ViJiT
Vijith Pujari
SEBI paper on short selling...most welcome
The stock market is all about bulls and bears. But, more often than not, its the bulls who emerge as the winners in the day-to-day slugfest with the bears. Markets tend to rise more than they fall. In short, the bears are mostly at the receiving end. This has been true in the three-year rally on the Indian bourses. The Sensex has skyrocketed, from under 3,000 at the end of April 2003, to an all-time peak of 9,689.68, struck on January 9. Barring a few hiccups, like the Black Monday (May 17, 2004) crash and the one last October, the bulls have been pretty much in control of proceedings so far. And, though the benchmark BSE index has taken a breather of sorts, 10,000 is certainly a possibility in the near future. India is clearly one of the hottest markets in the world right now, with billions of dollars lined up for investments despite expensive valuations. Last year, the FIIs pumped in a record $10.6bn, eclipsing the previous year's all-time high of $8.56bn. However, there are more than a few voices of dissent who are worried about the gravity-defying rise in the Indian market and are warning of a reversal this year after a three-year rally. The recent fall could be a sign of that.
Whether the bears are finally getting active or not is anybody's guess. But, the moot point is that stock market needs both bulls and bears. For that matter, any market requires both buyers and sellers. So does the stock market. "We need more, not less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the recent technology, media and telecom boom", Edward Chancellor, the noted financial expert wrote in 2001. Bernard Baruch, another renowned American broker, said some 90 years ago: "To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster." Looks like their wise words haven't fallen on deaf ears. After banning short selling twice - in June 1998 and in March 2001 - SEBI, the Indian stock market watchdog, has set the ball rolling for the reintroduction of one of the most dreaded trading practices in stock markets. In late December, it released a discussion paper seeking public opinion on short selling, and securities lending & borrowing.
Short selling means selling a security without actually owning the same. The short seller borrows the security from a broker and sells it, betting that it can be bought back at lower prices and returned to the broker. Short selling is a technique used to profit from the belief that a security is overvalued and is likely to fall. The short seller sells the shares borrowed from a broker at the current market price. If the price of the shares drops, the short seller covers the short position by buying back the shares. The broker of the short seller than returns the shares to the lender. The short seller makes a profit if the price of the security falls. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. But if the price of the shares increase, the potential losses are unlimited. Short selling is frowned upon world over as it is associated with a falling price of a security. It is one of the most heavily regulated market strategies around with significant legal and economic barriers.
Its no different in India. But, some of those regulatory restrictions might soon be thing of the past. SEBI, in its paper states that the present regulatory restrictions which allow only the retail investors to short sell should be removed to enable a level playing field for all classes of investors. In other words, the institutional investors who are currently prohibited by the respective regulations should be permitted to short sell. This is more than welcome, as short selling has a way of lending some sanity to an overheated market and curbs "irrational exuberance". What's more, short sellers also need to cover their positions, which in turn also provides a much-needed cushion to the market. Short selling can also contribute to the liquidity and efficient price discovery process, besides helping curb high volatility and risks associated with usual market fluctuations. In fact, globally there are some funds who earn their bread and butter by focusing only on short selling. U.S.-based Kynikos Associates is one such fund. What such types of funds do is undertake comprehensive research for identifying securities that are ripe for a big fall. Many a times such probes lead to the uncovering of shady dealings within an organisation. Many of the major U.S. corporate frauds and bankruptcies in the past 25 years or so were first exposed by short sellers. Enron and Tyco are just a few examples.
So, clearly the benefits of short selling outweigh the pitfalls. SEBI appears to have realised this and is looking to correct its past errors. While that's a good sign, what is not okay is that initially short selling may be allowed only in those stocks in which derivative instruments such as futures and options are available for trade. This clearly defeats the purpose of checking price manipulation. Here's how. Derivative products are available for most liquid stocks but it's the illiquid scrips that are soft targets for price rigging. Short selling is needed much more in the case of stocks that are prone to market manipulation, rather than the liquid, frontline scrips. So, not allowing short selling across the board is a bad choice. Also, for short selling to have a full impact as a strategy to mitigate risks, volatility and undue enthusiasm, a comprehensive securities lending and borrowing system needs to be in place. Regulators also need to strengthen their surveillance systems to keep audit trail of short sellers. Finally, there should be a clear distinction between manipulative short selling and legitimate short selling, to encourage genuine short sellers and eliminate the price manipulators. Kynikos Associates says that short sellers are the professional skeptics who go beyond the hype and hoopla to ascertain the true value of a stock. Imposing undue restrictions on them hurts market's efficiency and lowers the incentives for undertaking extensive research necessary to counter the irrational exuberance in the market.
