The place of short selling in the financial markets

by K. P. Krishnan, Renuka Sane, Ajay Shah, Anjali Sharma, Harsh Vardhan, Bhargavi Zaveri-Shah.

The Hindenburg report has reopened the Indian debate on regulatory restrictions on short selling. Is there market failure with activist short selling, that is, the practice of short sellers disseminating information (usually adverse) about the firms whose stocks they have shorted? Activist short sellers have the incentive to release negative information, which may be misleading or even false, aiming for maximal visibility. Does responding to adverse information impose an unreasonable burden of time and effort upon managers of the firm, and consequently higher costs on their customers? Is there a role for financial regulation to proscribe activist short selling or all short selling?

We argue that short seller activism improves market quality. The focus of financial regulation should be upon market abuse, and this includes market-based abuse and information-based abuse. In India, much of the policy discussion on short-selling is moot, given that short-selling, as is widely understood in the financial industry, is largely infeasible. In any case, in this globalised world, there is nothing that an Indian regulator can do about these activities taking place overseas.

Defining short selling

When a person has a negative view about the outlook for a financial price, she wants to sell. What happens when she does not own these shares? Short selling refers to the procedures on the market through which a person with a negative view can achieve a profit from successfully forecasting a price decline, even without directly owning the shares. There are roughly three ways to do this:

1. Sell stock futures.
2. Buy put options (or to sell call options).
3. Borrow shares and sell them.

The #3 is termed “short selling”. This involves (a) Borrowing shares (b) Selling them (c) Waiting (d) Buying back the shares from the market (at a hoped-for lower price) and (e) Returning the shares with interest.

In India, for all practical purposes, short selling is infeasible. While the institutional mechanisms for borrowing shares exist on websites of exchanges (such as the `Securities Lending and Borrowing Mechanism’ (SLBM) which was first operationalised in 2008), the liquidity available is negligible.

Methods #1 and #2 are constrained by a variety of regulatory restrictions, such as small position limits and high margin requirements. As an example, the position limit on the stock futures for Infosys (which has a market capitalisation of Rs.5.86 trillion) is Rs.30.8 million. This is 0.000526% of its market capitalisation. If a person successfully predicts a 50% stock price decline in Infosys, but is only permitted to have a position of Rs.30.8 million, the profit from a correct prediction is just Rs.15.4 million. This maximal profit (under extreme assumptions) is not large enough for professionals such as Hindenburg. One can only do such India-linked financial activities outside India.

The symmetry between longs and shorts

Everything that has been said above about short selling is true in reverse. When a person has a positive view about the outlook for a financial price, she wants to buy. Here too, the person can choose to act on her information in three ways: (1) Buy stock futures, (2) Buy call/Sell put options, and (3) Borrow money and buy shares.

The freedom to transact in the securities markets is analogous to the freedom to speak. A healthy arrangement is one where both positive and negative views are expressed. The market price is the outcome of both kinds of persons transacting with each other, and financial policy should be neutral between these two kinds. One has a long position, who may speak in the public domain about the stock being undervalued and likely doing well in the future. The other has a short position, who may speak in the public domain claiming that a stock is overvalued.

At present, in India, there is full symmetry between longs and shorts when it comes to expressing views through the futures and options (in that both optimists and pessimists have limited possibilities to put their money where their mouth is). On the #3 path, however, it is easier to borrow money when compared with borrowing shares.

A marketplace of ideas

The securities market is a classic example of a ‘marketplace of ideas’. There are many lines of reasoning which lead to diverse predictions about whether prices will go up or down. Each trader chooses an information set and an analytical strategy which makes sense to her. As Milton Friedman emphasised, there is a Darwinian process where those who forecast poorly lose their capital and end up having a lower influence on prices, and vice versa.

Sometimes, the phrase “market efficiency” is overstated to expect perfect forecasts. It is more useful to think of the market as a human construct, as an aggregation mechanism where multiple individuals, each with different sets of incomplete information, try to forecast better than each other. If this process is to deliver efficiency, it requires an environment of freedom: freedom to enter the market, to obtain and process information, to express views through trades, and through speech.

