short selling
Image source - https://bit.ly/3iwuW8j

This article is written by Anuraag Bukkapatnam, pursuing a Certificate Course in Capital Markets, Securities Laws, Insider Trading and SEBI Litigation from Lawsikho.com.

(Arguments presented are the personal opinion of the author)

 

Table of Contents

Introduction

‘Short selling’ refers to a trading strategy wherein the trader seeks to benefit from the decline in the price of any security. In stock markets, short sellers often borrow stock from their brokers and sell this to other traders with the promise of buying them back at a future date at the market rate then applicable. In this manner, the seller seeks to adopt a strategy of selling high and buying low. In order to borrow shares from the broker in order to sell them, the trader has to deposit a particular amount known as margin with the broker. When the price of the underlying share increases (which is detrimental to the trader’s short position), the margin balance decreases to that extent and vice versa in the case the market value of the underlying security decreases. The core of this strategy remains that at the time of entering into the short position, the trader has possession of the shares which he seeks to sell. 

Naked Short Selling

Naked short selling, however, is opposed to this idea of possessing the underlying security at the time of entering into the position. In naked short selling, the trader who sells (basically enters into an agreement to sell) shares does not actually possess the shares. As a result, the trader risks defaulting on delivering the shares to the counterparty. Moreover, this gives rise to a scenario where the market is trading on shares that aren’t even in existence, thereby increasing the volatility of the market. This is often termed as a fraudulent practice and is banned across multiple jurisdictions (including in India). This article, although, deals with a specific category of naked short selling i.e. in the context of ‘Credit Default Swaps’ (‘CDS’). Before discussing this, it is crucial to understand CDS as an instrument. 

Credit Default Swaps

A CDS can be understood as a financial derivative which is used to hedge the risk of its underlying security (a bond). This instrument works similar to an insurance agreement where two parties enter into a contract wherein one party (the insurer) insures the other party (bondholder) from the risk of default of the underlying bond. In exchange for providing such protection against the default of the underlying security, the insurer charges the bondholder premiums on a periodical basis, the value of which is determined based on the credit rating of the underlying bond. When the risk of default increases, the value of the CDS increases and vice versa. As the insured tend to benefit from the agreement when the underlying security performs worse or declines in market value, such positions are analogous short positions with respect to the underlying security. 

When the insurer enters into several such swap agreements, it can use the premiums from other parties to off-set the loss caused by default to any one particular party. As a result, more participants are encouraged to invest in the Corporate Bond market and provide finance to slightly riskier companies. The development of a CDS market can facilitate the development of the Bond market. The same was also recognized by the working group on the development of the Corporate Bond market in India, which referred to the introduction of the CDS market as an “intended outcome yet to be achieved”. 

The aforementioned paragraphs referred to the practice of entering in such swap agreements to hedge the risk of securities which one owns. However, naked short selling in the context of CDS refers to the practice of seeking insurance on securities which the insured does not possess. Instead of seeking to hedge the risk of underlying securities, the insured in this case would be engaging in purely speculative trading in order to make a profit when the underlying security drops in value. This practice of naked short selling of CDS had come under a lot of scrutiny in the 2008 global financial crisis as well as the European Debt crisis, where this practice was accused of being one of the major culprits. 

2008 Financial Meltdown and the European Debt Crisis

For years preceding the financial crisis, major financial institutions in the United States of America traded heavily in Mortgage-Backed Securities (‘MBS’), which refers to bonds which derive their value from the mortgage payments being made by the public at large which took home loans. A lack of regulatory oversight led to the creation of a system wherein home loans were approved by banks without necessary due diligence, thereby increasing the default potential drastically. Despite such lax practices being adopted by the institutions which provided home loans, the credit rating agencies which were tasked with rating these securities always rated them as being an extremely safe investment.

This in turn meant that the MBS which large financial institutions were trading has very less inherent value (if any). Lack of any correction in this price for a long period of time led to the creation of a bubble where all the MBS traded on the market were overpriced. Once traders and investors began to realise the true value of the MBS, they began to short them. This was done by entering into CDS agreements with other parties, whereby the traders paid premiums to the counterparty in exchange for a promise of a pay-out in case the underlying bonds failed. Once the true nature of MBS began to be revealed to the public at large, the value of the CDS began to increase (as the risk of default was now considered extremely high). In this process, a few select hedge funds, traders, and investors were able to make billions by shorting the housing market. 

