Short selling by FII

Institutional Investors : Enter Short Selling

Sebi's decision to allow short selling by institutional investors is expected to not only help reduce market volatility but also facilitate better price discovery for investors.

This (move) will enable FIIs and domestic institutions to hedge their risks. It will also help contain volatility and create a deeper market.

- Andrew Holland,
Managing Director,
DSP Merrill Lynch.

Soon, short selling (the strategy of selling a stock without actu- ally owning it) will become a reality for institutional players like Foreign Institutional Investors (FIIs) and mutual funds as they have long since craved for a level playing field (with retail investors) and a mechanism to hedge their risk in the spot market; institutional investors, at the moment, can hedge their risk only in the derivatives market. "Allowing MFs to short sell will have a threefold impact. It will deepen the market, will provide better options to find houses to execute their views and strategy and, most importantly, it will offer investors a wider range of products," said Pankaj Razdan, Managing Director, ICICI Prudential AMC. To begin with, the institutional investors would be allowed to go short only on a universe of the same 159 stocks in which derivatives trading is allowed. Another rider is that these large investors also have to pay margin money like retail investors do; institutional investors are exempted from paying margin money in the spot market, so far.

The news has been received well by large investors including hedge funds, the largest users of the short-selling approach, as well. Sebi's intention to move towards introducing a system that allows short selling is good because it will create more liquidity and deepen the market.

While India has emerged as the favorite destination for FIIs, they will get that extra fizz with Sebi opening the doors for short selling. Apart from them, even the domestic retail investors are likely to get the benefit of carrying forward the short position, which was hitherto not offered to them. As of now, they have to square up the trade (by buying the equivalent amount of share sold on the same day). While it sounds great, there are nonetheless some concerns as skeptics feel that institutional short selling will worsen the situation instead of minimizing volatility.

Taming volatility

The Indian markets have undergone many changes since the ban of short selling in 2001. The contribution from domestic and foreign investors has dramatically increased, resulting in a big take-off by the derivatives market. Further, the indices have consistently moved upwards since mid-2003 and to touch 14,500 in early 2007. However, the rise has also been characterized by much volatility. The sharp run-up in the market has created big worries in the minds of the investors. Increased volatility has, however, forced the regulators to allow institutions. Therefore, Sebi finally approves institutional investors to indulge in short selling in March 2007. It will act as a balancing factor to maintain the market equilibrium as the initiative would improve the economic performance by injecting liquidity, thus helping to reduce volatility and checking undue price rises in the market. Sandesh Kirkire, CEO, Kotak Mahindra Asset Management Ltd., said, "It will enable institutions to take advantage of both sides of the market—rising and falling. Earlier, investors could only use the derivative route to hedge their portfolio when markets fell. This move will allow institutions to participate in a falling market." As well, Jayanth R Varma, Professor, IIM-Ahmedabad, said, "Allowing institutional investors to sell short will act as a kind of resistance when the market moves in one direction. In the short run, it may cause some volatility, but in the longer run, it will definitely help in curbing volatility and improve price discovery."

Some glitches yet

According to Sebi, initially short selling would be restricted to only 159 liquid stocks for which derivative trading is allowed. However, it is a negligible number for the Indian bourses. Justifying its move, Sebi's Chairman, M Damodaran, reasoned, "When you do something new like this, it is important to make sure that the system stabilizes first. To begin with, the 159 derivatives stocks are a good starting point. Once the system stabilizes, the facility can be extended to more stocks."

In another first, unlike in the past when institutions did not have to pay a margin while trading at the stock market, but now those opting for short selling have to pay margin money at the same rate that the investors pay. However, in another initiative, Sebi has also brought the benefit of freeing institutions from Securities Transaction Tax (STT) if they are going to be lenders, attracting more number of sellers of security into the market. "Introduction of short selling settled by delivery and securities lending and borrowing to facilitate delivery by institutions will help enhance the depth of the capital market and the flexibility for the participants and provide total mechanism for the market price discovery," said Nimesh Kampani, Chairman, JM Financial Group.

Sebi is likely to widen the scope of the lending and borrowing scheme for the institutional investors. For this, the market regulator is going to approve more entities by identifying the potential lenders in the market. Big institutions like LIC, GIC and PSB need to get the board's approval if they want to lend their shares. It is a big opportunity for institutions because the lender can lend the stock rather than keep it idle. Moreover, there is no possibility of short-term uncertainties while it can be avoided through short selling by investors. In the case of foreign investors, Sebi shall put an obligation of borrowing shares through Securities Lending and Borrowing (SLB) mechanism.

India can take a leaf out of other countries' books regarding the same. Commenting on Sebi's approval to create the opportunity for institutional investors, Alan Burr, Principal Consultant, Etheios, said to HedgeWeek, an online news publication, "The ability to short sell, however, will enable hedge funds to gain the market access they desire, but first the market will need to provide certain infrastructure measures to accommodate this. This will require banks, prime brokers and custody providers to set up an effective stock lending and borrowing facility." These kinds of concerns would definitely pop up, since the markets abroad are much mature and the investors in these markets are big in size unlike the Indian investors trading in individual stock futures. "It is a good measure, but details of stock lending and how it is going to work are going to be very important," said Falguni Nayar, Managing Director of Kotak Investment Banking. "It is a big deal for us to be able to put them in place too. We have to study it right, and Sebi has to implement something that works easily, especially for investors," she added. Therefore, with a detailed study of markets, effective procedural and technical guidelines can be prepared, which are easy to implement.

Road ahead

The proposal by Sebi allowing institutional investors to short sell equities is likely to change the market dynamics by helping the investors to hedge their market risks more effectively. Ajay Bagga, CEO of Lotus India Mutual Fund said, "Overall, this is a good move to improve market efficiency. Short selling is a part of all developed markets in the world. It will lead to greater market depth. However, guidelines from Sebi are awaited for trading." Experts say that an ideal plan will help to develop an effective lending and borrowing mechanism with the much needed length and breadth in the Indian capital market. "The bottom line is that short-selling is a good thing for Indian investment. It gives investors a proven mechanism for hedging risk and over time should attract more capital to India and ultimately reduce volatility in that market," said Michael Purves, Partner and CFO, Hudson Fairfax Group. However, for now, it is welcome back short selling. How far the market depth will improve can only be identified once the guidelines are announced.

- Amit Singh Sisodiya and Kavitha Putta