[By Vikas Saran & Pritha Lahiri]
The authors are students of Institute of Law, Nirma University.
Overview:
In the dynamic landscape of securities trading, the contentious practice of short selling has emerged as a focal point of regulatory scrutiny. In response to the Adani Hindenburg fiasco and in alignment with the Supreme Court directive in the matter of Vishal Tiwari v. Union of India, the Securities and Exchange Board of India (SEBI) has introduced new regulations to address the risks associated with short selling.
The regulatory intervention reflects SEBI’s strategic approach of preventing, detecting and deterring, and underscores the importance of a balanced regulatory framework.
This article presents a detailed analysis of the recent framework introduced by SEBI. It provides insights from both domestic and international perspectives, offering a comprehensive examination of the regulatory landscape. Additionally, the authors offer innovative strategies for future improvements within this framework.
Revisiting SEBI Guidelines:
Regulation of short selling is not new in India; in 2007, SEBI introduced the first set of regulations on short selling, titled, “Circular on Short Selling & Securities Lending and Borrowing” wherein it defined short selling as the “practice of selling a stock which the seller does not own at the time of trade”. All classes of investors were permitted to short-sell with certain disclosure requirements put in place to ensure transparency. Pertinently, naked short selling, involving selling shares that have not been borrowed or even confirmed to exist at the time of the trade was not allowed by SEBI.
Fast forward to 2024, SEBI has overhauled its 2007 circular, integrating it into the “Master Circular on Short Selling and Securities Lending and Borrowing Scheme”. The new framework provides for:
- Inclusivity in Market Participation: The framework democratises the short-selling arena, extending the privilege to both retail and institutional investors alike.
- Prohibition of Uncovered Short Selling: In a bid to ensure the integrity of market transactions, the framework categorically proscribes the practice of naked short selling.
- Restrictions on Day Trading for Institutional Investors: Institutional entities are enjoined from day trading while engaging in short selling, with an imperative to satisfy their delivery commitments.
- Transparency as the Bedrock: The framework institutes rigorous disclosure mandates, requiring institutional investors to declare their short selling positions at the juncture of order placement, while retail investors are accorded a grace period extending to the trading day’s end.
- Dissemination of Short Interest Data: Brokers are tasked with the daily aggregation of short-sell positions, which are subsequently reported to the stock exchanges. This data is synthesised and released on a weekly basis, enhancing the market’s transparency quotient.
In its recent circular, SEBI has synchronised the framework for short selling, detailed in ‘Annexure 3’ of Chapter 1 of the Master Circular, with provisions from the rescinded SEBI 2007 circular. Notably, this has not yielded any material changes because the recent framework essentially replicates the structure and guidelines established by the earlier framework. Therefore, while the regulatory process was updated and streamlined, the substantive rules governing short selling remained largely unchanged.
However, the Expert Committee established by the Supreme Court, after the Adani Hindenburg episode, had suggested a proactive regulatory intervention. It had emphasised using market events for enhancements, inviting SEBI and the Indian government to engage in proactive improvements aligned with market dynamics.
This suggests that while SEBI’s recent circular revision reflects a commitment to regulatory stability, there is still scope for refinement and enhancement in certain aspects of the framework.
A Global Perspective:
To gain a comprehensive understanding of SEBI’s regulatory approach, it is essential to explore international practices and their potential impact on India’s securities market landscape.
United States
The US has a long history of regulating short selling, overseen by the Securities and Exchange Commission (SEC). Regulation SHO, implemented by the SEC in 2010, includes measures to limit manipulative short selling. Rule 201 mandates trading centres to enforce price limits on short sales during significant price drops.
Furthermore, Regulation SHO Rules 203(b)(1) and (2) establish ‘locate requirements’. These rules require broker-dealers to confirm that a security can be borrowed, guaranteeing its delivery on the settlement date of the short sale.
Recently, Rule 13f-2 was approved under the Securities Exchange Act of 1934, requiring managers with significant short-sale positions to report certain information to the SEC through Form SHO.
United Kingdom
In the UK, short selling is governed by the Short Selling Regulation (SSR) of 2012 which applies to financial instruments and sovereign debt traded in the UK. Key provisions include:
Notification Requirement: Holders of significant net short positions in shares or sovereign debt have to notify the Financial Conduct Authority (FCA) upon reaching specified thresholds.
Public Disclosure: Investors who hold significant net short positions in shares are mandated to publicly disclose these positions once they cross certain predefined thresholds.
Restrictions on Uncovered Short Positions: The SSR outlines restrictions on investors entering into uncovered short positions in shares or sovereign debt.
Exemptions: Stabilisation activities and market makers meeting specific criteria may apply to the FCA for exemptions from uncovered short-selling restrictions and notification requirements.
FCA Powers: The FCA has the authority to restrict short selling in specific situations to prevent disorderly price declines and threats to financial stability.
The SSR exempts sovereign debt and CDS from uncovered short-selling restrictions and notification requirements, aligning with the government’s stance. Once implemented, there will be no such restrictions or notification obligations for these instruments.
