Today, we are going to talk about a very important topic, which is  Pledging and the way I see it is that there are two very important aspects of pledging. One is the conceptual understanding of what pledging is all about and the second is the mechanism of doing pledging through your broker.

In this video, we will focus on the first part which is the conceptual understanding of Pledging and in the subsequent videos, we will talk about how you can pledge your shares through Zerodha, Upstox or any other broker. Pledging can be a complicated topic and hence we thought to make it a bit of fun by making it more of a conversation between two friends and I hope that you will like our approach.

So, let us get started. Srinivas has invested 10 lakh rupees in the stock market and some of them through Mutual funds, stocks and some in ETFs. Since he has invested most of his money, he doesn’t have any left for trading purposes. One day his friend suggested he pledge his investments to get the money that he needed.

His friend said that he pledged his shares and now he was earning in two ways. The first was the long-term growth of the investment itself and the second was the short-term returns that he would generate from trading. Srinivas was fine with it but did not understand the concept of Pledging. He asked his friend, “Are you saying that I have to sell my shares to get the money for trading?”

His friend says, “No.  You’re not selling the shares. When you are pledging, you are essentially loaning your shares to your broker and in return, the broker gives you what is called a Collateral margin, which is basically money that you can use for trading purposes”. It is actually a very straightforward process because most of the brokers nowadays have an online system for pledging and the whole process can be done within a couple of days.

So, Srinivas found it to be good and continued, “That sounds good. How much money will I get for trading? In my case I have 10 lakh rupees worth of investment and so will I get 10 Lakh rupees for trading? His friend says, “ You will get most of what you have invested as collateral margin, but brokers usually like to play safe and they give a little less margin than your investment’s current value and in their language, it is called Haircut percentage.

Hence if the haircut percentage is 10%, you will get a collateral margin of 90%. For an investment of one lakh rupees, for example, you will get a margin of 90,000 rupees. The higher the safety of the investment, the lower is the haircut. Another thing to keep in mind is that not every investment can be pledged.

While most of the investments such as Stocks, ETFs, sovereign gold bonds and active mutual funds can be pledged, there are some investments such as Passive mutual funds or certain debt funds that are not accepted as collateral. I recommend you to check with your broker either through their website or just call them to see what would be the haircut percentage for each of the investments that you hold.

Secondly, which investments are eligible for pledging purposes. Srinivas says, “okay, that makes perfect sense. Now, tell me this. What happens to the shares that I pledge? Do they get transferred from my account to the broker’s account? Well, that was the old process. Nowadays Sebi, our stock market regulator, has made the process more streamlined”.

“What happens nowadays is that your shares never leave your demat account. They always stay in your demat account, but if you pledge them, they will be locked. What that means is that you cannot sell your shares until you unpledge them”. Srinivas feels reassured and nods saying, “That sounds good. Now what about the dividends? Do I still get that or will the dividends be now given to the broker?”

As mentioned earlier, the shares are not leaving your demat account. So what that means is that you will still keep getting your dividends directly in your bank account and there is nothing to worry about. This is all sounding good. Now tell me the cost. How much would the broker charge for all this? Do they charge any interest on the money that they are loaning?”

Well, they are not lending you any money as such and so there is no interest you pay on the margin. It is not that they are giving you money to do something. They are giving you just margin to trade and there is  no interest as such that you have to pay on that margin, but they do charge a nominal fee of about 30 to 40 rupees on each pledging request.

It is again a very small amount and does not matter whether you are pledging a thousand shares or 10,000 shares. However, here is the thing. If you take trades where the margin required is greater than the collateral margin you got, then the broker will charge you a delayed payment on the margin shortfall.

Hence it is very important for you to make sure that you only trade within your limits and you never exceed the margin that you got from Pledging.

To this, Srinivas says, “ It sounds like the broker is not benefiting from this whole pledging process. As a trader, I am using their money. So why do these brokers allow this pledging? Is there any hidden agenda behind it?”

Well, that is a great question. Even though the brokers are not directly making any money from pledging, they do make money when you trade from their account and that is the main incentive for these brokers to give this pledging facility.

“That sounds exciting and great. So tell me, what can I do with this margin? Are there any restrictions on what I can and cannot trade with this money?” So the friend said, “You can use the collateral margin for trading stocks on an intraday basis and you can also use that collateral margin for selling futures and options, but you cannot buy options through this collateral margin and that is one important thing that you need to keep in mind.”

Further, there are some restrictions on how much collateral that you can use for holding overnight positions and so you should definitely check with your broker on that as well.

That was the basic concept of pledging that I wanted to explain in this video and in the subsequent videos, we will talk about the mechanism of pledging through different brokers.

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