering a safe earning opportunity to investors.

Vinay Punjabi, Head, Markets and Sales, Ventura Securities, says, “The investor gets an opportunity to earn an additional income from lending the shares lying idle in his demat account. The borrowers get access to shares that they can sell if they feel a share is over-priced, and buy back at a later date when the price corrects.”

Investors route deals through the automated screen-based trading platforms of market participants or brokers, which are linked to an authorised intermediary or clearing corporation of the respective stock exchange.  This facilitates the online matching of trades, based on price-time priority. The authorised intermediary also stands guarantor to all the trades, making the entire system free of default risk.

As Punjabi explains, “The whole process of securities lending and borrowing is well monitored by the exchange from a risk perspective like any other cash market transaction. So, it is very safe for an investor to lend shares.” As of February 1, 2019, a total of 365 stocks were eligible for SLB on both exchanges. These include 199 stocks in the Futures and Options (F&O) segment, 166 others.

How It Works

All categories of investors, retail, High Networth Individuals (HNIs) and traders, can lend and borrow stocks through stockbrokers or trading members of the stock exchanges. Approved institutional market participants like banks, custodians, mutual funds and insurance companies, collectively known as Domestic Institutional Investors (DIIs), and Foreign Portfolio Investors (FPIs) can also participate directly through terminals that are directly linked to the authorised intermediary.

Stocks are usually borrowed so they can be short-sold in the market. If traders get a negative view on the price of a stock they do not own, they can borrow the stock through SLB, sell it and buy it back when the price falls. The difference between the selling and buying price, minus the interest and other costs, is the trader’s profit.

Bhavesh Damania, Founder, Wisdom Edge Investments, says, “Retail investors can certainly take advantage of SLB products. For lenders, it gives additional income and remains entitled to any corporate announcements in terms of dividend, bonus, stock split, or rights. So, the idle securities held by investors can earn a decent income.”

Stocks can be borrowed for the duration of one to 12 months. Every transaction is marked with the month in which it is to be settled. The first Thursday is the settlement date for every month when the transaction is reversed and the shares are returned to the lender.

After the first contract, a rollover can be done for one month at a time. The entire contract period cannot exceed 12 months. Within this tenure, the lender can recall the shares at any point. The borrower can also reverse the transaction early and return the stocks before the tenure ends. However, this will bear market rates of borrowing and lending fees, which need to be paid before the settlement.

Lenders can offer their shares online, any time between 9.15 am and 5.00 pm on a regular trading day. When they do so, they have to pay a margin of 25 per cent of the value of the stocks in addition to an end-of-the-day, marked-to-market margin. This margin is released once the stocks are submitted the next day at 9.30 am. The borrower, on the other hand, has to pay a 100 per cent margin on day T+1 (trading date plus one day), as well as lending fees (Rs 1.50 to Rs 2.00 per share in L&T Finance and Rs 10 to Rs 20 per share in PVR Cinema), which are blocked from the collateral.

Both the lender and borrower route their transactions through their respective brokers. These brokers forward the transaction requests to the exchange’s online order matching platform or match them with an anonymous order book on a price-time priority basis. On the next day, (T+1), the lender pays in the securities at 9.30 am and receives the lending fees at 11 am. The borrower too pays out the lending fees at 9.30 am and receives the securities in his account at 11 am.

If for some reason, the lender does not deliver the securities then it culminates in financial closure. Here the lender has to pay the borrower, who is also refunded the lending fee.

Lending periods expire on the first Thursday of the relevant month or the month until which the lender has agreed to lend the shares. In case the borrower fails to deliver the securities, the clearing corporation replaces the lender’s securities by accessing these through an auction mechanism along with the capital market and debits the borrower’s account accordingly. In case these are not available in the auction, there is a financial closure or closeout, and the debt is raised to the borrower. If the first Thursday of a month becomes a trading holiday, then the next working day is considered for reverse leg settlement.

There could be other situations in the market to borrow shares:

Arbitrage (Reverse Cash-Futures Arbitrage) Traders can sell securities short against an offsetting derivatives position to take advantage of a difference in price between the cash and derivatives market. Products like SLB can help in increasing the trading volume of the market and can contain the market volatility successfully. It can also help in making money through arbitrage opportunities.

Leveraging Ban Period Demand When a particular stock in the derivatives segment is in the ban period, the trader can borrow the stock in the cash market and sell to benefit during a bear phase.

Financing Transactions (Funding Products) Traders can borrow stocks and sell them in the capital market to make gains. The amount received could be used for more profitable propositions, after covering the incurred cost.

Cover Unintended Short Sales Borrowed stocks could be used to cover unintended short positions created in the books. “The borrower can square off the position in cash and derivatives for a reasonable fee determined by the market. These would help a trader to square off the position without auction of shares, which are usually at a high discount to the market price,” explains Damania.

It is often seen that long-term big investors like HNIs, DIIs, and FPIs indulge in SLB. This is because they have the advantage of owning a large number of shares and their holding period is of a longer horizon. These long-term investors can earn lending fees in addition to their dividend income, during the holding period.

Overall Benefits Investors can earn a risk-free steady income. Despite lending shares, the lender can retain all corporate benefits like dividend, rights, bonus, stock split, and others announced by the company.

Let’s say a share of a particular company is lent through SLB, and the company announces dividends during that period. In this case, the share is collected from the borrower by the clearing corporation and credited to the lender’s account for dividend collection.

In case of a stock split or bonus announcement, the position of the borrower is adjusted and the lender receives the resultant quantity as the stocks are returned.

Other corporate actions like rights, mergers, open offers, or foreclosure on the ex-date are incorporated in the lender’s account accordingly. In case of a foreclosure, the lender has to pay back the proportionate lending charges received and the borrower receives the same. A new series has been added in which there is no foreclosure in the event of annual or extraordinary general meetings.

Last but not the least, SLB is considered to be a tax-efficient product.  These transactions are not to be regarded as a “Transfer.” However, in the case of a closeout, it would come under the purview of capital gains since the closeout would be considered as a sale of the security. Also, SLB transaction does not attract Securities Transaction Tax (STT) and income generated is shown as “other income” or “business income” for taxation purposes, depending on the entity.

Hence, a steady income from SLB can greatly improve your portfolio performance with added tax sops.

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Short-Sellers Vs Small Investors

Globally, SLB is a popular mechanism as it is seen to provide liquidity to equity markets, thereby increasing the market efficiency. In most western countries, this is an over-the-counter product, wherein the custodian facilitates the transaction of borrowing and lending among institutions. In these negotiated transactions, the lender has to deal with counterparty risk, collateral adequacy, and other related risks, whereas in India, this settlement is guaranteed by a clearing corporation of the exchange.

SLB is more popular in western markets, where naked short-selling is allowed. In case of a shortfall in delivery obligation, the broker has to make the arrangements on behalf of clients. This is the reason why there is a significant turnover involved in the deal.

In India, Sebi has put investors’ interests in the forefront and has put in place a safety mechanism by routing all the trades through an exchange platform. The regulator has put the onus on the clearing corporations to settle and guarantee trades.

According to market participants, to make the product safer, there is a regulation over compliance, which is impacting its growth in India.

yagnesh@outlookindia.com