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By Muthoki Mumo | Business Daily, Kenya
Treasury secretary Henry Rotich has gazetted regulations allowing investors to borrow and sell shares at a profit, opening a new frontier for Nairobi Securities Exchange (NSE) traders.
The regulations will see traders borrow shares from stock market investors betting that a future price drop will enable them to buy back the same stock cheaply and repay their debt at a profit.
This form of trading, referred to as short selling, is intended to boost liquidity and efficiency of the NSE as a market for discovering the true valuation of listed stocks.
In short selling, investors approach a fund manager, an investment banker or broker and enter into a contract to borrow, for instance, 10,000 shares of a stock currently trading at Sh25 a piece.
These shares are normally acquired from investors who are holding stocks for the long term with no intention to sell.
The investor (borrower) then sells them in the open market at the prevailing price, pockets the Sh250,000 and commits to reimburse the exact number of shares at a future date.
Based on their independent research, they are betting that the stock’s value will dip to, let’s says Sh15 per share, allowing them purchase the shares borrowed at a cheaper cost, pay their broker a commission and book the balance as profit.
“Short selling allows people to trade in shares they don’t own, hoping that the market will be favourable to enable them make some money and meet their obligations,” said Job Kihumba, a director at Standard Investment Bank (SIB).
“As long as the market behaves in the anticipated manner, investors will make money on their transactions. However, if the share price rallies contrary to their expectation, they get burnt.”
The proponents of short selling say the process helps expose managerial incompetence, corporate fraud through the intense research done prior to placing ‘bets’ against companies or overvaluation of a company.
The Capital Markets Authority (CMA), the originator of the Capital Markets (Securities Lending, Borrowing and Short-Selling) Regulations, 2017, lauds its potential to increase “overall market liquidity and flexibility of financing by increasing the volume of securities potentially…available for trading.”
Geoffrey Odundo, the NSE’s chief executive, has previously stated that introduction of short selling will make the “market more sensitive to the performance of, and announcements by, companies listed on the exchange.”
However, the practice remains highly controversial in markets like the United Kingdom and the United States, where, companies, regulators and politicians blamed aggressive forms of speculation for exacerbating the financial crisis of 2008.
The European Union introduced short selling regulations in 2012 after capital markets regulators raised concerns the practice was damaging to the markets and was possibly being abused.
These included suspending short selling on a stock when a suspiciously sharp drop in a share’s price was noticed.
“Dick Fuld of Lehman Brothers blamed short sellers for the firm’s demise. This was not true,” said Aly-Khan Satchu, the chief executive of investment advisory firm Rich Management.
“However, investors can impair a company’s bona fides deliberately by short selling stock in order to create uncertainty and panic.”
The new rules state that only “regulated persons” can engage in short selling, a restriction Mr Kihumba says will restrict this trade to “fairly large institutions and fund managers.”
Short sellers will also be required to give a collateral — government papers or cash —which must be worth enough to cover the borrowed securities in the event of a default.
This requirement is called covered short. Each party in the transaction continues to enjoy the economic benefits of their respective assets, including dividends and interest if collateral is parked in an interest-earning account.
When submitting an order for trading in the market, sellers must also declare it as a short sale. Anybody who holds a short position in a security equivalent to five per cent or more of a company’s issued shares must report this “position immediately to the relevant exchange or trading platform and the CMA.”
Investors are also forbidden from holding a short position of more than 10 per cent of the issued shares of a single company.
The CMA has the power to revise these limits if and when it is deemed necessary as it has to suspend short sales or impose caps on the prices that can be quoted by traders.
“Where the CMA has reviewed a suspension of a short sale or the imposition of price controls on a short sale, it may maintain the suspension or the price control, lift the suspension or remove the price control,” the new rules state.