What is a Rebate Broker?

In finance, there is no free lunch. The adage is commonly used and denotes that nothing is free, someone always has a price to pay. The price may not always be monetary. If someone gets something for free, then there is a cost to be paid somewhere in the wider economic system.

The phrase also implies that things that appear to be free always have some hidden or implicit cost to someone irrespective of whether they benefit from it or not. There is always a cost associated with decision-making and consumption.

Discounts, rebates, and cashback are some instances where a reduction or refund in the purchase price is given to the buyer by the seller for various reasons. In the stock market, similar rebates on stock purchases are allowed by rebate brokers.

Rebate Broker

The meaning of a rebate is a discount on purchases. The purchaser is compensated by way of reduction, return or refund that is paid retrospectively. Rebate refers to money that is returned to the customer on the execution of a transaction.

Primarily, rebates are offered as below:

• Cashback: Rebate may be offered as a cashback on the purchase of a product or service. For example, on the purchase of an electronic, a certain percentage of the purchase price is returned to the customer.
• Flat-rate: Flat-rate rebate refers to the automatic deduction of a fixed rate from the purchase price.
• Conditional Rebate: Conditional rebate is offered only if the underlying conditions are fulfilled. Examples of conditional rebates are the ‘buy one, get one free’ offer, rebates based on the volume of purchase, etc.

Some conditional rebates may need the purchaser to furnish forms and proof of payment to apply for the rebate.

Why is a rebate offered?

Often, a rebate is used as a marketing tool to lure customers who are enticed by the idea of receiving cashback on expensive items. Most businesses find a way to pull out profit from products offered at a rebate. At times, the seller may incur a loss by offering rebates on purchases but customers may purchase other items too giving a net profit to the business.

Another strategy adopted by some entities is ‘price protect’. Rebates are offered on some products to offer other products at a higher price. Thus, the rebate offered on certain products is nullified by the elevated price point of the other products.

Rebate; Financial Instruments

Rebates are also commonly offered in securities trading, especially for short sale transactions. A portion of the dividend or interest is paid by the short seller to the owner of the securities as a rebate. Short selling requires a margin account.

Rebate in Securities Trading

Essentially, a rebate is involved in short selling transactions. A short sell is executed when the price of an asset or securities is expected to decline. The purpose of short selling is to benefit from the decline in prices of security by repurchasing it at a lower price after the sale.

In a short sale, the trader is exposed to unlimited risk since there is no limit on the potential increase in the price of the shares. Nevertheless, the trader can exit a short sale at any time to reduce the risk.

Short selling enables the trader to sell securities that are not owned by the trader. A trader must borrow securities from the owner and deliver them to the buyer. The trader is expected to deliver the securities to the buyer on the settlement date.

Any benefits which accrue to the borrower between the trade date and the settlement date is to be paid to the owner of the securities. If stock is borrowed then the dividend paid to the borrower is to be forwarded to the lender. Likewise, in the case of bonds, the interest is reimbursed to the owner.

When a short seller borrows shares then the seller may pay a rebate fee to the lender to compensate for benefits accrued by holding the securities. Generally, brokers, dealers, large institutions, and market markers qualify for rebates. In most cases, individuals are not eligible since the sum of securities lent may not be substantial.

Rebate Fee

Whenever shares are borrowed for a short sale transaction, a rebate fee is to be paid by the borrower to the lender. The quantum of rebate fees is a factor in the number of sales and the availability of shares in the market. If the shares are expensive or difficult to borrow then the rebate fee is higher.

In some cases, a brokerage firm may have to force a trader to buy the securities in the market before the settlement date if the firm believes that the securities might not be available on the settlement date. This is referred to as forced buy-in.

Margin Accounts and Rebates

Margin accounts and the rebate is another interesting aspect of a short sale transaction. In a short sell transaction, a trader is required to maintain a margin with the broker. The purpose of maintaining margin is to safeguard the broker from potential losses in a customer’s account. The margin for stock, futures, options, and currencies differs from each other.

In India, the margin requirement for shares is 20%. For example, if the transaction value of a short sale is Rs. 100,000 then a margin of Rs. 20,000 is to be maintained with the broker. If the price of the security increases, then the borrower will be asked to maintain a higher margin to protect against larger losses. If the price of the security continues to rise and the borrower is unable to deposit more capital, the position will be liquidated. The borrower is liable for the entire loss even if it is greater than the capital in the account.

Rebates vs. Discounts and Reduced Interest Rates

Discount refers to a reduction in the purchase price given to the buyer by the seller. Rebate is the amount refunded by the seller to the buyer upon payment. Discounts are applied before the purchase while rebate is collected after payment. They are offered by retailers whereas rebates are more likely offered by manufacturers such as automakers.

In contrast, a reduced interest rate lowers the monthly payment on large purchases such as electronics. A discount or rebate provides the buyer with immediate liquidity but a lower interest rate may provide significant savings in the long run.

Example of a Rebate

Let’s suppose a trader has borrowed shares of HDFC Bank Limited worth Rs. 10 Lakhs for short selling. The trader has agreed to pay a flat rebate fee of 5% on the trade settlement date. This indicates that the account balance of the trader must be Rs. 10.5 Lakhs on the date of settlement. At the time of entering the position, the trader is also required to maintain a margin of Rs. 2 Lakhs with the broker. If the price of HDFC Bank Limited reduces then the short seller earns a profit and no change is to be made to the margin.

On the contrary, if the price of HDFC Bank Limited increases to Rs. 15 Lakhs overnight then the trader will have to increase the margin to Rs. 3 Lakhs to keep the trade open. Alternatively, the trader can also take the loss and close the position. The rebate of 5% also has to be compensated to the broker when the position is closed.

Conclusion

Before executing a short sell transaction, you must check with your broker about the short sale rebate on the stock. The rebate fee must be commensurate with the risk associated with a short-sell transaction.