These traders, however, were criticised for exacerbating the crisis by entering into this position. It was argued that rising CDS prices caused a spiral in the stock market, which would not have taken place so dramatically had there been restrictions on this practice. Moreover, criticism was also levelled against the motives of such traders. As these traders do not actually possess the underlying security, they have no incentive to ensure that its value does not drop. Consequently, it is alleged that many such traders engaged in manipulative practice of affecting public perception of the underlying bonds and actively trying to ensure that the bonds fail. 

Similar concerns were also raised in the context of the European Debt Crisis, wherein various European politicians accused hedge funds of ‘manipulating’ the sovereign debt CDS market. In particular, it was alleged that hedge funds who owned no sovereign debt deliberately keep purchasing CDS contracts, thereby ‘artificially’ inflating the price of the instrument. With an increasing CDS price, the perception of a national sovereign debt default increased, as a result of which sovereign lenders were less willing to lend to distressed countries. Thus, an increase in lending costs created by the increase in CDS cost ultimately resulted in an increase in the potential for a national sovereign default, which some argue might have been averted in case CDSs did not create such a perception. 

In a nutshell, the criticism against this practice primarily stems from the fact that the trader has no underlying interest in the security, and can thus manipulate the market and hammer the value of the underlying instrument in order to profit from it. Legendary investor Warren Buffett referred to naked short selling of CDS as ‘a weapon of mass destruction’ and compared it with ‘buying a fire insurance for your neighbour’s house’. In the next section, I would be analysing these claims. 

https://lawsikho.com/course/diploma-companies-act-corporate-governance

Arguments for naked short selling in the CDS market

One major advantage of a system which allows naked short selling in the CDS market is the increase in liquidity of the instruments. If the CDS market is restricted only to those participants who hold the underlying bonds, the number of participants who can trade in these instruments becomes extremely limited. Lesser participants would not just decrease the liquidity for these instruments but would also result in participants having to pay higher protection to the insurer. 

When entities that do not possess the underlying instrument can purchase CDS for it, it increases liquidity of those instruments which further incentivizes financial institutions to purchase debt and enter into CDS markets. Furthermore, with a greater number of participants, the overall premiums paid by each individual bondholder would also decrease. The end consequence of this is the strengthening of the domestic corporate bond market, which acts in tandem with the banking sector to provide credit to the economy. Given the fact that naked short sellers in this market perform this crucial function, it is imperative to critically analyse their role in stock market crashes. 

One of the primary functions of short selling in a market is ensuring an effective system of price discovery. When markets become overvalued and create a bubble, a correction is bound to take place. It would be wrong to blame naked short sellers for the financial crisis for multiple reasons. Firstly, there is no evidence to suggest that the market correction would not have taken place if not for these big shorts. The core problem (i.e. a huge pile of bad debt) was the key factor in the crash, and short sellers had nothing to do with it. Given the magnitude of the problem, a market correction was bound to happen. 

Secondly pinning the blame on short sellers alone diverts us from another core issue which led to the crisis, which is the poor work done by the credit rating agencies. Had the credit rating agencies performed their functions in a proper manner, the MBS would have been rated very poorly. In this scenario, naked short sellers might not have found it profitable to purchase CDS contracts for these risky MBSs as they would have been extremely expensive. One could argue that the short sellers performed a crucial function of revealing the true nature of MBS which might have evaded public eye for a longer period of time because of the credit rating agencies. 

Thirdly, it might not be correct to advocate a ban on naked short selling because of potential market manipulation. The problem in this case is not naked short selling as a practice, as much as the actions of particular traders. Moreover, this problem is not unique to naked short selling, and applies very well to traditional forms of shorting. Market manipulation is a serious offence, and must be dealt with by regulators in an appropriate way. Trying to combat the same by imposing a blanket ban on naked short selling is akin to throwing the baby along with the bath water. 

Conclusion

In comparison to other major emerging economies, the Indian Bond Market fares poorly in being able to raise funds for companies. In order to improve ease of doing business in India, we must take steps to develop the bond market and increase the avenues for businesses to raise finance. In order to achieve this, market participants must be allowed to make use of financial tools like CDS to manage their risk efficiently. While banning/ placing restrictions on short selling can seem like an attractive option to create a façade of stability of the markets in the short run, the same just hinders the efficient functioning of the markets by preventing accurate price discovery of the securities. RBI must reconsider the ban on naked short selling in the CDS market in order to ensure that the bond market can flourish. However, any such consideration must also include effective means of keeping credit rating agencies in check and ensuring that regulators can identify manipulative practices associated with naked short selling and nip them in the bud. 


Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.

LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:

Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.

LEAVE A REPLY

Please enter your comment!
Please enter your name here