A short course on short sales

Securities and Exchange Board of India (Sebi) on Thursday allowed short-selling by all classes of investors in the Indian stock market.

The date of implementation will be announced after the stock exchanges and depositories put the required systems in place. Business Standard dissects the concept of short-selling and its implications for the benefit of the lay investors.

What is short-selling?

Short-selling is the sale of shares that the seller does not own at the time of trading. Despite being a long-standing market practice worldwide, short-sales have been the subject of considerable debate and divergent views in most securities markets.

The votaries of short-selling view the practice as a desirable and essential feature of a securities market.

They argue that in a weak market, short-covering of positions taken at the beginning of a downturn, would arrest the declining trend. Critics of short-selling, on the other hand, are convinced that short-selling poses potential risks and can easily destabilise the market directly or indirectly.

Is short-selling being introduced in the Indian market for the first time?

No. Short-selling was prevalent till 2001. Sebi banned short-selling after the stock prices crashed in 2001 under the weight of heavy short-selling by big operators, who exploited the downturn in equity prices during the Ketan Parekh scam. This accentuated the fall.

So how is it different this time?

Sebi has tried to plug the loopholes in the earlier system this time. The regulator has barred naked short-selling.

The traders would be required to mandatorily honour the obligation of delivering the securities at the time of settlement. No institutional investor would be allowed to indulge in day trading, that is, squaring off their transactions intra-day.

Does this means that short-selling will not exacerbate market falls?

Genuine short-selling could exacerbate the price decline, but that by itself may not be construed as a manipulative activity unless there are evidences of market misconduct. However, abusive short-selling practices to manipulate the price of a stock will continue to be treated as market misconduct and attract appropriate regulatory action.

Why do investors undertake short-selling?

Investors execute short-selling for two reasons. 1) When they feel the price of a stock is overvalued, they go short on that stock, expecting the prices to come down. Short-sellers hope to buy back the stock at a lower level. 2) Traders also prefer to go short on the cash market when the spot price of a stock is higher than the futures (derivatives) prices.

Currently, investors in the Indian market cannot do this even while they are able to do arbitrage if the spot prices are lower than the futures. It means that they can buy in cash and sell in the derivatives segment. Sebi hopes to remove this distortion with the introduction of short-selling.

What are the other key features?

Sebi intends to introduce a vibrant stock lending and  borrowing (SLB) programme along with short-selling. This means traders are required to borrow shares they sell short from the SLB scheme to honour their trades.All classes of investors (including retail), who own shares, can participate in the SLB scheme and earn a fee for lending their shares to short-sellers.

Institutional investors are also required to disclose upfront at the time of placement of order whether the transaction is a short-sale and demonstrate their ability to borrow to the satisfaction of the broker.

Retail investors, however, would be permitted to make a similar disclosure before the end of trading hours on the transaction day.