Allowing investors to sell shares they don’t own is the most significant improvement in the Indian equity market since derivatives were permitted in 2000.
The Indian regulator’s decision to relax rules on short-selling from next month is also a part of a larger Asian trend.
For its top 50 stocks, Taiwan last year removed the so-called uptick rule, which is a restriction on shorting falling stocks. In Malaysia, where the government had proposed mandatory caning for short-sellers in 1995, such transactions made a legitimate return, albeit on a limited scale, in January 2007.
South Korea’s market for borrowing and lending securities—crucial to a short-sale regime—has already matured.
It’s now India’s turn to give up its mistrust of short-sellers as a destabilizing force and embrace them as a key ingredient of a healthy market.
As of now, only individual investors in India are allowed to sell short in the cash market, betting that a stock will fall.
Institutional investors have been denied this flexibility since March 2001.
Not just that. The Indian regulator made it a point to conduct detailed inquiries into even the smallest infringement of the short-sale ban, especially if it happened to have been committed by a high-profile overseas institution.
Following such an investigation, a unit of Credit Suisse Group was fined in 2005.
Franklin Templeton Investment Funds and Halliburton Company Employee Benefit Master Trust were given a warning in December 2006 for selling shares—in 2002—in an Indian software company that they didn’t own at the time of the transaction.
Quick to fault
The amounts involved were small: Franklin Templeton had made a princely profit of $105 (Rs4,147.5) on the trade. Its short-selling wasn’t even intentional: buy orders had been executed before the sales were made, but the shares were yet to be credited into the institutions’ accounts.
The sub-account of Credit Suisse that was found to have shorted shares in Reliance Industries Ltd in December 2002—because of what it claimed to be nothing more than a trading error—actually incurred a small loss when the excess shares sold by it were auctioned by the exchange.
Yet, Credit Suisse couldn’t avoid taking a rap on the knuckles. “No man can take advantage of his own wrong,” the regulator said in its order.
That dictum is more appropriate for the short sellers’ enemies: the company managers who enrich themselves at the expense of the hapless shareholders.
Short-selling is a powerful weapon against corporate fraud and misreporting. Unsurprisingly then, “corporate India doesn’t like short-selling,” says Jayanth Varma, a finance professor at the Indian Institute of Management in Ahmedabad. Even now, “opponents of short-selling have many avenues open to them to delay if not block much-needed reform,” Varma says on his website.
There are several concerns.
Initially, short-selling will be allowed in only about 5% of publicly traded securities, which happen to be the same set of stocks in which investors can even now express a negative view by either buying put options or selling futures.
Unless the list of securities is expanded quickly, interest in the short-selling experiment may wane.
The success of the effort will also hinge on the willingness of large investors to take advantage of stock lending to earn a higher return on their holdings.
This participation can’t be taken for granted. Mutual funds in shallower emerging markets are often reluctant to lend shares to short-sellers. They are concerned that by doing so they may end up contributing to a decline in the value of their own holdings.
A 24 December editorial in the Business Standard said the Indian market regulator may have erred in its decision to establish an exchange-traded market for stock loans when the practice globally is one of over-the-counter (OTC) transactions, which are more flexible.
However, OTC markets for stock loans are also opaque, relationship-based and far from perfect.
As Owen Lamont, a finance professor at Yale School of Management, has noted in his research: “Getting the borrow,”—the industry jargon for obtaining the stock loan—can be difficult. “Favoured customers stand a better chance,” he wrote. “There have been reports of short-sellers exchanging drugs and sex in order to get the borrow.”
More recently, hedge fund managers have grumbled that prime brokers, as their stock lending agents, give them a raw deal.
“A portion of the hedge fund market is looking for a combination of electronic access, transparency and data from securities lending providers,” Vodia Group Llc., a Concord, Massachusetts-based research firm, said in November. “There is reason to think that the age of electronic bid/offer markets may not be so far off after all.”
The Indian model of screen-based securities lending with a clearing house guaranteeing against counterparty risk may well turn out to be a superior one.
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