Why ban short selling?

Financial Express, 26 October 2008

When markets fall, it is popular to demand the heads of the short sellers. A short seller is someone who has a negative view on a stock. A person who feels Infosys share prices will go down would borrow shares of Infosys and sell them off. If he is right, later on he will be able to buy shares of Infosys on the market and return them - and pocket a profit.

The short seller makes money when prices go down (and loses money when prices go up). When prices go down, many shareholders get offended at the thought that someone is rejoicing. Hence, short sellers have been the target of much anger. Governments have often tried to crimp short selling.

However, the basic principle of a financial market is that the price must reflect all kinds of views. Some people are optimistic and buy a security; some people are pessimistic and sell a security. The consensus comes together to make the price. Interfering with short selling leads to pricing distortions. Banning short selling in capitalism is akin to banning opposition parties in democracy.

In the West, in the recent financial crisis, financial regulators resorted to unprecedented restrictions against short selling of shares of banks. Some people have then jumped to the conclusion that if the SEC and FSA have done this, so must we. There are three flaws with this argument.

  1. The SEC and FSA moved against short selling in a moment of dire crisis. They had experienced failures of Bear Stearns and Lehman Brothers -- a comparable event in India would be the bankruptcy of two banks the size of SBI. Their government was engaged in desperate crisis management. A few bad ideas, such as banning short selling for bank stocks, slipped through.

  2. These bans did not work. They did not halt the price declines of bank stocks in London and New York.

  3. In India, stock lending (as in borrowing shares and selling them) is a miniscule activity. The main plank -- a Securities Lending and Borrowing Mechanism -- is dysfunctional and has an average lending quantity of zero. Within India, some people borrow shares from friends and family, and there is no data about the extent to which this takes place. Outside India, FIIs privately lend out shares to a small extent.

    Short selling is a valuable part of the financial system. SEBI and the exchanges need to get their act together and make an elegant and unified securities lending mechanism work, for shares, government bonds, mutual fund units, and corporate bonds. But as of today, we are not there. The size of securities lending that is taking place is insignificantly small.

    How does the Indian equity market, then, function? How do people express negative views? The main platform where negative views are expressed is the derivatives market. A person with a negative view about Infosys can sell Infosys futures. Or, he can buy a put option on Infosys (where a fixed price is paid and a profit is made depending on how large a future price drop is). Or, he can sell a call option on Infosys (where a fixed insurance premium is earned and if a price drop takes place, there is no further payment due). India has one of the world's best markets for derivatives on individual stocks. It uses cash settlement: the most efficient means for organising this market. The person with a negative view adopts a position on this market, bears the risk, and if he turns out to be right, earns a profit in rupees. No shares need to be borrowed or lent.

    The derivatives market is now the backbone of both price discovery and stock market liquidity in India. Optimists buy futures, pessimists sell futures, and the two come together to make the futures price. Price discovery takes place in this fashion for both individual stocks and for stock market indexes (Nifty and Nifty Junior). The Indian equity derivatives market is deep and liquid and the envy of the world.

    To ban short selling in India, you would need to ban stock options and stock futures. Two things would then follow. First, there would be a steep and dramatic drop in stock market liquidity, for the bulk of the depth of the stock market today is found on the derivatives. When a stock is more liquid, investors pay a liquidity premium for it. Conversely, when a stock becomes less liquid, investors would pay less for it. Thus, stock prices in India would drop sharply when a ban on stock derivatives yields a sharp reduction in stock market liquidity.

    The second event would take place in Singapore. The Singapore Exchange (SGX) would bless their good fortune, and launch stock futures trading on Indian stocks. The optimists and pessimists would then take their business to Singapore.

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