At the outset, it may be useful to provide a brief background on the concept of short selling and its related jargon in very simple (and non-financially savvy) terms.
Short selling is a sale of shares by a person without actually owning those shares. What occurs is that the seller borrows shares from someone else that actually owns the shares (let us call that person a lender) and then sells them in the stock market. The borrower/seller retains the proceeds of the sale. However, the loan in respect of the shares is still outstanding from the borrower to the lender. That loan is squared off subsequently when the borrower buys further shares in the market and returns those to the lender.
What is the purpose of entering into these seemingly complex transactions? One would find that the seller would stand to benefit in a bear market. For instance, if the shares are borrowed and sold when the market price is high, the seller stands to gain if the market price subsequently drops and it only has to purchase shares at a lower price so as to return the shares to the lender. The seller/borrower pockets the difference between the sale price and purchase price. Of course, if the market price were to move the wrong way, the seller/borrower would risk bearing the loss as well. Short sales and such other complex investment strategies are usually undertaken by sophisticated financial investors such as foreign institutional investors (FIIs) and hedge funds.
Naked shorting is the practice of selling stocks that are neither owned nor borrowed by the seller. This practice is generally considered to be illegal.
(Conversely, a long position is one where an investor purchases shares with the expectation that the market price of the shares would rise and that the investor may make a profit by selling at a higher price in future)
For a glossary of terms on short selling, see this Hindu Business Line report and this Q&A in Rediff News.
Short selling has hitherto been permitted only for retail investors and not for institutional investors. However, by way of a SEBI circular issued on December 20, 2007, short selling has now been made available to all types of investors, including institutions such as FIIs. In order to enable short sellers to borrow shares, SEBI has announced a securities lending and borrowing (SLB) scheme. Consistent with the position in most jurisdictions, naked shorting has been banned. The stock exchanges are now required to put in place the necessary systems and process as also amend their regulations and bylaws to enable shorts sales to be commenced by institutional investors.
The Reserve Bank of India (RBI) has also issued a circular on December 31, 2007 permitting FIIs to participate in short selling of securities so long as they comply with the policy on foreign direct investment and they do not short sell securities that are in the ban list or caution list of the RBI.
While market participants await action from the stock exchanges before short sales can become operational, there has been a fair amount of discussion on the implications of short sales on the Indian financial markets.
The new announcements by SEBI and RBI are important since this represents a relaxation of the previous ban on short selling introduced in 2001 (after the stock scam that surfaced then). On the one hand, commentators argue that the move is consistent with developments world over and that there will be a discernible boost to the capital markets. In a Bloomberg report, Andy Mukherjee notes:
“The Indian regulator's decision to relax rules on short- selling from next month is also part of a larger Asian trend.Others have, however, expressed skepticism as to the workability of the short sales due the unavailability of a robust stock lending mechanism in the Indian markets. A post on Ajay Shah's blog notes:
For its top 50 stocks, Taiwan last year removed the so- called uptick rule, which is a restriction on shorting falling stocks. In Malaysia, where the government had proposed mandatory caning for short sellers in 1995, such transactions made a legitimate return, albeit on a limited scale, in January 2007.
South Korea's market for borrowing and lending securities -- crucial to a short-sale regime -- has already matured.
It's now India's turn to give up its mistrust of short sellers as a destabilizing force and embrace them as a key ingredient of a healthy market.”
“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.A recent article in LiveMint echoes this view, and states that it may be difficult for market participants to cover their short sale positions due to the lack of large sellers in the Indian markets.
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. …”
Yet another stumbling block could be dislike of corporates towards short selling as pointed out by Prof. Jayanth Varma in his Financial Markets Blog.
It is clear that while SEBI and RBI have taken the important step of initiating the process of reintroducing institutional short sales in the Indian markets (by laying down the basic framework), there still remain several issues to be ironed out before the mechanism can be flawlessly implemented. This perhaps explains the lack of a clear timeline during which the implementation is expected to take place.
Further, from a purely legal standpoint, there are several other considerations that could operate: (i) the need for careful and unambiguous contractual documentation that cover the borrowing and lending of securities; (ii) the availability of quick, less expensive and credible dispute resolution mechanism (either through the stock exchanges or otherwise; and (iii) prevention of abusive short sales that are made with a view to manipulate the markets. These considerations too need to be given adequate attention while implementing short sales in the Indian markets.