Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Wed, 26 Dec 2007

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.

Posted at 15:09 on Wed, 26 Dec 2007     View/Post Comments (2)     permanent link