With market regulators in some countries announcing curbs on short-selling of equities to arrest the slide in prices, there were reports today that SEBI too may consider a similar move. (However, NSE later clarified that SEBI was not mulling the decision.)

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Short selling is a market practice in which an individual trader or fund manager sells a stock, in the hope of buying it back at a lower price.

When market sentiment turns extremely bearish, like was seen during the global meltdowns in 2001 and 2008, regulators resort to a ban on short-selling when no other measure seems to work.

The strongest argument against a ban on short selling is that it interferes with natural price discovery, and reduces liquidity. That apart, there is no credible evidence that curbs on short-selling in the past have helped stabilise stock prices.

In September 2008, the US Securities and Exchange Commission (SEC) had temporarily banned short sales in nearly 1,000 financial stocks to halt the free fall in prices. Stock prices rebounded briefly but then continued to decline for the rest of the period when the short sale ban was in effect.

At that time, SEBI and the finance ministry had jointly taken a stand that they would not ban short selling. This was in contrast to the regulator’s view during the market crash of 2001 when it had blamed “bear hammering” as the cause, despite markets globally being in a downturn.

Some months later, SEC Chairman Christopher Cox expressed regret at the decision to ban short selling.

“While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again. The costs appear to outweigh the benefits,” Cox had told Reuters.

There is another reason why it makes little sense to ban short selling in the Indian market. Developed markets have a robust stock lending and borrowing mechanism. So it is possible for traders and fund managers to borrow shares in huge quantities for a fee and sell them in the market. And stock exchange regulations require these investors to disclose their short positions on a daily basis. So it is easy for the regulator to track short-selling activity.

In contrast, the stock lending and borrowing mechanism in India is not liquid enough. Though it has been in existence for 12 years now, and despite numerous tweaks in rules, the mechanism failed to take off in a big way. The main reason is that market participants did not find it cost-effective to borrow shares through this window.

The futures and options market—particularly futures—is a far cheaper and liquid route for those looking to short sell.

What regulators worldwide are concerned about is naked short sales, meaning sales without owning any security in the first place. It makes sense to restrict naked short selling under certain market conditions, because such sales have the power to set off a vicious cycle wherein falling prices triggers panic and prompts more people to dump their holdings, in turn pushing prices further down.

It is possible to monitor naked short sales in the cash market, as the regulator just has to ensure that every sell trade is backed by delivery of the shares. In other words, a seller cannot square off his sell position during the day and has to deliver the shares.

But it will be tough for the regulator to ban short sales in the futures segment, particularly index futures. The regulator could issue a diktat that trades in the futures segment should be purely for hedging not a bet on the direction of the market. But if the rule is enforced for Nifty futures, it could affect liquidity, because other than institutional investors, nobody will own the entire set of Nifty stocks for being eligible to sell Nifty futures.

Similarly, in the case of single stock futures, it will be up to the broker to ensure that its clients own shares to be allowed to sell in the futures segment. In theory, this is possible. But can SEBI really count on the brokers to enforce the rule, particularly where large clients are concerned.

And even if the rules are enforced, it will certainly come at the cost of liquidity. Short positions in the market form the basis for relief rallies when markets fall sharply. That is because short-sellers cover their positions periodically by buying back what they have sold. This helps stabilize the market.

In 2008, SEBI had not outright banned short-selling but managed to plug a key source of short selling by foreign institutional investors. Back then, many SEBI-registered FIIs used to issue participatory notes (PNs) to global investors who wanted to trade in Indian shares but without registering with the regulator.

Under SEBI rules, the shares bought on behalf of the global investors would remain with the FIIs issuing the PNs. When sentiment turned bearish amid the global financial crisis, the PN-issuing FIIs loaned out these shares to hedge funds and other such short term investors wanting to go short on India. This was mostly done without the knowledge of the PN investor on whose behalf the shares had been bought. When SEBI got wind of this, it insisted that FIIs disclosed such trades, and within weeks, clamped down on this practice.