The Hindu Business Line : Short-selling can go a long way in steadying prices

Allowing short-sales by financial institutions is virtually the home-stretch to bringing the Indian stock market on a par with the advanced markets.

The recent decision of the Securities and Exchange Board of India (SEBI) to permit institutional investors such as banks, mutual funds, insurance companies and Foreign Institutional Investors (FIIs) to short sell in the cash market fills a vital gap that exists between the Indian stock exchanges and the advanced markets.

Short selling will also put institutional investors on a par with individuals and others allowed recourse to this approach and thereby remove the discrimination between institutional investors and others. After all, market has to treat all players alike.

Demand-Supply balance

Short selling, that is, selling without owing the securities, and long buying, that is, buying securities without owning the money, are two sides of the same coin. While the latter can be done easily by borrowing money and also by margin financing, the former needs also to be encouraged to achieve a perfect balance between supply of and demand for securities at any point of time.

Contrary to the general belief that short selling can result in depressed prices, it indeed stabilises them. What is not commonly appreciated is that short selling is a double-edged weapon, as short sellers sooner or later, depending on their perception of the level of price of a security, have to cover their short sales by buying back the security to square the position, popularly known as bear-covering.

The Saviours

It is an almost impossible task to say what exactly should be the level of price of a security at any point of time. It is the outcome of several factors — fundamental and technical — and ultimately the perception of thousands of persons operating in the market simultaneously. Even so, there can be over-bought as also over-sold situations. It is the short sellers who save the act in an over-bought market.

This is particularly so in a frenzied bullish market when every one is caught in the hysteria. It is again the short-sellers who act as a check against the attempts to rig up the prices of select securities by interested parties only to dump them later at higher levels to the detriment of the common investors. In a contra situation, when the market is an acute bearish phase, short sellers come to the rescue of the market by buying back the security to square their positions.

Short selling leads to better discovery of prices, as in a rising market where the demand outpaces the supply of securities, it is the short sellers who augment the supply by borrowing from those who keep the instruments idle, and thereby enhance the supply of tradeable securities in the market. Again, in a falling market, where the supply of securities exceeds the demand, short sellers meet the excess demand by buying back the securities to square their positions. These operations of short sellers not only enhance liquidity in the market but also help reduce volatility in the market.

A legitimate question that demands an answer is the need to permit short selling in the cash market in the context of a vibrant futures market, the turnover in which is often more than double in the cash market, where short selling by institutional investors is freely allowed.

Real Price discovery

Despite the large turnover in the futures market, the real price discovery in India takes place not in the futures segment but in the cash segment of the market. Moreover, in the futures segment it is contracts in the nearer months that get actively traded while borrowing securities can be for as long a time as the borrower needs. It also needs to be noted that futures contracts are permitted in only 150 shares and even here only half a dozen account for bulk of the trade. In contrast, short selling in the cash market can be done in all the actively traded securities.

Extension of the short selling facility to the institutional investors will also result in increased arbitrage transactions between the cash and the futures markets. This, in turn, will help improve price discovery. Arbitrageurs take into account the spreads in prices between the cash and futures markets and effect their sales or purchases in the cash market offset by purchases or sales in the futures market, as the case may be, to narrow the spreads in prices between the two segments of the market.

A sine quo non for a successful operation of short selling is an active, transparent, screen-based, properly regulated market freely accessible to all participants, including individuals, for borrowing and lending securities. Indian markets have yet to develop such a market.

Cash collaterals, partly if not wholly, taken against borrowings can be deployed by the entity running the market for borrowing and lending securities in the money market to generate income. From this income, borrowers can be compensated. If the compensation that can be offered by such an arrangement falls short of what the lenders would demand, the balance has to be met by the borrowers. It is necessary to ensure that the cost of borrowing remains reasonable for the market to be active. In fact, in most developed markets, the cost of borrowing does not exceed 3 per cent per annum. Such a market will incidentally help holders of securities lying idle by giving them some return, apart from dividend, and other benefits arising from rights, bonus and capital appreciation.

An active borrowing and lending market for securities incidentally fills the gap arising out of abolition in 2001 of `badla' trading, which provided the facility of carrying forward the transactions from one settlement period of seven days to another settlement period. `Badla' was a unique instrument which provided not only a market for carrying forward long purchases and short sales but for also other services such as investing money in `badla' and earning interest thereon, by lending the securities by doing `vyaj badla' and raising money by doing `mal badla' wherein the operator delivers the shares he has.

Allowing short sales by financial institutions, coupled with an active borrowing and lending mechanism for securities, is virtually the last leg to putting the Indian stock market on a par with the advanced markets of the world.

(The author is a former Executive Director, Bombay Stock Exchange.)

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