Question
Differentiate between 'Pledging' and 'Hypothecation' of shares. Explain the process involved in pledging of shares with the help of an example.
Answer :
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Skip in 10
Pledging and hypothecation of shares are two commonly used methods in equity markets that allow shareholders to use their holdings as collateral to raise funds, but they differ significantly in terms of ownership, control, and the legal framework involved. Understanding these differences is essential for investors, lenders, and financial institutions to manage risk and ensure proper compliance with regulatory requirements. Pledging of shares refers to the process by which a shareholder, known as the pledgor, offers their shares to a financial institution or lender, called the pledgee, as security for a loan. In this arrangement, the ownership of the shares remains with the pledgor, but the lender acquires a lien over the shares until the loan is repaid. Pledging typically involves shares that are freely transferable and can be held in dematerialized form in the investor’s account. The key feature of pledging is that the lender has the right to sell the shares if the borrower defaults on repayment, ensuring recovery of the loan amount. The shareholder retains all other rights associated with the shares, such as receiving dividends and voting rights, unless specifically restricted by the terms of the pledge agreement. Hypothecation of shares, on the other hand, is slightly different in its nature. Under hypothecation, the borrower offers the shares as collateral to the lender without physically transferring possession or creating a formal pledge. The ownership and control of shares remain fully with the borrower, and the lender only has a charge over the shares. Hypothecation is most commonly used in margin trading or when banks provide loans against securities. One major distinction is that in hypothecation, if the borrower defaults, the lender has to follow a legal process to seize and sell the shares, whereas in pledging, the lender can sell the pledged shares directly as per the terms agreed upon. Hypothecation is often considered less secure from the lender’s perspective compared to pledging because enforcement depends on legal and regulatory processes. To summarize the key differences, pledging creates a direct lien in favor of the lender with the
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