Mumbai: Stock market regulator Securities and Exchange Board of India (Sebi) plans to improve the securities lending and borrowing (SLB) platform it introduced in April, by extending the current seven-day tenor for stock lending, because there haven’t been many takers for the current contracts.
The April move was prompted by Sebi’s desire to enhance liquidity and price discovery, but because of the poor response, the capital markets regulator will increase the tenor of these SLB contracts, a person familiar with the development said, asking not to be identified. The person added that details such as the duration by which the tenor would be raised is yet to be decided.
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Apart from a handful of trades in the first two weeks since its launch on 21 April, there have been practically no trades in SLB.
SLB was the last missing link in India’s equity market infrastructure, and market participants were eagerly looking forward to its launch. But few expected the platform to take off given the restrictive regulations. SLB and short-selling (this, too, became operational, for institutional investors, in April) go hand-in-hand.
Short-selling, or shorting, is the process of selling securities one does not own. The settlement obligations for the short sale are met by borrowing the shares which are lent under the condition that they will be returned to the lender on a specified date. Adequate “margins” are also collected to safeguard the interest of the lender. The mechanism under which shares are loaned and borrowed is known as SLB.
When it launched SLB, Sebi decided that this would be available only on shares which trade in the derivatives segment. It’s far easier and cheaper to go short on shares using futures and options, and that left only one reason for the use of the SLB mechanism.
This is by a trader who engages in arbitrage between the cash and derivatives segments. When derivatives contracts trade lower than their fair value, traders can buy these derivatives contracts and hedge their bets by selling the underlying stock. This results in risk-free profit.But few arbitrageurs own the underlying stock and need to borrow the shares before they can go short. That’s where SLB steps in.
Derivatives contracts have a fixed expiry date and are available for tenors ranging from one-three months. The restriction of seven days for borrowing stock makes it is difficult to take advantage of arbitrage opportunities between cash and derivatives markets. What if the arbitrage opportunity that is available is not in multiples of seven days?
For instance, there are 24 days left for the expiry of the derivatives contracts in the August series. (Contracts expire on every last Thursday of the month.)
But based on current regulations, a trader can only borrow for seven days at a time. He could either do it for 21 days, or 28 days, even if he keeps rolling over his position, which is not only cumbersome, but also expensive, since there are transaction costs involved every time. The arbitrage isn’t perfect. The short position in the cash market will be taken for a period slightly different than the long position taken in the derivatives market.
This is the reason market intermediaries have been asking Sebi to be more flexible with SLB contracts. Custodians, or entities that hold securities, say that as much as extension of SLB contracts is necessary, there should also be flexibility for both borrowers and lenders to close their positions before the agreed expiry date.
One head of custodial services at a foreign bank, who did not wish to be identified, said the contracts should be open-ended with the option given to borrowers and lenders to close their positions before the maturity date. “The best way is to leave it to the lender and borrower to decide the trade on their terms,” said a senior executive at another foreign bank operating in India, which is also a custodian services provider. If not open-ended, the contracts should at least match the expiry of the derivatives contracts. Again, while the expiry date may be fixed, borrowers and lenders should have the flexibility of closing positions.
In developed markets, SLB functions as an over-the-counter (OTC) market run by brokers and custodians, who match trades between their clients. The OTC format offers flexibility.
Still, Sebi has its reasons for insisting on an exchange-traded format—the success of the equity cash and the derivatives markets. While experts on securities market infrastructure agree that the transparency of exchange trading is desirable even with SLB, they say that the rigidity of fixed-tenor contracts will restrict participation.
According to experts and market participants, the regulator also needs to look at expanding the list of stocks for which SLB is available, since it’s more convenient to go short using futures and options.
The real benefit, they say, will be for stocks on which derivatives trading is not available.