Trading in the stock markets is usually based on the investment strategy of “Buy Low, Sell High”. However, trading members also engage in a reverse approach of “sell high, buy low”, more commonly known as ‘short selling’. Short selling, although considered as a legitimate practice by capital markets across the world, has been a historic target of criticism for its role in driving down the price of the shares and creating market volatility.

Short selling in India has been in the news as highlighted by the events triggered by the publication of a report by Hindenburg Research, targeting the Adani group entities (the “Hindenburg Report”). The Hindenburg Report disclosed that persons associated with it may have taken short positions against the Adani group stocks through bonds and non-Indian derivative instruments traded in the United States.

What is Short Selling

The Indian securities market regulator, the Securities and Exchange Board of India (the “SEBI”) defines short selling as ‘selling a stock which the seller does not own at the time of the trade.’ Shorting is undertaken by (a) borrowing stocks (generally from a broker/dealer), and (b) selling such stocks at the prevailing price, with the intent to buy them later to return them to the broker/dealer at a lower price and keeping the difference earned as profit.

As a general matter, transactions may take place where the seller neither owns nor borrows the securities in time to deliver to the buyer within the settlement period (a ‘naked short sale’) or through a transaction in which the seller may or may not have the securities at the time of the sale, but has an arrangement for borrowing the securities prior to the settlement of the securities (a ‘covered short sale’).

Evolution of Short Selling Rules in India

The SEBI first considered regulating short selling pursuant to the report of a committee constituted in 1996 under the chairmanship of Mr. B. D. Shah. In the background of certain stock exchange scams during the late 1990s and early 2000s, a Joint Committee of Parliament noted in 2002 that the SEBI has been inactive in regulating short selling and urged the SEBI to formulate a clear policy on issues relating to short selling. Based on the recommendations of the Joint Committee, the Secondary Market Advisory Committee of SEBI (“SMAC”) issued a discussion paper on Short Selling and Securities Lending and Borrowing in 2005.

Subsequently, in 2007, the SEBI issued a circular for permitting all classes of investors to short sell, and for enabling such short selling, also proposed a mechanism for borrowing of securities to enable the settlement of securities that are sold short, subject to compliance with the frameworks for short selling (“Short Selling Framework”) and securities lending and borrowing (“SLB Framework”).

Short Selling Framework

The implementation of the Short Selling Framework allowed both retail and institutional investors to engage in short selling. However, the Short Selling Framework expressly prohibits naked short selling and requires investors to mandatorily honor their obligation of delivering the securities at the time of settlement.[1] The SEBI and the stock exchanges also prescribe an ad valorem penalty based on the amount of the securities involved in case of failure to deliver and settle at the prescribed time. In essence, this mandatory obligation of settlement as per the SEBI prescribed timelines is a deterrent for engaging in naked short selling.

To ensure that shorting is not undertaken in a manner detrimental to retail investors, institutional investors are mandatorily required to disclose short positions prior to the placement of an order. Similarly, retail investors are also required to make a similar disclosure by the end of trading hours on the relevant day. The Short Selling Framework mandates that the brokers shall be responsible for collecting stock-wise data of short positions and upload it to stock exchanges before commencement of trading on the following day. The stock exchanges are required to publicly disseminate such data on their websites on a weekly basis.

On January 5, 2024, the SEBI issued a further circular outlining a framework of short selling which is a reproduction of the Short Selling Framework discussed above.

It is noteworthy that at present, securities traded in the F&O market are permitted for shorting.

SLB Framework

The SEBI introduced the SLB Framework in 2007. The SLB Framework mandates that lending and borrowing of securities shall only be undertaken through a clearing corporation/clearing house attached to a stock exchange having nationwide terminals and registered as approved intermediaries (“AIs”). These AIs shall provide an automated, screen based, order-matching platform independent of other trading platforms.

To facilitate the lending and borrowing of securities, AIs are required to enter into an agreement with clearing members (generally banks or custodians) which will specify the rights, responsibilities and obligations of the parties to the agreement. All SLB transactions are settled on a T+1 day basis. Additionally, the SLB Framework restricts lending and borrowing in stocks during the period in which certain corporate actions are being undertaken such as dividend declaration, stock splits or mergers and acquisitions.

