Ban on Short Selling in a Market Crisis: The Right Call?
[This post has been authored by Arnav Maru, fourth-year B.A. LL.B. (Hons.) student from Maharashtra National Law University Mumbai ]
CoVID-19, better known as the novel coronavirus, hit the Hubei Province in China in the early days of December 2019. However, it was not until mid-February that the rest of the world realized the pandemic scale of the outbreak. The USA had a mere 15 positive cases tested until February 13, 2020. On March 20, 2020, the USA had confirmed 14,366 cases with 217 fatalities, sending the country and its economy into a partial lockdown. In the seven-day stretch between February 24 and March 3, short sellers made $51.3 billion in market-to-market profits, riding on a nose-diving US economy. The S&P 500 fell by 10.02% in the same period. Similarly, the BSE Ltd. benchmark, Sensex, has crashed 18% in the month of March alone. Amidst the pandemic panic and fears of a worldwide recession looming, Securities and Exchange Board of India (“SEBI”) has considered banning the market practice of short selling to try to rescue the falling market. The focus of this post will be to, first, acquaint the reader with what short selling is, its history in the Indian capital markets, the current position in law, and SEBI’s action to regulate the practice amidst the prevailing conditions.
What is Short Selling?
Short selling, or shorting a stock, is an investment strategy that relies on an expectation that the price of the concerned stock will decline in the future. SEBI defines a short sale as a “selling a stock which the seller does not own at the time of trade”.[i] Put simply, short selling is a process where a person X borrows shares of a company A from the market and sells them to person Y, in the hopes that the price of the shares of A will fall below the present level. When (and if) the prices drop, X will buy the shares from the market at the prevalent (lower) price and return them, closing his position, and turning a profit. This is sometimes seen as the exact opposite of holding a long position, which is the conventional practice of buying shares and holding them with the expectation of an increase in value. Both short and long sales happen on regular trading platforms, with the process of borrowing and lending shares being handled behind the scenes by the stock brokers and market intermediaries.
Brief History and Current Position
The Bombay Stock Exchange followed a badla system of trading up until the year 2000.[ii] The High Powered Committee on Stock Exchange Reforms (1984-85) observed that the “pattern of trading where there is no prior commitment to compulsorily make payment for shares purchased and to give delivery of the shares sold, leads either to excessive buying by bulls or unwarranted large selling by bears.”[iii] The committee was also of the opinion that the badla system was very conducive to short selling and hence prone to disproportionate speculation, and bull and bear side excesses. With the advent of liberalization in India and an increased focus on the stock market for economic growth, economic reformers felt that the badla system and short selling had to be regulated to protect the market. Hence, a rolling system of settlement was proposed, in place of the carry-forward system. SEBI mandated a t+5 settlement period in 2001 and moved to the present day t+2 settlement in April 2003.
A brief ban on short-selling was imposed in the year 1998 amid increased volatility, but it was lifted shortly. Another five-month ban on short-selling was imposed in 2001, where all transactions had to be backed by a delivery. This was also preceded by extreme volatility in the markets.
The current regulation on short selling in India is encapsulated in SEBI’s Circular dated December 20, 2007. This circular permits all classes of investors to engage in short selling. It prohibits naked short selling, which means that all investors mandatorily need to honor their obligation to deliver the securities at the time of settlement. The implication is that short selling may only be carried out on a strictly intraday basis in Indian cash markets. The circular mandates stock exchanges and intermediaries to frame regulations to take appropriate action against brokers who fail to deliver before the settlement deadline. An upfront disclosure of a short sale is also required to be given by the investor to the exchange.
Effects on a falling economy
The US and its securities watchdog, the Securities and Exchange Commission (“SEC”), have enforced regulation on short selling since 1937.[iv] The US rule allows for short sales when the scrip in question is in an upward trend. A short sale is, therefore, allowed at a price above the last ‘tick’ or the immediately preceding sale. The regulation serves a dual purpose of preventing manipulative short selling and protecting scrips from speculators in downward moving markets. Thus, the underlying assumption is that short selling will have an adverse impact on a downward trending market. Similarly, various committees set up in India on the subject have suggested measures with an implicit assumption that short selling has a general ability to further push down a falling market. For example, the B.D. Shah committee recommended charging a higher margin on daily outstanding short sale positions than on long purchase positions. The Dave committee, in 1997, suggested differential margins in the ratio of 3:1 respectively on bears and bulls in a falling market and in a reverse ratio in a rising market.[v] The most recognized shortcoming of short sales is a “bear raid”, where equity security is sold short in an effort to drive down the price of the security by creating an imbalance of sell-side interest. [vi]
On the other hand, short selling also helps market efficiencies in two key ways. First, short-sellers offset temporary imbalances in supply and demand for securities and provide liquidity. Second, overvalued stocks are corrected when short-sellers seek to profit from the divergent price of the stock as opposed to its true economic value. Further, the practice of short selling finds support in the free market hypothesis, which forms the basis of most modern-day economies.
SEBI’s action banning short sales
Various news reports have speculated that SEBI plans a temporary ban on short-selling to curb market volatility.[vii] If the ban is implemented, SEBI will have acted in tandem with its European counterparts in countries such as France, Italy, Spain and Belgium, who have imposed a strict ban on short sales. The USA, UK and Germany have, on the other hand not taken any such measures.
A ban on short-selling would, however, be undesirable. The two above listed benefits of short selling also act as two of the strongest arguments against a ban. That is to say, a ban on short-selling would interfere with natural price discovery, and reduce liquidity. Further, there is no evidence to suggest that a ban on short-selling stabilizes falling stock prices. The 2008 market crash is a case in point. The SEC placed a temporary ban on short sales when the crisis hit Wall Street. After a brief rebound, the stock prices continued to fall, even when the ban was in place. It is also important to note that even in the 2008 recession, SEBI did not impose a ban on short sales.
In a press release dated March 20, 2020, SEBI undertook certain measures to tackle the volatility by tightening the path to making short sales. SEBI raised the margin requirement for the cash segment, required traders to have more capital to play in the market, reduced the monetary limit for each entity in the derivatives segment, and increased the penalty for flouting position limits.
Since the introduction of the curbs, the markets world over have shown an upward trend, while Indian markets have shown to be outliers, with the Nifty 50 dropping about 5%. Commentators have cited the ban-induced decrease in liquidity as a reason for the drop, but the true picture will only be seen in the course of time when the volatility of the markets begins to settle.
[i] SEBI’s Discussion paper on Short Selling and Securities Lending and Borrowing. The paper can be accessed here. [ii] The Business Line Article titled “Badla and single stock futures” provides a concise overview of badla trading. It can be accessed here. [iii] Report of the High Powered Committee on Stock Exchange Reforms (Ministry of Finance, Government of India, 1986), para 7.66 [iv] Section 10a of the Securities Exchange Act, 1934 regulates Short Sales in the USA. The rule adopted is also known as the up-tick rule. The Act can be found here. [v] NSE Research Initiative, Paper no. 12, Short Selling and its Regulation in India in International Perspective, by Dr. L. C. Gupta. The paper can be found here. [vi] The SEC Concept Release on Short Sales recognizes this. The note can be found here. [vii] The Business Standard, Economic Times, and the Business Insider have reported the consideration, citing sources close to the regulator.