Stock lending nears, amid some debate

MUMBAI: He who sells what isn’t his, must buy it back or go to prison, goes an old Wall Street adage.

Napolean Bonaparte, the great French general, deemed short sellers as enemies of the state.

A few years back the finance ministry of Malaysia said that caning would be the right penalty for short-sellers

“Though it can be abused in various ways, it is a legitimate tactic whose practitioners shouldn’t be universally demonised,” said John Allen Paulos, a professor of mathematics at Temple University in Philadelphia and the author of the best selling book A Mathematician Plays the Stock Market.

Stock market regulators the world over, obviously, recognise this and thus have allowed short selling of shares.

In India, short-selling of shares was disallowed in 2001 after the Ketan Parekh scam came into light.

Come April 21, and short-selling will be allowed again.

Stockbrokers who operate through the Bombay Stock Exchange and want to offer this facility to their clients will have to first enter into a separate agreement with Bank of India Shareholding Ltd (BOISL), the bourse’s clearing house.

The securities lending and borrowing session will happen between 10 am and 11 am on days when the stock market is open.

So investors looking to short-sell a stock on a particular day will have to first borrow it in the morning between 10 am and 11 am.

Short-selling essentially refers to selling a share that one does not own, in the hope of buying it again later at a lower price and making money on the difference.
If an investor feels that a stock is overvalued at Rs 100, he can sell it, and then wait for the stock price to fall. If the stock price falls to Rs 80, he can then buy the stock at Rs 80 and pocket the difference of Rs 20.

Currently retail investors are allowed to short-sell. However, they have to settle their position by the end of the day.

But no naked short-sales will be allowed.
What this means is that anyone (institution or retail investor) looking to sell a share he does not own will have to borrow it first.

Investors can borrow shares from the stock lending and borrowing scheme, short it and then buy it back at a lower price, to make a profit.

Institutional investors short-selling will have to specify at the time of selling that the order is a short-sale.

Retail investors have time until the end of trading hours. The stock lending and borrowing shall take place on an automated, screen based, order-matching platform, which will be provided by the approved intermediaries like BOISL. This platform shall be independent of the other trading platforms.

Those borrowing the stock will have to maintain a margin of 140% of the amount of stock borrowed with his broker. The broker will have to be maintain a similar margin with the exchange. So if stock worth Rs 10,000 is borrowed, then a margin of Rs 14,000 would have to be maintained. This step will effectively ensure that the retail investor will find it very difficult to be a part of this game.

The stock that has been borrowed for short-selling has to be returned within a period of eight days.

Retail as well as institutional investors can participate in this scheme and lend their shares to short sellers.

The investor borrowing will have to pay a certain fees to the investor lending.
“Mutual funds and high networth individuals will see at least 5-7% higher returns as they will be able to lend out stocks which, until now remained idle while maintaining long term view and benefiting from the dividend yields,” points out a recent report from broking house Latin Manharlal Securities.

But there are others who are not as optimistic. “In my intuition, demand for borrowing is small and the supply (with institutional investors) is quasi-infinite, so access to borrowed shares should become possible at very low prices,” writes Ajay Shah, senior fellow at National Institute of Public Finance and Policy on his blog http:ajayshahblog. blogspot. com. Currently investors can short sell only those stocks whose derivates are available.

There are 227 stocks which fall into this category. Experts question this arrangement as well.  If a stock is overvalued an investor easily sell a future on the stock or buy a put option on it, to profit from the situation.

This transaction is much more easier than first borrowing the stock and then selling it. “Short-selling needs to be quickly expanded beyond the derivative stocks to at least the top 1,000 or 2,000 stocks,” writes J R Varma, professor at IIM, Ahmedabad in his blog.

He also questions the merit of a seven-day contract. “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.”

This would clearly help investors drive down prices of stocks they feel are clearly overhyped and hence prevent stock market bubbles.

Currently investors can only profit stock futures quoting at a greater price than the share price.

They can buy the share in the cash market and sell the same stock in equal quantity in the futures market. On the settlement date, they can sell the share and buy back futures, to make a profit. This is known as arbitrage.

But with stock futures being allowed, investors can reverse arbitrage. Reverse arbitrage comes into the picture, when the futures price is quoting at a discount to the share price in the cash market.

In this situation futures can be bought and shares can be sold to make an arbitrage profit. Nevertheless, this would involve selling shares the investor does not own and would amount to short selling. With the new arrangement in place, investors can borrow shares and short-sell them. Arbitrage opportunities are known to exist primarily in a bullish market. In a bearish market, reverse arbitrage opportunities are thrown up more. With markets not doing well lately, this could mean another source of income for investors.

 k_vivek@dnaindia.net
 n_subramanian@dnaindia.net