 India’s equity market infrastructure, touted to have reached global standards with electronic trading, rolling settlements, a growing derivatives market and a smooth clearing and settlement process, has had one major chink in its armour — the absence of a functional securities lending and borrowing system. That lacuna will be remedied this year, thanks to Sebi’s initiatives and a green signal from finance minister P. Chidambaram in this year’s Budget speech.
Securities lending facilitates short selling and makes the settlement process in the cash market efficient. It also enhances arbitrage activity between the derivatives and cash markets, leading to better price discovery. For these reasons, both market participants and financial economists have been waiting for its introduction with baited breath. “We need it as of yesterday,” says Ajay Shah, senior fellow at the Delhi-based National Institute of Public Finance and Policy (NIPFP). Vikramaaditya, head, HSBC Securities Services (India), in Mumbai says, “Securities lending and borrowing will enable the market to reach the next level in terms of infrastructure, and increase the options available to market players.”
The high interest was evident at the recent international securities lending conference in Shanghai, where V.S. Sundaresan, representative of Mumbai-based Securities and Exchange Board of India (Sebi), was the most popular delegate. “European and American players are very excited about this and are keen to get on board as soon as possible,” says Craig MacDonald, London-based editor of International Securities Finance.
Short Sales
One of the major benefits of short selling — selling a stock one does not own — is that it increases liquidity in the market, and makes price discovery more efficient. Besides, it curbs manipulation of stocks as informed investors are able to go short on stocks they feel are higher than fair value.
But investors, including institutional players, can already go short on the 159 stocks on which futures trade. However, this is just a fraction of the thousands of stocks that are listed. Shah says that the biggest benefit of shorting would be on the remainder of the shares.
The irony of the matter is that Sebi plans to restrict short sales and securities lending to only those stocks on which derivatives trading is already available. Damodaran reasons, “When you do something new like this, it is important to make sure that the system stabilises first. To begin with, the 159 derivatives stocks are a good starting point. Once the system stabilises, the facility can be extended to more stocks.”
But experts say that the caution is exaggerated. Susan Thomas, assistant professor, Indira Gandhi Institute of Development Research in Mumbai says, “In terms of securities regulation, we seem to be doing everything in baby steps these days, unlike in the early periods of the reform process when giant steps were taken. Much has been done to provide varied financial services for liquid stocks, but the key now would be to make these services work even for the less liquid stocks.”
Sebi’s concern stems from the history of securities lending in India. In 1997, Sebi introduced a ‘Securities Lending Scheme’, but it never really took off as intended. Instead, both the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) used the scheme to introduce products that were akin to the popular carry-forward system, or badla. BSE’s BLESS (borrowing and lending of securities scheme) and NSE’s ALBM (automated lending and borrowing mechanism) were essentially securities lending and borrowing arrangements, but were clubbed with the settlement process of the respective exchanges.
This made them as convenient as the badla system for traders wanting to avoid taking delivery of shares and carry forward their outstanding positions to the next settlement cycle. But this heady cocktail of spot market trading, leverage akin to a futures market and securities lending and borrowing led to serious mishaps. A payment crisis at the Calcutta Stock Exchange and findings of the joint parliamentary committee on the 2000 stockmarket scam finally led to a ban on BLESS, ALBM and other such products in mid-2001.
Many, however, think that this is all in the past. Besides, a lot more checks and balances are now in place. J.R. Varma, professor, Indian Institute of Management, Ahmedabad, says it is fine to start with the derivatives stocks as long as there is a time frame set out to include the others. “It would be unfortunate if we get stuck with the derivatives set. Ideally, within a year, there should be short selling and securities lending available on all listed stocks.”
It may be a while before this happens, but for derivatives traders, short selling is a blessing. Futures ought to trade at a fair premium to spot prices. But at times, futures trade at a low premium, or even at a discount to spot prices (see ‘Futures Disconnect’). This presents an arbitrage opportunity, where a trader can buy the low-priced futures contract and then sell in the spot market. “With short sales being allowed, such arbitrage opportunities can result in actual profit,” says Sanjiv Shah, executive director at Benchmark Asset Management in Mumbai.
