«Discussion paper on Short Selling and Securities Lending and Borrowing Executive Summary I. Short selling – the sale of a security that the seller ...»
Discussion paper on
Short Selling and Securities Lending and Borrowing
I. Short selling – the sale of a security that the seller does not own – is one of the long-standing
market practices, which has often been the subject of considerable debate and divergent views
in most of the securities market across the world. The votaries of short selling consider it as a
desirable and an essential feature of a securities market. The critics of short selling on the other
hand are convinced that short selling, directly or indirectly, poses potential risks and can easily destabilise the market. In an efficient futures market, the relationship between spot price and futures price of the underlying asset is governed by cash-and-carry arbitrage and reverse cashand-carry arbitrage. The latter requires that traders should be able to sell the underlying security short unless of course there are enough number of traders who own the security and are able to sell it cash to take advantage of too low a futures price (Paragraphs 1.1 and 1.2).
II. It is noteworthy though, that despite the conflicting schools of thought, securities market regulators in most countries and in particular, in all developed securities markets, recognise short selling as a legitimate investment activity. Such jurisdictions also have an active market for equity derivatives which includes stock futures. Some of the jurisdictions even recognise the usefulness of naked short sales in certain circumstances and instead of prohibiting short sales;
the regulators have permitted it to take place within a regulated framework.. The International Organisation of Securities Commissions (IOSCO) has also reviewed short selling and securities lending practices across markets and has recommended transparency of short selling, rather than prohibit it (Paragraph 1.3).
III. A vibrant securities market should necessarily provide for lending and borrowing of securities.
Securities markets all over the world, mostly, have an active market for securities lending and borrowing scheme, which besides complimenting short selling in securities also enable the investors to earn returns on their idle securities (Paragraph 1.4). Vibrant securities lending and borrowing scheme is, therefore, considered necessary to provide sufficient impetus for short selling (Paragraph 5.7).
IV. Presently, there is no prohibition on short selling by retail investors. The “Institutional investors” viz. the mutual funds and the Foreign Institutional Investors (FIIs) registered with SEBI, banks and insurance companies are expressly prohibited under the respective regulations from short selling and are mandatorily required to settle on the basis of deliveries of securities owned and held by them. As they are to settle by deliveries, no margin was levied on the transactions of institutional investors (Paragraph 3.1).
V. While international securities market regulators have recognised that short selling can exacerbate market falls and lead to manipulative activities, most of the jurisdictions have also recognised short selling as a legitimate investment activity that has contributed significantly to market liquidity. International securities market regulators have, therefore, permitted short selling with adequate safeguards to prevent any abusive/manipulative market practices. Similar issues may arise in the Indian context also. Genuine short selling could exacerbate 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.
VI. The FSA is of the view that short selling is not in itself manipulative. Rather, [FSA] sees it as a valid investment practice that, in essence, represents the opposite of taking a long position.
VII. In the Indian securities market, “short selling” may be defined as selling a stock which the seller does not own at the time of trade (Paragraph 5.2).
VIII. Because of the regulatory restrictions in the Indian markets which have enabled only retail investors to short sell, there is no level playing field between various classes of investors. There was a need to bridge this gap and provide equal leveraging opportunities for all classes of investors. The present regula tory restrictions which allow only the retail investors to short sell should be removed to enable a level playing field for all classes of investors. In other words, the institutional investors who are currently prohibited should be permitted to short sell (Paragraph 5.3).
IX. In the Indian context, naked short sales would not be permitted. All investors would be required to mandatorily honour their obligation of delivering the securities at the time of settlement. No institutional investor shall be allowed to do day- trading i.e., square off their transactions intraday. In other words, all transactions would be grossed for institutional investors at the custodians’ level, and the institutions would be required to fulfil their obligations on a gross basis. The custodians, however, would continue to settle their deliveries on a net basis with the stock exchanges (Paragraphs 5.4 and 5.5).
X. The stock exchanges should frame a uniform penalty structure and take appropriate action against the brokers for failure to deliver securities at the time of settlement which would act as a sufficient deterrent against naked short selling. (Paragraph 5.6).
XI. As regards the stocks in which short selling may be permitted, to begin with, short selling may be permitted only in those stocks in which derivative products are available (Paragraph 5.8).The lending and borrowing may also be, initially, restricted only in those stocks in which derivative products are available (Paragraph 8.4).
XII. The institutional investors would be obligated 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. However, the retail investors would be permitted to make a similar disclosure before the end of the trading hours on the transaction day. (Paragraph 5.9) XIII. All stock brokers should be mandated to maintain sufficient documentation regarding the ability of their clients to borrow and deliver the securities at the time of settlement so as to ensure sound audit trail. Such information and documents should be readily available during inspections by the stock exchanges and SEBI. In respect of institutional transactions, the brokers must satisfy themselves that the institutional clients have made sufficient arrangement for borrowing securities before executing the order for short sale.(Paragraph 5.10) XIV. The data on scrip-wise short position is of significance, and, therefore, needed to be disclosed in the public domain. The brokers shall be mandated to collect the details on scrip-wise short sell positions, collate the data and upload it to the stock exchanges before the commencement of trading on the following trading day. The stock exchanges will then consolidate such information and disseminate the same on their websites for the information of the public to begin with, only after the close of market hours of the next trading day. Ideally, such information should be disclosed before the commencement of the market hours on the next
XV. The transactions executed by all institutional investors may be margined similar to the transactions executed by the retail investors. The institutional investors should also have the same flexibilities as regards the manner and type of collateral, similar to retail investors, subject to other applicable regulations (Paragraph 5.12).
