New Delhi: After Hindenburg Research, a US-based short seller, released a report on the Adani Group alleging accounting fraud and stock manipulation, the company’s stocks crashed and market value halved in a week.
Since then, several questions have been raised on short selling – if it’s ethical, how it’s done, is it legal in India, etc.
Two petitions have been filed in the Supreme Court on this matter. One of them asked the top court to make ‘short selling’ an offence of fraud. Both the petitions raised similar concerns on how short selling affects innocent investors and asked the court to investigate the contents of the report.
The Union government on February 13 agreed to set up a panel to improve regulatory mechanisms.
What is short selling?
Short selling involves borrowing stock you do not own, selling the borrowed stock, and then buying and returning the stock only if and when the price drops.
It’s completely opposite to how a bullish transaction takes place. In such transactions, you buy a stock hoping the price will go up. You wait until it goes up to a certain extent.
However, short selling is mostly done to earn in a falling market. In this case, the investor is bearish on the markets.
For instance, an investor borrows a certain number of shares from a broker, and sells these shares in the market for Rs 100. In the future, when the price of the shares fall to Rs 80, then the investor can buy them at a lesser price, return them to the broker, thereby making a profit of Rs 20.
Investors short sell (or short) when they believe a stock is overvalued and expect the stock price to go down. And, according to a podcast on the Economist, that’s what attracted Hindenburg Research to dig into the Adani Group stocks.
Hindenburg said that the Adani Group has “substantial debt” and that the stock prices of the listed companies are overvalued by 85%.
This is how a financial system offers investors a mechanism to express negative views of stocks, bonds, etc. and let them generate profits if their forecast turns out to be correct.
How is short selling done in India?
“At present, in a realistic sense, there is no short selling in India,” Ajay Shah, markets expert, who was a member of the SEBI committee on the evolution of markets, told The Wire.
Shah, who’s the co-author of Indian Financial Markets: An Insider’s Guide to How the Markets Work, asked me to be careful with using the word ‘short selling’ in the Indian markets’ context.
This is because actual short selling – which involves borrowing shares for a multi-day horizon – is absent in India.
However, there’s severe confusion around the terminology of this word in India.
Shah explained this subject with the help of methods and examples.
The first step requires a speculator who has a negative view of a share price while not owning the shares herself.
1. For any stock, it’s possible to sell it within the day. Now, all open positions at the end of the day have to be settled, and that would not work because the speculator does not own the stock.
Therefore, the short seller has to sell intraday, hoping that her forecast works out correctly, and buy back within the same day before trading ends.
In an ideal event, the speculator, for instance, will sell at 2 pm when the stock is trading at Rs 100, buy it back at Rs 90 at 4 pm, and there’s a clean profit of Rs 10 within two hours for forecasting the price of the stock correctly.
This is colloquially called ‘short selling’, but this is strictly not a correct moniker, Shah said.
2. The second method is true short selling. This involves borrowing shares for multi-day horizons. The speculator goes to the market and sells the shares she does not own.
When the time comes to take the delivery of the shares, she goes to some institutional investor and borrows the requisite shares.
This generally requires paying an interest rate for the privilege of borrowing and also submitting a collateral to ensure that there is no risk of default.
Some days or weeks later, the speculator will buy back the shares from the market and return them to the lender, and earn a profit.
In an ideal event, what would happen is, for instance, you sell today at Rs 100, and deliver based on borrowed shares. In a month, you buy it back at Rs 90, and some of the raw profit of Rs 10 goes away as the interest cost of borrowing the shares for a month.
“This method is absent in India, but is amply prevalent elsewhere in the world,” Shah told The Wire.
“I think Hindenburg may have short sold Adani Group bonds in the US in this fashion,” he added.
3. The third method is the use of stock futures. An investor expresses a negative view of the stock by selling the futures.
[Futures are financial derivative instruments used to buy or sell a specific commodity asset or security at a set future date for a set price. If the price of the underlying asset (for example, Reliance Industries share) increases, then the price of the derivative (Reliance futures contract) also increases.
Suppose the price of a Reliance Industries share is Rs 2,000. And a Reliance futures contract is currently selling at Rs 2,186. You expect the price of the share will go up after, say, three weeks, so you buy a futures contract. But you don’t need to pay for it right away. You make the payment only when squaring off the futures contract on the specified date.]
When an investor has a negative view of a stock, she will sell the stock futures.
In an ideal scenario, Shah explained, she will sell the futures at Rs 100 and buy them back some days later at Rs 90 and make a clean profit of Rs 10. This process also requires posting a collateral, he added.
“Here also, the phrase ‘shorting the futures’ is used colloquially but this is not ‘short selling’, it’s just futures trading,” he said.
4. The fourth method uses the options. There are many ways in which an option position can express a negative view. For instance, an investor can buy put options, which gain in value when the price goes down. But this is also not called ‘short selling’.
