Prudent and propitious – that’s what one could gauge of the introduction of the securities lending and borrowing scheme (SLBS). In the light of the chugging-it-along movement of the markets, the very reach and the inherent advantages involved in SLBS makes it an easily accessible and powerful tool to increase your wealth.
Yet to gain popularity, the SLBS has potency, which makes it more attractive than traditional short selling. Here is an analysis of the mechanism, positives, and negatives and how-best-you-can-use-for- yourself to insulate your portfolio from the dips in the markets.
The nitty-gritty
SLBS is a system wherein one can lend and borrow securities for T+8 days, or the day the trade was made plus eight more days. This also involves a lending fee. SLBS (earlier automated lending and borrowing mechanism) was launched in 1997 to fulfill the demand for funds and security created due to being overbought or oversold respectively on a single day. It was banned in mid-2001 due to less transparency and no specified process.
With more technology available and better regulatory mechanisms in place, the new SLBS is supposed to increase liquidity in the cash market, which would lead to efficient price discovery and also using it as another platform for trading opportunity.
Basically, the SLBS involves the owner of shares who can lend them and earn a fee on these idle assets. And, on the other hand, traders can borrow these shares and take short positions without actually owning the shares. To trade in SLBS, margins are taken from both the parties for security purposes just like in the derivative market. These margins are essentially deposits taken because there is an obligation on the both the borrower and the lender.
Now let us understand the process of lending and borrowing. Firstly, the client has to open an account to trade in SLBS with the participant having a Central Depository Securities Ltd (CDSL) or National Securities Depository Ltd (NSDL) account. The participant could be a brokerage, banks, custodians, etc. Participants also have to register with the approved intermediary (AI), for instance the National Securities for Clearing Corporation Ltd (NSCCL), by depositing Rs 10 lakh for collateral purpose. AI acts as middle person between both the participants to smoothen the process and mitigate the risks.
SLBS works in a similar fashion like the cash market, where the order matching is on a price time priority. However, the market timing is available from 10 am to 11 am when the lender and borrower can come and trade in SLBS.
As earlier stated, the lending and borrowing settlement tenure is for T+8 unlike T+2 in the cash market and one month in futures and options (F&O). In this settlement period two transactions are executed. First is the lending part where shares are transferred from lender to borrower. This transaction is known as first leg and the settlement period is T+1.
Second is the obligation part or the reverse leg, where the borrower returns the requisite number of shares of specified security to the lender. The settlement day for reverse leg is T+8. One thing to note here is that the borrower has to buy the security from the cash market on T+5 day ,only then will the shares come on T+7 and subsequently can be delivered on T+8.
Margins
Other than the settlement period, margins are to be kept by both the parties with the respective participants in the first leg and in the reverse leg only the borrower has the obligation to pay the margins. The rationale behind the margin payment in the first leg is to avoid default because after the transaction, both the lender and borrower have the obligation to give the securities and funds respectively.
Later, the margins are released instantly after the pay-in and pay-out is completed on T+1. After this, the lender gets his fee and is not obligated to pay anything. So no margin is levied afterwards. But the borrower has the obligation to give back the shares, so except the lending fee margin, all others are continued till the reverse leg is executed.
Margins are of five types: value at risk (VaR), extreme loss (ELM), 25% of lending price, mark-to-market (MTM), and 100% of lending fee. These are deposits kept by the approved intermediary, for instance the National Securities Clearing Corporation Ltd (NSCCL) for security purposes. We would explain the margins by taking Bhel as an example. VaR margin varies on a daily basis in the cash market. For instance, VaR for Bhel on May 9, 2008 was 11.11%. In case of ELM the percentage is fixed on a monthly basis and it is 5.03%. The third one is 25% of the lending price. Lending price is the previous day share price of any security. The lending price on May 8, 2008 was Rs 1761.50 and 25% would be Rs 440.37. (The complete cost structure is explained in the table.)
As explained before, the lending fee is paid by the borrower. However, the borrower has to deposit an additional 100% of the lending fee other than the fee paid. The last margin is MTM, where, if the investor has taken a short position in the cash market and the price goes up (in loss), then the difference between the previous lending price and the closing security price would be taken from his account at the end of the day. If the price goes down (in profit) then no amount would be taken from the borrower. While paying the margins, the borrower also has to pay the transaction price, which is the settlement amount and includes lending price plus lending fee.
