[By Zoya Farah Hussain & Vasundhara Mukherjee]
The authors are students of National Law University Odisha.
INTRODUCTION
The volatile nature of the Indian securities market has effected various changes in the regulations overseeing the sector but despite the existence of this structured mechanism, there are numerous trading methods undertaken by investors for profit maximisation. In light of the recent announcement by SEBI, we aim to analyse the phenomenon of one such method, called, short-selling.
In a scenario where an investor borrows shares from someone else, sells them at the current market price, and then buys them back later at a lower price, he can pocket the difference as profit. It’s like betting against a stock’s performance, and it can help bring balance to the market by reflecting both positive and negative sentiments. This is called short-selling. But there is a riskier version called naked short-selling whereinstead of borrowing shares, investors sell stocks they don’t even own. It’s like promising to deliver something you do not have — a practice that can introduce chaos and uncertainty into the market. This creates a potential for abuse and market manipulation, as it generates counterfeit shares that don’t exist.
Short-selling, when done responsibly, can improve market efficiency by reflecting true market sentiment. It adds liquidity and helps in price discovery, but when things get out of hand — especially with naked short-selling — it can wreak havoc. Excessive short-selling can lead to wild swings in stock prices, erode investor confidence, and even destabilize the entire financial system. Here, we understand the possible implications of the recent announcement by SEBI regarding short-selling.
UNDERSTANDING SEBI’s GUIDELINES
SEBI initiated discussions on short-selling in 1996 through a committee chaired by Shri B.D. Shah who defined short-sale as the sale of shares without physical control until settling prior purchases or countering ongoing deliveries. The ban on short-selling was short-lived, as SEBI introduced a Securities Lending and Borrowing (SLB) framework later in December 2007, following recommendations from the Secondary Market Advisory Committee, permitting both retail and institutional investors to engage in short-selling again, with certain conditions.
The Adani-Hindenburg saga unfolded against the backdrop of, Hindenburg, a US-based financial research agency, who short-sold some shares of Adani Group accusing them of engaging in deceptive practices and inflating the value of its companies. Consequently, the ED carried out an investigation directed by the apex court of India which observed that no substantive losses were faced by the investors, implying that SEBI regulations were well in place, but keeping in view the current rise in the stock market trend of price manipulation, SEBI being an independent regulatory authority was directed to formulate further guidelines to ensure a proper framework for short-selling activities so that no investor is at a risk of being victim to violation of market practices.
Making Room for Everyone
This new framework opens the door for a wide spectrum of investors. but with the doors wide open, we also need to be more careful. Novice retail traders entering this complex arena face the risk of exacerbating market volatility and becoming susceptible to manipulative tactics. To ensure a fair playing field for all, SEBI must prioritize comprehensive investor education and diligent monitoring. This step could include understanding the investing capacity and the trading intention of new investors and equipping them with the requisite knowledge of the operations of the market and official financial information of the listed companies, by registered securities educators or mentors, enabling them to make an informed decision.
Cracking Down on Risky Business
SEBI has put in place an important rule: if you’re selling shares you borrowed, you’ve got to deliver those shares. This is meant to stop naked short-selling which is a risky move that can mess with stock prices, just like when Porsche tried to short-sell Volkswagen in 2008. When Volkswagen’s price shot up, Porsche could not deliver the shares it owed, causing a lot of problems for hedge funds and making the market go crazy. SEBI’s mandatory delivery requirement aims to prevent similar scenarios by promoting responsible short-selling and curbing predatory behaviours.
Being Transparent About Trades
SEBI has also mandated transparency through disclosure requirements. Institutional investors have to disclose upfront if they’re making a short sale, while regular retail investors like us have to make a similar disclosure by the end of the trading day. Additionally, brokers have to keep track of all the short-selling positions for each stock and upload this data to the stock exchanges before the next trading day commences.
IMPACT OF THE ANNOUNCEMENT
It’s undeniable that the most recent SEBI short-selling rules have two sides. One may argue that naked short-selling is a good thing for the financial markets. Additionally, they opine that it may enhance the way the securities markets for borrowing and lending operate. The primary contention is that the issue of who serves as the lender is the sole distinction between covered and naked short sales. In contrast to naked shorting, when the lender is the new buyer, covered shorting involves the lender as the present owner of the stocks. It’s possible that this will not have a big impact on determining the fair price, but they also present the counter-argument that the new buyer might not be aware of it and will not voluntarily enter into the lending relationship he/she will not even get paid for it. Nonetheless, the new buyer is in a secure position and may even profit from the interest on the money that is held until the assets are delivered, thanks to the clearing houses’ centre-counterparty arrangement and the option to start the buy-in process.
The suddenness of the share price drop invites investors involved in naked short selling to sell even the unborrowed shares to benefit from it at least in the short-run. This creates competition in the market for security lending by allowing a new buyer to provide the service of being owed the share rather than allowing only the current owner to do so.
Naked short-selling may be good for the financial markets and morally righteous if we believe that competition in the lending market is desirable. This is because it will guarantee more equitable pricing discovery in the securities lending exchange market.
In hindsight, the good-to-go approach for short-selling can have its shortcomings as well. The most frequent argument is that it encourages unethical activity by, for example, disseminating erroneous information about corporations being shorted. The distinction between the tool and the tool’s user might serve as an illustration of this idea. A life insurance, for example, is a highly useful tool but it may be abused if the insured person’s beneficiary chooses to reduce their life expectancy. In addition, while disseminating misleading information may be immoral, advising investors not to purchase an inflated stock is, on the other hand, morally right. In regards to the potential for price lowering, even if the price drops for a little while, other knowledgeable investors will purchase the shares of the company and drive the price back to its usual fair value, if the short-seller was incorrect in his/her judgment. However, if the short-seller is correct, it is evident that controlling the market is morally acceptable.
CONCLUSION
Although short-selling isn’t inherently destabilizing, it becomes problematic when utilized to manipulate markets, particularly targeting stocks favoured by retail investors. This raises an ethical dilemma: How can we safeguard these vulnerable stakeholders without impeding market activity? The current announcement can act as a hooting call for all categories of investors where the statures of each one of them would be highly varied. In such a situation, it becomes important for the regulatory authorities to take some steps towards assuring the safeguard of all investors, especially the ones who are smaller in size and are affected by any monopolistic activities of big institutional investors. In sight of this, the first step could be making a one-stop-grievance-redressal mechanism, or investor-care lines which will work to ensure liquidity of shares while addressing anti-competitive moves in the market.
This initiative could entail one-stop services and toll-free call options for any investor aggrieved by unfair practices happening in the market due to any exploitative steps taken by any influential investor(s).
Furthermore, short-selling surely is a risky practice to be carried out hence, investor-education platforms can be institutionalized or encouraged so that smaller investors do not fall prey to the waves of the market. Short-selling undoubtedly is a double-edged sword that can act both as a boon and a bane and in light of this, SEBI and other regulatory authorities involved should be more vigilant towards any exploitative methods being employed. Current regulations such as SEBI’s (Issue of Capital and Disclosure Requirements) and (Listing Obligations and Disclosure Requirements) aim to protect investors by promoting transparency. However, these measures often fall short of shielding retail investors from their emotional responses and the anonymity institutional investors provide to manipulative entities. The aspect of naked-shorting in light of the recent turbulence in the exchange market is better off the books but in the near future if the trading health of the investors and the conducive environment of the market permits it in favour of the overall well-being of the Indian stock system, then the concept of controlled naked short-selling can be introduced given its hidden benefits.