02 November 2008

Short selling - modification to the borrowing and lending mechanism of securities

Day before yesterday (31 Oct 08), SEBI has come out with some modifications to the borrowing and lending scheme of securities, which as proposed in Dec 2007 has been a non starter. The SLB scheme (Securities Lending and Borrowing) was expected to jump start the market in short selling, as it is not possible to short sell securities unless there is a viable mechanism to borrow securities to complete delivery. The amendment makes the following important change:

1 Tenure
Tenure for SLB may be increased to 30 days from the present 7 days.

However, this is unlikely to revive the market as there are continuing design failures in the short selling mechanism. In addition, in today’s environment, where short sellers are seen as criminals (see my previous posts here, here, here and here) it is highly unlikely that anyone will short sell with such visibility – it’s almost like walking around a shooting range with a bulls-eye painted on your head.

In any case, even if the persecution of short sellers were to abate, the market is unlikely to take off for the following reasons in that order:

A) Restricting the borrowing and lending facility to the exchange is a bad idea. If I want to borrow from my good friend who has securities to lend, the present mechanism doesn’t allow that. This is important because two big institutions who want to enter into a bi-lateral transaction for borrowing and lending are prohibited from doing so. This kills the most obvious and simplest of facility for big players who do not want the whole world to know that they have borrowed securities (which is a dangerous thing to do, when you are short the stock – see point B below).

B) The disclosure of positions by the exchange at the end of the week make the market wholly unattractive. At the time of the creation of the short position, the seller has to declare that it is a short position. While, the short position is not immediately disclosed to the market, they are disclosed weekly. This is again like walking in a shooting range with a bulls-eye painted on your head. A short position disclosure will invite people to hurt the short sellers by ‘squeezing them out’ as everyone knows the approximate date when the short seller will be forced to buy from the market whatever be the price. In fact every rational person would try to squeeze out the short and thus profit from the short seller if this data is in the public domain while the short position is open. This makes a short sale unviable. Even if the current disclosure norm is made monthly in line with the change in the tenure, the problem will persist. It may sound counter-intuitive, but more disclosure in this case is not good.

C) The securities eligible for short selling and thus SLB are only the most liquid of securities (those which are eligible to be traded on the derivatives market). This is wrong – those securities which are most in need of short selling i.e. to control manipulators, are outside of this list.

D) The tenure of 1 month is too artificial. It automatically excludes anyone with a view of over 1 month from short selling. Why should there be a hard tenure for borrowing, this rigidity combined with point A) above will ensure that the market will not take off.

Of course the intra-day or two day short selling will continue amongst day traders, but that is hardly the same as taking a month long or a quarter long position on a stock. In any case, negative views can be expressed through the futures and options markets by creating a synthetic short on a stock or simply dumping existing stock.

Update: See piece by Mobis Philipose in Mint of 4 Nov 08 on the isssue.

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