Positive
The lending and borrowing mechanism has created option for investors to carry forward their short position for five additional days in the cash market. Now the ones who are hesitant to take exposure in futures and options due to high leveraging risk can choose SLBS to increase returns when the investor expects the market to go down.
Also, the institutional players who may not be able to take positions in the F&O market due to freeze in the market wide limit can go through SLBS and buy shares in quantity. The market-wide limit is another point worth noting. A single participant can have an open position of more than 10% of the market-wide limit or Rs 50 crore, whichever is lower in one company. The same limit is applicable for foreign institutional investors/mutual funds. On a client level the market-wide position limit is not more than 1%.
Other than short-selling, this system would bring idle securities in the cash market. This would increase the liquidity, which could result in efficient pricing. Holding long and short positions in the cash market will give a healthy balance and remove the chance of unnecessary price manipulation.
Sebi has recently approved cross margining. Cross margining is a method to mitigate the burden of margin payment on institutions. As the institutions pay margin in the derivative segment, now they don’t have to pay VaR margin in the cash market.
Negative
After the launch of SLBS on April 21, 2008, the response was very muted from the market considering expectations and apprehensions. On a daily basis only few shares with one or two trades are executed may be on an experimental basis. Also, SLBS is not yet officially launched as a product by any brokerage for their clients. The good news is that around 70 players have registered themselves for SLBS. As it is a new market every one is resistant to trade in SLBS due to certain limitations.
We have addressed some limitations, which hover around SLBS’s current guidelines. The carry forward of positions is for a limited period and this is the most important concern. As compared to SLBS where you get a tenure of only T+8, F&O gives you one, two, and three months rolling settlement period. Other than settlement period, if one buys options no need to pay any margins.
Promoter holding doesn’t come under the purview of SLBS. Ideally, a majority of the promoters don’t sell their holdings often and it is kept in both physical or dematerialisation form. Permission to lend the securities of the promoter’s stake could have resulted in a huge jump in the liquidity and another source of income for the promoters.
How best you can use it?
* Bearish phase
Ideally it is difficult for any normal investor to take a call for one day about the market trend. And many times they lose a lot of money on a daily basis by going short. On the other hand if the investor took a long-position, at least he can take delivery and sell afterwards if the price goes up.
Post the January crash a lot of opportunity has been given to exploit the advantage of short-selling but investors have to square off their position at the end of the day. Now as the markets are slowly drifting down, investors can take the opportunity of this bear phase by borrowing securities through SLBS. An investor can hold on to its short-position for additional five working days excluding the transaction day. Due to the carry forward facility, the probability of losing money in short-selling becomes relatively less. Further, short-selling would lead to better price discovery for the scrip in the cash market.
* Advantage as a lender
There are long-term investors who have earned very good returns on their portfolio by being patient and disciplined in their investing. And they may not like to sell the stock considering the tremendous gain and further it would add to the returns. There are some of those who had not yet converted their physical shares into dematerialisation. Now they may feel the need to convert. Through securities lending investors can enhance their portfolio returns by lending their securities for a fee other than capital appreciation. This fee could be in the approximate range of 15-30% per annum depending on demand and supply factors.
Trading opportunity
SLBS has opened another parallel market to trade other than the cash market and F&O, and gave traders the opportunity to earn on a daily basis. Due to introduction of SLBS, which has a different screen-based platform, traders can lend and borrow on the same day and can gain from the appreciation. However, netting of two positions cannot be done in SLBS unlike in derivatives, where if one takes a simultaneous long and short position, they have to pay the net obligation and not gross. You can also gain from arbitrage opportunity.
International scenario
In the international market, trades in SLBS are conducted over-the-counter (OTC) completely opposite from India’s system. The OTC market functions on bi-lateral contractual agreements between the participants. Due to this, world-wide securities market regulators don’t generally seen to be directly involved in regulation of securities lending transactions. Just the periodical reports are submitted to entities like central banks, clearing corporations, depositories, etc. Some emerging markets like Hong Kong, Korea, Singapore depositories and custodians provide an electronic platform for executing the transactions.
Domestically, mutual fund houses are looking at SLBS as a platform to launch new fund offers with an objective to earn long-term capital appreciation by long and short positions in equity and equity-related securities. Once the lending and borrowing mechanism picks up, one can expect fund houses coming out with new schemes.
Finally, SLBS is a new system and it has just started. It may take some more time to pick up the volumes on a participant level, as there are limitations like the settlement period. Later, participants may give the opportunity to their clients to trade.
