Short Selling…a fine art to fast profits in falling markets
Short selling, or shorting, is the practice of selling securities one does not own. The settlement obligations for the short sale are met by borrowing the shares. The shares are lent under the express condition that they would be returned to the lender at a specified date and adequate margins are collected to safeguard the interest of the lender. The mechanism under which the shares are borrowed and lent is known as Stock Lending and Borrowing Mechanism (SLB).
Retail investors have been doing it in the spot market for long. However, lack of proper procedures to execute and regulate these transactions kept the scope of short-selling limited. A new set of guidelines and procedures, for both institutional and retail investors, have been put in place by market regulator Securities and Exchange Board of India (Sebi), stock exchanges and brokers, to execute the transaction. Institutional trades in the cash segment have thus far been exempted from margins. The capital market regulator has now stipulated that even cash trades by institutional investors will be margined, just as they are in the case of retail participants. To start with, margins would have to be paid a day after the trade, and from 16 June’08 margins would have to be paid up front like by any other investor.
So far, retail investors, by the end of the trading day they had to execute the transaction to cover the shares they sold short without owing them. The new system provides for borrowing shares for a seven-day period and using them to settle the sale of shares within a T+2 (trading day + two days) deadline. The stock exchanges will give an automated platform for an hour everyday to facilitate borrowing and lending of shares, and trader will be allowed to sell short only after he enters into a deal to borrow the shares. Till now, the lack of a proper system to borrow shares was a big bottleneck for short selling. Initially, short selling will be permitted only in 227 stocks that are also traded in the futures and options segment, where deals can be entered into for making transactions at a future date. Later, the stock exchanges may decide to extend short selling to a larger universe of stocks.
You can sell stocks that you don’t own. You can give delivery of the shares to the buyer by borrowing them from other investors who are willing to lend the shares. But, you need to enter into a deal to borrow the shares before you sell them short. Retail investors need to inform their brokers about the short sale they entered into before the end of the trading hours. Institutional investors will have to inform the broker upfront, if they are selling short. The brokers will have to assign a unique client identification number to each investor who wants to participate in the lending and borrowing of shares. The identification number will be mapped to the investor’s permanent income-tax account number, so that any effort to manipulate stock price can be tracked. The stock exchanges may levy stiff penalties on brokers for violation of this rule. As there will be limits on what percentage of each company’s shares can be borrowed or lent, there won’t be much scope for any investor to short-sell stocks through multiple brokers. Brokers will have to enter into an agreement with stock exchanges’ clearinghouses—Bank of India Shareholding Ltd for the Bombay Stock Exchange and National Securities Clearing Corp. for the National Stock Exchange— for offering the facility.
To borrow and lend stocks, you need to first enter into an agreement with your broker that will specify the terms and conditions of the stock borrowing and lending transaction. Brokers may put such terms and clauses to ensure that you do not default in any lending or borrowing transaction.
On every trading day, there will be a one-hour trading session between 10am and 11am where lenders and borrowers of shares can try to match their orders through a trading screen. So, if you want to borrow 100 shares of company ABC Ltd., your broker will find an investor who will be willing to lend the same number of shares in that company. After you put the order for borrowing the shares during the one-hour trading session, you will get the shares the next day. You can keep the shares for seven days and then return, often by buying the shares from the market. Only one contract will be available for each security in the SLB market and the period of lending and borrowing is fixed at seven days.
On the flip side, It may take months for a short position to turn profitable and an investor using the SLB mechanism to take a short position would have to keep rolling the contract over several times, making it cumbersome. The main beneficiary of the SLB system would be arbitrageur, wanting to profit from the pricing inefficiencies in the derivatives market. Futures contracts, for instance, are closely linked to the price on the cash segment and whenever they deviate from their fair value, there arises a risk-free opportunity for arbitrageurs. When futures prices are lower than their fair value, arbitrageurs seek to buy them and sell the underlying stock in the cash segment. Currently, only those investors who own the underlying stock can benefit from such trades. With SLB, the stock can be borrowed and then sold on the cash segment by other investors as well. But again, the rigidity of the seven-day SLB contract can be a dampener for arbitrageurs. What if the arbitrage opportunity in the market is not in multiples of seven days? A trader may need to borrow a stock for just three days, but would have to pay interest for seven days.
