What is Collateral in Margin Trading? Types of Acceptable Collaterals and Significance of Collateral Margin

Investing in the market often requires substantial capital, which you may not always have readily available. Borrowing from friends, family, or financial institutions can feel uncomfortable or impractical. This is where margin trading offers a strategic solution, allowing you to leverage your existing assets as collateral to access additional funds

Collateral margin means that you pledge your assets as collateral to get loan for more investing. This allows for a simple method to secure funds and grow your investment portfolio while not putting your current investments at risk. However, these might pose certain risks for both lenders and borrowers, which are important to take note of.

This article explores collateral margin, margin trading, eligible assets, key benefits, and a step-by-step guide to using collaterals effectively.

What is Collateral in Margin Trading?

Collateral in margin trading, also known as collateral margin or margin against shares. refers to the assets pledged by a trader to secure a loan from a broker. This is provided against the shares, stocks, bonds and other investment securities used for stock market trading.

Pledging your investment securities gives you a margin limit. Additionally, your collateral protects the broker in case of a default. In case of a loss, the broker can liquidate the collateral to recover the principal amount.

Let’s understand this with an example.

Portfolio Value

You have a portfolio with ₹10,00,000 worth of shares. These stocks are eligible to be used as collateral for margin trading. This means your broker will consider these shares as security for a loan to enable you to trade with borrowed money.

Margin Limit

If your broker allows a margin ratio of 70%, it means you can borrow 70% of the value of your eligible portfolio to trade.

Hence, your broker assigns you a margin limit of ₹7,00,000. This means that out of the ₹10,00,000 worth of shares in your portfolio, you can borrow up to ₹7,00,000 for margin trading. This extra ₹7,00,000 can now be used for trading purposes, such as buying more shares or executing other trades.

Using the Margin

Now that you have access to ₹7,00,000 in margin, you can use this amount to take additional positions in the market. For example, if you decide to invest in more stocks worth ₹7,00,000, you can do so, but you have to be mindful that this money is borrowed from the broker.

Interest on Borrowed Amount

The ₹7,00,000 you borrowed from the broker is not free; you will have to pay interest on this amount. The interest will depend on the broker’s terms and the duration of borrowing. For example, if the broker charges a 10% interest rate annually, and you borrowed the full ₹7,00,000, you’d be required to pay ₹70,000 in interest over the year.

Margin Limit Adjustment

Your margin limit of ₹7,00,000 is based on your current portfolio value of ₹10,00,000. However, the value of your portfolio is subject to fluctuations. If the value of your shares increases or decreases, your margin limit will adjust accordingly.

For instance:

• If the value of your portfolio increases to ₹12,00,000, your new margin limit may increase to ₹8,40,000 (assuming the same margin ratio). You could borrow more funds to trade with.
• On the other hand, if the value of your portfolio decreases to ₹9,00,000, your margin limit may drop to ₹6,30,000. This means you can borrow less, and if you’ve already used the full margin, you might receive a margin call to deposit additional funds or sell part of your holdings

Types of Acceptable Collaterals

To be eligible for MTF trading, you must use certain financial securities or investments as collateral. However, only a limited type of securities are accepted as collateral with so many different investment options in the market. Some types of acceptable collaterals are –

1. Cash

When it comes to investing in the financial market, cash is the regular type of collateral. It is accepted due to its instant liquidity. Using cash protects you and your broker from a volatile market, lowering the price of the security.

2. Shares

You can use your pre-existing shares to get loans for further investments. Generally, your borrowing ability is based on the market value of your shares. Brokers may also apply a ‘haircut’ on the share. A haircut is a reduction in the price of the shares according to their risk, liquidity, and volatility.

3. Bonds and Government Securities

In Margin trading, government securities and bonds are more stable than any other collaterals. You usually get a percentage of the bond’s market value depending on various aspects, such as the bond’s maturity.

4. Mutual Fund Units

You can use diversified mutual fund units as collateral in the market, which usually offers them better collateral security. However, mutual fund units generally pose a greater market fluctuation risk than other collateral margins and, hence, can have a higher haircut.

The Significance of Collateral Margin

Collateral margin is generally regarded as a better alternative to other options when it comes to borrowing for investments. It not only allows investors to get better margin limits without spending more money but also secures brokers in case of losses. Here’s some major points reflecting the significance of collateral margin –

1. Easy Access to Credit

With the collateral margin, you receive simple loan access. Any other type of loan is relatively more complicated. Your credit score and other eligibility factors should work in your favour, which takes time. But the collateral margin is simple and easy.

2. Lower Borrowing Costs

In the margin trading facility, collateral loans often come with lower interest rates than unsecured loans. As you will be pledging up your asset, the lender finds it relaxing as they can recover the losses against the basic in the event of a default. This makes borrowing easier for the lender, and therefore, it’s a good chance to get better borrowing conditions.

