Play time for big boys

When the opening bell rings on the stock exchanges across the country on April 21, it will signal not just the start of another trading day but also the coming of age of the Indian capital markets. That day will see the reintroduction of short selling by institutional investors, albeit in a modified form, after a gap of seven years.

Though the Securities and Exchange Board of India (SEBI) announcement on allowing institutional investors to short sell was made last year and even included in the 2007-08 Budget proposals, it has taken the market watchdog more than a year to come out with guidelines for the same.

While short selling by retail investors has been allowed for a long time, the entry of institutional investors in this segment is expected to alter the market dynamics.

However, institutional brokers say they are still awaiting the fine print from SEBI and are not sure how the issue will pan out.

SEBI's directive To begin with, short selling will only be allowed in the F&O segment All such trades will be margined on a transaction day + 1 (T+1) basis with margin being collected from the custodian upon confirmation of trade From June 16, 2008, collection of margins will be on an upfront basis Maximum duration for securities lending and borrowing (SLB) is seven days and the borrower has to return the securities on T+8 SLB limit not to exceed 10 per cent of free float of equity Institutional investors not allowed to do day-trading While institutional investors will have to disclose at the time of order placement if the transaction is a short sale, retail investors may do so at the end of trading hours on the transaction day

“It’s too early to say what effect it will have on the markets. At first glance, however, it does seem like a positive step and will help reduce volatility on the bourses,” feels Dharmesh Mehta, Head (Equities), Enam Securities.

He says that since most large institutions hold on to their stocks, there is a perennial shortage of stocks in the markets. With short selling coming in, many of these stocks will now be traded in the market.

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But much will depend on how the regulators implement the new measure— in particular, borrowing and lending norms for institutions. “It will be a great step if SEBI allows large institutions and mutual funds to lend. It will be crucial for the success of this measure. They can also deliver better returns to their investors by lending for a profit,” he points out.

Currently, institutional investors cannot short the market and can only trade in shares that they have invested in—short selling was banned in the wake of the Ketan Parekh-engineered scam in 2001.

The new norms will allow them to borrow and lend stocks to other institutional investors for short selling.

The measure has fuelled apprehension that with the big boys of the stock markets playing on the short selling circuit, an already sensitive market—which has lost over a third of its value from its peak in January—may tank further.

Observes Arun Kejriwal, Founder, Kejriwal Research and Investment Services, “If some institutional brokers band together to hammer down a stock, there’s nothing much one can do.

Also, while I feel the step will boost the market sentiment in the long term, how the market pans out in the short term is still nebulous.”

Profit and loss account Advantages: Allows institutions to take a contrarian view of the market and earn even in a downswing Provides for a level playing field for institutional investors as hitherto only retail investors could short sell A long-term investor can use his idle stock to lend and earn revenues on them Will create more liquidity and reduce volatility in the market Stock prices rise much faster and higher after bouts of short selling Will allow for another price discovery mechanism Disadvantages A real fear that institutional investors can hammer down stocks deliberately and, thus, depress the market The time duration for settlement is only eight days.most borrowers would prefer dealing in the F&O segment directly rather than through short selling on borrowed securities Borrower does not get any interest for the margin deposited with the exchange for eight days

However, Kejriwal says that even if the institutional investors do decide to hammer down certain stocks, it will be discovered very quickly by others who will then try to prop up those stocks by buying aggressively. The short sellers can lose a lot of money by playing this sort of a game.The fear, therefore, that allowing institutional investors to short may depress the market further has little basis. “Had the norms come into effect when the Sensex was above 20,000, the new short selling norms would have been blamed for the subsequent market crash, which would have happened anyway,” argues Kejriwal.

According to him, reforms introduced during dull and lethargic conditions are received more positively than in boom periods, when they tend to negate the positive sentiment.

Besides, as both he and Mehta point out, the rebound after a spell of short selling is always fast and furious. “Not allowing the institutions to take a negative view was severely hampering liquidity in the market. This step will create a more level-playing field,” avers Kejriwal.

The move, says SEBI’s Executive Director, Manas Ray, will also allow mutual funds and domestic institutions to lend securities in the market and earn revenues.

“Currently, these two are the biggest stock holders and the lending mechanism can earn them some money,” informs Ray. He is categorical that SEBI will not permit naked short selling—that is, there will be no settlement without delivery.

The securities lending and borrowing will be done through an automated, screen-based, ordermatching platform, which will find the ideal lender for a borrower and vice versa, after both the lender and the borrower upload a quote for the stock and the fee at which they are willing to lend or borrow (see How it Works).

Of course, while this will mean more work for brokers, stock exchanges, too, will need to customise their software to remove any glitches in the operation.

They will also have to make necessary amendments in the regulations for implementing the SEBI directive.

The spin-off for retail investors and HNIs who short sell is that they will be able to borrow securities henceforth, which will enable them to take longer bets.

Currently, retail investors who wish to short sell have to square off transactions during the same day. But like everybody else in the market, they too need to wait and watch before taking the plunge.