Over time, the National Stock Exchange (NSE) and BSE launched a stock lending and borrowing (SLB) mechanism that offered similar flexibility, but with tighter rules.
SLB is not used widely these days as traders mostly rely on the equity derivative market—the futures and options (F&O) segment—for leveraged bets, bearish trades (buy put-sell call options/sell futures), as well as carry forward their positions by rolling-over of F&O contracts.
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SLB still has its use cases though. Investors with long-term portfolio can gain from lending fees on their portfolio, while still being eligible for the dividend, bonus, split, rights issue, etc., that are associated with such shares. While stocks that are part of F&O segment are also part of SLB (although that number is comparatively less), certain stocks are only available to trade via SLB. And these include shares of YES Bank, Paytm, Nykaa, Zomato, Aavas Financers, Home First Finance Company, etc. Short-sellers or arbitrageurs can tap the SLB mechanism to borrow these shares for their trades.
Lending fees & break-even
Share lenders get a fee on the stock that is borrowed from them by short-sellers or arbitrageurs, who want to profit from a potential fall in a stock’s price and execute their ‘sell high, buy low’ trades. For instance, a borrower needs 5,000 shares of company A. The lender originally bought the shares at ₹100 each (total investment: ₹5 lakh). Now, a borrower is willing to pay 50 paise for each share in lending fees, which works to ₹2,500 for the 5,000 shares. For the lender, this works out to an annualized yield of 6% on ₹5 lakh worth of shares (see graphic). This is how investors earn additional return on their portfolio. In the same example, the borrower would need to gain over and above the lending fees of ₹2,500 to make a net positive return on his or her trade.
Margin & minimum limit
The borrower is required to put 125% of the value of shares he or she is borrowing as margin. As shown in the above example, where the shares are worth ₹5 lakh, the borrower would need to put 125% of value as margin, or ₹6.25 lakh. This margin is also mark-to-market. So, when the prices move against borrower’s position, these unrealized or notional losses are debited from the margin. The borrower needs to ensure that the margin is restored and maintained.
One of the reasons why investors prefer stock futures in F&O instead of SLB is the lower margin requirements (17-25%). Still, stocks that lack liquidity have higher margin requirement.
The lender needs to put 25% as margin, but this is immediately released after the shares move out from the lender’s demat account. Some brokers ask the lender to transfer the security the same day, in which case the 25% margin requirement doesn’t arise. The order value per securities should be ₹1 lakh for lenders, while the minimum borrowing requirement is that of 500 shares.
Liquidity
Unlike the F&O segment, the SLB segment lacks liquidity. The transactions between lender and borrowers usually happen for a small number of shares. In FY23, the SLB segment on NSE saw a turnover of just ₹29,314 crore. Comparatively, the futures segment of NSE clocked a turnover of ₹285 trillion in the same period, while the options segment saw a whopping ₹33,389 trillion turnover.
“SLB segment allows lenders to make additional income on their long-term investments, apart from dividend. However, this segment lacks depth and liquidity. Borrowers create demand which is fulfilled by lenders with ease. Long term investors, who act as lenders, do not have demand for all their scrips at all points of time,” says Ashish Nanda, president and digital business head of Kotak Securities.
Arbitrage play
Apart from executing a short-sell to profit from the fall in a stock’s price, SLB can be used for arbitrage opportunities between futures and cash market.
During volatile periods, the spot prices in the cash market of certain stocks can trade at a premium to the prices of their future contracts. Usually, future prices trade at a premium to spot prices (current stock prices), as it accounts for the cost of buying the derivative instrument.
Arbitrageurs can take advantage of this anomaly (known as reverse arbitrage) by selling the stock as its price is expected to trade at a discount to the price of its futures contract. During such instances, the demand for certain stocks in SLB goes up.
What if the borrower defaults?
The clearing corporations of NSE and BSE—National Securities Clearing Corporation and Indian Clearing Corporation—act as approved intermediaries (AI) and guarantee the settlement on SLB. The job of the AI is to collect the margin from both lender and the borrower. In case, the borrower defaults on returning the share, the AI will use the margin deposited by the borrower to purchase the shares in auction and return it to the lender.
Cost of accessing SLB
Stock brokers need to take separate access to SLB segment. So, you first need to check if your broker has access to the segment. If that’s the case, you will have to inform your broker that you would like to lend shares and also share the stock list in your portfolio that you wish to lend. As and when there is demand for borrowing of shares that matches your list, your broker will inform you about the lending opportunities.
However, if you don’t deliver the shares on time, there can be heavy penalties. So, check your stock portfolio thoroughly before sharing the stock list.
Through SLB mechanism, investors can earn a certain yield on their long-term portfolio, but the final fees would depend on the borrowing demand and frequency of such borrowing. Remember, shares are usually borrowed for two-three weeks, as these are often meant for short-term trades. Brokers charge 15-18% brokerage on lending fee and goods and services tax of 18% is applicable.
SLB in global markets
In international markets, SLB is an over-the-counter product, which means regulators do not directly regulate lending and borrowing transactions. According to data from US-based Financial Stability Oversight Council’s report, the estimated value of securities on loan globally was $3.1 trillion in September 2021. The US share of global activity is estimated to be around 58%.
In international markets, entities like the custodians and depositories run the lending and borrowing scheme and have their own screens for meeting the demand and supply of securities from their clients. The transactions are, by and large, privately negotiated transactions outside the centralized trading platform.
In India, market regulator Sebi decided that exchanges and their clearing corporations should play a key role in the SLB market. It wanted to ensure that there is a centralized platform that enables lending and borrowing of securities through a screen-based platform and automatically matches the demand and supply of securities.
Highlighting its approach in its discussion paper in 2005, Sebi said, “This would be transparent and enable an audit trail of transactions in the process of securities lending and borrowing, besides giving the advantages of speedier execution, and fair and automated discovery of prices.”
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