The short sales ban drama and its implications

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: At the moment, there is considerable rabble being roused over the fact that the Securities & Exchange Board of India (Sebi) will be banning short sales. Matters started boiling up when the regulator asked overseas investors who are allowed to issue participatory notes (P-note) to furnish data regarding their lending of shares in the overseas market for short sales or related synthetic short sales (read derivatives). When the data was available, for 33 of the 34 FIIs from October 10 till 17, it could be seen that foreign institutional investors (FIIs) had lent shares in excess of Rs 600 crore in the overseas market, the regulator issued a communication expressing its disapproval of this practice, and they have been directed not to take any fresh positions in the overseas markets.

This is seen by many as a precursor for banning short sales in India. The reasoning is based on the fact the markets have witnessed a huge slide thanks to some incessant shorting by certain sections of the market. Moreover, with many other regulators resorting to banning of short sales, it is perceived that the Indian regulator would also follow suit.

The ban

Earlier this month, when the restrictions on the P-note issuances were done away with, Sebi chairman Chandrakant Bhaskar Bhave had categorically mentioned that they had not seen any alarming signs in the market place and that the system was operating well. “In the Indian market you have delivery-based short sales, not like other countries which have banned short sales,” he mentioned in the post-board meeting conference.

“Banning short sales would be interfering in the market mechanism of effective price discovery,” says Motilal Oswal, chairman Motilal Oswal Securities. And this is the sentiment that most market denizen have expressed. And most do not think that the regulator would take action on this front.

The reasoning is that it is quite not required. “Every bear is a potential bear and every bear a potential bull,” reckons Parag Parikh, chairman of PPFAS and a bestselling author. The market when ‘shorted’ would require the person to cover the short sale and therefore buy the shares. Similarly, when you investors go ‘long’, they also have to sell to make good their commitments. “It has a balancing effect and eventually the market finds its own levels, high or low,” adds Parikh. Tampering with it is tampering with the market mechanism.

The technical committee members of the International Organisation of Securities Commissions (IOSCO) also note that short selling plays an important role in the market for a variety of reasons, including providing more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities and, more importantly, upward market manipulations.

The talk of banning short sales probably emanates from the action taken by other regulators who have or had banned short selling. The US authorities had banned short selling for a period, but have taken away the ban. Analysts have a mixed reaction over this. Some reckon that the ban was ineffective and therefore was revoked, and the others believe that the ban was a temporary one, anyway meant to cool things and when the objective was met it was revoked. However, some markets, like Australia, still continue to have the ban in place.

The IOSCO also notes that the short-selling may be problematic in the midst of a loss in market confidence. For example, in the context of a credit crisis, where some entities face liquidity challenges but are otherwise solvent, a decrease in their share price induced by short selling may lead to further credit tightening for those entities, possibly resulting in bankruptcy. In addition, there are circumstances in which short-selling can be used as a tool to mislead the market.

For example, short selling can be used in downward market manipulation, whereby, a manipulator sells the shares of a company short and then spreads lies about the company’s negative prospects. This harms issuers and investors as well as the integrity of the market.

At the moment, there is no large credit crisis in the notice. Yes, there are concerns, but not of the scale witnessed in the West. And yes, there have been instances of alleged market manipulation, especially in the case of ICICI Bank, where the bank has taken action against a section of market intermediaries for rumour mongering. But, at the moment, instances are few.

Overseas factor

The concern therefore goes back to the overseas investors and their short selling activities overseas. At the moment, the regulator has asked them not to take any fresh positions at the moment and may ask them unwind their overseas positions as data becomes available.

There are experts who reckon that if this move has been done with a view to stem the market fall, then it would not have much of an impact, as the overseas lending volumes are insignificant.

“Moreover, there are the futures and options available for people to go short on,” says Dharmesh Mehta, head, broking, Enam Securities. At the same time, there is a need to keep a tab on these activities and in some cases take stern action as well.

“When you, as a domestic investor, fill up a form for making an investment, you have to answer thousands of questions. Then how can the foreign investors not answer them,” said Ajit Dayal, director, Quantum Advisors in an interview with FE. “Who are these players, what are they up to? We need to know them. May be they are good for the system, may be they are not.”

Oswal concurs, “We need to have more transparency in this area.” And this is exactly what the regulator is up to. They have asked overseas investors to furnish more data to understand the pattern. And Sebi has clearly mentioned that they are against the lending for short sales overseas. The reasoning, reckon experts, is because most of the trades are in the over-the-counter segment, which means that they are customised. Exchange-based transactions have a greater transparency and credibility.

In a speech given at a recent event, Sebi chairman Bhave had stressed on the need to have trust and credibility in the market, even in competitive times.

He mentioned that the current financial meltdown was exaggerated due to the fact that the trust factor has collapsed and people were not sure that the counter party would fulfill their obligations.

In a similar vein, a huge build-up in overseas lending, which is not monitored, has the potential to create a huge crisis. At the moment, the deals are small, but they have the potential to blow up if not monitored closely or curbed totally.