Lending and borrowing of shares will happen at a price, which will be determined by the market. In other words, it will depend on the number of borrowers and lenders available for a particular stock. For example, if you want to borrow shares of company ABC Ltd. at Rs10 per share as the borrowing price and if there are lenders at the same price, your transaction will be done. If the lenders quote Rs15, you can ask your broker to negotiate a deal. The lending and borrowing costs will also depend on the previous day’s closing price of that stock. Besides this cost, the borrower will have to ensure that he has enough funds to pay the margin; this is to safeguard the interests of the lenders. Long-term investors can earn short-term income by lending shares. But mind you, it won’t be a completely risk-free way. If the borrower is unable to return the shares after seven days, then the exchange will carry out a buy auction to ensure that you get the shares. If the shares can’t be bought through the auction, then the exchange will compensate you for the value of shares you lent. The value of shares will be computed according to a certain formulae, which will take into account the market price of the shares. According to Tax authorities, lending and borrowing transactions will not be considered as a transfer of securities and hence, it will be exempt from capital gains tax and the securities transaction tax.
Securities lending and borrowing is not new to India. In May 1997, Sebi specified a scheme but that hardly took off in its intended form of being a pure SLB mechanism. Instead, in order to counter the Bombay Stock Exchange’s (BSE) popular carry-forward system called badla, the National Stock Exchange launched ALBM (automated lending and borrowing mechanism) in accordance with the provisions of Sebi’s Securities Lending Scheme, or SLS. Whenever the markets fell sharply, badla trades, which were essentially leveraged trades, tended to see defaults, leading to payments crises on stock exchanges. Badla was banned after the 1992 scam, when broker Harshad Mehta used loopholes in the banking system and the leverage and non-transparency of the badla system. But it was allowed again in 1996 with restrictions such as broker-wise limits. ALBM soon grew in popularity and BSE eventually replaced its badla system with an ALBM clone called BLESS (borrowing and lending of securities scheme). But both these schemes were partly blamed for another scam that hit the market in 2001. This time, Ketan Parekh was in the spotlight. In June 2001, when options were introduced on individual securities, both carry forward mechanisms were discontinued. Later, in November 2001, futures on individual securities were introduced to take care of the need for leverage traders had, at least for the list of securities in which derivatives trading was permitted.
It has taken more than six years for a stand-alone SLB mechanism to be introduced. In its current form, the system will function as a pure SLB mechanism, and traders will have to meet their settlement obligations on both the cash and SLB segments separately. This will avoid the fiasco with SLS of 1997, under which carry-forward systems such as ALBM and BLESS prospered. This is for the first time institutional investors will be allowed to go short in the cash segment as Sebi guidelines specifically prohibit mutual funds and foreign institutional investors from engaging in short-selling of securities.
Ulike the practice in overseas markets where SLB in India will work on an Over-The-Counter (OTC) platform, stock market regulator Securities and Exchange Board of India (Sebi) has chosen the exchange-traded format. In developed markets, custodians who hold a large pool of securities on behalf of clients offer lending and borrowing services. The OTC format has been successful primarily because it enables the borrower to have the flexibility of the period for which he wants the stock loan.
Understandably, short-sellers are not very popular and are often accused of causing huge market fluctuations. But, they are also credited as the ones who ring the warning bells—they trade on expecting negative news. Having an efficient SLB mechanism and permitting short sales will enhance the liquidity and price discovery. Since informed investors can now go short on stocks they feel are highly priced, manipulation of stock prices will be more difficult. Those with a large pool of securities, such as institutional investors, can earn additional income by lending them in the SLB system.
