COVID-19 AND STOCK MARKET CRASH: SHOULD SEBI BAN SHORT-SELLING?

Tanuj Agarwal, Institue of Law, Nirma University

Introduction

Covid-19 pandemic has raised serious apprehensions surrounding health and safety causing a lockdown in India.  The pandemic has caused a worldwide recession and has spooked investors’ sentiment. Prior to the coronavirus outbreak, the Indian stock market was in full positive swing as Sensex and Nifty had reached their all-time intraday peak of 42,273.87 and 12,430.50 respectively in January, 2020. Even after attaining such progress, the Indian stock market is witnessing the most difficult period for the past few months. The stock market has observed lower circuit levels after 12 years on March 13, 2020. Afterward, the equity index discerning a continuous downfall. On March 19, 2020, Sensex crashed below 27,000 and Nifty breached the level of 7,900, thereby attained their five-year closing low levels. Consequently, an approximate downfall of 37% is evident in both the equity indices within a period of just 2 months. The stock market has seen a considerable collapse due to high market volatility. This downfall has degraded the financial market and faded the interest of investors and corporates. Thereby, the concern is whether such a market downturn can be controlled by restricting short-selling.

Short-Selling and its Impact on the Stock Market

Short-selling means selling a stock which the seller does not own at the time of the trade. It is a practice in which financial traders hold bets on specific shares that they expect a fall in price. A modest fee is paid to borrow some stock in the company to sell them. Further in case the market obliges, the financial trader will buy the shares at the lower price and book the profit. All classes of investors including retail and institutional investors are permitted to do short-selling. The mechanics of short-selling are such that it inflows supply of specific shares in the stock market. These are the shares that are not even owned by the supplier. Consequently, such a scenario creates an excessive supply in the stock market. Thereby, this excess supply leads to a decrement in the price of these shares to settle for an equilibrium with the demand in the market. The mechanism is at times also useful for real price discovery of overpriced share. However at the same time, excessive short selling may decrease the price more than the actual worth of the company, as apart from the business competence, the prices in the stock market are highly determined by market forces.

 Covid-19 and Short-Selling

Amid Covid-19, India is under lockdown for the past 2 months. This raises serious business concerns and results in depression of various industries. Thereby, there is an apparent market expectation of fall in the stock market too. In pursuance of such expectation, the market speculators are expected to do massive short-selling with a view to pocket profit in case of a fall in the price of shares. Consequently, the huge amount of shorting by big market players leads to a decrease in the price of shares in excess of what it naturally (through market forces) might have observed because of a business downturn. The fall in the price of shares because of business disgrace due to coronavirus is very much conceived, however, the question is regarding the excessive decrease in price due to excessive short-selling. In view of the corona-pandemic, market players would be tempted to capitalize on the downfall of share price caused by business loss. Indian stock market has observed a huge short-selling in future segments of an index such as Sensex, Nifty and Bank Nifty. During the last week, the net shorting in the equity index reached 173,000 contractsMoreover, foreign portfolio investors have also piloted enormous shorting in India. These investors have perceived Rs. 26.32 lakh crore of speculative volume in derivatives. Such a scenario of extreme shorting resulted in incessant fall in the stock market.

Ban on short-selling: A temporary yet effective solution

The permanent solution to improve the market condition is to get rid of coronavirus which seems to be difficult considering the present set-up. However, effective steps are required to be taken to control the ongoing menace in the capital markets. As demonstrated that short-selling plays a vital role in the downturn of equity index and leads to abnormal fall in share prices in such panic business conditions, ban on short-selling practice, for the time being, can be an effective solution to control the continuous drop in the stock market.

Short-selling market speculators worsen the general market scenario. Amid excessive panic triggered short-selling, the capitalization on the reduction of a share value intensifies market fluctuations. Such stock market instability impersonated a serious threat to confidence of retail market players in India as shorting can surge price swings which lead to deterioration of financial markets. The ban on short-selling will help to restore steadiness in the distressed financial market. Notably, the ban can diminish the speculative hammering of the shares and consequently, to some extent, would aid in alleviating the market.

Many countries such as Italy, Spain, France, and Belgium banned short-selling intending to control the fall in their equity index. On the other hand, the U.S. has not suspended the practice of short-selling, even after observing a huge market crash. The U.S. short-sellers have made a profit of $343.67 billion in a month, at the cost of public investment in such an ongoing darkened stock market. India should not adopt the U.S. approach which permits short-sellers to make a profit by using excessive market volatility due to coronavirus pandemic. An increase in short-selling doesn’t indicate improvement in the bearish market. This would be detrimental to public shareholders and may expose the Indian stock market at risk, likewise of the 2008 financial crisis. China has also wisely handled the corona-outbreak concerning its volatility of stock exchange. China is miserably shaken by the colossal flood of cases of coronavirus, yet Shanghai Composite Index (SCE) has observed a deterioration of a mere 2.53% since the first case was reported in the country. To stabilize the effect of such panic conditions, China’s central bank has injected liquidity of 1.2 trillion Yuan into market through reverse repo operationsChina has also limited the short-selling activities to curb the financial market. Since the situation in India is not that alarming as compared to China, the ban on short-selling can be an effective method to stabilize the stock market.

In line with the same approach, SEBI, on March 20, 2020, toughens the short-selling from March 23, 2020. SEBI has proposed to increase the margin for the cash market stocks to 40%. Also, the market-wide position limit on Futures & Options may well be cut to 50%. These measures were applicable for one month. These steps certainly provided some recovery in the stock market which enabled Nifty 50 to maintain a base of 8100 after such a downfall. However, the market is still observing high volatility as there is an incessant intraday variation of 250-400 points in Nifty 50. Hence, a temporary ban on short-selling would be an effective approach to control market volatility and eradicate bearish market sentiment. SEBI’s critical approach towards short-selling in this pandemic would be beneficial to investors as well as corporates to maintain the integrity of the financial market.

[The blog was originally posted on NLIU-CBCL blog]

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