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 3:09 pm IST on Wed, 26 Dec 2007 permanent link

Categories: regulation, short selling

Comment	Response
A CDO is a leveraged play on the underlying, banks forget that the ‘deltas’ of the underlying portfolio can be quite large and mean substantial MtM volatility. I think a good test of the market is around the corner when the credit cycle turns and we see a number of downgrades on existing tranches making them economically unviable. (Mrinal Sharma)	A bank is also a leveraged play on the underlying loan book. But banks do not M2M their loan book and when the credit cycle turns, the impact is gradual. When there is no M2M, downgrades do not matter only defaults do.
‘Correlation risk’ and how it affects pricing is also a term misunderstood by banks and frequently ignored. (Mrinal Sharma)	Most of the risk of a bank’s loan book is also correlation risk though it is more commonly called concentration risk.
Tranching creates a slicing of risk whereby the 0-3% (in 5 years CDOs) is labeled as an equity investor. By receiving this name it would equate to the equity investor in any business, i.e., a bank. Nevertheless the actual risk/return characteristics of a non tranched equity stakeholder (i.e., a bank equity holder) are very different to those of a 0-3% holder in a CDO, aren’t they? (Francisco Casanova)	In a bank also, there are actually many tranches – demand deposits, time deposits, subordinated debt, hybrid capital and equity. If there were no central bank to bail out the bank, this would behave much like a CDO. When things start getting bad, the demand deposits will pull out quickly and will be paid out in full – this is like the AAA tranche. Time deposits might involve some loss if pulled out but the loss might be very small – an A or AA tranche. Some of the subordinated debt and hybrid capital would be like the BB tranche. Equity would be like the equity tranche. The precise attachment points of the tranches in the CDO reflect three things – the quality of the underlying pool, the lack of central bank bail out and the rating errors of the rating agencies. The big difference between banks and CDOs is the lender of last resort (the central bank)
Also, this permanent presence of the idiosyncratic vs systemic signals debate arising from the correlation movements in trading (which I do not know how accurately could be extrapolated to a bank), or the fact that, ceteris paribus (collateral spreads unchanged), a change in correlation reallocate expected losses among tranches in a zero sum game (i.e., an increase in default correlation expectations shifts risk allocation from junior to senior CDO tranche holders)... Or the mere fact that you can trade pure correlation views if you take delta hedged positions... (I guess you could do the same if all stakeholdings in a bank were securities form...). (Francisco Casanova)	It is interesting to note that the Basle II formula for corporate exposures is based on the same one-factor Gaussian copula models that are often used to price CDS index tranches. It is also useful to look at the following paragraphs from the second consultative package (Jan 2001) on Basle II that introduced the formula: 424. Credit risk in a portfolio arises from two sources, systematic and idiosyncratic. Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers. Borrowers may differ in their degree of sensitivity to systematic risk, but few firms are completely indifferent to the wider economic conditions in which they operate. Therefore, the systematic component of portfolio risk is unavoidable and undiversifiable. Idiosyncratic risk represents the effects of risks that are peculiar to individual firms, such as uncertain investments in R&D, new marketing strategies, or managerial changes. Decomposition of risk into systematic and idiosyncratic sources is useful because of the large-portfolio properties of idiosyncratic risk. As a portfolio becomes more and more fine-grained, in the sense that the largest individual exposures account for a smaller and smaller share of total portfolio exposure, idiosyncratic risk is diversified away at the portfolio level. In the limit, when a portfolio becomes “infinitely fine-grained,” idiosyncratic risk vanishes at the portfolio level, and only systematic risk remains. 425. The design and calibration of the IRB approach to regulatory capital relies on decomposing risk in this manner. Under an IRB system, the risk weight on an exposure does not depend on the bank portfolio in which the exposure is held. That is, while capital charged on a given loan reflects its own risk characteristics, such as the credit rating of the obligor and the strength of the collateral, it is not permitted to depend on the characteristics of the rest of the bank’s portfolio. To get this property of portfolio-independence, we must calibrate risk weights under the assumption of infinite granularity. Without this assumption, the appropriate capital charge for a facility would depend partly on its contribution to the aggregate idiosyncratic risk in the portfolio, and therefore would depend on what else was in the portfolio. With the assumption of infinite granularity, idiosyncratic risk can be ignored, so the appropriate capital charge for a facility depends only on the systematic component of its credit risk. 426. Of course, no real-world portfolio is infinitely fine-grained. Thus, there is always some idiosyncratic risk that has not been fully diversified away. If this residual risk is ignored, then a bank just satisfying IRB capital requirements will in fact be undercapitalised with respect to the intended regulatory soundness standard. To avoid such under-capitalisation, IRB risk weights have been scale upwards by a constant factor from the infinite granularity standard. The constant factor was chosen to approximate the effect of granularity on economic capital for a typical large bank. In order to capture variation across banks in granularity, we furthermore introduce a portfolio-level “granularity adjustment.” This additive adjustment to risk-weighted assets is negative for banks with relatively fine-grained portfolios, and positive for banks with more coarse-grained portfolios.
If the concepts of CDO and Bank are so fundamentally close, why are CDOs facing this acute lack of consensus in the valuation methodologies which is not present in the valuation of banks by equity and debt analysts? (Francisco Casanova)	Banks are well diversified as compared to many CDOs. The few banks like Northern Rock that are not so diversified have seen huge valuation volatilities similar to CDOs. In the past, banks that have faced deterioration of a major part of their portfolio have seen values go down to zero very quickly. For example, think of what happened to some of the largest East Asian banks during the Asian Crisis. In the late 80s/early 90s, some analysts had a target price of zero for Citi stock before it clawed its way back from the brink. This leads to the interesting question as to why CDO investors did not apply the lessons of centuries of bank management and regulation to CDOs. Why did they accept sector concentrations that would have raised eyebrows in banking? One possible answer is that this was a new field and investors were learning the lessons the hard way. The other answer is that the investors were diversifying across CDOs and so risk concentration in any one CDO did not matter. If this is so, then big value changes in individual CDOs do not matter; what matter is value changes of diversified portfolios of CDOs. These latter changes have been much less dramatic. The attachment points for AAA and AA tranches in many CDOs seem to have been badly off. A well run AA rated bank probably has a capital of 10% and a price to book ratio of 1.5 implying a cushion of 15% on a globally diversified asset pool with very little sector concentration. If we apply this benchmark to a CDO, the AA attachment point was I think badly off the mark. If the rating agencies had thought of CDOs as mini banks, would they have given these ratings? I think the answer is clearly no. Bank valuations have not suffered much because they had huge liquidity support. If the central banks had gone to sleep, what would have been the volatility in the valuations of the big banks? The CDOs have had no liquidity support. It would be interesting to compare the actual default rate in investment grade CDO tranches during this crisis with the default rate of banks during the days before central banking became so widespread. I suspect the default rates have actually been lower so far, but it will take a year or so to find out. If CDOs can survive this crisis without any central bank bailout, they may emerge stronger with better risk management, better valuation models, better rating practices, greater transparency and less moral hazard. In the long run, this crisis might be the best thing that ever happened to CDOs!