The Securities and Exchange Board of India (Sebi) has finally allowed short sales by institutional investors and will soon put in place a securities lending mechanism.

This comes 10 months after the finance minister gave the go-ahead to these much-needed reforms in the financial markets. To be fair to Sebi, it has been pushing the case for securities lending for some time now.

New ideas: Sebi Chairman M. Damodaran

According to reports, it was the central bank that had worries about short sales and securities lending as it would cause an increase in capital inflows.

But the format which Sebi has prescribed for introducing this may well ensure the product doesn’t take off. A securities lending mechanism is primarily used by short-sellers who borrow stock to honour their obligations to the clearing house. To start with, Sebi will allow short sales and securities lending only on stocks that are already available for trading in the derivatives segment.

Investors, including institutional players, can already short these stocks by selling futures or buying put options. Since the derivatives market is much more liquid, and involves just one transaction, investors will naturally prefer it. Shorting on the cash segment will involve another transaction, in the securities lending market, which may not be particularly liquid. Sebi chairman M. Damodaran has said that the idea of starting with derivatives is because a new system is being tried. According to him, once the system stabilizes, this can be extended.

If short-sellers stay away and continue using the derivatives market, the new system may well not take off. It’ll then be a pity if the securities lending facility isn’t extended to other stocks simply because of an unenthusiastic experience with the derivatives stocks.

Another type of stock borrower is one who engages in arbitrage between cash and derivatives segments. Currently, without a securities lending mechanism in place, arbitrageurs can only take advantage of a pricing disparity if futures contracts are trading at an excessive premium. They simply go short on the futures contract and buy the underlying stock in the cash segment. But when futures trade at a discount, only investors who own the stock can take advantage of the arbitrage opportunity, buying the stock cheap in the futures segment and selling it in the cash segment. Once securities lending is in place, any investor can borrow stock and go short in the cash segment.

But the securities lending mechanism envisaged by Sebi may not be attractive to such reverse cash and carry arbitrageurs. According to the regulator, “The tenure of lending/borrowing shall be fixed as standardized contracts. To start with, contracts with tenure of seven trading days may be introduced." What if there’s an arbitrage opportunity three days before expiry, or for that matter ten days before expiry? The rigidity of the seven day contract would prevent such opportunities from getting exploited and keep players away.

The world over, securities lending is practised in an over-the-counter (OTC) framework, where large brokers match orders between lenders and borrowers, with as much customization as possible.

Foreign brokers pushing for securities lending in India have continually stressed upon the case for an OTC system, citing it as the only successful model world-wide. Financial market experts in India, however, have agreed to Sebi’s preference for a transparent, exchange-based platform, given its runaway success in the cash and derivatives segments. Moreover, the securities lending market in Brazil has grown rapidly despite following an exchange-traded format with a central counterparty. But the rigidity of standardized contracts may keep most borrowers away.

The only area where securities lending will be immensely useful is with partial settlements/short delivery, since it will do away with the burden of an auction process.

In the case of a shortage, sellers can now simply borrow and make good their obligation. While this will be a boon for the markets as a whole, as it does away with the auction system, it may not add heavily to securities lending turnover. This is because settlement shortages are less than 0.5% of total settlement turnover.

Interest from lenders is likely to be high, given the high level of idle stock held by savvy institutional investors such as FIIs and the extra income they can earn. But with little motivation on the borrower’s front, the success of the new product is at serious risk. It could be another false start for securities lending, the only missing link in India’s equity market infrastructure.

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