I have a very basic question about pledging of shares. I have read and understood how to pledge, what all I can do by pledged margin and risks associated with it but I didn’t see any clear answer on what broker achieves or how broker benefits from allowing pledge of their clients and giving back the collateral margin without any need to pay interest. How does this work?
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in short, brokerage generated from trading using pledged margin.
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Yeah that’s one of the reason. Is there anything else apart from that is what I was wondering?
Pledges are accepted by clearing guys, so i think the brokers don’t need extra funds for this ( intraday/FNO).
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Okay with whoever is accepting pledge and returning margin after haircut with out any interest ,other than earning through trades taken with that margin by traders, is there any other benefit for them?
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interest is charged on loans based on default risk. This isn’t exactly a loan & there isn’t any default risk over the regular cash trades, so why would brokers need to charge interest? or why would we pay to receive margin?
Let’s take the example of gold. You go and pledge it for money, after taking haircut he would give you 70% of the value lets say. Now you need to pay interest right on that money right? I am trying to understand the difference on how it benefits the one who is giving us the margin. Nothing is free no.
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different game. He’s loaning you cash & expects interest on it, keeping gold as loan collateral. He can’t do anything with that gold & has to return all of it once you pay back loan. You get cash, which is expected to generate additional income which you would ideally use to pay back loan.
Broker isn’t giving you cash to trade, you still have to keep cash to meet your mtm losses. Yes, no cash is provided so nothing here is free.
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Interest rate charged by a bank is based generally on the following:-
- Funding Cost or Cost of Funds - based on customer deposits or other money market options. +
- Operating costs + Loan Tenor +
- Risk premium to compensate the bank for the degree of default risk inherent in the loan request +
- Profit margin on each loan that provides the bank with an adequate return on its capital. +
= Effective rate on loan.
I had the same doubt when I joined this forum. I was also thinking how could a broker offer margin limits without interest against pledge of security. @VijayNair had explained and tried to drill it into my head that in margin trading there is no interest. The way I understood is, there is no cashout when you do a trade, these are notional which gets offset on maturity date of the deal. It is for this reason, I am told, this margin which brokers give are only for trade and not for actual buy of shares in the cash segment.
I hope I am right @VijayNair
Something similar happens in cash segment. When you sell the cash actually comes in after one day, but brokers allows you to buy against this limit as the cash inflow gets offset by cash outflow
I hope I am right and please do not school me that this is equal to 8th grade maths etc.
gold gets you 90% that too in cash category
every other parameter is fixed. So effectively, the only changing metric is default risk.
The exchange doesn’t ask broker for any additional cash/margin while i pledge and trade. So, why would broker charge me interest?
that’s quiet straightforward. You obviously can’t pledge share and buy more shares using the pledge (this will essentially lead to 10x leverage if haircut was 10%)
what is quite straightforward. If it was so straightforward, why would a user ask this question.
This is quite straightforward, Obviously none of the parameter is fixed. Even default risk parameter change based on the tangible and in tangible security that the customer is willing to provide apart from other consideration.
from individual to individual, it is.
You can’t buy reliance share and pledge it to buy more reliance shares. I don’t think i can explain this any simpler.
You dont have to. I understood the concept years ago
This would have been useful information 5 comments ago 
Share is the collateral. If the value decreases the margin allocated also decreases. Also if there is a client shortfall the broker can square off holdings quickly. Typically pledging is allowed only for those instruments that have near zero square off risk for the broker. In short the risk at broker level is minimised in several different ways unlike other loans that we take like gold loans.
Delivery volume at the exchange is around 1% of total traded volume. Besides equity brokerage is zero with many brokers now. So brokers make money only from active traders. Pledging unlocks capital for active traders and broker can make money from brokerage generated from their trading activity. The risk reward is skewed heavily in favour of the broker.
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Agree on all aspects, but this looks so skewed because of leverage.