Short-Selling Lessons for Bangladesh Capital Market

Last week, the global financial stage witnessed two starkly contrasting approaches to short selling as South Korea and the Philippines charted their courses. South Korea announced a comprehensive ban on short selling activities, effective until June 2024. 

In contrast, the Philippines welcomed short selling into its market starting from November 6, 2023. These divergent decisions highlight the unique strategies employed by different nations in their quest for economic stability and market enhancement.

South Korea's short selling ban is the second time in two years that the country has taken such a measure. The Financial Services Commission (FSC) said that the ban is necessary to stabilise the stock market and protect investors. If you dig further, the timing of this ban is also interesting.

The Bloomberg article titled 'South Korea to Ban Short Selling of Stocks Until June Next Year' published on November 5, 2023, stating "The regulator's announcement comes ahead of general legislative elections to select National Assembly members in April. Some ruling party lawmakers have urged the government to temporarily end stock short selling in response to demands by retail investors who have staged protests against the practice."

With 1 in 5 Koreans having a trading account, this political undercurrent adds an extra layer of complexity to South Korea's short selling ban.

On the other side of the spectrum, the Philippines has embarked on a journey to enhance stock market trading and liquidity by legalising short selling. Ramon Monzon, president of the Philippine Stock Exchange, emphasised the importance of short selling during an interview.

He stated, "Without short selling or any index futures, we will be a long-only market, so if there's uncertainty on the economy, the political situation, or even in emerging markets, they will all sell. With short selling, they can stay here and hedge."

Monzon's focus on attracting foreign investors and revitalising the market speaks to the challenges the Philippine Stock Exchange faces, including a nearly 40 percent drop in daily stock transactions over the past decade and a sixth consecutive year of declining foreign equity investments. This situation is eerily similar for Bangladesh's Stock Markets.

The divergent paths chosen by South Korea and the Philippines illuminate the multifaceted nature of short selling. Some forms of short selling can offer significant benefits, while others come with ethical and systemic concerns.

In the context of Bangladesh, where the capital market primarily revolves around long equities, there is a notable absence of efficient risk-hedging mechanisms. To address this gap, Bangladesh should explore the introduction of various financial instruments and rules, including Exchange Traded Funds (ETFs), Index Futures, and Short Selling, which have been legislatively enabled but are awaiting the launch of supporting infrastructure.

What is short selling?

Short selling is a trading strategy that speculates on the decline in a stock or other security's price. It involves borrowing shares of a stock, bond, or other asset that the investor believes will decrease in value, selling them to buyers willing to pay the market price, and then buying them back at a lower cost before the borrowed shares must be returned. In a nutshell, selling a borrowed security before actually owning it and pocketing the price difference.

Short selling offers several advantages for the Bangladesh Stock Market. Firstly, it plays a crucial role in boosting market liquidity and promoting more efficient pricing of stocks. By providing a mechanism to profit from declining stock prices, it introduces a valuable check on upward market manipulations, preventing the sudden rise of "bad" stocks and correcting irrational overpricing.

Additionally, short selling serves as a risk management tool for investors, allowing them to hedge against potential losses associated with long positions in the same security or related ones. This diverse set of benefits contributes to the overall health and functionality of the market, fostering transparency, fair pricing, and risk mitigation strategies for market participants.

The most critical action our regulators should take when we eventually embrace short selling is to take the "naked" out of it (selling shares without borrowing or locating them first - a crucial reason for South Korea's troubles, as discussed in a Bloomberg Article on November 5 titled "South Korea to Ban Short-Selling of Stocks Until June 2024)".

In fact, truly the main reason why many stock markets struggle with short selling in one form or another is because they allow, or are unable to restrict, naked short selling.

Naked short selling is a practice which involves selling shares of a stock or other security without owning them or having borrowed them—a controversial tactic that can introduce significant risks to financial markets. Naked short selling can be particularly problematic as it invites market manipulation, counterfeiting, and exacerbates market volatility.

Moreover, it hinders informed decision-making and poses a risk of panic selling due to the absence of seller accountability and the potential for settlement failures. Notably, these consequences primarily favor sophisticated investors while disadvantaging retail investors and smaller market participants.

The dangers of naked short selling became apparent on a global scale during the 2021 meltdown of Archegos Capital Managment, a family office led by its founder, Bill Hwang. Archegos Capital Management employed naked total-return swaps, a type of derivative contract, to bet on stocks without owning or borrowing them. This strategy led to substantial losses for several investment banks that had lent money to Archegos, including Goldman Sachs, Nomura Holdings, Credit Suisse, and Bank of America.

The Wall Street Journal's article "Inside Archegos's Epic Meltdown," published on April 1, 2021, documented the turmoil. In fact, a contributing factor to the collapse of Credit Suisse, a 166-year-old global banking giant, was due to its exposure to the Archegos Capital meltdown.

Bangladesh needs a conservative yet prudent short selling policy:

As Bangladesh contemplates its own short selling policy, it must adopt a prudent approach. The introduction of short selling has the potential to transform the capital market, increasing efficiency and liquidity while mitigating excessive risk-taking.

However, this introduction must be accompanied by robust regulation and vigilant supervision to prevent market abuse and fraud. Of paramount importance is the prohibition of naked short selling, which poses grave risks to market stability, fosters manipulation, and threatens investor protection.

To realise these objectives, it is essential for the Bangladesh Securities and Exchange Commission (BSEC), the Dhaka Stock Exchange Ltd (DSE), the Chittagong Stock Exchange Ltd (CSE), the Central Depository Bangladesh Ltd (CDBL), the Central Counterparty Bangladesh Limited (CCBL) and other relevant authorities to collaborate on introducing short selling without the possibility of naked short selling. These entities must also pave the way for the inclusion of other financial products, such as active and passive ETFs, Index Futures, Derivatives, and more.

Simultaneously, the archaic Floor Price Rule, a regulation that artificially prevents stocks from falling below a specific price, must be permanently abolished to encourage transparent market dynamics, reduce price distortions, and stimulate trading activity.

The global landscape of short selling presents diverse approaches, with South Korea opting for a politically motivated ban to "protect" its market and the Philippines embracing it for trading and liquidity enhancement. As Bangladesh formulates its strategy, it must delicately balance innovation with regulation, steering clear of the risks associated with naked short selling while harnessing the benefits of short selling to elevate the efficiency and resilience of its capital market. Through these deliberate measures, Bangladesh can stimulate growth, instil investor confidence, and establish a robust foundation for its financial future.

The writer is the managing director of Midway Securities Ltd and Adot Curve Ventures Ltd