Stock Lending and Borrowing(SLB): A source of additional income for investors

SLB i.e. Stock Lending and Borrowing  is a medium by which traders who don’t have the stock can borrow it from Investors who own those stocks and in order to borrow those stocks the market participants (Investors) should pay interest, put up collateral and also decide on the duration which is very similar to how you do when you take a loan. As per SEBI rules, the stocks can only be borrowed for a maximum of 12 months. The interest rate varies for different stocks and it is not decided by the lender but by the market forces such as the supply and demand. The collateral value should generally be 100% of the value of the security’s market value. In India, more than 200 stocks are available on the SLB platform for borrowing. 

Stock Lending and Borrowing(SLB)

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The lenders are usually HNIs (High net worth Individuals) or large corporations and firms. The reason they loan out the stocks to traders is because the corporations usually have the stocks as a form of long-term investment and instead of allowing them to lie idle in their account they loan them out to generate income. As a part of the lending agreement, all the rights of the stocks are transferred to the borrower which includes the dividends, voting rights if they have any, and any other distributions which are recorded and later returned back to the lenders.

Now you might question why would people want to borrow stocks? The reason is because the borrowed stocks can be used to generate income by using different strategies like short selling, reverse arbitrage, etc.

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Benefits of borrowing

  • Short selling: short selling is a trading strategy in which the borrower speculates the decline in the price of a stock in the future and hence he buys the stock now and sells it immediately in the open market so that he can later buy back the stock when the price declines this allows the short seller (borrower) to make a profit due to the difference in selling and buying prices.

Let me give you an example, say a trader speculates stock price of Abc Company which is currently selling at ₹500 to fall in the next few weeks so now he borrows 100 shares of the company from a lender and immediately sells the share in the open market at the current price (100×500 = 50,000), he waits a few weeks and as he speculated the stock price falls to ₹350 (100×350 = 35,000) now he buys the stock from the open market and returns the borrowed stock to the lender. This is how the trader makes a profit of ₹15,000 (50,000-35,000) by short selling.

This strategy is generally used by experienced traders/investors because of the high risks involved due to speculation.

  • Reverse Arbitrage: reverse arbitrage is a strategy that can be used when the future price of the stock is a discount to the underlying stock price. This strategy is only worthwhile if the future contract price is cheap when compared with the current stock price (spot price).

Let me give you an example this helps you get a better understanding of this strategy, say an Investors/Trader finds a stock with a future contract value of ₹700 and the current stock price is ₹750 now the investor shorts the stock at ₹750 and simultaneously buys the stock futures at ₹700. At the expiration date when the price of both the stock and the futures are the same the investor accepts the delivery of the asset (stock) against the future contract and uses it to cover the short position and makes a profit of ₹50 (750-700).

This strategy may feel like it’s completely risk-free but there are some risks involved such as an increase in carrying cost or lending fees but it does prevent any risks due to market movement because once the trade is in motion the only thing that remains is the delivery of the stock to the lender by exercising the future contract.

  • Hedging: The best way to understand hedging is, it is a type of insurance. It is a method of taking positions that are usually opposite to your investment position in order to limit risk. Borrowers can use the SLB method as a hedge to mitigate the risks either by short selling or just holding it until the expiry date. There is a risk and reward trade-off in this method because even though it limits the risks it would also reduce the potential gains.

For most investors, hedging doesn’t come in to play in their usual financial activities and the typical “buy and hold” (long term) investors tend to ignore the short-term fluctuations in the market.

Also read: 6 Factors that Affect Stock Prices in India

SLB Relevance

SLB was generally used for reverse arbitrage but now that the SEBI has announced the Indian derivatives markets move from cash to physical settlements it has brought more short sellers into the market. SEBI has also placed many regulations on the SLB platform including a reliable settlement system. In most counties, SLB is an OTC (Over the counter) product but in India, it is an exchange-traded product which is settled by clearing corporations, which means that there is no counterparty risk involved.

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Conclusion

Stock Lending and Borrowing(SLB) opens up a new avenue for investors to generate income by using different strategies or can be used as a form of insurance by hedging the risks. The governing body SEBI placed many regulations to help it gain traction among investors but as always Investors should be extremely conscious about the risks involved in these strategies.

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