The Hindu Business Line : Short 'em

`Short' is in — players with big money can now sell stocks they do not own (or `short' them, in stock market parlance). Institutional investors, who were hitherto allowed to sell short only in the derivatives market, would soon be doing the same in the cash market.

The recent proposal by the Securities and Exchange Board of India (SEBI) allowing institutional investors to short-sell equities is likely to change the market dynamics for good.

Apart from helping the institutional investors hedge their market risk more effectively (take contrarian positions to reduce portfolio risk), it may also lead to improved liquidity and market depth (total number of buy and sell order for a particular security).

A look at what this proposal means and how it is likely to affect the market. To begin with, the basics of short selling mechanism that have been proposed for implementation.

Short selling — a sneak peek

Short-selling can be defined as the selling of shares that a trader does not have in his demat account, but promises to deliver to the buyer before the lapse of the delivery cycle. Typically, any retail investor can short-sell a particular stock after paying a minimum upfront margin to his broker.

However, the seller has to make sure that the stock (which he short sold) is borrowed on time and is made available for delivery to the buyer on the second day after the transaction (T+2).

The seller can then buy those shares at a lower price (within the stipulated time) and deliver it to the borrower, pocketing the difference as profit.

The short-selling proposal that is on the cards for institutional investors seeks to follow a similar mechanism. However, naked shorts (without assured delivery to the buyer) will not be allowed under the proposal. Short-selling, for starters, will be introduced only for select stocks. It will be introduced only after the setting up of a well-structured securities lending and borrowing (SLB) mechanism. Banks, custodians and other such SEBI approved financial institutions would do the stock lending.

Institutional investors, on the other hand, would borrow stocks from them after paying them an interest for the same. The institutional investors will also be required to pay an upfront margin before going short in equities. However, more clarity on these rules and regulations are still awaited.

The introduction of short-selling, though a common tool in other developed markets, was a much-awaited one in the Indian bourses. A look at how it will affect the market and its participants.

For institutional investors

Institutional investors have for long awaited the introduction of short-selling in the cash market. It is likely to give them a level-playing field vis-à-vis other classes of investors, helping them take advantage of both sides of the market (both a rising and falling market).

The move may help them hedge their market risk more effectively, and provide them with arbitrage opportunities, helping them use the price differences in derivative and spot prices of stocks to their advantage.

Moreover, it will also offer them more liquidity in comparison to the derivative market, for it enjoys higher participation. In addition to this, the long-term life of equity also acts as an adherent. Financial institutions such as LIC, GIC and other such players, which are likely to act as lenders, will also benefit by way of the interest fee that they will earn.

For stock market

The introduction of short-selling is likely to benefit the market in more ways than one. Apart from improving efficiency and liquidity, it will also help increase participation in a falling market (since institutions will try to take advantage of such a market by going short), thus improving the market depth. In addition to this, it will also lead to the setting up of a vibrant stock lending and borrowing mechanism and could lead to actual delivery against futures and options in the future.

Further, since investors would be allowed to take both long and short positions on stocks at any point of time, it is likely to result in the proper price discovery of stocks, which hitherto stood the risk of over-valuation. It would also lead to buoyancy in the market, since any short position created in the market would have to be covered (bought back).

For investors

Though the introduction of short-selling by institutions will not affect retail investors directly, it will be a positive in terms of the overall improvement in liquidity and benefits that accrue to mutual funds.

Mutual funds, which would be able to take advantage of the short-selling proposal, would, in turn, pass on the benefits to the retail investors invested in them.

Furthermore, mutual funds in the future could introduce a plethora of products in the market, which specialise in short-selling, thereby expanding the product choice for retail investors.

Please send suggestions and queries to younginvestor@thehindu.co.in, or

The Research Bureau,

The Hindu Business Line,

859-860, Anna Salai, Chennai-600002.

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