Stock lending coming to life

Financial Express, 1 October 2010

While India has a world class equities trading ecosystem, one of the last missing building blocks is a mechanism to borrow shares. Stock lending is important because it will improve the pricing of stock futures, and because it will enable expression of bearish views about non-derivatives stocks. A stock lending mechanism has been under development for a decade. In 2010, there seems to finally be some traction in this. If this works out, then one of the last missing pieces of the equity ecosystem would fall into place.

Divergent views of an array of participants are the essence of finance. If a person feels optimistic about a stock, he can borrow money and buy shares. What about the pessimist? When a share price is Rs.100, a pessimist borrows shares and sells them on the market. He is obliged to return the shares at a later date. If the pessimist is right, the share price goes down to (say) Rs.90. He then buys the shares back at Rs.90 and returns them, for a profit of Rs.10.

The ability to borrow shares is thus essential to a free and fair market: Just as optimists can borrow money, pessimists should be able to borrow shares. While this is the right way to think about thousands of listed firms in India, there is a privileged group of 200 firms who are different. They have stock futures trading. India is unusual by world standards in having achieved success with stock futures at NSE. Stock futures are cash settled, thus giving true symmetry between the optimist (who would buy the stock futures) and the pessimist (who would sell the stock futures).

While stock lending is not important for a healthy and balanced speculative price discovery to come about for these 200 stocks, there is still a vital role for it, in the process of stock futures arbitrage. Derivatives pricing is done by arbitrage. The futures price should reflect an interest cost of carry over the spot price. If the futures price on the market is too high, then arbitrageurs step in, who buy an equal quantity of shares on the spot market and sell the futures. They make a profit while taking no risk, and perform the socially beneficial function of pushing prices back to sanity.

But what happens if the futures price is too low? The arbitrage strategy then requires buying the futures (where the price is too cheap), and simultaneously selling an equal quantity of shares on the spot market. But what if the person doing this arbitrage does not own those shares? He needs to be able to borrow them. Hence, a stock lending mechanism fosters pricing efficiency for the stock futures, by connecting shares (in the portfolios of lenders) with the arbitrageur. Indeed, without a stock lending mechanism, a sharp decline in the stock futures price is hard to correct.

In the international experience, stock lending is done on a bilateral basis. The borrower and lender meet each other and undertake the lending. This leads to trouble when the borrower defaults, in which case the lender stands to lose his shares. In India, a unique path was chosen by SEBI: that of requiring a counterparty guarantee of the clearing corporation, and of having a transparent screen-based system for borrowing.

For many years, this did not work out. There have been times when the present author has despaired of making this work and recommended that we drop down to bilateral mechanisms, as is done in the West. In 2009 and 2010, finally, it appears that the problems are being resolved. SEBI revised its rules about the stock lending mechanism. In June, NSE's clearing corporation (NSCC) implemented a screen based matching platform and a full counterparty guarantee, reflecting these new rules.

In recent weeks, this has started exhibiting some traction. Over 10 weeks, lending worth Rs.300 crore has taken place, with an average of Rs.5.5 crore a day. A total lending fee of Rs.64 lakh was paid. While these numbers are puny, they are a lot better than zero. They suggest that basic design mistakes are absent. With further debugging, there is a potential for fairly big numbers to rapidly come about. Every investor who has shares sleeping in a depository account now has an opportunity to make a little revenue by lending out these shares.

At present, there are two key constraints. First, institutional investors are absent on the lending side. For any investor, earning a little additional revenue by stock lending is a free lunch, since NSCC guarantees the return of shares thus eliminating credit risk. The constraints which hold back mutual funds, FIIs, banks and insurance companies from lending shares need to be removed.

Secondly, for firms lacking stock futures trading, stock lending is of critical importance in enabling the expression of negative views. Absent stock lending, stock prices have a positive bias since optimists can take positions while pessimists cannot. Hence, the scope of stock lending needs to be broadened beyond the derivatives list.

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