1The author wishes to acknowledge the financial assistance by National Stock Exchange under NSE Research Initiative. The views expressed and the approach suggested are of the author and not necessarily of NSE. This article is published here with the permission of Dr. L. C. Gupta
The Society for Capital Market Research and Development, and former Member, SEBI
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In India, the need for introducing regulation of short sales her been felt for many years but no tangible progress has been made in evolving such regulation. In order to understand the regulatory problem, one needs some foundational knowledge. The concept of short selling, its desirability or otherwise, its effects on the market and the economy and its appropriate regulation, are matters which are not generally understood in India. This study begins by providing a theoretical foundation for understanding the various aspects of short selling in a systematic way distinguishing between its legitimate uses from abusive uses. Its regulation has to be designed to prevent the abusive uses.
A short sale is a sale of securities which the seller does not own at the time of effecting the sale. The U.K. and the U.S. represent two diametrically opposite approaches to the regulation of short sales. The U.K. never had, nor felt the need, for any regulation of short sales till now. In the U.S., on the other hand, the need for short sales regulation was felt very acutely in the depression period after the October 1929 stock market crash. The U.S. Securities and Exchange Commission (SEC), established in 1934, introduced short-selling regulation in 1937 as a very crucial component of its securities market regulation.
The study brings out the distinctive characteristics of the London Stock Exchange (LSE), specially in order to understand why it felt no need to regulate short selling.
Upto early 1994, London had a fortnightly settlement system. India too had a fortnightly system. Many people are mistakenly under the impression that India's and U.K.'s fortnightly settlement systems were similar. It was not so. All trading of LSE was always delivery-based even when it had fortnightly settlements before adopting rolling settlement in 1994. In contrast, in India, deliveries were only about 10% of the trading volume. Such a huge difference explains why the Indian stock market had recurrent cries throughout, but it was nothing like that in the U.K. Further, while London was able to change to rolling settlement system since 1994 smoothly and without resistance from brokers, the rolling settlement was stiffly opposed by the brokers community in India.
Our analysis brings out that the quality of stock exchange's governance is the most important differentiating factor among the stock markets of the world. In the U.K., apart from the London Stock Exchange's traditional conservatism, the usual surveillance and disciplinary measures by exchange authorities themselves have sufficed to stop abuses, like price manipulation and over-speculation. On the other hand, in India, the governing bodies of broker-controlled exchanges have been extremely lax throughout. The comparison of the historical evolution of stock market of U.K., U.S. and India made it clear that the most critical factor, which made all the difference to the regulatory structure and its effectiveness, was the quality of governance of the stock exchanges.
The U.S. before 1930s and India even today represent failure of governance of their exchange. After the creation of the Securities and Exchange Commission (SEC) in 1934 in the U.S., the New York Stock Exchange (NYSE) and other exchanges were brought under SEC's supervision. Among the first acts of the SEC was to change NYSE's governance structure. India is still struggling with this problem.
The study goes into the evolution of shortselling regulation in U.S. The SEC, which was created in 1934, designed its shortselling regulation to achieve the objective of allowing relatively unrestricted short selling in an advancing market but preventing short seller from, accelerating a declining market.
The SEC Rule 10a-1 prescribes that short-selling is permitted at a price as defined below:
At a price At the last sale price if it is higher than the last different price (zero-plus tick.)
This rule, known as “tick-test”, is linked to the last reported market price. In no case in any short sale permitted below the
The SEC rule also requires that every short sale transaction has to be disclosed up-front to the dealing broker who is held responsible for ensuring that the transaction does not violate the tick test. This prevents surreptitious short selling.
An important merit of the U.S. system of short selling regulation is that the regulator is not required to prove short seller's intent or motive of abuse, even though it is designed specifically to strike at the abuse. Proving intent is always difficult, often impossible. The administrative distraction is also entirely excluded under the tick test.
In India, the High Powered Committee on Stock Exchange Reforms (1984–85) for the first time expressly stated that India needed short selling regulation on the U.S. pattern because of serious weakness of the governance of stock exchanges. This supports our point about the critical importance of the quality of stock exchange governance. The Committee found that speculative activity in Indian stock market was excessively high on both bull and bear sides. This is indicated by the fact that only a minute fraction (around 10–15%) of the total trading volume in India is delivery-based. Strangely, as per NSE data, deliveries continue to be almost at the same low level even after the adoption of rolling settlement system. There is need for looking into the persistence of such a low level of deliveries in India.
In late 1996, due to prolonged depression in the stock market, the need for controlling bear-side speculative activity began to attract special attention. The SEBI appointed the B.D. Shah Committee to recommend a suitable system for regulating short selling. The Committee came up with the idea of “differential margins”, i.e. charging a higher margin during market's declining phase on daily outstanding short sale position than on long purchase position and doing the opposite during a bull phase. Our detailed examination shows that the Committee's recommendations were perfunctory and of not much value.
On the basis of our detailed examination of the provisions of the U.S. short selling regulation and its long history of working for over 60 years, we are convinced that the tick-test of the U.S. type would be the ideal way of regulating short selling in India. To improve it further and simplify its implementation without reducing its effectiveness in the least, we are suggesting an important change in the benchmark price to be used for its application in India. The proposed change is explained below.
We suggest the use of closing price of the preceding day as the benchmark for applying the tick test in India instead of the last reported price available at the time of short sale on the transaction day itself. The use of preceding day's closing price would make the regulation more effective and simpler. There are two weighty reasons in favour of our suggestion. Firstly, it becomes difficult to apply the tick-test on the basis of the last reported price at the time of short sale in an environment of quick, and sometimes violent, up and down intra-day movements. Secondly, it can be argued that the successive intra-day price movements cannot really be regarded as indicating a declining or rising market trend, which the tick-test formula is intended to distinguish.
From the viewpoint of ensuring compliance and preventing manipulative use of shortselling, we consider that the upfront identification of every short sale transaction is absolutely essential, as in the U.S. It is not at all valid to argue that upfront disclosure is not possible in India. If the U.S. could implement it over 60 years ago when modern technology was not even available, why can India not do it today with state-of-the-art technology? The study has also suggested a regular system of reporting “short interest”, i.e. scrip wise aggregate outstanding short sale positions on daily basis.
We suggest that the short selling regulation should apply generally to all listed shared subject to certain practical consideration, like availability of trading price and traded volume data on regular basis. The Shah Committee scheme arbitrarily covered only 15 most actively traded scrips.
Undoubtedly, the absence of short selling regulation in the speculatively surcharged atmosphere of the Indian stock market has been a critical regulatory gap. This should be filled. At the same time, we feel that without regulating the bull-side excesses also, not much can be achieved by shortselling regulation alone. The Indian stock market has suffered because it had no forward-looking and systematic regulation of both bull and bear-side excesses. We must plan to regulate both on a consistent and well thought out basis and not haphazardly on ad hoc basis from day to day, as till now.
It is absolutely necessary that the shortselling regulation should be operated along with margin trading regulation. In our opinion, the minimum initial margin for margin trading should be 50%. While the short selling regulation would help to control bear-side (down-side) speculative excesses, the initial margin for margin trading in share will be incremental in controlling the bull-side (up-side) speculative excesses. A regulatory system designed in this manner can acquire the automatism of thermostat control.
