Short selling: What SEBI changed; who will take onus for any mishap?

Market regulator SEBI’s January 5, 2024 circular brought back two rules in its “framework” for short-selling which have far-reaching consequences: (a) “the institutional investors shall disclose upfront at the time of placement of order whether the transaction is a short sale” and (b) “the brokers shall be mandated to collect the details on scrip-wise short sell positions, collate the data and upload it to the stock exchanges before the commencement of trading on the following trading day”.

Before explaining the implications, it must be noted that these changes came two days after the Supreme Court directed, on January 3, 2024, that “SEBI and the investigative agencies of the Union Government shall probe whether the loss suffered by Indian investors due to the conduct of Hindenburg Research and any other entities in taking short positions involved any infraction of the law and if so, suitable action shall be taken”.

The last word on the Adani-Hindenburg saga, which prompted the court’s directive, has not been heard yet because (i) although the court said the SEBI’s investigations into 22 of 24 cases have been “completed” it is not yet in public domain (“SEBI submitted a status report dated 25 August 2023 providing comprehensive details about all the investigations”) and (ii) the court gave SEBI more time (“preferably within three months”) to complete investigations in the remaining two.

The significance of both, the directive and SEBI’s tighter rules on short selling, would be clear soon.

First, what changed?

The relevant elements in SEBI’s January 2024 “framework” circular are:

(i) Short selling is allowed for institutional and retail investors but “naked” short selling is not.

(ii) No day trading for institutional investors but allowed for retail investors.

(iii) Institutional investors need to “disclose upfront” if they are short selling (at the time of placement of order); for retail investors, disclosure by end of the transaction day.

(iv) Brokers “mandated” to collect, collate, and upload data on short selling before commencement of trading the next trading day.

(v) No restriction on short selling in F&O segment.

It also added: “In this regard, it is mentioned that the contents of ‘Annexure 3’ of Chapter 1 of the Master Circular dated October 16, 2023 shall be read as under (which are in line with the provisions of rescinded SEBI Circular No. MRD/DoP/SE/Dep/Cir-14/2007 dated December 20, 2007)…” Then the points listed above follows, along with others.

In effect, the “rescinded” SEBI circular of 2007 (when short selling was first allowed) stands restored. So is also the July 5, 2021 framework (before the Hindenburg report of 2023) – which was identical to the 2007 circular mandated. But the “master circular” of October 16, 2023 had removed the two rules (iii) and (iv) – which were quoted in full at the beginning. Hence, the January 2024 framework was brought “in line” with the 2007 framework.

Virtual ban on short-selling

Why did the SEBI liberalise or remove rules (iii) and (iv) from the framework on October 16, 2023?

The SEBI did not explain and hence, the suspense would continue but the timing needs to be noted. It came after the Hindenburg report hit in January 2023; the tightened checks of January 5, 2024, came after the Supreme Court backed SEBI’s investigations (and ruled out handing it over to the CBI or a SIT) on January 3, 2024.

A tightened regulation was expected and understandable when short selling was first introduced in India in 2007 (initial hesitation). During the 2007-09 Great Recession, India did not ban short selling but the US and European countries did (the US regrated later, vowing never to do it again). During the pandemic crisis of 2020, India and some European countries banned it but the US did not. The World Federation of Exchanges (WFE), of which India’s NSE is a member, reacted strongly to the ban in April 2020, presenting a host of global studies to assert that a ban on short selling did the opposite of what is intended by market regulators (to stop further market crash) – and that a ban harms market by reducing liquidity, increasing price inefficiency, and hampering price discovery.

It must also be noted that corporate entities all over the world vigorously demand ban on short selling when markets are going down (to prevent further fall). The Hindenburg report did cause a crash in the Adani group’s stocks but by January 6, 2024, those stocks had recovered or bettered the pre-Hindenburg price levels.

A tighter regulation of the kind the SEBI reintroduced on January 5, 2024 (for institutional investors to make upfront declarations and brokers to upload such information before the next day’s trading) is a signal to investors and stock markets that (a) the Hindenburg-type short selling is being viewed with suspicion and will be watched closely. The Supreme Court’s directives (b) to the SEBI and the Centre to “probe” into “any infraction of the law” in short selling causing “loss” to investors, and take “suitable action” will have further chilling impact on institutional investors thinking of short selling.

The combined impact of the two amounts to a virtual ban on short selling by institutional investors – a situation the WEF strongly opposed in April 2020 and which also goes against the SEBI’s very arguments supporting short selling in its discussion paper of 2005 that eventual allowed its introduction in 2007.

Short-selling is a legitimate and logical investment practice. It is an efficient tool to (i) accelerate price corrections (ii) check price anomalies and (iii) facilitate liquidity. By virtue of such characteristics, short selling (iv) prevents stock market bubbles (v) checks stock manipulations (vi) promotes good corporate governance and (vii) helps in regulatory oversight.

A virtual ban on it would mean stock investment is a one-way traffic – betting only for upward movement, notwithstanding weak fundamentals, financial frauds and stock manipulations. Recall the Satyam Computers’ collapse in 2009 or more recently, the National Financial Reporting Authority (NFRA) pointing out deficiencies in auditing by the Big 4 – KPMG, Deloitte, PwC and EY and their associates. These are evidence of true betrayal of investors. It would be patently wrong to presume that a tighter regulation on short selling will protect investors or stock markets by bringing a misdirected transparency in short selling.

The world has repeatedly paid a heavy price because of stock price manipulations and/or stock market bubbles which eventually burst, hurting ‘real’ economy. The 2007-09 Great Recession caused big multinational banks and other financial institutions to collapse overnight, wiping out immense wealth and millions of jobs – thereby causing global recession and forced the US and other countries to spend huge sums in bailing out many “too big to fail” corporations. This has happened many times since the 1929 Great Depression.

Overvalued Indian stock markets

It is no secret that Indian stocks and stock markets are highly overvalued. Stock market booms are known to be disconnected from ‘real’ economy. The RBI used to repeatedly warn against the stock market booms after the initial collapse in early part of 2020 (warned also in 2021) but stopped thereafter as a secular boom continued.

Here is another historical prospective.

The Economic Survey of 2022-23 said Indian stock markets were way too “expensive”. It pointed out that the Nifty50 with a PE multiple (price to earnings ratio) of 21.8x in 2022 was overpriced compared to its global peers – the PE of MSCI World (large and midcaps of 23 developed economies) was 17.3x and that of MSCI EM (24 emerging economies) was 14.6x (in 2022). In the previous five years between 2017-2021, the PE of Nifty50 averaged 27.4x – against MSCI World’s 19.4x and MSCI EM’s 14.6x (Economic Survey of 2022-23).

What is the status now? Not different at all

As on December 29, 2023 (the latest data easily available), the PEs of MSCI World and MSCI EM were 20.7x and 14.5x, respectively – when the Nifty50 was far higher at 23.17x.

What happens if the galloping stock markets panic due to the virtual ban on short selling? Would SEBI and the Supreme Court take responsibility for any mishap in the markets?