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Monday, December 24, 2007

SEBI's move on short selling

SEBI has moved on short selling and securities lending. See the two PDF files at the bottom of this page. For the motivation, about why this is important, and the political economy of the constraints, see this blog post by Jayanth Varma. A quick summary of where we stand on this question:

  • Instititional investors are prohibited from selling a security they do not own, but some of them (mutual funds, FIIs) have fairly good flexibility on using single-stock futures where shorting is easy and convenient.
  • Non-institutional investors - who make up the bulk of the market - are able to go short, but lack a mechanism for borrowing shares. Once again, shorting is easy and convenient using the single-stock futures. In addition, many day traders short-sell within the day but are forced to buy back within the same day since borrowing shares is infeasible.

My sense of the situation is that India does not suffer from a significant problem in the ability to express negative views about stocks, given the strength of the individual stock futures market. However:

  • Reverse cash and carry arbitrage requires access to borrowed shares.
  • Many securities lack individual stock futures. Obtaining market efficiency on these critically requires that speculators have a mechanism for selling borrowed shares.

SEBI's announcement envisages short selling for the same stocks where individual stock futures are available. The impact there will, then, be limited to enabling the activities of arbitrageurs. While that is beneficial, much more remains to be done.

The really important issue is the mechanism for borrowing shares. Will this work frictionlessly? In my intuition, demand for borrowing is small and the supply (with institutional investors) is quasi-infinite, so access to borrowed shares should become possible at very low prices. I wonder what the charges for borrowing securities are in the UK and the US.

As emphasised in the MIFC report, the need of the hour is an integrated securities lending mechanism covering shares, corporate bonds and government bonds, so that short selling can flourish on all three markets. SEBI needs to urgently solve the problems of the borrowing mechanism, so as to then move forward on implementing this larger agenda. Short selling is more urgently needed on the bond market, where the minimum semblance of market efficiency is presently lacking.

Mobis Philipose has a good article in Mint reviewing the SEBI announcements and their consequences, and Business Standard had a good editorial on this subject today:

Economic liberalisation is, ultimately, about the idea that resource allocation driven by markets works better than that driven by a Planning Commission. This requires markets that work well. This calls for ample information disclosure, checks against market power, and a free play of both optimistic and pessimistic views. Short selling - expressing a negative view about a stock that one does not own - is thus an integral part of any well-functioning financial system. Sebi's recent moves on short selling are, hence, based on the correct vision for financial sector policy.

When derivatives trading on individual stocks began, a "technology" for expressing speculative views about individual stocks became available. An optimist can buy futures or call options, or sell put options. A pessimist can sell futures or call options, or buy put options. Thus, with derivatives trading, a level playing field between positive and negative views is assured; short selling is no longer a big issue. Unfortunately, Sebi says that short selling will only be available for these stocks. Sebi would do well to permit derivatives trading and short selling on more stocks. Short selling for stocks on the derivatives list matters only insofar as it supports reverse cash and carry arbitrage. When the futures price is `too low', arbitrageurs borrow shares, sell them, and buy the futures. The impact of this announcement will, then, be indirect: it will help cure the persistent underpricing of futures that has been found in India.

Some features of Sebi's announcements are unfortunate. Institutional investors are prohibited from squaring off positions within the day. They are required to disclose that an order is a short sale at the time the order is placed. Retail investors are being asked to make the same disclosure at the end of day. Brokers have to supply this data to exchanges who will then release these to the public. These notions are not grounded in serious policy analysis. For the spot market, short selling is invisible: on T+2, when deliveries have to be made, the short seller supplies shares just like any other seller. A thorough policy analysis effort on Sebi's part would have led to the simple removal of all restrictions on short selling.

The real challenge is not in short selling but in effecting borrowing of shares. Sebi proposes to set up an exchange-traded mechanism for borrowing shares. This involves one key rigidity that will hamper its success: borrowing and lending can be done only for seven days. This is inconsistent with the needs of futures arbitrage. When an arbitrage opportunity surfaces (say) three days from futures expiration, the futures arbitrageur needs a way to borrow shares immediately for a maturity of three days. While an exchange traded mechanism sounds sophisticated, the mainstream solution found internationally - that of merely borrowing securities OTC from institutional investors - appears to be a superior solution.

Update: Andy Mukherjee disagrees, saying that India might well be onto something very important by emphasising an anonymous order-matching mechanism for borrowing shares.


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