Monday, December 5, 2011

Detailed Note on Automated Lending and Borrowing Mechanism

Automated Lending and Borrowing Mechanism

IN A stock market where fancied companies trade at astronomical prices, most people may be confronted by a dilemma: Should one enter at the current level when risks seem high? Will staying away mean losing a good opportunity?
Buying shares is not the only way to participate in the ongoing bull run in the stock market. Lending of securities and funds is a way by which individuals can take advantage of and participate in the bull run. Lending securities and funds allows one to participate in the market without worrying about downside risks and incidental problems.
The scheme was originally started a couple of years ago by lending securities (such as equity shares) to those who had sold without being in possession of the instruments (short-sellers). Simultaneously, it helped generate income for those with idle secu rities. This was to benefit the stock market as a whole through improved liquidity.
Subsequently, the scope of the scheme was widened to include lending of funds or financing those buying shares without funds. Typically, when traders are optimistic about the trend in share prices, they look for funds to make purchase. And in a bull mark et, as now, traders are willing to pay very high interest for funds.
Such a securities/funds lending scheme is offered by the National Stock Exchange (NSE) called the Automated Lending and Borrowing Mechanism (ALBM). The scheme is operated by the NSE for the securities traded on the exchange.
Here is how the scheme works: To lend money or shares to traders, one has to approach a stock broker who puts through such deals. A separate ALBM session is held on Wednesdays the NSE's settlement cycle starts on Wednesdays and ends on Tuesdays. On Wedne sdays, the person who wants to lend either funds/securities intimates the broker.
Once the lender commits funds/securities, he need not physically buy in the money/securities till the following Tuesday. This is because the settlement cycle allows a week's gap between the settlement close and the payment/receipt for contracts. For inst ance, when a settlement ends on a Tuesday, the obligations that investors may have, such as payment for a purchase of shares, is met the following Tuesday.
The next week, the lenders deliver funds/securities to the broker. The funds/securities enter the stock market system and are used by the borrowers to fulfil their obligations. At the next settlement, the lender gets his money/securities back with intere st. For instance, in the above example, the accounts would be settled on the second Tuesday following the Wednesday when the original commitment to lend was made.
The ALBM session determines the interest rate at which funds/securities are borrowed. In the current market with most traders keen to buy shares, it is largely financing that takes place. In last Wednesday's market, the interest rate was over 30 per cent _ an indication of the demand for funds.
Of concern to a lender is that at over 30 per cent, is there not a huge risk involved? Strangely enough, there is practically none. The ALBM is part of the NSE's stock market trading options. Therefore, the entire deal is guaranteed by its clearing corpo ration _ the National Securities Clearing Corporation (NSCCL).
The other matter of concern is what happens with some lending physical certificates and others opting for the dematerialised mode. The problem of physical certificates has been eliminated with the NSCCL allowing scrips only in the demat form to participa te in the ALBM. At present there are over 200, including the most active ones, in the category.
While the system looks almost free of risks in the short-term, investors must exercise caution even in this market. If the size of the market increases enormously, and given the volatile nature of trading in equity shares, the system can collapse. At the moment, however, such a possibility appears remote.
FAQs on securities lending
What is securities lending?
Securities lending was envisaged as a method wherein a person with idle shares can lend them to a borrower who does not have the shares to fulfil his obligation.
Who regulates it?
Securities lending is regulated by the Securities and Exchange Board of India. In 1997, SEBI introduced guidelines which provide a framework for the scheme. At another level, an approved intermediary handles the operational details of the scheme.
Who is an approved intermediary?
This is an entity registered with SEBI acting as an intermediary between lenders and borrowers. It is expected to guarantee the scheme, that is, if the borrower fails to honour his obligation the approved intermediary makes good the loss.
Can securities lending not take place without the intermediary?
No, the Securities Lending Scheme clearly states that there will be no direct contact between a borrower and a lender. In any case, if there has to be a nationwide market for determining the interest rate at which lenders are willing to part with securit ies and borrowers are willing to borrow, only a large entity would be able to provide the infrastructure.
Who holds the title of the securities lent?
The title temporarily vests with the borrowers. The borrower only has an obligation to return the equivalent number of securities along with any benefits (such as dividend) within a specified time-frame.
Does the borrower have any other obligations?
The borrower has to put up collateral to borrow securities. Generally, it may be the cash margin that is levied on the shares concerned by the authorities.
What are the tax implications of securities lending?
Income from securities lending is exempt from capital gains tax.
What is ALBM?
Automated Lending and Borrowing Mechanism (ALBM) is a scheme introduced by the NSE that acts as a facilitator for securities lending. It also facilitates financing in addition to securities lending.
How is the interest decided in financing?
As with securities lending, the interest rate for those who finance is also decided by demand and supply. The NSE provides a trading platform where the demand and supply is matched through computers and the interest rate determined.
What are the key terms in ALBM?
Securities Lending Price: The benchmark rate at which all lending and borrowing transactions are effected by the NSCCL. It is the closing price of the security at the NSE a day prior to ALBM.
Transaction price: The rate at which transactions are executed in the spot book of the trading system of the NSE.
Execution date: The date on which lenders and borrowers of securities have to deposit required securities/funds respectively, with the approved intermediary.

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