SHORT SELLING:
"Short selling" is defined as, selling a stock which the seller does not own at the time of trade. Short selling occurs when an investor borrows a security and sells it in the open market on the stock exchange, planning to repurchase the security later, at a price lesser than the price at which the sale was undertaken. The investor aims to profit from a decline in a security's price by borrowing shares and selling them, hoping that the stock price will fall, enabling the investor to purchase the shares back at a lesser price. In other words, sellers sell shares that they do not own, but are instead borrowed from a stock broker, thus opening a position. They sell it at the prevailing market rate, thus shorting the position and wait for prices to drop. Eventually, the sellers need to buy back those shares they sold short, to close such a position.
To enable the mechanism of short selling, the facility of securities lending and borrowing mechanism ("SLB Mechanism" ) has been put in place by Securities and Exchange Board of India ( "SEBI" ), discussed later.
"Naked short selling" is however not permitted by SEBI. In "naked short selling", a seller sells securities without owning, borrowing or securing them. Ordinarily, a seller has to first borrow the security before selling them. However, in "naked short selling", seller sells securities without owning them and subsequently purchases and delivers the security at the then prevailing market price, hoping for a profit. But if the seller can't afford to buy the security or if it is not available, then the chances are that the seller would fail to deliver the security which he first sold at the time of settlement. "Naked short selling" is thus risky because sellers sell the security based on the assumption that they will be able to acquire them, at a lower price before the settlement. Hence all investors are mandatorily required to honour their obligation of delivering the securities at the time of settlement (Covered short selling). Shorting through SLB Mechanism is better, since it's backed by actual shares, unlike in case of a "naked short selling".
SEBI does not permit institutional investors to do day-trading i.e. square off their transactions intra-day. All transactions are grossed for institutional investors at the custodian level, and institutions are be required to fulfil their obligations on a gross basis. The custodians, however, would continue to settle their deliveries on a net basis with the stock exchanges. In terms of the provisions of SEBI (Foreign Portfolio Investors) Regulations, 2019, FPIs are not allowed to short sell, except as allowed under SLB Mechanism of SEBI. Sales against open purchases are not permitted for FPIs and FPIs can sell such securities only after their settlement. Synthetic short activities, where ODIs are issued, which has the effect of short sale in Indian securities, is also prohibited for FPIs. In simple terms, synthetic short spread replicates the risk-reward dynamic of a short stock position. Similarly, in terms of SEBI (Mutual Funds) Regulations, 1996, mutual funds are permitted to engage in short selling of securities, only in accordance with the framework relating to short selling and securities lending and borrowing specified by SEBI.
Institutional investors are obliged to disclose upfront at the time of placement of order, whether the transaction is a short sale and demonstrate their ability to borrow to the satisfaction of the stock broker. Retail investors are permitted to make a similar disclosure before the end of the trading hours on the transaction day. Securities traded in F&O segment are eligible for short selling. Short selling strategies such as: fundamental, technical, short squeeze or event driven; requires thorough risk assessment and proper due diligence, as they have significant level of risk involved. Market sentiment can quickly reverse, resulting in unexpected increase in prices leading to potential losses for short sellers. In market downturns, short selling is a good choice for investors looking to profit from overvalued companies. Potential gains are finite, however potential losses could be unlimited in short selling.
SLB MECHANISM:
SLB Mechanism has been put in place to complement and provide the necessary impetus to short sell. SLB Mechanism is a process through which one can lend or borrow shares from other investors at a specified price. Transactions in SLB Mechanism are for a fixed tenure and has a rate of interest which the lender earns. Borrowers in SLB Mechanism are short-sellers, while lenders are investors who have purchased shares for long-term purpose and which are lying idle in their demat accounts, thus allowing them to earn incremental returns on the portfolio. SLB Mechanism is beneficial to both lender and borrower, since lenders can earn income by lending securities by charging fees to the borrower of securities and it allows borrower to undertake short-selling position or arbitrage. Lender is also eligible for all corporate actions, since the shares which are lent continue to remain in the name of the lender. In SLB Mechanism, the beneficial owner does not change. In case of corporate actions other than dividend and stock split, transactions are closed prior to the ex-date. For dividends, dividend would be collected from the borrower and passed on to the lender at the time of record date. In respect of stock split, the borrower's obligation is revised as per the proportionate split and would be passed on to the lender during the reversal leg. Rationale for borrowing securities could be to take advantage of arbitrage opportunities, or if the seller is of the view that the price of the stock will go down in future or fulfil the obligation to deliver physical securities for F&O trades. SLB Mechanism therefore increases market efficiency by providing liquidity and depth to the market, apart from providing an additional source of revenue to the lender. SLB Mechanism also has the benefit of managing risk and reducing the cost of trading, while enabling investors to take advantage of short-term market movements resulting in effective price discovery.
SLB Mechanism is executed through an Approved Intermediary ("AI") registered with SEBI. Lending and borrowing is facilitated on an automated screen based platform. Participants (trading / clearing members, banks and custodians) are required to quote the lending fee per share on the order matching platform. Orders are executed, if the quotes match on the screen based platform on 'price time priority' on the basis of lending fees and quantity. A participant desirous of lending or borrowing, can do so either on their own behalf or on behalf of its clients. All participants in SLB Mechanism have to deposit margins based on their transactions as computed by the Clearing Corporation. No margins are levied on the lender participant in the return leg transaction. Margins are collected from the collaterals of participant/custodian in the form of cash, fixed deposit or bank guarantee. Tenure of lending and borrowing is available up to a period of twelve months. The platform provides the lender the facility for placing 'early recall' request for the securities lent and provides borrower the facility to make an 'early repayment' of securities and further 'relend' them. Majority of the securities traded in F&O segment are eligible for lending and borrowing. Only securities that are eligible for SLB Mechanism can be lent and borrowed.
An AI is required to enter into an agreement with its Clearing Member / participant for the purpose of facilitating SLB Mechanism. The agreement specifies the rights, responsibilities and obligations of the AI and Clearing Member / participant. Lending and borrowing can be undertaken by the participants, either on their own account or on behalf of their clients registered with them.
A vibrant market for SLB, not only complements short selling in securities, but also enables the investors to earn returns on their idle securities. SLB is an alternatives to derivatives market for the purposes of hedging. Transactions executed under the SLB segment are guaranteed by Clearing Corporations and hence do not carry any counter party risk. SLB Mechanism is an important aspect of Indian securities market, that plays a pivotal role in maintaining liquidity and facilitating investment strategies. The additional returns which the lenders earn in SLB Mechanism may not be possible through the typical buy-and-hold strategy. Thus, instead of leaving securities dormant in their demat accounts, lender can earn fees, which can effectively improve the overall return on their investment portfolios. SLB Mechanism therefore provides lenders to diversify their revenue segment.
The concerned department of SEBI by way of an Informal Guidance has clarified that, considering the nature of SLB Mechanism read with the definition of "trading" under SEBI (Prohibition of Insider Trading) Regulations, 2015 ("PIT Regulations"), the transactions of borrowing / lending done under SLB Mechanism constitute trade, and accordingly no insider shall trade in securities, when in possession of "unpublished price sensitive information" with respect to underlying securities, and such insiders may prove their innocence by demonstrating the circumstances mentioned in the PIT Regulations. In view of the above, all "designated persons" to whom the PIT Regulations apply, should ensure compliance, if they intend to lend securities of listed companies in SLB Mechanism.
SLB Mechanism is a critical component of Indian securities market, and apart from widening & deepening the market, serves variety of needs such as promoting price discovery, infusing liquidity and helping to maintain equilibrium between the futures and cash market.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
