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Should short-selling be banned?
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October 15, 2008

A ban on futures would lower liquidity and make the markets more volatile. In any case, the recent US experience shows such bans don't stop markets from falling.

Surjit Bhalla, MD, Oxus Research and Investments

"The stocks in which short sales were banned in the US fell the most! Investors who want to get out, will do so through the cash market if need be"

The reason why short sales shouldn't be banned is a simple one - the ban won't achieve anything, it cannot. The US banned short sales of certain financial stocks (like Goldman Sachs, for instance) - it announced a freeze on such sales for a certain period, not an outright ban -but these stocks collapsed the most!

Where do you have the possibility of short sales? First, you can borrow stocks, in return for a fee/interest income to the owner of these stocks, and then sell them. We've tried to introduce this in the market since a measure that increases volumes is, in principle, a market-stabilising measure.

But this kind of stock-lending hasn't really taken off since there are a host of irritating regulations governing it. The short point, though, is that we don't have short sales via this measure in India as yet.

The other way to sell shares you don't own is through the futures market. To stop this, however, will mean you have to bring the F&O market to a halt. That means the price discovery process that takes place through the F&O market which has much greater volumes (since it allows greater leverage) than the cash market will no longer take place.

And by virtue of the depth F&O provides, the market automatically gets more stable. The authorities, of course, can take a decision to crash the F&O market by banning sales, but the question to ask is what impact this will have. If it has the impact you want (to halt a downward movement in the market), then that's a call you take.

We've seen that in the US where such bans were imposed, they didn't work and that's why the US lifted them. Once you understand the process, it's easy to see why a ban, if it is imposed, won't work. So let's say there are no futures markets and that a group of investors, generally seen as FIIs in today's environment, want to exit. So what do they do?

They sell in the cash market. So the market collapses anyway. But, the argument will be, the presence of circuit filters will prevent the cash market from a collapse. That's not true since all the filter does it to halt trade for a while to allow passions to cool. Once trading resumes, if people still want to get out, they will. All that the presence of filters does is to ensure the fall is limited in a particular period in time.

So maybe you can look at the possibility of keeping the futures market the way it is but introducing some kind of circuit filters here as well as a temporary measure. That'll ensure price movements, in any direction, are kept within a band. It will not, however, prevent the market from falling if that's where it is going. In any case, it's useful to keep in mind there are two parties to every transaction - if someone's selling, someone's buying at the same time.

(As told to Sunil Jain)

Deven R Choksey, MD, KR Choksey Shares & Securities

"These are not normal times and the markets are falling due to short sales which create a downward pressure on prices. A ban is critical right now"

If we want investors to be protected from losing faith in the system and protect the rupee, the bear hammering has to be stopped till the market returns to normalcy. As world markets are crumbling due to continued short selling, we need to ban short selling in the cash and derivative markets simultaneously till the time global market stabilises.

At present, intra-day short selling is allowed and it is fuelling speculation as can be seen from the fact that only around 30 per cent of the average daily volumes in equity markets end up in delivery - this then leads to a massive fall in prices during the day and then an intra-day recovery under short-covering which then leads to huge volatility.

In abnormal times such as now, short selling is counter-productive and needs to be banned and it should be ensured that entire volume results in delivery in the cash market. After banning short sales, global regulators mysteriously lifted the ban last Friday, only to see mass-scale selloffs resuming.

If regulators restrict players from adding to their existing positions in the F&O markets, this will stop the selling spree. Once short selling via the derivatives market is stopped, this will prevent the market from collapsing further.

Unfortunately we continue to allow short selling in the derivatives markets and the market is yet to be delivery-settled. Regulators will take India's market to the next level of growth when they bring delivery-settled F&O markets; not only will this increase the volumes but it will also make place for investors in the F&O market which is currently driven by traders. The reason why global regulators don't want to ban short selling in the F&O market is because hedge funds operate out of these markets and don't wish to be regulated.

Another thing the regulators need to do is to ban P-note trading in India and the Nifty in Singapore as hot funds from global markets operating in these markets transmit a fear psychosis to bring down prices in our market. Curiously, however, regulators have relaxed P-note norms to increase FII inflows. Mark-to-market norms must also be kept in abeyance till after the liquidity situation becomes normal.

Regulators must act with full confidence on these issues as half hearted measures won't protect our economy. Our markets and investors need the confidence of regulators more than mere explanations and assurances.

Any inaction will ensure investors who've left the market will not return and a further fall in the market runs the risk of weakening the collateral kept with banks ... this, in turn, can weaken banks and, eventually, the economy. In other words, we need to understand the importance of keeping the stock markets healthy and take timely and appropriate action.

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