Share pledging is a method used by shareholders, investors, traders, promoters, etc. to raise money by pledging the shares they hold. 

The shares are pledged and the money is taken as a loan. In other words, the shares are taken as collateral by the lender and the money is lent to the borrower. Though the shares are owned by the borrower, the lender has the right to sell the shares in case of non-payment of the loan. 

More often than not promoters or investors run into shortage of funds and pledging of shares comes to their rescue. Let us take a look at share pledging in detail in this blog. 

Why does someone pledge shares?

Pledging shares is a smart way to hold on to your asset and at the same time raise funds for your financial needs. 

Both retail investors and promoters of a company benefit from pledging their shares, but both of them use it for different reasons. 

Any normal retail investor, use it for funding their trading or investment activities as pledging would give them the leeway to tap into any new opportunities in the stock market. 

On the other hand, promoters often use pledging in more strategic ways. They pledge shares to raise additional capital to meet their operational expenses, support related businesses, invest in subsidiaries, launch new ventures or fund business expansion. These moves are typically part of broader growth plans of the company to increase the company’s revenue. 

Moreover, when shares are pledged, the investor who has pledged the shares and who is also a borrower, still earns dividend income and potential capital appreciation on those holdings. 

What is a haircut in share pledging?

Whenever you pledge shares, you do not get a loan for the entire value of the shares. The lender usually cuts a portion of the total value of the shares and then lends you the money. 

For example, if the total value of the shares is Rs 1 crore, then the borrower will receive only 70% or 80% of the total value of the shares. Here, that would be Rs 70 or 80 lakhs. So the haircut is 20% to 30%. This is done by the lenders to protect their interest in case the share price falls and this haircut acts as a buffer for the lenders. 

The haircut can be higher based on the stock as well as the lender’s evaluation of creditworthiness of the borrower. If the stock that is pledged is very volatile, then the haircut can be higher and if the stock is less volatile or the price is steady, the haircut can be low. If the share price falls and the total value of the shares pledged is lower than the money lent, then the lender has the right to ask the borrower for margin money. 

Advantages 

If you need money but don’t want to sell your investments, pledging your shares can be a better method to raise funds. This way, you can maintain full ownership of your holdings and also not give up on any potential long-term capital appreciation. 

Even if the market goes up during the pledged period, you still benefit from the price rising and there will be no loss of any upside potential. Your stocks continue to grow, and dividends keep flowing in just as they always have. 

Further, you do not have to pay any capital gains tax when you pledge your assets. Since you’re not selling, there is no profit made to tax it. This makes the process more tax-efficient and more flexible. It’s a stress-free way to manage your short-term financial needs, while protecting your long-term investments.

Disadvantages

If the market goes through a correction and if you are unable to bring in the margin money, lenders might step in and sell the shares without any room for discussion. This would affect an investor’s long-term wealth creation plans. 

If there is mass selling by lenders, it could create a domino effect, pushing the stock price down further. This would dampen the overall market sentiment and also put additional pressure on the shares you are still holding.

When a company’s promoters pledge shares as collateral to raise money, it often raises eyebrows among investors. It may seem like the company is under financial stress, and there are chances that people will question if the business is truly stable or if it is relying too heavily on debt to keep its operations alive. 

Is stock pledging safe or risky?

Stock pledging is neither safe or risky inherently. If it is used cautiously and responsibly then it is useful for promoters or investors. Promoters often rely on it whenever there is shortage of funds and have to run their business smoothly during tough times. 

Investors or traders may use it to boost their margin and stay in the market during volatile periods or to seize any short-term opportunities in the market. But here is something every investor or promoter or trader must remember which is with every benefit comes risk. If you are considering pledging to raise funds, you must do it minimally as per your risk appetite because you have to repay the amount with interest. 

As an investor, you must keep a close eye on your holdings, stay informed about promoters pledging their company shares. You should never be in a position of overleveraged. 

Conclusion

Share pledging is an important tool for traders, investors and promoters for securing funds and understanding how stock pledging works is important for anyone involved in the stock market. 

Share pledging can provide quick access to cash without selling your assets and it can help you maintain your position in the market. It is essentially a loan against your holdings and like any other loans you are bound to repay the principal amount with interest.  

Therefore, it is crucial for you to be cautious before pledging and you must carefully assess the pros and cons of it. You should also make sure that you do not pledge all of your holdings and it is aligned with your financial goals and risk tolerance.