What is ‘naked short selling’?
Ordinarily, traders must first borrow a stock before they sell it short.
However, in naked short selling, which is now illegal, stocks are not borrowed. Therefore, in times of panic, more people could dump their holdings, without any obligation to fulfil their settlements, thereby pushing the prices of the stock further down.
In short selling, for instance, if an investor has sold a number of shares she borrowed from a broker, she must, sooner or later, ‘close’ the short by buying back the same number of shares.
For instance, if you sold a stock at Rs 100, in the hope that the price will go down, but on the contrary, it increases to Rs 120, then you’ll have to buy it at a loss of Rs 20. Basically, you’ll have to complete the settlement.
After the 2008 Global Financial Crisis, the Securities and Exchange Commission (SEC) prohibited naked short selling.
According to CNBCTV18, in September 2008, the US SEC had temporarily banned short sales in nearly 1,000 financial stocks to halt the free fall in prices. Following this, stock prices recovered for a brief period but continued to decline for the rest of the period when the short sale ban was in effect.
However, months later, SEC chairman Christopher Cox had regretted the decision, saying “the costs appear to outweigh the benefits.”
[If you’ve seen the movie The Big Short, which is an adaptation of author Michael Lewis’s best-selling book of the same name, Michael Burry (Christian Bale), the manager of hedge fund Scion Capital, bets on the booming housing market. He shorts the housing markets assuming that the prices would fall. The collapse of the US housing market led to the 2008 financial crisis.]
What did Hindenburg short in Adani Group?
Hindenburg Research’s report also alleged that the Adani Group has used offshore shell companies linked to Adani’s family to drive up share prices.
According to a podcast by the Economist, the share price growth of Nifty50 is what attracted Hindenburg to research on India over the last few years. The Adani stock chart was pretty much straight up for the year, and it’s an overvalued stock, it said.
Hindenburg believes that the Adani Group has “substantial debt” and that the stock prices of the listed companies are overvalued by 85%.
However, the US-based firm has revealed little about the size of its bets and the kind of derivatives and reference securities it used in this case, Reuters reported.
The short seller said it held its position “through US-traded bonds and non-Indian-traded derivatives, along with other non-Indian-traded reference securities.”
“I wanted to short it myself, but I was not able to find a way to do it with my prime broker,” Citron Research founder Andrew Left, referring to Adani Enterprises and other companies, told Reuters.
Hindenburg also declined to comment to Reuters on the method it used to place its bets against Adani.
Can Hindenburg be held accountable for not disclosing its bets?
According to Shah, “our financial activities should be well shrouded in privacy. You or I should not have to disclose our speculative bets. Our financial activities should be as secret as our health records.”
He added that if short selling were to be introduced in India, there needs to be no disclosure going with it. “At a conceptual level, you borrow shares from me and sell them on the market. Your selling on the market is already protected by privacy. Why should your borrowing from me not be equally protected?” he said.
He further said that the single secret information on the NSE is the name of the participant who is doing the trading. “Everything else about the market – the price of a security, the orders present about the security, etc. – are freely released into the public domain.
In the historical context, what were SEBI’s views on ‘short selling’?
In a 2005 discussion paper on this subject, the Securities and Exchange Board of India had noted that “the votaries of short selling consider it as a desirable and an essential feature of a securities market. The critics of short selling, on the other hand, are convinced that short selling, directly or indirectly, poses potential risks and can easily destabilise the market.”
“In their view, the restrictions on short selling distort efficient price discovery, ‘gives promoters the unfettered freedom to manipulate prices, and favours manipulators than rational investors,” the paper had said.
This paper led to the opening up of ‘short selling’ to more market participants in 2007.
In December 2007, SEBI allowed all classes of investors to short sell, after recommendations by the Secondary Market Advisory Committee, which provides suggestions to SEBI to improve market safety, efficiency and transparency.
The 2005 paper had said, “It is noteworthy though, that despite the conflicting schools of thought, securities market regulators in most countries and in particular, in all developed securities markets, recognise short selling as a legitimate investment activity. Such jurisdictions also have an active market for equity derivatives which includes stock futures. Some of the jurisdictions even recognise the usefulness of naked short sales in certain circumstances and instead of prohibiting short sales; the regulators have permitted it to take place within a regulated framework.”
Harassment of short sellers
Exposing fraud is in the public interest, The Conversation said, adding that “if the report is truthful, blaming Hindenburg for Adani’s crash is like blaming an alarm for a fire.”
In fact, fundamental short selling can be a valuable indicator of fraud and misrepresentation, fund manager, Fahmi Quadir at Safkhet Capital, notable for her forensic research on companies like Valeant Pharmaceuticals and the Germany company Wirecard, had said.
The regulator had focused on probing so-called short-sellers and journalists behind reports which questioned Wirecard’s accounts, halting short-selling in the stock, rather than immediately investigating the company. Wirecard eventually went bust.
