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Short selling is a recognized practice across capital markets globally and involves the principle of “Sell High, Buy Low”. It occurs when investors speculate a stock price decline -borrowing stocks from a lender and selling those stocks at prevailing market prices, with the aim of repurchasing these at a lower price to return to the lender (along with commission). The profit retained from the price difference marks the end of the transaction. This practice is essential for liquidity, price correction, market efficiency, and risk management within the securities market.

Advent of SEBI’s Current Framework on Short-Selling:

The Securities and Exchange Board of India (“SEBI”) in its framework (“Short Selling Framework”) defines short selling as “selling a stock which the seller does not own at the time of the trade”. Following the Hindenburg Adani incident, SEBI reiterated this frameworkearlier this year.  This move came after the Supreme Court sought SEBI’s insights on the role of short sellers in market volatility and possible regulatory measures.

The Hindenburg Report prompted a decline in the share price of the Adani group companies. Hindenburg held a short position on Adani group stocks through non-Indian traded derivative instruments and US traded bonds. The publication of the Hindenburg Report had a similar ripple effect on the Indian markets.

SEBI stated that restrictions on short selling could distort efficient price discovery and enable promoters to manipulate prices. Instead, SEBI recommended enhancing regulations and transparency around short selling rather than outright prohibition. The Supreme Court stated that additional measures may be deliberated upon by SEBI and the government to regulate short selling. Currently, a review petition has been filed against this judgment passed by the Supreme Court and its decision is awaited.

Some key aspects of the short selling framework inter alia include:

a) To facilitate short selling, a securities lending and borrowing scheme (“SLB”) was put in place. SEBI has mandated that lending and borrowing must be undertaken through a clearing corporation house affiliated with a nationwide stock exchange and registered as approved intermediaries (“AI(s)”). These AIs will operate an automated, screen-based order-matching platform independent of other trading platforms for securities lending and borrowing.

b) Retail as well as institutional investors are allowed to short-sell and securities traded infutures and options (“F&O”) segments are allowed to be transacted through the short-sell mechanism.

c) The concept of naked short selling is forbidden. This practice involves selling shares without first borrowing or ensuring their availability, unlike traditional short selling where borrowing precedes the sale. As part of the prohibition on the same, both retail and institutional investors are required to fulfil their obligation to deliver securities during settlement. 

d) Institutional investors are required to disclose their short positions before placing orders, while retail investors can do so by the end of the trading day.

Analysis of Short-Selling Dynamics in the Indian Market:

Varying regulatory measures for institutional and retail investors aim to prevent stock manipulation and provide essential reassurance to retail investors. However, this can also trigger a phenomenon known as ‘short squeeze’. Short sellers borrow shares that they don’t own and sell them with the anticipation that the prices of such shares would decline, allowing them to re-purchase these shares at a lower price, return them to the lender, and make a profit from the difference.

However, due to the current asymmetry in disclosures, it is possible that the short transaction of an institutional investor can be countered by retail and/or other institutional investors with dedicated buying support for the shorted stock. Consequently, if the stock price of the shorted stock starts rising,contrary to the expectations of the short seller, the short seller could face potential losses. To limit this, short sellers are then forced to re-purchase these shorted shares at higher prices, also known as covering their short positions (as they have to complete their short trade and return these shares to the lender). This buying activity can further drive up the stock price, triggering a chain reaction where other short sellers also rush to cover their positions. This cycle of buying to cover shorts can lead to a sharp and sudden increase in the stock’s price, creating a short squeeze. Examples of such market incidents include the 1982 stock market crash in India, GameStop in 2021 and Volkswagen in 2008, when, as a result, it became the world’s largest company by market capitalisation.

To address such risks, India may consider altering its disclosure requirements such that irrespective of the nature of the investor, for certain stocks, additional information may be required to address any short squeeze related concern. While this may seem to be a step-back for retail investors, it may be required to avoid targeted market or stock specific volatility.

Conclusion:

While SEBI’s framework provides a robust structure to regulate short selling, continuous monitoring and adjustments are necessary to address emerging market dynamics and risks. Enhanced transparency and tailored regulatory requirements will certainly help in maintaining a balanced approach.

References:

1. Short selling and securities lending and borrowing - https://www.sebi.gov.in/legal/circulars/dec-2007/short-selling-and-securities-lending-and-borrowing_9463.html.

2. Framework for Short Selling - https://www.sebi.gov.in/legal/circulars/jan-2024/framework-for-short-selling_80448.html.