Institutional investors expect a slow start to short-selling

Institutional investors expect a slow start to short-selling
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First Published: Mon, Apr 21 2008. 12 23 AM IST

Setting the rules: Sebi chief C.B. Bhave. This is the first time that institutional investors will be allowed to go short in the cash segment. (Photo: Ashesh Shah/Mint)
Setting the rules: Sebi chief C.B. Bhave. This is the first time that institutional investors will be allowed to go short in the cash segment. (Photo: Ashesh Shah/Mint)
Updated: Mon, Apr 21 2008. 12 23 AM IST
Mumbai: Short-selling for institutional investors as well as a securities lending and borrowing (SLB) mechanism becomes operational this week, but experts say institutional investors will be preoccupied with the other measure that will be implemented on Monday—the imposition of margins for all institutional trades in the cash market.
Setting the rules: Sebi chief C.B. Bhave. This is the first time that institutional investors will be allowed to go short in the cash segment. (Photo: Ashesh Shah/Mint)
Institutional investors have been busy putting the necessary procedures, such as stan-ding instructions to custodians for foreign exchange deals, in place to meet the deadline.
“Short-selling can wait, but getting the act together on ma-rgining can’t,” says the head of custodial services at a foreign bank who didn’t want to be named. He points out that investors will be busy focusing on operational modalities of the new margining system and, as a result, short-selling and SLB will take a back seat.
Short-selling, or shorting, is the practice of selling securities one does not own. The settlement obligations for the short sale are met by borrowing the shares. The shares are lent under the express condition that they would be returned to the lender at a specified date and adequate margins are collected to safeguard the interest of the lender.
If the price drops, the seller can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, the seller has to buy it back at the higher price, and he loses money. The most obvious reason to short is to profit from an overpriced stock or market. The mechanism under which the shares are borrowed and lent is known as SLB.
Vikramaaditya, head of HSBC Securities Services India, says, “Some of our clients have expressed interest in short-selling and the securities lending and borrowing scheme, while some others may start depending on the markets’ response to the scheme.” Vikramaaditya goes by just one name.
Institutional trades in the cash segment have thus far been exempt from margins. The capital market regulator has now stipulated that even cash trades by institutional investors will be margined, just as they are in the case of retail participants. To start with, margins would have to be paid a day after the trade, and from 16 June, margins would have to be paid up front like by any other investor. These requirements are likely to take centre-stage this week. Besides, as the head of institutional sales at a domestic brokerage house, who didn’t wish to be named, says: “Investors are still trying to understand how the SLB scheme will work.”
Enhancing liquidity
Yet, hardly anyone disagrees on the fact that having an efficient SLB mechanism and permitting short sales will enhance the liquidity and price discovery. Since informed investors can now go short on stocks they feel are highly priced, manipulation of stock prices will be more difficult. Those with a large pool of securities, such as institutional investors, can earn additional income by lending them in the SLB system. “Over the long term, it will improve liquidity and reduce the volatility in Indian markets,” says James Breiding, managing director of Switzerland-based investment firm Naissance Capital Ltd.
In its current form, however, the short-selling and SLB mechanism doesn’t offer investors anything substantially new. The new facilities will be available only for a set of 227 stocks on which futures and options trading is already available. Investors can already go short on these stocks in the derivatives segment at a fraction of the cost involved with cash segment, since the margin to be put up in the SLB segment will be much higher.
Experts on securities market infrastructure such as Ajay Shah of the National Institute of Public Finance and Policy and J.R. Varma of the Indian Institute of Management, Ahmedabad, feel that the list of stocks on which short-selling and SLB is available needs to be expanded.
Also, unlike the practice in overseas markets where SLB works on an over-the-counter (OTC) platform, stock market regulator Securities and Exchange Board of India (Sebi) has chosen the exchange-traded format. In developed markets, custodians who hold a large pool of securities on behalf of clients offer lending and borrowing services. The OTC format has been successful primarily because it enables the borrower to have the flexibility of the period for which he wants the stock loan.
