Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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