India permits investors to engage in short selling, the process of borrowing and then selling a security to profit from its price decline. However, this has not always been the case. From 2001 to 2008, the practice was prohibited after allegations of insider trading contributed to a crash in stock prices.
Key Takeaways
- Short selling involves the sale of a borrowed security with the intention of buying it again at a later date at a lower price.
- The practice was banned by the Securities and Exchange Board of India (SEBI) between 2001 and 2008 after insider trading allegations led to a decline in stock prices.
- India's regulations permit short selling, but financial authorities require traders to identify short sales at the time of the order.
- Naked short selling remains illegal in India, along with day trading by institutional investors.
- Indian regulators instituted a temporary ban on short selling between March 2020 and October 2020 because of the economic turmoil related to the pandemic.
In 2008, Indian regulators reinstated short sales with additional protection from the potential negative effects of short sales. These regulations require investors to disclose short sales, prohibit day trading by institutional investors, and establish a platform for short sales. Indian regulators temporarily restricted short selling again between March 2020 and October 2020 during the economic turmoil at the onset of the COVID-19 pandemic.
What Is Short Selling?
Experienced investors probably know a thing or two about short selling. But many don't, even after the memorable attempts at explaining its technical aspects in the cameos of “The Big Short,” Adam McKay's 2015 movie depicting those who bet against the U.S. housing market in the mid-2000s. Short selling is counterintuitive because it involves making money off something you don't own, and you're then making money as things go to pieces. Yet, it works, and it's been around long enough that the first stock in the 1600s was the first stock to be shorted. These are the steps:
- First, the investor borrows from a broker shares of a stock they expect to go down, typically paying a fee for the service.
- Next, they sell the borrowed shares on the open market at their current price.
- Later, if the stock price goes down, the investor buys the same number of shares back at the lower price.
- Then these shares are returned to the broker, and the investor pockets the difference between the selling price and the repurchase price as profit, subtracting any fees or interest paid for the loan of the shares.
By sanctioning short selling, regulators are, in effect, enabling traders to bet against overvalued stocks. This can have several positive effects; short sellers offer a balance in the market against the hype behind trending stocks. In theory, this should help prevent speculative bubbles, recalibrate market mispricing, and make for better and more accurate stock valuations.
However, the public continually says it hates the practice, which usually gains notoriety during major market downturns. Just as many, including those farthest from Wall Street, lose their livelihoods and financial future, word spreads of the few profiting in the midst of the misery. When there’s a downturn in the market, many find it easier to blame predatorial short sellers, not missteps by company management or wider trends.
The opponents of short selling argue that it leads to market declines. They say that widespread short selling can trigger a downward spiral of stock prices, crashing the market and, by extension, the wider economy. Opponents also claim that short selling leads to manipulative efforts to crash a stock or entire market to score a profit.
India's Ban on Short Selling
Until relatively recently, India had few limits on short selling. Then, the Securities and Exchange Board of India (SEBI) banned short selling for much of the first decade of the 2000s, beginning in 2001. The ban was instituted in part because of a major decline in stocks amid allegations that Anand Rathi, then president of the BSE (the stock exchange in Mumbai), traded on confidential information he got from the exchange's surveillance department. Rathi was later absolved of any wrongdoing by SEBI, but the wider damage to investors was done.
Indian securities regulators instituted a temporary ban on short selling again in March 2020 just after the beginning of the pandemic. The ban was lifted in October 2020.
New Short Selling Guidelines
The ban on short selling proved short-lived. In 2007, SEBI published a securities lending and borrowing (SLB) framework permitting retail and institutional investors to engage in short selling again. There were conditions:
- Failures to deliver prohibited: The SLB allowed retail and institutional investors to sell securities they don't own through short sales. However, they are required to deliver these securities when the trade is settled. Essentially, this is a ban on naked short selling, where the seller cannot access the securities.
- Limits on trading: Institutional investors are prohibited from day trading. In 2007, only securities for futures and options could be shorted, but soon, the list included index exchange-traded funds.
- Disclosure requirements: Institutional investors must disclose short sales when placed, and retail investors have until the end of the trading day to do so. Brokers must keep detailed records on all shorts and report them to the relevant Indian stock exchange, which then publishes the information online.
- A specific platform for short selling: The SLB system relies on platforms provided by clearing corporations or the clearing houses of the stock exchanges. The independent, automated platforms are only for borrowing or lending securities and are to be accessed through banks or custodians approved by the stock exchanges.
- Restrictions on short selling by foreign portfolio investors (FPIs): FPIs can only short sell stocks in companies with at least 2% foreign investment available before hitting regulatory caps and companies not on the RBI's caution or ban lists. They must also follow certain margin requirements, and their custodian banks are responsible for reporting all their short-selling activities daily.
Day trading involves the squaring off of transactions on an intraday basis.
No Naked Short Selling
Even though Indian authorities lifted the restrictions on short selling, naked shorting remains illegal. In this type of transaction, a trader shorts shares that have not been determined to be tradable. This could mean that the short positions taken on a stock come to exceed the actual number of tradable shares in the market.
Like the U.S. Securities Exchange Commission (SEC), which restricts naked short selling through Regulation SHO, India's SEBI argues that the ban is needed. Unchecked naked shorting, it says, would put artificial downward pressure on stock prices and affect liquidity in the market.
185
The approximate number of securities traded in the futures and options segment of the Indian stock market eligible for short selling.
Who Regulates the Indian Stock Markets?
The most important securities regulator in the country is the Securities and Exchange Board of India (SEBI). The board plays a role like that of the Securities and Exchange Commission in the U.S. SEBI has broad powers to regulate securities markets in India, investigate infractions, and impose fines on violators.
When Should I Short a Stock?
Investors often short a stock to hedge another position or if they anticipate a decline in prices. Short sales can be very profitable if the stock does, in fact, lose value. However, if the price goes up, the short seller could face significant—theoretically unlimited—losses. With this in mind, short selling is not a suitable strategy for novice investors and should be undertaken only after fully understanding the risks involved.
Which Countries Have Banned Short Selling?
India was not the only country to limit short selling in response to the pandemic. Countries in Europe and Asia instituted bans or restrictions on short sales as the pandemic wreaked havoc on global markets in early 2020. In November 2023, South Korea reinstated its prohibition on short sales, which will remain in place until mid-2024.
The Bottom Line
Although regulations in the country allow short selling, India restricted the practice between 2001 and 2008 and again in 2020. Naked short selling remains prohibited, and authorities say such limits keep the market fairer for all participants.