3. Leveraged Trading

With leverage in stock market, your collateral margin can potentially earn you a higher profit as this margin can be used to invest more in the market, thus increasing your holdings. Additionally, having a greater margin allows you to manage market fluctuations better. You can strengthen or simply reaffirm your trading positions depending on the condition of the market.

How Collateral Works in Margin Trading?

Before leveraging your collaterals in margin trading, you must understand how collateral loans work. The process is as follows.

1. Protecting the Broker

The broker or lender often gives out an amount based on the loan to value ratio. In such cases, the lender will give you a percentage of the actual market value of the pledged asset. Maintaining this margin enables the broker to limit potential losses. They can also demand more collateral in the event of market downturns.

2. Protecting the Trader

Traders can also benefit from collateral margin since they can get loans against the pledged assets. They can use the idle asset to get a better margin and increase their investment in the market. This also enables them to get a loan if they are not eligible for personal or unsecured loans. At the same time, they also keep ownership of the previously pledged assets, diversifying their portfolio.

Managing Collateral Effectively

Managing different types of collateral effectively helps keep unwanted losses at bay. Here’s how you can effectively manage your collateral.

1. Regular Monitoring of Pledged Assets

Regular monitoring of pledged assets enables you to ensure that you have the desired margin to meet yourmargin trading limit. This is important as an asset’s value can increase or decrease due to the changing market conditions.

A decline in value can lead to a margin call, during which your broker may ask you to pledge more securities. By actively tracking your collateral,, you can address these situations and avoid the risk of forced liquidation of your positions.

2. Understanding Broker Specific Policies

Different brokers in the market have different rules when it comes to margin trading. They can have different eligibility criteria, types of collateral that can be pledged, margin interest rates, procedures to get margin calls, maintain margin levels, etc.

Understanding the broker’s policies ensures you meet compliance and their requirements and helps manage risk effectively. Additionally, by understanding these details you can continue to make undisrupted investments.

Step by Step Guide: Acquiring Collateral Margin

While getting collateral margin is a quick process, you need to understand the eligibility, process, and requirements for acquiring an MTF in trading.

1. Eligibility Assessment

First off, the lender assesses your eligibility. This is done by calculating the shares, securities or bonds one holds, their market value, the borrower’s creditworthiness and general market fluctuations.

2. Loan Amount Evaluation

Lenders often calculate the eligibility of the loan by evaluating the value of the pledge shared and the maximum lender loan to value ratio. This ratio determines the exact amount that you will receive against your assets.

3. Pledge Agreement Execution

After the loan terms are approved and agreed upon, a pledge agreement is proposed for you to sign. Signing this official document ensures that the shares are pledged as collateral for the loan.

4. Funds Disbursement

After the pledge agreement is executed, the lender disburses the amount agreed upon as a loan to you. This loan amount is usually disbursed to your registered margin trading account.

Collateral Margin vs. Pledge Shares: How Do They Differ?

Even though collateral margin and pledge shares seem alike, they have certain distinguishable features among them. Here are the basic attributes of collateral margin and pledge shares:

1. Collateral Margin

Collateral marginrefers to using existing investment assets to secure loans to buy newer shares or bonds in the market. You can get a loan in exchange for pledging your shares, which you can use in the financial market to make more investments. However, during the loan period, the borrower does not lose ownership of the pledged assets.

2. Pledge Shares

Pledge shares are a way by which you can hold shares as a pledge to meet your margin requirements. You can only utilise your holdings in shares and not other investment assets, unlike acceptable collateral, to get the collateral margin. In addition, while the collateral is pledged, the ownership remains with the borrower. However, the lender has the right to sell the pledged assets to recover their margin funding in case of a default.

Is Collateral Margin a Secure Option?

While collateral margin offers a relatively better option to obtain a loan without compromising the ownership of your assets, it also poses a great risk for you. With the assets at stake, in case of any unforeseen market fluctuation, you can incur a loss, and the lender may decide to sell off the assets to recover the principal. Other times, a margin call may be induced. The margin call is a situation where the broker or the lender demands more collateral to keep up the basic margin requirement.

Meanwhile, for lenders, collateral margin offers enhanced security. If you incur a loss at the hands of a market downturn, they may recover their losses through a margin call or an outright sale of your assets pledged. However, it is also important to note that while granting the loan against your assets, a thorough portfolio and creditworthiness check is deemed important to minimise the risks associated with lending loans.

Conclusion

Collateral margins offer a new way to secure better loans while maintaining their asset holdings. You can pledge your shares and bonds and get loans to expand your portfolios. Meanwhile, the lenders are assured of minimised risks with the pledging of assets that might be utilised in case of losses.

Therefore, collateral margin acts as a powerful way to leverage your existing investment to expand your investment portfolio. It also enables you to expand your market holding and maintain stable creditworthiness. However, understanding the associated risks and adhering to the terms of the loans may increase the chances of a more profitable venture.