Demystifying Short-Selling in Kenya’s Stock Market

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.

1. What is short-selling in the stock market?

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.

2. Mechanics of short selling

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.

3. Who are the participants in a short selling transaction?
4. The lenders of securities are mostly long term institutional fund managers like insurance and pension funds. They lend securities to increase the financial performance of the fund with minimal risk to the fund.
5. The lending agent provides support services to lenders such as maintaining a pool of assets available for lending. This improves liquidity by unlocking securities to facilitate trades and in increasing the number of transactions in the market.
6. Borrowers of securities are usually active market participants who take advantage of price movements. They include market makers, arbitrageurs and players in the derivatives markets.

4. How are lenders of securities protected?

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.

5. Do I still own the shares after lending them?

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.

6. Why short sell and what are the benefits of short selling?
7. To profit from a bearish market by selling overvalued stocks with the intention of closing the position at a lower price in future.
8. For dealers, to make markets which increases market liquidity by facilitating trades.
9. To hedge, protect another investment or portfolio. If one holds a number of long positions, one can protect the portfolio with short positions. This is mostly through derivatives which acts as an insurance policy on one’s current portfolio.

Read: Linking of Six Stock Market Exchanges ‘High Priority’ says NSE Boss

7. What are the risks in short selling?

1. Unlimited risk. Theoretically, there is not limit of how much you can lose (price can go up to limitless levels). This can be restricted by adding a stop-loss to the short position so that the maximum potential loss is capped.
2. Short sellers do not benefit from dividend payments. Dividends declared on the stocks under the short-sale are passed on to the lender of the securities.
3. Restrictions by regulators e.g. if a lot of people were to short sell stocks from a certain sector this would affect public confidence as it suggests that traders think the share price is likely to fall, encouraging more selling.
4. Being a leveraged strategy its a risky proposition for the investor especially if prices rallies or when the lender requests the shares back at an inopportune time. This would require the investor to cover the position at a loss.

8. Does short-selling help the markets?

1. It is argued that short sellers make stock markets more efficient by improving liquidity, reducing overpricing and speeding up price discovery by quickly factoring new information into share prices.
2. Encourages market makers. Market makers cannot make proper markets if they do not have the ability to short stocks. Makers always run short positions. When they receive an order to buy stock they often do not have the stock on their books so they short sell to the buyer and hope to acquire the stock at a later date at a lower price.

9. Arguments against the practice of short selling in the stock market

1. Possibility of stock manipulation through short selling can create artificially low prices. There are concerns that short sellers drive down prices of company stocks — since they bet on the share price dipping for the sole purpose of making money.
2. Speculative activity can be exacerbated by short selling trades which would create uncertainty and panic in a stock with prices falling further. The European Union has in place provisions for suspending short selling on a stock when a suspiciously sharp drop in price is noted.
3. Heavy short selling can undermine the commercial confidence in a listed company.

10. When can we expect short selling trading to start?

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.

11. Who is short selling recommended to?

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: research@genghis-capital.com