It’s been six and a half months since India got its first pure securities lending and borrowing (SLB) mechanism. Right from the time the Securities and Exchange Board of India (Sebi) released guidelines for SLB, it was evident that the market wouldn’t take off. In the 133 trading sessions since its inception, there have been all of 15 trades in this segment. Hardly any market participants are surprised with the muted response to the new facility. Even Sebi, under its new leadership, has been saying for some time that it’s taking feedback from market participants and exchanges and that it would revise the guidelines for the segment.
The revision has finally come, but one would have hoped that the new guidelines would be more market friendly, especially given the long period for which Sebi has been taking feedback and studying the market. The proposal to increase the market’s timings from the present one hour in the morning to normal trade timings of 9.55 am to 3.30 pm is certainly welcome, as it will give traders greater flexibility in placing their trades.
But the other, more fundamental problem of an inflexible and low stock borrowing period hasn’t been changed adequately. Currently, stocks can be borrowed for a fixed period of seven days. This has been revised to 30 days, which is a significant increase, but which still carries the current problems of inflexibility.
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In overseas markets, stock lending and borrowing transactions are either open-ended or are for long durations where the lender has the option of calling back the shares, and the borrower has the option of returning the shares ahead of schedule. Else, the borrowing period is fixed at, say, six months, and the contract is then rolled over if the borrower desires to hold on to the shares for a longer period, again with a put and call option with the borrower and the lender. In other words, SLB contracts are flexible in nature. Since shares are borrowed primarily by short-sellers, and it isn’t immediately clear how long it may take a short position to turn adequately profitable, such flexibility helps a borrower.
In India, traders clearly prefer the liquid futures route to short-sell stocks. Since SLB is available only on stocks on which futures are also available, there is hardly any reason for a short-seller to go through the long-winded route of borrowing shares, selling it in the cash market and reversing both transactions at a later date. With futures, a short position can be taken easily taken for 30 days since the near-month contracts are liquid. If SLB were available for a longer tenure, perhaps short-sellers would explore that route to avoid the hassle of rolling over the stock futures contracts every month.
But even if all short-sellers turn to the stock futures market, SLB still has a utility in enabling arbitrage between the cash market and the futures market. Currently, if the price of the stock futures contract is lower than it ought to be relative to the price of the underlying stock in the cash market, there is a risk-free arbitrage called reverse cash-and-carry possible. Here, a trader needs to sell shares in the cash market, and buy them cheaper in the futures market. Currently, only institutions that own stocks can do this since the SLB market for borrowing shares and selling them in the cash market is dysfunctional.
One feedback Sebi got from market participants was to increase the stock lending tenure so as to coincide with the expiry of the derivatives contracts. The extension of the tenure to 30 days seems to be aimed at such an audience, although it still leaves some complications.
Take, for instance a trader who wants to engage in reverse cash-and-carry arbitrage, which involves buying futures and selling shares in the cash market. If, for instance, the arbitrage opportunity presents itself next Monday, that is 10 November, that’s 17 days away from the expiry of the derivatives contract on 27 November. The problem is the stock borrowing transaction is for a fixed period of 30 days, even though the requirement is only for 17 days.
After 17 days, the arbitrageur will reverse both his buy futures and short cash positions but will be left with an open position on the stock borrowing transaction. Now, this doesn’t involve any price risk, since the shares have to be eventually returned to the lender in another 13 days. But the trader has to fund this position. Not only will he have to pay borrowing fees for an additional unnecessary period, he will also have considerable amount of capital locked up.
The stock borrowing transaction involves high margins, which are funded by the short-sell transaction. Put simply, when a trader short-sells shares he has borrowed, the consideration (pay-in) he receives is used to fund the margins (pay-out) for the stock borrow. In the above example, the trader will end up buying back shares from the cash market in 17 days’ time, and will then have to bring in fresh capital to fund the margin pay-out for the remaining 13 days on the stock borrow. This may well dissuade arbitrageurs from engaging in reverse cash-and-carry trades.
Sebi’s thought process seems to be that standardized contracts have worked well in the equity derivatives market, and the same model can be applied in other segments. But SLB is a different animal altogether. The guidelines should be aimed at encouraging stock borrowers, and it is evident that they need more flexibility rather than one standardized contract. Sebi would do well to at least introduce another contract whose expiry coincides with that of the derivatives cycle.
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