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 r