The Securities and Exchange Board of India (Sebi) is proposing to streamline processes for investors wishing to short stocks, with plans to increase the availability of shares for borrowing. The adjustments are seen as a way to encourage greater activity in the cash equity market, which has been overshadowed by the considerably larger derivatives market. Reports indicate that these changes, if approved, would represent a significant transformation in India’s stock lending and borrowing system.

Current regulations restrict access to stock borrowing, with only 176 companies out of nearly 2,600 listed on the National Stock Exchange (NSE) eligible. Sebi aims to almost double this number by modifying certain eligibility criteria. This relaxation is intended to allow a broader selection of liquid stocks to be shorted, potentially increasing investor participation.

Under the proposed reforms, Sebi is expected to adjust current eligibility requirements, which stipulate factors like trading volumes and liquidity. Currently, a stock must have an average trading turnover of at least Rs 100 crore monthly over six months to qualify. The new measures may include easing these thresholds to extend the borrowing framework.

Understanding Short Selling

Short selling, or “shorting,” allows investors to profit from a decline in a stock’s price. This strategy involves borrowing shares, selling them at market value, and later repurchasing them at a lower price. For example, if an investor borrows shares valued at Rs 1,000, sells them, and later buys them back for Rs 900, they would retain a profit of Rs 100, excluding costs. Conversely, should the stock price increase, the investor could incur significant losses as they are still required to buy back the shares.

The expansion of short selling options could provide institutional investors and sophisticated traders with enhanced tools for hedging against portfolio risks or capitalising on falling stock prices. Additionally, investors who lend shares could benefit from additional earnings through the stock lending and borrowing mechanism.

Despite improved opportunities, it is important to note that short selling is inherently high-risk, with the potential for unlimited losses if stock prices continue to rise. Stakeholders need to consider these risks carefully before engaging in short selling activities.

Reasons Behind Current Limitations

The strict stock lending regulations in India are largely a response to past market scams, with regulatory measures tightened in the early 2000s and between 2017 and 2020. This has led to a limited number of stocks qualifying for borrowing, despite the vast number of equities available on the NSE. A working group was established by Sebi last year to assess the stock lending and borrowing framework in light of evolving market conditions.

As India’s stock market has expanded significantly, the derivatives segment has witnessed even faster growth, with market capitalisation of NSE-listed entities increasing from approximately $1 trillion to over $5 trillion. The derivatives market now encompasses capital levels three times greater than that of the cash market, raising concerns among regulators about excessive retail participation, with reports indicating nearly 90 per cent of retail investors incurring losses in this space.

In efforts to restrain speculation in derivatives trading, the government has implemented measures to raise costs associated with such activities. By facilitating easier short selling in the cash market, Sebi aspires to pivot trading behaviours towards transactions involving actual shares instead of those reliant on derivatives.

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