ECONOMYNEXT – Sri Lanka has begun regulated short selling with the first transactions recorded on November 06, the Colombo Stock Exchange said.
Some John Keells Holdings and NDB shares were traded, brokers said.
An explainer issued by the Colombo Stock Exchange on regulated short selling and stock borrowing and lending is given below
What is Stock Borrowing and Lending (SBL)?
Stock Borrowing & Lending (SBL) is a mechanism that is introduced by the Colombo Stock Exchange (CSE) through the Central Depository System (CDS) to facilitate the lending and borrowing of shares among investors. SBL involves connecting lenders of shares with borrowers for a pre-determined period and interest rate.
In order to carry out an SBL transaction on the CDS, the lender and the borrower must enter into SBL agreements with their respective CDS Participants, i.e., Stockbrokers or Custodian Banks.
What is Regulated Short Selling (RSS)?
Regulated Short Selling (RSS) is the sale of shares by a borrower of shares (the short seller) on the trading system of the CSE based on a SBL Agreement. RSS transaction is carried out by the short seller (borrower of shares) with the intention of buying back such shares at a future point in time, ideally at a price which is lower than the initial sale price, in order to deliver the said shares to the lender.
Under what circumstances Regulated Short Selling is permitted by the CSE?
A short seller could engage in a RSS transaction under two specific circumstances: either by borrowing the shares first and then executing the short sale transaction or by executing the short sale transaction first and then ensuring that the required number of shares are borrowed through an SBL transaction before the conclusion of trading on the same market day.
Under either of these methods, the borrower must enter into a SBL agreement with the Participant prior to entering the short sale order.
What are the eligible securities for RSS and SBL?
A list of shares will be specified by the CSE/CDS as “Eligible Securities” for both RSS and SBL. The list of Eligible Securities will be determined by the CSE/CDS on a criterion which is primarily based on liquidity. These Eligible Securities will be reviewed every three (3) months and the updated list will be duly published on the CSE/CDS websites.
What are the benefits to investors by participating in RSS?
Lenders of shares could lend part of their dormant portfolios which are not available for trading in the immediate future and earn a fee-based income during the SBL period.
Borrowers of shares could profit from potential price movements in the market by short selling the borrowed shares. If an investor is of the view that the price of a particular share eligible for RSS and BSL may decline in the future, he/she could borrow the shares from a lender and carry out a short sale transaction on the CSE. The borrowed stock can be sold in the market at the prevailing market price. The borrower has the obligation to return the shares to the lender on the agreed date. If the price of share declines (as he/she expected), the borrower (short seller) could make a profit as the difference between the price the shares were sold in the market through the short sale and the purchase price the shares will be his profit, minus the lending fee.
What are the measures adopted by the CSE to address a downfall in share prices due to RSS?
The shares eligible for RSS is selected based on a liquidity criteria where the most liquid as well as the less volatile shares are selected. Further, when the price of a share deprecates by 10% during the day, all RSS orders will be validated against an ‘Uptick Rule’. Under the Uptick Rule, all incoming RSS orders entered into the system after the 10% price depreciation must be at least one (01) tick size above the last traded price of that particular share.
Also, CSE has brought in an additional safeguard where, if the price of a share depreciates by 20%, RSS for the particular security will be temporally suspended until the price appreciates upto the permissible limit.
The objective of these measures is to minimize the acceleration of rapid declines in prices resulting from RSS transactions. Such measures would result in stabilizing the market, especially in downward market sentiments.
What about corporate action benefit, who will get the corporate action benefit from the company? Borrower or lender?
Since the Lender has already parted with the shares, he/she will not be eligible for corporate actions of the listed company arising during the SBL period. The borrower would have also carried out an RSS transaction and therefore, may not be entitled to the corporate action either. Whoever the shareholder who holds the shares on the ’Record Date’ of the corporate action will be entitled to the corporate benefit from the listed company.
However, as per the Rules of the CSE/CDS, the borrower must return to the lender all corporate benefits arising during the SBL period Therefore, an obligation will be created to the borrower to pay the value of the corporate action as a ‘manufactured payment’ to the lender in lieu of the corporate action benefit he would have received if he/she held the shares.
However, the lender can recall the shares from the borrower in instances where there are corporate actions are declared by the listed company by providing three (3) market days’ notice to the borrower.
What is the benefit to the Sri Lankan capital market as a whole?
Short selling enhances market efficiency and the market microstructure of the CSE. This improves the price discovery mechanism of the CSE by incorporating the views of the short sellers in determining the share price, effectively bringing the share price of an overvalued stock closer to its fundamental value. It also narrows the bid-ask spreads and minimizes the impact cost, which ultimately results in improving the liquidity of the market.
Introduction of short selling will also help the CSE to be on par with other regional exchanges which have already introduced this facility.
Any risks involved for Lender?
The risks to lender have been minimized to a greater extent through several risk mitigation actions by the CDS. In this regard, a question may arise whether the lender would receive the shares back from the borrower on the ‘Return Day’, as agreed by the borrower. As specified above, the shares subject to SBL and RSS are the most liquid shares listed on the CSE. Therefore, the borrower should not find it difficult to purchase the shares from the market in order to return such shares to the lender.
The CSE will closely monitor the SBL transactions and issue the required notices to the borrowers through their respective Participants (Stockbrokers and Custodian Banks) well in advance of the Return Date.
In a highly unlikely scenario where the borrower fails to return the shares and/or the lending fee to the lender on the Return Date, the CSE/CDS will ensure that the lender receives a monitory value in the form of a compensation, which is more than adequate to cover the market value of the shares on the Return date. This compensation comprises of the value of the shares based on the current market price, the lending fee and a penalty component, so that the lender will have adequate funds to buy the quantity of shares from the market on the next day.
For this purpose, the CSE/CDS would require the borrowers’ Participants (Stockbrokers and Custodian Banks) to maintain adequate collateral to support the SBL transactions on a continuous basis. Such collateral can be in the form of cash, bank guarantee or certain types of shares. The SBL transactions and collateral provided in the form of shares will be daily valued based on the current market prices, which ensures that sufficient collateral is available with CSE/CDS to be utilized in the event of a default scenario on any given day.
Further, the borrower is also under the obligation to return all corporate actions to the lender during the period. In the event of a breach, the CSE/CDS can utilize the collateral provided by the borrower’s Participant to pay the corporate benefit to the lender.
The lender also has the privilege of recalling the shares lent during the SBL period in the event of a corporate action or a voting announced by the listed company, with prior notice to the borrower. This minimized the risk to the lender as well. Additionally, RSS and SBL transactions will be carried out through regulated Participants of the CSE/CDS. They will be subject to certain enforcement actions in the event of breach.