XVI. A vibrant securities lending and borrowing scheme is, therefore, considered necessary to provide sufficient impetus for covered short selling. (Paragraph 5.7) In this context, the securities lending scheme of 1997 (SLS, 1997) was inoperative and was not active in the Indian securities market.
XVII. Pursuant to the recommendations of the erstwhile SMAC in 2003, SEBI had specified the operational modalities for Clearing Corporation/House of the stock exchanges to borrow and lend securities for the limited purpose of handling settlement shortages. However, the stock exchanges are in the process of putting in place, the necessary systems for dispensing off the auction mechanism and are, therefore, yet to operationalise the process of securities lending and borrowing for handling settlement shortages (Paragraphs 6.4 and 6.5) XVIII. While the present scheme of lending and borrowing securities in the Indian securities market by the clearing corporation/house (CC/CH) of the stock exchanges for handling settlement shortages addresses the need for lending and borrowing in a limited way, there is no scope for investors to capitalize on the demand for their securities in the market and thus, earn a return on the same by lending such securities. The scope of the existing securities lending and borrowing scheme must be widened into a full-fledged lending and borrowing scheme enabling participation of all classes of investors, including retail investors. (Paragraph 6.7).
XIX. While introduction of such a scheme was necessary in the present context of the market, a phased and cautious approach would be appropriate in the initial stages. (Paragraph 6.7).
XX. World over, securities lending and borrowing transactions were, by and large, over-the-counter (OTC) contractual obligations executed between lenders and borrowers. It was also observed that international securities market regulators do not directly regulate the lending and borrowing transactions. In various international markets, entities like the custodians and depositories run the lending and borrowing scheme and have their own screens for meeting the demand and supply of securities from their clients (Paragraphs 7.1).
XXI. The introduction of a full-fledged securities lending and borrowing scheme should be simultaneous with the introduction of short selling by the institutional investors. (Paragraph 5.7).
XXII. The CC/CH of the exchanges should act as Approved Intermediaries (AIs) for the limited purpose of lending/borrowing securities for meeting settlement shortages and the stock exchanges should go ahead with the operationalisation of the close-out procedure for handling settlement shortages and dispense of the auction mechanism. Apart from the lending and borrowing of securities by CC/CH for settlement shortages, a full fledged securities lending and
XXIII. A cautious approach should be adopted, while permitting entities to act as AIs for securities lending and borrowing scheme. In the first stage, only custodians, Banks and FIs may be registered as AIs for the purpose of lending and borrowing of securities. The securities lending and borrowing should be, initially, restricted only in those stocks in which derivative products are available. (Paragraph 8.4).
XXIV. The lending and borrowing transactions may be executed on an automated, screen-based platform which offers the demand and supply of securities for lending/borrowing on a real-time basis along with the facility of matching the demand with the supply. Any trading member/investor who wishes to borrow securities may borrow the same through the screen provided by the exchanges. The stock exchanges should undertake the risk management of such lending/borrowing transactions and the CC/CH should guarantee the return of the securities by the borrower to the lender by being the central counter party and should, thus, provide guarantee for counter-party risk. The stock exchanges would jointly work out and put in place uniform modalities for securities lending and borrowing which will also include the manner in which the securities borrowed will be returned to the lender and as the manner in which the exchanges will provide the guarantee. (Paragraphs 8.5 and 8.6).
XXV. With a view to align the agreements between the various parties to a lending/borrowing transaction, such transactions could be formalized in terms of robust lending and borrowing agreements on the lines of the model agreements provided by the Pan-Asian Securities Lender’s Association (PASLA) which obligate the borrowers to return the securities to the AI and agreements between the AI and the lender which enable the AI to allot the lender’ securities to the borrowers at a screen determined price (Paragraph 8.7).
1.1 Short selling – the sale of a security that the seller does not own – is one of the longstanding market practices, which has often been the subject of considerable debate and divergent views in most of the securities market across the world. The votaries of short selling consider it as a desirable and an essential feature of a securities market, not only to provide liquidity, but also to help price corrections in over valued stocks. In their view, the restrictions on short selling distort efficient price discovery, gives promoters the unfettered freedom to manipulate prices, and favours manipulators than rational investors. They argue that in a declining market, short covering of positions opened at the beginning of the downturn, arrests the declining trend. They also bring a body of academic literature in strong support of their case for short sales. Further, in an efficient futures market, the relationship between spot price and futures price of the underlying asset is governed by cash-and-carry arbitrage and reverse cash-and-carry arbitrage. The latter requires that traders should be able to sell the underlying security short unless of course there are enough number of traders who own the security and are able to sell it cash to take advantage of too low a futures price.