All You Need to Know About the Stock Lending and Borrowing Mechanisms

Have you heard of the ‘Buy and Hold’ investment philosophy? You buy stocks and simply forget about them. Over time, you expect the stocks’ value to rise as the companies grow and the economy prospers. There’s no concept of checking if the stocks are valued appropriately, or calculating the right levels to book profit, or even portfolio rebalancing.

This investment style relies on two key aspects: the steady flow of dividends and the inherent belief that the stocks will grow over time without the need for monitoring.

Now let’s add one more factor to the mix.

What if the investor were to earn an additional stream of earnings from the stocks s/he holds? Imagine, if they can ‘lend’ the stocks to borrowers and earn an ‘interest’ income—just the way banks do when they give loans. The best part is that they would continue to remain owners and even earn dividends and stock bonuses, if any. This is possible under the Stock Lending and Borrowing Mechanism, or ‘SLBM’.

What Is the Stock Lending and Borrowing Mechanism?

Simply put, this is a mechanism where you ‘lend’ your shares to market participants in exchange for an interest. Alternatively, you can ‘borrow’ shares from other lenders to play in the intraday trading market. Borrowers mostly use SLBM for activities like ‘short-selling’ or ‘hedging’.

Who Can Use SLBM?

• If you have stocks lying idle in your account for a long time, you can offer to lend these stocks under SLBM and earn an interest fee.

• If you want to enter into short-sell trades in stocks that you otherwise don’t own. These are trades when you sell a stock at a high price when you expect the market price to fall later in the day. When it does so, you buy back the stock and close the position. You can then ‘return’ the stocks you borrowed.

• If you want to hedge across segments. For example, let’s say Stock X is trading at Rs 100. However, its futures contract is available at Rs 95. You may then want to sell Stock X in the cash segment and buy in the Derivatives segment to pocket the difference of Rs 5 as profit. Such trades are also called as ‘arbitrage’ trades.

• If you want to take up ‘pair trading’. This is when you buy a security at a lower rate and sell another security at a higher rate. The difference between the two trades can be pocketed as your profit.

What’s in It for the Lender?

In many ways, it’s all gain and no loss. The lender gets to earn an income without losing ownership or giving up on other gains. Moreover, there aren’t any risks involved, either.

Benefits of SLBM

SLBM offers the following perks:

• Short Selling Facilitation
  The mechanism enables borrowers, often traders or institutions, to take short positions by borrowing shares they do not own. By borrowing under SLBM, they can sell the shares in the market and aim to buy them back later at a lower price, thus benefiting from downward price movements.

• Additional Income Generation
  SLBM allows investors holding idle shares in their demat accounts to lend them to borrowers for a fixed period in exchange for a lending fee. This creates an additional revenue stream without selling the holdings, helping investors monetise long-term positions. The lending fee is determined by market demand and supply for specific stocks, and it is credited directly to the lender’s account.

• Liquidity Enhancement
  SLBM improves market liquidity by increasing the availability of shares for trading, especially for less liquid stocks. When shares are lent, they re-enter the market for active trading. This enhances order book depth and narrows bid-ask spreads, making transactions smoother for both retail and institutional participants.

• Improves Transparency
  The formal structure of SLBM enhances market transparency by recording all borrowing and lending transactions through the exchange. Information on lending fees, volumes, and durations is visible to relevant participants, reducing opaque deals and informal arrangements.

• Encourages Institutional Participation
  SLBM encourages active involvement from institutional investors such as mutual funds, insurance companies, and banks. These institutions often hold large volumes of shares and can participate in lending programs, increasing the pool of securities available in the market. Their participation improves market efficiency, stability, and credibility.

Are There Any Risks Involved with SLBM?

No, there aren’t any risks involved with SLBM. This is because every transaction is guaranteed by the NSE Clearing Corporation Ltd (NSCCL). This ensures your stocks are safe.

The NSCCL maintains a detailed risk management system. This system constantly monitors and prevents any market failures. This system ensures that every trading member’s obligations are met.

How Does The SLBM Process Work?

You sign up for SLBM. On an every-day basis, a dealer will inform you if there is an opportunity available to lend some of the stocks in your portfolio. The stocks that can be given on loan or borrowed under SLBM are updated daily on the NSE page here.

The interest rate differs for each stock, the length of the borrowing period as well as the market conditions. Once you hear all the details, you need to agree to lend the stocks. That’s it, you’re done.

How To Participate in SLBM?

To participate in SLBM, follow the steps below:

• Step 1: First, ensure the broker offers SLBM services and that SLBM is activated on your account. Now, check stocks allowed by different exchanges. Typically, F&O-listed securities can be lent or borrowed.
  

• Step 2: As a lender, submit details, such as stock, quantity, tenure (1 to 12 months), and lending fee. As a borrower, provide stock, quantity, tenure, and the cost you are willing to pay.
  

• Step 3: Place a margin deposit.
  

• Step 4: The broker’s or exchange’s system, backed by the NSCCL or Indian Clearing Corporation Limited, matches orders. Once matched, shares transfer the next day (T+1), and margins/fees are rubber-stamped by the clearing corporation to eliminate the counterparty risk.
  

• Step 5: During the tenure, lenders are entitled to dividends, stock splits, etc. Borrowers pay dividends back to lenders via exchange. Borrowers can also short sell, engage in arbitrage, or meet delivery obligations.
  

• Step 6: At the contract end, the borrower returns shares; the lender receives them plus the agreed fee. Margin deposit is refunded. Transactions can be rolled over if both parties agree.
  

The misconception about SLBM taxation

Many stock traders often feel that they may attract short-term capital gains tax if they start the lending process within the first year of buying the stocks. That is just a myth. Once you have started lending your stocks, the interest you earn is accountable as income from other sources or as income from a lending business. There is no capital gains tax involved in this whole transaction, as the stocks are not considered sold. So there’s no question of a ‘capital gain’ here.

Are there any charges involved?

We, at Kotak Securities, charge up to 15% of the lending fees or 0.10% per share whichever is higher. Additionally, GST will be charged.