“The release of this information [related to fraud and misconduct] ultimately benefits shareholders who deserve the opportunity to assess a company’s true value without disruptive regulatory overreach. The simultaneous actions taken to investigate mainstream, credible news agencies reporting on Wirecard may prevent additional whistleblowers from coming forward with price-critical information,” Quadir had said.
The Economist in the podcast noted that short sellers conduct very thorough research on the company before publishing the report. The reactions of the market and of the company, however, tell to what extent the report was true.
Adani Group called the report “malicious”, “baseless” and a “calculated attack on India”. Several people, including Bharatiya Janata Party leaders, allegedly used Twitter to spread misinformation against the short seller.
Instead of scrutinising the allegations against the group, whose rapid growth, that too in line with Prime Minister Narendra Modi’s political career, had raised concerns, several people made it a “nationalist issue”, including Adani himself.
However, as mentioned earlier, SEBI has said that it will conduct a detailed examination into the companies’ stocks.
In a separate case in 2019, the Delhi high court had called out the threatening tactics used by Indiabulls against a short-focussed researcher.
In August 2012, Veritas Investment, a Canadian company, had published a research report on Indiabulls, titled Bilking India. The report alleged corporate governance issues against the company. It was published based on the public filings of Indiabulls Financial Services, Indiabulls Real Estate and other group firms, Business Standard had reported.
Indiabulls responded with a criminal complaint against the two authors of the report, and even got one of them arrested.
The Delhi high court had in 2019 called out Indiabulls for “harassment” of equity analysts, the Economic Times had reported. It had said: “Such litigation could also result in genuine researchers being dissuaded from writing articles which would not be in the interest of the investing public.”
If short selling is a legitimate activity in the markets, then why is it seen in such a negative light?
In India, most of the trading in equity futures and options is settled in cash. The settlement happens after the expiry of a contract. This is when the buyer and the seller have to fulfil their obligations. And since it’s a speculative activity, it’s not seen in a positive light.
Sanjiv Shah, mutual fund industry veteran and co-founder of Benchmark Asset Management, told The Wire over the phone, “It’s more like a human psychology. People profiting from selling and price reducing rather than making money from price increases –that’s a human psychology more than anything else.”
Abhishek Mundra, a stock market analyst, full-time trader and investor, told The Wire on LinkedIn: “This is because everyone is taught to look at the markets rising to higher levels on hope. Most of the participants don’t know how to sell high first, and buy low later. [It’s] just the systematic thinking since early ages.”
The Indian market, according to an Economic Times report, is considered to be one of the most speculative in the world as far as derivatives contracts go. Dalal Street has a high derivative to cash turnover ratio.
In 2020, Bloomberg reported that the NSE surpassed America’s CME Group Inc. to become the world’s largest derivatives bourse by volume. NSE traded the most contracts in the world in 2019, the report said.
As of February 15, 2023, the derivatives to cash ratio is 2.9 on the NSE. Basically, it’s three times more. Sanjiv Shah explains: “for example, if Rs 100 worth of stock has been traded in the underlying [asset], which is, Rs 100 worth of shares have been transferred in the cash segment. So, [suppose] everybody put together a Rs 100 in the [cash] market. The same activity in the derivatives – the futures and options market – is Rs 300.”
In 2018, the derivatives to cash market ratio for India had increased to 29.6.
Meanwhile, in the wake of the recent onslaught in the trading sessions last month, SEBI has said it will ascertain the role of short sellers in bringing the market down.
It’s important to note that India has limited options for short selling. According to Mint, it is difficult to short sell a stock that’s not in the F&O system. There is a securities lending and borrowing or SLB system on paper.
However, most shorting happens through derivatives (futures and options) rather than the SLB mechanism. “This is because the SLB mechanism has high interest rates of 1-1.5% per month and very low liquidity. There are also additional frictions and paperwork involved in SLB,” Nikhil Kamath, co-founder of Zerodha and True Beacon, an alternative asset manager, told the business daily.
In futures, he added, that there’s only a roll-over cost, which is much less as compared to SLB. “But naturally, this restricts shorting to the stocks in F&O,” he told the newspaper.
Sanjiv Shah further explained, “Basically, I will borrow the stock, sell in the market, hoping that one or two months later, I will be able to buy it back when the price falls. But FIIs cannot do that. So, they go short on the futures market.”
What are the advantages of ‘short selling’, especially for retail investors in India?
“Retail investors are protected when the big boys will spot problems in stock prices and use short selling to bring about a correction,” Ajay Shah said.
“For the top 50 to 100 stocks, where derivatives trading is available, de facto this is now being done using the derivatives. But for the remaining securities, this is currently not being done. This is where short selling mechanisms (i.e., securities lending mechanisms) will help.”
“I do not recommend that retail investors engage in short selling, or in active financial markets trading. They are better off being long-term investors using index funds,” he added.