Singapore
In Singapore, the Monetary Authority of Singapore (MAS) regulates short selling through its Guidelines on Short Selling Disclosure under Section 321 of the Securities and Futures Act, 2001. The Central Depository (Pte) Limited (CDP) addresses settlement disruptions via buying-in processes, with costs and penalties for sellers failing to deliver securities. The SGX-ST conducts surveillance to prevent market abuse.
The SGX-ST’s rules mandate disclosure for sell orders: Rule 8A.3.1 requires market participants to indicate if an order is a short sell. Rule 8A.5.1 necessitates reporting short sell order volumes before each market day. Additionally, Rule 8A.6.1 allows for the correction of erroneously marked sell orders.
While the regulatory frameworks in the US, the UK and Singapore share common objectives of maintaining market integrity, there are differences in specific provisions and enforcement mechanisms. For example, the US emphasises pre-trade verification of securities availability, while the UK focuses on post-trade disclosure of short positions. Singapore’s framework emphasises real-time monitoring and reporting to ensure timely regulatory oversight. These differences highlight the diverse approaches adopted by regulatory authorities worldwide to address the challenges of short selling in securities markets.
Future Trajectory:
While SEBI’s recent regulatory measures are commendable, there is still room for improvement in aligning India’s approach with global best practices. India can explore approaches that balance regulatory oversight and market dynamism:
1. Alternative Trading Systems:
In 2004, the SEC recognised the increasing financial innovation and introduced Rules and Regulations on Alternative Trading System (ATS) or dark pools. These rules aim to facilitate the development of innovative securities trading and other trading markets. The legal and regulatory oversight of dark pools is primarily managed by the SEC. Through regulations like Regulation ATS, the SEC mandates registration for dark pools and disclosure of operational information which enables it to oversee dark pools and verify their adherence to regulatory standards.
Furthermore, in an effort to stop market manipulation, authorities such as the SEC have put in place regulations like Regulation SHO, which require companies to locate and deliver shares prior to short selling. In addition to using data analytics and advanced technology, the regulations enable the SEC to monitor trading activity in real time and identify possible instances of abusive or manipulative trading strategies.
To effectively regulate short-selling activity, India could implement regulatory frameworks akin to Regulation ATS and Regulation SHO. This includes directing short selling platform registration, requiring operational information disclosure, and adopting monitoring systems similar to “Broken Windows” in the United States that use advanced technology and data analytics to detect and prevent market manipulation. ATS can thus offer innovative features and trading mechanisms that cater to the evolving needs of market participants, further enriching the short-selling landscape in India.
2. Transparency and Disclosure Requirements:
Transparency is key to maintaining market confidence and reducing the likelihood of market disruptions caused by undisclosed positions or trading activities. The Financial Conduct Authority (FCA) mandates the disclosure of significant short positions, under the Short Selling Regulation (SSR) by investors, that exceed certain thresholds.
Along similar lines, SEBI has recently stated that institutional investors will have to disclose upfront whether a transaction in shares involves short selling, while retail investors will have to report it by the end of the day when such a sale is conducted. However, public disclosure requirements can expose investors to targeting wherein retail investors may retaliate against institutional short sellers, causing losses, as has been exemplified in the recent Gamestop short squeeze, which ultimately lead to illegal practices like naked short selling and market manipulation.
In this regard, SEBI may take into account the prospect of integrating regulatory compliance tools, such as wizards or checklists, into trading platforms. By offering real-time monitoring and reporting capabilities, these technologies can help regulatory bodies better manage market compliance levels. They can also help investors navigate the disclosure process and make sure they understand and abide by the requirements.
3. Market Making and Liquidity Provision:
Market players ensure market stability by providing liquidity and facilitating smooth trading. Through market-making activities, they absorb buying and selling pressure, reducing volatility.
Exemptions for market makers in short-selling regulations can help ensure continuous liquidity provision without unduly restricting market activities. For example, Section 9 of the Australian Securities and Futures (Short Selling) Regulations, 2018 provides exemptions for market makers who place an order on approved exchange from certain short-selling restrictions to facilitate liquidity provision. Market makers are allowed to engage in short-selling activities to maintain orderly trading and provide continuous liquidity in the market.
By exempting market makers from certain short-selling regulations, India can take a similar tack to Australia. By enabling them to short-sell on recognised exchanges, liquidity would be maintained along with strengthening the resilience and stability of the market.
By adopting agile and innovative approaches, India can ensure a resilient and inclusive financial market that meets regulatory standards while fostering growth and dynamism.
Concluding Remarks:
While the new framework represents a significant milestone in fortifying market integrity and investor trust within India’s securities trading sphere, it is imperative for India to harmonise regulatory vigilance with market innovation. Drawing insights from global practices, India can explore alternative trading systems, amplify transparency, and facilitate market-making to cultivate a resilient financial ecosystem. SEBI’s adaptable and forward-thinking strategy will be essential in managing the changing regulatory landscape, guaranteeing a delicate balance of regulatory stringency and market dynamism. By embracing progressive measures and collaborative strategies, India has the opportunity to emerge as a trailblazer in promoting market integrity while driving sustainable growth and stability in its securities markets.