Make Risk-free Gains on Your Stocks Irrespective of Market Movements

Securities Lending and Borrowing
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Securities Lending and Borrowing (SLB) was introduced and implemented in India over a decade ago. In December 2007, SEBI issued guidelines to put in place a Securities Lending and Borrowing Mechanism in India. The system became operational in April 2008 and has been operational ever since, although there has been some revision implemented in June 2010 by NSE Clearing Ltd (NCL; formerly known as the National Securities Clearing Corporation Limited or NSCCL).

Globally, Stock Lending and Borrowing is a very popular mechanism as it is seen to provide liquidity to the equity market and thereby increases the market efficiency. At an investor level, it offers lenders and borrowers a secured platform to transact, without the worry of counterparty defaults. More importantly, it gives long term investors, who own stocks, a chance to earn risk-free returns while they still own their shares and enjoy all the corporate benefits attached to holding them.

In most other countries, this product is an OTC (Over the counter) product, wherein the custodian facilitates the transaction (borrowing and lending) among institutions. In these negotiated transactions between two parties, the lender has to deal with counterparty risk, collateral adequacy and other related risks.

In India, SLB is an exchange-traded product and both the NSE and BSE offer an anonymous trading platform and give players the advantage of settlement guarantees. While the SLB platforms of NSE & BSE are similar, the volumes on NSE’s platform are significantly higher. Hence, we will talk about NSE’s platform only.

What is Stock Lending and Borrowing?

 

Stock lending and borrowing is a system through which traders borrow shares that they do not already own, or lend stocks that they own but do not intend to sell immediately.  Just like in a loan, SLB transactions are executed at a rate of interest and tenure that is fixed by the two parties entering the transaction. However, there are some differences – crucially, the rate of interest is market-determined and free of control.

In India, lenders and borrowers route their transactions through the automated screen based trading platforms of market participants (brokers), which are linked to an Authorized Intermediary (AI),  NSE Clearing Ltd (NCL), which facilitates with the online matching of trades, based on price-time priority. The AI also stands guarantor to all the trades, making the entire system free of the risk of default.

Is Stock Lending and Borrowing applicable to all stocks?

As on 1st February 2019, a total of 365 stocks were eligible for SLB. These include all stocks in the F&O segment (a total of 199 stocks) some others (166 stocks) too.

Who participates in this market?

All categories of investors and traders can lend and borrow stocks through intermediaries/brokers (trading members) of NSE. In addition, approved institutional market participants such as, banks, custodians, Mutual Funds, Foreign Portfolio Investors and Insurance companies can also participate directly through terminals which are directly linked to the AI.

Why do traders borrow stocks?

Stocks are usually borrowed so they can be short-sold in the market. When traders have a negative view on the price of a stock they do not own, they could borrow this 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.
Some situations wherein securities can be borrowed for gains:

  • 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.
  • Leveraging ban period demand: When a particular derivatives scrip is in the ban period, the trader can borrow scrips and sell them in the market to benefit during a bear market.
  • Financing Transactions (Funding Products): Traders could borrow stocks and sell them in the capital market segment 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

Who lends these shares and how do they benefit?

Stocks are lent by long-term investors, like HNIs and Institutions, who own a large number of shares that they do not intend to sell in the near future. These long term investors can earn lending fees in addition to their dividend income, during the holding period.

  • Risk- free income.
  • Retention of all corporate rights as owner.
  • Settlement guaranteed by NSE Clearing Ltd.
  • Low transaction costs.
  • Potential to improve the portfolio performance.

How does SLB impact the lender’s rights in the event of corporate action with respect to the shares?

  • In the case of a Dividend – These are collected from the borrower on the record date by the NCL and passed on to the lender.
  • Stock Split / Bonus – The position of the borrower is adjusted and the lender receives the resultant quantity when the stocks are returned.
  • For Other Corporate Actions, such as Rights, Mergers, Open Offers, there is a foreclosure on the ex-date. In the case of a foreclosure, the lender has to pay back 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 AGMs/EGMs.

For how long can a stock be borrowed?

Stocks can be borrowed for any tenure up to 12 months. Each SLB transaction is marked with the month in which it is due to be settled. The first Thursday of each month is the settlement date for that month (the date on which the transaction must be reversed and the shares must be returned to the lender).

The first contract can be for either 1 month or 2 months, after which a rollover can be done for one month at a time. However, the entire contract period cannot exceed 12 months.

The tenure is, however, not strict, and the lender of the stocks has the right to recall the shares at any point during the tenure. The borrower also has the option to reverse the transaction early and return the stocks before the tenure ends. However, this will be at market driven rates (Lending & Borrowing Fees).

How does it work?

The settlements of SLB transactions are routed through the existing stock market infrastructure.

Lenders can offer their shares for SLB online, any time between 9.15 am and 5.00 pm on regular trading days. When they do so, they have to pay a margin of 25% of the value of his stocks in addition to an EOD mark to the 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% margin on day T+1, as well as lending fees (fees due to the lender), which are blocked from his collateral.

Both the lender and borrower route their transactions through their respective Trading member intermediaries forward these transaction requests to the NSE’s online order matching platform (matching with an anonymous order book), which matches orders on a price-time priority basis.

On the next day, (T+1), the lender pays in the securities at 9.30AM and receives the lending fees at 11 AM. The borrower pays out the lending fees at 9.30 AM and receives the securities in his account at 11 AM.

Securities Lending and BorrowingSecurities Lending and Borrowing

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

Lending periods expire on the first Thursday of the relevant month (i.e. the month until which the lender has agreed to lend his shares). In case the borrower fails to deliver the securities, the NCL replaces the lender’s securities by accessing these through the 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 close-out and the debt is raised to the borrower.

Securities Lending and Borrowing

*if during any month Thursday is a holiday, the next working day will be considered for reverse leg settlement).

What are the tax implications of SLB?

As per a CBDT circular (no. 2/2008 dated 22-2-2008) SBL transactions shall not be regarded as a “Transfer”.  However, in the case of a closeout, it would come under the preview of capital gains rules as the closeout would be considered as a sale of the security. STT is not levied in case of SLB transactions (specified in the same circular) and income generated from SLB activity should be shown as “Other Income” or “Business income” for taxation purposes, depending on the entity.

How can I participate in SLB?

If you have completed all your KYC requirements with your broker, all you need to do is submit a signed Enablement Form and you’re all set to participate in SLB.

If you have any queries or would like further clarification on anything related to SLB, write to us at bharatshah@ventura1.com or call us on 9821022970

 

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