Security Lending To Short Selling; Growth & Value Traps

Security Lending to Short Selling; Growth & Value Traps
Short Selling & Security Lending

Short selling & security lending complement each other, as short selling requires borrowing of securities, which is provided by security lending. If regulated appropriately, short selling may enhance market liquidity and price discovery.

Security lending is an arrangement of loan given to the borrower, predominantly borrowing include financial investments such as stocks, derivatives contracts like futures, commodities, currency etc. The borrower of the securities is required to deposit collateral in the form of cash, security, letter of credit. In return, the ownership of the securities is transferred to the borrower for a term.

Security lending is mostly facilitated by market participants, including custodians, brokers, intermediaries. Short selling means to sell the securities at prevailing prices in anticipation to gain from fall in prices of those securities.

Short selling is a very normal activity in daily trading, and it only becomes a controversial subject, when stock prices are falling rapidly in bear markets. At the same time, short selling is established as a means for hedging portfolio risk and managing derivative risks. Regulatory bodies require swift disclosures of such activities to maintain sovereignty in the market, while promoting fair trade practices and safeguarding the interests of investors.

Short Selling Transactions

The Australian Securities & Investment Commission (ASIC) deals with the matter of market regulations in Australia. ASIC has clearly segregated short selling transactions in two categories, namely naked short selling and covered short selling.

Short Selling transactions are required to be disclosed under the guideline of the ASIC:

  • Any short sale in the licensed market (includes major stock exchanges in Australia) is required to be disclosed.
  • Short sales are reported separately as short selling transaction & short selling position reporting.
  • Failure to comply with the disclosure requirement is an offence.

In Australia, a person may short sell products defined in Section 1020B, which includes securities, managed investment products, financial products under s764A(1)(j) and other financial products prescribed by the regulations.

Naked Short Selling

Naked short selling refers to an arrangement in which the investors short sells without security lending arrangement. Under the Corporations Act, a person should not sell any security if one doesn’t have the ability to deliver the securities under a short sale transaction settlement.

A few exemptions to naked short selling are as follows –

  • Prior Purchase Agreement
  • Market makers: ETFs & Managed Funds
  • Exchange traded options: Sales effected by exercising options
  • Exchange traded options: Sales effected by issuing options
  • Debentures: Clearing and settlement participants

There are more exemptions to this type of short selling defined by ASIC in its Regulatory Guide 196 (RG 196). This guide provides exhaustive information regarding the exemptions and products covered under those exemptions.

Covered Short Selling

Covered short selling refers to the transaction of short selling, wherein the person executing the short sale has a security lending arrangement in place to meet the delivery requirements at the time when the short sale is settled.

Under Corporations Act, covered short selling is permitted, which deems covered short selling as a mechanism for price discovery and liquidity, subject to disclosure and intervention by the ASIC.

Short Selling in Australian Markets

A person would require working with a respective broker in order to facilitate short selling transactions, and necessary regulatory requirement to comply with the laws as well. Generally, short selling requires a person to have:

  • A margin account with a broker.
  • Security lending arrangement by broker.
  • Collateral against security lending arrangement.

Brokers may deny these facilities considering the acumen, credentials or financial health of any person. At the same time, the broker may not possess adequate resources to facilitate short selling trades.

Can you short sell all stocks in the market?

No, it is not possible that all stocks in the market could be available. There are certain guidelines that provide the basis for deciding the viability for a short sale transaction in any particular security.

These guidelines may consider the pre-defined parameters to test the viability of the stock for lending purposes, including the number of shares available for trade, market capitalisation, free float capitalisation etc.

The approved list of stocks is provided by the stock exchanges, and more precisely, brokers regularly update the list of the stocks available for lending purposes, which could be obtained from brokers.

Investor Protection
  • The markets have restrictions on the number of shares that could be sold short as a percentage of total product in issue, which sets a limit for short sales while preventing the market abuses.
  • Any short sale should not be executed at a lower price compared to the last sale price of the security. It is designed to prevent short sellers from driving down the price of the stocks.

Short selling may be used as a decent strategy to hedge against the risks associated with long positions. At the same time, short selling is relatively riskier and complicated than taking a long position.

Long Position vs Short Position
  • Long position in any security expose an investor to an unlimited profit, if the price of the security is rising, and there is no extent to the rise in the price of any security.
  • Long position also exposes investors to limited loss, which would be the market value of holding is zero, when the market price falls to zero.
  • Short position/short selling exposes an investor to a limited profit, when the price of the security falls to zero.
  • Short position/short selling exposes an investor to unlimited losses, in a case when the price of the security is rising, and there is no extent to the rise in the price of any security.
Options – An alternative to short selling

Pu options are alternative to short selling, and call options could be an alternative to long positions. Put options gives the right, but not the obligation to holders of the options, to sell the underlying securities in the option contract at a specified price before a specified date.

Generally, the value of the above-mentioned put option would increase, when the price of the underlying security drops.

Growth & Value Traps

Growth & Value traps are always omnipresent in the markets. At times, the market oversells any stock leading wider gaps in the valuation multiples, which often gives rise to a question, whether the underlying multiples reflect a true picture or not.

Now, the factors to support, upgrade or degrade the existing underlying multiples may vary from stock to stock. These factors might justify the existing valuation multiples or contradict rationale behind the prevailing multiples in terms of upside and downside.

Growth traps might be associated with favourable growing results, and as growth companies are predominantly viewed in terms of value creation by the growth. This feature of growth companies leads us to a question, whether these underlying growth prospects in the company would lead it to the ultimate prize.

More specifically, the amount of capital and resources applied to any development prospects, growth strategy should have far-reaching impacts that are favourable for the company, which would ultimately deliver the value.

Let us go through an example, Alcatel and Lucent became a merged entity in the year 2006, and this was in response to the rise of low-cost technology manufacturers in the Asian markets through creating a multinational telecommunications company. In 2016, the merged entity was acquired by Nokia, following a series of unprofitable financial periods.


Disclaimer

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