Current regulatory approach

The present Indian thinking on the role of having skin-in-the-game is confusing. On some occasions, the Indian state has held the lack of skin-in-the-game against market participants. In fact, if the person had no skin in the game, then she could say anything, and face no consequences. When she can lose money if she is wrong, the quality of the forecasts backing the speech is likely to be higher.

The Indian debate on government control upon short selling also needs to recognise that in the globalised world, the constraints on this activity in India have helped push it overseas, beyond the reach of Indian regulators.

Benefits for society from short selling

The resource allocation of the market economy is controlled by financial prices. As the old saying goes “finance is the brain of the economy”. When this brain works better, the scarce resources of the society get put into better use, thus improving the translation of savings/investment into growth.

Prices constantly fluctuate, frequently becoming a bit too high or a bit too low. The job of continuously correcting them is done by traders, who constantly look at these prices, and who form a judgement about whether a certain price is too high or too low. The people with forecasts are often not the people with the securities or money. It is efficient for society to create mechanisms through which people with forecasts are able to take buy or sell positions, thus feeding their information into prices. These activities continuously push prices towards fair value. It is best for these activities to be symmetric: buying and selling are both equally legitimate as both over-priced and under-priced securities are equally a problem.

Consider a share with a fair value of Rs.100. When mispricing takes place in the lower direction, i.e. the market is underpricing the share, the price can go as low as Rs.0. On the other side, however, the mispricing can go up without constraints. There is no arithmetic limit on how high prices can go, to Rs.1,000 or Rs.10,000 or beyond. Some entrepreneurs have pursued get-rich-quick schemes, where over-pricing of share leads to benefits such as achieving power in a society that glorifies financial success, obtaining enlarged loans against overvalued shares as collateral, and raising capital through primary issuance at elevated securities prices.

In advanced economies, the gains from short sellers are well established in the research literature and in policy thinking. Short sellers played a key role in calling out Enron’s accounting fraud, the Wirecard fraud and several other such situations with falsified financial statements. Researchers have found that short selling activity helps uncover firms that misreport financials faster. There is a well-known bias in favour of buy recommendations by stock analysts. Short sellers have often countered these over-optimistic valuations and often won the debate. Investigative reports by short sellers have often acted as cues for enforcement authorities to commence investigations into potential wrongdoing. For example, after Hindenburg’s 2020 report into the E.V. Maker Nikola, the SEC began an investigation into the company that led to conviction of the CEO of Nikola for fraud.

Every society suffers from problems of fake it until you make it. In the Indian institutional environment, there is certain appeal of schemes which generate meteoric financial success, which can help create financial and political capital for use in intimidation and fending off future investigations. Short selling is, then, particularly valuable in India given the limitations of state capacity in financial market regulation: the optimal space for short selling in India should be greater than that seen in advanced economies.

How does this connect up into financial markets regulation?

In the standard toolkit of financial markets regulation, e.g. as is done by the Financial Sector Legislative Reforms Commission (FSLRC), there are three classes of interventions by the state that address market failure:

• Market-based abuse: The use of market power on the market to force the price away from fundamentals.
• Information-based abuse: Falsification of the information set of the market so as to force the price away from fundamentals.
• Insider trading regulation: The use of insider information for profitable trades by insiders (which bring the price closer to fundamentals).

Regulators should enforce against all these three problems, regardless of whether short selling (or long buying) is in the picture. However, if it is felt that short selling (or long buying) always involves one or more of these three classes of problems, this is incorrect. There are many short selling (and long buying) transactions in this world which are free of these three problems.

In India, the `Prohibition of Fraudulent and Unfair Trading Practices’ (PFUTP) Regulations are designed to deal with market abuse of both kinds (market-based abuse and information-based abuse). PFUTP regulations have been one of the most frequently enforced regulations in the Indian securities market with a reasonably high conviction rate (Damle and Zaveri-Shah, 2022). SEBI may issue directions to pre-empt such conduct and impose sanctions in the form of monetary penalties, with the directions often having a punitive effect as well.

Finally, under present Indian law, defamation, including corporate defamation, is a civil and a criminal wrong. For instance, recently, Edelweiss sued Moody’s for defamation for misrepresenting the former’s financials, demanding exemplary damages. An analyst went to jail for writing about Indiabulls. A firm could choose to act against an activist short seller through these tools also. In these threats also, the Indian setting is different from that in advanced economies.

