The gazettement of the Capital Markets (Securities Lending, Borrowing and Short-Selling) Regulations 2017 introduces a new product aimed at improving market liquidity at the bourse which is in line with the capital markets master plan geared at deepening the Kenyan capital markets.
The regulations will effect short-selling, a practice of selling borrowed shares hoping to buy them back later on (at a lower price) to return to the lender. It’s basically a wager that a stock’s price will decline.
The typical investing practice is buy low sell high, while short selling is sell high then buy low.
Temporary transfer of securities from one party to another with a simultaneous formal agreement to return the securities at a pre-agreed price on demand or at an agreed date in the future.
Simply put, short selling is selling high then buying low.
Under a short selling arrangement, investor A who feels that a share of company Y are overpriced borrows shares of Y (for a lending fee) from investor B who is willing to lend the shares. Investor A sells the borrowed shares in the market, hopeful that shares of Y will fall within a set duration of time, so that he can buy them back at the lower price and return the shares to investor B. If this pans out as expected, investor A pockets the profit from the difference of the higher selling price and the lower buying price. Investor B gets his shares back plus the lending fee. The short seller, therefore, make profits when shares are falling in price.
The borrower must place collateral – (cash or treasury bonds & bills or other liquid securities). Collateral must be of equivalent value to the borrowed securities and will be placed with a party agreed upon by the borrower and lender beforehand. Returned securities should be of equivalent value to the borrowed securities.
Notably, legal title to the shares is transferred to the borrower. This allows the borrower to sell the shares. However, the lender still retains economic interest in the shares including voting rights, dividend participation and other corporate actions. Additionally, the lender earns a lending fee from lending out his shares.
What we currently have is the legal framework set out by the Capital Markets Authority (CMA). What’s required next is the operational framework to be finalized by the Nairobi Securities Exchange (NSE) and the Central Depository & Settlement Corporation (CDSC). CDSC is currently setting up an enhanced depository system which is expected to facilitate day trading, securities lending and borrowing in addition to supporting the derivatives market. This is expected to come online this year. The NSE has mentioned that it is configuring its trading system to allow short selling and will be ready in 2Q18. Additionally, a collateral placement platform needs to be intact before trading can begin. Investor education is also critical part of this process.
The practice is be restricted to regulated persons, likely the large institutional investors. Our view is that the practice be left to those sophisticated investors. The fact that this is a new strategy, it may take a while before investors grasp the gist of the practice and also for market participants to structure winning short selling strategies. In established capital markets, short selling is practiced by hedge funds (aggressive leveraged investors).
Lessons on short selling from established markets
Short selling has been credited with an increase in market liquidity, depth and efficiency in the capital markets through price discovery. Short selling tend to prevent rallies from going too high – as they provide a mechanism to sell shares when they become ‘overvalued’, even if the momentum of the bulls is trying to carry the market upward. Last year’s bullish sentiment on Apple Computers, Alphabet Inc (Google) and Amazon, the largest corporates in the world, made these stocks a favourite on short-sellers 2017 menu.
Additionally, short sellers have been fast in uncovering corporate fraud way before this information comes to market. This is through the intensive research they do before taking their short-sale position. This was the case of James Chanos and the Enron Corporation at the turn of the millennium). The quantitative analyst Harry Markopolos had warned of the Madoff Ponzi Scheme (captured in the classic No One Would Listen) years before the scheme exploded. These two are the largest case study corporate frauds in financial history.
Genghis Capital Limited Email: firstname.lastname@example.org