The stock market is all about bulls and bears. But, more often than not, its the bulls who emerge as the winners in the day-to-day slugfest with the bears. Markets tend to rise more than they fall. In short, the bears are mostly at the receiving end. This has been true in the three-year rally on the Indian bourses. The Sensex has skyrocketed, from under 3,000 at the end of April 2003, to an all-time peak of 9,689.68, struck on January 9. Barring a few hiccups, like the Black Monday (May 17, 2004) crash and the one last October, the bulls have been pretty much in control of proceedings so far. And, though the benchmark BSE index has taken a breather of sorts, 10,000 is certainly a possibility in the near future. India is clearly one of the hottest markets in the world right now, with billions of dollars lined up for investments despite expensive valuations. Last year, the FIIs pumped in a record $10.6bn, eclipsing the previous year's all-time high of $8.56bn. However, there are more than a few voices of dissent who are worried about the gravity-defying rise in the Indian market and are warning of a reversal this year after a three-year rally. The recent fall could be a sign of that.
Whether the bears are finally getting active or not is anybody's guess. But, the moot point is that stock market needs both bulls and bears. For that matter, any market requires both buyers and sellers. So does the stock market. "We need more, not less, shorting activity if, in the future, we are to avoid wasteful bubbles, such as the recent technology, media and telecom boom", Edward Chancellor, the noted financial expert wrote in 2001. Bernard Baruch, another renowned American broker, said some 90 years ago: "To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster." Looks like their wise words haven't fallen on deaf ears. After banning short selling twice - in June 1998 and in March 2001 - SEBI, the Indian stock market watchdog, has set the ball rolling for the reintroduction of one of the most dreaded trading practices in stock markets. In late December, it released a discussion paper seeking public opinion on short selling, and securities lending & borrowing.
Short selling means selling a security without actually owning the same. The short seller borrows the security from a broker and sells it, betting that it can be bought back at lower prices and returned to the broker. Short selling is a technique used to profit from the belief that a security is overvalued and is likely to fall. The short seller sells the shares borrowed from a broker at the current market price. If the price of the shares drops, the short seller covers the short position by buying back the shares. The broker of the short seller than returns the shares to the lender. The short seller makes a profit if the price of the security falls. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock. But if the price of the shares increase, the potential losses are unlimited. Short selling is frowned upon world over as it is associated with a falling price of a security. It is one of the most heavily regulated market strategies around with significant legal and economic barriers.
Its no different in India. But, some of those regulatory restrictions might soon be thing of the past. SEBI, in its paper states that the present regulatory restrictions which allow only the retail investors to short sell should be removed to enable a level playing field for all classes of investors. In other words, the institutional investors who are currently prohibited by the respective regulations should be permitted to short sell. This is more than welcome, as short selling has a way of lending some sanity to an overheated market and curbs "irrational exuberance". What's more, short sellers also need to cover their positions, which in turn also provides a much-needed cushion to the market. Short selling can also contribute to the liquidity and efficient price discovery process, besides helping curb high volatility and risks associated with usual market fluctuations. In fact, globally there are some funds who earn their bread and butter by focusing only on short selling. U.S.-based Kynikos Associates is one such fund. What such types of funds do is undertake comprehensive research for identifying securities that are ripe for a big fall. Many a times such probes lead to the uncovering of shady dealings within an organisation. Many of the major U.S. corporate frauds and bankruptcies in the past 25 years or so were first exposed by short sellers. Enron and Tyco are just a few examples.
So, clearly the benefits of short selling outweigh the pitfalls. SEBI appears to have realised this and is looking to correct its past errors. While that's a good sign, what is not okay is that initially short selling may be allowed only in those stocks in which derivative instruments such as futures and options are available for trade. This clearly defeats the purpose of checking price manipulation. Here's how. Derivative products are available for most liquid stocks but it's the illiquid scrips that are soft targets for price rigging. Short selling is needed much more in the case of stocks that are prone to market manipulation, rather than the liquid, frontline scrips. So, not allowing short selling across the board is a bad choice. Also, for short selling to have a full impact as a strategy to mitigate risks, volatility and undue enthusiasm, a comprehensive securities lending and borrowing system needs to be in place. Regulators also need to strengthen their surveillance systems to keep audit trail of short sellers. Finally, there should be a clear distinction between manipulative short selling and legitimate short selling, to encourage genuine short sellers and eliminate the price manipulators. Kynikos Associates says that short sellers are the professional skeptics who go beyond the hype and hoopla to ascertain the true value of a stock. Imposing undue restrictions on them hurts market's efficiency and lowers the incentives for undertaking extensive research necessary to counter the irrational exuberance in the market.