Partial Settlements
One of the problems faced by investors in India is that of partial settlements, which are caused by a short delivery of shares by sellers. Currently, the required shares are acquired through an auction process. But this is not popular with buyers, since they do not recieve the entire lot of shares on the intended date. Further, if the buyer cannot acquire the shares he requires through the auction, the transaction is ‘closed-out’, and cash is transferred to the buyer in exchange for the pending shares. In the case of a close-out, there are additional problems involving taxation and record-keeping for institutional investors. “Securities lending and borrowing will also minimise partial settlements. In case of a settlement shortage, stocks can be borrowed to ensure full delivery,” says HSBC’s Vikramaaditya.
On the face of it, the issue of partial settlements does not seem to be a problem — settlement shortages are less than 0.5 per cent of total settlement turnover. But NIPFP’s Shah adds that the current auction process is a waste of resources. “Not only does it impose a burden of cost on infrastructure providers, it is also a waste of effort and time.”
| THE ROAD LESS TRAVELLED |
 THE world over, securities lending is done through over-the-counter (OTC) transactions, where the intermediary takes on the counterparty risk in exchange for collateral from the borrower. Market regulator Sebi (Securities and Exchange Board of India), however, has recommended a screenbased, exchange-traded system, where the exchange’s clearing corporation collects the collateral and acts as a central counterparty.
Overseas market participants say this may not be popular with offshore investors as credit risk is concentrated with one central intermediary, and there may be concerns about foreign exchange risk on collateral held onshore by the clearing corporation.
Sunil Daswani, chairman, Pan Asia Securities Lending Association, in Hong Kong, says, “Offshore institutional investors hope for developments such as OTC transactions and collateral managed bilaterally offshore, to allow their participation.” Lawrence Komo, Asia Pacific head (securities finance), Citibank says, from Singapore, “Offshore institutional investors will always be intially cautious when there is a new structure or model in the market.”
The worry is that offshore investors may be uncomfortable or unaware of the credit worthiness of Indian clearing corporations. But Ajay Shah, senior fellow, National Institute of Public Finance and Policy says that is not an issue, pointing to the derivatives market where offshore investors are big players precisely because the clearing corporation is their trusted counterparty. In the derivatives market, foreign institutional investors account for 38 per cent of total outstanding positions. Vikramaaditya, head, HSBC Security Services in India says, “It is a question of the investor undertaking due diligence on the clearing corporation and being comfortable with the arrangement.” J.R. Varma, professor, Indian Institute of Management in Ahmedabad, feels foreign exchange risk concerns for investors are secondary compared to the larger risk of going short. Besides, forex risk can be hedged in the forward market.
Similar models have been adopted in countries such as Malaysia and Brazil, with mixed responses. The Malaysian market has not taken off, but the Brazilian securities lending system has seen five years of rapid growth, despite the fact that the Brazilian Clearing and Depository Corporation acts as the central counterparty for all securities lending transactions and holds all collateral. Yet, persistent demands by offshore investors have caused Brazilian regulators to look at adopting the OTC model of developed markets. However, experts such as Varma are convinced that the model proposed by Sebi is best suited for the market. Not only does it provide transparency, it also ensures equal opportunities for both retail and institutional players.
While the debate over which model is superior continues, it is hard to disagree with Komo: “Each market has the right to choose a model they feel is most appropriate for their conditions. The important thing is to get started, whatever the format.” |
Lender’s Motivation
In markets such as the US and Japan, the supply of stock for securities lending is many times more than the actual value borrowed. These high-liquidity markets allow lenders to earn annualised returns of about 20 basis points. Since liquidity will be lower here to start with, lenders can expect higher returns. Investors here also have an opportunity to earn additional income on their idle securities. Sanjiv Shah says that if the transaction costs are reasonable, Benchmark would be willing to lend securities and earn additional income for its investors.
In any case, supply should hardly be an issue. Institutional investors hold stocks worth nearly $200 billion. It remains to be seen if borrower demand could get much higher than the obvious needs arising from settlement shortages and from cash-derivatives arbitrageurs. Unless short sales and securities lending is allowed in non-derivatives stocks, experts feel they may not be a very high demand for borrowed stock to go short.
Given the high level of interest, the Indian market could well be among the leaders in the Asia-Pacific region (ex-Japan). Hong Kong and Australia currently enjoy the highest volumes with a turnover of $70 billion each, while Korea is next with $20 billion. But turnover alone would not capture the significance of securities lending. As Ajay Shah says: “The importance of securities lending is disproportionately higher; it goes well beyond numbers.”
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