This new margin pledge system reduces your collateral risk

From time to time, SEBI introduces/revises regulations to govern a stock market. These help the watchdog regulate the stock markets, bourses, and protect investors’ interest. This time around, SEBI has made a significant change to the margin pledge system, which is set to kick-in from 1st Sep 2020.

The new margin pledge system aims at preventing your stock broker from misusing the stocks that you transfer to them for margin purposes. Now, if you are a newbie in stock investing, this regulation may sound alien to you. But fret not, we are breaking it down here.

What is a margin?
In general, you can only trade stocks through a stock broker, which makes them a middleman between you and the stock exchange. That said, when you want to buy stocks with your stock broker, you need to maintain a margin for your trade, which can either be in cash or stocks.

A margin is a certain percentage of your stock price — an advance — that you pay to your stock broker to secure your shares. In other words, it is like a token price that you pay your property broker or landlord to block a rental space. But what is the need for a margin in stock trading? Well, to ensure that buyers and sellers fulfil their trade obligations regardless of the uncertainties in the movement of a stock price.

Let’s understand the concept with an example. Say that you want to purchase 100 shares of RIL. Ergo, you are required to place a buy order for 100 shares with your stock broker by paying Rs 1,000. But for that, you are required to pay a margin of 10% per share. This comes to Rs 100 (Rs 1000x10x10%) in all.

If you have Rs 100 in cash, you can pay it upfront. But if you don’t, you can transfer your existing stocks as margin to your broker’s account. Your stock broker, in turn, pledges these stocks with the Clearing Corporation to fulfil the margin requirement and completes the transaction.

But there are chances of you failing to arrange the purchase amount of Rs 1,000. What happens then? You may not want to buy the stock. Meaning the seller, who is actively looking to liquidate their holdings, loses a deal. That is why, you are required to pay a margin when placing a buy order, to ensure that you don’t default at a later point in time. Note that margin also applies to sell orders. We’ll see why later on.

Now, let us say you have the money but still change your mind about buying the stock. But what are the reasons for such a refusal? We’ll tell you one.

Volatility in the movement of a stock price
In a stock exchange, every buyer is matched with a seller, only then a trade happens. By virtue of that, if a buyer fails to bring the purchase price to the table, the seller loses a deal. The opposite is also true; if a seller refuses to sell their shares, the buyer would suffer losses.

With that premise, let’s proceed. It is no secret that stock prices are volatile. Remember that the margin requirement in our example is Rs 100. Let us suppose that you pay the margin at the start of the day. If by the end of the day, the price per share falls by Rs 5, the stock will be devalued at Rs 5.

This brings down the total value of the transaction to Rs 500 and you suffer a notional loss of Rs 500. In this case, your notional loss is greater than the margin. Due to such unprecedented loss in value, you may change your mind and refuse to pay Rs 1,000 to buy shares worth just Rs 500.

Now let us also look at the seller’s perspective. Say that the stock price appreciates by Rs 5, increasing the transaction value to Rs 1,500. In this case, the seller may not want to sell the stock at Rs 1,000. Why would they suffer a loss of Rs 500? But that would put the buyer in a tough spot because they cannot buy the shares at all.

Further, in a stock exchange, every buyer is matched with a seller, only then a trade happens. By that virtue, if a buyer fails to bring the purchase price, the seller loses a deal. The opposite is also true, in which case you are at a loss.

In both cases, either of the parties has to bear a loss. To avoid this and ensure that both buyers and sellers fulfil their obligations, SEBI requires the parties to fulfil the margin requirements. This way, both buyer and seller are compelled to honour the transaction.

What is the new margin pledge system?
The revised SEBI regulation, which would come into force from 1st Sep 2020, doesn’t permit your stocks to be transferred to your broker’s account. Meaning, the stocks that you want to use as a margin will remain in your demat account. Instead of being transferred to your broker’s account, such stocks will be marked as a pledge in favour of your broker. This gives your stock broker a lien on your pledged shares.

For this purpose, your broker will have to open a separate demat account called ‘TMCM — Client Securities Margin Pledge Account’, where TMCM stands for Trading Member Clearing Member. Once your stocks are pledged with your broker, they re-pledge them in favour of the Clearing Corporation of the Stock Exchange and obtain margins.

What was the old margin pledge system?
As per the old margin pledge system, in order to buy stocks, you were required to transfer your demat holdings/stocks as collateral to your broker’s account. Meaning, your stocks would leave your demat account and sit in your broker’s account, which would leave your holdings to the broker’s care.

To make this happen, you were to give a power of attorney (POA) on your demat account to your broker. This way, your stock broker would reach out to you for approval of pledge transfer via the OTP route. Once you validate the credentials, the pledge would be completed.

Why the change in the margin pledge system?
As mentioned, your broker is the middleman between you and the stock exchange; ergo, you normally can’t trade without a stock broker. This means, your stock broker is responsible to manage your funds and securities. When your stocks are transferred to the broker, their ownership title is also transferred. However, this system leaves room for manipulation.

Some brokers misuse the ownership title of your stocks and use your securities to obtain a margin from other clients, thus risking your assets. In the new system, the chances of your broker misusing your securities as margin for other clients reduce, as the stocks don’t leave your demat account.

Further, even though your pledged stocks are eligible to receive benefits such as bonus, dividends, and rights. While your broker should voluntarily transfer these to you, in case they don’t, and you forget to claim the same, you may miss the benefits. That’s all folks! Watch our blog for more such informative articles on the stock market, current events, and personal finance. And spread the word if you like them and want your squad to know about us 🙂