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B. Venkatesh

THE recommendation on short sales by SEBI's Secondary Market Advisory Committee is pragmatic and laudable. The suggested definition of short sales, if accepted, may provide the much-needed balance to the market, which clearly has an upside bias at present.

Current scenario: At present, there is a ban on short sales. SEBI defines short sales as a transaction where the person sells a stock without owning it. A daring person can easily flout this rule. How? A trader may sell, say, Steel Authority of India (SAIL) at Rs 48 in early trade, and buy the stock at Rs 40 later in the day. This ensures that the position is covered at the end of the day.

The exchange or SEBI cannot prima facie know that the trader has engaged in short selling. This is because it is very difficult for the stock exchanges to monitor transactions even at the broker-level.

The only way for the stock exchanges to track such short-selling is to get a list of buy/sell transactions for each stock for each client per broker. And that is an arduous task. Few traders, however, defy the existing short sales rule. So, there exists an upside bias in the market.

Volatility: The upside bias leads to high volatility. The SAIL stock, for instance, galloped from Rs 15 to Rs 50 in less than three months. Many traders who considered the stock overvalued at some level were unable to act on their view, because they could not short the stock.

When traders who held the stock finally started taking profits at higher levels, the price fell from Rs 50 to Rs 38 in just two trading sessions. Had short-selling been allowed, the stock may not have risen from Rs 15 to Rs 50 in such a short span.

Logically, then, the decline would also have been soft. Essentially, this suggests that SEBI's ban on short sales may be one of the reasons for excess stock volatility in the market.

Proposed definition: The Secondary Market Committee has now recommended that the short sales definition be changed to mean any transaction that does not result in delivery. That essentially changes the market microstructure, because excess stock volatility may be controlled. How?

A trader can now legally short, say, SAIL, if she is of the opinion that the stock may decline from current levels. The trader has to ensure delivery of the shares as required under the settlement system (T+2).

If the stock does not fall intra-day so as to make it worthwhile for the trader to cover her position, she can deliver the shares using equity repos. This is a fancy name for stock lending.

The trader may buy SAIL from, say, a mutual fund, promising to give back the stock at a later date. The trader expects to buy the stock from the secondary market at a lower price the next day, or thereafter, to deliver the stock to the lender.

Enhanced returns: The change in the short sales definition, along with the development in equity repos, will enable institutions and long-term investors to increase their holding returns. How?

Suppose an insurance company has invested in HDFC and Reliance Industries to part-immunise its liabilities on the long-term life insurance contracts. When equity is used for immunising purposes, it essentially means that the holder is unlikely to sell the shares in the near term.

The insurance company can use these shares to enhance returns by lending them to the traders who have shorted HDFC and Reliance Industries. Of course, the insurance company runs a higher risk if it lends directly to the traders. What if the traders do not return the securities to the insurance company?

For this purpose, the Secondary Market Committee has suggested ways to develop stock lending. The committee has recommended that the Clearing Corporation handle the stock lending process. This changes the credit risk exposure for the insurance company. The Clearing Corporation will act as a counter party, thereby lowering the risk for the insurance company.

In short, the recommendation of the Secondary Market Committee on short sales and stock lending is a welcome step in furthering the process of market reforms.

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