Sebi has chosen the exchange-traded format because of the success it has had with this format in other segments of the stock market. But market participants say that Sebi has been too rigid about the contract specifications. Only one contract will be available for each security in the SLB market and the period of lending and borrowing is fixed at seven days. At a February seminar conducted in Mumbai by Dun and Bradstreet Information Services India Pvt. Ltd, investors and market intermediaries agreed that the seven-day contract would not be enough to create an active market.
It may take months for a short position to turn profitable and an investor using the SLB mechanism to take a short position would have to keep rolling the contract over several times, making it cumbersome. Few expect investors to take short positions in the cash segment by borrowing from the SLB market. It’s much simpler and cheaper to do it with futures and options.
The head of another custodial services points out that the main beneficiary of the SLB system would be arbitrageurs, wanting to profit from the pricing inefficiencies in the derivatives market. Futures contracts, for instance, are closely linked to the price on the cash segment and whenever they deviate from their fair value, there arises a risk-free opportunity for arbitrageurs. When futures prices are lower than their fair value, arbitrageurs seek to buy them and sell the underlying stock in the cash segment. Currently, only those investors who own the underlying stock can benefit from such trades. With SLB, the stock can be borrowed and then sold on the cash segment by other investors as well.
But again, the rigidity of the seven-day SLB contract can be a dampener for arbitrageurs. What if the arbitrage opportunity in the market is not in multiples of seven days? A trader may need to borrow a stock for just three days, but would have to pay interest for seven days. The delegates at the Dun and Bradstreet seminar felt that the period of borrowing should at the minimum match with the settlement period of the futures market.
For now, most players are in the wait-and-watch mode. Custodians are saying their clients are typically ones who will evince lending interest, given the large pool of securities they hold on their behalf. But most of them are waiting to see the borrower interest first before taking the plunge.
Chequered history
Securities lending and borrowing is not new to India. In May 1997, Sebi specified a scheme but that hardly took off in its intended form of being a pure SLB mechanism. Instead, in order to counter the Bombay Stock Exchange’s (BSE) popular carry-forward system called badla, the National Stock Exchange launched ALBM (automated lending and borrowing mechanism) in accordance with the provisions of Sebi’s Securities Lending Scheme, or SLS. By coinciding the settlement cycle of the ALBM market with that of the cash market, ALBM not only matched badla‘s features, users had other benefits as well, such as the lack of scrip-wise limits applicable on badla.
Badla was a carry-forward system invented on BSE to enable traders to roll over their outstanding positions in the market to the next settlement cycle. For a long position, a trader would strike a deal with a financier by paying a borrowing fee while for a short position a trader would strike a deal with a stock lender. These lending and borrowing trades were intermingled with the settlement procedures of the normal cash market and hence lacked transparency.
Whenever the markets fell sharply, badla trades, which were essentially leveraged tr-ades, tended to see defaults, leading to payments crises on stock exchanges. Badla was banned after the 1992 scam, when broker Harshad Mehta used loopholes in the banking system and the leverage and non-transparency of the badla system. But it was allowed again in 1996 with restrictions such as broker-wise limits.
ALBM soon grew in popularity and BSE eventually replaced its badla system with an ALBM clone called BLESS (borrowing and lending of securities scheme). But both these schemes were partly blamed for another scam that hit the market in 2001. This time, Ketan Parekh was in the spotlight.
In June 2001, when options were introduced on individual securities, both carry forward mechanisms were discontinued. Later, in November 2001, futures on individual securities were introduced to take care of the need for leverage traders had, at least for the list of securities in which derivatives trading was permitted.
It has taken more than six years for a stand-alone SLB mechanism to be introduced. In its current form, the system will function as a pure SLB mechanism, and traders will have to meet their settlement obligations on both the cash and SLB segments separately. This will avoid the fiasco with SLS of 1997, under which carry-forward systems such as ALBM and BLESS prospered.
This is for the first time institutional investors will be allowed to go short in the cash segment as Sebi guidelines specifically prohibit mutual funds and foreign institutional investors from engaging in short-selling of securities.
Rachna Monga contributed to this story.
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First Published: Mon, Apr 21 2008. 12 23 AM IST