Short Selling at Long Last?

In February 2007, the Indian Finance Minister announced in his
budget speech that institutions would be allowed to short sell and
that a securities lending mechanism would be put in place. Nearly ten
months later, The Securities and Exchange Board of India has announced
the Broad
framework for securities lending and borrowing and the Broad
framework for short selling but it is not yet clear as to when the
exchanges would operationalize these products. Given the considerable
similarities in software requirements between the proposed securities
lending mechanism and the old ALBM system, I would think that the
exchanges should not need more than 2-3 weeks to get this off the
ground. So the absence of a specific timetable is disturbing.

Globally, the corporate world hates short selling and does its best
to discredit it and even prevent it if possible. In the US for
example, the SEC took 70 years to remove short sale restrictions and
even that happened only after Enron had weakened the credibility of
corporate America. Even now, the SEC is to my mind unduly harsh on
what it calls “abusive short selling” as I discussed in my
blog
post earlier this year.

In India too, I know from my conversations with corporate leaders
that corporate India does not like short selling and would like the
proposals to be diluted and delayed as much as possible. After I
expressed this fear publicly in a television interview earlier this
week, I have been assured by the regulators at the highest level that
they do not feel any pressure from the corporate sector and would not
be swayed by any pressure even if it were sought to be applied. I can
only conclude that the corporate lobby is concentrating on those whose
convictions on short selling are weaker and can therefore be more
easily swayed. Since the short selling and securities lending
framework require concurrence of the tax authorities and of the
central bank while operationalization requires action by the exchanges
and perhaps the depositories, opponents of short selling have many
avenues open to them to delay if not block much needed reform.

I have been arguing the case for free short selling for several
years now to the point of beginning to sound like a broken record:

In India, [severe restrictions on short selling] are the single
most important culprit for the frequency and severity of episodes of
stock market manipulation that have taken place in this country during
the last decade. Indian
Journal of Political Economy, October-December 2002

A market without short selling is an open invitation to company
managements and other manipulators to rig up the prices of stocks.(Business
Line March 15, 2004)

Removal of all restrictions on short-selling would be the single
most important step towards making Indian capital markets cleaner,
safer and more efficient.(Economic
Times, October 3, 2005)

But I think the battle is not over yet. All of us who have a stake
in clean and vibrant capital markets must therefore keep up the vigil
to ensure that unscrupulous corporate managements do not succeed in
delaying this reform any further.

It is equally important to move quickly beyond the broad framework
that has been published now. First, short selling needs to be quickly
expanded beyond the derivative stocks to at least the top 1,000 or
2,000 stocks as I discussed in my blog
post two years ago. Second, the position limits need to be
increased substantially. Third, mechanisms for borrowing stocks for
much longer periods than seven days need to be created. The proposed
framework requires gross settlement at client level so that even a
roll over of the seven day contract into the next contract would be
cumbersome. Global experience suggests that when short positions are
established in stocks on the suspicion of fraud or misreporting by the
company, the position has to be maintained for several months for the
short sellers to expose the fraud and make a profit on the
position.

But all these problems should not hold up progress. The better
should not become the enemy of the good. SEBI, RBI and the exchanges
must work hard to make short selling and securities lending a reality
in January 2008.

FASB tries to define equity and liability

The Financial Accounting Standards Board (FASB) in the United
States has put out a very interesting document
outlining its preliminary views on a consistent definition of equity
and liabilities. As highlighted in Table 2 at the end of the document,
the FASB proposals would involve substantial changes in current
accounting practice. In particular, it would allow gains or losses to
be recognized when a company enters into derivative transactions on
its own stock.

Years ago, while writing a paper
on Enron, I came across instances where current accounting treatment
for such transactions is not in line with economic realities, but
thought that the changes required to bring them in alignment would be
too drastic for accountants to countenance. It is fascinating to find
that FASB is prepared to contemplate making these drastic changes and
it is likely that the International Accounting Standards Board (IASB)
would move in the same direction as well.

SEC Admits that it Rigged Share Prices!

I find it hard to believe this, but the SEC press release
explicitly says that as part of its sting operation, it and the FBI
did actually manipulate the share market – the SEC/FBI
“bought the stock defendants were promoting. Every buy
transaction had a material effect on the stock trading volume of the
companies in question”. Will the SEC/FBI compensate genuine
investors who traded on the basis of the false volumes or prices? The
SEC says “Our office worked closely with the criminal
authorities and provided information and technical assistance
throughout the FBI sting operation in order to minimize harm to
innocent investors.” But minimize is not the same as prevent.

Another puzzling thing in the press release is that after saying
that “In fact, there was no hedge fund”, it goes on to say
that “the hedge fund bought the stock”. Perhaps, it was a
drafting error in the press release.

Financial markets and financial information

There is a chicken and egg relation between financial markets and
financial information: the markets need data to function well but the
data is generated only when the markets become vibrant. This was my
response to Peeyush Mishra who emailed me this week with a comparison
of the richness of data that is available about the US housing market
(OFHEO, Case-Shiller, NAR, NAHB and Commerce Department) with the
paucity of such data for India. Peeyush asked me whether we should
make a sustained push to collect and organize more of this data and
put it in the national domain.

My argument was that we have already traveled down this top-down
route with the National
Statistical Commission that submitted its report in 2001 and the
National
Statistical Commission that was established in 2006 following the
recommendations of that report.

The alternative (bottom-up) approach is to rely on the demand pull
that emerges from well developed financial markets. These markets not
only create demand for financial data, but this demand is backed by
willingness to pay for the data – it is as the economists like
to say “effective demand”. Both private sector and public
sector providers respond to this demand. It may appear surprising but
it is a fact that even Indian public sector providers respond to
private sector demand for data particularly when this demand starts
being met by private sector providers. Once they get into the game,
public providers also sometimes try to shut out the private providers
on vague grounds related to the integrity of the data. Viewed in this
light, the main reason why the US has such rich data on housing is the
huge mortgage and mortgage derivative market in that country.

It is also true that data providers (both private and public) are
more reliable when the data they generate is used by financial markets
than when it used primarily by academics. This is because while
academics are content to run some outlier tests and get rid of the
worst errors in the data, market participants have less tolerance for
mistakes in the data. The private sector can also help in scrutinizing
the validity of the methodology. For example, in 2003, Statistics
South Africa was forced to correct flaws in the estimation of the
housing rentals component of the consumer price index in response to
complaints by analysts.