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Allowing
investors to sell shares they don’t own is the most
significant improvement in the Indian equity market
since derivatives were permitted in 2000.
The
Indian regulator’s decision to relax rules on
short-selling from next month is also part of a larger
Asian trend.
For its
top 50 stocks,
Taiwan
last year removed the so-called uptick rule, which is a
restriction on shorting falling stocks. In Malaysia,
where the government had proposed mandatory caning for
short-sellers in 1995, such transactions made a
legitimate return, albeit on a limited scale, in January
2007.
South Korea’s
market for borrowing and lending securities—crucial to a
short-sale regime—has already matured.
It’s now
India’s turn to give up its mistrust of short-sellers as
a destabilizing force and embrace them as a key
ingredient of a healthy market.
As of
now, only individual investors in India are allowed to
sell short in the cash market, betting that a stock will
fall.
Institutional investors have been denied this
flexibility since March 2001.
Not just
that. The Indian regulator made it a point to conduct
detailed inquiries into even the smallest infringement
of the short-sale ban, especially if it happened to have
been committed by a high-profile overseas institution.
Following such an investigation, a unit of Credit Suisse
Group was fined in 2005.
Franklin
Templeton Investment Funds and Halliburton Co. Employee
Benefit Master Trust were given a warning in December
2006 for selling shares—in 2002— in an Indian software
company that they didn’t own at the time of the
transaction.
Quick to
fault
The
amounts involved were small: Franklin Templeton had made
a princely profit of $105 on the trade. Its
short-selling wasn’t even intentional: buy orders had
been executed before the sales were made, but the shares
were yet to be credited into the institutions’ accounts.
The
subaccount of Credit Suisse that was found to have
shorted shares in Reliance Industries Ltd. in December
2002—because of what it claimed to be nothing more than
a trading error—actually incurred a small loss when the
excess shares sold by it were auctioned by the exchange.
Yet,
Credit Suisse couldn’t avoid taking a rap on the
knuckles. “No man can take advantage of his own wrong,”
the regulator said in its order.
That
dictum is more appropriate for the short-sellers’
enemies: the company managers who enrich themselves at
the expense of the hapless shareholders.
Corporate resistance
Short-selling is a powerful weapon against corporate
fraud and misreporting. Unsurprisingly, then, “corporate
India
doesn’t like short-selling,” says Jayanth Varma, a
finance professor at the Indian Institute of Management
in Ahmedabad.
Even
now, “opponents of short-selling have many avenues open
to them to delay, if not block, much-needed reform,”
Varma says on his web site.
There
are several concerns.
Initially, short-selling will be allowed in only about 5
percent of publicly traded securities, which happen to
be the same set of stocks in which investors can even
now express a negative view by either buying put options
or selling futures.
Unless
the list of securities is expanded quickly, interest in
the short-selling experiment may wane.
The
success of the effort will also hinge on the willingness
of large investors to take advantage of stock lending to
earn a higher return on their holdings.
This
participation can’t be taken for granted. Mutual funds
in shallower emerging markets are often reluctant to
lend shares to short-sellers. They are concerned that by
doing so, they may end up contributing to a decline in
the value of their own holdings.
Correct
design
A
December 24 editorial in the Business Standard, a local
newspaper, said the Indian market regulator may have
erred in its decision to establish an exchange-traded
market for stock loans when the practice globally is one
of over-the-counter (OTC) transactions, which are more
flexible.
However,
OTC markets for stock loans are also opaque,
relationship-based and far from perfect.
As Owen
Lamont, a finance professor at Yale School of
Management, has noted in his research, “getting the
borrow,”—the industry jargon for obtaining the stock
loan—can be difficult. “Favored customers stand a better
chance,” he wrote. “There have been reports of
short-sellers exchanging drugs and sex in order to get
the borrow.”
More
recently, hedge-fund managers have grumbled that prime
brokers, as their stock-lending agents, give them a raw
deal.
“A
portion of the hedge-fund market is looking for a
combination of electronic access, transparency and data
from securities lending providers,” Vodia Group Llc., a
Concord, Massachusetts-based research firm, said in
November. “There is reason to think that the age of
electronic bid/offer markets may not be so far off after
all.”
The
Indian model of screen-based securities lending with a
clearing- house guaranteeing against counterparty risk
may well turn out to be a superior one. |
