Comment . Market crash: Why SEBI should not ban short-selling

With global central banks having loosened their purse strings considerably to support their economies as well as the financial markets in the ongoing turmoil, stock market regulators are also beginning to look closely at ways to control market volatility. One of the tools that many regulators have recently used is banning short-selling of shares. This is however, not a good idea; one that the Securities and Exchange Board of India, should not follow.

Short-selling involves selling a stock, without having possession, with the intent of purchasing it at a lower level. This is a trading strategy commonly adopted in market declines, just as going ‘long’ (involving buying first to sell at higher levels), is used in bull markets. It is also common for market participants to demand restrictions or ban on short-sales in extended market declines, as they look for scapegoats to blame for the crash.

But restricting traders from using one particular trading strategy amounts to tampering with efficiency of markets and the in-built price discovery mechanism. Trading in markets project the expectations of market participants regarding future price movements. Banning short-sales therefore, means that the regulator is dictating the price movement, indirectly.

Also, empirical data shows that tampering with market functioning through such restrictions have been quite ineffective is stemming declines.

Panic all around

Equity markets have been witnessing a blood bath since February 21, 2020. Many prominent equity benchmarks, including Dow Jones Industrial Average (down 28 per cent from the recent peak), UK’s FTSE 100 (down 31 per cent), Germany’s DAX (35 per cent) and Italy’s MIB (40 per cent) are currently sporting deep gashes. The Sensex and the Nifty 50 have also lost 30 per cent since their recent peaks.

Market regulators are therefore, under considerable pressure – from the government as well as investors – to take actions to stop the decline. While the Indonesian and Sri Lankan regulators have shut down their markets temporarily, there have been a slew of short-selling ban by other regulators.

France’s Autorité des Marchés Financiers temporarily barred short-selling in 92 stocks that had fallen the most on Monday, until the end of Tuesday’s session. The European Securities and Markets Authority (ESMA), on Tuesday, tightened disclosure requirement by halving the threshold at which short positions must be disclosed. Italian regulator, Consob, halted short trades in 20 shares for 24 hours, while the Spanish regulator has laid out that net short positions will be frozen at Tuesday’s level for a month. The UK’s Financial Conduct Authority (FCA) has also temporarily banned shorting of 37 Belgian and Italian stocks and the Belgian regulator banned shorting of a basket of stocks on Tuesday. South Korea has banned short-selling for six months.

Given these moves, voices are being raised to make the Indian regulator to also impose a ban on short-selling of stocks that are getting badly pummelled.

Not effective in the past

This may be unnecessary as ban on short-selling has not been effective in stopping market declines in the past. A study of the ban on short-selling imposed in the 2001 and 2008 market crashes by various countries shows that the indices continued falling in the 10-day period following the ban. In the current instance too, stock declines in countries such as Italy, Spain and South Korea have witnessed no respite since the ban on short-selling.

Academic research also shows that effectiveness of short-selling is debatable. In a paper, Efficiency and the Bear: Short Sales and Markets around the World, Arturo Bris, William N Goetzmann and Ning Zhu found that at the market level, where regulators might expect short-sale restrictions to reduce the severity of broad declines, such restrictions appear to make no difference.

Measures in force

SEBI had acted wisely in the 2008 crash and had restrained itself from imposing a ban on short-selling, despite other markets, including the US, doing do. The Indian regulator issued a statement last week that it was closely monitoring the market turbulence and would take action as required.

This is a sane reaction. Improving transparency and disclosure requirements and increasing margins to contain volatility is a continuous process and SEBI has been taking measures in this regard through the year.

Also, trading margins in India are among the highest in the world and these margins are calculated at the client level on a gross basis, real-time. What this means is that the margin requirement is calculated as the client puts through his transaction. In many other markets, margins are collected at the broker level, that too after netting the buy and sell transactions.

Given the robust margin collection system and surveillance at the client level on a real-time basis, it is doubtful if any unnatural activity can go unnoticed. The disclosure of block and bulk deals further help in identifying such large and abnormal activities and exchanges do take action on these.

Finally, these are times of unprecedented volatility, the kind never witnessed by most of us. Regulators should desist from making knee-jerk moves that only create more panic and mess with price discovery, in these conditions.