Do you recall the infamous ‘2021 Gamestop episode’ in the US? To recap, hedge funds and institutional investors had borrowed Gamestop shares, expecting the stock price to decline and intending to buy back the shares later at lower price—a practice known as short-selling. Retail investors on an online platform noticed this and collectively bought Gamestop shares, driving its price endlessly higher. In other words, retail investors triggered a short squeeze (rapid increase in price of stock, increasing the loss of short sellers). This episode led to market volatility, manipulation and questions about market fairness.
Since 2021, the US Securities and Exchange Commission (SEC) has been investigating short sellers involved in Gamestop saga. Subsequently, in October 2023, it issued rules requiring institutional investors meeting a certain threshold to report short positions to the SEC; and the companies lending out the shares to report it to FINRA, the US self-regulatory organization. The SEC will aggregate the scrip-wise data and disseminate it on delayed basis to maintain confidentiality of the reporting fund managers. However, few hedge fund groups filed a lawsuit against these rules. They asserted that the SEC’s stance of delayed sharing to maintain confidentiality and simultaneously mandating individual daily disclosure of securities loans (“serve as a proxy for short-sale activity”) are contradictory.
In the Indian context, however, “short selling” framework with disclosures have been laid down since 2007. Naked short selling is not permitted in India; intra-day trading for institutional investors is prohibited; and ‘short selling is permitted in F&O stocks’. Market regulator Sebi has reiterated its short selling framework with emphasis on disclosures: (a) First, institutional investors are required to make upfront disclosures regarding short sales during order placement, while retail investors must disclose by the end of the trading hours on the transaction day. (b) Second, brokers have been mandated to collect details on scrip-wise short-sell positions, collate the data and upload it on stock exchange platform before commencement of trading on the following day.
The stock exchanges have been publishing scrip-wise short-sale quantity on a daily basis; however, data reporting with above mentioned bifurcation would lend more credibility and aid informed investing. Thus, a key takeaway for investors is to examine short-selling data before entering into new trades. Perhaps, integrating the short-selling metric (short-ratio) as an early alert in trading systems when initiating trades could be useful. These measures would prove beneficial in curbing fraudulent activities. Additionally, market infrastructure institutions should develop systems for monitoring various forms of short selling, reducing reliance on brokers for data uploads. Perhaps this could be achieved through decentralized stock markets and adoption of blockchain technology.
A discussion on short-selling provides an opportunity to educate investors about the availability of securities lending and borrowing (SLB) window. In India, short-selling is allowed on mandatory delivery of securities at settlement, and the SLB framework ensures a crucial role in ensuring this delivery. In short, SLB provides necessary impetus to short selling. The SLB platform enables long-term investors to lend stocks held by them to a short-seller and earn an interest through one’s SLB account with the broker. In SLB framework, the borrower pays interest (determined by market demand and supply for the stock) to the lender and the lender must return the borrowed stock before the agreed upon tenure concludes. This entire mechanism (i.e. borrowing rate, lender, borrower, margins) is operated through MIIs (market infrastructure institutions) automated systems. Investors can consult their brokers before participating in the SLB programme. SLB platform has not gained much traction (in terms of liquidity and depth). Most of the shorting by investors is done through futures and options. Therefore, reforms in SLB platform are highly desired to enhance its effectiveness.
In conclusion, empirical research confirms that short selling enhances market efficiency, facilitates price discovery and mitigates market manipulation. Notably, short sellers played a pivotal role in revealing critical information during the Enron episode. Thus, it’s time to strengthen the SLB platform with calibrated disclosures but not impeding short-selling.
Rasmeet Kohli works with the National Institute of Securities Markets. The views expressed are personal.
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Published: 22 Jan 2024, 10:39 PM IST