What is SLB?
Securities Lending and Borrowing (SLB) is a mechanism through which investors can borrow or lend shares to other market participants. The platform provides a viable alternative to the derivatives market for purposes of hedging. Borrowers in SLB are usually short-sellers, i.e., traders who want to sell shares that they don’t own. Lenders, on the other hand, are those investors who have bought shares for long-term purposes, and such shares are lying idle in their Demat accounts.
Why SLB?
Just like a loan you avail from a bank, if you have borrowed the shares from another investor, an interest has to be paid for the lender. The interest rate varies from stock to stock and also depends on the tenure of such borrowings. As per SEBI rules, stocks can be borrowed for a maximum period of 12 months. The interest rate for such lending is not fixed but is determined by the market conditions. Globally, long-term investors such as mutual funds or insurance companies are key lenders in SLB. On the other hand, SLB is a less risky option for short-sellers compared to the more complex options and futures contracts. In India, over 200 stocks are available on the SLB platform for borrowing, and some of the stocks that are not part of derivatives or that see thin volumes in the futures market are available for borrowing on SLB.
The current relevance of SLB?
Market regulator SEBI has announced the transition of the Indian derivatives market from cash settlement to physical settlement by September last year. Investors mainly use SLB for reverse arbitrage opportunities, i.e., those situations where future contracts of a company are trading at a discount to the cash market prices. In such scenarios, traders sell stocks and buy futures contracts. However, SEBI’s decision to move to the physical settlement brought more short-sellers to the SLB platform.
Typically an F&O trader has three courses of action available for him. Either he can square-off his position before expiry and pay the cash differential, or he can roll-over the contract for next month. If the investor doesn’t choose any one of these two options, the contract gets expired, and under the physical settlement, shorts will have to offer shares to cover the open position. In such a scenario, rather than buying shares from the open market to cover positions, a trader can go to the SLB platform and borrow the required shares for covering. At a later stage, when the share prices are favorable, he could purchase the shares from cash markets and return them to the lender. This process is known to be more cost-efficient than buying shares from the open market.
What is the risk involved?
Market regulator SEBI has placed several safeguards for the platform, including a reliable settlement system. “Unlike many other countries, SLB is an exchange-traded product in India, settled by the clearing corporations, which means there is no counterparty risk,” “Investors should ideally lend out stocks and make an additional return as every penny counts. While yields are a function of the demand, we have seen attractive lending fee levels in the past 18-24 months, in many stocks.”
Benefits to lenders
- Risk-free Income.
- Protection of all rights as owner.
- Settlement Guaranteed by NSCCL.
- Low costs.
- Potential to improve portfolio performance.
Motivation for Borrowers
The reasons to borrow securities may vary among borrowers like securities required to support a trading strategy, financing strategy, or simply fulfilling a settlement obligation at the Exchange.
Some strategies where securities can be borrowed are listed below:-
- Cover short sale position: Cover unintended short position created in the books.
- Arbitrage: Sell securities short against an offsetting derivatives position to take advantage of dislocation between cash and derivatives markets.
- Pair Trading: Buys the undervalued security and sell overvalued security.
- Financing Transaction: Trader borrows low volatility stock at a lower price range and sells the same in the capital market segment. The amount earned is used in more pro table proposition to cover the incurred cost. Reverse cash and carry arbitrage can be used in most of the situations discussed above. SLB market supports these strategies to fetch securities at a considerably low cost to deliver in the cash market.
SEBI has allowed all categories of investors, including retail and institutional, to borrow as well as lend securities. Currently, securities available for trading in the F&O segment of the National Stock Exchange of India Ltd. (NSE) are permitted.
