Last Updated on Dec 9, 2022 by Aradhana Gotur
From time to time, the Securities and Exchange Board of India (SEBI) introduces new regulations and revises existing ones to regulate the stock market and bourses. The regulations are also aimed at protecting investor interest. This time, SEBI has made a significant change to the margin pledge system, which is set to kick-in from 1st Sep 2020.
Let’s read more about how this margin pledge system protects investors like you.
Table of Contents
What is the new margin pledge system?
The new margin pledge system prevents your stock broker from misusing 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. So we are breaking it down for you here.
A margin is a certain percentage of the price of the stocks you want to buy—an advance—that you have to pay to your stock broker to secure them. In other words, it is like a token price that you pay to your property broker or landlord to block a rental house.
To sum it up, in the stock market, when you want to buy stocks through your broker, you need to maintain a margin for your trade with them. This can either be in the form of cash or stocks.
What is the need for a margin in stock trading?
In general, you can only trade stocks through a stock broker. This makes them a middleman between you and the stock exchange. On a daily basis, like you, there are millions of buyers and sellers of stocks. In the stock market world, stock brokers collect a margin from buyers and sellers to ensure they fulfil their trade obligations.
Margin pledge meaning
A pledge acts like a mortgage. It is the process of creating a lien on stocks in demat accounts in favour of the broker. It is subject to liquidation on failure to pay a margin. Based on this pledge, the broker may increase or decrease your trading.
Let’s now understand how margin can help you (investors):
- Margin allows you to leverage your positions and to increase your returns within a short time frame. Using this, you can deal in high-value trades without investing the full value.
- If you have limited cash to be used as margins, you may lose opportunities. But if they have enough stocks or ETFs in your demat accounts, you can pledge these securities as collateral margins.
But be mindful of using a margin. Stock brokers can liquidate your shares in case you fail to fulfil your obligations. Giving away all the stocks in your demat account or even a higher sum can be risky.
Example of margin pledge system
First things first. In a stock exchange, a trade happens only when a buyer is matched with a seller.
Now, 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. 1,000x10x10%) 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 a 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. This means that the seller who is actively looking to sell their stocks loses a deal because the buyer (you) refused it.
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 the margin pledge system 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
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 an 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.
If a buyer of a stock 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. In both cases, either of the parties has to bear a loss.
To avoid this and ensure that buyers and sellers fulfil their obligations, SEBI requires the parties to fulfil the margin requirements. This way, both buyers and sellers are compelled to honour their transactions.
Remember, the margin can either be in the form of stocks or cash. With that in mind, let’s continue.
What is the new margin pledge system?
The revised SEBI regulation, which came into force on 1st September 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.
A few points about SEBI margin rules to note
- Under the new system, your stocks/holdings don’t get transferred to your broker’s collateral account. Instead, depositories provide a separate pledge type – ‘margin pledge.’
- Stock brokers cannot use a power of attorney (POA) for pledging anymore. A trader looking for margin trading has to produce a margin pledge separately.
- Intraday profits realised by you cannot be used for new positions on the same trading day. You can use them after the settlement only, i.e., after T+1 days. However, the profits will continue to reflect in the account.
- Brokers maintain proper records of your collateral to ensure that it is not used for any other purposes than meeting your margin requirements or pay-ins, which include:
- Receipt of collateral from you and acknowledgement issued to you
- Trader authorisation for a collateral deposit towards margin with the exchange/clearinghouse
- Record of margin deposit with exchange/clearing corporation/clearing house
- Record of credit of corporate benefits to traders
- Record of return of collateral to the trader
New rules of margin pledging
- Stock brokers have to collect upfront margins from traders for both buying and selling of securities. Failing to do so will attract a penalty.
- The new system has put the power of attorney practice to an end. You can not give authority to the broker over your demat securities through POA, and it can’t be used for margin pledging anymore. A separate ‘margin pledge’ is mandatory for traders to use the margin facility.
What is the process of margin pledge?
Step 1: Request your broker to pledge a specific number of securities
Step 2: Once your pledge request is submitted, the clearing corporation will send you a link to your registered mobile/email id
Step 3: Visit the link you have received on your registered mail ID or mobile number
Step 4: Once you click the link, the authentication process starts. The link will redirect you to the NSDL/CDSL web page, where you are required to verify your PAN number or demat account number
Step 5: After verifying the details, click on generate OTP to authorise the pledge
Step 6: You will receive an OTP on your registered mail ID and mobile number
Step 7: Enter the OTP to authenticate your request on the NSDL/CDSL platform. You will receive a confirmation message for your pledging margin request, and the pledge request will take a couple of hours to be activated
Now let’s go a little back in time to understand the old system so you can appreciate the new one.
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 on your Demat account to your broker.
Why the change in the margin pledge system?
Since your stock broker is a middleman between you and the stock exchange, they are responsible for managing your funds and securities. So when your stocks are transferred to your broker as margin, their ownership title is also transferred. However, this system leaves room for manipulation.
- Stock brokers extended trading limits based on their client’s demat holdings, along with their trading account cash balances, and considered these as collateral for margins.
- Some brokers misused the ownership title of your stocks and used them to obtain a margin from other clients, thus risking your assets. Thankfully, in the new system, the chances of your broker misusing your securities as margin for other clients reduce because the stocks don’t leave your demat account.
- Your pledged stocks are eligible to receive benefits such as bonus, dividends, and rights. Your broker should voluntarily transfer these to you. In case they don’t, and you forget to claim the same, you miss the benefits. So the new system solves this issue as well
The new margin pledging system does not leave any room for manipulation. Your funds and securities are now safer. Under the close monitoring system of SEBI and rules like margin pledge, stockbrokers can no longer misuse the ownership title of securities and margin funds.
Keep a tab on SEBI rules and regulations to stay safe in the stock market. And watch our blog for more such informative articles relating to the stock market, personal finance, and the economy.