In a significant move aimed at reducing market volatility, the Securities and Exchange Board of India (SEBI) has cracked down on the controversial practice of naked short selling. While allowing short selling for all investor categories, SEBI has strictly prohibited selling shares without first borrowing or securing them. This comes nearly a year after the Hindenburg-Adani case reignited concerns about short selling’s potential to manipulate markets.

Sebi said that short selling i.e. futures transactions will be allowed in all stocks available for trading in futures trading. In naked short selling, short selling of shares is done without buying the shares or ensuring that the shares will be bought in the future.

Before this, short selling in India was technically banned for retail investors and permitted only for institutional players under specific conditions. However, concerns arose about loopholes that allowed certain practices, like naked short selling, to go unchecked. This sparked anxieties about manipulation and volatility, particularly in light of the Hindenburg report’s impact on Adani Group stocks.

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New framework issued by SEBI

The new framework addresses these concerns head-on, instituting mandatory delivery obligations for all investors during settlement. This essentially eliminates the possibility of naked short selling, where sellers offload shares they don’t possess, potentially driving down prices artificially. Additionally, SEBI has mandated disclosure requirements, with institutional investors declaring short-selling upfront and retail investors disclosing after the trading day.

This clampdown on naked short selling aims to create a more level playing field in the Indian stock market. By ensuring responsible short-selling practices and enhancing transparency, SEBI seeks to curb excessive speculation and foster a more stable trading environment that benefits all investors. While some market participants might oppose the restrictions, the potential for long-term stability and investor confidence appears to outweigh these concerns.

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SEBI said, “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. The stock exchanges shall then consolidate such information and disseminate the same on their websites for the information of the public every week. The frequency of such disclosure may be reviewed from time to time with the approval of SEBI”.

What is Short Selling?

During normal short selling, investors are allowed to sell stocks that they do not own at the time of trading. In a typical short sale, the investor first borrows the stock and then makes a deal to sell the stock. In naked short selling, the trader trades without borrowing i.e. the trader does not have any shares, but sells the shares which he did not even buy.

Overall, SEBI’s revised short-selling regulations mark a significant step towards a safer and more efficient stock market in India. This move signifies a commitment to protecting investors and fostering a transparent trading environment, laying the groundwork for a more robust and sustainable financial future.

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Examples of Short Selling Bans in Past

1. The Great Depression (1930s): In the aftermath of the 1929 stock market crash and the ensuing Great Depression, the U.S. responded with regulatory actions. The Securities Exchange Act of 1934 introduced rules governing short selling, establishing the Securities and Exchange Commission (SEC) to enforce them.
2. Global Financial Crisis (2008): The 2008 financial crisis prompted several countries, including the U.S., the UK, Australia, Canada, and parts of Europe, to temporarily ban short selling in financial stocks. This concerted effort aimed to shield financial institutions and restore market confidence during a precarious period.
3. Eurozone Debt Crisis (2011): Amid the eurozone debt crisis, countries like Spain, Italy, France, and Belgium imposed temporary bans on short selling specific stocks in the banking and financial sectors. These measures sought to stabilize and protect vital components of the banking systems.
4. COVID-19 Pandemic (2020): The unprecedented market volatility spurred by the COVID-19 pandemic led various countries, including Spain, Italy, France, South Korea, and Greece, to implement short-selling bans or restrictions. The goal was to curb market declines and maintain financial stability during the global health crisis.

These instances underscore a recurring theme: short-selling bans are frequently deployed during severe economic distress to prevent exacerbation of market declines, safeguard critical economic sectors, and uphold investor confidence. However, the efficacy and long-term impact of such bans remain subjects of debate among economists and financial experts.

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Why Some Countries Bas Short Selling

Short selling is outright illegal or heavily restricted in certain jurisdictions due to various reasons:

1. Market Stability: Short selling can intensify market downturns, contributing to a snowball effect of price declines. Banning it is considered a preventive measure to avert spirals of panic selling and market crashes.
2. Preventing Market Manipulation: Short selling has been exploited in market manipulation schemes, such as bear raids, where traders spread negative information to drive stock prices down. Such practices are illegal.
3. Maintaining Investor Confidence: Increased short selling during economic uncertainty can undermine investor confidence, potentially leading to reduced investment and economic slowdown. A ban aims to prevent such turmoil from rippling through the broader economy.
4. Protecting Companies: Short selling pressures struggling companies, affecting their ability to raise capital and maintain operations. A decline in stock prices due to short selling could lead to layoffs, reduced investment, and other challenges for the firm.
5. Regulatory Challenges: In some markets, the regulatory framework may be insufficient to effectively monitor and regulate short-selling activities. This can lead to illegal practices like naked short selling, prompting the outright ban of the practice.
6. Economic Policy Considerations: Banning or restricting short selling may align with broader economic policies, particularly during financial crises, where governments take measures to protect their economies.

While short-selling bans can provide short-term market stability, their long-term effects, including reduced market liquidity and compromised price discovery mechanisms, remain subjects of scrutiny. The dynamic interplay between market regulation and economic stability continues to shape the landscape of global finance.