[Diya and Khushi are students at Gujarat National Law University.]
The Securities and Exchange Board of India (SEBI) issued a circular titled "Framework for Short Selling" on 5 January 2024. The circular introduces disclosure requirements for short selling, restricts institutional investors from engaging in intra-day trading, and prohibits naked short selling. This article delves into the contextual background of the circular and offers an analysis of the regulatory framework governing short selling in the securities market.
Short Selling v/s Naked Short Selling: How are They Different?
In order to understand the contents of the circular, it is pertinent to understand the difference between short selling and naked short selling. While the former is regulated, the latter is prohibited. In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. SEBI defined ‘short selling’ as selling a stock which the seller does not own at the time of trade. Short selling occurs when an investor borrows a security, sells it on the open market, and expects to buy it back later for less money, while pocketing the difference.
‘Naked short selling’ is a type of short selling. The main difference between short selling and naked short selling is that, in the latter case, a trader trades without either borrowing or owning any underlying asset. For instance, “A” makes a sell option of 10 shares of XYZ stock for $100 each, even though he does not actually have them. Later, the stock price drops to $80, and he would make a buy option for 10 shares for $800. “A” then pockets the $200 difference.
This is a riskier and unethical practice because unlike short selling, wherein the trader has first borrowed a stock, here the existence of stock cannot be guaranteed. The aim is to profit from a decline in the asset price by later buying the shares at a lower cost to cover the short position. This practice can lead to multiple defaults in delivering securities at the time of settlement and contributes to market volatility.
The Adani-Hindenburg Backdrop
The circular comes in light of the recent judgment delivered by the Hon’ble Supreme Court of India (SC) on 3 January 2024 in the Adani and Hindenburg controversy. The legal fight between the two began when Adani Group urged the SC to investigate the accusations that were leveled against them by a report published by the Hindenburg Research Corporation. The report accused the group of stock manipulation, accounting fraud and other irregularities. In its report, Hindenburg Research admitted to taking a short position in the Adani group through US-traded bonds and non-Indian traded derivative instruments.
The SC expressed its concern over the volatility created in the market by the short trade entered by Hindenburg, underscoring that though volatility is an inherent feature of the market it becomes a matter of concern when it has wide ramifications. Consequently, the court directed SEBI to enhance a robust regulatory framework for short selling trades.
Key Features
The circular swiftly followed the SC's verdict. Short selling has been a practice in the Indian markets since 2008, coinciding with SEBI and Reserve Bank of India’s announcement relaxing the ban on short selling imposed in 2001. This move received accolades for aligning with global trends, emphasizing a robust push for liquidity.
Reiterating the framework outlined in the master circular dated 16 October 2023, the SEBI circular provided clarity on short selling regulations. While permitting short selling for all investors, the circular expressly prohibited the practice of naked short selling. In a bid to enhance accountability, stock exchanges were entrusted with the authority to formulate uniform deterrent provisions. These provisions empower exchanges to take appropriate action against brokers failing to deliver securities at the settlement, acting as a significant deterrent against such failures. Simultaneously, the circular advocated for the implementation of a securities lending and borrowing scheme, designed to promote short selling and improve overall market dynamics.
Furthermore, the circular imposed a restriction on institutional investors, mandating them to refrain from engaging in day trading. Institutional investors are now required to square off their transactions intra-day, with all transactions grossed at the custodians' level. The obligation for institutions is to fulfill their obligations on a gross basis.
Additionally, the circular ensures that all securities traded in the futures and options segment are eligible for short selling, with SEBI reserving the right to periodically review the eligibility of securities. Against the backdrop of the Adani-Hindenburg tussle, SEBI introduced more stringent mandates on the disclosure of short sales. Institutional investors must now disclose, at the time of placing an order, whether the transaction is a short sale. In contrast, retail investors have the flexibility to make a similar disclosure by the end of the trading hours on the transaction day.
Taking transparency further, the circular mandates that brokers collect details on scrip-wise short sell positions. Brokers are then obligated to collate this data and upload it to the stock exchanges before the commencement of trading on the following trade day. This information will be consolidated and disseminated by the stock exchanges on a weekly basis, enhancing market participants' access to timely and relevant data.
Analysis
The circular underscores a renewed commitment to regulation and heightened disclosure standards by SEBI concerning short trades.
First, a distinctive aspect highlighted in the circular is the imposition of a ban on day trading for institutional investors. Therefore, upon analysis, it can be understood that, the said ban, only with respect to institutional investors, is not expected to have major ramifications. This is because short sales are more popular among retail investors rather than institutional investors, hence while in theory, it offers changes, it would not have practical impact.
Second, SEBI has introduced the said mandate only for trade in the Indian stock markets; its implications do not extend beyond India. Given that Hindenburg Research Corporation is an American investment research firm that traded in American bonds and non-Indian derivative instruments, the parameters within the circular would not be of much use in preventing a recurrence of such an incident.
Third, the importance of short selling in the market cannot be undermined. SEBI’s discussion paper on short selling elucidates that short selling is a desirable and essential feature of a securities market, not just to provide liquidity, but also to help price corrections in overvalued stocks. Therefore, it is recommended that the liberalization of the short market should not be hindered by excessive regulation. The risks of manipulation and fraud are not exclusive to the short-side market but also apply to the long-side market. Consequently, downsizing one part of the market would not be ideal, as this could cause untimely maturity of the short sale market in India, curbing liquidity.
Conclusion
From the above analysis and discussion, one can infer that overregulation of short selling market is undesirable. It is merely a short-sighted solution. Short selling has positive impact on the market. It is an efficient way of price discovery. It provides both positive and negative public information about a stock's true value by allowing investors to express views on a company's prospects. It also positively impacts overall market quality through improvements in market liquidity. When a short-seller offers borrowed stock for sale, it adds to the volume of the market. Stringent regulations may discourage certain market participants, including institutional investors, from engaging in short-selling activities. This could limit the diversity of market participants and perspectives, potentially hindering the overall health and efficiency of the market.
In total, there is a clear imperative to prioritize the improvement of enforcement efficiency within the short market. While the current circular represents a positive stride in establishing a robust framework, it is crucial not to misconstrue it as an endorsement for overregulation. Striking a balance between effective regulations and fostering a conducive environment for market dynamics is key to sustaining a healthy and resilient financial landscape.