Settlement of short sells

Given that the SEBI prohibits naked short selling, it is necessary to close short positions prior to the close of the trading day and ensure delivery of stocks.

The Short Selling Framework requires stock exchanges to formulate deterrent provisions and take action in the event brokers fail to deliver the securities at the time of settlement. Similarly, the SLB Framework puts the obligation to ‘guarantee delivery’ of securities on the borrower and return the securities to the lender within the rolling settlement cycle of T+1 days.

To manage the risk in the event of short delivery, all SLB transactions are subject to margin requirements. The National Stock Exchange of India Limited (“NSE”) and the BSE Limited (“BSE”) require depositing of collateral in the form of cash equivalents, i.e., cash, fixed deposits and bank guarantees which can be liquidated in the event of short delivery of securities.

Hindenburg-Adani

The publication of the Hindenburg Report led to a rapid decline in the share price of publicly traded Adani group companies.

Pursuant to multiple petitions filed with the Supreme Court raising concerns about drastic wipe out of shareholders value and alleged violations of securities laws by the Adani group, the Supreme Court of India constituted an expert committee (the “Expert Committee”) to consider whether there has been regulatory failure in dealing with the contraventions alleged in the Hindenburg Report.

The Expert Committee in its report dated May 6, 2023 noted that prima facie there had been no regulatory failure by SEBI.

Additionally, the Supreme Court sought inputs with respect to the role of short sellers in market volatility and rules governing their actions as well as measures which may be taken to regulate them, to identify and fix the contribution of short selling in the market volatility during such period and whether there was any violation of law by entities engaged in short selling.

The SEBI submitted before the Supreme Court that restrictions on the practice of short selling may distort efficient price discovery and provide promoters unfettered freedom to manipulate prices. The SEBI recommended regulating short selling and increasing transparency instead of prohibiting short selling.

The Supreme Court in its final judgement issued on January 3, 2024, recorded a statement on behalf of the Government that (additional) measures to regulate short selling will be considered by the Government and the SEBI. The Supreme Court further held that the SEBI and other investigative agencies shall also enquire into whether there was any infraction of the law by the entities which engaged in short selling in the case at hand.

Balance between disclosure and confidentiality

One key issue which regulators around the world continue to grapple with as they regulate short selling is the balance between disclosure and confidentiality.

Under the Short Selling Framework, while stock brokers are required to collate data on short sell positions (which can be inspected by the SEBI) and upload it to the stock exchanges before commencement of trading on the following day, the stock exchanges are only required to disseminate such information on a weekly basis.

A requirement for more immediate disclosure may result in a loss of confidentiality, which is important for investors betting against the bullish trend of the stock. Such disclosure may result in short squeezes, as memorably happened with the American stock GameStop in 2021. Short squeezes will force an artificial price rise in the shares, overwhelming short sellers leading to increased volatility.

In a significant development in the United States in October 2023, the US Securities and Exchange Commission voted three to two to require lenders of securities to report new loans and modifications to existing ones by the end of each trading day.

The chair of the SEC commented at the time that the new regime would “bring greater transparency and efficiency to this important part of capital markets.”

The SEC first proposed the securities lending disclosure rule in 2021. The final rule dropped initial plans for publishing deal details within 15 minutes of trades being struck. Consolidated data is instead required to be published the next morning and individual loan amounts are only required to be published 20 business days after the deal was reported.

Conclusion

Benefits and disadvantages of short selling have long been discussed among market participants and regulators. However, short selling has been viewed as a generally positive practice helping in price discovery and liquidity. Market regulators across jurisdictions have sought transparency in short selling rather than outright bans. So far, India has followed a similar approach.

Authors: Rajat Sethi, Durga Prasad Mohapatra, Samyak Jain

[1] Currently, India follows a settlement cycle of T+1 which is proposed to be transitioned into T+0 in a phased manner. The SEBI board in their meeting held on March 15, 2024 have approved the launch of a beta version of T+0 settlement for 25 stocks with a limited set of brokers.