After New York-based short-seller Hindenburg Research released a critical report last month levelling a number of allegations against the Gautam Adani-headed Adani group, the impact on stock market was immediate and massive.
Ever since the report became public, the company’s stocks crashed and market value halved in a week.
But what caught everyone’s attention was that the allegations were made by an investment research firm that is known primarily for short-selling of securities i.e., earning gains when the price of an asset falls.
Since then, several questions have been raised regarding the legality of short selling in India, and importantly, what is it?
What is short selling?
The Securities and Exchange Board of India (SEBI) said short selling usually involves investors borrowing shares and selling them, expecting to buy them back later at a lower price before returning them to the lenders. They make profits on the difference between the higher sale price initially and the lower purchase price subsequently.
"Short selling is considered by some to be a desirable and an essential feature of the securities market, as it provides liquidity and also helps price corrections in overvalued stocks.
"Thus, any restrictions on short selling, per se, may distort efficient price discovery, provide promoters unfettered freedom to manipulate prices, and favour manipulators rather than rational investors," it said, adding others consider it an undesirable activity that flourishes on distressed selling and is vulnerable to its own form of manipulation.
Sebi has indicated to the Supreme Court that it is not in favour of banning short-selling or sale of borrowed shares, and said it is investigating allegations made by a tiny short-seller against the Adani Group as well as its share price movements.
The market regulator Sebi in a written note before a bench headed by Chief Justice DY Chandrachud, which was hearing two PILs relating to the recent Adani Group shares crash, described what short-selling is and what the Hindenburg Research did but did not once name the Adani Group in the 20-page document.
What are the advantages of short selling for retail investors?
Allows investors to make profits in bear markets: Short selling enables investors to take advantage of decreasing stock prices by profiting from the difference between the price at which the stock was shorted and the lower price at which it is eventually bought back.
Provides portfolio diversification: Short selling allows investors to diversify their portfolios by investing in both long and short positions, reducing their overall risk.
Enhances liquidity: Short selling increases the liquidity of the stock market by adding more buyers and sellers to the market.
Can be used to hedge against losses: Short selling can be used to hedge against other positions in a portfolio by offsetting losses in one position with gains in another.
Helps to identify overvalued stocks: By shorting a stock, investors can identify stocks that they believe are overvalued and could potentially fall in the future.
Is short selling legal in India?
Securities market regulators in most countries, particularly in all developed securities markets, recognise short selling as a legitimate investment activity.
"Thus, in all major jurisdictions, instead of prohibiting short sales per se the regulators have permitted it to take place within a regulated framework," SEBI added.
Meanwhile, the International Organisation of Securities Commissions (IOSCO) has also reviewed short selling and securities lending practices across markets and has recommended transparency of short selling, rather than prohibiting it.
"India follows this policy of regulated short selling and has framed its regime accordingly," it said, detailing the framework for regulating short selling in Indian capital markets.
Even during turbulent times such as at the start of the Covid pandemic when Nifty fell by around 26 per cent in 13 trading days in March 2020, Sebi did not ban short selling despite demand, the note to the court said.