Shorts Story

Finally the securities & Exchange Board of India (SEBI) has decided to bite the bullet on short sales. The regulator has firmed up plans to introduce short sales in the cash market for both domestic and foreign institutional investors. This will bring the Indian stock markets on a par with advanced markets. SEBI Chairman M. Damodaran told Business Today that the regulator is "very close to introducing short sales within a matter of a few weeks."

A short sale, very simply, is a bearish position on a stock taken by an investor. This is where an investor borrows shares, promises to return them in future, and then sells them. If the short seller's view holds and the stock price dips, he can buy the shares back at a lower price, return the shares to the original owner and pocket the difference between the price at which he had sold and the new lower price.

The SEBI green signal for short-sales, analysts say, is a step in the right direction. Says BSE member Ramesh Damani: "It'll make the markets more stable. Now market participants can express both views as they are allowed to go both long and short." In a rising market, where demand for shares exceeds supply, a short seller steps in with borrowed securities; when the markets are sliding, the short seller squares his position by buying back the shares. This not only beefs up the market liquidity but also makes it less volatile.

The lack of short selling in the cash market also perhaps explains the immense popularity of stock futures. In the futures segment, short-selling is permitted. This has often led to the cash market taking signals from the futures market. Explains Damani: "Very often the spot price in the cash market runs ahead of the futures. This is partly due to the absence of short sellers."

The move is also expected to make the markets more efficient by presenting proper arbitrage opportunities between the cash and the futures market. Arbitrage funds that today buy stocks in the cash market and sell in the futures market would now be in a position to go in for reverse arbitrage in a bearish market. This will help in proper price discovery.

But SEBI is planning to move cautiously ahead of the introduction of short-selling even as it evolves a mechanism for lending and borrowing securities. To begin with, it may be permitted only in those stocks in which derivative products are available; and only covered short sales will be permitted. Then a cap is likely on the extent of borrowing and lending in a particular stock-it may not be more than 10 per cent of the floating stock. Exposure limits on brokers and clients will also be imposed.

In the past, there have been concerns that the short sales have been used to artificially depress prices-particularly after the 2001 securities scam when it was feared a bear cartel had artificially rigged prices by excessive short-selling following which SEBI had banned short sales. But now analysts feel the Indian markets have matured enough to re-introduce short-selling.