India’s tighter rules on bank financing are prompting some proprietary traders to find alternative ways to build leveraged equity derivatives positions, including by using shares held by wealthy investors in their networks as collateral, according to six people, including prop traders and brokers.
Instead of pledging their own shares, the traders arrange to use idle securities held by high-net-worth individuals with surplus shares as collateral in return for a share of the trading profits, according to two of the people. For prop traders, the appeal is leverage: clients’ idle shares can be used as collateral to support larger derivatives positions without tying up their own capital.
Investors, meanwhile, get an additional return on shares they would otherwise simply hold. But the arrangement also exposes investors to losses if trades go wrong and raises questions over whether it effectively recreates the leverage the RBI sought to curb.
Arrangements involving third-party securities to support proprietary trading positions would need to be examined carefully against the applicable collateral and risk-management framework, Moin Ladha, Partner at Khaitan & Co said."The key regulatory question is whether, in substance, the structure results in leverage being obtained in a manner that aligns with the intent of the underlying funding restrictions set by the RBI," Ladha added.
The workaroundFor example, a proprietary trader may approach an acquaintance holding ₹10 crore worth of blue-chip shares and offer to generate an additional return from the idle holdings. The trader may pitch a strategy backed by historical data showing annual returns of 7-8%, promising the investor a share of the earnings.
Once the arrangement is agreed, the trader pledges these shares with the broker and uses it as margin for trades. Margin is the amount a trader must put up against the total value of a position. A trader using ₹1 crore worth of shares as margin, for instance, could support a derivatives position of up to ₹5 crore if the applicable margin requirement is 20%.
The practice has gained relevance after RBI in February this year tightened rules governing bank financing for capital-market intermediaries. Earlier, a prop trader that lacked ₹1 crore in cash or cash equivalents could obtain a ₹1 crore bank guarantee by providing 50% of that amount as collateral, effectively obtaining a ₹1 crore trading limit against ₹50 lakh.
Under the new norms, traders are required to provide 100% collateral, with 50% in cash and 50% in non-cash items, which can then be used as margin. The revised rules took effect on 1 July, but bank guarantees typically remain valid for a year. Some guarantees issued before the deadline may therefore remain valid until July 2027.
Mint's queries emailed to the Securities and Exchange Board of India and RBI remained unanswered. The workaround has raised questions over whether private arrangements involving third-party securities could effectively recreate the leverage that RBI's rules were intended to restrict.“Still, not a lot of traders have started doing this, but once the bank guarantees expire, a lot of people will start doing this,” said one of the prop traders, who asked not to be identified.
The trades are executed with the trader having access to the client's demat account holding the shares, according to two prop traders.“We usually keep a profit-sharing ratio between us and whose shares we have used as collateral,” said the second prop trader.
Legal View is MixedAkshaya Bhansali, managing partner at Mindspright Legal, said the Securities Lending and Borrowing Mechanism allows investors with an active demat account to participate.“Considering that a structured exchange mechanism already exists, a private arrangement between entities for lending and borrowing of securities for the ultimate purpose of trading in securities might be considered as illegal,” Bhansali said, adding that such arrangements could be viewed as deliberate circumvention of legal provisions.
Debarpita Pande, senior associate at Trilegal, said that even if the holder has authorized the arrangement, the use of the shares would depend on the scope of that authorization. If the holder has not consented to the shares being pledged as security, using those securities for that purpose would present a clear issue, she said.