Columnists

Hidden market of share pledges for securities-backed lending

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Summary

  • Banks will issue loans at a significant discount to the prevailing price of the shares to mitigate risks of loss in case the borrower defaults and/or the stock price declines.
  • A crucial aspect of this facility is that while the pledged shares are blocked by the lender bank, they remain in the borrower’s name meaning the investor continues to enjoy dividends and bonus shares.
  • Nonetheless, there’s a good reason why such a market remains small — it carries a lot of risks.

On days like these, investors seek liquidity from several sources just to keep going. One of many sources is share-backed loans.

In this scenario, an investor gets instant liquidity for taking care of immediate needs and other personal needs, all backed by his/her equity investment. Typically, a loan is offered by banks with a credit limit decided by the market value of shares.

Banks will issue loans at a significant discount to the prevailing price of the shares to mitigate risks of loss in case the borrower defaults and/or the stock price declines.

Pledged shares are then “frozen” and investors only regain full control of the stocks after clearing their bank loan.

A crucial aspect of this facility is that while the pledged shares are blocked by the lender bank, they remain in the borrower’s name meaning the investor continues to enjoy dividends and bonus shares.

Having said that, it seems to me that securities-based lending at the Nairobi Securities Exchange (NSE) is not as red hot as I would expect.

As of September 2021, only a total of 41,000 investors pledged more than 6.5 billion shares according to the latest Capital Markets Authority (CMA) third-quarter 2021 report.

This number of investors represents 2.36 percent of the total number of shareholders. In fact, the number has dropped, from a high of 45,000 in March 2020, perhaps a reflection of lenders’ risk aversion to a downward market and weak investor sentiment.

But back in the heady days of 2006-8, banks were encouraging customers to borrow against their stock portfolios to paper over their budget gaps and cash needs, rather than sell their investments.

But maybe I could be wrong. With pledged shares accounting for 6.6 percent of the total (98.78 billion) equities listed on the NSE #ticker:NSE the valuation of the shares pledges could easily sit north of Sh130 billion. If this is even half correct, it means the market is an important one and shares are likely to be mostly liquid stocks of large, profitable companies like Safaricom #ticker:SCOM Equity #ticker:EQTY and KCB #ticker:KCB.

Nonetheless, there’s a good reason why such a market remains small — it carries a lot of risks. After all, a serious bear market is enough to force some clients to liquidate their investments to repay their borrowings, causing a chain reaction of forced selling that drives stock prices lower.

This is why the value of your investment portfolio is what matters most. If you can’t repay, lenders can sell your investments to recoup what they have loaned out.

It’s therefore important that the portfolio is diversified. If you are overly concentrated in a particular stock, you could quickly find yourself below the required maintenance threshold if that investment declines considerably.

However, with a diversified portfolio, one can change the securities offered in a pledge if the pledgee [lender] agrees.

Anyway, on days like these, it’s beneficial to have more expendable cash on hand. Borrowing against stock without selling is the right financial aid for investors. Borrowing money against the value of stocks makes money readily available. Ready cash covers immediate and future needs while your stocks continue to build.

Mwanyasi is the managing director at Canaan Capital