Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 26 Dec 2007

Short Selling at Long Last?

In February 2007, the Indian Finance Minister announced in his budget speech that institutions would be allowed to short sell and that a securities lending mechanism would be put in place. Nearly ten months later, The Securities and Exchange Board of India has announced the Broad framework for securities lending and borrowing and the Broad framework for short selling but it is not yet clear as to when the exchanges would operationalize these products. Given the considerable similarities in software requirements between the proposed securities lending mechanism and the old ALBM system, I would think that the exchanges should not need more than 2-3 weeks to get this off the ground. So the absence of a specific timetable is disturbing.

Globally, the corporate world hates short selling and does its best to discredit it and even prevent it if possible. In the US for example, the SEC took 70 years to remove short sale restrictions and even that happened only after Enron had weakened the credibility of corporate America. Even now, the SEC is to my mind unduly harsh on what it calls “abusive short selling” as I discussed in my blog post earlier this year.

In India too, I know from my conversations with corporate leaders that corporate India does not like short selling and would like the proposals to be diluted and delayed as much as possible. After I expressed this fear publicly in a television interview earlier this week, I have been assured by the regulators at the highest level that they do not feel any pressure from the corporate sector and would not be swayed by any pressure even if it were sought to be applied. I can only conclude that the corporate lobby is concentrating on those whose convictions on short selling are weaker and can therefore be more easily swayed. Since the short selling and securities lending framework require concurrence of the tax authorities and of the central bank while operationalization requires action by the exchanges and perhaps the depositories, opponents of short selling have many avenues open to them to delay if not block much needed reform.

I have been arguing the case for free short selling for several years now to the point of beginning to sound like a broken record:

In India, [severe restrictions on short selling] are the single most important culprit for the frequency and severity of episodes of stock market manipulation that have taken place in this country during the last decade. Indian Journal of Political Economy, October-December 2002

A market without short selling is an open invitation to company managements and other manipulators to rig up the prices of stocks.(Business Line March 15, 2004)

Removal of all restrictions on short-selling would be the single most important step towards making Indian capital markets cleaner, safer and more efficient.(Economic Times, October 3, 2005)

But I think the battle is not over yet. All of us who have a stake in clean and vibrant capital markets must therefore keep up the vigil to ensure that unscrupulous corporate managements do not succeed in delaying this reform any further.

It is equally important to move quickly beyond the broad framework that has been published now. First, short selling needs to be quickly expanded beyond the derivative stocks to at least the top 1,000 or 2,000 stocks as I discussed in my blog post two years ago. Second, the position limits need to be increased substantially. Third, mechanisms for borrowing stocks for much longer periods than seven days need to be created. The proposed framework requires gross settlement at client level so that even a roll over of the seven day contract into the next contract would be cumbersome. Global experience suggests that when short positions are established in stocks on the suspicion of fraud or misreporting by the company, the position has to be maintained for several months for the short sellers to expose the fraud and make a profit on the position.

But all these problems should not hold up progress. The better should not become the enemy of the good. SEBI, RBI and the exchanges must work hard to make short selling and securities lending a reality in January 2008.

Posted at 15:09 on Wed, 26 Dec 2007     View/Post Comments (2)     permanent link

Mon, 10 Dec 2007

FASB tries to define equity and liability

The Financial Accounting Standards Board (FASB) in the United States has put out a very interesting document outlining its preliminary views on a consistent definition of equity and liabilities. As highlighted in Table 2 at the end of the document, the FASB proposals would involve substantial changes in current accounting practice. In particular, it would allow gains or losses to be recognized when a company enters into derivative transactions on its own stock.

Years ago, while writing a paper on Enron, I came across instances where current accounting treatment for such transactions is not in line with economic realities, but thought that the changes required to bring them in alignment would be too drastic for accountants to countenance. It is fascinating to find that FASB is prepared to contemplate making these drastic changes and it is likely that the International Accounting Standards Board (IASB) would move in the same direction as well.

Posted at 08:09 on Mon, 10 Dec 2007     View/Post Comments (0)     permanent link

Sun, 09 Dec 2007

SEC Admits that it Rigged Share Prices!

I find it hard to believe this, but the SEC press release explicitly says that as part of its sting operation, it and the FBI did actually manipulate the share market – the SEC/FBI “bought the stock defendants were promoting. Every buy transaction had a material effect on the stock trading volume of the companies in question”. Will the SEC/FBI compensate genuine investors who traded on the basis of the false volumes or prices? The SEC says “Our office worked closely with the criminal authorities and provided information and technical assistance throughout the FBI sting operation in order to minimize harm to innocent investors.” But minimize is not the same as prevent.

Another puzzling thing in the press release is that after saying that “In fact, there was no hedge fund”, it goes on to say that “the hedge fund bought the stock”. Perhaps, it was a drafting error in the press release.

Posted at 16:35 on Sun, 09 Dec 2007     View/Post Comments (2)     permanent link

Fri, 07 Dec 2007

Financial markets and financial information

There is a chicken and egg relation between financial markets and financial information: the markets need data to function well but the data is generated only when the markets become vibrant. This was my response to Peeyush Mishra who emailed me this week with a comparison of the richness of data that is available about the US housing market (OFHEO, Case-Shiller, NAR, NAHB and Commerce Department) with the paucity of such data for India. Peeyush asked me whether we should make a sustained push to collect and organize more of this data and put it in the national domain.

My argument was that we have already traveled down this top-down route with the National Statistical Commission that submitted its report in 2001 and the National Statistical Commission that was established in 2006 following the recommendations of that report.

The alternative (bottom-up) approach is to rely on the demand pull that emerges from well developed financial markets. These markets not only create demand for financial data, but this demand is backed by willingness to pay for the data – it is as the economists like to say “effective demand”. Both private sector and public sector providers respond to this demand. It may appear surprising but it is a fact that even Indian public sector providers respond to private sector demand for data particularly when this demand starts being met by private sector providers. Once they get into the game, public providers also sometimes try to shut out the private providers on vague grounds related to the integrity of the data. Viewed in this light, the main reason why the US has such rich data on housing is the huge mortgage and mortgage derivative market in that country.

It is also true that data providers (both private and public) are more reliable when the data they generate is used by financial markets than when it used primarily by academics. This is because while academics are content to run some outlier tests and get rid of the worst errors in the data, market participants have less tolerance for mistakes in the data. The private sector can also help in scrutinizing the validity of the methodology. For example, in 2003, Statistics South Africa was forced to correct flaws in the estimation of the housing rentals component of the consumer price index in response to complaints by analysts.

Posted at 15:55 on Fri, 07 Dec 2007     View/Post Comments (0)     permanent link