We enumerate these features of the Indian legal system to shine a light on the existing methods through which state power can be brought down upon behaviours adjacent to the short selling debate, and not to endorse them. The present frameworks need much improvement. The PFUTP regulations have imprecise drafting and leave ample scope for discretion. The economic logic of harsh penalties against insider trading is questionable, as insider trading takes the market price closer to fair value. The Indian limitations on freedom of speech -- all the way to the 1st amendment -- need to give way to the blossoming of enlightenment values. For the present discussion, however, we wish to point out that when we think of bad behaviour that might go alongside short selling (or long buying), there is an institutional apparatus (that needs much improvement) which addresses these. There is nothing special about short selling (or long buying) that calls for new work by way of state coercion.

What should managers do in the information space?

Finally, we turn to the burden upon managers to respond to rumours / allegations in the information space. Firms release a set of regulated disclosures into the public domain, and are held accountable for the veracity of these claims. It is the responsibility of the managers of listed companies to operate the information process through which these facts are created and disseminated. Firms with listed securities are coerced by the state to release a certain set of correct facts about the firm, into the public domain, to enable and assist the process of speculative price discovery that creates the public goods of an efficient price and market liquidity. Such firms are also coerced on not speaking publicly, in ways which release information, outside of the regulated processes for information release.

There is, however, no role for state coercion in favour of public release of facts about market participants. As there is no market failure, they should be free to trade and speak as they please, other than the rules about disclosure of insider trades.

The information space that shapes the stock price is populated with numerous elements outside the firm:

1. The full information space is vastly greater than the set of mandatory disclosures. There is an important information space of unregulated facts. Third parties can and do construct facts about the firm with no involvement of the firm, and outside of the regulated facts overseen by SEBI. For example, a private person can obtain private satellite imagery and count the number of cars parked at DMart locations, and thus estimate revenues of DMart. It should be the privilege of such a person to compute and/or release such estimates, and be fully free on using precise or imprecise methods in the computation.
2. Third parties knowingly or unknowingly do create false facts about the firm. This is a normal and healthy part of the information space. Freedom of speech contains the freedom to utter sentences that are wrong. Obtaining precise facts is difficult and should not be crushed under state coercion where persons are punished for uncovering or speaking false facts.
3. Third parties can apply diverse analytical techniques based on which forecasts are made about the operating performance or future stock price movements of the firm. These forecasts are subjective and (in a healthy society) will diverge greatly. All these are inputs for speculators who then come together into the process of price discovery on the financial markets.
4. In this rich landscape, the state cannot be the arbiter of what is true vs. what is false. The state does not have such institutional capacity -- this is the work of market participants -- and it would constitute censorship.

What should managers of firms do about this information space? Most firms voluntarily choose to have an investor relations capability, through which they are able to engage with some institutional investors and communicate the state of the firm to them. These conversations are, of course, limited by concerns about leaking non-public information to some investors and thereby giving them an edge.

Should managers do anything else, over and beyond these traditional investor-relations activities? Should managers monitor blogs and social media, and scotch false rumours about the firm? Once there is ample trading by diverse kinds of persons on the financial market, there will be reasonable levels of market efficiency. The astrologers and technical traders and econometricians will sort out their differences -- on the market. Liquid and efficient markets are quite able to absorb all manner of influences. The difficulties of information space reiterate the prime objective of financial economic policy as creating conditions for market liquidity - by having a stock lending mechanism that works, by not having tiny position limits, by freeing up capital controls, by not reducing exchanges into arms of the state, etc.

It is not the job of a cricket team to influence the speech or bets of spectators. We think that managers competing in the information space is a bad use of managerial time and energy. If we were members of the board of a company, we would generally favour the application of the resources of the firm towards strengthening the operations and the outputs of the firm. SEBI recently proposed amending its Listing Obligations and Disclosure Regulations to require large listed companies to confirm, deny or clarify false rumors in the market. We do not see the market failure that can motivate such state coercion: this should be the prerogative of the board and not forced by the government.

References

Damle, D., & Zaveri, B. (2022). Enforcement of Securities Laws in India: An Empirical Overview. Social Science Research Network.