Share financing refers to the act of getting leverage by pledging shares as collateral in order to obtain access to more funds for trading more shares.
It is a form of margin trading that enables an investor or trader to invest or trade in more stocks and shares with the goal of multiplying their profits.
For example, a person with $10,000 worth of blue chip stocks might pledge it with a lender for share financing. He then receives 3 times that amount for trading while retaining the ownership of the shares pledged. This allows the borrower to conduct more trading activities he would otherwise not be able to.
A person with $10,000 worth of DBS shares might use the liquid assets as security to a lender to obtain a trading account with $30,000 inside to trade the markets with. He then uses the funds to purchase 30,000 of a particular stock at $1 each and sells them for $1.10 each. He then makes a profit $3,000 without affecting the shares he had initially pledged for the share financing loan.
The opposite happens when the stock price drops.
If the shares were sold at $0.90 instead of $1.10, then the investor books a $3,000 trading loss instead.
There would be no need to sell the current holding of stocks in order to purchase other stocks.
With more capital to play with, an investor can also use the extra funds diversify his or her portfolio to hedge against risks.
Disadvantages of share financing
While the thought of getting more funds to work with can be tempting, especially when you are on a good run, there would inevitably always be certain terms that work against the borrowers.
The first thing that borrowers should instinctively understand that share financing is essentially a loan.
This means that a borrower can fully expect to be charged an interest rate for the funds borrowed.
It would serve as a double-whammy should losses be incurred from share trading too. The interest expense would compound the total losses incurred by the borrower.
The interest rate depends on economic factors and market condition. But it is common for interest rate to be 3% and above.
If that seems low, it is.
As it is a basically a secured loan, one can expect interest rates to be much lower than unsecured loans such as personal loans and credit cards.
With margin trading, traders also naturally take on the risks of margin calls where the margin ratio falls below a specified target and required to top up the investment in order to raise the ratio to acceptable levels.
The real implications of share financing
The main players that offer share financing services are brokerages and financial institutions such as banks.
While they make a nice interest revenue by issuing loans to traders with an appetite for risks, what they don’t say is that these credit facilities have the indirect objective of encouraging borrowers to trade more frequently using their trading facilities.
This enables them to generate revenue from the services they provide to the borrower.
For example, the more trades traders do with the trading account, the more commissions brokerages or the trading arms of banks make.
This is on top of , etc.
In fact, the list of items that incur charges can be so exhaustive that it would be no surprise to find more than 10 types of different essential services they charge users.
These itemized expenses can include:
- Facility fee
- Administrative charges
- Maintenance fees
- Late settlement fee
- Cashier order
- Printing of statement
- Cash dividend processing fee
- CDP maintenance
- Foreign share custody fee
- Foreign share transfer fee
- etc
There might even be a fee charged on the trader for depositing pledged shares into the holding account!
These expenses when viewed individually can seen insignificant, especially when we talk about accounts worth tens of thousands of dollars.
But they can really add up and eat into your profits (if any) from trading.
So before signing for share financing do not let the advantage of being able to trade more shares blind your vision from seeing the actual expenses that you would potentially incur as you use these facilities.
